EARNINGS MANAGEMENT USING EARNINGS MANAGEMENT USING LOAN LOSS PROVISIONS IN LOAN LOSS PROVISIONS IN

BULGARIAN BANKSBULGARIAN BANKS

Presenter : Azlan AliPresenter : Azlan AliCo-authors: Fanya Filipova, Anita AttanasovaCo-authors: Fanya Filipova, Anita Attanasova

University of Economics, VarnaUniversity of Economics, VarnaBulgariaBulgaria

INTACCT WORKSHOPINTACCT WORKSHOPVarnaVarna

44--55 March 2010 March 2010

IntroductionIntroductionPurpose of the studyPurpose of the studyContributionContributionBanking development in BulgariaBanking development in BulgariaLiterature reviewLiterature reviewConjecture Conjecture Data and MethodologyData and MethodologyStatistical resultStatistical resultConclusion, limitations and suggestionConclusion, limitations and suggestion

Purpose of the studyPurpose of the studyTo investigate earnings management To investigate earnings management through loan provisions by commercial through loan provisions by commercial banks in Bulgaria, and how corporate banks in Bulgaria, and how corporate governance mechanisms affect earnings governance mechanisms affect earnings management. management.

Bulgaria presents an Bulgaria presents an unique studyunique study – Banks in Bulgaria are officially obliged to adopt IFRS for their Banks in Bulgaria are officially obliged to adopt IFRS for their

financial reporting purposes since 2003, according to the financial reporting purposes since 2003, according to the Bulgarian Accounting Law (BAL) and since 2002 according to Bulgarian Accounting Law (BAL) and since 2002 according to National Accounting Standards (NAS). National Accounting Standards (NAS).

– Dependence of economy on banks (Koford and Tschoegl ,1999)Dependence of economy on banks (Koford and Tschoegl ,1999)

Potential ContributionsPotential Contributions

This study will provide a positive This study will provide a positive contribution to existing research on contribution to existing research on banking industry, especially in the banking industry, especially in the countries that are under the transition.countries that are under the transition.

Pioneer work on Bulgarian commercial Pioneer work on Bulgarian commercial banks banks

Potential ContributionsPotential Contributions

Interesting findings in an environment that Interesting findings in an environment that obviously differ from Anglo-Saxon systems obviously differ from Anglo-Saxon systems in terms of corporate governance. in terms of corporate governance. – the lower risk of litigation, as compared to the the lower risk of litigation, as compared to the

responsive US litigation system.responsive US litigation system.– highly concentrated of ownership structure vs. highly concentrated of ownership structure vs.

widely held ownership structure in the USwidely held ownership structure in the US

Banks in BulgariaBanks in BulgariaBanking industries have a great importance Banking industries have a great importance to Bulgarian economic. to Bulgarian economic. – Total assets of Bulgarian commercial banks at Total assets of Bulgarian commercial banks at

the end of 2007 stood about 105 per cent of the end of 2007 stood about 105 per cent of Gross Domestic Product and at the end of in Gross Domestic Product and at the end of in 2009- they are valued around 70.9 billion 2009- they are valued around 70.9 billion Bulgarian leva.Bulgarian leva.

– Small number of banks – 30Small number of banks – 30– Foreign controlled 22 banks , only 1 bank Foreign controlled 22 banks , only 1 bank

controlled by statecontrolled by state

Banks in BulgariaBanks in Bulgaria– Only 5 banks are listed in the Bulgarian stock Only 5 banks are listed in the Bulgarian stock

marketmarket– provider of funds for corporationsprovider of funds for corporations– The banking system is highly capitalized with The banking system is highly capitalized with

most banks continuously to record high capital most banks continuously to record high capital adequacy ratio (CAR) above than EU banking adequacy ratio (CAR) above than EU banking standard (between 4-8%).standard (between 4-8%).

– banks in Bulgaria are the earliest mandatory banks in Bulgaria are the earliest mandatory adopter of IAS/ IFRS in Europe and among the adopter of IAS/ IFRS in Europe and among the earliest mandatory adopters in the world:earliest mandatory adopters in the world:

LiteratureLiterature

Earnings management Earnings management – defined as the used of managerial discretion defined as the used of managerial discretion

to influenceto influence the accounting figures published the accounting figures published to the company’s stakeholders (Degeorge et to the company’s stakeholders (Degeorge et al., 1999, p. 2).al., 1999, p. 2).

– is recognized as attempts by management to is recognized as attempts by management to influence or manipulate reported earnings by influence or manipulate reported earnings by using specific accounting methodsusing specific accounting methods

LiteratureLiterature3 groups of discussions for an earnings management 3 groups of discussions for an earnings management research model in Bulgaria research model in Bulgaria

FactorsFactors which are influencing Earnings Management in which are influencing Earnings Management in banks and in any company; banks and in any company; – Financial systemFinancial system– Accounting standardsAccounting standards– Legal system – lack of investor protection, intensity Legal system – lack of investor protection, intensity

and effectiveness of prosecutionand effectiveness of prosecution– Quality of corporate governance – ownership Quality of corporate governance – ownership

structure, board characteristic, auditors rolesstructure, board characteristic, auditors roles– Level of economy developmentLevel of economy development– Economy and monetary policiesEconomy and monetary policies

LiteratureLiterature

IncentivesIncentives (motives, objectives) (motives, objectives) – for Earnings management- this is more for Earnings management- this is more

subjective and closely connected with subjective and closely connected with management in the banks and bank policy; management in the banks and bank policy; the most important for modeling and research, the most important for modeling and research, according to our opinion; according to our opinion;

– to satisfy financial analyst expectation and to satisfy financial analyst expectation and public reputation (public reputation (Burgstahler and Eames, Burgstahler and Eames, 1998; 1998; Blasco and Pelegrin, 2005Blasco and Pelegrin, 2005))

LiteratureLiterature– To avoid losses (Degeorge, Patel & To avoid losses (Degeorge, Patel &

Zeckhauser, 1999)Zeckhauser, 1999)– Managerial job’s concern and remuneration Managerial job’s concern and remuneration

((Kanagaretnam et al. 2003; Kanagaretnam et al. 2003; Karaoglu, 2004Karaoglu, 2004))– Competition (Bagnoli and Watts, 2000)Competition (Bagnoli and Watts, 2000)– Minimization of costs (Dechow et al. 1996 ; Minimization of costs (Dechow et al. 1996 ;

Stolowy and Breton, 2000) Stolowy and Breton, 2000) – Regulatory requirements (Zhou and Chen, Regulatory requirements (Zhou and Chen,

2004)2004)

LiteratureLiterature

ToolsTools– Discretionary accruals (Discretionary accruals (Degeorge et al.1999) Degeorge et al.1999) – Account manipulation and disclosuresAccount manipulation and disclosures– off–balance sheet financing, off–balance sheet financing, – related-party transactions, related-party transactions, – revenue recognition revenue recognition Blasco and Pelegrin Blasco and Pelegrin

(2005)(2005), , – loan and lease loss reserve (McNichols, loan and lease loss reserve (McNichols,

2000; Zhou and Chen, 2004; Cornett et al. 2000; Zhou and Chen, 2004; Cornett et al. 2006; Kanagaretnam et al. 2003)2006; Kanagaretnam et al. 2003)

Conjecture Conjecture

Banks use loan loss provisions for Banks use loan loss provisions for matching regulatory capital requirement matching regulatory capital requirement and smoothing incomeand smoothing incomeBank’s decision in loan loss provision is Bank’s decision in loan loss provision is influenced by corporate governance influenced by corporate governance mechanisms mechanisms

Data and MethodologyData and Methodology

– Sample from 18 Bulgarian banking institutions Sample from 18 Bulgarian banking institutions from 2005 until 2008. from 2005 until 2008.

– Data obtain from banks’ annual report. 8 variables Data obtain from banks’ annual report. 8 variables – LLP: Loan loss provisions/total average loansLLP: Loan loss provisions/total average loans– BSIZE: Number of board members;BSIZE: Number of board members;– BIG5: Dummy variable. 1 if the auditor is member BIG5: Dummy variable. 1 if the auditor is member

of the Big 5; 0 otherwiseof the Big 5; 0 otherwise– CGLN: Change in outstanding loans (in value)CGLN: Change in outstanding loans (in value)

Data and MethodologyData and Methodology– LWO: Write-offs loans/average total assets LWO: Write-offs loans/average total assets – SIZE: Log of Total AssetsSIZE: Log of Total Assets– CAR: Capital adequacy ratio.CAR: Capital adequacy ratio.– EBPT : Earnings before taxes and loan loss EBPT : Earnings before taxes and loan loss

provision/average total assetsprovision/average total assets..

MODELMODEL

LLPLLPitit = = ββ00 + + ββ11BSIZEBSIZEitit + + ββ22BIG5BIG5itit + +ββ33CARCARitit + + ββ44CGLNCGLNitit + + ββ55LWOLWOitit + + ββ66SIZESIZEitit + +ββ77EBTPEBTPitit + e + eitit

Descriptive StatisticsDescriptive Statistics

Notes : Notes : ** Correlation is significant at the 0.01 level** Correlation is significant at the 0.01 level * Correlation is significant at the 0.05 level* Correlation is significant at the 0.05 level

VariablesVariables MeanMean MedianMedian Std DevStd Dev MinMin MaxMax Corr. w/ Corr. w/ LLPLLP

LLPLLP 0.026 0.019 0.023 0.0011 0.106 1.0001.000

BSIZEBSIZE 8.22 8.0 2.04 13 5 -0.1211

BIG5BIG5 0.83 - 0.38 - - -0.0728

CARCAR 16.89 14 8.25 12.11 58.67 0.5718**

CGLNCGLN 447,909 195497 651683 -27,825 3,186,658 -0.2483

LWOLWO 0.0027 0.0008 0.0043 0 0.02204 -0.1915

SIZESIZE 13.90 13.895 1.1974 16.2148 -11.3528 -0.3638**

EBTPEBTP 0.0335 0.01570.0157 0.04250.0425 -.0001-.0001 0.18730.1873 -0.1311

Regression 1Regression 1Prediction sign Full sample

Intercept ? 0.1552 (2.51)**

BSIZE+ -0.00045

(-0.42)

BIG5+ 0.0252

(2.78)***

CAR+ 0.0013

(3.61)***

LWO+ -0.2161

(-0.41)

CGLN+ -1.06E-08

(-1.51)

SIZE? -0.0126

(-2.70)***

EBTP+

0.3234 (2.95)***Adj. R-squared 0.3723

Sensitivity analysisSensitivity analysis

LLPit = b0 + b1CGLNit + b2LWOit + eit

DLLPit = b0 + b1BSIZEit + b2 BIG5it +b3CARit + b4CGLNit + b5LWOit +b6SIZEit+ b7EBTPit + eit

Regression 2Regression 2Prediction sign Full sample

Intercept ? 0.131875(2.03)**

BSIZE+ -0.00045

(-0.42)

BIG5+ 0.025277

(2.78)***

CAR+ 0.00127

(3.61)***

CGLN+ -3.32E-09

(-0.47)

LWO1+ 0.3490494

(0.67)

SIZE? -0.0126377

(-2.70)***

EBTP+ 0.3233742

(2.95)***

Adj. R-squared 0.3681

ConclusionConclusionThis paper examines earnings management in This paper examines earnings management in Bulgarian commercial banks through specific Bulgarian commercial banks through specific accrual and also explores the impact of board size accrual and also explores the impact of board size and BIG5 auditors on earnings management. and BIG5 auditors on earnings management.

Board size is not an effective governance Board size is not an effective governance mechanism. This result indicates that the Anglo-mechanism. This result indicates that the Anglo-Saxon governance model may not appropriate in Saxon governance model may not appropriate in the transition economy condition.the transition economy condition.

ConclusionConclusionThe The appointment of appointment of Big FiveBig Five-audit firms do -audit firms do have impact with regards to management’s have impact with regards to management’s decision on discretionary LLP.decision on discretionary LLP.The results of this study support previous The results of this study support previous evidence on the motive of earnings evidence on the motive of earnings management in banks i.e. capital requirement management in banks i.e. capital requirement and smoothing income.and smoothing income.

ConclusionConclusion

This study also supports that discretionary This study also supports that discretionary loan loss provisions is used by Bulgarian loan loss provisions is used by Bulgarian commercial banks as earnings commercial banks as earnings management tool.management tool.

LimitationsLimitations

Small sample – 18 banksSmall sample – 18 banksLack of availability of corporate Lack of availability of corporate governance datagovernance data– Details on board of directors e.g. Details on board of directors e.g.

directorships, directors’ shareholding and directorships, directors’ shareholding and remunerationsremunerations

– Independent director statusIndependent director status

Variability in disclosure in annual reportsVariability in disclosure in annual reports

SUGGESTIONS & COMMENTSSUGGESTIONS & COMMENTS

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