Journal of Accounting and Economics

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Journal of Accounting and Economics 35 (2003) 347–376

Management of the loss reserve accrual and the distribution of earnings in the property-casualty insurance industry$ William H. Beaver, Maureen F. McNichols, Karen K. Nelson*
Department of Accounting, Graduate School of Business, Stanford University, Stanford, CA 94305, USA Received 2 March 2002; received in revised form 14 January 2003; accepted 27 January 2003

Abstract We document that property-casualty insurers with small positive earnings understate loss reserves relative to insurers with small negative earnings. Furthermore, loss reserves are managed across the entire distribution of earnings, with the most income-increasing reserve accruals reported by small profit firms, and the most income-decreasing reserve accruals reported by firms with the highest earnings. We analyze this pattern separately for public, private, and mutual companies, and find that public companies and mutuals manage loss reserves to avoid losses, but that private companies do not. We also find evidence of reserve management to avoid losses by financially healthy and distressed firms. r 2003 Elsevier B.V. All rights reserved. JEL classification: M41; G22; G28 Keywords: Earnings management; Earnings distribution; Discretionary accruals; Property-casualty insurance

We appreciate the helpful comments and suggestions of Jerry Zimmerman (the editor), an anonymous reviewer, and workshop participants at the American Accounting Association Annual Meeting, the 11th Annual Conference on Financial Economics and Accounting, Athens University of Economics and Business, Columbia University Burton Workshop, Harvard University Kennedy School of Government, Indiana University, MIT, University of Oregon, Stanford University, and Syracuse University. Research assistance was provided by Qintao Fan and Yvonne Lu. We gratefully acknowledge the support of the Stanford Graduate School of Business Financial Research Initiative. *Corresponding author. Present address: Department of Accounting, Jones Graduate School of Management, Rice University, Houston, TX 77005, USA; Tel.: +1-713-348-5388; fax: +1-713-348-6331. E-mail address: nelsonk@rice.edu (K. Nelson). 0165-4101/03/$ - see front matter r 2003 Elsevier B.V. All rights reserved. doi:10.1016/S0165-4101(03)00037-5

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W.H. Beaver et al. / Journal of Accounting and Economics 35 (2003) 347–376

1. Introduction This study examines the relation between discretionary loss reserve accruals and the distribution of reported earnings for a sample of property-casualty (P&C) insurers. Two distinctive features of the P&C insurance setting motivate studying earnings management in this sector. First, required disclosures for a material accrual, the claim loss reserve, allow us to develop a relatively reliable measure of management’s exercise of discretion over earnings. Second, a variety of ownership structures exist within the industry, including public, private, and mutual companies. This variation allows us to examine more directly than in most prior research how incentives inherent in different ownership structures affect earnings management behavior. Our first research objective is to examine the relation between management of the loss reserve accrual and the distribution of reported earnings. For a sample of non-insurance firms, Burgstahler and Dichev (1997), hereafter BD, and Degeorge et al. (1999) find a discontinuity in the distribution of earnings in the region immediately around zero, which they interpret as evidence that firms manage earnings to avoid reporting losses. However, lacking a model of accruals or an estimate of discretionary accruals, there is ambiguity in interpreting these results. We document that P&C insurers report small positive earnings with greater frequency than expected given the relative smoothness of the remainder of the earnings distribution, and that these firms significantly understate the loss reserve accrual relative to firms with...
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