1. EARNINGS MANAGEMENT USING LOAN LOSS PROVISIONS IN BULGARIAN BANKS Presenter : Azlan Ali Co-authors: Fanya Filipova, Anita Attanasova University of Economics, Varna Bulgaria INTACCT WORKSHOP Varna 3-4 March 2010

2. Introduction Purpose of the study Contribution Banking development in Bulgaria Literature review Conjecture Data and Methodology Statistical result Conclusion, limitations and suggestion

3. Purpose of the study To investigate earnings management through loan provisions by commercial banks in Bulgaria, and how corporate governance mechanisms affect earnings management. Bulgaria presents an unique study –Banks in Bulgaria are officially obliged to adopt IFRS for their financial reporting purposes since 2003, according to the Bulgarian Accounting Law (BAL) and since 2002 according to National Accounting Standards (NAS). –Dependence of economy on banks (Koford and Tschoegl,1999)

4. Potential Contributions This study will provide a positive contribution to existing research on banking industry, especially in the countries that are under the transition. Pioneer work on Bulgarian commercial banks

5. Potential Contributions Interesting findings in an environment that obviously differ from Anglo-Saxon systems in terms of corporate governance. –the lower risk of litigation, as compared to the responsive US litigation system. –highly concentrated of ownership structure vs. widely held ownership structure in the US

6. Banks in Bulgaria Banking industries have a great importance to Bulgarian economic. –Total assets of Bulgarian commercial banks at the end of 2007 stood about 105 per cent of Gross Domestic Product and at the end of in 2009- they are valued around 70.9 billion Bulgarian leva. –Small number of banks – 30 –Foreign controlled 22 banks, only 1 bank controlled by state

7. Banks in Bulgaria –Only 5 banks are listed in the Bulgarian stock market – provider of funds for corporations –The banking system is highly capitalized with most banks continuously to record high capital adequacy ratio (CAR) above than EU banking standard (between 4-8%). –banks in Bulgaria are the earliest mandatory adopter of IAS/ IFRS in Europe and among the earliest mandatory adopters in the world:

8. Literature Earnings management –defined as the used of managerial discretion to influence the accounting figures published to the company’s stakeholders (Degeorge et al., 1999, p. 2). –is recognized as attempts by management to influence or manipulate reported earnings by using specific accounting methods

9. Literature 3 groups of discussions for an earnings management research model in Bulgaria Factors which are influencing Earnings Management in banks and in any company; –Financial system –Accounting standards –Legal system – lack of investor protection, intensity and effectiveness of prosecution –Quality of corporate governance – ownership structure, board characteristic, auditors roles –Level of economy development –Economy and monetary policies

10. Literature Incentives (motives, objectives) –for Earnings management- this is more subjective and closely connected with management in the banks and bank policy; the most important for modeling and research, according to our opinion; –to satisfy financial analyst expectation and public reputation (Burgstahler and Eames, 1998; Blasco and Pelegrin, 2005)

11. Literature –To avoid losses (Degeorge, Patel & Zeckhauser, 1999) –Managerial job’s concern and remuneration (Kanagaretnam et al. 2003; Karaoglu, 2004) –Competition (Bagnoli and Watts, 2000) –Minimization of costs (Dechow et al. 1996 ; Stolowy and Breton, 2000) –Regulatory requirements (Zhou and Chen, 2004)

12. Literature Tools –Discretionary accruals (Degeorge et al.1999) –Account manipulation and disclosures –off–balance sheet financing, –related-party transactions, –revenue recognition Blasco and Pelegrin (2005), –loan and lease loss reserve (McNichols, 2000; Zhou and Chen, 2004; Cornett et al. 2006; Kanagaretnam et al. 2003)

13. Conjecture Banks use loan loss provisions for matching regulatory capital requirement and smoothing income Bank’s decision in loan loss provision is influenced by corporate governance mechanisms

14. Data and Methodology –Sample from 18 Bulgarian banking institutions from 2005 until 2008. –Data obtain from banks’ annual report. 8 variables –LLP: Loan loss provisions/total average loans –BSIZE: Number of board members; –BIG5: Dummy variable. 1 if the auditor is member of the Big 5; 0 otherwise –CGLN: Change in outstanding loans (in value)

15. Data and Methodology –LWO: Write-offs loans/average total assets –SIZE: Log of Total Assets –CAR: Capital adequacy ratio. –EBPT : Earnings before taxes and loan loss provision/average total assets. MODEL LLP it = β0 + β1 BSIZE it + β2 BIG5 it + β3 CAR it + β4 CGLN it + β5 LWO it + β6 SIZE it + β7 EBTP it + e it

16. Descriptive Statistics Notes : ** Correlation is significant at the 0.01 level * Correlation is significant at the 0.05 level VariablesMeanMedian Std Dev MinMax Corr. w/ LLP LLP0.0260.0190.0230.00110.1061.000 BSIZE8.228.02.04135-0.1211 BIG50.83-0.38---0.0728 CAR16.89148.2512.1158.670.5718** CGLN447,909195497651683-27,8253,186,658-0.2483 LWO0.00270.00080.004300.02204-0.1915 SIZE13.9013.8951.197416.2148-11.3528-0.3638** EBTP0.03350.01570.0425-.00010.1873-0.1311

17. Regression 1 Prediction signFull sample Intercept?0.1552 (2.51)** BSIZE + -0.00045 (-0.42) BIG5 + 0.0252 (2.78)*** CAR + 0.0013 (3.61)*** LWO + -0.2161 (-0.41) CGLN + -1.06E-08 (-1.51) SIZE ? -0.0126 (-2.70)*** EBTP + 0.3234 (2.95)*** Adj. R-squared0.3723

18. Sensitivity analysis LLPit = b0 + b 1 CGLNit + b 2 LWOit + eit DLLPit = b0 + b 1 BSIZEit + b 2 BIG5it +b 3 CARit + b 4 CGLNit + b 5 LWOit +b 6 SIZEit+ b 7 EBTPit + eit

19. Regression 2 Prediction signFull sample Intercept?0.131875 (2.03)** BSIZE + -0.00045 (-0.42) BIG5 + 0.025277 (2.78)*** CAR + 0.00127 (3.61)*** CGLN + -3.32E-09 (-0.47) LWO1 + 0.3490494 (0.67) SIZE ? -0.0126377 (-2.70)*** EBTP + 0.3233742 (2.95)*** Adj. R-squared0.3681

20. Conclusion This paper examines earnings management in Bulgarian commercial banks through specific accrual and also explores the impact of board size and BIG5 auditors on earnings management. Board size is not an effective governance mechanism. This result indicates that the Anglo-Saxon governance model may not appropriate in the transition economy condition.

21. Conclusion The appointment of Big Five-audit firms do have impact with regards to management’s decision on discretionary LLP. The results of this study support previous evidence on the motive of earnings management in banks i.e. capital requirement and smoothing income.

22. Conclusion This study also supports that discretionary loan loss provisions is used by Bulgarian commercial banks as earnings management tool.

23. Limitations Small sample – 18 banks Lack of availability of corporate governance data –Details on board of directors e.g. directorships, directors’ shareholding and remunerations –Independent director status Variability in disclosure in annual reports

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