Earnings management through derivative activities: Evidence from banks

This study examines whether banks manage earnings through derivative activities. Under SFAS No. 119, trading and non-trading derivatives are accounted for differently. Trading purpose derivatives are measured at fair value with gains or losses recognized in earnings. While non-trading purpose derivatives need not be recognized in the financial statements, their fair values have to be disclosed in the footnotes. This difference in accounting treatment provides banks an opportunity to manage earnings by manipulating derivative classification. ^ Tests for earnings management are conducted by regressing the discretionary components of fair value changes of trading and non-trading derivatives on proxies for earnings management incentives. These incentives include earnings smoothing, avoidance of debt-covenant violation, loss aversion, and bonus maximization. Consistent with prior literature (McNichols and Wilson, 1988; Guidry et al., 1998), the discretionary components are first estimated indirectly using a separate model. ^ Empirical results indicate that banks engage in earnings management to smooth reported earnings and to avoid reporting losses. There is also partial evidence of earnings management to maximize bonus awards. These results suggest inadequacy in current accounting standards, and support the ongoing efforts of the FASB and the SEC to improve the accounting for and disclosure of derivatives.