1-s2.0-S0165410101000039-Main The E!ects of Regulatory and Contracting

Journal of Accounting and Economics 30 (2001) 159}186
The e!ects of regulatory and contracting

costs on banks' choice of accounting
method for other postretirement
employee bene"ts
K. Ramesh*, Lawrence Revsine

Charles River Associates Incorporated, Boston, MA 02116-5092, USA
J.L. Kellogg Graduate School of Management, Northwestern University, Evanston, IL 60208-2002, USA
Received 16 January 1998; received in revised form 1 November 2000
Abstract
This paper examines banks' choice of accounting methods in a new regulatory
environment that more closely ties regulatory monitoring to GAAP numbers. The study
"nds that banks' choice of the implementation method for SFAS 106 is consistent with an
attempt to balance the increased regulatory costs with earnings management bene"ts.
Moreover, banks strategically chose the adoption timing of both SFAS 106 and SFAS
109 to further reduce regulatory costs. The implementation method choice is consistent
with a portfolio approach where managers simultaneously consider the existing
The views expressed herein are those of the authors and do not necessarily re#ect those of
Charles River Associates Incorporated. We are grateful for the comments and suggestions provided
by Ashiq Ali, Eli Amir, Ray Ball, Dorsey Baskin, Jr., Anne Beatty, Bala Dharan, Jim Brickley, Dan
Gode, Julia D'Souza, Bruce Johnson, S.P. Kothari (the editor), Jody Magliolo (the referee), David
Mayers, Jim McKeown, Cli! Smith, Rick Tubbs, Joe Weber, Steve Ze!, Jerry Zimmerman, the
workshop participants at the University of Arizona, University of California at Riverside, Charles
River Associates Incorporated, Dartmouth College, University of Iowa, University of Maryland,
Rice University, The Pennsylvania State University and the participants at the 1997 American
Accounting Association Annual Meetings. We acknowledge the expert research assistance provided
by Anjali Arora, Anne Hunt (Olin Fellow), Murali R. Gopal, Sunil Thakor, and especially, Jonathon
Singer.
* Corresponding author. Tel.: #1-617-425-3054; fax: #1-617-425-3132.
E-mail address: kramesh@crai.com (K. Ramesh).
0165-4101/01/$- see front matter 2001 Elsevier Science B.V. All rights reserved.
PII: S 0 1 6 5 - 4 1 0 1 ( 0 1 ) 0 0 0 0 3 - 9
The absence of funding was attributable to two factors. First, the Employee Retirement and
Income Security Act of 1974 (ERISA) did not require funding for these types of bene"ts. Second, the
income tax law provided a disincentive to advance funding since tax deductions were only allowed
on a &pay-as-you-go' basis.
discretionary accrual levels vis-a` -vis the "nancial reporting e!ects of impending ac-
counting standards. 2001 Elsevier Science B.V. All rights reserved.
JEL classixcation: C25; G21; G28; M41
Keywords: Accounting methods choice; Bank regulatory capital; Earnings management;
FDICIA
1. Introduction
Regulations based on "nancial reporting numbers potentially impose addi-
tional contracting costs on "rms subject to the regulations, beyond those
experienced by non-regulated "rms. Banks are an example. In the early 1990s
two new regulatory standards that had the potential to signi"cantly increase
banks' contracting costs were introduced:
1. Beginning in 1991, banking regulation more closely tied regulatory monitor-
ing to reported GAAP numbers. Speci"cally, banks faced increased regula-
tory costs from the Federal Deposit Insurance Corporation Improvement
Act, 1991 (FDICIA). Section 121 of FDICIA mandates that accounting
principles used in regulatory reports (RAP) cannot be less stringent (or less
conservative) than generally accepted accounting principles (GAAP). Thus,
FDICIA eliminated some of the discretion provided to regulators to deviate
from GAAP in order to bolster the capital ratios of "nancially distressed
depository institutions.
2. In December 1990, the Financial Accounting Standards Board (FASB) issued
SFAS No. 106 (Employers' Accounting for Postretirement Bene"ts Other
Than Pensions, hereafter SFAS 106). These formerly unrecognized liabilities
(hereafter OPEB) were either materially underfunded or totally unfunded for
virtually all "rms. The FASB permitted "rms to recognize the OPEB
liability either all-at-once in the adoption-year income statement or to
amortize it into net income over future years (hereafter, the adoption method
choice).
Coincidentally, 1993, the last year banks could have adopted SFAS 106, was
also the "rst year that the new banking regulation became fully e!ective.
Therefore, the GAAP accounting method for implementing SFAS 106 had
a direct e!ect on banks' regulatory capital levels. Speci"cally, weaker banks
160 K. Ramesh, L. Revsine / Journal of Accounting and Economics 30 (2001) 159}186
would have su!ered a further reduction in regulatory capital by recording the
SFAS 106 liability all at once, and consequently, faced increased probability of
costly regulatory oversight.
This paper examines whether the #exibility in the adoption method for SFAS
106 enabled banks to mitigate the increased contracting and regulatory costs
(Watts and Zimmerman, 1986) that arose from the new accounting standard.
We study SFAS 106 because of its large impact on "rms' "nancial statements
and the resulting potential economic consequences on existing "rm contracts.
The banking industry, in addition, o!ers an interesting setting since the SFAS
106 adoption behavior in this industry was in stark contrast to that of other
industries. Almost 70% of banks chose to amortize the SFAS 106 transition
liability rather than expense it, in comparison to only 15% of non-bank "rms
(Lehavy and Revsine, 1994; see also Amir and Livnat, 1997; Amir and Ziv, 1997).
Our research design incorporates the fact that managers have numerous
mechanisms at their disposal in implementing reporting discretion. While prior
studies have typically examined a single reporting choice (managing discretion-
ary accruals or choice among accounting principles), our study is among the "rst
to consider a portfolio of accounting choices available to managers (see
Zmijewski and Hagerman (1981) for early work on a portfolio approach to
choosing accounting principles). We examine whether banks' choice of SFAS
106 implementation method is consistent with the view that managers consider
a portfolio of accounting choices involving accounting principles and discretion-
ary accruals for earnings and capital management.
We explore this &portfolio' approach to managing accounting numbers in two
ways. We "rst examine how the "nancial statement e!ects of adopting SFAS
No. 109 (Àccounting for Income Taxesa, hereafter SFAS 109) in#uenced the
banks' choice of adoption method for SFAS 106. In contrast to SFAS 106, the
new accounting standard for income taxes had a positive e!ect on the net
income and owners' equity of most banks that were a!ected by the standard.
Since the adoption timing of SFAS 106 and SFAS 109 overlapped, banks had an
opportunity to choose strategically the adoption timing of the two standards to
mitigate the adverse e!ects of SFAS 106 on their earnings and capital. Second,
we also examine how the choice of SFAS 106 implementation method was
in#uenced by an important discretionary accrual for banks, i.e., the loan loss
reserve. We hypothesize that banks that &under provided' for loan losses are
more likely to choose the amortization approach to mitigate the e!ect of
impending bad debts on capital levels, especially if they are poorly capitalized.
If regulatory costs were the only contracting consideration, one would expect
all banks to have adopted SFAS 106 using the amortization method. In our
sample 30% did not and we hypothesize that this phenomenon is explained by
an o!setting earnings management e!ect for well-capitalized banks. Speci"cally,
the all-at-once adoption method for SFAS 106 avoids the continuing future
&drag' on earnings that ensues under the amortization method.
K. Ramesh, L. Revsine / Journal of Accounting and Economics 30 (2001) 159}186 161
Our results are consistent with banks trying to mitigate contracting costs by
(1) strategically selecting the adoption method for SFAS 106, (2) coordinating
the adoption timing of SFAS Nos. 106 and 109, and (3) managing discretionary
accruals. Speci"cally, we "nd:
1. Regulatory costs to be a key determinant of banks' choice of the accounting
method for SFAS 106 as evidenced by a monotonic association between
capital levels and the choice of accounting method for SFAS 106. For
instance, while only 15% of banks with a low regulatory capital level chose
the all-at-once approach, the proportion increases monotonically to more
than 33% (40%) for "rms in the middle (high) capital level groups. By
focusing on a single industry, our study examines a scenario where ac-
counting standards' economic consequences are likely to be transparent
(Watts and Zimmerman, 1990, p. 152).
2. Banks e!ectively managed their earnings and capital by a judicious choice of
adoption method and adoption timing for the OPEB and income tax ac-
counting standards.
3. Among poorly capitalized banks, the probability of choosing the all-at-once
approach is positively related to the degree of conservatism in their ac-
counting for loan losses, i.e., banks that expected future reductions in their
capital due to increased provisions or write-o! of bad loans chose the
amortization approach to mitigate the adverse e!ects of these loan losses. In
essence, bank managers seem to consider discretionary accruals as part of the
portfolio of accounting choices for managing earnings and capital.
Taken together, our research setting captures di!erential incentives for strong
versus weak banks and trade-o!s between regulatory costs versus earnings
management e!ects. Our results suggest that models of accounting methods
choice can provide greater insights when interactions between "rm character-
istics and "nancial statement e!ects of accounting standards are considered
(Watts and Zimmerman, 1990; Ali and Kumar, 1994).
Finally, the results of our study are relevant to accounting policy makers. In
recent years, the Financial Accounting Standards Board (FASB) has sometimes
provided "rms with choice in both adoption methods and adoption timing for
implementing new accounting pronouncements (e.g., SFAS No. 87, SFAS 106,
SFAS 109). Extant literature suggests that providing transition options reduces
the political costs to the FASB by minimizing "rms' adverse implementation
e!ects (Balsam et al., 1995). However, "nancial analysts believe that #exibility in
transition methods results in extended periods of noncomparability among the
"nancial statements of "rms choosing di!erent transition methods. AIMR (a
national professional association of "nancial analysts) has urged the FASB to
abandon multiple transition methods when implementing new accounting
standards (see AIMR, 1993. pp. 69}73). While analysts are concerned about
information processing costs, this study's results suggest that the FASB would
impose contracting and regulatory costs on "rms if choice in implementation
methods for new accounting standards is eliminated.
The paper is organized as follows. Section 2 describes the hypothesis develop-
ment. Section 3 discusses the descriptive analysis and the results of our empirical
tests. Section 4 presents concluding remarks.
2. Hypotheses development
We examine whether the e!ects of SFAS 106 on pre-existing bank contracts
and the portfolio of accounting choices in#uenced banks' choice of the
transition accounting method. We initially develop a set of hypotheses that
focus on regulatory capital management and earnings management incentives.
We next develop hypotheses on whether banks' choice of SFAS 106 implemen-
tation method is consistent with the "nancial reporting e!ects of the impending
accounting standard on income taxes and the existing level of discretionary
accruals.
2.1. Regulatory capital management versus income management
Regulatory capital adequacy is likely a key determinant of the SFAS 106
adoption method. Under current banking regulation, banks whose capital ratios
fall below the regulatory minimum are subject to prompt regulatory super-
vision. Conversely, banks whose capital levels are substantially above the
required minimum obtain regulatory bene"ts. For example, under FDICIA,
only well or adequately capitalized banks (as de"ned by banking regulators) can
accept brokered deposits (large CDs sold through brokerage "rms) or o!er
pass-through insurance protection for accounts established under employee
pension plans (Greenbaum and Thakor, 1995). Well-capitalized bank holding
companies are permitted to buy or redeem their own securities without notifying
the Federal Reserve Bank in advance. In addition, regulators favor highly
capitalized banks pursuing acquisitions from the RTC and the FDIC. Further-
more, FDICIA mandates the FDIC to charge risk-based deposit insurance
premia that vary with banks' regulatory capital. In summary, both regulatory
costs and bene"ts vary with bank capital levels.
The e!ect of accounting methods choice on the expected regulatory bene-
"t/cost is straightforward. For a poorly capitalized bank, an immediate reduc-
tion in regulatory capital can potentially limit the bank's operating #exibility
due to possible regulatory scrutiny. In contrast, a highly capitalized bank's
manager might face substantially lower costs from adopting the all-at-once
approach. The only potential cost to a highly capitalized bank arises due to
the loss of some #exibility in managing regulatory capital if future adversity
` In one sense, the regulatory capital and earnings management trade-o!s faced by managers can
be viewed in terms of their compensation, i.e., managers care about regulatory costs and earnings
management only to the extent they a!ect the present value of the stream of their expected future
compensation income (Gaver and Gaver, 1998). Consequently, a bank manager may be willing to
take a hit to regulatory capital and earnings if the action is expected to increase the manager's
wealth.
materializes unexpectedly. This is because SFAS 106 does not allow a bank to
switch from one implementation method to the other at a later date if its capital
level subsequently deteriorates.
Anecdotal evidence suggests that banks with high capital levels considered
themselves less vulnerable to the negative e!ects of SFAS 106. For instance, the
CEO of Norwest Corporation said that `[o]ur strong capital position, with the
highest risk-based capital level among the largest regional banks in the coun-
try
2
allows Norwest to take this non-cash, one-time charge [for the SFAS 106
liability]a. (PR Newswire, December 7, 1992). Similarly, in another PR News-
wire article ` PNC [Financial Corp.] said it opted to record the cost of FAS 106
in 1992 to take advantage of its strong earnings and capital positiona. (PR
Newswire, January 7, 1993). Although highly capitalized banks may be less
susceptible to the e!ects of SFAS 106, it is not clear why such banks would
voluntarily choose an accounting method that immediately reduces their regula-
tory capital. All banks should have adopted SFAS 106 using the amortization
approach if regulatory capital were the only concern. Since some banks chose
the all-at-once approach, we consider earnings management incentives as a pos-
sible explanation for the lack of a corner solution.
The earnings management e!ect arises because the accounting expense from
the two implementation methods are re#ected in di!erent accounting periods as
well as in di!erent segments of the income statement. The all-at-once approach
results in a one-time charge (&big bath') that shifts accounting earnings from the
current to future periods by lowering future expenses when compared to the
amortization approach. In addition, the expense for the transition obligation
could be a nonrecurring &below the line' item or a recurring &above the line' item
depending on whether the "rm chooses the all-at-once or the amortization
approach, respectively. Managers of highly capitalized banks with incentives to
either take a big bath in the adoption year and/or boost future earnings are
more likely to choose the all-at-once approach (Murphy and Zimmerman, 1993;
Gaver and Gaver, 1998). These managers would trade-o! the earnings manage-
ment bene"ts of a big bath against the regulatory capital bene"ts from the
amortization approach.` The analysis of costs and bene"ts of the adoption
methods leads to our "rst hypothesis stated in the alternative form:
H
: Banks with lower (higher) regulatory capital ratios are more likely to use
the amortization (all-at-once) approach for the transition obligation.
Watts and Zimmerman (1990, p. 143}144) suggest that models in positive
accounting studies could be misspeci"ed since they rarely consider potential
interactions between the contracting variables. Consistent with this intuition,
Ali and Kumar (1994) "nd that incorporating interactions between "rm charac-
teristics and the "nancial statement e!ects of an accounting method increases
the explanatory power of models designed to explain accounting methods
choice.
H
suggests that while poorly capitalized banks are likely to mitigate regula-
tory costs by choosing the amortization method, highly capitalized banks would
obtain earnings management bene"ts by adopting the all-at-once approach. In
addition, these costs and bene"ts are expected to vary with the magnitude of the
accounting e!ect. Among poorly capitalized banks, the increase in regulatory
costs from the adoption of SFAS 106 is likely to be positively related to the
relative magnitude (or the materiality) of the OPEB liability. By contrast, in
highly capitalized banks the larger the transition obligation, the greater the
economic bene"ts of earnings management. In other words, the big bath
approach o!ers bene"ts proportionate to the level of the transition obligation.
Taken together, the magnitude e!ect of the transition obligation is summarized
in the following hypothesis:
H
`
: Poorly (highly) capitalized banks with larger OPEB transition obliga-
tions are more likely to amortize the transition obligation (choose the all-at-
once approach).
2.2. A portfolio approach to accounting choices
We examine whether banks considered a portfolio of accounting choices
involving accounting principles and discretionary accruals for earnings and
capital management when implementing their accounting method for the SFAS
106 transition obligation. If the set of accounting principles and discretionary
accrual choices remain "xed, then managers would make changes to their
portfolio of accounting methods and discretionary accruals only in response to
unexpected changes in business conditions or investment opportunities.
However, accounting standard setters periodically introduce either new ac-
counting principles or mandate changes to the existing set of accounting choices.
SFAS 106 introduced such an externality by mandating the expensing of the
previously unrecorded liability for OPEB. However, "rms were given a choice
between the all-at-once and the amortization approaches for recording this
transition liability. We posit that the adoption method choice for the transition
obligation would be determined by the "rm's existing level of discretionary
accruals as well as any impending mandatory accounting changes.
We explore this portfolio approach to managing accounting numbers in two
ways. We "rst examine how the "nancial statement e!ects of adopting SFAS 109
` For example, under APB Opinion 11, Paragraphs 45}47, a "rm can record a deferred tax asset
only when there is &assurance beyond any reasonable doubt' that the "rm will generate su$cient
future taxable income to absorb the current accounting expenses. The SFAS 96 criterion was
similarly onerous.
(Àccounting for Income Taxesa) in#uenced the banks' choice of adoption
method for SFAS 106. In contrast to SFAS 106, the newaccounting standard for
income taxes had a positive e!ect on the net income and owners' equity of most
banks that were a!ected by the standard. Since the adoption timing of SFAS 106
and SFAS 109 overlapped, banks had an opportunity to choose strategically the
adoption timing of the two standards to mitigate the adverse e!ects of SFAS 106
on their earnings and capital. Second, we also examine how the choice of SFAS
106 implementation method was in#uenced by an important discretionary
accrual for banks, i.e., the loan loss reserve. We hypothesize that banks that
&under provided' for loan losses are more likely to choose the amortization
approach to mitigate the e!ect of impending bad debts on capital levels,
especially if they are poorly capitalized.
Prior to the issuance of SFAS 109 in February 1992, the accounting for
income taxes was guided by either APB Opinion 11 or SFAS 96. Both of these
standards contained provisions that essentially precluded recognition of net
deferred income tax assets.` By contrast, SFAS 109 allows "rms to record
deferred tax assets subject to satisfying a less stringent realization criterion.
Speci"cally, "rms can record the full potential amount of the deferred tax asset
but must reduce it by a valuation allowance such that the net balance represents
an amount that ìs more likely than not to be realizeda (SFAS 109, para 17e).
The FASB permitted "rms to record the adoption e!ect of SFAS 109 using
either the cumulative e!ects approach or the retroactive approach (SFAS 109,
paras 51 and 163). Some banks that were considering adopting SFAS 106 using
the all-at-once method faced uncertainty about their ability to record the
deferred tax asset from the tax bene"ts on the OPEB transition liability. Unless
they adopted SFAS 109, these banks could have failed to meet the more
stringent requirements for recording this deferred tax asset under APB 11 or
SFAS 96 (Coopers and Lybrand, 1992). Thus, banks considering the all-at-once
method had an incentive to adopt SFAS 109. The adoption of SFAS 109 would
have a positive e!ect on net income and owners' equity. In addition, banks could
also record a deferred tax asset for unrecognized tax bene"ts from reserves for
credit and loan losses, loss on real estate acquired in satisfaction of debt and loss
carryforwards.
Both SFAS 106 and SFAS 109 were e!ective for "scal years beginning after
December 15, 1992, although early adoption of each standard was permitted by
the FASB (SFAS 106, para 108 and SFAS 109, para 50). SFAS 109 was expected
to o!set the predominantly income decreasing e!ect of SFAS 106 as well as
" Statements made in early 1993 by some of the banks are consistent with this scenario. For
example, Peter Tobin, Chief Financial O$cer, Chemical Banking Corp. was quoted as saying that
the àdoption of FAS 106 and FAS 109 accounting changes will add $35}$40 million to "rst quarter
net income and Tier One capitala (Reuters, January 20, 1993). Similarly, another article suggests that
the e!ect of SFAS 109 `should add a welcome 0.25}0.30 [basis points] to Citicorp's [Tier One
capital] ratioa (Reuters, April 1, 1993). See also The Thrift Accountant, April 6, 1992, April 13, 1992,
and January 11, 1993.
` The e!ect of loan loss provision versus loan write-o!s on regulatory capital di!ers across the
Tier 1 Capital, Total Capital, and leverage ratios (12 CFR Part 225, Appendices A and D). (see
Moyer, 1990, for a discussion of this e!ect under prior regulatory regimes.) Loan loss provisions
immediately reduce Tier 1 Capital, and therefore, decrease both Tier 1 and leverage ratios. However,
since some of the loan loss reserve is included in Tier 2 capital, only actual write-o!s will decrease
Total Capital in some instances. Our analysis (not reported) suggests that while most sample banks
will experience a decrease in Tier 2 Capital (which is part of Total Capital) from any additional
provisions or write-o!s, poorly capitalized banks that &under-provided' for loan losses are likely to
su!er the most.
possibly increase the likelihood of recording the tax bene"t from the OPEB
transition liability. In addition, the permitted adoption timing of the two
standards materially overlapped. Thus, banks could choose the adoption
method and timing of the two standards strategically in order to mitigate the
e!ects of SFAS 106 on regulatory costs.
However, the e!ect of SFAS 109 on banks' capital was somewhat uncertain
during the adoption window provided by the FASB. Since SFAS 109 is less
conservative than the prior accounting standards for income taxes, there was
a possibility that Federal regulators might force banks to use a more conserva-
tive accounting approach. While the banks' ability to obtain a regulatory capital
boost from SFAS 109 was less than certain, the expectation during the SFAS
106 adoption window indicated that at least some of the deferred tax asset
would count towards regulatory capital." Collectively, our discussion leads to
the following joint hypothesis:
H
`
: The probability of choosing the all-at-once approach is positively related
to the extent to which banks can o!set their SFAS 106 transition obligation
against SFAS 109 bene"ts. Additionally, ceteris paribus, banks not a!ected by
SFAS 109 are more likely to choose the amortization approach.
Next, we examine how the existing level of loan loss reserve impacted the
choice of SFAS 106 implementation method. To the extent banks have
&under provided' for loan losses, we hypothesize that they are more likely to
choose the amortization approach to mitigate the e!ect of impending bad debts
on capital levels (Ahmed et al., 1999; Kim and Kross, 1998). Ceteris paribus,
these banks expect a larger decline in future capital levels than banks that have
a conservative provision. The economic consequences would be especially
pronounced in banks that are poorly capitalized.` This discussion leads to our
" Firms are classi"ed as having immaterial amount of OPEB liability based on their own
statements in the annual reports.
"nal hypothesis:
H
"
: Poorly capitalized banks that &under provided' for loan losses (are
conservative in their loan loss estimates) are more (less) likely to amortize
their OPEB transition obligation.
3. Empirical results
In this section, we "rst discuss our sample selection procedure and provide
descriptive statistics. We next compare the "nancial characteristics of banks
conditioned on their SFAS 106 adoption method and timing. Finally, we discuss
the results of our hypotheses testing.
3.1. Sample selection and descriptive statistics
The sample consists of all banks for which we were able to obtain annual
reports for the "scal year 1993. Our initial sample of 328 banks represents
a substantial majority of the population of bank holding companies. After
eliminating banks that do not provide OPEB bene"ts or had an immaterial
amount of OPEB liability, our "nal sample consists of 140 banks (see Table 1)."
Table 1 provides the frequency distributions grouped by adoption timing and
adoption method both in our sample and in Lehavy and Revsine (1994). Recall
that the sample in Lehavy and Revsine consists primarily of non-bank "rms.
The evidence in Table 1 suggests that banks are almost 5 times more likely to
choose the amortization approach compared to non-bank "rms. In addition,
unlike non-bank "rms, a substantial majority of banks delayed adopting SFAS
106 until 1993.
Next we examine whether the choice of adoption method by banks is consis-
tent with di!erential regulatory costs. We assign banks into one of three groups
based on their capital ratios in the year prior to the adoption year. Since
one-fourth of the banks adopted SFAS 106 prior to 1993, we adjust for
inter-temporal changes in capital ratios by subtracting the industry median for
the year. Table 2 reports the results of ` tests for independence between capital
ratios and adoption method.
The results indicate a positive association between capital ratio levels and
a bank's propensity to adopt SFAS 106 using the all-at-once approach. Based
on the total capital ratio (TCR), we "nd that only 16% of banks in the low
capital group chose the all-at-once approach compared to 39% in high capital
Table 1
Determination of sample size
N %
1993 Bank annual reports obtained 328 100.0
Less: banks that do not provide OPEB 160 48.8
Less: banks with immaterial amount of OPEB liability 28 8.5
Final sample size 140 42.7
Adoption timing and adoption method This study
Lehavy and
Revsine (1994)
N % N %
All-at-once "rms 42 30.0 348 85.1
Early all-at-once "rms (FAS 106 adopted prior
to 1993)
23 54.8 245 70.4
Late all-at-once "rms (FAS 106 adopted in 1993) 19 45.2 103 29.6
Amortization "rms 98 70.0 61 14.9
Early amortization "rms (FAS 106 adopted
prior to 1993)
9 9.2 5 8.2
Late amortization "rms (FAS 106 adopted in 1993) 89 90.8 56 91.8
Total of all early adopters (FAS 106 adopted
prior to 1993)
32 22.9 250 61.1
Total of all late adopters (FAS 106 adopted in 1993) 108 77.1 159 38.9
Total "rms 140 100.0 409 100.0
This includes one bank (First Empire State) which appears to be using accrual accounting for
OPEB expense even prior to 1991.
For our sample, the null hypothesis of independence between adoption timing and the choice of
accounting method is rejected using a ` statistic (34.64) at a p-value of less than 0.0001.
group. Overall, the univariate categorical test is consistent with the posited
relation between regulatory costs and adoption method choice.
Mian and Smith (1990) document that "rms that were adversely a!ected by
the exposure draft to SFAS 94 lobbied the FASB more often by writing
comment letters. Consistent with their evidence, we "nd that none of the banks
that wrote comment letters on the exposure draft to SFAS 106 is well capital-
ized. Of the 14 "rms that wrote comment letters, 11 (3) belong to the low
(medium) total capital ratio group.
Apart from considering regulatory costs, another distinctive feature of our
study is the incorporation of the interactive e!ects of SFAS 106 and SFAS 109.
In Table 3, we provide descriptive statistics on the absolute and relative
magnitudes of the adoption e!ects of the two standards.
Table 2
Association between total capital ratio and choice of FAS 106 accounting method
All-at-once "rms Amortization "rms Total
Low capital 7 38 45
15.56 84.44 32.85
Medium capital 15 31 46
32.61 67.39 33.58
High capital 18 28 46
39.13 60.87 33.58
Total 40 97 137
29.20 70.80 100.00
`"6.505 (p-value"0.039)
In each cell, the row percentages are provided below the cell frequencies.
` In the adoption year, only 29 banks disclosed the e!ect of SFAS 106 on their OPEBexpense. For
the remaining banks, we estimate this e!ect as the OPEB expense in the adoption year minus the
OPEB expense in the previous year. Note that the computed SFAS 106 e!ect (for both disclosing
and non-disclosing "rms) includes the transition e!ect from amortization. Therefore, in order to
compute the &pure' accrual e!ect, we subtract the amortization of transition obligation for those
"rms that chose the amortization approach. The resulting number is de#ated by the sum of net
interest income and non-interest income. To examine the robustness of our proxy variable used for
the non-disclosing "rms, we correlate the reported e!ect with our estimated e!ect for the 29
disclosing "rms. The Spearman correlation between the two is 0.872 (p(0.0001).
SFAS 106 a!ects net income in two ways. First, the di!erence between the
annual accrual OPEB expense and its pay-as-you-go counterpart reduces oper-
ating income of virtually all "rms (hereafter, the accrual e!ect). Second, depend-
ing on the chosen implementation method, "rms either take a one-time charge
below the line (under `Cumulative E!ects of Change in Accounting Principlea)
or gradually amortize the transition obligation (the transition e!ect) over future
years as a part of OPEB expense (above the line).
The average OPEB liability at the time of adoption of SFAS 106 (the
transition e!ect) is slightly more than $37 million and is about 2% of the market
value of equity. However, the average liability for non-banks is substantially
higher than that for banks (see Amir and Ziv, 1997, Table 4). This suggests that
the regulatory costs to the banks result in a higher total contracting costs per
dollar of OPEB liability for banks when compared to non-bank "rms. In
addition to the transition e!ect, the OPEB expense for an average bank
increased by 0.13% of its gross income due to the accrual e!ect in the adoption
year.` However, neither the accrual e!ect nor the transition e!ect is statistically
signi"cant across the two adoption method samples suggesting that the "nancial
statement e!ect by itself cannot explain the choice of accounting methods.
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The average bene"t from adopting SFAS 109 is about $23 million for the
sample "rms, which is less than 1% of the market value of equity. In addition,
the SFAS 109 bene"t was slightly less than 50% of the OPEB liability for all
banks. More importantly, we "nd systematic di!erences in both the absolute
and relative values of SFAS 109 bene"t across the SFAS 106 adoption method
samples. For instance, the mean SFAS 109 bene"t expressed as a percentage of
market value of equity is more than twice as large in the all-at-once sample
compared to the amortization sample; similarly, the SFAS 109 bene"t expressed
as a percentage of the SFAS 106 liability (the transition e!ect) is more than
6 times larger. Furthermore, while a majority of the amortizers were una!ected
by SFAS 109, less than 30% of the all-at-once "rms were. Taken together, the
evidence suggests that banks' choice of SFAS 106 adoption method was in-
#uenced by the interactive e!ects of SFAS 106 and SFAS 109.
3.2. Financial characteristics of banks choosing diwerent adoption methods
In Table 4, we compare the "nancial characteristics of the all-at-once "rms
with the amortization sample in the year of SFAS 106 adoption. Similar results
are obtained when the comparisons are made using data from the year prior to
the adoption year (results not reported). The variables reported in Table 4 are
designed to capture the "ve characteristics that regulators consider to be key
determinants of banks' "nancial health. These are: capital adequacy, asset
quality, management ability, earnings level and quality, and liquidity, which are
collectively referred to as the CAMEL rating. (See Eccher et al. (1996) for
empirical evidence on the association between these variables and "rm value.)
Except for long-term debt values, which were hand collected from the annual
reports, all the other variables used to calculate the "nancial ratios are obtained
from a 10-K database provided by SNL Securities, L.P.
To control for inter-temporal changes, we adjust the "nancial ratios by
subtracting the industry median for the year. The only exception to this adjust-
ment is the long-term debt to equity ratio (DE) because the level of DE itself,
rather than its deviation from the industry median, is more likely a proxy for
closeness to debt covenants. In Table 4, we report both the unadjusted values of
the "nancial characteristics as well as values adjusted for inter-temporal changes
in industry median.
The t-test results reported in Table 4 suggest that the all-at-once "rms are
"nancially stronger than the amortization "rms along several dimensions such
as market-to-book ratio, capital levels and return on assets. Since the results are
similar for the 2 years, we focus only on the adoption year. The major reason for
the higher return on assets appears to be due to better control over operating
expenses. In addition, we "nd that the loan portfolio of the amortization "rms is
of substantially lower quality compared to that of the all-at-once sample. The
amortization "rms have consistently higher loan foreclosure expense and higher
loan loss provisions. Furthermore, the lower expenses of the all-at-once "rms
are apparently not due to under-estimation of bad debts since these "rms have
a higher proportion of bad debt expense to bad debt write-o!s and higher levels
of loan loss reserves to non-performing assets. Even though the amortization
"rms have lower quality loans, their loan loss reserve as a percentage of loans is
no higher than that of the all-at-once "rms. In essence, the all-at-once "rms have
higher loan quality and utilize more conservative accounting estimates for loan
losses.
The balance sheet structures of the two samples indicate some signi"cant
di!erences as well. The all-at-once "rms have higher liquidity as indicated by
lower levels of their loans-to-deposits ratio as well as their loans-to-assets ratio.
However, we do not "nd a signi"cant di!erence between the debt-equity ratio of
the two samples. Taken together, our evidence suggests that "nancially weaker
banks are more likely to choose the amortization approach in order to minimize
their regulatory and contracting costs.
To see whether our results are due to di!erences in the adoption timings
reported in Table 1, we replicate the analysis in Table 4 for sub-samples formed
by both adoption timing and adoption method choices (see Lehavy and Revsine,
1994; Amir and Ziv, 1997). Although early all-at-once "rms are "nancially the
healthiest, the results (not reported) indicate that both early and late all-at-once
"rms are stronger than the late amortization "rms on several measures of
"nancial soundness. This evidence suggests that the results in Table 4 are not
due to the adoption timing e!ect.
3.3. Multivariate analysis of the determinants of the choice of adoption method
The univariate analyses discussed so far suggest that banks' choice of the
adoption method for SFAS 106 is associated with proxies for regulatory costs
and the moderating e!ects of SFAS 109. Using the following multivariate logit
model, we next examine jointly how the choice of adoption method is related to
the determinants discussed in Section 2, i.e.,
Method " #
TCR
R
#
`
LowCap;E!ect106
#
`
HghCap;E!ect106#
`
E!ect109#
`
NO109
#
"
LowCap;LLRNPAD
R
#
DE
R
#
`
Size
R
#
`
NoAccb#
"
Turnover#
`
CurtBef#,
where
Method " amortization "rms are coded &1' and all-at-once "rms are
coded &0',
TCR
R
" Total capital ratio in the year before adoption minus its
industry median,
LowCap
and HghCap" De"ned below,
` An alternative approach is to identify poorly capitalized banks as those that do not meet or that
are expected to violate the minimum regulatory capital ratio. Given that the regulatory climate was
in a state of #ux during SFAS 106 adoption window, a rigid classi"cation based on minimumcapital
guidelines may not re#ect the uncertainty about the expected regulatory costs. Regulators were then
in the process of developing revised risk-based capital standards under Section 305(b) of the
FDICIA to incorporate interest rate risk to satisfy the statutory mandate. (see Financial Regulation
Report, October 1992; Derivatives Week, June 14, 1993.) Consequently, banks with capital ratios
much above the minimum regulatory threshold could have faced signi"cant uncertainty about the
expected regulatory costs.
E!ect106 " Initial OPEB liability divided by market value of equity at the
end of the adoption year,
E!ect109 " SFAS 109 adoption e!ect divided by the initial OPEB
liability,
NO109 " 1 for "rms that were una!ected by SFAS 109 and coded 0 for
"rms that had a non-zero e!ect from the adoption of SFAS
109,
LLRNPAD
R
" Loan loss reserve divided by the sum of non-performing
assets#loans 90 days past due, minus its industry median,
measured at the end of the adoption year,
DE
R
" fair value of long-term debt divided by the sum of fair value of
long-term debt#market value of equity, all measured at the
end of the adoption year,
Size
R
" natural logarithm of total assets at the end of the adoption
year,
NoAccb " 1 for banks that have no accounting- or pro"t-based incentive
plans, and 0 otherwise,
Turnover " 1 if there is a change in CEO in the year before, year of or the
year after the adoption of SFAS 106, and 0 otherwise, and
CurtBef " 1 (0) for "rms that curtailed (did not curtail) OPEB bene"ts
before adopting SFAS 106.
Based on the extant literature, we include several control variables to capture
other determinants of accounting methods choice (see Christie (1990) for a sum-
mary of prior evidence). The and slope coe$cients are used for the
hypothesized and control variables, respectively. The subscripts for the slope
parameters correspond to the hypotheses' numbers. The expected signs for the
logit parameters are positive for
`
and
`
, and negative for the others.
Hypothesis H
`
suggests that the directional association between SFAS 106
adoption method and the magnitude of OPEB liability is conditional on the
level of regulatory capital. To distinguish between highly versus poorly capital-
ized banks, we rank our sample "rms on TCR
R
and assign them in approxim-
ately equal numbers to three capital ratio groups. LowCap (HghCap) is
a dummy variable which equals one for "rms in the lowest (the middle or the
highest) capital ratio group and zero otherwise.`
" Beginning in 1992, FDICIA has restricted regulators' discretion in protecting larger banks and
their uninsured depositors. However, the statute does retain an exception for bank failures that
might have a systemic adverse e!ect on economic conditions or "nancial stability (Section 141,
FDICIA). Given their economic signi"cance, larger banks are expected to receive disproportionate
regulatory protection even under the new regulatory regime. See &The Too-Big-to-Fail Problem' by
Gary Stern, The Wall Street Journal, October 6, 1997, p. A22.
During the early 1990s, bank holding companies made a conscious e!ort to
boost their capital level in anticipation of impending capital regulations under
FDICIA. At the end of 1993, the capital ratios of most banks were substantially
above regulatory thresholds. Based on a sample of more than 350 bank holding
companies, we "nd that the median TCR monotonically increased from 11.6%
at the end of 1990 to about 14% in 1993. Consequently, while regulatory cost
could be the major factor in the LowCap group (
`
'0), we expect that
earnings management e!ects to be dominant in the high capital ratio group
(
`
(0).
While the proxy for regulatory capital (TCR
R
) is consistent with prior
research, those for the interactive e!ects of SFAS 106 and SFAS 109 (NO109
and E!ect109) follow naturally from the joint hypotheses discussed in H
`
. We
consider LLRNPAD
R
as a proxy for conservatism in loan loss accounting, i.e.,
the higher the value of LLRNPAD
R
, the less likely that a bank has &under
provided' for loan losses.
In contrast to prior research, Flannery and Sorescu (1995) "nd a disciplining
role for debt in "nancial institutions (see also Beatty et al., 1996). We include the
"nancial leverage variable (DE
R
) as a control for the e!ect of the mandated
accounting change on the likelihood of violating debt covenants (see Espahbodi
et al., 1991; Smith, 1993; Watts and Zimmerman, 1990). Banks with higher
(lower) "nancial leverage are more (less) likely to choose the amortization
approach.
In the banking industry, "rm size is considered to be a proxy for regulatory
leniency, typically referred to as the &too big to fail' hypothesis (Kaufman, 1989;
O'Hara and Shaw, 1990; Bishop and Lys, 1992). Ceteris paribus, larger banks
are more likely to choose the all-at-once approach."
A control variable for compensation contracts, NoAccb, is coded one when
the compensation report from the 1992 and 1993 proxy statements makes no
reference to accounting- or pro"t-based incentive plans, or when the compensa-
tion committee uses subjective criteria in determining incentive pay (e.g., àlign
compensation with the Company's overall business strategy
2
a). Banks with-
out explicit accounting- or pro"t-based incentive plans are more likely to choose
the all-at-once method since incentive compensation is not a!ected by the
one-time charge (Watts and Zimmerman, 1978; Hagerman and Zmijewski,
1979).
We also control for the e!ect of CEO turnover on discretionary accruals and
accounting methods choice by including turnover as an explanatory variable.
Prior studies (e.g., Murphy and Zimmerman, 1993; Pourciau, 1993) examine
earnings management through discretionary accruals surrounding CEO depar-
tures. Pourciau (1993) "nds large write-o!s surrounding the time of nonroutine
executive changes. However, after controlling for "rm performance, Murphy
and Zimmerman (1993) "nd that the accruals behavior surrounding CEO
turnover is not consistent with a &big bath'. In this paper, we focus on change in
top management close to the time when a "rm is required choose between
alternative implementation methods for a newly mandated accounting stan-
dard.
Using the 1992 and 1993 proxy statements, we identify CEO turnover where
the change in the leadership took place in the year before, the year of, or the year
after the adoption of SFAS 106. The CEO changes that took place in the year
after adoption were all discussed in the proxy statements pertaining to the
adoption year. In each of the cases, the new CEO took o$ce during the "rst
month of the following "scal year.
The "nal control variable (CurtBef) is used to test whether "rms with in-
creased contracting costs arising fromSFAS 106 are more likely to curtail health
care bene"ts prior to adopting SFAS 106 (see Mittelstaedt et al., 1995; Sincav-
age, 1995). Curtailment of OPEB bene"ts reduces banks' exposure to regulatory
and contracting costs. Consequently, banks that curtailed may be more inclined
to choose the all-at-once approach. Data on curtailments are collected from the
annual reports for 1992 and 1993.
In Table 5, we provide the Spearman correlations among the dependent and
independent variables. For those independent variables that are signi"cantly
correlated with the dependent variable, the correlations are in the predicted
directions. For instance, we observe a signi"cantly negative association between
method and TCR
R
. Similarly, the correlation between adoption method and
the magnitude of OPEB liability is moderated by regulatory and contracting
costs faced by the banks. Consistent with the predicted interaction e!ects, we
"nd that in banks with low (high) levels of capital ratios, the incentive for
minimizing regulatory costs (maximizing earnings management bene"ts) is
stronger. Finally, the univariate correlations for the interactive e!ects of SFAS
109 are consistent with our hypothesis. The negative correlation for E!ect109
suggests that "rms that recorded larger deferred tax assets under SFAS 109 are
more likely to adopt SFAS 106 using the all-at-once approach. We also "nd that
banks that experienced a CEO turnover are more likely to choose the all-at-
once approach. The remaining independent variables are insigni"cantly corre-
lated with method.
Several interesting regularities emerge from the correlation matrix for the
independent variables. For example, larger banks have lower capital ratios,
higher long-term debt to equity ratios, and are more likely to have
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" The tenor of the empirical results is una!ected when the risk-adjusted assets in the year before
the adoption year is used as the de#ator for E!ect106. In addition to the balance sheet metrics used,
we considered an income statement approach to measuring the SFAS 106 accrual e!ect, i.e., the
decrease in the operating income in the year of adoption from adopting SFAS 106 (excluding
amortization of transition obligation) divided by the sum of net interest income and non-interest
income. Once again, our inferences remain unchanged. However, when both the balance sheet and
income statement variables are jointly considered, neither one is statistically signi"cant in the high
capital ratio group. This result appears to be driven by the high correlation between the two
measures ("0.44).
Univariate statistics are consistent with the results of our logit analysis. When banks are
assigned to three groups based on the magnitude of LLRNPAD, we "nd that only 17% of the banks
in the lowest LLRNPAD group chose the all-at-once approach compared to almost 36% in the
other two groups. This suggests that banks that under provided for loan loss are more likely to
choose the amortization approach to mitigate regulatory costs. Speci"cally, the mean (median)
after-tax e!ect of SFAS 106 adoption would have reduced the regulatory capital by 27 (19) basis
points if these banks had chosen to use the all-at-once approach.
accounting- or pro"t-based incentive schemes. In addition, larger "rms more
often curtailed the OPEB bene"ts before adopting SFAS 106. Although several
of the correlations are statistically signi"cant, in most cases, their magnitudes do
not indicate any severe multicollinearity problem. The high correlation between
"rm size and debt-equity ratio is a notable exception.
The results of estimating our logit model reported in Table 6 are consistent
with many of our predictions." Since very similar results are obtained using the
probit estimation procedure, we focus exclusively on the logit model results. The
reported logit model results were obtained after eliminating two outliers based
on their e!ect on the model `.
Except for
`
, we "nd that the test variables are statistically signi"cant at the
0.10 level. We document a monotonic association between the choice of ad-
option method and the level of regulatory capital, i.e., banks with lower (higher)
TCR
R
more often chose to adopt using the amortization (all-at-once) ap-
proach.
We also "nd that since regulatory costs were lower, managers of highly
capitalized banks took actions consistent with a &big bath'; these actions would
lead to potential earnings management bene"ts.
Similar to the capital and earnings management hypotheses, the results are
consistent with the intuition that managers employ a portfolio approach to
managing their accounting choices. Our results suggest that, in poorly capital-
ized banks, the probability of choosing the all-at-once approach rises with
increase in the conservatism of the loan loss estimation. Moreover, consistent
with our intuition, we did not "nd statistical signi"cance when a separate slope
coe$cient was estimated for LLRNPAD
R
in highly capitalized banks (results
not reported).
Table 6
Determinants of the choice of FAS 106 accounting methods
Results of logistic regression model (N"125)
Variable Hypothesis Coe$cient
Expected
sign
Slope
estimate p-value
Intercept ? 9.97 0.014
Test variables:
Capital and earnings
management variables
TCR
R
H
! !0.18 0.086
LowCap;E!ect106 H
`

`
# 0.11 0.690
HghCap;E!ect106 H
`

`
! !0.62 0.007
Variables for portfolio
of accounting choices
E!ect109 H
`

`
! !0.39 0.053
NO109 H
`

`
# 1.91 0.002
LowCap;LLRNPAD
R
H
"

"
! !1.91 0.040
Control variables:
DE
R

# 2.15 0.388
Size
R

`
! !0.50 0.057
NoAccb
`
! !2.65 0.019
Turnover
"
! !2.60 0.001
CurtBef
`
! !1.11 0.063
Model ` 54.58 0.0001
C 0.886
Classixcation accuracy:
Overall 80.8%
Amortization "rms 90.0%
All-at-once "rms 57.1%
Method"amortization "rms are coded &1' and all-at-once "rms are coded &0', TCR
R
"total
capital ratio in the year before adoption minus its industry median, E!ect106"initial OPEB
liability divided by market value of equity at the end of the adoption year, E!ect109"SFAS 109
adoption e!ect divided by the initial OPEB liability, NO109"coded 1 for "rms which were
una!ected by SFAS 109 and coded 0 for "rms that had a non-zero e!ect from the adoption of SFAS
109, LLRNPAD
R
"loan loss reserve divided by the sum of non-performing assets #loans 90 days
past due, minus its industry median, measured at the end of the adoption year, DE
R
"fair value of
long-term debt divided by the sum of fair value of long-term debt #market value of equity, all
measured at the end of the adoption year, Size
R
"natural logarithm of total assets at the end of the
adoption year, NoAccb"1 for banks that have no accounting- or pro"t-based incentive plans, and
0 otherwise, Turnover"1 if there is a change in CEO in the year before, year of or the year after the
adoption of SFAS 106, and 0 otherwise, and CurtBef"1 (0) for "rms that curtailed (did not curtail)
OPEB bene"ts before adopting SFAS 106. Firms are assigned to three capital ratio groups based on
TCR
R
. LowCap (HghCap) is a dummy variable which equals one for "rms in the lowest (middle or
highest) capital ratio group and zero otherwise.
&C' is a measure of the rank correlation between observed responses and predicted probabilities.
Finally, the expected interactive e!ects of SFAS 106 and SFAS 109 emerge
clearly in our logit models. Holding other things constant, we "nd that "rms
that are not a!ected by SFAS 109 are more likely to choose the amortization
approach. As discussed earlier, these "rms cannot strategically time the ad-
option of SFAS 109 to mitigate the adverse economic consequences of SFAS
106. For those with a non-zero adoption e!ect from SFAS 109, we "nd that
"rms with larger SFAS 109 bene"ts are more likely to choose the all-at-once
approach.
After controlling for the level of the regulatory capital ratio (H
), we "nd only
partial support for hypothesis H
`
. Recall that in highly capitalized banks, the
bene"t from earnings management dominates the e!ect of incremental regula-
tory costs, consistent with H
`
. However, we "nd no association between poorly
capitalized banks' propensity to choose the amortization method and the
magnitude of the OPEB liability. Recall that the univariate correlation between
Method and LowCap;E!ect106 is positive and statistically signi"cant (see
Table 5). While this result is consistent with H
`
, we "nd no supporting evidence
in the multivariate model. In summary, while the multivariate analysis only
partially supports H
`
, the di!erential signi"cance of E!ect106 across the capital
ratio groups indicates a trade o! between regulatory costs and potential earn-
ings management bene"ts.
Except for the "nancial leverage variable (DE
R
), all the control variables have
the predicted sign and are signi"cant at conventional levels. Speci"cally, our
results provide support for the notion that "rm size is a proxy for regulatory
bene"ts in the banking industry. We "nd that banks without explicit accounting-
based incentive plans are more likely to choose the all-at-once method, as
indicated by the negative coe$cient for NoAccb. Furthermore, consistent with
a &big bath', we "nd that banks that experienced CEO turnover surrounding the
period of SFAS 106 adoption more often adopted using the all-at-once method.
Finally, we "nd banks that curtail their OPEB bene"ts before adopting SFAS
106 are more likely to take a &big bath'. In e!ect, these banks reduced their
exposure to regulatory and contracting costs by eliminating some of the post-
retirement bene"ts.
The overall model `'s are highly signi"cant across all speci"cations and the
predicted probabilities from our logit models are highly correlated with the
observed responses (denoted as &C' in Table 6). The in-sample classi"cation
accuracy is about 81%. Taken together, our results suggest that banks' choice of
method for adopting SFAS 106 is consistent with a range of di!erential regula-
tory and contracting costs and bene"ts.
3.4. Examination of potential omitted ewects
We next examine whether our logit model outliers are systematically asso-
ciated with any potential omitted e!ects. Our objective here is to provide
` In "ve of the 11 banks, while the CEOs received cash bonuses, they did not reach the maximum
target bonus under the pro"t sharing plans. For example, the CEO of First of America Bank
Corporation received a cash bonus equal to 135% of the target award when the maximum bonus
was 160% of the target award. By excluding the e!ect of adopting SFAS 106, it appears that the top
executives of these companies increased their cash compensation in the adoption year. In the
remaining six cases, the proxy statements did not indicate whether the CEOs bonus awards reached
the maximum under the pro"t sharing plans.
descriptive evidence that might enable future researchers to examine additional
contracting variables. To identify potential omitted e!ects, we rank our sample
observations in the descending order of their expected e!ect on model `. The
two banks with the largest e!ects are Provident Bancorp, Inc. and Premier
Bancorp, Inc.
The annual reports, 10-K and proxy statements of these banks were examined
to uncover any potentially omitted variables. Although our Logit models
consistently predicted the all-at-once adoption method for Premier Bancorp,
Inc., the "rm actually chose the amortization approach. Our examination
revealed that during 1993 Banc. One had an option to buy Premier Bancorp,
Inc. The contract stipulated an exercise price as a percentage of Premier
Bancorp's common stockholders' equity. Consequently, the management's
choice of the amortization method was consistent with maximizing "rm value to
the current stockholders (see Dye, 1988). Since the banking industry continues
to experience signi"cant consolidations, potential merger targets are more likely
to engage in such earnings management.
As indicated earlier, the earnings management incentives examined in this
study are more general in nature and encompass the compensation incentives
faced by managers. To explore the potential role of compensation in the choice
of adoption methods, we reviewed the compensation section of the proxy
statements of all of our sample banks for any explicit mention of SFAS 106. We
"nd that in the case of 11 banks, compensation committees had excluded the
cumulative SFAS 106 e!ect when determining managerial incentive compensa-
tion.`
If our independent variables capture all of the determinants of the adoption
method choice, this additional information on the 11 banks is unlikely to
improve the explanatory power of our logit model. In contrast, however, we "nd
that the forecast errors from the logit model are highly correlated with an
indicator variable capturing the exclusion of the SFAS 106 adoption e!ect by
the compensation committee ('0.35, p-value (0.0001). Speci"cally, all-at-
once "rms that were misclassi"ed as amortizers are more likely to have had the
cumulative SFAS 106 e!ect excluded when determining managerial incentive
compensation. Obviously, these managers might not have chosen the &big bath'
approach unless they had strong priors about the compensation committees'
favorable response. In other words, the choice of adoption method and the
exclusion of the SFAS 106 e!ect from bonus calculations are jointly determined.
This suggests that examining the determinants of such exclusions is likely to
provide insights about omitted explanatory variables of accounting methods
choice.
4. Concluding remarks
Our research "ndings are consistent with the notion that one category of
highly regulated "rms (banks) chose the adoption method for SFAS 106 stra-
tegically in order to lower their regulatory and contracting costs. Balsam et al.
(1995) posit that the adoption method and timing options that are increasingly
contained in new FASB statements are designed to lower the Board's political
costs. This is achieved by lowering their constituents' costs of adopting new
pronouncements, and thereby, lowering political resistance to FASB initiatives.
Our results provide evidence that "rms adopting SFAS 106 did indeed utilize
these opportunities since the observed cross-sectional di!erences in adoption
method are broadly consistent with our hypotheses.
Another relevant concern in evaluating adoption options contained in new
"nancial reporting rules is the cost imposed on regulators. The strategic ad-
option behavior documented in this study might make it more costly for
banking regulators to e!ectively manage weaker banks. This is because the
weaker banks have, in e!ect, avoided further deterioration in their capital ratios
by using the #exibility a!orded in the SFAS 106 implementation method.
Finally, whether adoption method #exibility increases the costs of "nancial
analysis, as some have conjectured, is an interesting question. Our "ndings are
consistent with the notion that "nancially stronger banks have used the ad-
option method choice as a credible signalling mechanism which could be
potentially informative to analysts. Clearly, the relative magnitudes of the costs
and bene"ts of adoption method and timing #exibility represent an important
issue for future inquiry.
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1-s2.0-S0165410101000039-Main The E!ects of Regulatory and Contracting

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Journal of Accounting and Economics 30 (2001) 159}186

The e!ects of regulatory and contracting

K. Ramesh*, Lawrence Revsine

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