Review of Quantitative Finance and Accounting, 17: 45–62, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Economic Consequences of the Cancellation
of Inner Reserves for Hong Kong Banks
AND RONALD ZHAO
Department of Accountancy, City University of Hong Kong, Kowloon, Hong Kong
Abstract. Inner reserves, which allow banks to report a higher or lower earnings at managerial discretion, bring
into focus the ability of the market to make an informed judgment of banks’ performance. This study examines the
market response to the disclosure and elimination of inner reserves by Hong Kong banks resulting from a change
in the regulatory reporting system. Test results show that despite a signiﬁcant increase in the variability of bank
earnings in the post-compared to the pre-disclosure period, there is no evidence of a signiﬁcant increase in banks’
systematic risk in the post-disclosure period. Earnings-returns association is signiﬁcantly stronger in the post- than
in the pre-disclosure period, indicating an improvement in the value relevance of reported earnings. Disclosure of
inner reserve transfer is found to provide incremental information over reported earnings over a short disclosure
window. These results suggest that the increased value relevance of earnings outweighs the costs of inner reserve
cancellation, thus supporting greater reporting transparency for Hong Kong banks.
Key words: banks, accounting earnings, inner reserve, income smoothing
JEL Classiﬁcation: M41, G28
Prior to 1994, banks incorporated in Hong Kong were allowed to maintain inner reserves
and make undisclosed transfers to or from them by a special provision in the Hong Kong
Companies Ordinances (1990). Inner reserves, also known as hidden or secret reserves,
are unreported earnings accomplished by increasing reported liabilities through excessive
provision for expenses or decreasing reported assets through underreporting of revenues.
Relics from the early days of private banking, inner reserves allow disclosure exemptions
to banks. This special privilege has a history in British company law (Schedule 8 of the
1948 Companies Act), based on the argument that banks are subject to wide ﬂuctuations in
investment’s value and periodic losses on lending which can be disproportionate to single
year proﬁts, and the stability of banks is a nationally important asset as their deposits form the
essential working capital of the banking system. Reﬂecting investors’ increasing demand for
operating transparency of ﬁnancial institutions, the British Bank Account Regulation (1991)
ended this practice. Similar development with regards to inner reserves has evolved in other
Address correspondence to: Sidney Leung, Department of Accountancy, City University of Hong Kong, Kowloon,
Hong Kong, Tel (852) 2788-7924, Fax (852) 2788-7944 or 9565, E-mail: email@example.com.