Loan Loss Provisioning , Income Smoothing , Signaling , Capital Management and Procyclicality : Does IFRS Matter ? Empirical Evidence from Nigeria

Prior research show that banks have various motivations for influencing loan loss provisions. This study examines these motivations and the behaviour of loan loss provision in relation to the business cycle. After controlling for the impact of Basel regulation on LLP, I find strong evidence for income smoothing, capital management and procyclical LLP behaviour during the voluntary, not mandatory, adoption of IFRS in Nigeria. I find evidence of signaling only after including interaction terms in the model. Additionally, I find that (i) banks increase loan loss provisioning after the implementation of Basel; (ii) banks have some incentive to signal via LLP in the post-IFRS period relative to the pre-IFRS period (iii) banks have joint motivations to manipulate LLP and may face trade-offs in the choice of managing regulatory capital or smoothing income in the post-IFRS period. Overall, I conclude that IFRS reinforces LLP motivations and procyclical patterns. The findings of this paper are relevant to current concerns of accounting standard setters and bank regulators on the current model of loan loss provisioning as well as the on-going debate on the mandatory implementation of IFRS in Nigeria.


Introduction
Provision for bad debt or loan loss provision, hereafter LLP, is a deduction from bank net interest income to cover expected credit losses on bank loan portfolio. Bank regulators continue to stress that loan loss provision should be sufficient to minimize loan loss on bank loan portfolio. However, emerging empirical studies suggests that bank managers may have other incentive(s) to influence or manipulate reported loan loss provision estimates other than mitigating expected credit loss. Though standard setters emphasize transparency in the measurement of provisioning estimates to avoid opportunistic managerial behaviour, studies find that banks may influence LLP to reduce the variability of income (income smoothing), manage regulatory capital, and signal loan quality. Also, studies in the banking literature, argue that bad debt provisioning is procyclical with the business cycle. They argue that banks delay provisions until it is too late. The effect of the 2008 financial crisis has raised debates among regulators and academics about IFRS's backward looking provisioning model.

Motivated by these concerns and the voluntary adoption of IFRS reporting among commercial banks in
Nigeria, I examine whether bank managers influence LLP to smooth income, manage capital, signal loan quality and whether provisioning is procyclical with the business cycle during the voluntary adoption of IFRS. Furthermore, I test for joint motivations in the pre-and post-crisis period and IFRS period. First, I predict and find strong evidence for income smoothing in the post IFRS period after controlling for Basel capital regulation. Second, I predict and find strong evidence that banks use LLP to manage regulatory (Tier 1) capital to avoid violating regulatory capital requirements. Third, I find evidence for signaling in the IFRS period. Based on further test, I find evidence that managers may have joint motivations for influencing loan loss provision estimates. Finally, I predict and find that banks delay provisions until a recession materializes.
First, this paper contributes to the accounting choice literature which suggest that managers have various incentives for choosing and influencing some accounting numbers, in this case, loan loss provisions.
Second, this paper contributes to the recent literature in favour of the debate to improve the current IFRS provisioning model which is highly criticized for its inherent procyclical pattern. Third, this paper contributes to the banking literature on bank capital adequacy. The literature argues that strong capital buffers ensure that bank capital is sufficient to absorb unexpected losses and external shocks. I find that banks use LLP as a form of capital which can be increased (decreased) when capital is low (high). Fourth, this paper is the first to examine income smoothing, earnings management, signaling and procyclicality of LLP in Nigeria. I provide a developing country evidence for the concerns raised about the validity of IFRS's current provisioning model. By employing recent bank data, inferences based on the result may inform financial reporting policies. Finally, this empirical evidence contributes to the current debate that criticizes the recent mandatory implementation of IFRS by the Central bank of Nigeria in 2012.
The remainder of this paper is organized as follows: Section 2 reviews the empirical literature and develops the hypotheses based on the literature review. Section 3 presents the methodology. Section 4 discusses the empirical results. Section 5 concludes.

LLP and earnings management
Earlier studies documents evidence for earnings management using LLP (Ma, 1988;Hasan and Hunter, 1994;Lobo and Yang, 2001;Hasan and Wall, 2003). Also, the recent literature provide evidence for income smoothing. For example, Kanagaretnam et al., (2004) found that banks use discretionary LLP to smooth income but not to signal private information. Anandarajan et al. (2007) show that publicly traded commercial banks in Australia engage in earnings management practices. Perez et al. (2008) found evidence for income smoothing using 142 Spanish banks from 1986 to 2002. Leventis et al. (2012), using a sample of 91 EU banks, found that income smoothing is more pronounced among risky banks but this smoothing behaviour is less aggressive after implementation of IFRS. In a US study, El Sood (2012) found strong evidence for income smoothing. Balbao et al. (2013), using 9442 US banks from 1999 to 2008, found evidence for income smoothing but suggest that this relationship may be driven by non-linear patterns. Curcio and Hassan (2013) find strong evidence for income smoothing among non-EU credit institutions. They report that EU firms within markets with high protection of creditor right do not smooth income. On the other hand, some studies show conflicting evidence (for example, Wetmore and Brick, 1994;Ahmed et al., 1999). Ahmed et al. (1999) found no evidence to support the income smoothing hypothesis after the implementation of Basel 1. Overall, the literature documents more positive evidence of smoothing via LLP. Therefore, consistent with these studies, I hypothesize that there is a positive relation between LLP and pre-tax and pre-provision earnings in the post-IFRS period. This follows the reasoning that when bank profits is abnormally high (low) banks tend to increase (decrease) LLP either to minimize the volatility of earnings or to avoid regulatory scrutiny (Wall and Koch, 2000). Thus, H1: A positive relation exist between LLP and pre-tax and pre-provision earnings in the post IFRS period.

LLP and signaling
Managers tend to signal private information about their firm to reduce information asymmetry and to communicate positive inside information to investors (Akerlof, 1970). The literature reports a positive relation between stock returns and abnormal LLPs and a negative relation between normal LLP and stock returns, suggesting that investors perceive LLP as a tool used to signal private information about future firm performance (Wahlen, 1994;Beaver and Engel, 1996;Liu et al. 1997). After controlling for nondiscretionary changes in LLP, Wahlen (1994) found a positive relation between discretionary provisions and stock returns and future cash flow which suggest that investors interpret abnormal provisions as a signal of good news rather than as a signal of bad news (high expected credit losses). Liu et al. (1997) reports that investors interpret high LLP as good news when banks are experiencing default problems.
Also, they showed that banks, with low regulatory capital ratio in the fourth fiscal year, had positive stock market reaction following unexpected increase in LLP. Kanagaretnam et al. (2005) found that the propensity to signal private information is positively related to the degree of information asymmetry and that undervalued banks use LLP to signal private information about future performance. Bouvatier and Lepetit (2008) in a study of European banks found evidence to support the signaling hypothesis. Curcio and Hasan (2013), investigated earnings management in the context of the capital adequacy among EU banks and non-EU credit institutions. Interestingly, they found that non-Euro area banks use earnings to signal private information to investors. On the other hand, Ahmed et al. (1999) did not find strong evidence to support the signaling hypothesis among US banks. In a study of Spanish commercial banks, Anandarajan et al. (2003) and Perez et al. (2008) both do not find strong evidence to support the signaling hypothesis. Subsequently, Anandarajan et al. (2007) found insufficient evidence to support the signaling theory among Australian banks.
To develop the signaling hypothesis, Wahlen (1994) suggests that LLP will contain some positive signal about loan quality after controlling for other non-discretionary indicators of loan default such as changes in non-performing loans and loan charge-offs. Following this reasoning, if bank managers believe that investors view abnormal increase in LLP as a signal of loan quality, a positive relation between LLP and future earnings can be expected. Also, IFRS emphasizes the need to disclose information to investors and other users of financial reports. Therefore, bank managers, under IFRS, might take advantage of this disclosure opportunity, to use LLP to signal loan quality to investors, implying a positive relation. Similar to prior studies, I hypothesize: H2: A positive relation between LLP and one-year ahead change in pre-provision earnings in the post IFRS period is expected.

LLP and regulatory capital management
Prior studies suggest that, to avoid the cost associated with violating capital regulatory requirements, bank tend to manage regulatory capital using LLP (Whalen, 1994;Ahmed et al., 1999). These studies argue that banks tend to increase (decrease) LLP when regulatory capital is low (high) (Moyer, 1990;Beaver and Engel, 1996;Wall and Koch, 2000). For example, Moyer (1990) finds that managers adjust the timing of LLP to avoid violating bank capital limit. Beatty et al. (1995) argue that LLP influences loan quality and capital management decisions. Similarly, Ahmed et al. (1999) found evidence that banks use LLP to manage capital adequacy ratios to avoid violating minimum capital requirement. Anandarajan et al. (2007) found evidence to support the capital management hypothesis. Bouvatier and Lepetit (2008) After the convergence to Basel capital regulation in Nigeria immediately after the crisis, there were costs associated with violating minimum capital requirement. If the cost of violation is perceived to be severe, bank managers may have an incentive to influence regulatory capital ratio via LLP. This is consistent with Ahmed et al. (1999) and Wall and Koch (2000). This incentive will be greater if banks view LLP as a form of capital. Therefore, I hypothesize: H3: A negative relation between LLP and Tier 1 regulatory capital ratio in the post-IFRS period.

LLP and Procyclicality
Studies report that LLP is negatively related to the business cycle measured by GDP growth rate (Arpa et al., 2001;Laeven and Majnoni, 2003;Bikker and Metzemakers, 2005;Perez et al., 2006;Floro, 2010;Packer and Zhu, 2012). Laeven and Majnoni (2002) found that banks delay provisioning until it is too late, suggesting procyclical LLP behaviour. Bikker and Metzemakers (2005) (2012), in a study of Asian banks, found that provisioning was procyclical among Japanese bank but countercyclical for banks in India. Therefore, consistent with these literature, I hypothesize that banks delay increased provisioning until a recession sets in. Therefore, I hypothesize: H4: A positive relation between LLP and change in gross domestic product in the post-IFRS period.

Data and sample selection
The dataset employed in this study were extracted from bank financial statement and World Bank which gives a total of 120 bank-year observations. This period is sufficient enough to capture economic downturn and upturns, financial crisis as well as alternative regulatory regimes (IFRS and Basel).

Model Specification
To test the three hypotheses -income smoothing, regulatory capital and signaling, I adopt a modified model derived from existing models in the literature (Ahmed et al., 1999;Anandarajan, et al., 2007;and Leventis et al., 2011). The modelling of LLP takes the functional form below:

LLP = f [(non-discretionary), (discretionary), (control variables)]
For this study, the econometric model adopted is panel-data regression with fixed effects.

Variable Description
The dependent variable is LLP. After controlling for non-discretionary (NPL, LOAN, LLPt-1,) and discretionary influences on LLP (EBTP, SIGN, MCAP), the variables of interest in the main regression are IFRS*EBTP and IFRS*SIGN. Non-discretionary variables employed are non-performing loans, beginning loan loss provision (LLPt-i), ratio of loans and advances to customers divided by total bank total asset (LOAN). These variables explain external factors beyond managerial control that have an influence on LLP. This is consistent with prior studies (Ahmed et al, 1999;Hasan and Wall, 2004;Bouvatier and Lepetit, 2008;Fonseca and Gonzàles, 2008). NPL controls for non-discretionary influence on specific provisions while LOAN controls for general reserves. A positive sign is expected because when banks predict that loan will go bad, they would increase provision, accordingly. Also, a positive sign is expected on LOAN variable. LLPt-1 should have a negative sign. It follows the reasoning that when banks increase provisions in the previous period, provisions for the current period is unlikely to increase proportionately.
Discretionary influences on LLP include EBTP, MCAP and SIGN variable. Using the EBTP variable to indicate smoothing is consistent with prior studies (e.g. Ahmed et al, 1999;Anandarajan, 2007;Bouvatier and Lepetit, 2008;Fonseca and Gonzàles, 2008;Leventis, et al., 2011;Curcio and Hasan, 2013). A positive sign on the coefficient indicates income smoothing, a negative sign indicates otherwise. Also, Ahmed et al. (1999), Leventis, et al. (2011) and Curcio and Hasan (2013) (2013), I employ the SIGN variable defined as the one-year ahead change in earnings before taxes and LLPs (that is, EBTPi,t+1 -EBTPi,t)/0.5(TAi,t + TAi,t+1). TA represents total asset. I expect that banks may or may not take advantage of the disclosure arbitrage in IFRS to signal loan quality to investors.
POST indicates the change to Basel capital regulation after the financial crisis. This dummy variable takes the value of 1 for post-Basel (or post crisis) period, otherwise 0. I expect increased provisioning after the crisis as a precautionary risk management behaviour among banks. Therefore, I expect a positive sign between LLP and POST. Also, I expect that IFRS dummy variables takes the value of I when banks voluntarily adopted IFRS and 0, otherwise. In 2009, commercial banks in Nigeria voluntarily adopted IFRS. However, it is difficult to predict this sign because differences in implementation and enforcement of IFRS across countries may significantly affect this relationship. Further, a positive sign on EBTP*SIGN indicates that banks jointly smooth income and signal future prospects, otherwise, negative.
A positive sign on EBTP*MCAP and EBTP*TRC indicates greater incentives to smooth income than to manage capital, and vice versa. A negative sign on TRC*SIGN and MCAP*SIGN indicates greater incentives to manage capital than to signal, and vice versa. GDPR tests whether LLP is procyclical with the business cycle. This is consistent with prior studies (Laeven and Majnoni, 2003;Bikker and Metzemakers, 2005;Anandarajan et al., 2007;Fonseca and Gonzàlez, 2008;and, Curcio and Hasan, 2013). A negative sign indicates LLP is procyclical, otherwise, positive. Size is expected to have a positive sign. It follows the reasoning that large banks tend to have larger loan portfolio and will tend to increase provision more.  However, these conflicting signs are not statistically significant. Finally, for the entire sample period as shown in Table 3, a significant positive correlation between LLP and POST is observed indicating that Basel capital regime, after the 2008 crisis, led to significant increase in loan loss provisioning among Nigerian banks. Year 2002-2012 2002-2007 2009-2013 2002-2006 2010-2013 Variables Mean

Main Regression Result
First, to test that the sign on the coefficients are consistent with theoretical expectations, I regress LLP with discretionary and non-discretionary variables, IFRS and POST. I exclude all interactive variables.
Regression 1, show that all variables are consistent with theoretical expectations except SIZE and LOAN.
Second, to examine the impact of IFRS on EBTP and SIGN, I introduce two interactive variables, IFRS*EBTP and IFRS*SIGN. Regression 2 show a significant positive coefficient for IFRS*EBTP and IFRS*SIGN at the 1% and 10% significance level, respectively. The support for smoothing and signaling hypothesis is significant after the inclusion of the interactive IFRS variables. Also, I find a significant positive sign on the POST coefficient and a significant negative sign on the IFRS dummy variable which suggests that regulators emphasize increased bank provisioning while the IFRS tend to discourage aggressive provisioning for transparency concerns. This is consistent with theory. Table 3 reports the robustness analysis. First, I divide the period into pre-crisis (2002)(2003)(2004)(2005)(2006)   I find strong evidence to support the capital management hypothesis in the post-IFRS period relative to the pre-IFRS period as shown in Regression 4b (i) and (iii). It reports a significant negative relation between LLP and MCAP (t-stat = -3.48) in the post-IFRS period.

Robustness Test
Finally, testing for joint motivations in the post IFRS period in regression 4b (iii), I find a significant positive sign on EBTP*MCAP coefficient (3.94). This suggest that when banks are faced with two conflicting motivations, that is, smoothing and capital management, Nigerian bank managers may prefer to smooth income rather than manage regulatory capital. This is inferred based on the more positive sign on the EBTP*MCAP interactive variable. Also, when faced with the choice between signaling and capital management (MCAP*SIGN), Nigerian banks may prefer to manage Tier 1 capital than to signal loan quality. This is indicated by the significant negative sign on the MCAP*SIGN coefficient (-1.73, α=10%).
Interestingly, I find strong evidence that banks in Nigeria seem to have no incentive to jointly smooth income and signal loan quality. This is inferred from SIGN*EBTP (-3.68, α=1%)

Conclusion
Consistent with Healy and Wahlen (1999), it is important for regulators to understand accrual-based accounting numbers used by bank managers to influence reported earnings, as well as, bank capital. The findings in this study is the first to provide evidence for smoothing, signaling and capital management via LLP in Nigeria. Ahmed et al. (2014)