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Article Excerpt
I. INTRODUCTION
Burgstahler and Dichev (1997) and Degeorge et al. (1999) document that publicly held firms report small declines in earnings less often than small increases in earnings. Although this pattern is consistent with managers using accounting discretion to avoid small earnings declines, an alternative explanation is that this pattern simply reflects the underlying distribution of earnings changes.
Our study investigates the validity of the earnings management explanation by examining the stream of earnings changes and the components of these changes for publicly vs. privately held bank holding companies (banks) during 1988-1998. (1) We focus on the public vs. private distinction because we argue that shareholders of public banks are more likely than those of private banks to rely on simple earnings-based heuristics, such as comparisons of current vs. prior period earnings, in evaluating bank performance. Therefore, we expect public bank managers to face more pressure to report consistently increasing earnings.
We focus on the banking industry because it provides comparable earnings data for a large number of both public and private firms. Data for private firms are rarely available in other industries. In addition, by focusing on the banking industry we can use industry-specific models of accounting discretion in the loan loss provision and realized security gains and losses (e.g., Beatty et al. 1995; Collins et al. 1995) to develop powerful tests of earnings management associated with small earnings changes.
We begin by replicating the analysis of small earnings changes that Burgstahler and Dichev (1997) conducted on a heterogeneous sample of public nonfinancial firms, to ascertain whether their inferences also hold in our samples of banks. We find that public banks report more small increases and fewer small decreases in earnings than expected. We find only weak evidence that private banks report fewer small decreases in earnings than expected. Furthermore, we find that public banks report more small increases and fewer small declines in earnings than private banks, even after controlling for differences in the operations of public vs. private banks, measured by bank size, asset growth, cash flows, loan characteristics, and geographic region.
If public banks' lower incidence of small declines in earnings is attributable to earnings management, then public banks should be more likely than private banks to use discretionary accounting choices to avoid reporting small declines in earnings. Consistent with this prediction, we find that public banks are more likely than private banks to use income-increasing discretionary loan loss provisions and realized security gains and losses to transform small declines in earnings before discretion to small increases in reported earnings.
Finally, if public banks are more likely than private banks to manage earnings to avoid reporting small decreases in earnings, then public banks, on average, should enjoy longer strings of consecutive earnings increases. Our tests confirm this expectation, even after controlling for differences in operating characteristics.
This study's results are important because we exploit a powerful setting to provide more direct and compelling evidence that the unusual pattern of small earnings increases of publicly held firms observed by prior research is due to earnings management and not to the underlying characteristics of the distribution of earnings changes. Our findings should be of interest to the SEC in its ongoing initiative against earnings management. In addition, our finding that private banks do not exhibit an abundance of small increases in earnings adds to our understanding of earnings management in private firms. Investors and auditors of private firms should be interested to learn that private firms are not as strongly inclined to report consistently increasing earnings.
We have organized the paper as follows. Section II compares public and private banks' incentives to manage earnings to achieve simple earnings-based benchmarks. Section III describes the research design, while Section IV describes the sample and provides descriptive statistics. Section V presents the results of the empirical tests, and conclusions appear in Section VI.
II. EARNINGS-BASED BENCHMARKS
Ownership of publicly traded firms in the United States is diffuse (Shleifer and Vishny 1997). Black (1992) argues that diffuse owners only obtain a small fraction of the benefits from monitoring firms' activities due to their small shareholdings. These benefits likely fall short of the costs of storing, retrieving, and processing all information available to assess financial performance. As a result, Burgstahler and Dichev (1997) conjecture that investors in publicly held firms rely on simple low-cost heuristics, such as earnings-based benchmarks, in firm valuation. (2)
Empirical evidence suggests that investors in publicly traded firms use simple earnings-based benchmarks in making firm valuation decisions. (3) Barth et al. (1999) demonstrate that firms with longer strings of consecutive earnings increases are priced at a premium, and that, when these firms experience declines in earnings, the premiums fall substantially. Similarly, DeAngelo et al. (1996) find that a break in a pattern of consistent earnings growth is associated with a substantial decline in stock price. The stock price penalties for falling short of prior earnings combined with the effect of stock price on manager's wealth (Core et al. 2000), gives managers of publicly held firms an incentive to report a pattern of increasing earnings. (4)
In contrast to publicly held firms, ownership of privately held firms is concentrated. Privately held firms usually have a small number of shareholders and substantial majority shareholder participation in the management, directions, and operations of the firm. For example, Nagar et al. (2001) find more than 84 percent of their sample of 2,776 privately held, small, nonfarm, nonfinancial corporations as of year-end 1992 have four or fewer owners. In addition, for nearly 75 percent of the firms, the manager is an owner. Shareholders of private firms, therefore, have a relatively low marginal cost of acquiring and disseminating information and reap a large share of the benefits. In addition, shares of private companies are rarely traded, leaving private shareholders with little incentive to assess firm value continuously. As a result, private investors are likely to use a fairly rich information set, rather than relying on simple earnings-based heuristics. Consistent with this argument, results in Ke et al. (1999) suggest that shareholders in private companies directly monitor management rather than rely on explicit earnings-based compensation contracts to determine compensation.
Relatedly, Beatty and Harris (1999) argue that private firms have both less information asymmetry and a greater proportion of long-run investors than public firms and, therefore, less incentive to manage earnings. Beatty and Harris (1999) provide evidence that private firms manage earnings less aggressively, but they do not consider the use of simple earnings-based heuristics and therefore do not examine small changes in earnings and the duration of consecutive earnings increases.
Based on these arguments, we predict that private banks report more small declines in earnings, fewer small increases in earnings, and shorter strings of consecutive earnings increases than do public banks. We test these predictions by comparing the distribution of changes in earnings around zero and the duration of strings of consecutive earnings increases for public and private banks.
Our analysis should not be affected by other incentives for earnings management. For example, regulators and depositors provide additional incentives for banks to manage earnings. However, FDIC insurance protects most depositors of public and private banks, and explicit regulatory reporting and capital requirements are the same for public and private banks. Incentives to manage earnings for these stakeholders should be similar across public and private banks, and therefore should not explain observed differences in earnings management.
Banks may have an incentive to manage earnings to minimize taxes, but we see no reason for taxation to increase the incentive to avoid small declines in earnings. In addition, tax rules are generally the same for public and private banks during our sample period. The one notable exception is that banks with less than $500 million in assets were allowed to take a tax deduction for the loan loss provision, while banks with more than $500 million in assets tax deduct their loan losses on a cash basis. Because private banks are likely to be smaller, this difference may confound our analysis of differential earnings management. To address this difference, we perform sensitivity tests of our loan loss provision analysis on both large and small private banks.
Public and private banks differ in their access to equity markets. Because public banks have more access to external equity financing, they are likely to be larger, to grow faster, and to be more profitable. Our empirical tests control for these differences by including measures of size, asset growth, and cash from operations. These controls should help mitigate concerns that the differences between public and private banks that we document are driven by differential economic performance, rather than by differences in earnings management incentives.
III. RESEARCH DESIGN
Univariate Analysis of Small Earnings Changes
Our first set of tests examines small changes in earnings for public and private banks. Similar to Burgstahler and Dichev (1997), we first examine histograms of the change in return on assets ([DELTA]ROA), which we calculate as the current year's net income less the previous year's net income, divided by total assets at the beginning of the previous year. In constructing our histograms we use a bin width of twice the interquartile range of the variable multiplied by the negative cube root of the sample size, as Degeorge et al. (1999) recommend. Based on this formula, the bin width we apply in the histograms is 0.0004.
To test whether the distribution of earnings...
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