The deregulation of the banking market has an unintended consequence where corporations are increasingly resorting to concerning financial practices, according to a new study from the University of Surrey.

The paper, published in the International Review of Financial Analysis, shows that, since 1994, the loosening of banking regulations has transformed the landscape of corporate earnings management, leading to a significant trade-off between two types of banking styles: accrual-based earnings management (AEM) and real earnings management (REM). Accrual-based earnings management involves manipulating financial statements through accounting choices and estimates, affecting reported earnings without cash flow impact. 

While AEM involves adjusting financial statements to present a more favourable picture of a company’s financial health, REM entails altering actual business operations, such as cutting research and development costs to inflate profits. Such practices may offer immediate financial relief but pose long-term risks to sustainability and innovation.

Professor Liang Han, lead author of the study at the University of Surrey, said:

“While banks are better equipped to monitor financial practices, the reality is that corporations are now more inclined to engage in risky behaviour that could have detrimental effects on their long-term performance. It’s imperative that we address this issue before it spirals out of control.”

Researchers reviewed 63,846 financial statements from across the US. They analysed how corporate behaviour changed in response to deregulated banking environments, focusing on the relationship between improved bank monitoring capabilities and corporate earnings management strategies. 

Researchers found that as banks gained more market power and improved their ability to monitor borrower performance, companies shifted from AEM to REM, making riskier decisions that could jeopardise their future.

Professor Liang Han continued:

“As banks gained more market power and enhanced their monitoring capabilities, we observed a concerning trend: companies began to shift from accrual-based earnings management (AEM) to real earnings management (REM). This shift often involves riskier decisions that can jeopardise a firm's future performance. The lessons from the 2008 banking crisis highlight the dangers of such practices, where short-term gains can lead to long-term consequences.

“As the landscape of corporate finance continues to evolve, it is essential for stakeholders to remain vigilant about the potential pitfalls of deregulation and the necessity of responsible financial practices in safeguarding the economy.”

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