1 Introduction
In accounting, earnings management is the alternative accounting methods to make financial statements look better. When companies can incur expenses and recognize revenue, earnings management takes advantage of how accounting rules can be applied. Earnings management can be regarded as the results of the flexibility of accounting principles. In general, banks manipulate their earnings by using loan loss provisions or realizing security gains or losses to window dressing their income statements. Schipper (1989) and Healy and Wahlen (1999) stated that earnings management was the alteration of firms reported economic performance by insiders to either ‘‘mislead some stakeholders’’ or to ‘‘influence contractual outcomes’’. However, financial institutions, including commercial banks, are often excluded from the research of corporate earnings management because characteristics of financial institutions differ fundamentally from corporations (Peasnell et al., 2000).
The banking industry is highly regulated and is subject to government policies.
Compared to corporations, banks might have less opportunities to manipulate their earnings. The approaches for managing earnings in banks might be different from those in corporations. Most of the existing literature in banking has focused on loan loss provisions (LLPs) or loan loss reserves as proxies for earnings management. Some studies find that banks use the loan loss provision to manage regulatory capital (Moyer 1990; Beatty et al. 1995; Ahmed et al. 1999; Pérez et al. 2008). However, there are few studies pay attention to available-for-sale (AFS) securities as a tool for earnings management in banks. Therefore, the objective of this study is to examine the earnings management of banks by using AFS securities.
After December 15, 1993, FASB Accounting Standards Codification (ASC) Topic 320 categorizes firm investments in three categories. They are held-to-maturity securities, trading securities, and available-for-sale securities. Held-to-maturity securities are the securities that firms have the positive intent and ability to hold to maturity. Those securities are reported at amortized cost. Trading securities are the securities that are bought and held principally for the trading purpose in the near term.
Those are reported at fair value and the unrealized gains and losses are included in earnings. Available-for-sale (AFS) securities are the securities which are not classified as either held-to-maturity securities or trading securities. They are also reported at fair value, but the unrealized gains and losses of AFS securities are excluded from earnings and reported in a separate component of shareholders' equity.
In general, existing literatures use loan loss provisions (LLPs) as the proxy of earnings management of the banking industry. LLPs are the accounting items in the income statements and reflect the probability of future losses from defaults on outstanding loans. The recording of LLPs reduces net income. Commercial bank regulators view accumulated LLPs, the loan loss allowance account on the balance sheet, as a type of capital that can be used to absorb losses. In addition, banks can use LLPs to smooth bank earnings and affect bank capital through the adjustment of the earnings. However, there is alternative that banks can use the AFSs to prevent the fluctuation of the earnings. Furthermore, AFS securities can affect bank capitals without influencing the earnings. Nissim and Penman (2007) and Laux and Leuz (2010) report that banks classify 95% of non-trading securities as AFS, which represents 16% of total assets. Therefore, change of AFS securities as the proxy of earnings management can be an alternative approach for banks to manipulate their earnings and capital. Moreover, Basel III requirement more banks capitals in terms of quantity and quality. Banks have
more incentives to increase their AFS securities to manipulate capital without affecting their earnings. Hence, this study mainly focuses on the use of AFS securities to investigate the influence on earnings management. Barth et al. (2017) find robust evidence that banks realize gains and losses on AFS securities to smooth earnings and regulatory capital. Before FASB Accounting Standards Codification (ASC) Topic 320, the unrealized gains and losses of AFS securities have no recognition in the financial statement based on their fair market values.1 ASC 320 starts measuring AFS securities at market fair value in the statement of financial positions and excluding the unrealized gains and losses from earnings. The unrealized gains and losses of AFS securities are reported in a separate component of shareholders' equity recognizing.
The International Accounting Standard 39 (IAS 39) Financial Instruments, issued by International Accounting Standards Board (IASB) in December 1998, is effective in January 2001. The Taiwan government take IAS39 to specify the recognition and the measurement. At present, the main specification of the bulletin for the recognition and measurement of financial instruments in Taiwan is at TW GAAP 34. Since the bulletin is initially set out in accordance with IAS 39 and has been revised several times, there is little difference between the contents. However, the Taiwan Domestic bulletin provides that the evaluation of financial products basically takes the fair value evaluation, if there is no clear fair value by cost evaluation. Therefore, the company is currently in the non-active market bonds and unlisted shares of the company, are recognized at the purchase cost. Unless there are signs of significant impairment, still recognized as the original cost. In contrast, according to IAS 39, even if the equity instrument is in non-active market, its fair value should be measured at fair value.
1
FASB Accounting Standards Codification (ASC) Topic 320 (formerly Statement of Financial
Accounting Standards No. 115, FASB 1993) created AFS securities and specified a new accounting
Therefore, there will be a difference in the accounting treatment of financial assets at the cost of domestic companies in Taiwan. For the part of the financial assets measured at cost, it is basically expected that the general business will be adjusted after the application of IAS 39. Compared to ASC 320, IAS 39 applies to a looser set of financial instruments. IAS 39 defined AFS securities are measured at fair value in the balance sheet. Fair value changes on AFS securities are recognized directly in equity, through the statement of changes in equity. Moreover, on 24th, July 2014, International Financial Reporting Standard 9 (IFRS 9) Financial Instruments be issued, replacing IAS 39 requirements for classification and measurement, impairment, hedge accounting and stopping recognition. IFRS 9 is effective for annual periods beginning on or after 1 January 2018. IFRS 9 eliminates the available for sale (AFS) category, and it also eliminates the AFS impairment rules.
After the financial crisis of 2007-2009, Bank of International Settlements (BIS) establishes more strict regulations on Basel Accord. One of the important issues of Basel III emphasizes on minimum capital requirements shown in Table 1. The minimum requirement of Tier 1 capitals will increase from 4.5% to 6% from 2013 to 2019 to ensure the operating capacity of banking institutions. The banks should maintain the BIS ratio at least 8% with 2.5% capital conservation buffer. Therefore, the official implementation of Basel III after 2019 will require the BIS ratio up to 10.5%.
The capital requirement of Basel III can improve not only the quantity but also the quality of banks’ capitals. However, it raises the costs of banks’ capital and operation.
Increasing capital might also dilute the earnings per share of banks. Therefore, banks might have incentives to maintain their earnings during the transition periods of Basel III from 2013 to 2019. This study adopts the unrealized gains and losses of AFS securities as the proxy to examine the earnings management behavior of banks.
Furthermore, this study tests the effects of earnings management on bank long-term performance.
The objectives of this study are to use AFS securities as a proxy to discuss the impacts of earnings management on banks. Furthermore, this study analyzes the bank’s capital adequacy ratio and long-term performance affected by earnings management.
The results can 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 remainder of the paper proceeds as follows. Section 2 reviews the literature on earnings management and previous studies shown to be important in other contexts.
Section 3 describes the data and methodology. Section 4 describes the empirical results and Section 5 concludes the paper.
Table 1: Basel III Phase-in Arrangements
Phases 2013 2014 2015 2016 2017 2018 2019
Capital
Leverage ratio Parallel run 1 Jan 2013 – 1 Jan 2017 Disclosure starts 1 Jan 2015
Migration to Pillar 1
Minimum common equity capital ratio 3.5% 4.0% 4.5% 4.5%
Capital conservation buffer 0.625% 1.25% 1.875% 2.5%
Minimum common equity plus capital conservation buffer
3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
Phase-in of deductions from CET1* 20% 40% 60% 80% 100% 100%
Minimum Tier 1 capital 4.5% 5.5% 6.0% 6.0%
Minimum total capital 8.0% 8.0%
Minimum total capital plus conservation buffer 8.0% 8.625% 9.25% 9.875% 10.5%
Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2capital
Phased out over 10-year horizon beginning 2013
Liquidity
Liquidity coverage ratio – minimum requirement 60% 70% 80% 90% 100%
Net stable funding ratio Introduce minimum
standard Including amounts exceeding the limit for deferred tax assets (DTAs), mortgage servicing rights (MSRs) and financials.
All dates are as of 1 January
Source: Bank for International Settlements