Audit Alert: A New Way To Identify Corporate Insider Trading
Wednesday, May 10, 2023
By Suzy Frisch
American capital markets are intended to offer a level playing field for all investors. However, it’s not a flawless system. New research from the University of Minnesota reveals that some public company leaders opportunistically use their inside knowledge surrounding audits to protect their personal portfolios from financial losses. The findings may guide future changes by federal regulatory agencies.
Researchers devised a novel way to identify whether C-suite executives and corporate directors use information from pending audits to sell stock before the report becomes public. Led by Carlson School of Management Assistant Professor Salman Arif, the team utilized companies’ annual reports, including the time-stamped audit report letter, to pinpoint the critical period between when the auditor privately submitted its report to the corporate board and the company publicly disclosed the audit results.
This clever approach enabled researchers to infer whether corporate insiders engaged in potentially illegal behavior by trading on nonpublic audit information. After evaluating about 2,000 companies to gauge whether there was an increase in executive or corporate director stock trading during that timeframe, the findings were striking. Many companies experienced spikes in selling by insiders. Insiders were able to avoid losses of 11 percent on average by selling their stock before public notification of the audit findings, Arif says.
“The whole point of an audit is to make sure a firm is reporting things truthfully and accurately,” he explains. “Another important function is to create a sense of trust so that investors are willing to give capital to those firms. It would be a problem that the very thing that is supposed to create trust and good governance could be manipulated or abused so that managers can take advantage of it.”
Other findings include:
- In firms that receive negative audit opinions, insider selling rises sharply in the weeks between when company leaders relay the audit report to the board but before the company makes the report public.
- Insider selling around audit reports leads to a 35 percent higher probability the company will subsequently restate its financial results.
- The abnormal increase in trading is concentrated among officers and non-audit committee independent directors. It also is most pronounced in first-time modified opinions and in years where companies subsequently restate their financial results.
Prior to this research, there were few ways to confirm nefarious activity among corporate insiders related to audits. This study forges a new path for regulators to identify opportunistic trading, highlighting a specific time period for monitoring.
Subsequently, the team presented its research to the U.S. Securities and Exchange Commission and the federal Public Company Accounting Oversight Board, which regulates public companies’ audits. With this new knowledge, Arif says, government agencies could adopt regulations to prevent company leaders from trading on inside information.
“We told them how audit information is potentially being abused by management,” Arif adds. “They were surprised and disappointed that the tool we created to protect investors through audits could in fact be used for the opposite. This calls for better safeguards to uphold investor protection and good governance.”
This article appeared in the Spring 2023 Discovery magazine
In this issue, Carlson School faculty examine crime enforcement on the Darknet, dual-income households, and the progression of disruptive science.