Earnings Smoothing, Executive Compensation, and Corporate Governance: Evidence from the Property-Liability Insurance Industry

Article excerpt

ABSTRACT

Unlike studies that estimate managerial bias, we utilize a direct measure of managerial bias in the U.S. insurance industry to investigate the effects of executive compensation and corporate governance on firms' earnings management behaviors. We find managers receiving larger bonuses and stock awards tend to make reserving decisions that serve to decrease firm earnings. Moreover, we examine the monitoring effect of corporate board structures in mitigating managers' reserve manipulation practices. We find managers are more likely to manipulate reserves in the presence of particular board structures. Similar results are not found when we employ traditional estimated measures of managerial bias.

INTRODUCTION

Earnings management has long been a topic of interest to academic researchers, stakeholders, industry practitioners, and regulators. Despite the ample evidence of earnings manipulation and the importance of corporate governance in curtailing such manipulation, little research has examined the collective impact of executive compensation and board structure on earnings management. In this study, we extend previous literature by investigating the combined effect of executive compensation and board structure on firms' earnings management behavior. We jointly consider that (1) managers use discretionary accounting components to affect earnings for compensation enhancement and (2) firms structure boards to exert more control over managers, thereby potentially mitigating some of these effects.

Consistent with the prior literature utilizing estimated abnormal accruals, our results show a direct link between the incentive component of executive compensation and earnings management. Specifically, we observe that managers who derive larger proportions of their compensation from bonus payments and restricted stock are more likely to engage in earnings management. We further see that corporate governance through board monitoring plays an important role in curbing managers' manipulation of earnings, with different corporate governance structures being associated with varying degrees of manipulation by managers. We find these results using observed outcomes of managerial decision making (i.e., insurer loss reserve errors) instead of estimated measures of earnings management typically used in the accounting and finance literature. Moreover, our results are not found when we employ estimated measures of managerial bias. Our research contributes to the literature in several other important ways. First, this study augments the earnings management literature in general. It is well known that insurance companies are subject to much heavier regulation than almost all other industries. Hence, our study serves as a stronger test for earnings management than prior studies examining other industrial firms not subject to the same level of regulatory scrutiny as insurance companies.

Second, this research expands the current limited understanding of corporate governance in the insurance industry specifically. Despite the abundant evidence of loss reserve manipulation among property-liability insurers (Petroni, 1992; Beaver, McNichols, and Nelson, 2003; Gaver and Paterson, 2000, 2004) and the link between executive compensation and earnings management (Healy, 1985; Holthausen, Larcker, and Sloan, 1995; Eckles and Halek, 2010), no prior research in the insurance literature has investigated how insurers' loss reserve practices are affected by the joint impact of executive compensation incentives and board structure. Further, this is the first article that uses reserve errors to observe the initial impact of the Sarbanes-Oxley Act (SOX) on corporate governance in the insurance industry.

Third, our article significantly adds to the narrow, yet growing literature regarding the interaction among executive compensation, board structure, and earnings management. Cornett, Marcus, and Tehranian (2008) and Cornett, McNutt, and Tehranian (2009) are the only two studies we know of that examine the joint effect of corporate governance and executive compensation on earnings management. …