The Interaction between LLP and SFAS 157 and Its Role in the Choice of Tools for Earnings and Capital Management by Banks during a Financial Crisis

In this study, we examine the role of fair value classification (based on three different categories as recommended by SFAS 157) on the use of Limited Liability Partnership (LLP) to manage earnings and capital during financial crisis periods. We examine the effect of fair value asset classification on the discretionary use of LLP to manage earnings and capital. Asset classification can be categorized into three classifications, with Level One giving least discretion and Level Three giving most discretion in asset valuation. Our study finds that during a financial crisis, relative to Level One fair value measurement, the use of LLP to manage earnings is accentuated by Level Two and attenuated by Level Three fair value measurements. In addition, we find that relative to Level One fair value measurements, Level Three fair value measurement decreases the use of LLP to manage capital ratio in the financial crisis period. Except for the effect of Level Two on earnings management, we find generally insignificant relationships in the subsequent economic recession period. The implications of these findings are discussed. In summary, re-examining the use of LLP to manage earnings and capital ratio is important especially during a period of financial crisis and subsequent economic slowdown. This is because the incentives to manage bank earnings and capital may have increased due to the slow economy and/or changed their holdings of fair value portfolios. Moreover, a few studies have examined these relationships in the banking industry.