The Relation between Real Activities based and Accrual-based Earnings Management in U.S. Banking Industry

We examine whether bank managers use real activities manipulation (or transaction-based earnings management) and accrual-based earnings management as substitutes in managing earnings based on U.S. banking industry. We find that bank managers trade off these two earnings management methods based on their relative costs and that managers adjust the level of accrual-based earnings management according to the level of real activities manipulation realized. In addition, banks with higher exposure to fair value accounting rely less on accrual-based earnings management using loan loss provisions as the extent of fair value exposure increases the availability of transaction-based earnings management. Finally, the trade-off relation between accrual-based earnings management and real-activities manipulation is more pronounced after the 2008 financial crisis. In sum, we provide evidence that bank characteristics and the level of alternative earnings management are important determinants of earnings management activities in banking industry. We also contribute to the literature on the effects of financial crisis and fair value accounting on earnings management choices. In particular, the role of fair value accounting in banks’ earnings management practices should be of interest to regulators as they consider ways to increase stability in the banking sector