DETECTING EARNINGS MANAGEMENT PRECEDING DIVESTITURE TRANSACTIONS IN THE LIFE INSURANCE INDUSTRY (INSURANCE)

The purpose of this research is to develop and test a model for detecting the existence of earnings management preceding a life insurance company corporate divestiture transaction. Financial statement disclosures provide information useful in making economic decisions, play a significant role in determining wealth transfers, and facilitate efficient allocation of resources in the economy (FASB 1973). The argument posited in this study is that life insurance company managers manage particular financial statement variables in the year preceding the divestiture of a business unit. The economic motivation for pre-divestiture earnings management behavior, based on agency theory, is the managers' desire to attain the highest possible price for the unit being divested. In accordance with GAAP and National Association of Insurance Commissioners (NAIC) regulatory accounting standards, managers can inflate or deflate accounting earnings through decisions regarding the selection of accounting methods, accruals, estimates, or the timing of discretionary cash flows. More generally, the argument in this study is that corporate restructuring transactions provide the incentive for managers to manage earnings. The rationale for predicting this relationship is that companies which are actively divesting strategic business units desire the highest price attainable for the units. Prior earnings management research has illustrated the existence of a relationship between earnings management practices and stock prices (Beaver and Engel 1995; Hansen 1996; Perry and Williams 1994). Therefore, companies involved in divestitures have incentive to manage the earnings of the divested unit to affect the transaction price.; Explaining and predicting earnings management in insurance companies requires the development of an earnings management model that captures the financial statement characteristics and discretionary accruals unique to the insurance industry. The motivation for the inclusion of the hypothesized variables in the earnings management detection model stems from prior research and experiential evidence that suggests firms are using restructuring costs and discretionary disclosures to manage reported earnings. Variables were selected for inclusion in the model based on the potential explanatory power of earnings management activities in life insurance companies engaged in corporate restructuring transactions. The earnings management variables tested in this study were changes in: reserves, commissions and expenses, reinsurance, accrued investment revenues, and surplus relief. Tests of the model provide evidence in support of the hypothesis that divesting life insurance companies manage earnings upward preceding the divestiture. Specifically, the empirical results indicate that managers managed a subset of the selected earnings management variables in the year preceding a divestiture transaction. This study will be useful to accounting, economics, and finance researchers, as well as regulators, managers, and shareholders interested in the motivations for strategic financial reporting in a corporate restructuring environment.; This dissertation outlines the theory, literature, hypotheses, and models for detecting whether divestiture transactions act as economic motivation for earnings management in life insurance firms. This line of research will contribute to the existing accounting, economic, and finance literatures by increasing the understanding of strategic financial reporting as types of earnings management decisions in the corporate restructuring setting. This study contributes to the literatures through tests of selected financial statement variables, providing evidence that life insurance companies manage earnings preceding divestiture transactions.