Jeffrey S. Paterson

Earnings management under changing regulatory regimes: state accreditation in the insurance industry

Abstract As discussed in our paper, state oversight of the insurance industry became the subject of intense congressional criticism as insurance firm failures escalated in the late 1980s. In particular, claims of possible manipulation of loss reserves were alledged. In response to these criticisms, the National Association of Insurance Commissioners instituted a program for accrediting states that met certain standards aimed at improving the quality of the financial statement information reported by insurers domiciled within their borders. Our study investigates the association between the timing of state accreditation and the loss reserving practices of financially struggling insurers in the property-casualty industry. The results suggest that under-reserving by financially weak insurers declined in the post-accreditation period. This relation is apparent even after controlling for other influences on the reserve choice, such as tax goals and exogenous time-dependent effects. An interpretation is that improvements in insurer solvency monitoring related to accreditation are associated with a decrease in insurers’ proclivities to use accounting discretion to circumvent regulatory oversight.

The Effects of Jointly Provided Tax Services and Auditor Size on Restatements

Abstract Prior research finds evidence that audit quality is positively associated with the joint purchase of tax nonaudit services (NAS) and concludes that jointly provided tax services result in audit-related knowledge spillovers that lead to improved audit quality. We extend this line of research. We examine the relation between auditor-provided tax services and restatements and determine whether this relation differs when the auditor is a small or large accounting firm. We also examine whether the Securities Exchange Commission’s restrictions on certain tax consulting practices (SEC, 2006) altered this relation. Specifically, we measure whether the probability of financial statement restatements varies with (1) variation in accounting firm size (measured as PCAOB annually inspected firms versus PCAOB triennially inspected firms), and (2) the joint provision of audit and tax services. We find a negative relation between auditor-provided tax services and restatements which is consistent with prior research. We also find that this relation is significantly more negative when the auditor is a small accounting firm. Finally, we find that the lower probability of a restatement associated with the joint provision of audit and tax services persists regardless of auditor size after the SEC-imposed restrictions on certain tax consulting services in 2006. Our study provides evidence that accounting firms, and particularly small accounting firms, benefit from knowledge spillovers when jointly providing audit and tax services and these benefits lead to improved audit quality. Prior research concludes that large auditors provide higher audit quality and that the provision of tax services improves audit quality. Our results provide evidence that audit quality improvements are greater for small auditors and their clients. This improvement narrows that audit quality gap between large and small auditors. We do not find evidence that the SEC’s restrictions on certain tax consulting services altered the relation between audit quality and tax services.