Do Firms Issuing Equity Manage their Earnings? Evidence from the Property-Casualty Insurance Industry

Do Firms Issuing Equity Manage their Earnings? Evidence from the Property-Casualty Insurance Industry

2000Working Paper No. 1605

This paper examines whether property-casualty insurance companies manage earnings to influence investor expectations at the time of equity issuances. Our tests focus on the discretionary component of a material accounting accrual recognized by property-casualty insurance companies, i.e., the reserve for policy claim losses. Required disclosures of revisions to loss reserve estimates allow us to develop a potentially more reliable measure of discretion than that used in prior research, and to examine firms' discretionary behavior for several years prior to initial public offerings. Based on a sample of 80 initial public offerings and 116 seasoned equity offerings between 1985 and 1997, we do not find evidence to support the hypothesis that managers opportunistically manage accruals prior to equity offerings. Because we do find evidence of earnings management in our sample, particularly by financially weak firms, our failure to document incremental earning magagement prior to equity offerings is unlikely to be attributable to a lack of power. Our results are inconsistent with prior research, however, and raise the question of whether the results of other studies are due to discretion over accruals or to the decision to issue equity being correlated with factors (such as a peak in sales and earnings growth) that cause firms' accruals to appear extreme.