Audit Process, Private Information, and Insider Trading

Salman Arif · John D. Kepler · Joseph H. Schroeder · Daniel J. Taylor

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Auditing, Earnings Management, Governance Financial Markets and Investment Strategies Corporate Finance and Governance

Abstract

Abstract While the shareholder benefits of audits are well documented, evidence on whether audits can facilitate opportunistic behavior by corporate insiders is scarce. In this paper, we examine whether the audit process facilitates one particular form of opportunism: informed trading by corporate insiders. We focus our analysis on insider trading around the audit report date. We find an increase in trading around the audit report date and that the increase is abnormally large for firms that subsequently report modified opinions. The abnormal increase in trading is concentrated among officers and non-audit committee independent directors, and most pronounced in first-time modified opinions and modified opinions in years where financial results are subsequently restated. These trades are highly opportunistic: they predict restatements, and as a consequence, we show they avoid significant losses. Collectively, our findings provide novel evidence that insiders appear to exploit private information about the audit process––a process ostensibly designed to protect shareholders––for opportunistic gain.

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References

2008The Cost to Firms of Cooking the Books 2004The behaviour of the maximum likelihood estimator of limited dependent variable models in the presence of fixed effects 2008The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity 2006The discovery and reporting of internal control deficiencies prior to SOX-mandated audits 2012Decoding Inside Information 2007Market reactions to the disclosure of internal control weaknesses and to the characteristics of those weaknesses under section 302 of the Sarbanes Oxley Act of 2002 2013The relation between equity incentives and misreporting: The role of risk-taking incentives 2005On the Timing of CEO Stock Option Awards

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