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Review of Accounting Studies

Erschienen in:

01.03.2009

Publicly traded versus privately held: implications for conditional conservatism in bank accounting

verfasst von: D. Craig Nichols, James M. Wahlen, Matthew M. Wieland

Erschienen in: Review of Accounting Studies | Ausgabe 1/2009

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Abstract

Compared with privately held banks, publicly traded banks face greater agency costs because of greater separation of ownership and control but enjoy greater benefits from access to the equity capital market. Differences in control and capital market access influence public versus private banks’ accounting. We predict and find that public banks exhibit greater degrees of conditional conservatism (asymmetric timeliness of the recognition of losses versus gains in accounting income) than private banks. We predict and find that public banks recognize more timely earnings declines, less timely earnings increases, and larger and more timely loan losses. Although public ownership gives managers greater ability and incentive to exercise income-increasing accounting, our findings show that the demand for conservatism dominates within public banks and that the demand for conservatism is greater among public banks than private banks. Our results provide insights for accounting and finance academics, bank managers, auditors, and regulators concerning the effects of ownership structure on conditional conservatism in banks’ financial reporting.

Vorheriger Artikel Experimental evidence of how prior experience as an auditor influences managers’ strategic reporting decisions

Nächster Artikel Tightening credit standards: the role of accounting quality

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Several notable studies examine private firms. Using data on small private companies, Ang et al. (2000) find that agency costs increase as managerial ownership percentages decline. However, they do not examine the tradeoffs of the public/private decision nor do they examine conservatism. Kwan (2004) provides univariate descriptive statistics on risks and returns across public and private banks but does not test the tradeoffs in the public/private decision or conservatism. Two studies examine earnings management across public and private banks. Beatty and Harris (1998) examine public and private banks’ realizations of securities gains and losses to manage reported earnings in response to tax, agency cost, and information asymmetry pressures. Beatty et al. (2002) compare public and private banks’ propensities to avoid earnings declines by managing realizations of securities gains and losses and the discretionary component of loan loss provisions.

In his AAA Presidential Lecture, Endogenous Expectations, Demski (2003) calls for more research on the nature of endogenously determined variables such as organizational structure and accounting information.

Beaver and Ryan (2005) adopt the term ‘conditional conservatism’ to distinguish the asymmetric timeliness of gain/loss recognition from unconditional conservatism, the predetermined understatement of the book value of net assets (for example, immediate expensing of the costs of internally developed intangible assets or accelerated depreciation or amortization lives that are shorter than expected economic lives of assets). In this paper we also adopt the term conditional conservatism and for expediency often refer to it simply as ‘conservatism.’

Testing these predictions empirically is difficult, however, because prior research provides little guidance on the determinants of the public/private choice, and those determinants likely are determined endogenously with factors that affect accounting. We therefore implement the Heckman (1979) two-stage approach to control for endogeneity bias in our empirical tests.

For example, the most stringent listing requirements are those of the NYSE, which requires firms to have a minimum size of $60 million in market value and 500 investors in order to list. Firms must maintain at least $15 million in market capitalization to remain listed on NYSE.

The thrift crisis of the 1980s and episodic bank failures (for example, Barings Bank in the early 1990s) illustrate the costly nature of these types of moral hazard and adverse selection problems.

If a private bank elects S-corporation status for tax purposes, its equity shares can become even less liquid due to tax law constraints.

Indeed, many of the current controversies about accounting principles involve verifiability (for example, estimating fair values for stock option grants and financial instruments and testing intangible assets for impairments).

Watts (2003, p. 207) states, “Conservatism is defined as the differential verifiability required for recognition of profits versus losses. Its extreme form is the traditional conservatism adage: ‘anticipate no profit, but anticipate all losses.’” Similarly, Guay and Verrecchia (2006) define conservatism as “More timely recognition of losses than gains resulting from asymmetric costs and benefits of reporting verifiable information by managers and/or firms with incentives to distort firm performance.”

Watts (2003) captures a similar distinction with news-dependent conservatism.

Although nonperforming loans are relatively nondiscretionary, bank managers can exercise two forms of discretion over them. First, they can make new loans to distressed borrowers to enable them to make payments on their existing loans and keep them ‘performing’ (reportedly a common practice among U.S. banks with loans to developing countries from the 1970s until 1987). Second, they can elect to charge off nonperforming loans. Both of these steps can be costly to banks, so we expect nonperforming loans to be relatively nondiscretionary.

Banks recognize loan chargeoffs by writing down the outstanding balance in loans receivable and the loan loss allowance by the uncollectible amount of the loan. Thus, a loan chargeoff has no effect on net income, total assets, or shareholders’ equity. Banks disclose loan chargeoffs in footnotes to the financial statements.

Federal regulators require that banks maintain a Tier 1 Capital Ratio of at least 10% (6%) to be deemed well-capitalized (adequately-capitalized). The Tier 1 Capital Ratio computation is roughly equal to common equity over total assets. In addition, banks must have a Risk-Based Capital Ratio of at least 6% (4%) to be deemed well-capitalized (adequately-capitalized). The Risk-Based Capital Ratio computation is roughly equal to common equity over risk-adjusted assets, in which low-risk assets such as cash receive very low weight, and risky assets such as loans receive full weight.

The existence of federally subsidized deposit insurance for banks creates a potential moral hazard problem between regulators (agents representing depositors) and bank managers (agents entrusted with depositors’ capital). Public and private banks alike have incentives to avoid or delay recognizing losses to remain adequately capitalized and maintain access to federal deposit insurance. These incentives could reduce conservatism, but they should not bias our tests of differences in conservatism across public and private banks.

Cloyd, Pratt, and Stock (1996) conduct a survey-based experiment and find that private bank managers are more likely than public bank managers to manage earnings downwards to reduce taxable income.

In theory, the choice to be public or private is an ongoing one (that is, banks can change ownership status at any point), and therefore ownership status and profitability, growth, risk, and conservatism are simultaneously determined. The data suggest that banks do not change ownership status frequently, so we treat ownership status as a predetermined correlated variable rather than as a simultaneously determined variable.

Viewing the choice to be public or private as the first stage model and our regressions as the second stage model, the correlation between first stage and second stage error terms produces biased and inconsistent estimates of the marginal effect of Dpub on the second stage dependent variables. This occurs because Dpub, which is a function of the first stage error term, is correlated with the second stage error term (Greene 2000). The inverse Mills ratio correlates with the expected value of the first stage error term, given the bank’s observable characteristics and ownership status. Thus, including the inverse Mills ratio in second stage regressions controls for the correlation between Dpub and the second stage error terms and produces consistent second stage Dpub coefficient estimates.

Ideally, our determinant variables would consist of the expected future costs and benefits that banks consider when evaluating public versus private ownership status. Given that these factors are unobservable, we rely on ex post realizations as proxies for ex ante expectations.

We examined several variations of the first-stage selection model (Eq. 2), altering several determinant variables. In general, the results reported in this paper for the first stage estimation and the second stage tests are robust to the different specifications we examined.

In untabulated results, we find that public and private banks have statistically indistinguishable proportions of loan portfolios in nonperforming status after controlling for size, loan portfolio composition, and endogeneity in the public/private decision. This suggests public banks do not take more loan portfolio risk than private banks, all else equal. Consequently, differences in credit risk are unlikely to explain our results.

We predict that β₁ (the coefficient on ΔNPL_t−1 for private banks) and β₇ (the coefficient on Dpub * ΔNPL_t−1 for public banks) will be positive. A positive relation between LLP_t and ΔNPL_t−1 may suggest that banks’ loan loss provisions recognize loan losses with some degree of delay (for example, untimely loss recognition, which is inconsistent with conservatism). We believe it is more likely that such a relation reflects that banks revise their loan loss expectations in year t when new information arrives in year t about the likelihood of loss for loans that became delinquent during year t − 1.

Also, loan loss provisions increase loan loss allowances, which increase Tier 2 regulatory capital ratios (Collins et al. 1995; Beatty et al. 1995; Ahmed et al. 1999; Kanagaretnam et al. 2003).

In untabulated tests, we allow the coefficient on the change in nonperforming loans to vary with the sign of the change. Compared with private banks, we find that loan loss provisions for public banks more strongly relate to changes in nonperforming loans only for bad news about credit losses (that is, increases in nonperforming loans), consistent with greater conditional conservatism.

Ryan (2007, p. 118) notes that overstated loan loss allowances should not be argued to be acceptable or beneficial applications of conservatism because they yield misleading financial reporting and provide banks with considerable ability to smooth or manage upward future reported income.

Loan recoveries can reflect bank managers’ changing expectations about collectability (for example, favorable information), in which case public bank managers may recognize less timely recoveries (relative to LCOs) because of conditional conservatism (delayed recognition of 'good news'). Loan recoveries can also reflect unexpected cash realizations (for example, favorable realizations of collateral values), in which case public banks may recognize less timely recoveries (relative to LCOs) because the accounting for the LCOs was conservative (the LCOs were timelier).

The significant positive coefficient on Dpub suggests that recoveries of charged-off loans from periods before t − 1 are greater (less timely) for public banks than for private banks, indicating more conservative accounting for recoveries.

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Titel: Publicly traded versus privately held: implications for conditional conservatism in bank accounting
verfasst von: D. Craig Nichols
James M. Wahlen
Matthew M. Wieland
Publikationsdatum: 01.03.2009
Verlag: Springer US
Erschienen in: Review of Accounting Studies / Ausgabe 1/2009
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-008-9082-3

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