The Effects of Taxes, Agency Costs and Information Asymmetry on Earnings Management: A Comparison of Public and Private Firms

Abstract

The realization of security gains and losses to manage earnings in publicly-traded bank holding companies has been documented in a large number of studies, but very little is known about why managers engage in this behavior. Two possible explanations for earnings management put forth by Warfield, Wild, and Wild (1995) are that managers engage in this behavior either to circumvent accounting-based contracts designed to mitigate agency problems or to reduce information asymmetry.

We compare public and private banks' security gain/loss realizations to determine how their earnings management differs. We find that public banks consistently engage in more earnings management than private banks and that the portion of their current period securities gains and losses realizations attributable to earnings management is more highly associated with next period's earnings before security gains and losses. These findings are consistent with earnings management occurring due to greater information asymmetry in public firms, and suggest that earnings management may not necessarily lead to the erosion in the quality of earnings suggested by Levitt (1988).

JEL Classification: M41, M43, D82