A new study from the University of Surrey has uncovered troubling consequences arising from the deregulation of the American banking sector. Since the mid-1990s, a loosening of financial regulations has transformed the landscape of corporate earnings management in the United States. The paper, published in the International Review of Financial Analysis, highlights a shift in corporate behaviour resulting from these regulatory changes. Rather than promoting transparency or responsible financial governance, deregulation has inadvertently encouraged corporations to adopt more concerning financial practices.

Central to the study is the observed trade-off between two distinct forms of earnings management: accrual-based (AEM) and real earnings management (REM). AEM alters reported financial outcomes by manipulating accounting assumptions or estimates, such as revenue recognition timing or expense accruals, without affecting the company’s cash flow. In contrast, REM involves adjusting genuine business activities—such as reducing research and development expenditure or overproducing inventory—to influence reported profits. While both strategies aim to present a more favourable financial position, REM has more tangible, and often more damaging, implications for long-term corporate health.

According to Professor Liang Han, the study’s lead author, deregulation has strengthened banks’ market presence and improved their ability to monitor borrowers. However, this increased oversight has not deterred earnings management; it has shifted the focus from AEM to REM. In other words, firms are not engaging in less manipulation—they are simply changing their methods. “While banks are better equipped to monitor financial practices,” Han notes, “the reality is that corporations are now more inclined to engage in risky behaviour that could have detrimental effects on their long-term performance.”

To support these conclusions, the researchers examined a vast dataset of 63,846 financial statements from U.S. corporations spanning several decades. The analysis showed a clear correlation between increased banking deregulation and the strategic shift from accrual-based to real earnings management. As financial institutions gained power and monitoring sophistication, corporations responded by adopting more subtle yet risk-laden tactics. These included cutting vital operational costs and altering business decisions to meet earnings benchmarks without regard for future viability.

The study warns that such shifts pose significant risks to sustainable corporate development and innovation. By its nature, REM sacrifices long-term strategic investments for immediate financial appearance. Cutting research spending or distorting production cycles might meet investor expectations temporarily but often leads to weakened innovation pipelines and volatile performance down the line. These findings echo the lessons of the 2008 financial crisis, where excessive short-termism, enabled by a lack of effective oversight, contributed to systemic instability.

Professor Han stresses the need for caution as deregulation reshapes corporate finance. “As the landscape of corporate finance evolves, 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.” The study calls on policymakers and regulators to consider the broader consequences of financial liberalisation, urging a balanced approach that encourages innovation without compromising the long-term stability of firms and markets.

More information: Liang Han et al, Balancing acts: Bank market deregulation and the dynamics of earnings management, International Review of Financial Analysis. DOI: 10.1016/j.irfa.2025.104040

Journal information: International Review of Financial Analysis Provided by University of Surrey