Earnings Quality and the Coinsurance Effect

We argue that coinsurance among a firm’s business units changes the properties of reported earnings through less volatile operations (financial synergies) and fewer estimation errors in the accrual process (accounting synergies). Consistent with a coinsurance effect, we find that diversified firms have on average higher earnings quality compared to industry-matched portfolios of focused firms. Specifically, diversification leads to more predictable earnings, superior mapping of accruals to cash flows, and lower absolute abnormal accruals. In addition, we find higher earnings quality for diversified firms with less correlated segment earnings and that the coinsurance effect is stronger for firms that operate in more volatile and uncertain environments. We contribute by identifying the coinsurance effect of diversification as a new determinant of earnings quality. Our findings complement prior literature on agency-related disadvantages of diversification for earnings quality by highlighting coinsurance related benefits of diversification for earnings quality.