Review of Accounting and Finance

Earnings Management to Reduce Earnings Variability: Evidence from Bank Loan Loss
Provisions
Kiridaran Kanagaretnam Gerald J. Lobo Robert Mathieu
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 Review of Accounting and Finance

Earnings Management to Reduce Earnings Variability:

Evidence from Bank Loan Loss Provisions
by Kiridaran Kanagaretnam, DeGroote School of Business, McMaster University,
Hamilton, Ontario, Canada L8S 4M4; Gerald J. Lobo, Whitman School of Manage-
ment, Syracuse University, Syracuse, NY 13244 - 2130, U.S.A. and Robert
Mathieu, School of Business and Economics, Wilfrid Laurier University, Waterloo,
Ontario, Canada N2L 3C5.

Abstract
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Prior research demonstrates that share prices reflect a risk premium that is associ-
ated with earnings variability. This suggests that managers can reduce the cost of
capital and increase share prices by reducing earnings variability. In this study, we
investigate bank managers' use of discretion in estimating loan loss provisions
(LLP) to reduce earnings variability. We find that banks with relatively high pre-
managed earnings have positive discretionary LLP and banks with relatively low
pre-managed earnings have negative discretionary LLP, results that are consistent
with the hypothesis of earnings management to reduce earnings variability. In addi-
tion, we find that bank managers' decisions to reduce earnings variability are related
to the need for external financing and to gains and losses on the sale of securities
which serve as substitutes for accomplishing their objective of earnings variability
reduction.
Key words: Earnings management, earnings variability, income smoothing, loan
loss provisions.
1. Introduction
The objective of this study is to investigate bank managers' incentives to manage
earnings to reduce their variability. Prior research demonstrates that share prices re-
flect a risk premium associated with earnings variability (Collins and Kothari, 1989;
Easton and Zmijewski, 1989; Barth, Landsman and Wahlen, 1995). Consequently,
managers can reduce the cost of raising capital by using their discretion in estimat-
ing certain components of earnings to reduce earnings variability. Managers will re-
duce reported earnings when pre-managed earnings are high and will increase
them when pre-managed earnings are low. This behavior is commonly referred to as
income smoothing. We investigate bank managers' use of discretion in estimating
loan loss provisions to reduce earnings variability.
Loan loss provisions (LLP), being one of the largest accruals of banks, can be
used in isolation to study such smoothing behavior. Bank managers estimate LLP to
reflect changes in expected future loan losses. This process allows them wide lati-
tude for discretion in the estimation of LLP. The SEC and bank regulatory agencies
have devoted considerable attention to how bank managers use that discretion. In
fact, the loan loss provision is one of the items under scrutiny by the SEC's task force
on earnings management (The Wall Street Journal, November 16, 1998). The
SEC's study of reserves stems from its broader concerns about earnings manage-
ment in banking and other industries. While some banks have been trimming loss re-
serves to increase earnings and bolster their banks' return on equity, there is

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 Volume 3 Number 1 2004

evidence that other banks have been conservative by overly providing for loan
losses (American Banker, June 29,1998). For example, on November 16, 1998 the
SEC ordered SunTrust Bank to trim the LLP it made in 1994,1995 and 1996, result-
ing in an upward restatement of Sun Trust's profits for the three years and a reduction
in its loan loss reserves to $666 million from $766 million.
After much debate on whether the alleged discretion over their major accrual
(i.e., LLP) is beneficial or detrimental to sound banking, the SEC and four bank regu-
latory agencies issued a statement on the allowance for loan losses of depository in-
stitutions (Federal Reserve Release, November 24, 1998). This statement
expresses their view that "[A]lthough management's process for determining loan
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loss allowance is judgmental and results in a range of estimated loss, it must not be
used to manipulate earnings or mislead investors " (italics added). These con-
tinuing concerns suggest that a study investigating bank managers' use of their dis-
cretion over LLP to smooth income and the underlying motives for that behavior
would be of significant interest and relevance to these regulatory agencies as well as
to academic researchers.
The extant literature on the use of LLP to manage earnings has mainly fo-
cused on detecting earnings management. However, the possible underlying mo-
tives that could explain bank managers' behavior remain largely unexplored. The
existing literature provides mixed evidence on the use of LLP to manage earnings.
Wahlen (1994) and Collins et al. (1995), among others, find evidence that banks use
LLP to manage income, whereas, Moyer (1990), Beatty et al. 1995), and Ahmed et
al. (1999) do not find support for the earnings management hypothesis. In this study,
we examine whether bank managers' incentives to use their discretion in estimating
LLP are related to earnings variability.
There is no clear consensus on how best to investigate earnings management
through LLP. Some studies examine earnings management towards a cross-
sectional target (Barth, Beaver and Wolfson, 1990; Beatty et al., 1995; among oth-
ers), while other studies use a time series target (e.g., Collins, Shackelford and
Whalen, 1995). Beatty et al. (1995) in their discussion on the earnings management
target state,
"|T]he use of cross-sectional comparisons is pervasive among ana-
lysts and regulators. For example, analysts often group banks by peer
group to generate relative performance ranks. Similarly, A User's
Guide for the Bank Holding Company Performance Report (published
by the Board of Governors of the Federal Reserve System) states that
"peer group ratio averages serves as a frame of reference for evalua-
tion of the financial conditions and performance of a specific company
relative with other firms with similar characteristics. This information
can be used as a benchmark against which to assess an individual
company's balance sheet structure and earnings." [p. 2-2] We have
also spoken to analysts and regulators about earnings management.
Although many believe it occurs, there was no consensus about its
form (i.e., toward a cross-sectional mean versus toward a time-series
mean) or its source (i.e., information versus monitoring)."

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 Review of Accounting and Finance

In this study, we investigate income smoothing towards both a time series tar-
get and a cross-sectional target. We hypothesize that the incentives to smooth in-
come are greater for banks with high or low levels of pre-managed income, relative
to other banks. More specifically, we test whether banks with relatively high pre-
managed income have high LLP (i.e., positive discretionary LLP) and banks with
relatively low pre-managed income have low LLP(i.e., negative discretionary LLP).1
The incentives and abilities of bank managers to smooth earnings through
LLP are likely to be affected by bank-specific factors. We study three such factors
that may influence the income smoothing behavior of bank managers. First, we ex-
amine incentives to reduce the cost of external borrowing to finance growth and/or to
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expand the lending portfolio. Second, we examine whether bank managers use
gains or losses from sale of securities as an alternative vehicle for smoothing earn-
ings. Third, we examine the effect of a bank's capitalization level on the extent of in-
come smoothing. Well-capitalized banks have less restrictions and less regulatory
supervision, thus allowing them more room to smooth earnings relative to poorly
capitalized banks.
Our results are consistent with the hypothesis that banks use LLP to smooth
earnings. More precisely, we provide evidence that managers use the discretionary
component of LLP to reduce the variability in earnings. We observe positive (nega-
tive) discretionary LLP for banks with a high (low) pre-managed relative perform-
ance, consistent with our hypotheses. Furthermore, the results of the multivariate
analysis indicate that managers take into account the need for external financing in
determining the discretionary component of LLP. The results also indicate that
banks use gains and losses on the sale of securities as a substitute for LLP to ac-
complish their income smoothing objectives. The results of the impact of bank capi-
talization on income smoothing behavior are not as clear, perhaps because
regulatory pressures may be asymmetrical. That is, regulators may prefer all banks
to be conservative in estimating LLP; however, only well-capitalized banks may
have the flexibility to increase earnings.
The remainder of this paper is organized as follows. We provide the rationale
for our hypotheses in Section 2. Section 3 describes the data and sample selection
process. We discuss our research design and results in Section 4 and present our
conclusions in Section 5.
2. Hypotheses Development
We begin this section by formally stating our income smoothing hypothesis. We then
present arguments linking three bank specific variables, namely, need for external fi-
nancing, alternative means of smoothing earnings, and bank capitalization, to
cross-sectional differences in income smoothing.
2.1 Income Smoothing Hypothesis
Managers of banks have incentives to smooth income to reduce the variability in re-
ported earnings. By reducing earnings variability, bank managers can reduce per-
ceived risk because earnings variability is a key indicator of risk. To smooth income,
a bank manager takes actions to increase reported income when actual income is

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 Volume 3 Number 1 2004

low, takes actions to decrease reported income when actual income is high, and
takes no action to adjust income when it is in line with expectations.
Gebhardt, Lee and Swaminathan (2001) provide evidence that the implied
risk premium is consistently higher for commercial banks and that variability and
predictability of earnings are key factors in explaining cross-sectional differences in
the implied risk premium.2 Financial practitioners often regard the variability of re-
ported earnings as a source of risk for firm valuation. In addition, earnings variability
is likely to capture fundamental cash flow risk (Gebhardt et al., 2001). Barth, Lands-
man and Wahlen (1995) argue that bank shareholders will require a higher risk pre-
mium for the increased risk perceived from a more variable earnings stream.
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Therefore, managers of banks with higher earnings variability will have stronger in-
centives to smooth earnings through LLP. This suggests the following hypotheses:
H1A: The propensity to decrease earnings by increasing discretionary
LLP is high for banks with relatively high pre-managed earnings.
H1B: The propensity to increase earnings by decreasing discretionary
LLP is high for banks with relatively low pre-managed earnings.

2.2 Factors affecting cross-sectional variation in income smoothing

We study three additional bank-specific factors that may influence the income
smoothing behavior of bank managers. First, we examine the incentives of manag-
ers of banks in need of external financing. Second, we investigate the impact of an
alternative mechanism for smoothing income that is available to bank managers.
Specifically, we focus on the relationship between discretionary loan loss provision
and realized gains or losses on securities held for sale. Third, we examine the regu-
latory environment, which may be conducive or act as an impediment to income
smoothing.
2.2.1 Need for external financing
It is often argued that the need for external financing is an important incentive for in-
come smoothing.3 Given that the cost of financing is a function of a bank's perceived
risk, bank managers have an incentive to smooth income to reduce large fluctua-
tions. Management and existing shareholders benefit from such behavior if the bank
can raise additional financing on more favorable terms (i.e., it can reduce its cost of
financing). Therefore, we explicitly consider the need for external financing as an ad-
ditional motivation for income smoothing by banks.
To measure the demand for external financing, we consider a bank's total
loans relative to its total deposits. When a bank's loan portfolio is greater than its total
deposits, it will need to borrow to finance its loan portfolio. Therefore, we use the ra-
tio of total loans to total deposits as our measure of the need for external financing.
This measure is often cited as a barometer for borrowing in practitioner journals (Pe-
tersen, 1999; Cocheo, 1997). Based on the above rationale, we hypothesize the fol-
lowing:
H2: The degree of income smoothing through discretionary LLP is
positively related to the demand for external financing.

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 Review of Accounting and Finance

2.2.2 Alternatives to income smoothing through LLP

Prior research indicates that bank managers use their discretion over the timing of
realization of gains and losses on securities held for sale to smooth income (Beatty
and Harris, 1999; Warfield and Linsmeier, 1992; Barth, Beaver, Wolfson, 1990). Be-
cause securities gains and losses are an alternative means of smoothing income,
bank managers can choose between DLLP and realized gains and losses on the
sale of securities to smooth income. Therefore, DLLP and securities gains and
losses act as substitutes (i.e., they have a negative relation). This leads us to the fol-
lowing hypothesis:
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H3: The degree of income smoothing through discretionary loan loss

provisions is negatively related to realized gains and losses on
securities held for sale.

2.2.3 Regulatory restrictions

The regulatory treatment of banks differs cross-sectionally depending on their capi-

talization levels (Kim and Kross, 1998). Regulatory actions such as the frequency of
examinations and restrictions imposed on banks' activities will vary depending on
how well banks are capitalized. Banks that are viewed by bank regulators as being
well-capitalized are less frequently audited and are less subject to intrusive regula-
tory actions than are banks that are not well-capitalized. Furthermore, as noted by
Kim and Kross (1998), the Federal Deposit Insurance Improvement Act (FDICIA) of
1991 requires that a full-scope, on-site examination of each insured depository insti-
tution be conducted not less than once during each 12-month period, but the period
is extended to18 months if the bank is well-capitalized. This increased regulatory
scrutiny of banks with low levels of capitalization (at risk banks) reduces their ability
to smooth reported income.
Consistent with Liu et al. (1997), we define banks with capital ratios above (be-
low) the sample mean total capital ratio as banks that are well- (not-well-) capital-
ized.4 We predict that banks that are relatively well-capitalized are more likely to
engage in income smoothing than are banks that are relatively not-well-capitalized.
Accordingly, we hypothesize that:
H4: The degree of income smoothing through DLLP is greater for
relatively well-capitalized banks than for relatively not-well-
capitalized banks.

3. Sample Description

The sample is composed of bank holding companies that are listed on the FDIC web
site. We only include the 2,545 banks that are listed over the entire period from 1992
to 2001, for a total of 25,450 bank-year observations. We lose 2,545 observations
because we deflate the variables used either by beginning loans or beginning as-
sets. Additionally, we exclude 265 observations due to their abnormal influence on
the results.5 This leaves us with a final sample of 22,640 bank-year observations for
our empirical analysis.

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 Volume 3 Number 1 2004

Table 1 presents descriptive statistics for our sample banks. In Panel A, we

present the mean, standard deviation and quartiles of the distributions of the vari­
ables used in our analysis and, in Panel B, we present similar information on capital
ratios. As indicated in Panel A, the loan loss provision represents, on average, 0.33
percent of beginning loans. On average, the banks included in our sample increase
the value of their loan portfolio and nonperforming loans from year to year. Consis­
tent with the strong economic climate in the 1990s, most banks are profitable and
lend, on average, two thirds of their deposits. Finally, as indicated in Panel B, the av­
erage value of banks' total capital ratio is 18% compared to 16% for tier 1 capital. The
correlation matrix between the key variables is presented in Table 2. As expected,
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change in total loans (CHLOAN), beginning balance of nonperforming loans

(NPLt-1), and change in nonperforming loans (CHNPL) are positively related to LLP.
4. Results
4.1 Univariate Analysis
To test our hypotheses, we need to estimate the discretionary component of loan
loss provisions (DLLP). The loan loss provision is comprised of a discretionary com­
ponent (i.e., DLLP) and a nondiscretionary component (i.e., NDLLP). Consistent
with prior research (Kim and Kross, 1998; Beaver and Engel, 1996; Beatty et a/.,
1995; Wahlen, 1994), we use change in nonperforming loans (CHNPL), the begin­
ning balance of nonperforming loans (NPLt-1), and change in total loans (CHLOAN)
to estimate the nondiscretionary component of LLP. The expected signs of the coef­
ficients on these variables are as follows. An increase in nonperforming loans is
likely to result in an increase in the provision for loan losses. The level of nonper­
forming loans at the beginning of the year is expected to be positively correlated with
the provisions for loan losses. That is, with a higher level of beginning nonperforming
loans, banks will have to make a higher provision for loan losses. The sign of the co­
efficient on change in total loans is expected to be positive because, ceteris paribus,
an increase in loans is likely to result in an increase in the loan loss provision due to
doubtful loans.

We use the following model to estimate nondiscretionary LLP:

LLPit =α0+α1NPL i t - 1+ α2 CHNPLit + α3 CHLOANit + εit [1]
where,
LLPit = provision for loan losses deflated by beginning loans;
NPLit-1 = beginning of period nonperforming loans deflated by
beginning loans;
CHNPLit = change in the value of nonperforming loans deflated by
beginning loans;
CHLOANit = change in the value of loans deflated by beginning
loans.
In equation [1], the independent variables account for the nondiscretionary
component of LLP and, therefore, the discretionary component (DLLP) is given by
the residual term. Results of estimating equation [1] are presented in Table 3. As ex-

133
 Review of Accounting and Finance

pected, the coefficients of the three variables are positive and significant at the 0.01
level. The adjusted R2 of the model is 0.41.
Table 4 presents the level of DLLP partitioned by relative performance using
both the change in pre-managed earnings and the level of pre-managed earnings
(EBTP deflated by beginning assets). We first classify banks into three groups (re-
ferred to as low, medium and high groups) based on either the relative change in an-
nual performance for each year or the relative level of annual performance. Thus,
banks are grouped on an annual basis rather than on a pooled time-series basis. Re-
call that Hypothesis 1 predicts that banks with high pre-managed performance, rela-
tive to other banks, have incentives to decrease reported earnings. Therefore, we
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should observe a high level of DLLP for these banks. Alternatively, banks with low
relative pre-managed performance have incentives to increase reported earnings.
Therefore, we should observe a low level of DLLP for these banks. We make no pre-
dictions for the medium group; therefore, we only present the results for the high and
low performance groups.
The results in Panel A of Table 4 are consistent with our predictions. DLLP is
negative and significant at the 0.01 level (t = -3.21) for banks with relatively low
change in performance. In contrast, banks with relatively high change in perform-
ance have significantly positive DLLP (t = 6.07; p<0.01). Additionally, the difference
in mean DLLP between the high change in performance and low change in perform-
ance subsamples is significantly greater than zero at the 0.01 level (f = 6.84).
Panel B of Table 4 replicates the analysis using level of earnings before tax
and loan loss provisions instead of change in earnings before tax and loan loss pro-
visions to classify banks into high and low relative performance groups. The results
are robust to this alternative classification method. For banks with low relative per-
formance, the mean DLLP is negative and significant at the 0.01 level (t = -14.42),
whereas for banks with high relative performance, it is positive and significant at
p<0.01 level (t = 11.65).6 Furthermore, the null hypothesis that the difference in
mean DLLP between the high and low performance groups is zero is rejected at the
0.01 level (t= 17.28).
4.2 Regression Analysis
In the previous section, we provide evidence that bank managers use the discretion-
ary component of the loan loss provision to smooth earnings. More precisely, the re-
sults indicate that bank managers increase (decrease) earnings by decreasing
(increasing) DLLP when the bank's relative performance is low (high). However,
managers' ability to smooth earnings can be limited by their banks' need to borrow or
to meet the minimum capital requirement. In addition, instead of using DLLP, bank
managers can use gains and losses on the sale of securities to smooth earnings. In
this section, we examine the combined effects of these factors on income smoothing
through DLLP.
To examine the impact of these other factors on cross-sectional differences in
income smoothing behavior, we perform a two-stage analysis. In the first stage, we
explicitly model the nondiscretionary component of LLP using equation [1] (see, for
example, Beaver and Engel, 1996; and McNichols and Wilson, 1988). In the second

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 Volume 3 Number 1 2004

stage, we regress the residuals from equation [1], which represent the discretionary
component of loan loss provision (DLLP), on the three factors identified above that
can potentially influence income smoothing behavior. We use the following empirical
model in the second stage:7,8
DLLPit =β0 + β1 RGLASSit + β2 L/DEPit + β3 WELLit + β4 EBTPit +
β5 LSIZEit + εit [2]
where,
DLLPit = discretionary component of the provision for loan
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losses estimated as the residual of equation [1];

RGLASSit = realized gains and losses on securities for sale
deflated by beginning total assets;
L/DEPit = ratio of loans to deposits;
WELLit = a dummy variable which equals 1 when a bank's capital
ratio is above the sample mean and equals
0 otherwise;
EBTPit = earnings before tax and provisions deflated by
beginning total assets;
LSIZEit = the natural logarithm of total assets.

The first three variables, RGLASS, L/DEP and WELL, are introduced to ex­
plain cross-sectional differences in DLLP. The fourth variable, EBTP, captures the
income smoothing incentive related to pre-managed performance and the fifth vari­
able, LSIZE, is a control variable. The predicted signs are as follows. For banks with
a high (low) pre-managed relative performance, we predict a positive (negative)
sign for the coefficient of L/DEP (hypothesis 2), a negative (positive) sign for the co­
efficient of RGLASS (hypothesis 3), and a positive (negative) sign for the coefficient
of WELL (hypothesis 4). In addition, we expect EBTP to be positively related to
DLLP because bank managers will increase DLLP when EBTP is high and de­
crease DLLP when EBTP is low in order to reduce earnings variability. There is no
clear a priori sign for LSIZE, which is included as a control variable.

Table 5 presents the results of estimating equation [2] for high and low relative
performance groups that are classified on the basis of change in earnings before tax
and provisions. The first three models examine the individual impact of each of the
three variables of interest, while the fourth model examines the combined effect of all
three variables. Panel A presents the results for the high relative change in perform­
ance banks. The variable EBTP is positive and significant at p<0.01 in all four mod­
els, suggesting that even when other potential determinants of income smoothing
are considered in the analysis, the change in performance of banks is still important
in explaining managers' discretionary behavior regarding LLP.
Consistent with hypotheses 2 and 3, the variables RGLASS and L/DEP are
significant, at the 0.01 level, and have the predicted sign. However, the variable

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 Review of Accounting and Finance

WELL does not have the predicted sign, indicating no support for hypothesis 4. A
possible explanation for this result is that regulators encourage banks to be more
conservative during good economic times in order to build up a reserve of loan loss
allowances.
Panel B of Table 5 presents regression results for the group of banks with low
relative change in performance. Once again, the variable EBTPispositive and sig-
nificant at the 0.01 level in all four regressions, suggesting that the magnitude of
pre-managed earnings explains cross-sectional differences in income smoothing.
Consistent with hypothesis 3 the coefficient on RGLASS is positive and significant at
p<0.05 in both models 1 and 4. The coefficient on WELL is negative and significant
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at p<0.01 in both models 3 and 4, a result that is consistent with hypothesis 4. In nei-
ther model 2 nor model 4 do we find the coefficient on L/DEP to have the predicted
sign. Therefore, we are unable to reject hypothesis 2. Finally, LSIZE is positive and
significant in all four models.
Table 6 reports regression results for banks classified into high and low cate-
gories based on the relative level of pre-managed performance rather than on the
relative change in pre-managed performance. This allows us to assess the sensitiv-
ity of our results to the method of classification. Panel A of Table 6 presents the re-
sults of estimating equation [2] for banks with high relative performance. The results
are consistent with those presented in Panel A of Table 5 and support hypotheses 2
and 3 but not hypothesis 4. Panel B presents the results for banks with low relative
performance. Once again, the results are consistent with those in Table 5, Panel B
and support hypotheses 3 and 4 but not hypothesis 2. These results suggest that our
tests are relatively insensitive to the method of classification of banks into relatively
high and low performance groups.
5. Summary, Conclusions and Limitations
This paper investigates bank managers' incentives to reduce earnings variability by
managing earnings through the use of discretionary loan loss provision. The existing
literature provides evidence that the market requires a premium for earnings vari-
ability. Therefore, managers have incentives to smooth earnings to reduce their cost
of raising capital. Managers will reduce reported earnings when pre-managed earn-
ings are high and will increase them when pre-managed earnings are low. This can
be accomplished through the use of managerial discretion in estimating certain ex-
penses. In this study, we investigate bank managers' use of discretion in estimating
LLP to reduce earnings variability. Because LLP is the largest accrual for most
banks, it can be use in isolation to study income smoothing behavior.
The incentives and abilities of bank managers to smooth earnings through
LLP are likely to be affected by bank-specific factors. We consider three such factors
that could potentially explain cross-sectional differences in the level of income
smoothing through LLP. First, we examine incentives to reduce the cost of external
borrowing to finance growth and/or to expand the lending portfolio. It is often argued
that the need for external financing is an important incentive for income smoothing.
Given that the cost of financing is a function of a bank's perceivedrisk,bank manag-
ers have an incentive to smooth income to reduce large fluctuations.

136
 Volume 3 Number 1 2004

Second, we examine the possibility that bank managers use gains or losses
on the sale of securities as an alternative mechanism for smoothing earnings. Since
securities gains and losses are an alternative means of smoothing income, bank
managers can choose between DLLP and realized gains or losses on the sale of se-
curities to smooth income. Third, we examine the effect of a bank's capitalization on
the extent of income smoothing. Well-capitalized banks have less restrictions and
less regulatory supervision, thus allowing them more room to smooth earnings rela-
tive to less well-capitalized banks.
Our results are consistent with the hypothesis that banks smooth earnings.
More precisely, we provide evidence that managers use the discretionary compo-
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nent of LLP to reduce the variability in earnings. We observe positive (negative) dis-
cretionary LLP for banks with a high (low) pre-managed relative performance,
consistent with our hypothesis. Our results also support our predictions regarding
the impact of external financing and the use of gains and losses on the sale of securi-
ties on income soothing. The results of the impact of bank capitalization on income
smoothing behaviour are not as clear, perhaps because regulatory pressures may
be asymmetrical. That is, regulators may prefer all banks to be conservative in esti-
mating LLP.
There are at least three important limitations of our study that should be noted.
First, our study does not explicitly examine whether the reduction in earnings vari-
ability resulting from exercising discretion over LLP leads to a reduction in cost of
capital or affects stock returns. Second, it does not specifically model and test the si-
multaneity between realized gains and losses on sale of securities and DLLP and
between the ratio of loans to deposits and DLLP. Third, our study does not account
for managing earnings variability through "real" actions by management; rather, it
only focuses on managing earnings variability through discretionary accruals.
Acknowledgements
Gerald Lobo thanks the Office of the Vice President of Research and Computing, the
George E. Bennett Research Center and the School of Management at Syracuse
University for financial support. Robert Mathieu thanks the Social Sciences and Hu-
manities Research Council of Canada for financial support.

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 Review of Accounting and Finance

Endnotes
1.Total LLP is comprised of both non-discretionary LLP and discretionary LLP
(DLLP). Non-discretionary LLP is related to future loan loss indicators such as
change in non-performing loans and change in total loans. Discretionary LLP cap-
tures the amount of discretion exercised by the bank managers. It is the variable of
interest in our study.
2. Gebhardt et al. (2001) define implied risk premium as the difference between the
implied cost of capital and the nominal risk-free rate.
3. Dechow et al. (1996) note that banks' financing needs have not received much at-
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tention in prior academic research.

4. Alternatively, we can use the minimum level of capital requirement as the thresh-
old to distinguish between banks that are at risk to incur these costs and other banks.
However, as indicated in Table 1 all of the banks in our sample meet the minimum
capital requirement.
5. Outliers are defined as observations with R-Student values greater than 3 in the
multivariate analysis.
6. We also examine our hypothesis using non-parametric tests. The results are con-
sistent with our hypothesis using both the Sign test and the Signed Ranks test. That
is, the level of DLLP is negative (positive) and significant, at the 0.01 level, for banks
in the low (high) annual relative performance.
7. There is likely to be simultaneity between DLLP and RGLASS because bank man-
agers can smooth income using DLLP and/or RGLASS. In addition to its relation to
DLLP, RGLASS is also influenced by tax incentives and market performance,
among other factors. Modeling these interrelationships is beyond the scope of this
paper. We do, however, examine the sensitivity of our conclusions to omitting this
potential simultaneity by estimating equation [2] without RGLASS as an independ-
ent variable. The inclusion or exclusion of RGLASS does not affect the main results
(compare, for example, models 3 and 4 presented in Tables 5 and 6), suggesting
that failure to model the potential simultaneity is unlikely to significantly affect our
conclusions.
8. The results are robust to the use of a one-stage model where LLP is used as the
dependent variable and all variables used in equations [1] and [2] are included in the
regression.

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 Volume 3 Number 1 2004

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TABLE 1
Descriptive Statistics
Panel A: Financial Data
Number of Standard
Variables Mean 25% 50% 75%
observations Deviation
LLP 22,640 0.0033 0.0073 0.0005 0.0021 0.0043
NPL 22,640 0.0113 0.0174 0.0024 0.0070 0.0150
CHLOAN 22,640 0.1511 2.7008 0.0254 0.0829 0.1505
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CHNPL 22,640 0.0006 0.0162 -0.0033 0.0000 0.0039

EBTP 22,640 0.0198 0.0544 0.0143 0.0181 0.0224
RGLASS 22,640 0.0001 0.0020 0.0000 0.0000 0.0001
UDEP 22,640 0.6610 0.2017 0.5595 0.6690 0.7657
Panel B: Capital Requirement Data
Standard
Number of Mean 25% 50% 75%
Variables Deviation
observations (in%) (in %) (in %) (in%)
(in%)
TRBCR 22,640 18.12 8.42 13.17 16.15 20.65
T1RBCR 22,640 16.99 8.43 12.03 15.01 19.54
Notes: LLP= loan loss provisions deflated by beginning total loans; NPL = non performing loans
deflated by beginning total loans; CHLOAN = change in loans deflated beginning total loans;
CHNPL - the change in nonperforming loans deflated by beginning total loans; DEBTP =
earnings before tax and provisions deflated by beginning total assets; RGLASS = realized gains
and losses on securities for sale deflated by beginning total assets; L/DEP = ratio of loans to
deposits; LSIZE = natural logarithm of total assets; TRBCR = total risk-based capital ratio;
T1RBCR = tier 1 risk-based capital ratio.

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 TABLE 2
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Pearson Correlations
LLP NPL CHLOAN CHNPL EBTP RGLASS L/DEP LASSET WELL
0.571 0.499 0.498 0.718 0.487 0.069 0.084 -0.068
LLP 1.000
(0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00)
1.000 0.425 0.688 0.527 0.449 -0.014 0.007 0.007
NPL (0.00) (0.00) (0.31) (0.29)
(0.00) (0.00) (0.03)
0.460 0.700 0.480 0.052 0.051 -0.008
CHLOAN 1.000
(0.00) (0.00) (0.00) (0.43) (0.00) (0.25)
0.571 0.461 0.046 0.050 -0.030
CHNPL 1.000
(0.00) (0.00) (0.00) (0.00) (0.00)
0.599 0.022 0.051 -0.002
EBTP 1.000
(0.00) (0.00) (0.00) (0.78)
142

0.007 0.062 -0.013

RGLASS 1.000
(0.29) (0.00) (0,05)
0.189 -0.405
L/DEP 1.000
(0.00) (0.00)

Review of Accounting and Finance

-0.150
LSIZE 1.000
(0.00)

WELL 1.000

Notes:
LLP = loan loss provisions deflated by beginning total loans; NPL = non performing loans deflated by beginning total loans; CHLOAN = change in loans
deflated beginning total loans; CHNPL = the change In nonperforming loans deflated by beginning total loans; EBTP = earnings before tax and
provisions deflated by beginning total assets; RGLASS = realized gains and losses on securities for sale deflated by beginning total assets; L/DEP =
ratio of loans to deposits; LSIZE = natural logarithm of total assets; WELL = a dummy variable which equals 1 when a bank's capital ratio is above the
sample mean and equals 0 otherwise.
 Volume 3 Number 1 2004

TABLE 3
Estimation of Discretionary Loan Loss Provisions
LLPit=β0 + β1CHNPLit +β 2 NPLH it+ β2CHLOANit + εit
Intercept CHNPL NPLt-1 CHLOAN
Expected sign ? + + +
Coefficient 0.00139 0.20660 0.15758 0.00079
T-statistic 28.05*** 74.10*** 52.23*** 50.08***
2
Adjusted R 0.4119
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Observations 22,640
Notes:
1
LLP = loan loss provisions deflated by beginning total loans; NPLt-1 = beginning nonperforming
loans deflated by beginning total loans; CHLOAN = change in total loans deflated by beginning
total loans; CHNPL =change in nonperforming loans deflated by beginning total loans.
2
*** indicates significance at p = 0.01.

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TABLE 4
Discretionary Loan Loss Provision Partitioned by Annual Relative Performance
Panel A: Partition based on Change in Earnings before Tax and Provisions
Change in Earnings before Tax and Provisions
Low High
Mean -0.00018 0.00053
Median -0.00074 -0.00022
Std Deviation 0.00482 0.00754
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Observations 7,543 7,546

Student's t -3.21 6.07
(p-value) (0.00) (0.00)
Panel B: Partition based on Level of Earnings before Tax and Provisions
Level of Earnings before Tax and Provisions
Low High
Mean -0.00075 0.00106
Median -0.00114 0.00054
Std Deviation 0.00452 0.00788
Observations 7,542 7,547
Student's t -14.42 11.65
(p-value) (0.00) (0.00)
Notes:
1
LLP= loan loss provisions deflated by beginning total loans; DLLP= discretionary loan loss
provision estimated as the residual from equation [1]; Earnings before tax and provisions is
deflated by beginning total assets.
2
Each year, observations are partitioned into three equal-sized groups on the basis of change in
earnings before tax and provisions or level of earnings before tax and provisions. High (Low)
represent observations with the lowest (highest) third values in a given year.

144
 Volume 3 Number 1 2004
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TABLE 5
Multivariate Analysis: Partitions based on Change In Earnings before Tax and Provisions
DLLPit = β0 + β1 RGLASSit + β2 L/DEPit + β3WELLit + β4EBTPit + β5LSIZEit + εit
Panel A: Partition with High Relative Change In Earnings before Tax and Provisions
Model 1 Model 2 Model 3 Model 4
Sign Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic
Intercept + -0.0033 -3.90"* -0.0033 -3.83*** -0.0018 -2.04" -0.0030 -3.43"*
L/DEP + 0.0022 6.37*** 0.0018 4.49***
RGLASS - -0.2815 -7.85*** -0.2852 -7.98"*
WELL + -0.0009 -5.27*** -0.0006 -3.48"*
EBTP + 0.0339 40.25*** 0.0401 34.62*** 0.0339 40.24*** 0.0402 34.82"*
LSIZE ? 0.0001 1.72* 0.0003 3.41*** 0.0002 2.05" 0.0001 1.84*
145

2
Adjusted R 0.1826 0.1848 0.1812 0.1905
Observations 7,546 7,546 7,546 7,546
 TABLE 5 (cont.)
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Multivariate Analysis: Partitions based on Change In Earnings before Tax and Provisions
DLLPit =β0 + β1RGLASSit + β2LDEPit + β3WELLit + β4EBTPit + β s LSIZE it + εit
Panel B: Partition with Low relative Change In Earnings before Tax and Provisions
Model 1 Model 2 Model 3 Model 4
Sign Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic
Intercept - -0.0062 -9.88*** -0.0067 -10.55*** -0.0051 -8.02*** -0.0053 -8.19***
L/DEP - 0.0016 5.35*** 0.0007 2.07**
RGLASS + 0.1217 2.53** 0.1204 2.51**
WELL - -0.0010 -8.64*** -0.0009 -7.12***

EBTP + 0.0326 4.72*** 0.0365 5.27*** 0.0399 5.78*** 0.0397 5.71***

LSIZE ? 0.0004 7.65*** 0.0005 8.51*** 0.0004 7.30*** 0.0004 6.83***

146

2
Adjusted R 0.0191 0.0162 0.0250 0.0263
Observations 7,543 7,543 7,543 7,543

Review of Accounting and Finance

Notes:
1
DLLP = discretionary loan loss provision estimated as the residual from equation [1]; RGLASS = realized gains and losses on securities for sale
deflated by beginning total assets;L/0DEP= ratio of loans to deposits; LASSET= natural logarithm of total assets; WELL = a dummy variable which
equals 1 when a bank's capital ratio is above the sample mean and equals 0 otherwise; EBTP = earnings before tax and provisions deflated by
beginning total assets; LSIZE = natural logarithm of total assets.
2
Each year, observations are partitioned into three equal-sized groups on the basis of change in earnings before tax and provisions. High (Low)
partitions represent observations with the highest (lowest) third values in a given year.
3
*** indicates significance at p = 0.01; ** indicates significance at p = 0.05; * indicates significance at p=0.10.
 Volume 3 Number 1 2004
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TABLE 6
Multivariate Analysis: Partitions based on Level of Earnings before Tax and Provisions
DLLPit =β0 + β1RGLASSit + β 2 L/DEP it + β3WELLit + β4EBTPit + β5LSIZEit + εit
Panel A: Partition with High Relative Level of Earnings before Tax and Provisions
Model 1 Model 2 Model 3 Model 4
Sign Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic
Intercept + -0.0017 -1.79* -0.0022 -2.31** 0.0012 1.25 -0.0013 -1.61
L/DEP + 0.0035 6.77*** 0.0023 3.30***
RGLASS - -0.2695 -6.81*** -0.2756 -6.53***
WELL + -0.0014 -8.55*** -0.0001 -3.21***
EBTP + 0.0337 37.80"* 0.0397 31.58*** 0.0336 37.76*** 0.0398 19.86***
LSIZE ? -0.0000 -0.20 0.0001 1.70* -0.0000 -0.44 -0.0000 0.33
147

Adjusted R2 0.1637 0.1638 0.1667 0.1714

Observations 7,547 7,547 7,547 7,547
 TABLE 6 (cont.)
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Multivariate Analysis: Partitions based on Level of Earnings before Tax and Provisions
Panel B: Partition with Low Relative Level of Earnings before Tax and Provisions
Model 1 Model 2 Model 3 Model 4

Sign Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic

Intercept - 0.0006 -8.45*** -0.0054 -8.90*** -0.0038 -6.04*** -0.0044 -6.94***
L/DEP - 0.0013 5.08*** 0.0006 2.21**
RGLASS + 0.0361 2.19** 0.0789 2.19"
WELL - -0.0008 -7.84*** -0.0007 -5.79***
EBTP + -0.0673 -6.95*** -0.0656 -6.75*** -0.0628 -6.49*** -0.0641 -6.62***
LSIZE ? 0.0004 7.48*** 0.0005 8.45*** 0.0004 6.78*** 0.0004 6.80***
Adjusted R2
148

0.0178 0.0151 0.0224 0.0225

Observations 7,542 ' 7,542 7,542 7,542
Notes:

Review of Accounting and Finance

1
DLLP = discretionary loan loss provision estimated as the residual from equation [1]; RGLASS = realized gains and losses on securities for sale
deflated by beginning total assets; L/DEP = ratio of loans to deposits; LASSET= natural logarithm of total assets; WELL = a dummy variable which
equals 1 when a bank's capital ratio is above the sample mean and equals 0 otherwise; EBTP = earnings before tax and provisions deflated by
beginning total assets; LSIZE = natural logarithm of total assets.
2
Each year, observations are partitioned into three equal-sized groups on the basis of level of earnings before tax and provisions. High (Low) partitions
represent observations with the highest (lowest) third values in a given year.
1
*** indicates significance at p = 0.01; ** indicates significance at p = 0.05; * indicates significance at p=0.10.
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