b s t r a c t
This paper examines whether corporate governance mechanisms affect earnings and earnings management at the largest publicly traded bank holding companies in the United States. We first find that performance, earnings management, and corporate governance are endogenously determined. Thus, OLS estimation can lead to biased coefficients and a simultaneous equations approach is used.We find that CEO pay-for-performance sensitivity (PPS), board independence, and capital are positively related to earnings and that earnings, board independence, and capital are negatively related to earnings management. We also find that PPS is positively related to earnings management. Finally, PPS and board independence are positively related and the relationship is bidirectional. While both PPS and board independence are associated with higher earnings, our results indicate that more independent boards appear to constrain the earnings management that greater PPS compels.
1. Introduction
Accountants and financial economists have recognized for years that firms use latitude in accounting rules to manage their reported earnings in a wide variety of contexts. Healy and Wahlen (1999) conclude in their review article on this topic that the evidence is consistent with earnings management “to window dress financial statements prior to public securities offerings, to increase corporate managers' compensation and job security, to avoid violating lending contracts, or to reduce regulatory costs or to increase regulatory benefits.”1 Since then, evidence of earnings management has only mounted. For example, Cohen et al. (2004) find that earnings management began to increase steadily around 1997, peaking in 2002. Performance-based compensation (e.g., option and stock) emerged as a particularly strong predictor of aggressive accounting behavior in these years (see Gao and Shrieves, 2002; Cohen et al., 2004; Bergstresser and Philippon, 2006; Cheng and Warfield, 2005). While there is an extensive literature on opportunistic earnings management in response to specific incentives to achieve one result or another, research looking at the impact of corporate governance on earnings management is quite limited. The few papers that address these issues (e.g., Klein (2002) and Warfield et al. (1995)) focus more on the magnitude than the direction of earnings management, and thus shed little light on the ability of these variables to offset the one-sided incentive of management to increase reported earnings that results from stock and option-based compensation.2 More recently, Cornett et al. (2008) examine the impact of incentive-based compensation and corporate governance on firm performance in light of potential earnings management. They find that incentive-based compensation has a significant impact on financial performance as measured by reported earnings. However, once earnings are adjusted for discretionary accruals the link between compensation and performance disappears. In contrast, the estimated impact of corporate governance variables on performance more than doubles when discretionary accruals are removed from measured profitability. This study examines earnings management at publicly traded commercial bank holding companies in the United States and particularly howcorporate governance mechanisms affect earnings management. For all but the worst performing banks, a bank's management has discretion with respect to the size of loan loss provisions as well as realized security gains and losses recorded in any period. Thus, during periods of low profit in other areas of the bank, management can smooth earnings by delaying reporting loan losses and increasing the realization of securities gains. Management discretion in these areas implies that management of commercial bank earnings can impact a bank's performance, cash flows, market value, and capital adequacy. Indeed, despite monitoring and oversight by regulators a bank's reported loan loss provisions and realized securities gains and losses are largely under the control of its managers. Rather than unwaveringly smoothing earnings, managers can use discretion to attain their own goals (i.e., to increase performance based compensation) by putting constant upward pressure on reported earnings, which runs counter to regulators' desires (i.e., earnings management can be used to artificially inflate reported capital adequacy ratios). We study earnings management at publicly traded U.S. commercial bank holding companies during the 1994 through 2002 period.3 In particular, we look at the interactions between firm performance, corporate governance mechanisms, and earnings management. We also examine whether the various corporate governance mechanisms and earnings management tools are chosen jointly or independently from each other. To do this, we model the interactions of firm governance, earnings management, and firm performance in a simultaneously determined system of equations that accounts for endogeneity.4 As noted earlier, the interaction of earnings management and corporate governance has been examined by Cornett et al. (2008). However, this study did not include bank holding companies. Adams and Mehran (2003) and Macey and O'Hara (2003) find systematic differences between the governance of banking and manufacturing firms and highlight the point that governance structures are industry specific. Thus, the results found in this paper for banks may very well be different than those found for nonbanks.