Accounting for Asset Sales : The Effect on Earnings Smoothing

We examine whether accounting rules can influence gains trading activities in financial institutions.Gains trading occurs when managers strategically sell invested assets to affect earnings.We focus on the U.S. insurance industry, where Life insurers are subject to a rule that requiresthem to amortize realized capital gains and losses over the remaining maturity of the bond sold.This rule dilutes the impact of realized capital gains and losses on earnings, as only a portioncan be recognized immediately as income. We find that the rule is effective in its design – eventhough managers of Life insurers make trades to offset operational losses, they do not significantlyaffect reported income. The rule imposes greater costs on managers with fewer near-maturitybonds, and we document more extreme gains trading in those situations. Our study contributesto the literature on gains trading among financial institutions, showing the impact of a uniqueaccounting rule which significantly influences the real activities of managers