Publication: Three essays on empirical financial accounting
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2020-05
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2020-07-13
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Abstract
As Barth (2015) states, financial accounting is essential to financial accountability, which
is essential to a prosperous society. Financial accounting research plays a significant role
in providing evidence to support or refute what is believed to be true and in providing
new insights into the potential shortcomings of current accounting as well as offering
insights into potential improvements. In particular, in this thesis, I focus on empirical
financial accounting of financial and non-financial firms using archival methods. The
emphasis of this work is twofold. Firstly, I focus on the financial reporting quality of
banks and the effect of regulation and monitoring agents in bank managers’ incentives.
Secondly, I focus on the role of common ownership in the financial reporting quality of
non-financial firms.
This thesis contains three chapters. In Chapter 1, we analyze the role of regulation
in shaping bank managers’ incentives relative to regulatory capital management. In
Chapter 2, we study the role of the auditor in securing banks’ financial reporting quality.
Finally, in Chapter 3, we study whether common ownership is related to firms’ financial
reporting quality.
Banks are critical to nationwide economic growth, and particularly to local economic
development, where small and medium enterprises rely on bank financing to run their
businesses, and ultimately, create employment and wealth. Because of their importance,
bank supervision is intended to protect the safety and soundness of the financial system
on behalf of depositors and shareholders. Hence, understanding banks’ financial
reporting choices and incentives is essential.
In Chapter 1, “Regulatory capital management to exceed thresholds” (co-authored with
Silvina Rubio), we document a discontinuity around the 10% regulatory capital ratio
of public and private US commercial banks. This threshold separates well-capitalized
from adequately capitalized banks, granting benefits to banks that fall into the former
category. We find that the strength of the discontinuity varies with changes in regulations
affecting banks’ incentives and ability to meet the threshold. Importantly, we
show that this behavior is also prevalent among non-listed banks, which reduces concerns
about other confounding factors, such as capital market pressures, driving our
results. We find that the significance and magnitude of the discontinuity varies predictably
with banks’ incentives to exceed the threshold: lower deposit insurance fees,
access to brokered deposits, and access to financial activities.
Banks use accounting and non-accounting tools to exceed the threshold. We find
that banks exercise accounting discretion over abnormal loan loss provisions and realized
gains and losses on available-for-sale securities to reach the well capitalized categorization.
Banks also rely on non-accounting discretion: they raise equity either directly
or through transfers from the parent holding company, and tilt risk weighted assets
towards safer asset classes to fall above the discontinuity. Lastly, we exploit this discontinuity
to show that regulatory capital management has detrimental effects on bank
stability when banks use accounting management but not when they raise the level of
equity.
We contribute to the literature on benchmark-beating behavior by showing that nonearnings
goals are also important drivers of accounting choices. We also provide new
evidence that when regulation sets explicit targets, it creates agents’ incentives to actually
meet these targets with unintended consequences. Besides, we contribute to the
literature on regulatory arbitrage by providing evidence that banks use real and accrual
management to increase regulatory capital at a specific threshold in contrast to previous
literature that assumes that reporting higher figures is better.
In a related project, we study the role of the auditor in securing banks’ financial reporting quality. In Chapter 2 “The unintended consequences of external auditing in small
private banks” (co-authored with Beatriz Garc´ıa Osma), we examine the interaction between
auditor and supervisor monitoring over the financial reports of private banks.
Despite coinciding objectives, their joint effects are far from obvious. In particular, we
analyze whether a voluntary audit impacts on bank managers’ choices between accrualbased
and real management to increase regulatory capital and whether these choices
differ according to supervisory scrutiny. We find that audited banks are more likely to
engage in real regulatory capital management. This suggests private banks may choose
to audit their accounting as a signaling tool for the supervisor. In the presence of a
strict supervisor and an auditor, there is a trade-off in banks’ choices between real and
accrual-based management. In the latter case, banks engage in accrual regulatory capital
management rather than real management. Taken together, the evidence suggests
that auditors’ insurance on the quality of financial reports negatively affects banks’ behavior.
Finally, in Chapter 3, “Common ownership and financial reporting quality” (co-authored
with Facundo Mercado and Silvina Rubio) we hypothesize that when institutional investors
have concentrated ownership within an industry, they are more likely to understand
the dynamics of firms’ operations, increasing their monitoring ability, what
ultimately reduces agency cost and managerial incentives to misreport. In preliminary
results, we find that there is a positive association between common ownership and
several measures of financial reporting quality, such as comparability, discretionary accruals,
and real earnings management. This association is not captured by institutional
ownership, product market competition or other known determinants of financial reporting
quality.