FAS 157 and Earnings Management

Henry Huang Yi Zhang

Gin ChongPrairie View A&M University

Introduction

Statement of Financial Accounting Standards No. 157 (FAS 157) provides a framework of Fair Value Measurements:

• Became effective from November 15 2007

• A uniform definition of fair value `the price that would be received to sell an asset or paid to

transfer a liability in an orderly transaction between market participants at the measurement date.

Introduction

• Requires all the US listed firms to measure and report their assets and liabilities in fair values using three levels inputs.

1. Level 1 inputs are from the quoted prices in active markets.

2. Level 2 inputs are from the observable markets other than quoted prices

3. Level 3 are based on unobservable and firm-generated inputs.

Hypothesis DevelopmentAccounting choice and managing earnings

• Fields, Lys and Vincent (2001, p260) define an accounting choice as “decision to influence the output of the accounting system in the financial statements published in accordance with GAAP, tax returns, regulatory filings, contracting, asset pricing, taxes, and regulations.”

• Christie and Zimmerman (1994), Groff and Wright (1989), DeAngelo (1988) and Song (2008) find that managers make accounting choices to increase their bonuses by manipulating total assets and liabilities.

Q: Do manager use FAS157 as an avenue for earnings management?

Hypothesis Development

Q: Do manager use FAS157 as an avenue for earnings management?

FAS 157 provides managers with discretions with regard to which input to use.

Assets with level 3 input are subject to more manipulation, thus we use the percentage of fair-value assets with level 3 input (TAL3%) as a proxy for earnings management. Higher TAL3% indicates more earnings management

Hypotheses Development

Banks that perform poorly are more likely to engage in income -increasing earnings management (Becker et al., 1998).

Hypothesis 1 - 3:Poor performing banks are associated with higher TAL3%.

Proxies for poor performance: Return on asset (ROA) Operating cash flow

Provision for loan loss

Large banks face more political costs and scrutiny.

Hypothesis 4: Large banks are associated with higher TAL3%

Data and Methodology

We use Form 10Qs submitted by the US commercial banks for the first two quarters of 2008, to test our research questions.

Out of 233 banks, 199 (85%) have used fair values in valuing their assets and liabilities.

• Regression methodology:

• Level 3%= Assets + Leverage + ROA + Operation Cash Flow + Allowance for loan loss + Provision for loan loss + Securities available for sale (SAFA) + Change in SAFA + Dummy Quarter

Regression Results Table 4. Regression Results of L3% Dependent Variable L3% L3% (1) (2) Intercept -0.0705 -0.0329 (-0.790) (-0.370) Assets 0.0077 * 0.0062 (1.910) (1.560) Leverage -0.0125 0.0370 * (-0.780) (1.810) ROA -3.4469 *** -2.8104 *** (-3.570) (-2.930) Operation cash flow -2.7671 *** -2.9207 *** (-2.950) (-3.170) Allowance for loan loss 0.1064 0.1169 (0.740) (0.830) Provision for loan loss 0.0008 *** 0.0007 ** (2.510) (2.230) Dummy Quarter -0.0128 -0.0111 (-0.860) (-0.760) Securities-available for sale -0.3340 *** (SAFS) (-3.820) Changes in SAFS 0.0028 (0.480) Adjusted R-square 0.0694 0.1052 Notes: *, **, and *** indicate significance level at 1%, 5%, and 10% respectively. Please see Table 1 for variable definitions.

FindingsWe find large banks and poor performing banks with lower returns on assets, lower cash flows, and higher amount of provision for loan losses, use more level 3 inputs on valuing their assets and liabilities.

Our results suggest that US commercial banks use Level 3 classification as an avenue for earnings management.

Future Research1. Current study is based on the first two quarters of compliance. A

longitudinal study could help identify the patterns and relevance of using the fair value measurements.

2. To incorporate larger samples or compare the findings across the sectors.

3. To include governance issues like board size, board composition, Big 4 versus non Big 4 and compositions of the audit committees.