Insider sales and earnings management

Abstract

This study examines the relationship between managers’ insider transactions and their strategic behavior on earnings management. Prior literature provides a theoretical basis to empirical studies of insider trading and earnings management ( Elitzur and Yaari, 1995; Trueman, 1990; Bar-Gill and Bebchuk, 2003). We predict that managers adjust discretionary accruals (DAs) to increase current-period earnings before they sell their own firms’ shares in the subsequent period. Our empirical results support that current discretionary accruals are higher for firms whose managers sell their ownership in the subsequent period than for other firms, indicating that managers of insider sales firms would have deliberately increased current-period earnings through DAs. However, the observed positive relationship between DAs and insider sales can also be explained such that managers may have adopted passive and opportunistic strategies by trading their shares after higher earnings are reported regardless of earnings manipulation. To address this causality issue, this study employs simultaneous equations approach. The two-stage least square estimation shows that our test results are insensitive to controlling for the possibility that managers time their transactions after observing unusually high accruals. We also find that, after accruals manipulation and insider sales, stock prices tend to be adjusted downward in the future and that current high discretionary accruals induced by the insider sales have an incremental explanatory power in explaining the post-transaction stock underperformance.