Skip to main content
SpringerLink
Log in

Loan Loss Provisions, Earnings Management and Capital Management under IFRS: The Case of EU Commercial Banks

  • Published:
Journal of Financial Services Research Aims and scope Submit manuscript

Abstract

Prior research has shown that loan loss provisions are primarily used as a tool for earnings management and capital management by listed banks. Effective 2005 all listed companies in the European Union (EU) are required to comply with International Financial Reporting Standards (IFRS). Adherence to IFRS, it is claimed, should enhance transparency of reporting practices relative to local General Accepted Accounting Principles (GAAP). The overall objective of this paper is to examine the impact of the implementation of IFRS on the use of loan loss provisions (LLPs) to manage earnings and capital. We use a sample of 91 EU listed commercial banks covering a period of 10 years (before and after implementation of IFRS). Since early adopters may have different incentives and motivations relative to those who adopt mandatorily, we dichotomize our sample into early and late adopters. Overall, we find that earnings management (using loan loss provisions) for both early and late adopters while significant over the estimation window is significantly reduced after implementation of IFRS. We also find that, for risky banks, earnings management behavior is more pronounced when compared to the less risky banks, but is significantly reduced in the post IFRS period. Capital management behavior by bank managers is not significant in both pre and post IFRS regimes. Overall, we conclude that the implementation of IFRS in the EU appears to have improved earnings quality by mitigating the tendency of bank managers of listed commercial banks to engage in earnings management using loan loss provisions.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

Notes

  1. We do not follow Barth et al. (2008) model since we focus only on financial institutions. Nonfinancial institutions have different characteristics to non-financial institutions i.e. necessity to meet capital adequacy ratios. Hence, the design of Barth et al., might not be directly suited for nonfinancial institutions.

  2. In the presence of strict and specific rules (less discretion) in the use of LLPs (post IFRS period) the amount of loan loss provision may be relatively higher compared to the pre IFRS period. Our data (see Table 2) support this. LLPs are no longer part of the numerator of the capital adequacy ratio. However, retained earnings are part of the numerator. When loan loss provisions are relatively higher, the bad debt expenses are relatively higher which reduces retained earnings. Retained earnings are part of the numerator of the capital adequacy ratio. So the numerator of the capital adequacy ratio will be relatively lower causing the capital adequacy ratio to be relatively lower (relative to pre IFRS). Hence, when capital adequacy is low there is an incentive to decrease LLPs to improve the capital adequacy ratio.

  3. The requirements of Basel II accord do not impinge on the requirements of IFRS and hence there is no confounding effect.

  4. Swiss banks are not officially part of the EU as yet. However, all Swiss banks follow all European legislation and the Basel accord. They also implemented IFRS with other European countries. Since they comply with all relevant legislation applicable to this study, banks from Switzerland have been included in our sample.

  5. We have modified the estimation of Boyd et al. (1993) on the market value of profits following Yasuda et al. (2004) by excluding dividends from the stock price since Penman (2001, p. 106) and Kothari (2001, p. 174) argue that dividends have no effect on the value of the firm because firm value depends on the forecasted profitability of current and forecasted future investments. Also empirical evidence by Chang and Chen (1991), Barro (1990), Blanchard et al. (1993) and Penman and Sougiannis (1997) verify the aforementioned assertions and suggest that it is appropriate to measure stock prices exclusive of dividends.

  6. Our untabulated findings indicate a material increase in both provisions and liabilities in the post IFRS era. While some increase was anticipated due to increase of liabilities by following new accounting methods (IAS 39 reporting liabilities at fair values gross), the increase in LLPs was proportionately higher.

  7. We thank an anonymous reviewer for this suggestion.

  8. We thank an anonymous reviewer for making this suggestion.

References

  • Ahmed ASC, Takeda C, Thomas S (1999) Bank loan loss provisions: a re-examination of capital management, earnings management and signaling effects. J Account Econ 29:1–25

    Article  Google Scholar 

  • Anandarajan A, Hasan I, Lozano-Vivas A (2003) The role of loan loss provisions in earnings management, capital management and signaling: the Spanish experience. Adv Int Account 16:45–65

    Article  Google Scholar 

  • Anandarajan A, Hasan I, McCarthy C (2007) Use of loan loss provisions for capital, earnings management and signaling by Australian banks. Account Finance 47:357–379

    Article  Google Scholar 

  • Anderson R, Fraser D (2000) Corporate control, bank risk taking and the health of the banking industry. J Bank Finance 24:1383–1398

    Article  Google Scholar 

  • Armstrong CS, Barth M, Jagolinzer AD, Riedl EJ (2010) Market reaction to the adoption of IFRS in Europe. Account Rev 85:31–61

    Article  Google Scholar 

  • Ashbaugh H, Pincus M (2001) Domestic accounting standards, international accounting standards and the predictability of earnings. J Acc Res 39:417–434

    Article  Google Scholar 

  • Australian Prudential Regulation Authority (2005) Adoption of International Financial Reporting Standards: Prudential approach 2. Tier 1 capital and securitization. APRA working paper, August 2005

  • Ball R, Robin A, Wu JS (2003) Incentives versus standards: properties of accounting income in four East Asian countries. J Account Econ 36:235–270

    Article  Google Scholar 

  • Bank for International Settlements (2005) International convergence on capital measurement and capital standards. Basel, Switzerland

    Google Scholar 

  • Barro RJ (1990) The stock market and investment. Rev Financ Stud 3:115–131

    Article  Google Scholar 

  • Barth ME, Landsman WR, Lang MH (2008) International accounting standards and accounting quality. J Acc Res 46:467–498

    Article  Google Scholar 

  • Basel Committee on Banking Supervision (2005a) The application of Basel II to trading activities and the treatment of double default effects. Bank for International Settlements, July 2005

  • Basel Committee on Banking Supervision (2005b) International convergence of capital measurement and capital standards. Bank for International Settlements. November 2005

  • Basel Committee on Banking Supervision (2005c) Amendment to the Capital Accord to incorporate market risks. Bank for International Settlements, November 2005

  • Beatty A, Chamberlain S, Magliolo J (1995) Managing financial reports of commercial banks: the influence of taxes, regulatory capital and earnings. J Acc Res 33:231–262

    Article  Google Scholar 

  • Beaver W, Engel E (1996) Discretionary behavior with respect to allowances for loan losses and the behavior of stock prices. J Account Econ 22:177–206

    Article  Google Scholar 

  • Bhat V (1996) Banks and income smoothing: an empirical analysis. Appl Financ Econ 6:505–510

    Article  Google Scholar 

  • Blanchard O, Rhee C, Summers L (1993) The stock market, profit and investment. Q J Econ 108:115–136

    Article  Google Scholar 

  • Breeden R (1994) Foreign companies and US markets in a time of economic transformation. Fordham Int Law J 17:77–96

    Google Scholar 

  • Boyd J, Graham S, Hewitt R (1993) Bank holding company mergers with non-bank financial firms: effects on the risk of failure. J Bank Finance 17:43–63

    Article  Google Scholar 

  • Burgstahler D, Hail L, Leuz C (2006) The importance of reporting incentives: earnings management in European private and public firms. Account Rev 81:983–1016

    Article  Google Scholar 

  • Busch A (2009) Banking regulation and globalization. Oxford University Press, USA

    Google Scholar 

  • Cairns D (1999) Degrees of compliance. Accountancy International 68–69

  • Chang SJ, Chen S (1991) Information effects of earnings and dividend announcements on common stock returns: are they interactive? J Econ Bus 43:179–192

    Article  Google Scholar 

  • Collins J, Shackelford D, Wahlen J (1995) Bank differences in the coordination of regulatory capital, earnings and taxes. J Acc Res 33:263–292

    Article  Google Scholar 

  • EFRAG (2009) European Financial Reporting Advisory Group. http://www.efrag.org/homepage.asp

  • Epstein BJ, Jermakowicz EK (2007) IFRS 2007: Interpretation and application of International Financial Reporting Standards. Wiley publications

  • Ewert R, Wagenhofer A (2005) Economic effects of tightening accounting standards to restrict earnings management. Account Rev 43:1101–1124

    Article  Google Scholar 

  • Financial Stability Board (2009) Report of the Financial Stability Board to G20 leaders, secretariat based in Basel, Switzerland

  • Greenawalt MB, Sinkey JF (1988) Bank loan loss provisions and the income smoothing hypothesis: an empirical analysis, 1976–1984. J Financ Serv Res 1:301–318

    Article  Google Scholar 

  • Grier W (2005) Valuing a bank under IAS/IFRS and Basel II. Self-study solutions

  • Hasan I, Wall L (2004) Determinants of the loan loss allowance: some cross-country comparisons. Financ Rev 39:129–152

    Article  Google Scholar 

  • Healy PM, Wahlen JM (1999) A review of the earnings management literature and its implications for standard setting. Account Horiz 13:365–384

    Article  Google Scholar 

  • Iannotta G (2006) Testing for opaqueness in the European banking industry: evidence from bond credit ratings. J Financ Serv Res 30:287–309

    Article  Google Scholar 

  • IASB (2008) International financial reporting standards. International Accounting Standards Board, London

    Google Scholar 

  • International Accounting Standards Committee (2003) IAS 39 Financial instruments: Recognition and Measurement. Revised version, December 2003, London, UK, IASC

  • Kim M, Kross W (1998) The impact of the 1989 change in bank capital standards on loan loss provisions and loan write-offs. J Account Econ 25:69–100

    Article  Google Scholar 

  • Kothari SP (2001) Capital markets research in accounting. J Account Econ 31:105–231

    Article  Google Scholar 

  • Lang M, Raedy J, Wilson W (2006) Earnings management and cross listing: are reconciled earnings comparable to US earnings? J Account Econ 42:255–283

    Article  Google Scholar 

  • Laurin A, Majnoni G (2003) Bank loan classification and provisioning practices in selected developed and emerging countries. World Bank Working paper 1, The World Bank

  • Liu C, Ryan S (1995) The effect of bank loan portfolio composition on the market reaction to and anticipation of loan loss provisions. J Acc Res 33:77–94

    Article  Google Scholar 

  • Liu C, Ryan S, Wahlen J (1997) Differential valuation implications of loan loss provisions across bank and fiscal agents. Account Rev 72:133–146

    Google Scholar 

  • Lobo GJ, Yang DH (2001) Bank managers’ heterogeneous decisions on discretionary loan loss provisions. Rev Quant Finance Acc 16:223–250

    Article  Google Scholar 

  • Ma CK (1988) Loan loss reserve and income smoothing: the experience in the US banking industry. J Bus Finance Account 15:487–497

    Article  Google Scholar 

  • Moyer SE (1990) Capital adequacy ratio regulations and accounting choices in commercial banks. J Account Econ 13:123–154

    Article  Google Scholar 

  • Penman S (2001) Financial statement analysis and security valuation. McGraw Hill, International edition

  • Penman S, Sougiannis T (1997) The dividend displacement property and the substitution of anticipated earnings for dividends in equity valuation. Account Rev 72:1–21

    Google Scholar 

  • Pérez D, Salas-Fumás V, Saurina J (2008) Earnings and capital management in alternative loan loss provision regulatory regimes. Eur Account Rev 17:423–445

    Article  Google Scholar 

  • PricewaterhouseCoopers’ Accounting Consulting Services Team (2009) IFRS Manual of Accounting 2009. PricewaterhouseCoopers

  • Scheiner JH (1981) Income smoothing: an analysis in the banking industry. J Bank Res 12:119–123

    Google Scholar 

  • Scholes M, Wilson GP, Wolfson M (1990) Tax planning, regulatory capital planning and financial reporting strategy for commercial banks. Rev Financ Stud 3:625–650

    Article  Google Scholar 

  • Shrieves R, Dahl D (2003) Discretionary accounting and the behaviour of Japanese banks under financial duress. J Bank Finance 27:1219–1243

    Article  Google Scholar 

  • Street DL, Gray SJ (2002) Factors influencing the extent of corporate compliance with International Accounting Standards: summary of a research monograph. J Int Account Audit Tax 11:51–76

    Article  Google Scholar 

  • Tarullo DK (2008) Banking on Basel: The future of international financial regulation. Peterson Institute for International Economics

  • Van Tendeloo B, Vanstraelen A (2005) Earnings management under German GAAP versus IFRS. Eur Account Rev 4(1):155–180

    Article  Google Scholar 

  • Wall LD, Koch TW (2000) Bank loan loss accounting: A review of theoretical and empirical evidence. Federal Reserve Bank of Atlanta Economic Review, second quarter, 1–17

  • World Bank (2003) Bank loan classification and provisioning practices in selected developed and emerging economies. World Bank working paper No. 26056, March 2003, The World Bank, Washington D.C

  • Yasuda Y, Okuda S, Konishi M (2004) The relationship between bank risk and earnings management: evidence from Japan. Rev Quant Finance Acc 22:233–248

    Article  Google Scholar 

Download references

Acknowledgments

We are grateful to an anonymous reviewer, Pauline Weetman, Mario Levis and Eli Amir for helpful comments on an earlier draft of this paper.

Author information

Authors and Affiliations

  1. School of Economics and Business Administration, International Hellenic University, 14th klm Thessaloniki-Moudania, 57101, Thessaloniki, Greece

    Stergios Leventis

  2. Department of Sport Management, University of Peloponnese, Orthias Artemidos & Plataion Str., P.C.23100, Sparta, Greece

    Panagiotis E. Dimitropoulos

  3. New Jersey Institute of Technology, School of Management, University Heights, Newark, NJ, 07102-1982, USA

    Asokan Anandarajan

Authors
  1. Stergios Leventis
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Panagiotis E. Dimitropoulos
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. Asokan Anandarajan
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Stergios Leventis.

Rights and permissions

Reprints and permissions

About this article

Cite this article

Leventis, S., Dimitropoulos, P.E. & Anandarajan, A. Loan Loss Provisions, Earnings Management and Capital Management under IFRS: The Case of EU Commercial Banks. J Financ Serv Res 40, 103–122 (2011). https://doi.org/10.1007/s10693-010-0096-1

Download citation

  • Received:

  • Revised:

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s10693-010-0096-1

Keywords

JEL codes

Search

Navigation