The Discretionary Use of Provisions – Evidence from Germany

Abstract

This study examines whether recognition and reversal of provisions according to IAS 37 are motivated by earnings management incentives. We focus on three earnings management incentives detected in prior literature: income smoothing, loss avoidance, and big bath accounting. Using a sample of German firms listed on DAX30, MDAX, and SDAX through 2007 to 2012 we estimate the discretionary change in provisions employing several important drivers at the first stage. The results of the second stage demonstrate that firms recognize larger provisions and/or report fewer reversals of provisions than necessary when they experience a loss, indicating that firms engage in big bath accounting through provisions. Further, we find evidence that firms use provisions to avoid reporting small losses; however, there is no evidence that firms use judgment in the recognition of provisions to smooth operating performance.

Keywords: Provision accounting, income smoothing, loss avoidance, big bath accounting

JEL Classification: M40, M41, M49