Contrarian insider trading and earnings management around seasoned equity offerings; SEOs

Transcription

1 Journal of Finance and Accounancy Conrarian insider rading and earnings managemen around seasoned equiy offerings; SEOs ABSTRACT Lorea Baryeh Towson Universiy This sudy aemps o resolve he differences in he lieraure regarding he paern of insider rading, around earnings managemen. The relaionship beween earnings managemen and conrarian insider rading around seasoned equiy offerings was herefore examined. While some sudies found ha insiders rade while managing earnings because here was a desire of insiders o sell heir sockholdings a inflaed prices as a moive for earnings manipulaion; (Agrawal, Anup and Cooper, 2007). Oher sudies on he oher hand showed ha insiders are conrarian. For insance (Sawiski, 2005) found ha invesors use his conrarian approach and end o buy socks ha have low book o marke raio and sell hem when heir value increases. This sudy found ha insiders of firms conducing SEOs were conrarian; hey bough recen losers and sold recen winners. Keywords: Earnings Managemen, Conrarian Insider Trading. Copyrigh saemen: Auhors reain he copyrigh o he manuscrips published in AABRI journals. Please see he AABRI Copyrigh Policy a hp:// Conrarian insider rading, page 1

2 Journal of Finance and Accounancy INTRODUCTION The relaionship beween earnings managemen and conrarian insider rading around seasoned equiy offerings was examined. This sudy is moivaed by he lieraure ha esablished a connecion beween qualiy of earnings and insider rading (Beneish 2001, Beneish and Vargus 2002, Park and Park 2004). Oher researchers have documened ha opporunisic endencies affec he bias in earnings forecass of managers of financially disressed firms and following insider rading he rading aciviy of non-managerial insiders are he primary conribuors (Irani 2001). Furhermore earnings managemen and insider rading are more prevalen when sock prices are high due o high pas reurns (Kadan, Ohad and Yang 2006). While some prior sudies have examined earnings managemen or insider rading, his is he firs sudy o examine conrarian insider rading and earnings managemen around seasoned equiy offerings (SEOs). The following research quesion; is invesigaed; Why do insiders behave in a conrarian manner around seasoned equiy offerings? This sudy aemps o resolve he differences in he lieraure regarding he paern of insider rading, around earnings managemen. While some sudies found ha insiders rade while managing earnings because here is a desire of insiders o sell heir sockholdings a inflaed prices as a moive for earnings manipulaion; (Agrawal, Anup and Cooper, 2007). Oher sudies on he oher hand showed ha insiders are conrarian. (Sawiski, 2005) found ha invesors use his conrarian approach and end o buy socks ha have low book o marke raio and sell hem when heir value increases. This sudy found ha insiders of firms conducing SEOs were conrarian; hey bough recen losers and sold recen winners. This sudy proceeds as follows; secion 2 develops he hypoheses. Secion 3 presens sample selecion, secion 4 presens he mehodology, secion 5 presens resuls and secion 6 presens conclusions. HYPOTHESIS DEVELOPMENT Managers inflaed earnings before hey sold sock, during he marke bubble s las years; firms ha managed earnings he mos experienced reurns of 21% higher han firms ha managed earnings he leas, and socks of firms where insiders sold he mos sock rose 59% higher han socks when insiders sold he leas. Also, sock correcions afer he bubble burs were srongly negaively associaed wih esimaed levels of earnings managemen and insider selling during he bubble. This was consisen wih allegaions ha lofy sock-based compensaion levels in he 1990s led managers o boos he sock price by manipulaing earnings before hey sold socks (Huddar, Louis, 2010). Beneish found ha firms ha violaed GAAP by earnings oversaemens engaged in income-increasing earnings managemen o hide deerioraing firm performance and ha insiders ook advanage of he marke s ignorance and sold heir shares. Beneish and Vargus conclude ha managers rading aciviies can be used exane o deermine earnings managemen and accrual qualiy. They found ha insiders sales were significanly higher han insiders buys when he accruals in he year ahead were income increasing. Furhermore, accrual mispricing (Sloan, 1996) was parly explained by mispricing of income increasing accruals. (Lakonishok and Lee, 2001) concluded ha insiders were conrarian invesors who bough (sold) sock wih poor pas performance. This sudy herefore hypohesizes ha insiders would use his conrarian approach will buy socks wih poor pas performance and vice versa. This leads o he following; Conrarian insider rading, page 2

3 Journal of Finance and Accounancy H1: Insiders of firms wih high negaive (posiive) discreionary accruals before (afer) he SEO are ne buyers. Jener (2005) found ha insiders were conrarian invesors who bough socks when hey were selling a low valuaion and sold hem when hey were high valuaion. Furhermore Sawiski (2005) found ha invesors used his conrarian approach and bough socks ha have low book o marke raio and sold hem when hey had high valuaion. This phenomena has however no been sudied for firms who are undergoing SEOs. This leads o he second hypohesis. H2: Insiders of firms wih high (low) book o marke raios, before (afer) he SEO are ne sellers (buyers). SAMPLE SELECTION The iniial sample is obained from 10,787 firms issuing seasoned equiy offerings beween 1985 o 2005, from he Thomson SDC Plainum new issues daabase. All SEOs made up of financial insiuions (SIC codes ), regulaed indusries (SIC codes ) and firms which do no have sufficien daa on Compusa, were deleed resuling in a sample of 2,783 firms. For each SEO, all non-issuing firms sharing he same hree-digi SIC code as he issuing firm in he year prior o he SEO were idenified. ( The sample selecion crieria as indicaed in Table 1, Appendix). METHODOLOGY Earnings Managemen The exen of earnings managemen using he cross-secional varian of he (Jones, 1990) mehodology developed in (Teoh, Welch, and Wong, 1998) was measured. This approach separaes accruals ino wo componens; normal, or non-discreionary, accruals ha resuls as a naural consequence of business srucure and operaions common o he indusry (i.e. credi policy, business condiions, ec ) and abnormal, or discreionary, accruals ha arise from earnings managemen. Abnormal accruals (our proxy for earnings managemen) using a wosep process was idenified. For each SEO firm, a regression using all non-seo firms in he same 3-digi SIC code as he SEO firm in he year prior o he announcemen of he SEO was esimaed. The coefficiens from he regression of ha equaion were used o calculae discreionary curren accruals (DCA) as follows: Sales i AR DCA i CAi 1 RO i Ai Ai A 0 1 2,, In equaion (1), discreionary curren accruals deflaed by lagged oal asses (henceforh referred o as DCA) is defined as he difference beween oal curren accruals and nondiscreionary or normal accruals (he brackeed erm on he righ hand side of he equaion). I represens he abnormal or managed componen of curren accruals and is used as our proxy for earnings managemen. A similar procedure in calculaing discreionary (i.e. abnormal) longerm accruals was followed. (1) Conrarian insider rading, page 3

4 Journal of Finance and Accounancy DTA 1 i TA Sales AR i PPE RO i 3 (2) Finally, Discreionary Long-erm Accruals (henceforh DLA) is defined as he difference beween discreionary Toal Accruals and Discreionary Curren Accruals: DL DT DC (3) A A A Shareholdings Of Insiders Since daa from he Thompson Financial (TFN insider Filing Daa) was obained, which conained informaion on all publicly raded U.S. companies, heir insider rading definiion was used which defined corporae insiders broadly o include hose ha have access o non-public, maerial, insider informaion. These insiders are required o file SEC form 3, 4 and 5 when hey rade in heir company socks. To analyze he paern of insiders of issuers of seasoned equiy offerings, he insider purchase raio used by (Pioroski and Roulsone, 2005) and (Sawicki, 2006) ha measured insider rading behavior was adoped. The insider purchase raio (IPR) was calculaed as follows; BUY IPR (4) BUY SELL Where BUY and SELL were (respecively) he number of shares purchased (sold) in open marke ransacions by regisered insiders of a firm during a given fiscal year relaive he year in which he SEO occurs. RESULTS The sample was divided ino quiniles based on he level of IPR, he relaive levels of abnormal accruals across groups was examined. The sample was also divided ino quiniles based on book o marke values. The relaive levels of abnormal accruals across groups was examined; (As indicaed in Table 2, Appendix). Table 2 Quinile 1 presens resuls for SEO firms which had he highes IPR raios which represened he majoriy sales group; while quiniles 5 represens firms wih low IPR raios which is majoriy purchases. Mos of he firms showed negaive discreionary accruals which represened income decreasing earnings. The firms in he majoriy sales group however exhibied income decreasing accruals (which is negaively significan) in he years before and afer he SEO while hey exhibied posiive or income increasing accruals in he year of he SEO. This shows signs of he conrarian approach where firms manipulae earnings downward in he year before he SEO and manipulae i upwards in he year of he SEO where hey sell heir shares and hen hey have o reverse he rend in he year of he SEO. For he high purchase group evidence of firms manipulaing earnings downwards in he year before he SEO bu upward in he year of he SEO and he year afer he SEO was found even hough none of hese were significan. (As indicaed in Table 2, Appendix) Table 3 shows he firms wih high and low book o marke raio. Quinile 1 and 2 shows firms wih high book o marke raio while quinile 4 and 5 shows firms wih low book o marke Conrarian insider rading, page 4

5 Journal of Finance and Accounancy raios. Firms in he high book o marke group exhibi income decreasing accruals which is significan in he year before he SEO while firms in he low book o marke exhibi income decreasing accruals in he year afer he SEO. (As indicaed in Table 3, Appendix) CONCLUSION Resuls confirm prior sudies which even hough were no conducing SEOs also found insiders o be conrarian; in buying recen losers and selling recen winners. The resuls also show ha insiders ha purchase in he curren year, increase income in he fuure year while insiders who sell shares in he curren year deflae pas years income. This is due o he fac ha firms in he majoriy sales group exhibi income decreasing accruals (which is negaively significan) in he years before and afer he SEO while hey exhibi posiive or income increasing accruals in he year of he SEO. The resuls exhibis signs of he conrarian approach where firms manipulae earnings downward in he year before he SEO and manipulae i upwards in he year of he SEO when hey sell heir shares and hen hey have o reverse he rend in he year of he SEO. For he high purchase group evidence of firms manipulaing earnings downwards in he year before he SEO bu upward in he year of he SEO and he year afer he SEO was found even hough none of hese were significan. Resuls also showed insiders o be omniscien ha is hey buy prior o good resuls and sell prior o bad resuls. This is because firms in he high book o marke group exhibi income decreasing accruals which is significan in he year before he SEOs while firms in he low book o marke exhibi income decreasing accruals in he year afer he SEO. Furher analysis includes deermining if he high and low quiniles of he sample will have any associaion wih reurns. REFERENCES Agrawal, A. and T. Cooper, (2007), Insider rading before accouning scandals. SSRN.com/absrac= Beneish M.D. (2001), Earnings managemen: A perspecive. Managerial Financ.e 27 (12) p3. Beneish M.D. and Vargus M.E. (2002), Insider Trading, earnings qualiy and accrual mispricing. The Accouning Review. Oc 77(4) p755 Huddar, S. J. and H. Louis, (2010), Insider selling,earnings managemen and he 1990s sock marke bubble. hp://ssrn.com/absrac= Irani, A. J.(2001), Managemen Earnings Forecas Bias and Insider Trading: Comparison of Disressed and Non-Disressed Firms" (April 2001). Available a SSRN: hp://ssrn.com/absrac = or DOI: /ssrn Jener, D. (2005), Marke iming and managerial porfolio decisions. The Journal of Finance 60 ( 4)p Kadan, O. and J. Yang (2005), Execuive Sock Opions and Earnings Managemen - A Theoreical and Empirical Analysis" December 10,. AFA 2006 Boson Meeings Paper Available a SSRN: hp://ssrn.com/absrac= Lakonishok J. and L. Lee, (2001), Are insider rades informaive? Review of Financial Sudies 14 (1)p Park and Park (2004), Insider sales and earnings managemen. Journal of Accouning and Public Policy. New York 23 (5) p.381. Conrarian insider rading, page 5

6 Journal of Finance and Accounancy Pioroski J.D. and Roulsone D.T. (2005), Do Insider Trades Reflec Superior Knowledge abou fuure cash flow realizaion? Journal of Accouning and Economics 39 p Sawicki J. (2005), Are Insider Trades and Earnings Managemen Relaed? Available a ssrn.com absrac = Sloan, R. G., (1996), Do sock prices fully reflec informaion in accruals and cash flows abou fuure earnings? The Accouning Review, 71, 3 (July) p Teoh, S. H., Welch I., and T.J. Wong (1998), Earnings managemen and he long-run marke performance of iniial public offerings. The Journal of Finance. Dec 53, (6) p Teoh, S. H., Welch I., and T.J.Wong (1998), Earnings managemen and he underperformance of seasoned equiy offerings. Journal of Financial Economics, 50 (1), pg 63. APPENDIX Table 1: Sample Selecion Sample No. of firms Toal SEO firms 10,787 SEO firms wih Financial 10,752 Insiuions & Regulaed Firms SEO firms on Compusa 2,783 Table 2: Insider Purchases And Sales Quiniles Variable N Mean Sd. Dev. -value 1 DTA DTA DTA DTA DTA DTA DTA DTA DTA DTA DTA DTA DTA DTA DTA Conrarian insider rading, page 6

7 Journal of Finance and Accounancy DTA -1 Discreionary oal accruals in he year before he SEO DTA Discreionary oal accruals in he year of he SEO DTA +1 Discreionary oal accruals in he year afer he SEO Table 3: Discreionary Accruals for high versus low book o marke value firms Quiniles Variable N Mean Sd. Dev. -value 1 DTA * DTA DTA DTA DTA DTA DTA DTA DTA * 4 DTA DTA DTA * 5 DTA DTA DTA DTA -1 Discreionary oal accruals in he year before he SEO DTA Discreionary oal accruals in he year of he SEO DTA +1 Discreionary oal accruals in he year afer he SEO Conrarian insider rading, page 7