Earnings Management through Capitalizing Operating Costs: Evidence from Accounting for Policy Acquisition Costs in the Insurance Industry

Choi, Diana
Wang, Xue
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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.
Earnings management, Accounting discretion, Insurance industry
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