This study uses AFS securities as a proxy to discuss the impacts of earnings management on banks, analyzing the bank’s capital adequacy ratio and long-term performance affected by earnings management. AFS securities gains and losses are recognized in earnings and, largely, in regulatory capital only when they are realized.
The results will be the evidence that whether IFRS 9 Financial Instruments, which is officially effective on 2018, is appropriate for eliminating AFS securities in the banking industry to replace IAS 39.
The samples of this study come from Taiwan of Taiwan Economic Journal Database, which is included all commercial banks and bank holding companies. The sample of examination periods is from September, 2008 to September, 2017. The period includes 2008 and 2009, which is the year that financial crisis happened. Therefore, this study uses the dummy variables to avoid the potential for the financial crisis to affect our inferences. In order to investigate the effect of the government taking Basel III, this study also tests the separated period in 2008 to 2012 and 2013 to 2017. The resulting sample comprises 38 banks of Taiwan.
First, this study examines the earnings smoothing hypothesis and the big baths hypothesis. By equation (1), determining whether banks use realized gains and losses on AFS securities to smooth earnings and whether banks with low regulatory capital realize more gains. And next to expand equation (1) by separating negative and positive net income (NI), the equation (2) tests whether banks with negative NI take a big bath and banks with positive NI smooth earnings. Second, this study uses two-stage least squares regression to test whether return on assets (ROA), return on equity (ROE), and capital buffer (Buffer) will affect the long-term performance.
The first earnings smoothing regression model shows that NI is positively significant on RGL, the banks tend to take big baths rather than realize securities gains and losses to smooth earnings. The NI×RegCapLow coefficient is not significantly different from zero, which indicates that there is no interaction between the incentives to smooth earnings and manage regulatory capital or that the interaction for positive and negative NI banks offset. Furthermore, the control variables such as UL and UG are positive significant on RGL, which indicates banks realize more losses (gains) when they have more accumulated unrealized losses (gains). Regardless the periods before or after the announcement of Basel III, the result of the regression model is the same.
The second big baths for managing earnings regression model shows that the
negNI are as predicted, they have a negative relationship on RGL. However, the negNI
coefficients is not significantly different from zero. This result indicates banks with more negative earnings realize more losses or fewer gains on AFS securities. It indicates that the banks smooth earnings. The posNI coefficients are significantly positive in all three regression models, which indicates that banks with more positive earnings realize more gains or fewer losses on AFS securities. It indicates that the banks take a big bath.Regardless the periods before or after the announcement of Basel III, the result of the regression model is the same.
However, the period before the announcement of capital proposal of Basel III shows the negNI×
UG
t−1 is significantly positive at 1% level, which indicates that banks with more negative earnings realize fewer net gains on AFS securities when they have more accumulated unrealized gains. It indicates that the banks take a big bath. TheposNI× UL
t−1is significantly positive at 1% level, which indicates that banks with
more positive earnings and larger accumulated unrealized losses engage in moreearnings smoothing management. The period after the announcement of capital proposal of Basel III shows the negNI×
UL
t−1 is significantly negative at 1% level, which indicates that banks with more negative earnings and larger accumulated unrealized losses engage in more big bath earnings management. The posNI×UL
t−1is
significantly positive at 1% level, which indicates that banks with more positive earnings and larger accumulated unrealized losses engage in more earnings smoothing management.The third bank long-term performance regression model shows that the endogenous variable, realized gains and losses on AFS securities (RGL) has a positive relationship on regression models. It indicates that RGL affects the long-term performance of the banks. The independent variable that loan loss provision (LLP) has significantly negative relationship on regression models, which indicates the banks of this study are similar to prior studies. Using LLP to manage earnings and affect the long-term performance of banks. Because the limit of the capital buffer, AFS securities does not significantly effects on long-term performance after the announcement of capital proposal of Basel III. It means IFRS 9 eliminates AFS securities is reasonable, the banks can’t use AFS securities as the tool to manipulate financial statements.
The findings of this study show that banks use realized gains and losses on AFS securities to manage earnings. The sampling banks reveal significant behavior on taking big bath rather than smoothing earnings. According to IFRS 9, bank managers view earnings as the earnings management targets. The bank managers do not view comprehensive income as the earnings management targets. Therefore, the appearance of unrealized gains and losses on AFS securities in other comprehensive income does not eliminate the incentive for banks to use realized AFS securities gains and losses to
manage earnings. However, IFRS 9 will terminate the AFS categories of the financial securities. The results of this study support this issue of the end of the AFS securities.
The banks will could not use AFS securities as the tool to manipulate financial statements.
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