Corporate Governance and Accounting Conservatism: Evidence from the Banking Industry

• Author: Stergios Leventis,Panagiotis Dimitropoulos,Stephen Owusu‐Ansah
• DOI: http://doi.org/10.1111/corg.12015
• Published date: 01 May 2013
• Date: 01 May 2013

Corporate Governance and Accounting

Conservatism: Evidence from the

Banking Industry

Stergios Leventis, Panagiotis Dimitropoulos, and

Stephen Owusu-Ansah*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: In this paper, we empirically investigate whether US listed commercial banks with effective

corporate governance structures engage in higher levels of conservative f‌inancial accounting and reporting.

Research Findings/Insights: Using both market- and accrual-based measures of conservatism and both composite and

disaggregated governance indices, we document convincing evidence that well-governed banks engage in signif‌icantly

higher levels of conditional conservatism in their f‌inancial reporting practices. For example, we f‌ind that banks with

effective governance structures, particularly those with effective board and audit governance structures, recognize loan loss

provisions that are larger relative to changes in nonperforming loans compared to their counterparts with ineffective

governance structures.

Theoretical/Academic Implications: We contribute to the extant literature on the relationship between corporate gover-

nance and quality of accountinginformation by providing evidence that banks with effective governance structurespractice

higher levels of accounting conservatism.

Practitioner/Policy Implications: The f‌indings of this study would be useful to US bank regulators/supervisors in improv-

ing the existing regulatory framework by focusing on accounting conservatism as a complement to corporate governance in

mitigating the opaqueness and intense information asymmetry that plague banks.

Keywords: Corporate Governance, Accounting Conservatism, Asymmetric Timeliness, Banking Institutions, Earnings

Quality

INTRODUCTION

In this paper, we investigate whether US listed com-

mercial banks that have effective corporate governance

structures engage in conservative f‌inancial reporting. We

document evidence suggesting that well-governed banks

signif‌icantly engage in higher levels of conditional account-

ing conservatism. For example, we f‌ind that banks with

effective governance structures report loan losses in a time-

lier manner than those with ineffective governance struc-

tures. We also f‌ind that banks with particularly effective

board and audit governance structures provide for loan

losses that are larger relative to changes in non-performing

loans compared to their counterparts.

While prior studies (e.g., Cohen, Dey, & Lys, 2008; He,

El-Masry, & Wu, 2008; Lobo & Zhou, 2006; Zhou, 2008) have

investigated the effect of corporate governance structures on

the quality of accounting information, they have focused

exclusively on nonf‌inancial/industrial f‌irms, leaving the

f‌inancial sector largely unexplored. However, Nichols,

Wahlen, and Wieland (2009) investigate the effect of equity

ownership structure of both privately held and publicly

traded banks on conservative reporting, but their analysis

was limited only to the era before the passage of the

Sarbanes-Oxley Act (SOX) of 2002. Beasley, Carcello, Her-

manson, and Neal (2010) observe less or no discernible,

systematic variation among f‌irms in their governance char-

acteristics following the passage of SOX. This led Carcello,

*Address for correspondence: Stephen Owusu-Ansah, Department of Accountancy,

College of Business and Management, University of Illinois Springf‌ield,One Univer-

sity Plaza, MS UHB 4093, Springf‌ield, IL 62703-5407, USA. Tel: 1217 206 8254; Fax:

1 217 206 7543; E-mail: stoansah@yahoo.com or sowus2@uis.edu

264

Corporate Governance: An International Review, 2013, 21(3): 264–286

© 2013 Blackwell Publishing Ltd

doi:10.1111/corg.12015

Hermanson, and Ye (2011:5) to call for further examination

of the relationship between governance characteristics

and accounting outcomes in the post-SOX environment.

However, Adams and Mehran (2003) had earlier noted a

systematic difference in governance structures between

banks and industrial f‌irms, suggesting that governance

structures may be industry-specif‌ic. Hence, our motivation

is to deepen our understanding of the association between

corporate governance structures and the accounting out-

come of conservatism in the post-SOX era, using the US

commercial banking sector as a case study.

It is imperative to study the associationbetween corporate

governance and accounting conservatism in the banking

industry in thatthe former is particularly important for banks

due to their complexities, intense information asymmetries,

opaqueness and contracting peculiarities coupled with the

failure of several prominent US banks due to corporate gov-

ernance lapses.1Effective governancestructures are essential

to achieving and maintaining public trust and conf‌idence in

the banking system, which are critical to the proper function-

ing of the banking sector and the economy as a whole.

Ineffective governance structures, on the other hand, may

contribute to bank failures, which can pose signif‌icant public

costs and consequences due to their potential impact on any

deposit insurance scheme and the possibility of broadermac-

roeconomic implications such as contagion risk and impact

on paymentsystems. In addition, ineffective governance can

lead markets to lose conf‌idence in the ability of a bank to

properlymanage its assets and liabilities, including deposits,

which could in turn trigger a bank run or liquidity crisis

(Basel Committee on Banking Supervision, 2006).

Accounting conservatism, which ensures the exercise of

caution in f‌inancial accounting and reporting under condi-

tions of uncertainty, complements corporate governance in

that it constrains managerial opportunism, mitigates agency

problems, and enables eff‌icient contracting in the presence

of asymmetric information (Ahmed & Duellman, 2007; Ball

& Shivakumar, 2005; Basu, 2005; García Lara, García Osma,

& Penalva, 2009).

Using a sample of 315 US listed commercial banks over

the seven-year period, 2003–2009, we document that banks

having effective governance structures engage in higher

levels of conditional accounting conservatism. For example,

relative to banks having ineffective governance structures,

those with effective governance structures report loan losses

(“bad news”) in a timelier manner, and provide for loan

losses that are larger relative to changes in non-performing

loans. Additional tests show that our f‌indings are robust to

the use of market- and accrual-based measures of condi-

tional conservatism and several sensitivity tests with respect

to different specif‌ications of the empirical models and

research design.

Wecontribute to the extant literature in two ways.First, we

provide empirical evidence that, in spite of having unique

governance challenges, banks with effective board and audit

governance structures, as opposed to effective executive and

director compensation and ownership policies and antitake-

overprovisions, practice higher levels of conditional account-

ing conservatism. Second, we extend García Lara et al. (2009)

and Nichols et al. (2009). Using a sample of nonf‌inancial

f‌irms, García Lara et al. (2009) examine the association

between corporate governanceand accounting conservatism.

Unlike their study, ours uses a sample of f‌inancial f‌irms –

commercial banks. For Nichols et al. (2009), while they inves-

tigate the effect of equity ownership structure of privately

held and publicly traded banks on conditional conservatism

in the pre-SOX era, we add to their work by investigating the

effect of corporate governance on conditional conservatism

by publicly listed banks during the post-SOX era.

We organize the rest of the paper as follows. We review

the extant literature and develop our hypotheses in the next

section by f‌irst describing the particularities of corporate

governance of banks and the problems they pose compared

to those of generic f‌irms. We then follow this by discussing

the concept of accounting conservatism and end the section

by reviewing the relevant literature associating corporate

governance with accounting conservatism. We describe the

sample selection procedure and our research design in the

third section. Wepresent the empirical f‌indings and perform

robustness checks in the fourth section. We conclude the

paper in the last section.

LITERATURE REVIEW AND HYPOTHESES

DEVELOPMENT

Corporate Governance of Banks

There is yet to be a generallyaccepted def‌inition of corporate

governance. However, for our purpose, we adopt the much

broader def‌inition of corporategovernance that is very much

in line with the understanding of banking supervisors, as

embodied in the Basel Committee on Banking Supervision’s

(2006) guidance, which states that from

a banking industry perspective, corporate governance involves

the manner in which the business and affairs of banks are

governed by the board of directors and senior management

which, inter alia, affects how they: (1) set corporate objectives;

(2) operate the bank’s business on a day-to-day basis; (3) meet

the obligation of accountability to their shareholders and take

into account the interests of other recognized stakeholders

(including, inter alia, supervisors, governments and deposi-

tors); (4) align corporate activities and behavior with the expec-

tation that banks will operate in a safe and sound manner and

in compliance with applicable laws and regulations; and (5)

protect the interests of depositors.

As noted, effective governance structures are essential to

achieving and maintaining public trust and conf‌idence in

the banking system, which are critical to the proper func-

tioning of the banking sector and an economy as a whole.

While banks are similar to nonf‌inancial/industrial f‌irms as

they all have stockholders, debt holders, board of directors,

and competitors, banks have unique governance structures

that are different from industrial f‌irms (Adams & Mehran,

2003). First, banks are opaque and more complex than non-

f‌inancial f‌irms (Levine, 2004). Although information asym-

metries plague all sectors of an economy, Furf‌ine (2001) f‌ind

evidence suggesting that information asymmetries are more

pronounced in the banking sector. For example, the quality

of bank loans is not readily observable, while the quality of

assets of industrial f‌irms is more easily discernible by third

parties (Mülbert, 2009). Morgan (2002) f‌inds that bond ana-

CORPORATE GOVERNANCE AND ACCOUNTING CONSERVATISM 265

Volume 21 Number 3 May 2013© 2013 Blackwell Publishing Ltd