Directory UMM :Data Elmu:jurnal:J-a:Journal of Accounting and Public Policy:Vol19.Issue3.Jun2000:
Journal of Accounting and Public Policy 19 (2000) 201±235
Loan, security, and dividend choices by
individual (unconsolidated) public and private
commercial banks
Frederick Niswander a,*, Edward P. Swanson b
a
b
Department of Accounting, School of Business, East Carolina University, GCB 3204 Greenville,
NC 27858, USA
Lowry Mays College and Graduate School of Business, Texas A&M University, College Station,
TX 77843-4353, USA
Abstract
Using call report data, we consider whether the discretionary portion of loan loss
provisions, loan charge-os, securities gains and losses, and dividends are in¯uenced by
the bank's level of capital, earnings, and taxes. We studied more than 11,000 banks. We
®nd that banks below a capital adequacy threshold often make discretionary choices
that reduce earnings and capital. Banks above the threshold exhibit dierent discretionary outcomes, with evidence of income smoothing and tax-advantaged
actions. Ó 2000 Elsevier Science Ltd. All rights reserved.
1. Introduction
The United States (US) savings and loan crisis and questions about the
viability of banks in some Asian countries serve as reminders of the importance
of realistic reporting of the economic condition of ®nancial institutions (White,
1991, pp. 82±87). Several studies have investigated whether bank managers use
their discretion in making accounting and ®nancing choices to manage
reported accounting information (Moyer, 1990; Scholes et al., 1990; Collins
et al., 1995; Wahlen, 1994; Beatty et al., 1995; Beatty and Harris, 1999). These
*
Corresponding author. Tel.: +1-252-328-6970; fax: +1-252-328-4091.
E-mail address: [email protected] (F. Niswander).
0278-4254/00/$ - see front matter Ó 2000 Elsevier Science Ltd. All rights reserved.
PII: S 0 2 7 8 - 4 2 5 4 ( 0 0 ) 0 0 0 1 3 - 2
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F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
studies suggest that bank managers often make accounting and ®nancing
choices to manage capital levels, earnings, and taxes. These choices can in turn
have a substantial eect on the evaluation of economic condition.
Our study uses data from Consolidated Reports of Condition and Income
(call reports) provided by the Federal Deposit Insurance Corporation (FDIC)
for each bank insured by the FDIC. For more than 11,000 banks, we examined
four accounting and ®nancing choices that allow bank managers substantial
discretion over the amount recorded. The four choices are the amount of the
loan loss provision, loan charge-os, securities gains and losses, and dividends.
For each choice, we ®t an ordinary least squares (OLS) regression model with
variables to control for non-discretionary behavior and examine whether the
remaining (discretionary) variation is associated with capital level, earnings,
and marginal tax rate. The OLS regression equations were estimated as a
system of simultaneous equations using seemingly unrelated regression (SUR)
for each sample year 1987, 1988, and on a pooled basis. During this period,
capital adequacy regulations did not vary (Koch, 1995, p. 389; Collins et al.,
1995, p. 266).
Our study contributes to understanding bank accounting and auditing in
four ways. First, we explicitly consider the roles of bank auditors and regulators as well as bank managers in our hypothesis development. 1; 2 As more
fully explained in Section 2.2, we suggest that, for low capital banks, auditors
and regulators prefer conservative accounting estimates which are usually at
variance with the preferences of managers. We predict that, for banks below a
capital adequacy threshold used by regulators, the conservative preferences of
auditors and regulators will prevail for accounting choices subject to year-end
adjustment. In particular, auditors and regulators close scrutiny of a low
capital bank's loan portfolio lead managers to exercise discretion conservatively.
Second, previous studies (e.g., Moyer, 1990; Beatty et al., 1995; Collins et al.,
1995) have investigated one or more of these four choices using data for approximately 150 consolidated public banks. Our research examines public
banks at the unconsolidated level, thereby including over 1,500 individual,
unconsolidated, public banks. 3 These individual banks are important because
1
Throughout our paper, auditor refers to independent auditors while regulator or examiner refers
to the governmental agency or agencies responsible for regulation of the bank.
2
It should be noted that, by design, bank examiners do not perform ®nancial statement audits.
Examiners spend considerable time appraising asset quality (particularly the loan portfolio) and
management (Koch, 1995, pp. 40±42). For an overview of the examination process, see Cocheo
(1986).
3
Consistent with prior research (Moyer, 1990, p. 132; Wahlen, 1994, p. 460; Beatty et al., 1995,
p. 246; Collins et al., 1995, p. 270), a bank is classi®ed as a public bank if it is listed on COMPUSTAT
(mainframe or PC version) or on CRSP. The remaining banks are classi®ed as private banks.
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203
regulatory capital constraints apply to subsidiary banks, as well as to the
consolidated bank holding company. The use of call report data also allows us
to include private banks, which have been omitted from other studies despite
their economic importance. 4 Our sample includes over 9,800 private banks.
The ability to examine choices of private ®rms on a large scale is probably
unique to the banking industry.
Third, literature (e.g., Moyer, 1990; Beatty et al., 1995; Collins et al., 1995)
suggests that the extent of audit and regulatory scrutiny is in¯uenced by a
capital adequacy threshold that distinguishes between potentially troubled
banks and those with a safe margin of capital. Managers may be less able to
use discretion to manage the capital level, earnings, and taxes for banks below
this threshold. Consistent with prior research (e.g., Moyer, 1990), we use a
research design that allows a separate analysis of choices by banks below and
above a capital threshold (proforma capital of 7.5%). 5 Four subgroups of
banks are considered: below-capital-threshold public, below-capital-threshold
private, above-capital-threshold public, and above-capital-threshold private.
Below-capital-threshold banks have greatest implications for public policy due
to the high cost of audit failure to taxpayers, stockholders, and others. Some of
our most important results are for these banks.
Fourth, we investigate whether discretionary choices dier depending upon
whether a bank is publicly or privately held. We examine whether dierences
occur in the magnitude and direction of their response to incentives provided
by capital levels, earnings, and taxes.
To our knowledge, our study is the ®rst to combine an extensive set of
jointly determined accounting and ®nancing choices, a research design that
permits detection of dierential discretionary choices across capital adequacy
thresholds, and a large sample of public and private unconsolidated banks. Our
expectations and primary ®ndings are summarized below. We organize the
discussion by below-capital-threshold banks, above-capital-threshold banks,
and the dierences between public and private banks.
The loan loss provision and loan charge-o decisions are the most material
discretionary choices and literature indicates that auditors and regulators
monitor these choices closely. For below-capital-threshold banks, we expect
auditors and regulators want conservative choices that reduce earnings or
capital and we expect their preferences will prevail. We found that banks with
proforma capital less than 7.5% use accounting discretion in a manner that
4
To the best of our knowledge, the only other studies to use call report data to investigate any of
these choices are Carey (1994) and Beatty and Harris (1999). Both examine only the securities gain
and loss choice.
5
By capital threshold, we mean a range, rather than a point estimate. As discussed later in the
paper, our results are not materially changed by moving the range up or down by 1%.
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F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
further reduces capital (earnings) by recognizing a larger discretionary loan
charge-o (loan loss provision). These ®ndings are consistent with auditors
mandating the use of estimates of earnings and capital for below-capitalthreshold banks that are conservative. (For the loan loss provision, in which
earnings and capital level provide con¯icting incentives, earnings dominates
capital.) The results are robust and apply to both public and private banks.
The results for discretionary securities gains and losses are less robust. 6
Consistent with auditor and regulator conservatism, we found that belowcapital-threshold public and private banks with the lowest capital realize
smaller net security gains, thereby further reducing capital. Marginal tax rates
are not related to discretionary securities gains and losses. For discretionary
dividends, there is no systematic relationship between capital level and dividends for below-threshold banks, possibly because most of these banks pay
little or no dividends.
For high-capital-threshold banks, we found that accounting and ®nancing
choices are often dierent than for below-capital-threshold banks. Of particular importance, there is little evidence of the auditor conservatism we found
for below-capital-threshold banks. Instead, we found evidence that public and
private banks with low (high) earnings tend to realize more (fewer) net securities gains, thereby smoothing income. Public banks also use the discretionary
portion of the loan provision choice in a manner consistent with smoothing
income. In addition, tax minimization has an in¯uence: contrary to our ®ndings for below-capital-threshold banks, we found evidence that higher marginal
tax rates result in more loan charge-os and fewer net securities gains by both
public and private banks above the capital threshold.
And ®nally, we provide evidence about the dierences in discretionary accounting and ®nancing choices between public and private banks. For belowcapital-threshold banks, we found that the magnitude of the conservative use
of accounting discretion for the loan loss provision (to reduce earnings) and for
the loan charge-os (to reduce capital) are larger for public than private banks.
These two dierences may be due to the greater potential legal liability to
external auditors from failure of a public bank.
In contrast, for above-capital-threshold banks, we found several dierences.
The magnitudes of the tax savings from realizing fewer net securities gains and
from greater loan loss charge-os are larger for public than private banks. This
dierence likely re¯ects more sophisticated tax-savvy managers at public
banks. The magnitude of income smoothing using the loan loss provision is
also greater for public than private banks above the capital threshold, probably
6
This observation is generally true of prior research as well. For example, Collins et al. (1995,
pp. 265, 266), comment ``. . . the relation between capital and securities gains and losses is less
robust than the others . . . :''
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205
due to greater pressure for public banks to meet expected earnings levels. And
®nally, as capital levels increase, public banks increase dividend payouts more
than private banks. Private banks may be retaining funds to minimize the
personal tax payments of the owners and to increase bank capital.
Results indicate audits and regulatory oversight counter the incentives that
managers at banks below a regulatory capital threshold have to use their
discretion to increase capital or earnings. The strong contrast between banks
above and below the capital threshold in their use of discretion emphasizes the
importance of auditor and regulator scrutiny. These conservative results exist
for both public and private banks. The issue of whether this conservative bias is
desirable is left to policy makers. 7
The remainder of the paper is organized as follows. Section 2 develops our
expectations about the in¯uence of auditor monitoring. Section 3 describes the
sample, and Section 4 reviews the research design. The empirical results are
presented in Section 5. Section 6 summarizes our results.
2. Eect of auditor and regulator monitoring on manager's use of accounting
discretion
2.1. Introduction
In this section, we examine whether the discretionary portion of accounting
numbers is likely to re¯ect the preferences of auditors, regulators, or managers
in speci®c settings. We ®rst consider banks with capital below a threshold that
increases regulatory scrutiny. Next, we discuss how accounting discretion may
be used dierently in banks above this capital threshold. Finally, we consider
whether accounting discretion is likely to be used dierently in public and
private banks.
2.2. Low capital banks
2.2.1. Preferences of managers, auditors, and regulators
The costs of regulation can be substantial (Darnell, 1982, pp. 9±10; Chang,
1982, pp. 19±20). Costs are clearly higher for banks with substandard or
marginal capital ratios: regulators can impose costly restrictions on managerial
¯exibility by refusing to permit establishment of a branch; refusing to approve
a merger; disapproving a change in ownership or control; requiring higher
7
Recently, the SEC cautioned banks to not use loan provisions to manage net income (Securities
and Exchange Commission, 1998). Relevant to the SEC position, we found that above-capitalthreshold public banks use the loan loss provision in a manner consistent with income smoothing.
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minimum capital requirements than required of other banks; and requiring
changes to ®nancial statement data (Code of Federal Regulations, 1990, paras.
3.10, 325.3, and 325.4). Ultimately, regulators have the authority to close a
bank (Code of Federal Regulations, 1990, paragraph 3.14). Because these steps
reduce or eliminate managerial control and managers' wealth is reduced by
many of these costs, managers of banks at or near regulatory capital constraints are expected to prefer accounting and ®nancing choices that increase
reported capital and/or earnings. This expectation is consistent with the views
of Moyer (1990, p. 153), Beatty et al. (1995, p. 232), and Collins et al. (1995,
p. 267).
Although managers of a bank with low capital may wish to reduce regulatory costs, banks that are close to their capital constraints come under increased supervision by regulatory authorities (Thomson, 1991, pp. 9±10;
Carroll, 1989, p. 16; Whalen and Thomson, 1988, pp. 17±19), including an
increased likelihood of a regulatory examination (Federal Deposit Insurance
Corporation, 1988, p. 4). Managers of a bank that is under increased regulatory scrutiny have less ¯exibility in using accounting or ®nancing discretion,
since available options would then be in¯uenced by the preferences of auditors
and regulators. As further explained below, we suggest that auditors and
regulators are likely to favor conservative estimates that fall within the range of
probable outcomes.
Extant banking literature (e.g., Koch, 1995) and regulatory guidance (e.g.,
Federal Deposit Insurance Corporation, 1990), speci®cally as pertains to
loan-related items, clearly indicates that regulators prefer conservative outcomes. Many bank management texts express the view of Koch (1995) who
states:
Regulators prefer that the banks err by overestimating potential
losses. In contrast, banks often prefer to report the lowest possible
reserve that still protects against losses because this provides the
highest possible reported net income (Koch, 1995, p. 742).
Koch's (1995) views are reenforced by Federal regulations. The FDIC
Manual of Bank Examination Policies requires banks to maintain a level of
loan loss allowance which is not only adequate, but is also conservative,
re¯ecting the diculty inherent in estimating future credit losses (Federal
Deposit Insurance Corporation, 1990, Section 3.1, Loans).
Further, bankers believe that examiners are conservative. In 1986, the
American Banking Association interviewed a cross-section of bankers. Paraphrasing the bankers' comments, the association's journal said that when a
bank gets into ®nancial trouble ``examiners don't want their present actions
second guessed'' and as a consequence they are conservative (Examiners grow
tougher..., 1986, p. 19).
F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
207
In accounting and auditing, there exists a long tradition of conservatism as a
response to uncertainty. Independent auditors are concerned with the risk and
consequences of audit failure, including its eect on their professional reputation and legal liability (Davis and Simon, 1992, pp. 66±67; Stice, 1991, p. 516;
Palmrose, 1988, p. 57). Accounting researchers have found that auditor conservatism plays a role in many empirical and experimental settings, including:
auditor switching (DeFond and Subramanyam, 1998, p. 37; Krishnan and
Stephens, 1995, pp. 195±196; Krishnan, 1994, p. 214); audit reporting (Francis
and Krishnan, 1999, p. 157); audit evidence search (McMillan and White, 1993,
p. 444; Trotman and Sng, 1989, pp. 566±568; Kida, 1984); analytical review
(Kinney and Uecker, 1982, pp. 66±68); and auditor accountability (Homan
and Patton, 1997, p. 228; Peecher, 1996, pp. 133±139). In particular, Hackenbrack and Nelson (1996, p. 45) found that ``. . . auditors tend to require highengagement risk clients to adopt conservative reporting methods.'' Thus, for
low capital banks, we expect auditors and bank examiners prefer conservative
measures of capital and earnings.
An alternative argument can be made that audits and examinations result in
unbiased, rather than conservative, accounting estimates. By demanding conservative estimates, independent auditors may be criticized by bank managers
and could lose future audit engagements. Regulatory examiners could be
forced to justify conservative actions to supervisors. 8 The argument for unbiased estimates has some merit, but since the accurate (unbiased) amounts are
unknown and the risk that auditors will be criticized for a bank failure is higher
if capital or earnings have been overstated, we believe a risk adverse auditor
would prefer conservative estimates for low capital banks.
2.2.2. Manager and auditor power
Limits on managers' use of their accounting discretion are in¯uenced by the
extent to which managers and auditors have con¯icting preferences and
whether one of the parties is in a position of power to strongly in¯uence or
dictate the outcome.
Con¯icts occur between an auditor and their client during the course of an
audit. Resolution of auditor/client con¯icts is often eected through a bargaining process (Lev, 1979, p. 166), wherein each of the participants can be
viewed as possessing a certain amount of power to enforce their respective
positions (Goldman and Barlev, 1974, pp. 707±711; Nichols and Price, 1976,
pp. 335±336). Given that disagreements occur and that management and
auditors may have con¯icting incentives, especially when the client is facing
8
Extant regulations, however, encourage conservative estimates and research ®nds that
accountability increases auditor conservatism (Homan and Patton, 1997, p. 228; Lord, 1992,
p. 103).
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F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
®nancial distress, the issue becomes: which party would be expected to prevail
in a given situation? To answer that question, extant literature suggests two
factors that must be evaluated.
The ®rst one concerns the audit service contract. Early theoretical work in
generalized audit settings suggests that managers are in a powerful position
relative to auditors, primarily because managers can in¯uence audit fees and
hire or ®re the auditor (Emerson, 1962; Goldman and Barlev, 1974, p. 710;
Nichols and Price, 1976, pp. 338±340). However, in bank audits, management's
position is much weaker. Unlike most businesses, banks are faced with two sets
of outside evaluators ± the external auditor hired by the bank and the bank
examiner. Although bank managers have a measure of economic power over
their external auditor, they cannot ®re the bank examiner. Further, although
non-bank management generally has wide latitude in negotiating the fees of
external auditors, bank examiners do not charge a separate fee that can be
threatened. 9 As a consequence, the power of bank management in an accounting con¯ict is likely much more limited than the power of non-bank
management.
The second factor aecting power is the ®nancial health of the client. Survey
and empirical research suggest that client ®nancial distress results in a shift of
power to the auditor. Knapp (1985, p. 202) found that clients in good ®nancial
condition are perceived as having the upper hand, while those in poor shape
are unlikely to prevail in a con¯ict with auditors. Using audit quality review
®ndings for government entities, Deis and Giroux (1992, pp. 467±469) developed an audit quality score. Deis and Giroux (1992, p. 476) found that audit
quality increased as ®nancial health of the client declined. Petroni and Beasley
(1996, p. 156) oer a maintained hypothesis that auditing eort is greater for
clients in poor ®nancial health. Hackenbrack and Nelson (1996, p. 45) also
support the notion that auditors prevail when clients are in poor ®nancial
health.
For these reasons, we believe that auditors' preferences are more likely to
dominate managers' preferences for banks below a capital threshold that results in increased regulatory scrutiny. In the next section, we relax this conclusion when the accounting or ®nancing choice is not subject to audit
adjustment.
2.2.3. Whether the accounting choice is subject to audit adjustment
The resolution (or even the very existence) of a con¯ict is in¯uenced by the
nature of the item being examined. Absent errors or irregularities, the accounting treatment of most transactions which occur during the year is not
9
Even if a portion of deposit insurance premiums is viewed as an indirect audit fee, the power of
bank managers is not increased since they are unable to modify the audit fee component.
F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
209
subject to change. An example is the gain or loss recorded on the sale of
marketable securities. The securities portfolio of a bank serves a number of
purposes: it is a storehouse of liquidity; it is an integral part of asset±liability
management; and the interest generated is an important contributor to bank
earnings (Sinkey, 1989, chapters 13, 15, and 16; Hempel and Simonson, 1991,
chapter 11). One or more of these purposes often dictates the purchase and sale
of securities throughout the year. If prudent bank management requires the
sale of securities, managers have considerable choice as to which securities to
sell; thus managers can in¯uence the magnitude of any gain or loss realized.
Since securities gains and losses are not subject to ex post audit adjustment,
regulators have little control over the level of securities gain or loss (Beatty and
Harris, 1999, p. 304, also make this argument). Accounting for dividend
payments is similar, since once the transaction has occurred, the ®nancial eect
is recorded and not subject to adjustment. Further, some evidence indicates
that bank regulators do not systematically intervene during the year to force
reduced dividend payments (French, 1991, p. 7; Horne, 1991, p. 15).
Unlike completed transactions, many accruals and estimates are not ®nalized until year-end and are subject to auditor adjustment. Important accruals
and estimates for banks include loan loss provisions and loan charge-os.
Signi®cant judgement is involved in estimating these loan-related items (Sinkey, 1989, pp. 543±546; Wahlen, 1994, pp. 457±458; Beaver et al., 1989, p. 162).
The vast majority of regulatory oversight time is spent on the loan portfolio,
including loan classi®cation (as performing vs. non-performing), loan loss
provision, and loan charge-os (Mitchell, 1984, p. 19; May, 1991, p. 61; Koch,
1995, pp. 40±43). In the 1980s, regulatory pressure was increased in the areas of
loan portfolios and the allowance process (Walter, 1991, pp. 24±25; Spinard,
1992, p. 59). This regulatory pressure leads to potential disagreements with
bank managers whose judgement may be questioned (Fleischer, 1991, pp. 33±
35; Nadler, 1991, p. 19). The extent of con¯ict can be substantial over loan
charge-os, since an increased amount reduces capital dollar-for-dollar. A
change in the loan loss provision also directly aects earnings, but it has a
smaller, and opposite, eect on capital. 10
To summarize, for banks below a capital threshold that results in increased
regulatory scrutiny, we expect auditor conservatism to prevail in con¯icts with
10
During the period of study, the primary capital adequacy ratio was de®ned as the book value of
stockholders' equity plus the loan loss allowance divided by total assets plus the loan loss allowance
(Scholes et al., 1990, p. 642; Beatty et al., 1995, p. 233). Capital is therefore increased by increasing
the loan loss allowance, which can be accomplished by increasing the provision or decreasing
charge-os. Increasing the provision by $1 increases the allowance by $1 and reduces book net
income by $1 1 ÿ t, where t equals the marginal tax rate for book purposes. The net eect is to
increase capital by $1 t. Decreasing charge-os by $1 increases the loan loss allowance by $1 and,
consequently, increases regulatory capital by $1.
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managers that involve accounting discretion over items subject to year-end
adjustment (e.g., loan loss provisions and loan charge-os). For completed
transactions (e.g., securities gains and losses, and dividends), we expect auditors are not able to restrict managers' use of discretion.
2.3. High capital banks
The shift of power to auditors that occurs when a bank is in poor ®nancial
health should shift back towards managers when a bank is in good ®nancial
condition. Further, since federal bank examiners operate in a resource-constrained environment, they concentrate their scarce audit resources on low
capital banks, not those with high capital (e.g., Federal Deposit Insurance
Corporation, 1988, p. 4). For example, during the period of this study (1987
and 1988), a goal of the FDIC was to audit troubled banks on a yearly basis,
but only to perform ®eld audits on non-troubled banks every two years
(Federal Deposit Insurance Corporation, 1988, p. 4). These two factors suggest
that managers' incentives should become dominant for all discretionary
accounting and ®nancing choices when capital is relatively high.
Yet, we expect managers of ®nancially healthy banks to no longer focus on
increasing capital and/or earnings. Managers may make positive or negative
discretionary accruals to maximize payments under a bonus plan (Healy, 1985,
pp. 86±87), to comply with accounting provisions in contracts (Watts and
Zimmerman, 1986, pp. 179±199), or to smooth income (Beatty and Harris,
1999, p. 30; Ronen and Sadan, 1981). Depending upon a bank's incentives,
managers may want to increase or decrease income. As explained in Section
2.4, we expect above-threshold public banks to manage earnings to a greater
extent than above-threshold private banks.
We also expect mangers of above-capital-threshold banks to incorporate the
eect of taxes in their discretionary choices. The marginal corporate tax rate
should aect the level of loan charge-os and realized securities gains and
losses but not loan loss provisions and dividends since these items do not aect
corporate taxable income (Collins et al., 1995, pp. 268±270). Following Scholes
et al. (1990, p. 633), we estimated relative marginal tax rates using the proportion of assets represented by municipal bond holdings. Higher levels of
municipal bonds are a surrogate for a higher marginal tax rate. As the marginal
tax rate increases, each dollar of loan charge-o provides a greater tax shield
and each dollar of realized securities gain costs more in taxes. As a result, we
expect a positive (negative) relationship between the marginal rate and loan
charge-os (net security gains). 11 These relationships are consistent with extant
11
We expect this relationship to be evident for banks above and below the capital threshold.
F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
211
literature (Scholes et al., 1990, p. 645; Collins et al., 1995, p. 270; Beatty et al.,
1995, p. 242; Beatty and Harris, 1999, p. 309).
2.4. Public and private bank comparisons
Empirical accounting research that explores dierences between public
and private ®rms is limited ± primarily because data are extremely dicult
to obtain. 12 Further, the banking literature contains relatively little theoretical work to guide our tests. Our analysis is therefore somewhat exploratory.
Unlike our tests for below- and above-capital-threshold banks, for public
and private banks we are not interested in whether the discretionary actions are
dierent from zero, but whether the actions of public and private banks are
dierent from one another. Our expectations are stated accordingly.
For banks with capital below the threshold, we do not expect any substantial dierences between the discretionary actions of public and private
banks. Auditors would continue to seek conservative numbers, and managers
would prefer to report higher capital and/or earnings. However, for abovecapital-threshold banks, we expect the discretionary actions of public and
private banks will diverge.
The manager and/or owner of a private bank typically has a greater proportion of his or her personal wealth concentrated in bank ownership (Sullivan
and Spong, 1998, p. 22). Hughes and Mester (1998, pp. 314±317) show managers use capital to signal risk and that there is a negative relationship between
capital and risk. Thus, compared to public banks, we expect private banks to
have higher capital (signaling lower risk) and to take discretionary actions to
maintain or improve capital. This can be accomplished by above-threshold
private banks recording a larger loan loss provision, more net securities gains,
fewer loan charge-os, and lower dividend payouts when compared to abovethreshold public banks.
In the case of the earnings incentive for banks above the capital threshold,
consistent with Beatty and Harris (1999, p. 302), we argue that information
asymmetry between managers and stockholders and/or agency cost issues will
result in greater earnings management by public banks when compared to
private banks. This could result in public banks making greater use than
private banks of the loan loss provision and net securities gains to smooth
income.
In Section 2.3 we argued that, ceteris paribus, banks seek to maximize the
tax shield provided by deductions and minimize the tax cost imposed on
12
For some available research, see Beatty and Harris (1999), Cloyd et al. (1996), and Penno and
Simon (1986).
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income. Cloyd et al. (1996, pp. 25±26) present evidence consistent with the
notion that private ®rms are more inclined to make decisions that increase taxrelated cash ¯ows when compared to public ®rms. Thus, we expect abovethreshold private banks will record greater loan charge-os and fewer net
securities gains than will above-threshold public banks, for a given a marginal
tax rate.
Our expectations for public and private banks are summarized at the bottom of Table 9.
3. Sample
The sample data were obtained from annual FDIC tapes. These tapes report
®nancial and other data for each bank covered by FDIC deposit insurance
(substantially all banks in the US). Data are provided at the individual bank
level, rather than as a consolidated group. The data are from 1987 and 1988.
These years were chosen because they are in the middle of a time period in
which capital ratio rules were stable (e.g., Koch, 1995, p. 389). Capital adequacy rules changed in 1985 and risk-adjusted capital standards were adopted
in late 1989 (to become fully eective in 1992) (e.g., Koch, 1995, p. 389). Thus,
1987 and 1988 are years in which bank data should be relatively free from nonrecurring adjustments for changes in capital adequacy regulations. 13
Table 1, panel A reports the number of banks used in the analysis, the
number removed, and the reasons for their removal. We ®rst deleted mutual
savings banks, foreign banks, banks in US possessions, and non-banks (banks
with Bank Charter Codes of 30 and above). 14 Next, new banks, those not in
existence for at least four years as of the end of the year, were removed because
evidence suggests that they are structured and operated in a dierent manner
than established banks (e.g., Avery and Belton, 1987, p. 252). 15 Small banks,
13
As suggested by a reviewer, the in¯uence of proposed changes in capital adequacy requirements
on bank accounting and ®nancing choices is also a subject worthy of study. Knowledge of behavior
under capital requirements that do not vary provides a benchmark for studying the eect of
changes.
14
These banks are included on the tapes because they must report to the FDIC, similar to
domestic banks. However, their regulatory structure diers substantially from other banks. Mutual
savings banks are similar to savings and loan institutions and are subject to regulations which
dier, in many material respects, from those for commercial banks. For the other types of banks
listed, their operations and, in many cases, primary regulators dier from those of US banks.
15
New banks require a number of years of operation before ®nancial statement balances re¯ect
normal operating relationships. For example, loans to total assets are low until the loan portfolio
becomes mature; loans are not seasoned so loan losses are more dicult to estimate; and new banks
have lower interest expense as a percentage of assets since liabilities are a smaller proportion of the
balance sheet (Avery and Belton, 1987, p. 252).
F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
213
Table 1
Sample informationa
Panel A: Number of observations
Banks on the FDIC tapes each year
Less reductions for:
Savings banks, foreign banks, banks in
possessions, and non-banks (charter codes
30 or higher)
Banks not in existence for 4 years as of
12/31/87 or 12/31/88, as appropriate
Assets less than $10 million
Zero assets, zero operations, zero loans,
in liquidation, or missing data required
to construct regressions
Total useable observations
1987
1988
14,799
14,246
1,183
1,202
853
684
785
726
358
302
11,620
11,332
Panel B: Observations classi®ed as public/private and high/low capital
PFCAP
PFCAP
1987 Data
Loan, security, and dividend choices by
individual (unconsolidated) public and private
commercial banks
Frederick Niswander a,*, Edward P. Swanson b
a
b
Department of Accounting, School of Business, East Carolina University, GCB 3204 Greenville,
NC 27858, USA
Lowry Mays College and Graduate School of Business, Texas A&M University, College Station,
TX 77843-4353, USA
Abstract
Using call report data, we consider whether the discretionary portion of loan loss
provisions, loan charge-os, securities gains and losses, and dividends are in¯uenced by
the bank's level of capital, earnings, and taxes. We studied more than 11,000 banks. We
®nd that banks below a capital adequacy threshold often make discretionary choices
that reduce earnings and capital. Banks above the threshold exhibit dierent discretionary outcomes, with evidence of income smoothing and tax-advantaged
actions. Ó 2000 Elsevier Science Ltd. All rights reserved.
1. Introduction
The United States (US) savings and loan crisis and questions about the
viability of banks in some Asian countries serve as reminders of the importance
of realistic reporting of the economic condition of ®nancial institutions (White,
1991, pp. 82±87). Several studies have investigated whether bank managers use
their discretion in making accounting and ®nancing choices to manage
reported accounting information (Moyer, 1990; Scholes et al., 1990; Collins
et al., 1995; Wahlen, 1994; Beatty et al., 1995; Beatty and Harris, 1999). These
*
Corresponding author. Tel.: +1-252-328-6970; fax: +1-252-328-4091.
E-mail address: [email protected] (F. Niswander).
0278-4254/00/$ - see front matter Ó 2000 Elsevier Science Ltd. All rights reserved.
PII: S 0 2 7 8 - 4 2 5 4 ( 0 0 ) 0 0 0 1 3 - 2
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F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
studies suggest that bank managers often make accounting and ®nancing
choices to manage capital levels, earnings, and taxes. These choices can in turn
have a substantial eect on the evaluation of economic condition.
Our study uses data from Consolidated Reports of Condition and Income
(call reports) provided by the Federal Deposit Insurance Corporation (FDIC)
for each bank insured by the FDIC. For more than 11,000 banks, we examined
four accounting and ®nancing choices that allow bank managers substantial
discretion over the amount recorded. The four choices are the amount of the
loan loss provision, loan charge-os, securities gains and losses, and dividends.
For each choice, we ®t an ordinary least squares (OLS) regression model with
variables to control for non-discretionary behavior and examine whether the
remaining (discretionary) variation is associated with capital level, earnings,
and marginal tax rate. The OLS regression equations were estimated as a
system of simultaneous equations using seemingly unrelated regression (SUR)
for each sample year 1987, 1988, and on a pooled basis. During this period,
capital adequacy regulations did not vary (Koch, 1995, p. 389; Collins et al.,
1995, p. 266).
Our study contributes to understanding bank accounting and auditing in
four ways. First, we explicitly consider the roles of bank auditors and regulators as well as bank managers in our hypothesis development. 1; 2 As more
fully explained in Section 2.2, we suggest that, for low capital banks, auditors
and regulators prefer conservative accounting estimates which are usually at
variance with the preferences of managers. We predict that, for banks below a
capital adequacy threshold used by regulators, the conservative preferences of
auditors and regulators will prevail for accounting choices subject to year-end
adjustment. In particular, auditors and regulators close scrutiny of a low
capital bank's loan portfolio lead managers to exercise discretion conservatively.
Second, previous studies (e.g., Moyer, 1990; Beatty et al., 1995; Collins et al.,
1995) have investigated one or more of these four choices using data for approximately 150 consolidated public banks. Our research examines public
banks at the unconsolidated level, thereby including over 1,500 individual,
unconsolidated, public banks. 3 These individual banks are important because
1
Throughout our paper, auditor refers to independent auditors while regulator or examiner refers
to the governmental agency or agencies responsible for regulation of the bank.
2
It should be noted that, by design, bank examiners do not perform ®nancial statement audits.
Examiners spend considerable time appraising asset quality (particularly the loan portfolio) and
management (Koch, 1995, pp. 40±42). For an overview of the examination process, see Cocheo
(1986).
3
Consistent with prior research (Moyer, 1990, p. 132; Wahlen, 1994, p. 460; Beatty et al., 1995,
p. 246; Collins et al., 1995, p. 270), a bank is classi®ed as a public bank if it is listed on COMPUSTAT
(mainframe or PC version) or on CRSP. The remaining banks are classi®ed as private banks.
F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
203
regulatory capital constraints apply to subsidiary banks, as well as to the
consolidated bank holding company. The use of call report data also allows us
to include private banks, which have been omitted from other studies despite
their economic importance. 4 Our sample includes over 9,800 private banks.
The ability to examine choices of private ®rms on a large scale is probably
unique to the banking industry.
Third, literature (e.g., Moyer, 1990; Beatty et al., 1995; Collins et al., 1995)
suggests that the extent of audit and regulatory scrutiny is in¯uenced by a
capital adequacy threshold that distinguishes between potentially troubled
banks and those with a safe margin of capital. Managers may be less able to
use discretion to manage the capital level, earnings, and taxes for banks below
this threshold. Consistent with prior research (e.g., Moyer, 1990), we use a
research design that allows a separate analysis of choices by banks below and
above a capital threshold (proforma capital of 7.5%). 5 Four subgroups of
banks are considered: below-capital-threshold public, below-capital-threshold
private, above-capital-threshold public, and above-capital-threshold private.
Below-capital-threshold banks have greatest implications for public policy due
to the high cost of audit failure to taxpayers, stockholders, and others. Some of
our most important results are for these banks.
Fourth, we investigate whether discretionary choices dier depending upon
whether a bank is publicly or privately held. We examine whether dierences
occur in the magnitude and direction of their response to incentives provided
by capital levels, earnings, and taxes.
To our knowledge, our study is the ®rst to combine an extensive set of
jointly determined accounting and ®nancing choices, a research design that
permits detection of dierential discretionary choices across capital adequacy
thresholds, and a large sample of public and private unconsolidated banks. Our
expectations and primary ®ndings are summarized below. We organize the
discussion by below-capital-threshold banks, above-capital-threshold banks,
and the dierences between public and private banks.
The loan loss provision and loan charge-o decisions are the most material
discretionary choices and literature indicates that auditors and regulators
monitor these choices closely. For below-capital-threshold banks, we expect
auditors and regulators want conservative choices that reduce earnings or
capital and we expect their preferences will prevail. We found that banks with
proforma capital less than 7.5% use accounting discretion in a manner that
4
To the best of our knowledge, the only other studies to use call report data to investigate any of
these choices are Carey (1994) and Beatty and Harris (1999). Both examine only the securities gain
and loss choice.
5
By capital threshold, we mean a range, rather than a point estimate. As discussed later in the
paper, our results are not materially changed by moving the range up or down by 1%.
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F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
further reduces capital (earnings) by recognizing a larger discretionary loan
charge-o (loan loss provision). These ®ndings are consistent with auditors
mandating the use of estimates of earnings and capital for below-capitalthreshold banks that are conservative. (For the loan loss provision, in which
earnings and capital level provide con¯icting incentives, earnings dominates
capital.) The results are robust and apply to both public and private banks.
The results for discretionary securities gains and losses are less robust. 6
Consistent with auditor and regulator conservatism, we found that belowcapital-threshold public and private banks with the lowest capital realize
smaller net security gains, thereby further reducing capital. Marginal tax rates
are not related to discretionary securities gains and losses. For discretionary
dividends, there is no systematic relationship between capital level and dividends for below-threshold banks, possibly because most of these banks pay
little or no dividends.
For high-capital-threshold banks, we found that accounting and ®nancing
choices are often dierent than for below-capital-threshold banks. Of particular importance, there is little evidence of the auditor conservatism we found
for below-capital-threshold banks. Instead, we found evidence that public and
private banks with low (high) earnings tend to realize more (fewer) net securities gains, thereby smoothing income. Public banks also use the discretionary
portion of the loan provision choice in a manner consistent with smoothing
income. In addition, tax minimization has an in¯uence: contrary to our ®ndings for below-capital-threshold banks, we found evidence that higher marginal
tax rates result in more loan charge-os and fewer net securities gains by both
public and private banks above the capital threshold.
And ®nally, we provide evidence about the dierences in discretionary accounting and ®nancing choices between public and private banks. For belowcapital-threshold banks, we found that the magnitude of the conservative use
of accounting discretion for the loan loss provision (to reduce earnings) and for
the loan charge-os (to reduce capital) are larger for public than private banks.
These two dierences may be due to the greater potential legal liability to
external auditors from failure of a public bank.
In contrast, for above-capital-threshold banks, we found several dierences.
The magnitudes of the tax savings from realizing fewer net securities gains and
from greater loan loss charge-os are larger for public than private banks. This
dierence likely re¯ects more sophisticated tax-savvy managers at public
banks. The magnitude of income smoothing using the loan loss provision is
also greater for public than private banks above the capital threshold, probably
6
This observation is generally true of prior research as well. For example, Collins et al. (1995,
pp. 265, 266), comment ``. . . the relation between capital and securities gains and losses is less
robust than the others . . . :''
F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
205
due to greater pressure for public banks to meet expected earnings levels. And
®nally, as capital levels increase, public banks increase dividend payouts more
than private banks. Private banks may be retaining funds to minimize the
personal tax payments of the owners and to increase bank capital.
Results indicate audits and regulatory oversight counter the incentives that
managers at banks below a regulatory capital threshold have to use their
discretion to increase capital or earnings. The strong contrast between banks
above and below the capital threshold in their use of discretion emphasizes the
importance of auditor and regulator scrutiny. These conservative results exist
for both public and private banks. The issue of whether this conservative bias is
desirable is left to policy makers. 7
The remainder of the paper is organized as follows. Section 2 develops our
expectations about the in¯uence of auditor monitoring. Section 3 describes the
sample, and Section 4 reviews the research design. The empirical results are
presented in Section 5. Section 6 summarizes our results.
2. Eect of auditor and regulator monitoring on manager's use of accounting
discretion
2.1. Introduction
In this section, we examine whether the discretionary portion of accounting
numbers is likely to re¯ect the preferences of auditors, regulators, or managers
in speci®c settings. We ®rst consider banks with capital below a threshold that
increases regulatory scrutiny. Next, we discuss how accounting discretion may
be used dierently in banks above this capital threshold. Finally, we consider
whether accounting discretion is likely to be used dierently in public and
private banks.
2.2. Low capital banks
2.2.1. Preferences of managers, auditors, and regulators
The costs of regulation can be substantial (Darnell, 1982, pp. 9±10; Chang,
1982, pp. 19±20). Costs are clearly higher for banks with substandard or
marginal capital ratios: regulators can impose costly restrictions on managerial
¯exibility by refusing to permit establishment of a branch; refusing to approve
a merger; disapproving a change in ownership or control; requiring higher
7
Recently, the SEC cautioned banks to not use loan provisions to manage net income (Securities
and Exchange Commission, 1998). Relevant to the SEC position, we found that above-capitalthreshold public banks use the loan loss provision in a manner consistent with income smoothing.
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F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
minimum capital requirements than required of other banks; and requiring
changes to ®nancial statement data (Code of Federal Regulations, 1990, paras.
3.10, 325.3, and 325.4). Ultimately, regulators have the authority to close a
bank (Code of Federal Regulations, 1990, paragraph 3.14). Because these steps
reduce or eliminate managerial control and managers' wealth is reduced by
many of these costs, managers of banks at or near regulatory capital constraints are expected to prefer accounting and ®nancing choices that increase
reported capital and/or earnings. This expectation is consistent with the views
of Moyer (1990, p. 153), Beatty et al. (1995, p. 232), and Collins et al. (1995,
p. 267).
Although managers of a bank with low capital may wish to reduce regulatory costs, banks that are close to their capital constraints come under increased supervision by regulatory authorities (Thomson, 1991, pp. 9±10;
Carroll, 1989, p. 16; Whalen and Thomson, 1988, pp. 17±19), including an
increased likelihood of a regulatory examination (Federal Deposit Insurance
Corporation, 1988, p. 4). Managers of a bank that is under increased regulatory scrutiny have less ¯exibility in using accounting or ®nancing discretion,
since available options would then be in¯uenced by the preferences of auditors
and regulators. As further explained below, we suggest that auditors and
regulators are likely to favor conservative estimates that fall within the range of
probable outcomes.
Extant banking literature (e.g., Koch, 1995) and regulatory guidance (e.g.,
Federal Deposit Insurance Corporation, 1990), speci®cally as pertains to
loan-related items, clearly indicates that regulators prefer conservative outcomes. Many bank management texts express the view of Koch (1995) who
states:
Regulators prefer that the banks err by overestimating potential
losses. In contrast, banks often prefer to report the lowest possible
reserve that still protects against losses because this provides the
highest possible reported net income (Koch, 1995, p. 742).
Koch's (1995) views are reenforced by Federal regulations. The FDIC
Manual of Bank Examination Policies requires banks to maintain a level of
loan loss allowance which is not only adequate, but is also conservative,
re¯ecting the diculty inherent in estimating future credit losses (Federal
Deposit Insurance Corporation, 1990, Section 3.1, Loans).
Further, bankers believe that examiners are conservative. In 1986, the
American Banking Association interviewed a cross-section of bankers. Paraphrasing the bankers' comments, the association's journal said that when a
bank gets into ®nancial trouble ``examiners don't want their present actions
second guessed'' and as a consequence they are conservative (Examiners grow
tougher..., 1986, p. 19).
F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
207
In accounting and auditing, there exists a long tradition of conservatism as a
response to uncertainty. Independent auditors are concerned with the risk and
consequences of audit failure, including its eect on their professional reputation and legal liability (Davis and Simon, 1992, pp. 66±67; Stice, 1991, p. 516;
Palmrose, 1988, p. 57). Accounting researchers have found that auditor conservatism plays a role in many empirical and experimental settings, including:
auditor switching (DeFond and Subramanyam, 1998, p. 37; Krishnan and
Stephens, 1995, pp. 195±196; Krishnan, 1994, p. 214); audit reporting (Francis
and Krishnan, 1999, p. 157); audit evidence search (McMillan and White, 1993,
p. 444; Trotman and Sng, 1989, pp. 566±568; Kida, 1984); analytical review
(Kinney and Uecker, 1982, pp. 66±68); and auditor accountability (Homan
and Patton, 1997, p. 228; Peecher, 1996, pp. 133±139). In particular, Hackenbrack and Nelson (1996, p. 45) found that ``. . . auditors tend to require highengagement risk clients to adopt conservative reporting methods.'' Thus, for
low capital banks, we expect auditors and bank examiners prefer conservative
measures of capital and earnings.
An alternative argument can be made that audits and examinations result in
unbiased, rather than conservative, accounting estimates. By demanding conservative estimates, independent auditors may be criticized by bank managers
and could lose future audit engagements. Regulatory examiners could be
forced to justify conservative actions to supervisors. 8 The argument for unbiased estimates has some merit, but since the accurate (unbiased) amounts are
unknown and the risk that auditors will be criticized for a bank failure is higher
if capital or earnings have been overstated, we believe a risk adverse auditor
would prefer conservative estimates for low capital banks.
2.2.2. Manager and auditor power
Limits on managers' use of their accounting discretion are in¯uenced by the
extent to which managers and auditors have con¯icting preferences and
whether one of the parties is in a position of power to strongly in¯uence or
dictate the outcome.
Con¯icts occur between an auditor and their client during the course of an
audit. Resolution of auditor/client con¯icts is often eected through a bargaining process (Lev, 1979, p. 166), wherein each of the participants can be
viewed as possessing a certain amount of power to enforce their respective
positions (Goldman and Barlev, 1974, pp. 707±711; Nichols and Price, 1976,
pp. 335±336). Given that disagreements occur and that management and
auditors may have con¯icting incentives, especially when the client is facing
8
Extant regulations, however, encourage conservative estimates and research ®nds that
accountability increases auditor conservatism (Homan and Patton, 1997, p. 228; Lord, 1992,
p. 103).
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F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
®nancial distress, the issue becomes: which party would be expected to prevail
in a given situation? To answer that question, extant literature suggests two
factors that must be evaluated.
The ®rst one concerns the audit service contract. Early theoretical work in
generalized audit settings suggests that managers are in a powerful position
relative to auditors, primarily because managers can in¯uence audit fees and
hire or ®re the auditor (Emerson, 1962; Goldman and Barlev, 1974, p. 710;
Nichols and Price, 1976, pp. 338±340). However, in bank audits, management's
position is much weaker. Unlike most businesses, banks are faced with two sets
of outside evaluators ± the external auditor hired by the bank and the bank
examiner. Although bank managers have a measure of economic power over
their external auditor, they cannot ®re the bank examiner. Further, although
non-bank management generally has wide latitude in negotiating the fees of
external auditors, bank examiners do not charge a separate fee that can be
threatened. 9 As a consequence, the power of bank management in an accounting con¯ict is likely much more limited than the power of non-bank
management.
The second factor aecting power is the ®nancial health of the client. Survey
and empirical research suggest that client ®nancial distress results in a shift of
power to the auditor. Knapp (1985, p. 202) found that clients in good ®nancial
condition are perceived as having the upper hand, while those in poor shape
are unlikely to prevail in a con¯ict with auditors. Using audit quality review
®ndings for government entities, Deis and Giroux (1992, pp. 467±469) developed an audit quality score. Deis and Giroux (1992, p. 476) found that audit
quality increased as ®nancial health of the client declined. Petroni and Beasley
(1996, p. 156) oer a maintained hypothesis that auditing eort is greater for
clients in poor ®nancial health. Hackenbrack and Nelson (1996, p. 45) also
support the notion that auditors prevail when clients are in poor ®nancial
health.
For these reasons, we believe that auditors' preferences are more likely to
dominate managers' preferences for banks below a capital threshold that results in increased regulatory scrutiny. In the next section, we relax this conclusion when the accounting or ®nancing choice is not subject to audit
adjustment.
2.2.3. Whether the accounting choice is subject to audit adjustment
The resolution (or even the very existence) of a con¯ict is in¯uenced by the
nature of the item being examined. Absent errors or irregularities, the accounting treatment of most transactions which occur during the year is not
9
Even if a portion of deposit insurance premiums is viewed as an indirect audit fee, the power of
bank managers is not increased since they are unable to modify the audit fee component.
F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
209
subject to change. An example is the gain or loss recorded on the sale of
marketable securities. The securities portfolio of a bank serves a number of
purposes: it is a storehouse of liquidity; it is an integral part of asset±liability
management; and the interest generated is an important contributor to bank
earnings (Sinkey, 1989, chapters 13, 15, and 16; Hempel and Simonson, 1991,
chapter 11). One or more of these purposes often dictates the purchase and sale
of securities throughout the year. If prudent bank management requires the
sale of securities, managers have considerable choice as to which securities to
sell; thus managers can in¯uence the magnitude of any gain or loss realized.
Since securities gains and losses are not subject to ex post audit adjustment,
regulators have little control over the level of securities gain or loss (Beatty and
Harris, 1999, p. 304, also make this argument). Accounting for dividend
payments is similar, since once the transaction has occurred, the ®nancial eect
is recorded and not subject to adjustment. Further, some evidence indicates
that bank regulators do not systematically intervene during the year to force
reduced dividend payments (French, 1991, p. 7; Horne, 1991, p. 15).
Unlike completed transactions, many accruals and estimates are not ®nalized until year-end and are subject to auditor adjustment. Important accruals
and estimates for banks include loan loss provisions and loan charge-os.
Signi®cant judgement is involved in estimating these loan-related items (Sinkey, 1989, pp. 543±546; Wahlen, 1994, pp. 457±458; Beaver et al., 1989, p. 162).
The vast majority of regulatory oversight time is spent on the loan portfolio,
including loan classi®cation (as performing vs. non-performing), loan loss
provision, and loan charge-os (Mitchell, 1984, p. 19; May, 1991, p. 61; Koch,
1995, pp. 40±43). In the 1980s, regulatory pressure was increased in the areas of
loan portfolios and the allowance process (Walter, 1991, pp. 24±25; Spinard,
1992, p. 59). This regulatory pressure leads to potential disagreements with
bank managers whose judgement may be questioned (Fleischer, 1991, pp. 33±
35; Nadler, 1991, p. 19). The extent of con¯ict can be substantial over loan
charge-os, since an increased amount reduces capital dollar-for-dollar. A
change in the loan loss provision also directly aects earnings, but it has a
smaller, and opposite, eect on capital. 10
To summarize, for banks below a capital threshold that results in increased
regulatory scrutiny, we expect auditor conservatism to prevail in con¯icts with
10
During the period of study, the primary capital adequacy ratio was de®ned as the book value of
stockholders' equity plus the loan loss allowance divided by total assets plus the loan loss allowance
(Scholes et al., 1990, p. 642; Beatty et al., 1995, p. 233). Capital is therefore increased by increasing
the loan loss allowance, which can be accomplished by increasing the provision or decreasing
charge-os. Increasing the provision by $1 increases the allowance by $1 and reduces book net
income by $1 1 ÿ t, where t equals the marginal tax rate for book purposes. The net eect is to
increase capital by $1 t. Decreasing charge-os by $1 increases the loan loss allowance by $1 and,
consequently, increases regulatory capital by $1.
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managers that involve accounting discretion over items subject to year-end
adjustment (e.g., loan loss provisions and loan charge-os). For completed
transactions (e.g., securities gains and losses, and dividends), we expect auditors are not able to restrict managers' use of discretion.
2.3. High capital banks
The shift of power to auditors that occurs when a bank is in poor ®nancial
health should shift back towards managers when a bank is in good ®nancial
condition. Further, since federal bank examiners operate in a resource-constrained environment, they concentrate their scarce audit resources on low
capital banks, not those with high capital (e.g., Federal Deposit Insurance
Corporation, 1988, p. 4). For example, during the period of this study (1987
and 1988), a goal of the FDIC was to audit troubled banks on a yearly basis,
but only to perform ®eld audits on non-troubled banks every two years
(Federal Deposit Insurance Corporation, 1988, p. 4). These two factors suggest
that managers' incentives should become dominant for all discretionary
accounting and ®nancing choices when capital is relatively high.
Yet, we expect managers of ®nancially healthy banks to no longer focus on
increasing capital and/or earnings. Managers may make positive or negative
discretionary accruals to maximize payments under a bonus plan (Healy, 1985,
pp. 86±87), to comply with accounting provisions in contracts (Watts and
Zimmerman, 1986, pp. 179±199), or to smooth income (Beatty and Harris,
1999, p. 30; Ronen and Sadan, 1981). Depending upon a bank's incentives,
managers may want to increase or decrease income. As explained in Section
2.4, we expect above-threshold public banks to manage earnings to a greater
extent than above-threshold private banks.
We also expect mangers of above-capital-threshold banks to incorporate the
eect of taxes in their discretionary choices. The marginal corporate tax rate
should aect the level of loan charge-os and realized securities gains and
losses but not loan loss provisions and dividends since these items do not aect
corporate taxable income (Collins et al., 1995, pp. 268±270). Following Scholes
et al. (1990, p. 633), we estimated relative marginal tax rates using the proportion of assets represented by municipal bond holdings. Higher levels of
municipal bonds are a surrogate for a higher marginal tax rate. As the marginal
tax rate increases, each dollar of loan charge-o provides a greater tax shield
and each dollar of realized securities gain costs more in taxes. As a result, we
expect a positive (negative) relationship between the marginal rate and loan
charge-os (net security gains). 11 These relationships are consistent with extant
11
We expect this relationship to be evident for banks above and below the capital threshold.
F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
211
literature (Scholes et al., 1990, p. 645; Collins et al., 1995, p. 270; Beatty et al.,
1995, p. 242; Beatty and Harris, 1999, p. 309).
2.4. Public and private bank comparisons
Empirical accounting research that explores dierences between public
and private ®rms is limited ± primarily because data are extremely dicult
to obtain. 12 Further, the banking literature contains relatively little theoretical work to guide our tests. Our analysis is therefore somewhat exploratory.
Unlike our tests for below- and above-capital-threshold banks, for public
and private banks we are not interested in whether the discretionary actions are
dierent from zero, but whether the actions of public and private banks are
dierent from one another. Our expectations are stated accordingly.
For banks with capital below the threshold, we do not expect any substantial dierences between the discretionary actions of public and private
banks. Auditors would continue to seek conservative numbers, and managers
would prefer to report higher capital and/or earnings. However, for abovecapital-threshold banks, we expect the discretionary actions of public and
private banks will diverge.
The manager and/or owner of a private bank typically has a greater proportion of his or her personal wealth concentrated in bank ownership (Sullivan
and Spong, 1998, p. 22). Hughes and Mester (1998, pp. 314±317) show managers use capital to signal risk and that there is a negative relationship between
capital and risk. Thus, compared to public banks, we expect private banks to
have higher capital (signaling lower risk) and to take discretionary actions to
maintain or improve capital. This can be accomplished by above-threshold
private banks recording a larger loan loss provision, more net securities gains,
fewer loan charge-os, and lower dividend payouts when compared to abovethreshold public banks.
In the case of the earnings incentive for banks above the capital threshold,
consistent with Beatty and Harris (1999, p. 302), we argue that information
asymmetry between managers and stockholders and/or agency cost issues will
result in greater earnings management by public banks when compared to
private banks. This could result in public banks making greater use than
private banks of the loan loss provision and net securities gains to smooth
income.
In Section 2.3 we argued that, ceteris paribus, banks seek to maximize the
tax shield provided by deductions and minimize the tax cost imposed on
12
For some available research, see Beatty and Harris (1999), Cloyd et al. (1996), and Penno and
Simon (1986).
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income. Cloyd et al. (1996, pp. 25±26) present evidence consistent with the
notion that private ®rms are more inclined to make decisions that increase taxrelated cash ¯ows when compared to public ®rms. Thus, we expect abovethreshold private banks will record greater loan charge-os and fewer net
securities gains than will above-threshold public banks, for a given a marginal
tax rate.
Our expectations for public and private banks are summarized at the bottom of Table 9.
3. Sample
The sample data were obtained from annual FDIC tapes. These tapes report
®nancial and other data for each bank covered by FDIC deposit insurance
(substantially all banks in the US). Data are provided at the individual bank
level, rather than as a consolidated group. The data are from 1987 and 1988.
These years were chosen because they are in the middle of a time period in
which capital ratio rules were stable (e.g., Koch, 1995, p. 389). Capital adequacy rules changed in 1985 and risk-adjusted capital standards were adopted
in late 1989 (to become fully eective in 1992) (e.g., Koch, 1995, p. 389). Thus,
1987 and 1988 are years in which bank data should be relatively free from nonrecurring adjustments for changes in capital adequacy regulations. 13
Table 1, panel A reports the number of banks used in the analysis, the
number removed, and the reasons for their removal. We ®rst deleted mutual
savings banks, foreign banks, banks in US possessions, and non-banks (banks
with Bank Charter Codes of 30 and above). 14 Next, new banks, those not in
existence for at least four years as of the end of the year, were removed because
evidence suggests that they are structured and operated in a dierent manner
than established banks (e.g., Avery and Belton, 1987, p. 252). 15 Small banks,
13
As suggested by a reviewer, the in¯uence of proposed changes in capital adequacy requirements
on bank accounting and ®nancing choices is also a subject worthy of study. Knowledge of behavior
under capital requirements that do not vary provides a benchmark for studying the eect of
changes.
14
These banks are included on the tapes because they must report to the FDIC, similar to
domestic banks. However, their regulatory structure diers substantially from other banks. Mutual
savings banks are similar to savings and loan institutions and are subject to regulations which
dier, in many material respects, from those for commercial banks. For the other types of banks
listed, their operations and, in many cases, primary regulators dier from those of US banks.
15
New banks require a number of years of operation before ®nancial statement balances re¯ect
normal operating relationships. For example, loans to total assets are low until the loan portfolio
becomes mature; loans are not seasoned so loan losses are more dicult to estimate; and new banks
have lower interest expense as a percentage of assets since liabilities are a smaller proportion of the
balance sheet (Avery and Belton, 1987, p. 252).
F. Niswander, E.P. Swanson / J. Accounting and Public Policy 19 (2000) 201±235
213
Table 1
Sample informationa
Panel A: Number of observations
Banks on the FDIC tapes each year
Less reductions for:
Savings banks, foreign banks, banks in
possessions, and non-banks (charter codes
30 or higher)
Banks not in existence for 4 years as of
12/31/87 or 12/31/88, as appropriate
Assets less than $10 million
Zero assets, zero operations, zero loans,
in liquidation, or missing data required
to construct regressions
Total useable observations
1987
1988
14,799
14,246
1,183
1,202
853
684
785
726
358
302
11,620
11,332
Panel B: Observations classi®ed as public/private and high/low capital
PFCAP
PFCAP
1987 Data