Academic journal article Journal of Risk and Insurance

Incentives for Discretionary Accounting Practices: Ownership Structure, Earnings, Size, and Taxation

Academic journal article Journal of Risk and Insurance

Incentives for Discretionary Accounting Practices: Ownership Structure, Earnings, Size, and Taxation

Article excerpt

Introduction

Although accounting conventions dictate the procedures for deriving and reporting earnings, opportunities for managerial discretion exist. In general, managers exercise discretion when choosing from alternative depreciation methods, inventory costing methods, or pension plan actuarial assumptions. It is widely understood that, given alternative accounting procedures, managers' selections will influence the level of reported earnings. The research issue here is not the impact of accounting choice on the level of reported earnings but rather the incentives underlying managers' decisions to exercise accounting discretion. This article empirically examines a hypothesis suggesting that control mechanisms for agency cost and political cost motivate managers to choose discretionary accounting practices which alter earnings reported in accordance with generally accepted accounting practices (GAAP). Since the insurance industry experienced a unique tax environment in 1984 and 1987, insurers affected by the tax law change of 1984 are examined independently.

Previous accounting choice studies exclude financial institutions, because their financial reporting processes tend not to conform with other industries.(1) The insurance industry is particularly well suited for a study of accounting choice due to the importance of estimated data such as loss reserves in insurer financial statements. An industry-specific approach is further motivated by the potentially confounding effects of ownership structure and managerial decision making in cross-industry studies. Ownership structure affects managerial decision making, while the firm's environment influences the appropriate ownership structure. An industry-specific analysis controls for many of these confounding variables. Finally, information regarding insurers' motivations for discretionary accounting adjustments is timely in light of initiatives by the Securities Exchange Commission and the Financial Accounting Standards Board.(2)

The next section reviews previous research regarding discretionary accounting practices and establishes the theory for the explanatory variables. Then, a discussion of the GAAP discretionary accounting practices available to insurance managers is followed by a description of the data and methodology and a discussion of the results. Insurers affected by the tax law change in 1984 are reexamined independently and results are reported before a final concluding section.

Explanatory Variables

The testable implications of discretionary accounting choices are established by agency theory (see Jensen and Meckling, 1976) and political cost theory (see Watts and Zimmerman, 1978). According to agency theory, widely-held (manager-controlled) insurers are more likely than closely-held (owner-controlled) insurers to make both income-decreasing and -increasing discretionary accounting choices. Also, insurers with reported profitability greater than the industry average are more likely to make income-decreasing accounting choices and less likely to make income-increasing accounting choices. According to political cost theory, large insurers are more hesitant to report increases in reported earnings due to political and regulatory pressures and therefore are more likely to execute income-decreasing accounting choices and less likely to execute income-increasing accounting choices.

The proxies for variables hypothesized as incentives for discretionary accounting practices among insurers are presented in Table 1. The hypothesized relation between each explanatory variable and income-decreasing and income-increasing behavior is reported. The rationale for each hypothesis is discussed in the next section. For income-decreasing behavior, write-offs are addressed independently for reasons established below.

Ownership Control

Mayers and Smith (1988, 1992) hypothesize that the coexistence of various forms of ownership structure is partly attributable to their relative efficiency in controlling agency costs. …

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