08 Financial: Earnings Management/Earnings Smoothing
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ItemEarnings Management through Capitalizing Operating Costs: Evidence from Accounting for Policy Acquisition Costs in the Insurance Industry( 2019-08-29)We examine whether managers of public insurers use reporting discretion in capitalizing policy acquisition costs to manage earnings, and the extent to which accounting standards that provide guidance in practice could deter insurers from managing earnings. The accounting standard, ASU 2010-26, establishes a higher threshold at which acquisition costs meet eligibility for deferral. We expect this guidance to reduce the discretion afforded to managers to categorize acquisition costs as an asset. We find empirical evidence that public insurers manage earnings through capitalizing acquisition costs before ASU 2010-26, which became effective in 2012, but not after 2012. We also find that this earnings management is achieved primarily through capitalizing discretionary rather than nondiscretionary acquisition costs. Furthermore, the capitalized acquisition costs are more significantly associated with contemporaneous stock returns and future insurance premiums in the period after ASU 2010-26, suggesting that the capitalization of acquisition costs under the ASU 2010-26 guidance is more value relevant for investors. Taken together, our empirical results indicate that public insurers manage earnings through capitalizing rather than expensing acquisition costs, and that accounting standards that limit such discretion can help reduce this pattern of earnings management and increase the value relevance of the accounting information.
ItemWhat’s my target? Analyst forecast dispersion and earnings management through effective tax rates( 2019-08-26)Kirk, Reppenhagen, and Tucker (2014) report that, consistent with the existence of private information, investors use individual analyst forecasts as additional benchmarks to evaluate reported earnings. Following this logic, we investigate whether managers consider the private information in a subset of analyst forecasts when managing earnings. Specifically, we test whether changes in year-end tax accruals are associated with analyst forecast dispersion, our measure of private information. We find that when pre-managed earnings would have beat the consensus and analyst private information is low (i.e., dispersion is low), managers increase tax expense and create cookie jar reserves. When analyst forecasts reflect increased levels of private information (i.e., dispersion is high), we find that firms use tax expense to further increase earnings even when pre-managed earnings would have beat the consensus. Additional analyses reveal that the effect of dispersion is conditional on the proximity of pre-managed earnings to the consensus forecast. Our results highlight how managers consider individual analyst forecasts to calibrate earnings management and contribute to our understanding of earnings management activity around consensus estimates.
ItemTHE CONTINUITY OF SPECIAL ITEMS AND THE LIKELIHOOD OF INCOME CLASSIFICATION SHIFTING( 2019-07-01)Income classification shifting is identified as the third form of earnings management that managers use, in addition to accrual-based and real earnings management. Income classification shifting is arguably less costly than the other two forms of earnings management (McVay 2006; Abernathy et al. 2014). However, there is a potential cost of classification shifting - the higher likelihood of missing the market expectations in subsequent periods because shifted core earnings of the current period 1) could bias upward analysts' forecasts for the subsequent periods and 2) would recur as core expenses unless firms can continuously shift their core expenses to special items in future periods. This paper hypothesizes that when firms have special items that allow them to shift income consecutively, they are more likely to engage in classification shifting by consecutively shifting, reducing potential costs. Consistent with expectations, the findings show that firms which report special items that tend to continue over multiple quarters (continuous special items) are more likely to classification shift than firms that report special items which tend not to continue over multiple quarters (non-continuous special items). Furthermore, this study documents that the difference in the likelihood of shifting between continuous and non-continuous special items is more pronounced for the first but not the last occurrence of a series of the same special item across time. The findings highlight the potential cost of classification shifting and its impact on a firm’s shifting behavior and offer valuable insight for investors and auditors when they assess the likelihood of classification shifting and the quality of earnings.