The impact of oversight on earnings management in the banking industry

The purpose of this research is to investigate earnings management purposes in the banking industry via loan loss provisions using a sample of 156 banks from 19 European countries under the Single Supervisory Mechanism over the period 2006-2016. Using a regression analysis, banks are tested for income smoothing, capital management and signaling purposes. This study contributes to the literature exploring the relationship between accounting quality and earnings management objectives by analyzing which one of the latter is the most important determinant. It considers as explanatory variable the loan loss provisions since banks based their business on credit intermediation and have substantial latitude in determining the amount of provisions, which is banks’ main accrual. The hypothesis of income smoothing and signaling are strongly approved since loan loss provisions consist as a tool for smoothing the amount of net profit and to convey private information to the market; on the contrary the capital management purpose is not supported. Additionally, the analysis finds that non-discretionary components of loan loss provisions (essentially non-performing loans) have played important role, especially during the financial crisis. Furthermore, the research is aimed at investigating the peculiar regulatory and supervisory environment in the banking industry on the basis of a set of indexes included in the “Bank Regulation and Supervision Survey”, carried out by the World Bank. Differently from previous literature, this study emphasizes the role of on-site inspection as main supervisory tool and extends the analysis of the interaction between bank regulation and supervision and earnings management. The results demonstrate that such controls can influence the behavior of bank managers in terms of income smoothing and signaling practices. Therefore they can be considered as effective instruments able at reducing banks’ management accounting discretion, making financial statements more reliable.