The Allowance for Loan Losses and Earnings Management

Abstract

The purpose of the Allowance for Loan Losses (Allowance) is to adjust gross loans for credit quality. Prior research has given conflicting evidence on whether Bank Holding Companies (BHCs) manage earnings through the Allowance. This paper reveals findings from a two stage regression for all BHCs in the U.S. over $150 million in assets from 1992-2003. Initially the Allowance is regressed against disclosed credit quality variables to test the extent the Allowance meets its purpose through public disclosures. Then the absolute value of the residual is regressed against hypothesized earnings management variables. Since size is found to be significant, the data is divided into three panels by BHC size and is analyzed separately for annual disclosures and quarterly disclosures. The hypothesized earnings management variables relating to a BHC's capital ratio, the absolute value of the change in its prior tax prior provision earnings, and the absolute value of the change in the Allowance are significant in most panels. For quarterly data the largest BHCs show significantly more evidence of earnings management than the other BHCs. These results are consistent with the hypothesis that large BHCs manage quarterly earnings. There is no support for hypotheses that the SEC case against SunTrust induced BHCs to reduce earnings management or that added disclose for loans past due more than 30 days has decreased earnings management.