Bank Earnings Management Through Loan Loss Provisions

The Financial Accounting Standards Board (FASB) has proposed revisions to Loan Loss Accounting rules after existing standards were criticized in the wake of the 2008 financial crisis. The changes could result in higher incidences of earnings management, which has implications for the integrity of financial reporting. To investigate a specific occasion of earnings management, we study United States banking institutions, a vital component of the country’s economy. A prevalent mechanism through which bank management manipulate earnings is Loan Loss Provisions. Since it is suggested that there are more incentives to manage earnings following a restructure of senior management, we examine here the relationship between Loan Loss Provision charges and bank management changes. In doing so, we hope to pinpoint one circumstance in which new accounting standards might provide an opportunity for earnings management.

Earnings management has been a concern of the Securities and Exchange Commission for many years. A commentary published by Paul M. Healy and James M. Wahlen in 1999 asserts that management discretion “creates opportunities for ‘earnings management,’ in which managers choose reporting methods and estimates that do not accurately reflect their firms’ underlying economics.” In 1999, Arthur Levitt, the Chairman of the SEC at that time, expressed concerns that management abuses of such implements as “big bath” restructuring charges and “cookie jar” reserves were threatening the credibility of financial reporting. Though there have been changes since this commentary was written, incentives to manage earnings remain. There are many reasons that management might manipulate financial statement items in order to smooth profits. There are also periods during the life of a company that might make profit-smoothing more likely. It would seem that one of these times can be observed following a change in senior management.