Earnings management and equity incentives: evidence from the European banking industry

• Date: 07 May 2019
• DOI: https://doi.org/10.1108/IJAIM-08-2017-0094
• Published date: 07 May 2019
• Pages: 244-261
• Author: Mohammad Alhadab,Bassam Al-Own

Earnings management and equity

incentives: evidence from the

European banking industry

Mohammad Alhadab

Department of Accounting, Al al-Bayt University, Mafraq, Jordan, and

Bassam Al-Own

Faculty of Finance and Business Administration, Al al-Bayt University,

Mafraq, Jordan

Abstract

Purpose –This study aims to examine the effectof equity incentives on earnings management that occurs

via the useof loan loss provisions by using a sample of 204 bank-yearobservations over the period 2006-2011.

Design/methodology/approach –The authors use the data of 39 European banks to test the main

hypothesis. Several valuation modelsand regressions are used to measure the main proxies for executives’

compensationand the determinant factors of loan loss provisions.

Findings –The empirical results revealthat earnings management that occurs via discretionaryloan loss

provisions is associated with equity incentives in the banking industry. In particular, European banks’

executives withhigh equity incentives are found to manage reported earningsupwards by reducing loan loss

provisions. The results therefore show thatincome-increasing earnings management via discretionary loan

loss provisions is widely practisedby the executives of European banks and that this is partly motivated by

executives’compensation.

Practical implications –The findings of this paperpresent important implications for regulators inthe

European Union,who should take further steps to reform the regulatory environmentto monitor and mitigate

the earnings management practices that occur via the manipulation of loan loss provisions. Earnings

management practices do not just negatively affect subsequent performance but are also found to lead to

firms’failure. Thus, regulators should take the necessary reforms to protect the wealth of stakeholders

(investors,creditors, etc.).

Originality/value –This study provides the first evidence on the relationship between equity incentives

and earningsmanagement in the European banking industry. The study shedsmore light on an issue of great

interest to a broad audience that does not receive much attention in the prior research, thus opening new

avenuesfor future research.

Keywords Equity incentives, Loan loss provision, Discretionary loss provision,

European banking industry

Paper type Research paper

The authors declare no potential conflicts of interest with respect to the research, authorship, and/or

publication of this article. There are no financial and personal relationships with other people or

organisations that could inappropriately influence (bias) their work.

Declaration of conflicting interests: The authors declare no potential conflicts of interest with

respect to the research, authorship and/or publication of this article. There are no financial and

personal relationships with other people or organisations that could inappropriately influence (bias)

their work.

IJAIM

27,2

244

Received1 August 2017

Revised4 October 2017

Accepted5 November 2017

InternationalJournal of

Accounting& Information

Management

Vol.27 No. 2, 2019

pp. 244-261

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-08-2017-0094

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

1. Introduction

This paper empirically examines the relationship between equity incentives and earnings

management in the European banking industry. Specifically, we examine whether banks’

executives engage in earnings management via discretionary loan loss provisions to meet

their compensation targets. Indeed, the European banking industry represents a unique

setting in which to examine the relation between equity incentives and earnings

management. All European banks adopt and apply common international accounting

standards and legal frameworks that aim overall to strengthen the regulatory environment

of the banking sector in Europe. Starting in 2005, all European banks are mandatorily

required to apply the International Financial Reporting Standards (IFRSs). Gebhardt and

Novotny-Farkas (2011) provide empirical evidence that the mandatory adoption of the

IFRSs in European Union(EU) countries reduces discretionary loan loss provisions.Further,

after 2004 and as recommended by the EU Commission, all European public listed firms

(including banks) should disclose more detailed information on their executives’

compensation plan(Conyon et al.,2013).

Executive compensation plansreceive substantial attention and are considered as one of

the main factors that contributedto the last financial crisis. Recent empirical literature raises

the need for regulatory reform of executives’pay plans (Uygur, 2013). This attention is

based on the fact that executive compensation plans are considered as an importanttool to

align management incentives correctly with those of shareholders (Holmstrom, 1979). A

manager’s risk aversion leads him to avoid risk taking, because his compensation is a

function of firm value, and this risk aversionconflicts with the best interest of shareholders.

Smith and Stulz (1985) and Jensen and Murphy (1990) suggest that shareholders can affect

the management’s risk aversionthrough the design of compensation contracts. Given thata

manager’s utility function is concave in expected wealth, shareholders may structure

compensation in sucha way as to counteract the effects of risk aversion.

This shows that compensationmay be structured as a linear, concave or convex function

of firm value. A linear contract (i.e. themanager is paid in shares of stock) forces utility to be

concave in firm value. The sameresult is obviously true of a concave compensation contract.

If utility is concave in firm value, the manager possesses utility-maximising incentives to

reduce risk. On the other hand, a convex compensationcontract suggests that the manager’s

utility is less concave in firm value.Depending on the extent of convexity in the contract, the

manager could be induced to engage in less risk-averse, risk-neutral or even risk-seeking

behaviour. However,many studies argue that equity-based compensation,such as stock and

stock options, may not always result in mitigatingmanagers’risk aversion and aligning the

interests between managers and shareholders. These studies show that the behavioural

responses of executives, such as earnings smoothing, can affect the incentive provided by

executives’compensationplan.

The perspective of agency conflict asserts that executive compensation contracts may

lead executives to manipulatestock-based performance results (Ke, 2001;Gao and Shrieves,

2002). The prior literature on earnings management shows different reasons for

manipulating financial results, one of which is executives’compensation plan (Gaver et al.,

1995;Bergstresser and Philippon, 2006;Cheng et al., 2011). Thus, executives’decisions to

smooth earnings can be related to the contractual motive of managers’compensation plan,

and earnings smoothing can be viewed as a reason for executives’opportunistic behaviour

to increase their compensation (Healyand Palepu,2001 Cheng and Warfield,2005;Das et al.,

2013).

According to the executive compensation literature, earnings smoothing can be defined

as the using of accounting techniques to under-report or over-report earnings via loan loss

Management

and equity

incentives

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