By Janko Cizel / Edward Altman / Herbert Rijken
Accounting discretion $\Longrightarrow$ ability to misrepresent true performance
Incentives to inflate true performance, especially in the state of financial distress.
Consequence: "jamming" of the accounting signal.
In an extreme case, the accounting signal may lose its ability to discriminate between healthy and unhealthy institutions.
Predictability of bank distress by accounting fundamentals varies substantially across countries.
Bank management has capacity and incentives to exercise accounting discretion in order to report inaccurate information.
Bank disclosure standards and their enforcement by regulators provide a constraint on accounting discretion and on their information revelation incentives.
Bank disclosures standards and stringness of their implementation = proxy of accounting discretion
For each index, higher values of the index correspond to either better disclosure standards, or a more stringent implementation of the standards by the regulator.
Hypothesis: Given a cross section of banks in country $c$ at time $t$, the marginal impact of an accounting fundamental, $x$, on the probability of bank distress, increases with the value of the regulatory disclosure index, $R$.
That is: performance of an accounting fundamental in classifying banks within a country is greatest in countries with stringent disclosure laws or the enforcement thereof.
Measure the information of content of an accounting fundamental,
$x$, as the absolute magnitude of the marginal impact of $x$ on
the probability that a bank becomes distressed 1 year in the
future, within a cross section of banks in country $c$ at time
$t$:
$$$$
$$ INFO_{ct}(x) =\Bigg|\Bigg| \left. \frac{\partial
Pr(\text{Distressed}_{ict} = 1)}{\partial x_{ict}}
\right|_{\text{c,t fixed}} \Bigg|\Bigg|$$
The hypothesis can be restated as: $$$$ $$INFO_{ct}(x)\Bigg|_{\substack{\\c\in\text{Good Disclosure Country}}} > INFO_{ct}(x)\Bigg|_{\substack{\\c\in\text{Bad Disclosure Country}}} \geq 0$$
Does a time series of an accounting signal produced by a distressed bank anticipates the bank's eventual failure?
A signal is judged as informative if its reported value immediately before the distress period is distinct from its value in the periods further from the distress event.
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