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Bank loan-loss accounting: a review of theoretical and empirical evidence

  • Larry D. Wall
  • Timothy W. Koch

The philosophy underlying a bank's accounting for loan losses might have a material effect on the net income the firm reports to investors, which is a concern for securities regulators. A bank's loan-loss accounting philosophy might also significantly affect its ability to absorb unexpected future losses, which is a concern for bank supervisors. For example, a bank that follows a conservative loan-loss philosophy (maintains a higher loan-loss allowance) may be better able to absorb unexpected losses but also may have more freedom to manage reported earnings. This article focuses on the extent to which securities regulators and bank supervisors should be concerned about banks' accounting. ; The authors' conclusion is that neither the bank supervisors' nor the securities regulators' concern is as serious as it may seem at first glance. Using currently available data, investors can and do form estimates of the "economically true" amount of banks' loan-loss allowances, provisions, net income, and equity capital. Strict adherence to Securities and Exchange Commission guidelines may improve the quality of the data, but the guidelines may not eliminate the benefit or reduce the cost of investors' making their own estimates. However, bank supervisors have the authority to require banks to hold additional equity capital if the bank's loan-loss allowance is judged inadequate to absorb future losses.

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Article provided by Federal Reserve Bank of Atlanta in its journal Economic Review.

Volume (Year): (2000)
Issue (Month): Q2 ()
Pages: 1-20

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Handle: RePEc:fip:fedaer:y:2000:i:q2:p:1-20:n:v.85no.2
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  1. Bruner, Robert F & Simms, John M, Jr, 1987. "The International Debt Crisis and Bank Security Returns in 1982," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 19(1), pages 46-55, February.
  2. Timothy W. Koch & Larry D. Wall, 2000. "The use of accruals to manage reported earnings: theory and evidence," Working Paper 2000-23, Federal Reserve Bank of Atlanta.
  3. John R. Walter, 1991. "Loan loss reserves," Economic Review, Federal Reserve Bank of Richmond, issue Jul, pages 20-30.
  4. Stein, Jeremy C, 1989. "Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior," The Quarterly Journal of Economics, MIT Press, vol. 104(4), pages 655-69, November.
  5. Moyer, Susan E., 1990. "Capital adequacy ratio regulations and accounting choices in commercial banks," Journal of Accounting and Economics, Elsevier, vol. 13(2), pages 123-154, July.
  6. Degeorge, Francois & Patel, Jayendu & Zeckhauser, Richard, 1999. "Earnings Management to Exceed Thresholds," The Journal of Business, University of Chicago Press, vol. 72(1), pages 1-33, January.
  7. Wall, Larry D. & Peterson, David R., 1987. "The effect of capital adequacy guidelines on large bank holding companies," Journal of Banking & Finance, Elsevier, vol. 11(4), pages 581-600, December.
  8. Persons, John C., 1997. "Liars Never Prosper? How Management Misrepresentation Reduces Monitoring Costs," Journal of Financial Intermediation, Elsevier, vol. 6(4), pages 269-306, October.
  9. Burgstahler, David & Dichev, Ilia, 1997. "Earnings management to avoid earnings decreases and losses," Journal of Accounting and Economics, Elsevier, vol. 24(1), pages 99-126, December.
  10. Edward Kane, 1997. "Ethical Foundations of Financial Regulation," Journal of Financial Services Research, Springer, vol. 12(1), pages 51-74, August.
  11. Guidry, Flora & J. Leone, Andrew & Rock, Steve, 1999. "Earnings-based bonus plans and earnings management by business-unit managers1," Journal of Accounting and Economics, Elsevier, vol. 26(1-3), pages 113-142, January.
  12. Healy, Paul M., 1985. "The effect of bonus schemes on accounting decisions," Journal of Accounting and Economics, Elsevier, vol. 7(1-3), pages 85-107, April.
  13. Holthausen, Robert W. & Larcker, David F. & Sloan, Richard G., 1995. "Annual bonus schemes and the manipulation of earnings," Journal of Accounting and Economics, Elsevier, vol. 19(1), pages 29-74, February.
  14. Beaver, William H. & Engel, Ellen E., 1996. "Discretionary behavior with respect to allowances for loan losses and the behavior of security prices," Journal of Accounting and Economics, Elsevier, vol. 22(1-3), pages 177-206, October.
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