The Cyclicality of Loan Loss Provision and Income Smoothing Behavior of Commercial Banks Pre and Post IFRS: Evidence from Ethiopia

Samrawit Shiferaw Almaw

doi:10.7176/rjfa/12-3-02

Abstract

Loan loss provision is the significant accrual in the banking sector. This accrual is necessary to lessen the expected credit losses, but in some extent, these accruals would be used for earning management purpose. Thus, the main purpose of this paper is to examine the cyclicality of loan loss provisions and income smoothing behavior of Ethiopian commercial banks in comparison of pre and post IFRS. Explanatory type of research design applied in this research. The paper used unbalanced panel of Ethiopian commercial banks for the period 2010-2019. In order to examine the income smoothing behavior and the cyclicality loan loss provisioning system, pooled panel data regression model has been used following the appropriate test and the complete specification of the model. The result of this paper revealed that loan loss provision of commercial banks in Ethiopia follows a dynamic provisioning system. There is also an evidence that support the existence of income smoothing behavior after IFRS adoption but not before. Moreover, this paper supports the capital management hypothesis and the result shows that IFRS do not intervene for capital management behavior of Commercial banks. Thus, the paper concludes that IFRS adoption in Ethiopian commercial banks do not enhance the reporting quality of banks. These findings suggest that the regulatory body of commercial banks (National bank of Ethiopia) and the regulatory body (including councils) of financial reporting (Accounting and audit board of Ethiopia) should strictly follow-up the adoption of IFRS in the banking sector. DOI: 10.7176/RJFA/12-3-02 Publication date: February 28 th 2021

Highlights

Bank loan loss provision is an amount set aside by banks to mitigate expected losses on the bank loan portfolio (Yang, 2001 as cited in Desta, 2017; Alhadab & Alsahawneh, 2016)
This study examined the cyclicality of loan loss provision and the income smoothing behavior of commercial banks in Ethiopia
The findings indicate that Ethiopian commercial banks were not use loan loss provision (LLP) for income smoothing behavior, after International Financial reporting standards (IFRS) adoption, commercial banks use LLP as income smoothing tool

Summary

Introduction

Bank loan loss provision is an amount set aside by banks to mitigate expected losses on the bank loan portfolio (Yang, 2001 as cited in Desta, 2017; Alhadab & Alsahawneh, 2016). If lending rates accurately reflected credit risks and as capital is still needed to cover unexpected losses, why banks set aside additional provisions? Banks might even take negative provisions if riskiness were reversed. Banks have discretionary power to vary loan loss provisions from negative to positive (max limited on the amount of total loan) for/by different motives (Desta, 2017; Alhadab & Alsahawneh, 2016, Laeven & Majnoni, 2003)

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