Value-relevance of the regulatory non-GAAP adjustments in the Korean banking industry

ABSTRACT

IAS 39 requires firms to use the incurred-loss model for bad debt expenses. However, the Korean Financial Supervisory Commission requires banks to record additional loan-losses based on the expected-loss model. These non-GAAP adjustments include adjustments to book values as well as net income. We examine the incremental value-relevance of these non-GAAP adjustments and fail to find incremental value-relevance over unadjusted IFRS net income. However, the non-GAAP book value adjustment does have a partial, incremental value-relevance over unadjusted book values of equity. In addition, the non-GAAP loan-loss adjustments required by regulators may be disclosed either on the face of the financial statements or in the notes, but the disclosure location also appears to lack value-relevance.

KEYWORDS:

• Banking industry
• additional loan-losses
• non-GAAP adjustments
• value-relevance

Acknowledgement

We gratefully acknowledge the helpful comments and editing services of Suresh Radhakrishnan (the editor), and Charles Pryor at Western Illinois University.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. Indicators of objective evidence of impairment include: significant financial difficulty of the issuer, breach of contract, the lender granting to the borrower a concession that would not otherwise be considered, the borrower facing bankruptcy or other financial reorganization becoming probable, the disappearance of an active market for the asset because of financial difficulties, or observable data indicating that there is a measurable decrease in the estimated future cash flows.

2. For a speedy recovery of the banking system in the wake of the global financial crisis, the Basel Committee pronounced the Basel III standards to replace the Basel II standards. The Basel III standards became effective from December 2013 in Korea. The Basel III standards require the Korean banks to set gradual targets over a period of time on the capital adequacy ratios for common share equity, basic equity and total shareholders’ equity, respectively, and report on the achievements of those ratios to the FSC.

3. Woori Bank Annual Report (2013) reports on the loan-loss reserve as follows: In accordance with the Korean Supervisory Regulations on Banking Business, Article 29, Items 1 and 2 ‘Guideline for computing loan-loss reserve’, additional loan-loss reserve is set aside as the deficit for individual capital adequacy ratio computed as: (1) Additional loan-loss reserve = sum {max (minimum loan-loss reserve, expected loss) – IFRS loan-loss provision} for each capital adequacy ratio. (2) The item (1) is to be computed by business entities, households, credit cards, credit guarantees and credit lines, respectively.

4. There is no known case where countries adopting IFRS require disclosure on non-GAAP income nor any prior studies of the nature that we do in this study. Therefore, we limit our review of the prior literature to the Korean banks.

5. According to the electronic financial information disclosing system run by the Financial Supervisory Service, called DART (Data Analysis, Retrieval, and Transfer), some financial institutions report the non-GAAP adjustments along with IFRS measures in the financial statements, and others report them along with the additional loan-loss reserve information in the notes to the financial statements.

6. Korean listed firms are required to use the Fair Disclosure System to file their financial statements with the FSC and the stock exchanges.

7. Unscaled variables are not included in the descriptive statistics for the sake of brevity.

8. The amount of additional loan-loss reserves as a percentage of IFRS income averages 5.73%. The average percentages by year are 4.74%, 11.28%, 3.00%, 3.19% and 6.50%, respectively, over the period of 2011 through 2015.

9. The annual return is electronically retrieved from KIS-Value data set. KIS-Value provides both annual stock returns and market-adjusted annual stock returns. The market-adjusted annual stock return for the i^th stock is measured as ‘(closing price of the stock in year t)/(closing price of the stock in year t-1) – (closing market index in year t/closing market index in year t-1)’.