Fair Value Accounting, Auditor Specialization, and Earnings Management: Evidence from the Banking Industry

Abstract

In this study, we examine whether the extent to which banks use the loan loss provision (LLP) and realized gains and losses on sales of investments to manage reported earnings is associated with the extent to which they hold assets that are recorded using fair value accounting. We argue and find that banks with a greater extent (or proportion) of assets reported using fair value accounting substitute LLP-based earnings management with transaction-based earnings management (i.e., earnings management achieved by timing the realization of gains/losses) to a greater extent. In addition, we find that banks engaging industry specialist auditors use less LLP-based and transaction-based earnings management. Our findings suggest that banks with a greater extent of assets reported using fair value accounting have a different and potentially less visible set of earnings management tools with which to achieve desired earnings outcomes. Our results should be informative to regulators, members of the banking industry, and academics interested in the association the use of fair value accounting and bank earnings management behavior.