Accounting Rules on Loan Losses and Security Gains Contribute to Earnings Management for the Banking Industry in Sri Lanka

One of the most serious concerns presently facing the accounting profession is the growing complexity, extension, and significance of issues adjoining fair value measurements. Many researchers and practitioners criticized the fair value accounting and blame for it causing economic failure. This paper studies licensed commercial banks and the financial institution listed under the Colombo stock exchange to examine the association between fair value accounting and earnings management. In this research, we are examining the provisions for loan loss and discretionary security gains and losses by introducing the fair value assets and liabilities. We used the statistical methodology followed by Beatty et al. (2002) to test the banks reported fair value assets and liabilities associated with provisions for loan loss. We test several robustness tests and sensitivity analysis for our research design. We use both the current year and one-year ahead data test the provision for loan loss, discretionary security gains, and losses after controlling bank-specific features. We found evidence that; banks reported fair value assets and liabilities are positively associate with provision for loan loss. We found the evidence that the level 2 fair value assets and liabilities are a predominant determination for the association between provisions for loan loss. Our evidence is consistent with past research and persuades us that banks use fair value measurements to manage the earnings.