Academic journal article Journal of Managerial Issues

The Role of Managerial Prudence in Bank Loan Loss Provisioning

Academic journal article Journal of Managerial Issues

The Role of Managerial Prudence in Bank Loan Loss Provisioning

Article excerpt

The recent market crisis has prompted greater awareness of the fragility of managerial estimates in bank financial statements. In the past, financial statement preparers were directed to employ conservatism in reported figures (Financial Accounting Standards Board, 2004). This practice could be perceived as favoring financial system stability because conservative accruals during good times would build capital buffers and preserve solvency and maintain stable market confidence during times of financial system volatility. Through a joint project with international accounting standard setters, the U.S. Financial Accounting Standards Board (FASB) has recently eliminated the characteristic of conservatism from its accounting framework and adopted an unbiased estimate or neutral approach of accounting (FASB, 2010; Watts, 2003). Watts (2003b) cautioned accounting standard setters to make this change only after obtaining a clear understanding of potential ramifications of removing the element of conservatism. This study investigates the relationship between management prudence (a management characteristic or trait characterized by a focus on the long-term viability of the enterprise) and accounting conservatism (a systematic approach to accounting that leads to a faster recognition of bad vs. good news as reflected in management's published accounting figures). While earnings management and loan loss provisioning has been extensively studied, prior studies have not evaluated the relationship between loss provisioning and characteristics of prudent management.

The characteristic of accounting conservatism, which Basu (1997) defines as early recognition of losses and delayed recognition of gains, has been extensively evaluated with respect to its relationship with negative attributes, such as hiding information from potential investors or regulators, smoothing earnings, or managing capital levels (e.g., LaFond and Watts, 2008; Liu and Ryan, 2006). To distinguish managerial prudence from accounting conservatism, this paper defines prudence as management's focus on the longterm viability of the organization and imprudence as management decisions that have been found to be associated with bank insolvency. To summarize, prudence/imprudence is a measure of how management's current decisions affect the long-term viability of the bank, whereas conservatism is a measure of how quickly the financial statements reflect the impact of management's imprudent actions. This study makes no claims about earnings management and does not investigate any deviation from a "natural" or "normal" level of accounting accruals. Rather, this study investigates if the loan loss provisions of prudent banking organizations appear to be different (either more or less conservative) than those of less prudent banking organizations.

This study attempts to isolate a managerial attribute and evaluate whether that attribute has a relationship with accounting accruals, specifically the loan loss provision. Finding an association would be consistent with the notion that managers use accruals to convey information about the nature of their organization's strategic view or other managerial traits. This study uses the bank setting because the loan loss provision is a well-documented managerial estimate and has been extensively studied (e.g., Kanagaretnam et al., 2004; Liu and Ryan, 2006). While other studies have evaluated accounting conservatism and accounting accruals in banks (e.g., Handorf and Zhu, 2006, Kanagaretnam et al., 2003; Kanagaretnam et al., 2004; Liu and Ryan, 2006), this study adds to the research on bank-specific accruals by investigating the link between accounting conservatism and management decisions.

Due to the lack of prior research defining quantitative attributes of management prudence in banks, this study develops a managerial prudence measure by isolating characteristics that have been associated with risky bank management behaviors and ultimately led to bank failures, according to the Office of the Comptroller of the Currency (OCC), a banking regulator (OCC, 1988), and other studies (e. …

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