Bank regulation: a controlled incentive for earnings management

Abstract

Under the political cost hypothesis of Positive Accounting Theory (PAT) managers of large profitable firms are expected to make income decreasing accounting choices in order to reduce the adverse effects of political costs, such as costs of increased labour demands or costs of government intervention that may step in with more regulation or taxation to lower profitability. In the banking industry, the political consideration creates incentives to manage earnings upwards because banks face regulatory monitoring that is explicitly tied to accounting numbers. The purpose of this paper is to explain how bank regulation creates an incentive for earnings management and how changes in regulatory standards and prudential supervision limit managerial flexibility for creative accounting.