Organizational Memory and Bank Accounting Conservatism

Posted by jjin - Feb 25, 2021
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In a recent study, published in the European Accounting Review (EAR), Yi Liu, Khalid Nainar and I examine the impact of banks’ organizational memory of past history on the conservatism of accounting policy. We investigate two types of bad time history: banks’ undercapitalization and the failures of other banks during financial crises. Using a large sample of U.S. banks over the period 1997–2013, we find that both types of bad times are positively related to timelier recognition of earnings decreases versus earnings increases in accounting income. We also find that following bad times, banks increase their allowance for loan losses. Collectively, our results suggest that banks’ organizational memory of bad times and macro-level banking crises lead to greater accounting conservatism in banks.

To measure bank-specific bad times, we focus on undercapitalization. To measure economic crises, we use two macroeconomic proxies for the severity of statewide and countywide crises. The first proxy is the average fraction of the number of banks failed in a state or county in a certain year. The second is the average fraction of failed banks’ assets in a state or county in that year. We measure accounting conservatism as the relationship between the change in net income and the lagged change in net income, allowing for differences in net income. Our results show that bad times, either bank-specific or economy-wide, are associated with increased bank accounting conservatism. In other words, banks that have been undercapitalized and/or witnessed other banks fail in an economic crisis recognize their own losses more timely and recognize proportionately larger loan loss allowances.

We design the path analyses and a survey questionnaire to differentiate between the effect of bad time memory of managers, boards, and auditors, and to identify which channel plays the major role. Our channel analyses provide the quantitative measures of the impact on the relationship between bad time memories and bank accounting conservatism for the three parties (managers, boards of directors, and auditors). The results of path analysis of CEOs, boards of directors, and auditors show strong evidence that CEOs and boards of directors can retain memories of bad time experiences and can be motivated to adopt more conservative accounting policies to preempt future risks and failures.

We also conduct a survey among senior U.S. bank executives (i.e., CEO, CFO, president, and chairman) to obtain corroborative anecdotal evidence/testimonies and identify which force plays the major role in impacting the relationship between memory of bad times and bank accounting conservatism. The responses from the survey participants generally confirm our findings that the bad time memories of managers and boards of directors are the most important forces heightening bank accounting conservatism. The survey responses also provide evidence that the bad time memories of auditors can heighten bank accounting conservatism but with less impact.

Our study provides original evidence that banks adopt conservative accounting policies after experiencing bank-specific and economic-wide bad times, indicating that experiencing a bad time is a determinant of bank accounting conservatism. We provide empirical results and anecdotal evidence that the tenure of bank managers and boards of directors contributes to the bad times memory of banks. Our findings have important implications for bank managers and regulators. The timely recognition of loan and lease losses is critical to the banking industry.

Discover more about our study at https://www.tandfonline.com/doi/full/10.1080/09638180.2020.1854808

To cite this article: Justin Jin, Yi Liu & Khalid Nainar (2020): Organizational Memory and Bank Accounting Conservatism, European Accounting Review.

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