Financial Restatement Announcements and Insider Trading

Oliver Zhen Li University of Notre Dame

Yuan Zhang

Columbia University

October, 2006

ABSTRACT We examine insider trading activities around financial restatement announcements and find strong evidence of informed trading by insiders. Focusing on the association between net insider selling and restatement announcement abnormal returns, we provide evidence of net insider selling before the restatement announcements, little net insider selling immediately around the announcements, and net insider buying after the announcements. The passage of the Sarbanes-Oxley Act constrains informed insider selling before the restatement announcements. Trading before the restatement announcements enables insiders to make a significant profit, especially pre-Sarbanes-Oxley. Overall, our results suggest that insiders trade on privileged knowledge about the forthcoming restatement announcements to their advantage and that they trade in a pattern that minimizes the possibility of insider trading allegations or violating internal corporate insider trading policies. ___________ We thank Mei Cheng, Jim Ohlson, and workshop participants at the University of Florida for helpful comments and suggestions. All errors are ours.

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Financial Restatement Announcements and Insider Trading

1. Introduction

Financial restatements are salient negative firm-specific events. Prior studies have shown that

financial restatements are associated with a decrease in firm value (Anderson and Yohn, 2002;

Palmrose, Richardson and Scholz, 2004), a decrease in future earnings prospect and an increase

in the cost of equity capital (Hribar and Jenkins, 2004). The negative valuation impact of

financial restatements may induce firm insiders, who presumably possess advance knowledge

about the timing, likelihood and severity of financial restatements, to trade shares in a pattern

that avoids the negative impact of financial restatements on their personal investment in the

restating firms.

In this paper, we examine insider trading activities around financial restatement

announcements. Specifically, using the Financial Statement Restatement Database complied by

the United States Government Accountability Office (formerly the United States General

Accounting Office; GAO, 2003 and 2006),1 we examine two issues: first, the direction and the

magnitude of insider trading activities around financial restatement announcements; and second,

the timing of their trades. We focus on the relation between net insider selling activities and

restatement announcement abnormal returns and find strong evidence of informed insider trading

activities around the announcements. We show that net insider selling is negatively related to

restatement announcement abnormal returns in Quarters -8 to -2 before the announcements.

During the quarter immediately preceding the restatement announcement (Quarter -1) and the

1 Effective July 7, 2004, the GAO's legal name changed from the General Accounting Office to the Government Accountability Office.

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quarter immediately after the announcement (Quarter 0), insiders cease restatement-related net

selling of shares. The relation between net insider selling and restatement announcement

abnormal returns is insignificant. During Quarters 1, 2 and 4 after the announcements, insiders

reverse the direction of their trades and start net buying of shares. The relation between net

insider selling and restatement announcement abnormal returns is positive. Further, the passage

of the Sarbanes-Oxley Act of 2002 appears to constrain information-motivated insider selling

activities before the restatement announcements. We also show that insiders make an

economically significant profit by trading before financial restatement announcements,

especially prior to the passage of the Sarbanes-Oxley Act.

Overall, our results suggest that: 1) insiders trade on private information about the

forthcoming restatement announcements in a direction that allows them to avoid the negative

wealth impact of the news on their investment in the restating firms; 2) insiders refrain from

trading too close to the announcements to minimize insider trading litigation risks and/or to

avoid violating internal corporate insider trading restrictions.

Our paper is related to studies that examine insider trading activities during periods of

fraudulent financial reporting (Beneish, 1999; Dechow, Sloan and Sweeney, 1996; Summers and

Sweeney, 1998). We note that financial restatements, often involving aggressive accounting, are

not necessarily fraudulent, although their announcements frequently trigger significantly

negative market reactions. More importantly, these prior studies focus on the manipulation

period (as opposed to the public disclosure of the manipulation) only and find mixed evidence.2

It is ambiguous whether insiders will engage in abnormal insider selling during periods of

earnings manipulations. On the one hand, insiders may sell stock during the misstated periods

2 For example, Beneish (1999) and Summers and Sweeney (1998) find evidence that insiders increase their selling during periods of fraudulent financial reporting, while Dechow, Sloan and Sweeney (1996) find no or very weak evidence of informed insider selling.

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while the stock price is supported by inflated earnings. On the other hand, insiders may postpone

selling in the hope that the accounting problems will not be revealed and that the stock price will

continue to rise (Agrawal and Cooper, 2006).

A concurrently developed study by Agrawal and Cooper (2006) also examines restatement-

related insider trading activities. They find evidence that top managers of restating firms sell

more stocks for some subsamples where insiders have greater incentives to sell before the

revelation of accounting problems, but not for the full sample of restating firms. Their research

methodology is different from ours. Specifically, they focus on the period from the first day of

the restated quarter to the restatement announcement date, which includes both the manipulation

period and the period prior to the public disclosure of the restatements. As discussed above,

insider trading activities during the manipulation period is difficult to predict. Further, prior

research has shown that insiders usually trade well in advance of, as opposed to immediately

prior to, major corporate disclosures (Seyhun and Bradley, 1997; Ke, Huddart and Petroni, 2003).

Thus, if there are muted informed insider trading activities during the test period or if there are

some informed insider trading activities in the control period, Agrawal and Cooper’s (2006)

research design may not be able to detect abnormal insider trading activities associated with the

announcements of financial restatements.

In contrast, we focus on the quarters around the public disclosure of financial restatements.

Since the stock prices of the firms announcing restatements usually drop significantly at the time

of the announcements (Anderson and Yohn, 2002), we expect insiders to have incentives to

engage in informed selling to avoid material personal losses in their investments in the restating

firms. Specifically, we link net insider selling activities to the market response to restatement

announcements in order to detect informed insider trading, if any. The reason for doing this is

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simple: It is the negative market response to financial restatements, not necessarily the

restatements per se, that motivates insider trading. Our paper also differs from Agrawal and

Cooper (2006) in that we present the timing pattern of insider trading activities. Further, our

sample includes restatements announced after June 2002, which enables us to investigate

whether there is any change in insider trading around restatement announcements after the

passage of the Sarbanes-Oxley Act of 2002.

Our paper makes a contribution to the insider trading literature. While it has been robustly

documented that insiders earn abnormal returns on trades of their firms’ stocks, there is relatively

limited evidence linking these trades to particular types of private information (Ke, Huddart, and

Petroni, 2003). Our paper improves our understanding of insider trading in this respect by

providing evidence that insiders trade on private information: specifically, the timing, likelihood

and severity of financial restatements. It has implications for insider trading regulations, both at

federal level and corporate level, regarding the timing of informed trading. Our results suggest

that insiders not only trade on private information, but also carefully time their trades around the

financial restatement announcements to avoid possible insider trading allegations and/or

violating internal corporate insider trading restrictions, consistent with Seyhun and Bradley

(1997) and Ke, Huddart and Petroni (2003).

Our paper also provides some initial evidence on the impact of the Sarbanes-Oxley Act on

insider trading activities. The Act aims to restore investor confidence in the capital market.

While its main provisions address issues related to financial reporting and auditing, the Act has

directly or indirectly affected almost every aspect of the capital market, including insider trading.

Our results show little evidence of information-motivated insider trading activities prior to the

public disclosure of financial restatements for periods after the passage of the Sarbanes-Oxley

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Act. This is in sharp contrast to periods before the Act, suggesting that the post-Sarbanes-Oxley

Act environment has at least constrained insiders from trading on privileged information to some

extent.

Our paper is subject to the caveat that we use insider trades reported under the filing

requirements of Section 16 of the U.S. Securities and Exchange Act of 1934. Thus, they

represent open market and “legal” insider trades (Seyhun and Bradley, 1997) as opposed to

illegal insider trading (Meulbroek, 1992). To the extent that there are unreported insider trades,

we measure insider trading activities with errors and perhaps biases. However, reporting errors

and biases are expected to be relatively small because insiders have reputation and employment

concerns and are subject to penalties imposed by insider trading legislations. Further, such errors

or biases, if any, should bias against finding information-motivated insider trading activities.

We also acknowledge that insider trading is not necessarily information-motivated. For

example, insiders may trade due to their liquidity needs. However, we argue that insiders are

more likely than outsiders to possess private information about their firms and to trade on that

information. Even if insiders trade due to their liquidity needs, they can still time their trades to

benefit from the private information they possess (Garfinkel, 1997; Huddart, Ke and Shi, 2006).

The directional magnitude of insider trading activities and the timing of their trades around

restatement announcements, and in particular, the statistical association between these trades and

the event period abnormal returns found in our study suggest strong evidence of insider trading

on privileged knowledge.

This paper is organized as follows. In Section 2, we discuss insider trading activities around

financial restatement announcements and develop hypotheses. In Section 3, we describe our data

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and sample selection process. In Section 4, we discuss the empirical results. We conclude in

Section 5.

2. Insider Trading Around Financial Restatement Announcements

Insider trading is often linked to trading based on privileged knowledge and earns firm

insiders abnormal profits. The literature has examined insider trading around major corporate

events (Elliot, Morse and Richardson, 1984; John and Lang, 1991; Sivakumar and Waymire,

1994; Seyhun and Bradley, 1997) and insider trading in asymmetric information environment

(Aboody and Lev, 2000; Beneish and Vargus, 2002; Frankel and Li, 2004; Aboody, Hughes and

Liu, 2005; Piotroski and Roulstone, 2005; Huddart and Ke, 2006). These studies suggest that

insiders take advantage of outsiders by trading on advance knowledge of specific firm events or

privileged understanding of certain firm characteristics, such as R&D. In this study, we examine

insider trading activities and profit around a major negative corporate event, the announcement

of financial restatement.

2.1 DIRECTION AND TIMING OF INSIDER TRADING

There are two essential aspects of informed insider trading: the direction of their trades and

the timing of their trades. Notwithstanding federal rules or corporate policies against informed

insider trading, insiders, with advance knowledge of future firm prospects, have a natural

tendency to trade to benefit from material positive private information and to avoid expected

losses from material negative private information. Since financial restatement announcements

are associated with significant negative abnormal equity returns (Anderson and Yohn, 2002;

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Palmrose, Richardson and Scholz, 2004; Hribar and Jenkins, 2004) and insiders have incentives

to avoid losses in their investment in the restating firms, we expect them to sell restating firms’

shares before the news of the restatements is announced to the general public. More importantly,

given their possession of private information, the intensity of their selling activities are expected

to be positively associated with the magnitude of the restatement announcement abnormal

returns, an indicator of the severity of a specific financial restatement. That is, the more severe a

financial restatement, the more shares insiders will sell before its announcement. Thus, our first

hypothesis deals with the directional magnitude of insider trading before the announcements of

financial restatements:

Hypothesis 1: The magnitude of the net insider selling activities before the financial restatement announcements is negatively related to the restatement announcement abnormal returns.

While insiders generally have the incentives to trade to benefit from the positive valuation

impact of good private information or to avoid the negative valuation impact of bad private

information, their trades are subject to insider trading regulations that trading on the basis of

material nonpublic information is prohibited. Such regulations can mitigate the kind of trading

activities that we predict in Hypothesis 1 above.3 For example, Garfinkel (1997) shows that after

the passage of the Insider Trading and Securities Fraud Enforcement Act of 1988, insiders

significantly alter their trading pattern by postponing liquidity sales until after negative earnings

announcements. Further, insiders are also subject to the filing requirements of Section 16 of the

Securities Exchange Act of 1934. Thus, firm insiders have to balance the gains from trading on

privileged information and possible sanctions from insider trading allegations. Apart from

3 The "manipulative and deceptive devices" prohibited by Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.

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securities laws that restrict insider trading, most firms also have corporate policies that regulate

insider trading activities. Bettis, Coles and Lemmon (2000) show that many firms have blackout

periods relative to earnings announcements or other important corporate events during which the

company prohibits trading by insiders. They provide evidence that these blackout periods are

effective in suppressing insider trading activities.

Based on the above discussion, the timing of trades is very important to insiders who trade

around a certain event, to regulators who legislate and enforce insider trading regulations, and to

researchers who examine insider trading activities. In fact, the timing of trades is an essential

aspect of insider trading. To avoid insider trading allegations and/or violating internal corporate

policies restricting insider trading activities, insiders have a tendency to avoid trading very close,

and especially just prior, to major corporate events. Prior studies have found that insiders trade as

early as two years before the break of a string of consecutive earnings increases (Ke, Huddart

and Petroni, 2003), and five years before bankruptcy (Seyhun and Bradley, 1997). We argue that

if insiders sell shares in restating firms before the financial restatement announcements, they will

trade well in advance of the announcements and will refrain from trading very close to the

announcements (Noe, 1999; Huddart, Ke and Shi, 2006). By following this trading pattern, they

minimize the risk of insider trading allegations and/or violating internal corporate insider trading

policies (Ke, Huddart and Petroni, 2003). Insiders have opportunities to trade well in advance of

the actual restatement announcements because of their knowledge of the ongoing

investigation/audit that leads to the restatements. Thus, our second hypothesis deals with the

timing of insider trading:

Hypothesis 2: Insiders commence trading well in advance of the financial restatement announcements and they avoid trading very close to the financial restatement announcements.

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When insiders actually commence trading and when they cease trading around financial

restatement announcements is an empirical question.

Another issue related to insider trading activities around financial restatement

announcements is that insiders may reverse the direction of their trades after the news of the

financial restatements has been made public.4 There are three possible reasons for this reversal: (i)

market overreaction to the restatement announcements that insiders can further exploit (Seyhun,

1990); (ii) insiders’ need to rebalance their investment portfolios after net selling of shares in the

restating firms; or (iii) a form of passive insider trading (Huddart, Ke and Shi, 2006). As Huddart,

Ke and Shi (2006) discuss, to avoid the negative impact of restatement announcements, insiders

can sell shares before the announcements or delay purchases until after the announcements.

Selling before material negative news events is a form of active insider trading while delaying

purchases until after the release of negative news is a form of passive insider trading. Therefore,

we also examine insider trading activities subsequent to the announcements. This kind of insider

trading may or may not be based on privileged information.

2.2 SARBANES-OXLEY ACT OF 2002

The Sarbanes-Oxley Act was signed into law in July 2002. This Act was initiated in response

to numerous accounting scandals that surfaced in 2001 and 2002. The Act aims to restore

investor confidence in and assure the integrity of the capital market. The reforms initiated by the

Act address nearly every aspect and participant in the capital market.5 For example, the Act

establishes the Public Company Accounting Oversight Board, which oversees, regulates,

4 For example, in August 2003, with the stock of Tyco International Ltd. dipping after the company announced an accounting restatement, ten company executives spent $1.1 million to buy Tyco stock (Cooke, 2005). 5 See testimony by SEC Chairman William H. Donaldson in front of the House Committee on Financial Services on April 21, 2005 (http://www.sec.gov/news/testimony/ts042105whd.htm).

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inspects, and disciplines accounting firms in their roles as auditors of public companies. The Act

also covers auditor independence, corporate governance and enhanced financial disclosure.

While the Sarbanes-Oxley Act does not specifically address insider trading, it has implications

for firm insiders who trade around corporate events. For example, the Act increases criminal

penalties for defrauding shareholders of publicly traded companies; it requires management and

principal stockholders to report their trades before the end of the second business day following

the day on which the transaction has been executed;6 it requires the disclosure of whether the

issuer has adopted a code of ethics for senior financial officers. Thus, after the passage of the

Sarbanes-Oxley Act, insiders are possibly subject to higher penalty and scrutiny for informed

trading, which can potentially restrain informed insider trading activities around financial

restatement announcements. We empirically investigate whether the passage of the Sarbanes-

Oxley Act affects the magnitude and the timing pattern of insider trading activities. We expect

that the Sarbanes-Oxley Act likely constrains information-motivated insider trading activities

before financial restatement announcements.

3. Sample Selection and Variable Definitions

3.1 SAMPLE SELECTION

Information on financial restatements is obtained from the Financial Statement Restatement

Database complied by the United States Government Accountability Office (formerly the United

States General Accounting Office; GAO, 2003 and 2006). This database focuses on financial

restatements resulting from accounting irregularities and excludes those from business 6 Prior to the Act, insiders were subject to Section 16 of the Securities Exchange Act which stipulated that, directors, officers and 10% or greater stockholders report changes in their beneficial ownership every month within 10 days after the close of the calendar month in which the transaction occurred.

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transactions such as mergers and acquisitions and those from general accounting changes or

bookkeeping errors. Thus, the restatements in this database are more likely due to aggressive

financial reporting, and hence are more likely to trigger negative market reactions upon their

announcements.

GAO (2003) includes 919 restatement announcements by 845 firms from January 1, 1997 to

June 30, 2002 and GAO (2006) includes 1,390 restatements announcements by 1,121 firms from

July 1, 2002 to September 30, 2005. Since we require insider trading data for five quarters after

the restatement announcements and our insider trading database terminates by the end of 2005,

we keep restatements announced between January 1, 1997 and December 31, 2004 for our

analysis.

The majority of the database is compiled using the Lexis-Nexis “Power Search” command

and the “U.S. News, Combined” database, with the keyword of “restate”, “restated”, “restating”

or “restatement” within 50 words of “financial statement” or “earnings”. The database also

includes some restatements identified through other sources, such as the SEC (GAO, 2003). For

each restatement announced, the database provides information on the date of the announcement,

the reasons for the restatement, and the party who initiated the restatement.

Insider trading information is obtained from Thomson Financial. The Insider Filing Database

compiled by Thomson Financial is designed to capture all insider activities as reported on SEC

forms 3, 4, and 5. Following prior studies, we focus on open market purchases and sells as

reported in Table 1 of Form 4 (Ke, Huddart and Petroni, 2003). To ensure data quality, we delete

all insider trading records that are assigned cleanse code “A” or “S” by Thomson Financial.7

7 Thomson Financial verifies the accuracy and reasonableness of insider reported figures by reference to external sources. The cleanse code “S” indicates no cleansing attempted and security not meeting Thomson Financial’s collection requirement; the cleanse code “A” indicates numerous data elements were missing or invalid and that reasonable assumptions could not be made.

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Consistent with Ke, Huddart and Petroni (2003), we restrict the definition of insiders to

officers and directors and exclude non-officer insiders (such as large shareholders, retired

officers) because officers and directors are more likely to possess private information regarding

the aggressive accounting, ongoing investigation, and the subsequent decision to restate prior

financial statements. As discussed earlier, we focus on quarters around the restatement

announcements as opposed to the periods of the aggressive accounting. Insiders are expected to

have information regarding the forthcoming announcements because the decision to restate prior

financial statements usually comes after a period of investigation or audit of the company’s

financial statements by the SEC, auditor, or the firm itself.8 However, information about the

duration of investigation or audit usually is not publicly available. We choose to focus on eight

quarters prior to the restatement announcements to capture any potential informed trading.9 We

also analyze five quarters after the announcement date to understand insiders’ trading behavior

subsequent to the significant market reaction at the announcement. Specifically, as illustrated in

Figure 1, we define the restatement announcement date as the event day, and define thirteen 91-

calendar-day periods around the event day: eight quarters before the event day and five quarters

after the event day.

For each quarter, we keep restating firms that have at least one insider transaction filed in

Table 1 of Form 4 in the corresponding calendar year in the Thomson Financial Insider Filing

database. A total of 1,274 restating firms with non-missing restatement announcement abnormal

return RACAR are represented in at least one quarter. Table 1 provides descriptive statistics

regarding these 1,274 restatement announcements. Panel A reports the magnitude of RACAR, the

8 For example, the restatement announcement by Xerox in April 2002 came in the wake of an audit ordered by the company of its books after SEC investigations in June 2000 and May 2001 of the company’s revenue and lease accounting. 9 A majority of our sample firms announced that they would restate financial statements filed one or two years ago, which suggests that the investigation period is not likely longer than two years for these firms.

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abnormal return from calendar Day -7 prior to the announcement to calendar Day 7 after the

announcement. The abnormal return is calculated as the difference between the firm return and

the equal-weighted market return. Consistent with prior research (Anderson and Yohn, 2002;

Palmrose, Richardson and Scholz, 2004), market reactions to the announcements are

significantly negative. The mean is -7.3% and the median is -3.8% for the full sample. Prior to

the passage of the Sarbanes-Oxley Act, the mean is -10.3% and the median is -5.5%. After the

passage of this Act, the mean is -4.0% and the median is -2.7%.10 Thus, market reaction to

restatement announcements is significantly lower after the passage of the Sarbanes-Oxley Act.

Overall, the significant decrease in market values for these restating firms provides incentives for

insiders to trade prior to the announcements to avoid significant losses in their personal

investment in the restating firms.

Panel B of Table 1 reports the frequency of different initiators of the restatements. For the

full sample, 52% of the restatements are initiated by the company itself, 11% are initiated by the

SEC, and 13% by the auditor. About 2% of the restatements are initiated by some other parties

such as IRS or external parties. A significant percentage (29%) of the 1,274 restatement

announcements did not identify an initiator.11 After the passage of the Sarbanes-Oxley Act,

auditor and company initiated restatements increase, from 8% prior to the passage of the

Sarbanes-Oxley Act to 18% after the Act and from 42% prior to the Act to 64% after the Act,

respectively, while SEC initiated restatements decrease from 14% prior to the Act to 7% after the

Act.12

10 In Table 1, restatement announcements are classified as pre-Sarbanes-Oxley and post-Sarbanes-Oxely based on the announcement date. In all remaining tables, firm-quarters are classified as pre-Sarbanes-Oxley and post-Sarbanes-Oxley based on the starting and ending dates of the corresponding insider trading quarter. 11 Since certain restatement announcements identify multiple initiators, the sum of the percentages is greater than 100%. 12 Note that the percentage of restatement announcements not identifying an initiator dropped from 36% to 21% after the Act.

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Panel C of Table 1 reports the indicated reasons for the restatements. Consistent with

Anderson and Yohn (2002) and Palmrose, Richardson and Scholz (2004), the most frequent

reason for restating financial statements is revenue recognition. 36% of the 1,274 restatements

involve revenue recognition. This percentage decreases from 42% pre-Sarbanes-Oxley to 29%

post-Sarbanes-Oxley. About 28% of the restatements affect cost or expenses. This percentage

increases from 20% pre-Sarbanes-Oxley to 37% post-Sarbanes-Oxley. Some other more frequent

reasons include accounting for mergers and acquisitions (6%), restructuring (16%), securities

(11%), and in-process R&D (2%).

For the majority of our tests, we exclude observations with no insider trading or zero net

selling in a particular quarter (Seyhun, 1986; Piotroski and Roulstone, 2005). This is because

without insider trading activities during a specific quarter, we cannot define our insider trading

metric as well as two important control variables, prior return and subsequent return. Within each

quarter, we aggregate all insider sells and purchases respectively for each firm and obtain total

numbers of shares sold or purchased. We delete observations within the top one percentile of

either shares bought or shares sold to mitigate the influence of extreme observations or potential

data errors. These procedures yield 639 firms in Quarter -8 and 514 firms in Quarter 4 relative to

the restatement announcement.

3.2 REGRESSION MODEL AND VARIABLE DEFINITIONS

To determine whether insiders engage in information-motivated trading around the

restatement announcements, we estimate the following regression for each of the thirteen

quarters around financial restatement announcements:

SNISi,t+Q = β0 + β1RACARi,t + β2RMi,t + β3SECi,t + β4COMi,t + β5PRERETi,t+Q + β6POSTRETi,t+Q + β7LCAPi,t + β8BMi,t + εi,t. (1)

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Note that in the above regression i denotes a restating firm, t denotes the time of the restatement

announcement and Q∈[-8, 4] denotes a quarter relative to t.

The dependent variable SNIS is the scaled net insider selling activities. We measure SNIS

based on the number of shares traded. SNIS is the number of shares sold by insiders minus the

number of shares bought by insiders scaled by the sum of total shares bought and sold by

insiders for a specific quarter Q, similar to John and Lang (1991) and Beneish (1999). It is

computed as (subscripts i and t omitted)

∑∑

∑∑

==

==

+

−= B

bbQ

S

ssQ

B

bbQ

S

ssQ

Q

BOUGHTSOLD

BOUGHTSOLDSNIS

1,

1,

1,

1,

##

##, (2)

where # SOLDQ,s is the number of shares sold by insiders in a sale transaction indexed by s∈[1,

S] and # BOUGHTQ,b is the number of shares bought by insiders in a buy transaction indexed by

b∈[1, B].

The above measure of net insider selling captures the directional intensity of insider trading

activities for a specific quarter relative to the restatement announcement. It is likely superior to

measures using unscaled net shares sold/bought or dollar value of shares sold/bought (Agrawal

and Cooper, 2006), since scaling captures the intensity of net insider selling (John and Lang,

1991; Beneish, 1999). Also note that we do not define a control period for measuring normal net

insider selling. Based on the literature, information-motivated insider trading activities are often

spread out over a long period of time and are absent immediately prior to the public disclosure of

material information (Seyhun and Bradley, 1997; Ke, Huddart and Petroni, 2003). Thus, the

control period and event period are often difficult to identify. The difference-in-difference

approach used in Agrawal and Cooper (2006) may not adequately capture abnormal insider

trading activities. We endeavor to detect information-motivated insider trading activities by

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linking net insider selling around the restatement announcements to abnormal announcement

period returns. If net insider selling before restatement announcements is related to the

restatement announcement abnormal returns in a pattern that reduces the negative wealth impact

of restatements on insiders’ investments in the restating firms, we provide evidence of insiders

trading on privileged information.

The independent variables that we use to detect informed insider trading activities include the

abnormal returns around the financial restatement announcements and certain characteristics of

the restatements. Since the nature and characteristics of the restatements are only made public at

the time of the announcements, any statistical link between net insider selling before the

financial restatement announcements and abnormal announcement returns as well as these

restatement characteristics is an indication of informed insider trading around the announcements

of financial restatements. This statistical link, if exists, suggests that insiders have private

information on the timing, probability, and severity of financial restatements and trade upon it.

As discussed above, the restatement announcement abnormal return RACAR is defined as

restating firm’s return from calendar Day -7 to Day 7 relative to the restatement announcement

minus the equal-weighted market return during the same period. Based on our argument earlier,

if insiders trade in a pattern to avoid the negative valuation impact of the financial restatements,

we expect net insider selling to be negatively associated with restatement announcement

abnormal return RACAR several quarters before the restatement announcements. In the quarter

immediately before the restatement announcement, we expect a reduced level of or no

association between net insider selling and restatement announcement abnormal return, if

insiders refrain from trading too close to the restatement announcements to avoid insider trading

allegations or violating corporate insider trading policies (Huddart, Ke and Shi, 2006; Bettis,

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Coles and Lemmon, 2000). In quarters after the restatements, we may see a positive association

between net insider selling and restatement announcement abnormal returns, if insiders rebalance

their portfolios after net selling of shares in the restating firms, detect possible market

overreactions to the restatements, or engage in passive insider trading.

We include three variables for the characteristics of financial restatements that are expected

to affect how insiders trade around the restatement announcements. RM equals one if the

restatement involves revenue manipulation and zero otherwise; SEC equals one if the restatement

is initiated by the SEC and zero otherwise; and COM equals one if the restatement is initiated by

the company itself and zero otherwise. Since revenue related restatements and SEC initiated

restatements are potentially more severe financial restatements (Anderson and Yohn, 2002;

Palmrose, Richardson and Scholz, 2004), we expect them to be positively related to net insider

selling before the restatement announcements. We include an indicator variable COM for

company initiated restatements to test whether such restatements are more likely to trigger

insider selling, especially in earlier periods, as insiders are more likely to possess information

about the company’s own investigation.

Seyhun (1986) shows that insider selling is positively associated with past returns and

negatively associated with future returns (also Rozeff and Zaman, 1998; Lakonishok and Lee,

2001; and Piotroski and Roulstone, 2005). We define past return for Quarter Q’s insider trading

activities as the cumulative return from the start of Quarter Q to the last insider trade in the

quarter minus the equal-weighted market return for the same period. It is denoted as PRERET.13

We define future return for Quarter Q’s insider trading activities as the cumulative return for a

91-calendar day period beginning on the last insider trade in Quarter Q minus the equal-weighted

13 We also measure PRERET over a 91-calendar day period that ends on the last insider trading day during a specific quarter. The results based on this measure are qualitatively similar.

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market return for the same period.14 It is denoted as POSTRET. See Figure 1 for a better

understanding of the definitions for PRERET and POSTRET. These two variables control for the

magnitude of a normal level of insider trading that is not necessarily related to any particular

event.

Rozeff and Zaman (1988) and Ke, Huddart and Petroni (2003) show that insider selling is

positively related to firm size. We thus include the logarithm transformation of market

capitalization LCAP at the end of the year during which the restatement announcement is made

to control for the size effect. We expect size LCAP to have a positive effect on net insider selling.

Following Rozeff and Zaman (1998) and Ke, Huddart and Petroni (2003), we also include book-

to-market ratio BM measured at the same time as LCAP and expect it to have a negative effect on

net insider selling.

4. Empirical Results

4.1 DESCRIPTIVE STATISTICS

Table 2 presents descriptive statistics of net insider selling for the thirteen quarters around

restatement announcements. In Panel A, we report means and medians of the two measures of

net insider selling: unscaled and scaled measures based on shares traded, for the full sample. In

general, all means and medians indicate net insider selling as opposed to net insider buying (i.e.,

NIS > and SNIS > 0) for all quarters. More restating firms have non-zero net trading in quarters

prior to the announcements than quarters after. From Quarter -8 to Quarter -2, the number of

firms with non-zero net trading ranges from 630 to 666 and from 53% to 57% as a percentage of

14 Seyhun (1986) shows that most of the abnormal returns related to insider trading occur within 100 days after the trading.

19

all restating firms included in the Thomson Financial database for a particular quarter. In contrast,

starting from Quarter -1, insider trading activities slow down, with the number of firms with non-

zero net trading ranging from 514 to 553 and from 46% to 48% as a percentage of all restating

firms included in the Thomson Financial database.15 These numbers indicate that trading is

heavier before than after the restatement announcements, consistent with the notion that trading

on private information is possibly lucrative before the information is released to the public.

While the frequency of insider trading appears to be higher before the restatement

announcements than after the announcements, it is not obvious whether net selling is necessarily

higher before the announcements than after the announcements. In fact, Quarters 2, 3 and 4 have

the highest level of scaled net insider selling activities.

Panels B and C of Table 2 report net insider selling before and after the passage of the

Sarbanes-Oxley Act, respectively. We use the end of June 2002 as the cutoff for classifying pre-

Sarbanes-Oxley and post-Sarbanes-Oxley insider trading quarters.16 Specifically, if an insider

trading quarter as defined ends before the end of June 2002, we include it in the pre-Sarbanes-

Oxley subsample and if an insider trading quarter starts after the end of June 2002, we include it

in the post-Sarbanes-Oxley subsample. In Panel B for the pre-Sarbanes-Oxley subsample,

unscaled net insider selling is generally higher in quarters prior to the announcements than that in

quarters after the announcements. As for scaled net insider selling, it is relatively high during

Quarters -8 to -4 (mean ranging from 0.153 to 0.220). It slows down in Quarters -3 to -1 (mean

ranging from 0.128 to 0.162) and drops further in Quarters 0 to 4 (mean ranging from -0.021 to 15 Note that the number of firms with non-missing RACAR included in the insider trading database varies across different quarters. 16 The Sarbanes-Oxley Act of 2002 was signed into law by President George W. Bush on July 30, 2002 and became effective on August 29. We use the end of June 2002 as the cutoff for classifying pre- and post-Sarbanes Oxley insider trading quarters because by the end of June, the passage of the Act became relatively certain and insiders may have started altering their trading behavior accordingly. For sensitivity analysis, we also use the end of July and the end of August 2002 respectively as the cutoff for classifying pre- and post-Sarbanes-Oxley insider trading quarters and obtain qualitatively similar descriptive and regression results.

20

0.099). In Panel C for the post-Sarbanes-Oxley subsample, the scaled net insider selling is

relatively low in Quarters -8 through -6 (mean ranging from 0.089 to 0.106). While net insider

selling is high in Quarters -5 to -1 before the announcements (mean ranging from 0.270 to 0.447),

it is similarly high in Quarters 1 to 4 after the announcements (mean ranging from 0.313 to

0.467).

In a comparison of insider trading activities between the two subsamples, we find that in

general, a smaller percentage of restating firms engage in insider trading post-Sarbanes-Oxley

than pre-Sarbanes-Oxley, especially in quarters prior to the announcements. In terms of the

scaled and unscaled net insider selling, both are lower in Quarters -8 through -6 post-Sarbanes-

Oxley than pre-Sarbanes-Oxley. However, starting from Quarter -5, net insider selling is

generally higher post-Sarbanes-Oxley than pre-Sarbanes-Oxley, with both the economic and

statistical differences largest for Quarters 1 through 4. Overall, it appears that insider trading

activities pre-Sarbanes-Oxley and post-Sarbanes-Oxley are noticeably different. While there is a

marked decline in net insider selling activities after the restatement announcements from before

the restatement announcements pre-Sarbanes-Oxley, this decline is not obvious post-Sarbanes-

Oxley.

In Table 3, we provide univariate tests of whether net insider selling is associated with

market reactions to the restatement announcements. Specifically, for each quarter, we classify all

firms with non-missing RACAR that are included in the Thomason Financial database into three

equal-sized portfolios based on the value of RACAR. We then report the number of firms with

non-zero net insider selling, and the mean and median of SNIS of these firms for each quarter and

each portfolio. The Low portfolio includes firms with the most negative market reactions to the

restatement announcements and the High portfolio includes firms with the highest market

21

reaction. We also report t-test (Wilcoxon test) for means (medians) for the difference in net

insider selling between the High and Low portfolios.

In general, there is some evidence that insiders’ net selling activities prior to the restatement

announcements (Quarters -8 to -2) are negatively correlated with abnormal returns around the

announcements. In Panel A based on the full sample, net insider selling for the Low RACAR

portfolio is higher than that for the High RACAR portfolio. However, it is only significant in

Quarter -3. There is no difference in net insider selling between Low RACAR and High RACAR

portfolios in Quarter -1 right before the announcements. After the restatement announcements,

net insider selling for the Low RACAR portfolio is significantly lower than that for the High

RACAR portfolio in Quarters 0, 1, 2 and 4.

In Panel B based on the pre-Sarbanes-Oxley subsample, net insider selling for the Low

RACAR portfolio is significantly higher than that for the High RACAR portfolio in Quarters -5

and -3 based on the t-test (in Quarters -7, -5 and -3 based on the Wilcoxon test) prior to the

restatement announcements. There is no difference in net insider selling between Low RACAR

and High RACAR portfolios in Quarter -1 right before the announcements. After the

announcements, net insider selling for the Low RACAR portfolio is significantly lower than that

for the High RACAR portfolio in Quarters 0, 1, 2 and 4 based on the t-test (in Quarters 0, 1 and 4

based on the Wilcoxon test). In Panel C based on the post-Sarbanes-Oxley subsample, net insider

selling for the Low RACAR portfolio is significantly higher than that for the High RACAR

portfolio in Quarter -8 prior to the restatement announcements. There is no difference in net

insider selling between Low RACAR and High RACAR portfolios in Quarter -1 right before the

announcements. After the announcements, net insider selling for the Low RACAR portfolio is

significantly lower than that for the High RACAR portfolio in Quarters 0 and 1.

22

To summarize, results in Table 3 suggest some evidence of net insider selling based on

restatement announcement abnormal returns prior to the announcements (supporting Hypothesis

1); no association between net insider selling and restatement announcement abnormal returns

immediately before the announcements (supporting Hypothesis 2); and net insider buying based

on restatement announcement abnormal returns after the announcements. There is limited

difference qualitatively between the pre-Sarbanes-Oxley subsample and the post-Sarbanes-Oxley

subsample.

4.2 MAIN REGRESSION ANALYSIS

We focus on the relation between scaled net insider selling SNIS and restatement

announcement abnormal return RACAR in the regression analysis. All regression t-statistics are

based on White’s (1980) heteroskedasticity consistent variance-covariance matrix. Panel A,

Table 4 presents results of regression analysis of Equation (1) based on the full sample. The

coefficients on RACAR from Quarters -8 to 4 are also depicted in Figure 2. From Quarter -8 to

Quarter -2 before the restatement announcement, the coefficient on RACAR is always

significantly negative, ranging from -0.673 (t = -3.69) in Quarter -3 to -0.354 (t = -2.21) in

Quarters -2. This suggests that for these seven quarters before the restatement announcements,

insiders sell shares when they expect that the restatement announcement will trigger a drop in

firm value. This result supports Hypothesis 1 that net insider selling is negatively related to

restatement announcement abnormal returns.

During Quarters -1 and 0, the coefficients on RACAR are insignificant, suggesting that

insiders cease trading activities that are related to restatement announcement abnormal returns.

This result is consistent with Ke, Huddart and Petroni (2003), who find little evidence of a higher

23

frequency of insider sales in the two quarters immediately preceding the announcement of a

break in an earnings increase string. It is also consistent with Noe (1999) and Huddart, Ke and

Shi (2006). Noe (1999) shows that insiders are careful not to make insider transactions

immediately before management earnings forecasts to avoid being seen as profiting from a piece

of news before it is made public. Huddart, Ke and Shi (2006) find scanty evidence of an

association between insider trades and announcement returns in a short window before the

earnings announcements.

The above timing pattern of insider trading supports Hypothesis 2 that insiders trade well in

advance of restatement announcements and that they avoid trading very close to the

announcements. This trading pattern potentially minimizes the risk of insider trading allegations

and/or violating corporate insider trading policies. In summary, the above directional magnitude

and timing pattern of insider trading activities provide strong evidence of insiders trading on

privileged knowledge of firm-specific events, such as financial restatements.

The coefficients on RACAR are positive for Quarters 1 to 4 relative to the restatement

announcement and are significant for Quarters 1, 2 and 4. This result suggests that insiders

reverse the direction of their trades after the restatement announcements. As discussed earlier,

there are three possible explanations for this result. First, if the market over-reacts to the

restatement announcements, insiders may reap further gains by exploiting this over-reaction.

This conjecture is consistent with Seyhun (1990), who shows increases in insider purchases after

the stock market crash of 1987 as evidence of overreaction to the crash. It should be noted that

securities laws prohibit round trip insider trading within a six-month period (Section 16b of the

Securities Exchange Act of 1934). However, insiders can, for example in Quarter 1, reverse

trades made in Quarter -2 and earlier, which is consistent with our evidence that insiders’

24

informed selling occurs in Quarter -2 and prior relative to the announcements while their buying

starts from Quarter 1. Second, insiders sell restating firms’ shares just temporarily to avoid

possible losses due to the restatement announcements and then they rebalance their portfolios by

buying back restating firms’ shares after the restatement announcements. Third, the reversal may

be a manifestation of passive insider trading, i.e., the delaying of purchases until after the

negative news is released to the public (Huddart, Ke and Shi, 2006).

As for the three major characteristics of restatements, RM is positively associated with net

insider selling in Quarter -8. SEC is negatively associated with net insider trading in Quarters -1,

0 and 4. The coefficients on COM are never significant.

Following Seyhun (1986), we use PRERET and POSTRET to control for the portion of

normal insider trading that is not necessarily due to any particular event. Consistent with Seyhun

(1986), the coefficient on PRERET is always positive and significant and the coefficient on

POSTRET is always negative and significant. These results suggest that insiders tend to sell

shares when the stock is doing well in the past and their selling predicts a drop in stock value in

the future (Piotroski and Roulstone, 2005).

The coefficient on LCAP is positive and significant in all quarters, suggesting that insider

selling tends to occur in large firms, consistent with Ke, Huddart and Petroni (2003). The

coefficient on BM is negative and significant in Quarters -5, -3 and 3, consistent with Ke,

Huddart and Petroni (2003). It is insignificant in all other quarters.

4.3 EFFECT OF THE SARBANES-OXLEY ACT OF 2002

To determine whether the Sarbanes-Oxley Act of 2002 affects insider trading patterns around

the financial restatement announcements, we run regression Equation (1) for the pre-Sarbanes-

25

Oxley and post-Sarbanes-Oxley subsamples separately. The results are presented in Panels B and

C of Table 4 and the coefficients on RACAR pre- and post-Sarbanes-Oxley are depicted in Figure

3. For the pre-Sarbanes-Oxley subsample (Panel B), the coefficients on RACAR are negative and

significant from Quarters -8 to -2 before the restatement announcements, insignificant in

Quarters -1 and 0 immediately around the announcements, and positive and significant in

Quarters 1 and 4 after the announcements. This pattern is very similar to results based on the full

sample and in particular, provides strong evidence of information-motivated insider trading prior

to the restatement announcements. For the post-Sarbanes-Oxley subsample (Panel C), the

coefficients on RACAR are all insignificant from Quarters -8 to -1 before the restatement

announcements. They are positive and significant in Quarters 0 and 4 after the announcements.

Results in Panel C suggest that net insider selling before restatement announcements is not

related to announcement abnormal returns after the passage of the Sarbanes-Oxley Act.

Apart from RACAR, all other control variables become less significant in explaining net

insider selling activities post-Sarbanes-Oxley than pre-Sarbanes-Oxley and the adjusted R2’s also

decline from the pre-Sarbanes-Oxley subsample to the post-Sarbanes-Oxley subsample. In

summary, our results suggest very different degree of information-motivated insider trading

activities between pre-Sarbanes-Oxley and post-Sarbanes-Oxley subsamples. It appears that the

Sarbanes-Oxley Act of 2002 has served to constrain information-motivated insider trading before

financial restatement announcements.

4.4 GAUGING THE PROFITABILITY OF INSIDER TRADING

So far, we have demonstrated evidence of informed insider trading activities around the

announcements of financial restatements. In this section we gauge the profitability of insider

26

trading prior to financial restatements. We construct profitability measures of insider trading for

both a long window and a short event window for all insiders. For the long window, insider

trading profit for Firm i (subscript omitted) during Quarter Q relative to the announcement,

LPROFITQ, is calculated as

sQsQ

S

ssQbQbQ

B

bbQQ ARETPRCSOLDARETPRCBOUGHTLPROFIT ,,

1,,,

1, ## ⋅⋅⋅⋅= ∑∑

=

−

=

, (3)

where # BOUGHTQ,b is the number of shares bought in a buy transaction b ∈ [1, B] in Quarter Q,

PRCQ,b is the price for transaction b, ARETQ,b is the market adjusted return covering the period

from the day of transaction b to the seventh calendar day after the financial restatement

announcement; # SOLDQ,s is the number of shares sold in a sell transaction s ∈ [1, S] in Quarter

Q, PRCQ,s is the price for transaction s, ARETQ,s is market adjusted return covering the period

from the day of transaction s to the seventh calendar day after the financial restatement

announcement. The above measure of insider trading profit aggregates all profits from individual

trades from the day of the trade to the seventh day after the restatement announcements. We also

measure the average profit of each trade in Quarter Q for the long window as

QQ

QQ SB

LPROFITALPROFIT

+= , (4)

where BQ and SQ are the numbers of buy and sell trades in Quarter Q, respectively.

We measure short window insider trading profit for Quarter Q relative to the restatement

announcement, EPROFITQ, as

RACARPRCSOLDRACARPRCBOUGHTEPROFIT PRES

sPREPRE

B

bbQQ ⋅⋅⋅⋅= ∑∑

=

−

= 11, ## , (5)

where # BOUGHTQ,b is the number of shares bought in a buy transaction b ∈ [1, B] in Quarter

Q and # SOLDQ,s is the number of shares sold in a sell transaction s ∈ [1, S] in Quarter Q.

27

PRCPRE is the closing price on the eighth calendar day before the restatement announcements and

RACAR is the announcement period abnormal return defined earlier. Note that EPROFITQ is

different from LPROFITQ in that PRCPRE and RACAR are common to all buy and sell trades for

Firm i. We devise EPROFITQ in order to measure insider trading profit that is purely due to the

avoidance of the negative wealth impact of restatements during the announcement period. We

also compute the average profit of each trade related to the event window in Quarter Q as

QQ

QQ SB

EPROFITAEPROFIT

+= . (6)

The results are reported in Table 5. Panel A is based on the full sample. The average

quarterly insider trading profit ranges from $100,068 in Quarter -4 to $713,871 in Quarter -6 for

the long window. It ranges from $71,157 in Quarter -6 to $221,854 in Quarter -5 for the event

window. The sum of the average total insider trading profit across the eight-quarter period from

Quarter -8 to Quarter -1 is $3,382,630 for the long window and is $981,852 for the event window.

Panel B is based on the pre-Sarbanes-Oxley subsample. The average quarterly insider trading

profit ranges from $103,526 in Quarter -4 to $844,311 in Quarter -6 for the long window. It

ranges from $79,634 in Quarter -6 to $322,405 in Quarter -2 for the event window. The sum of

the average total insider trading profit across the eight-quarter period from Quarter -8 to Quarter

-1 is $4,095,153 for the long window and is $1,288,706 for the event window. These numbers

are economically significant and suggest that insiders make a considerable amount of profit by

engaging in informed trading before the announcements of financial restatements.

Panel C is based on the post-Sarbanes-Oxley subsample. The average quarterly insider

trading profit ranges from -$11,523 in Quarter -5 to $330,923 in Quarter -7 for the long window.

It ranges from $31,971 in Quarter -3 to $84,702 in Quarter -5 for the event window. The sum of

the average total insider trading profit across the eight-quarter period from Quarter -8 to Quarter

28

-1 is $1,221,807 for the long window and is $459,499 for the event window. These figures are

considerably lower than those pre-Sarbanes-Oxley, suggesting that insiders make a significantly

lower level of trading profit after the passage of the Sarbanes-Oxley Act.

4.5 ADDITIONAL ANALYSIS

4.5.1. Dollar-Based Net Insider Trading. We define an alternative measure of net insider

selling activities that uses the dollar value of shares sold and bought by insiders during a specific

Quarter Q, computed as

∑∑

∑∑

==

==

+

−= B

bbQ

S

ssQ

B

bbQ

S

ssQ

Q

BOUGHT$SOLD$

BOUGHT$SOLD$$SNIS

1,

1,

1,

1,

_ , (7)

where $ SOLDQ,s is the dollar value of shares sold by insiders in a sale transaction indexed by

s∈[1, S] and $ BOUGHTQ,b is the dollar value of shares bought by insiders in a buy transaction

indexed by b∈[1, B]. When we use this dollar-based scaled net insider selling SNIS_$, we obtain

qualitatively similar results.

4.5.2. Including Firm-Quarter Observations Without Insider Trades. Our primary results are

based on firm-quarter observations with non-zero net insider trades.17 If during a specific quarter,

there is no insider trading activity, we cannot compute the scaled net insider selling metric. To

also consider these observations, we set their SNIS to zero (Huddart, Ke and Shi, 2006) and

include them in the main regression model. Since these observations have no trading dates which

are necessary for calculating PRERET and POSTRET, we exclude these two variables in the

regression. We obtain qualitatively similar results. 17 Very few firm-quarters excluded in our primary analysis have insider trading activities that net to zero.

29

4.5.3. Trades Made by Top Executives. We also conduct tests based on trading activities of

top executives (including CEO, CFO, Chairman, and President) only. We do not have a

prediction whether top executives are more likely to engage in informed trading than other

insiders because, while top executives are expected to have better access to private information,

their trading activities are also subject to tighter scrutiny by investors, analysts and regulators,

and hence have higher risks of insider trading allegations. Using top executives only, we obtain

qualitatively similar, though slightly weaker, results.

5. Summary and Conclusion

Do insiders trade around financial restatement announcements to their advantage? Our paper

provides an affirmative answer to this question. We examine insider trading activities around the

announcements of financial restatements. Financial restatements have been shown to negatively

impact equity value. Thus, insiders have incentives to sell shares of restating firms in advance of

the announcements to reduce potential losses in their investment.

We provide evidence that for the seven quarters starting Quarter -8 before the restatement

announcements, net insider selling is negatively related to restatement announcement abnormal

returns. That is, net insider selling is related to the severity of the restatements as reflected in the

announcement abnormal returns. During the quarters immediately before and immediately after

the restatement announcements, net insider selling is not related to the restatement

announcement abnormal returns. This is evidence that insiders trade in a pattern to minimize the

risk of insider trading allegations and the risk of violating corporate policies restricting insider

30

trading. After the restatement announcements, insiders reverse the direction of their trades. That

is, net insider selling is positively associated with restatement announcement abnormal returns.

Further, we provide evidence that the passage of the Sarbanes-Oxley Act of 2002 constrains

information-motivated insider trading activities before the restatement announcements. Finally,

we show that insiders make a considerable amount of profit by engaging in informed trading

before the announcements of financial restatements, especially prior to the passage of the

Sarbanes-Oxley Act. Overall, our results provide strong evidence of insiders trading on

privileged information to their advantage.

31

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34

FIG. 1. – Time line of events.

Event Day QTR =-8 QTR=-2 QTR=-1 QTR=0 QTR=4

QTR=q

Day L: last insider trading in QTR q

PRERET POSTRET 91st calendar day since Day L

RACAR

35

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4

Quarter

Coe

ffic

ient

on

RA

CA

R

FIG. 2. – Net insider selling and restatement announcement abnormal returns. This figure presents the coefficients on RACAR in Model (1) based on the full sample for the thirteen quarters around restatement announcements as reported in Panel A of Table 4.

36

-1.00-0.80-0.60-0.40-0.200.000.200.400.600.801.001.20

-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4

Quarter

Coe

ffic

ient

on

RA

CA

R

Pre-Sarbanes-Oxley Post-Sarbanes-Oxley

FIG. 3. – Net insider selling and restatement announcement abnormal returns. This figure presents the coefficients on RACAR in Model (1) for the thirteen quarters around restatement announcements pre-Sarbanes-Oxley and post-Sarbanes-Oxley respectively as reported in Panels B and C of Table 4.

37

TABLE 1 Description of Restatement Announcements

The descriptive statistics are based on all restating firms that are on the Thomson Financial Insider Trading database with non-missing RACAR. RACAR is calculated as the sum of daily return minus equal-weighted market return over calendar days [-7, 7] around the restatement announcement date. Initiators and reasons of restatements are obtained from the GAO (2003) and GAO (2006) database. The percentages do not add to 100% because certain cases have multiple initiators or reasons. In Panel C, only major reasons are listed.

Panel A: Abnormal Returns around Restatement Announcements (RACAR)

N Mean Median Std. Dev. 1st Quartile 3rd

Quartile 1,274 (All) -0.073 -0.038 0.211 -0.145 0.032

659 (Pre-SOX) -0.103 -0.055 0.247 -0.18 0.029

615 (Post-SOX) -0.040 -0.027 0.156 -0.105 0.036

Panel B: Initiators of Restatements All Pre-SOX Post-SOX

Auditor 163 (13%)

53 (8%)

110 (18%)

Company 666 (52%)

274 (42%)

392 (64%)

SEC 136 (11%)

93 (14%)

43 (7%)

Other 21 (2%)

11 (2%)

10 (2%)

Unidentified 370 (29%)

239 (36%)

131 (21%)

Panel C: Reasons of Restatements All Pre-SOX Post-SOX

Revenue Recognition 459 (36%)

280 (42%)

179 (29%)

Cost or Expense 359 (28%)

133 (20%)

226 (37%)

Restructuring 205 (16%)

92 (14%)

113 (18%)

M&A 78 (6%)

46 (7%)

32 (5%)

In-Process R&D 30 (2%)

30 (5%)

0 (0%)

Securities Related 137 (11%)

39 (6%)

98 (16%)

38

TABLE 2 Descriptive Statistics of Net Insider Selling

All insiders are all officer and directors. NIS is net insider selling based on number of shares traded. SNIS is NIS scaled by the sum of total buys and total sells. Asterisks in Panel B indicates the significance levels for the difference between pre-Sarbanes Oxley (reported in Panel B) and post-Sarbanes-Oxley (reported in Panel C) for each quarter. *, **, and *** indicate significance at 0.10, 0.05 and 0.01 levels respectively (2-sided). For percentages, it is based on χ2 test; for means, it is based on t-test; and for medians, it is based on Wilcoxon test.

Panel A: All Observations

Quarter N NIS SNIS Mean Median Mean Median

-8 639 (55%) 53607 5000 0.191 0.964 -7 658 (57%) 65582 5000 0.191 0.956 -6 664 (56%) 57066 4500 0.143 0.953 -5 630 (53%) 62172 5000 0.190 0.966 -4 666 (56%) 61979 8072 0.252 0.995 -3 657 (55%) 77957 7438 0.205 0.980 -2 641 (54%) 47956 5754 0.192 0.963 -1 553 (46%) 55041 7423 0.276 1.000 0 553 (47%) 59018 4000 0.123 0.847 1 531 (46%) 61953 4400 0.197 0.997 2 553 (48%) 64823 9000 0.277 1.000 3 520 (47%) 59229 7500 0.267 1.000 4 514 (47%) 59383 8827 0.299 1.000

Panel B: Pre-Sarbanes-Oxley Quarter N NIS SNIS

Mean Median Mean Median -8 543 (56%)*** 58534** 6400 0.220 0.968 -7 530 (58%)*** 75201*** 5284** 0.218 0.962 -6 523 (59%)* 60299 5000 0.153 0.944 -5 471 (55%)* 66046 4000 0.162** 0.948** -4 468 (58%) 56870 7000** 0.215* 0.972*** -3 409 (56%)* 73996 4585** 0.128*** 0.830*** -2 381 (56%) 42806 4000* 0.162 0.908* -1 292 (48%) 56693 4999** 0.153*** 0.927*** 0 277 (49%) 53033 2075 0.076 0.700 1 251 (50%)*** 41563*** 2000*** 0.099*** 0.818*** 2 229 (50%) 61165 1400*** 0.083*** 0.650*** 3 180 (47%) 63943 140*** 0.008*** 0.137*** 4 162 (46%) 40901** 281*** -0.021*** 0.049***

Panel C: Post-Sarbanes-Oxley

Quarter N NIS SNIS Mean Median Mean Median

-8 68 (52%) 31547 685 0.094 0.984 -7 86 (46%) 26838 1625 0.089 0.702 -6 123 (48%) 43773 1854 0.106 0.979 -5 142 (49%) 49282 10288 0.326 1.000 -4 173 (52%) 77241 14200 0.376 1.000 -3 205 (52%) 87797 14959 0.339 1.000 -2 238 (51%) 59710 8501 0.270 1.000 -1 225 (44%) 58260 10500 0.447 1.000 0 263 (45%) 62494 6000 0.177 0.933 1 257 (42%) 85009 10363 0.313 1.000 2 304 (46%) 68887 13672 0.395 1.000 3 315 (46%) 57198 11170 0.408 1.000 4 332 (46%) 69191 14731 0.467 1.000

39

TABLE 3 Net Insider Selling Conditional on Abnormal Return around Restatement Announcements

For each quarter, we classify all firms with non-missing RACAR that are on the Thomson Financial Insider Trading database into three (low, medium, and high) portfolios based on RACAR. We report the mean and median scaled net insider selling based on number of shares traded for each portfolio-quarter. We also report the t-test for means and Wilcoxon test for medians for the differences in net insider selling between high and low portfolios. *, **, and *** indicate significance at 0.10, 0.05 and 0.01 levels respectively (2-sided).

Panel A: All Observations

Quarter N Mean t-test Median Wilcoxon test

Low Medium High Low Medium High Low Mediu High

-8 209 206 226 0.221 0.207 0.148 0.82 0.973 0.976 0.941 0.75

-7 229 205 226 0.259 0.171 0.138 1.38 0.988 0.951 0.852 1.51

-6 210 240 216 0.140 0.186 0.098 0.45 0.936 0.977 0.825 0.51

-5 223 206 202 0.244 0.188 0.130 1.25 0.992 0.966 0.891 1.31

-4 227 213 229 0.305 0.227 0.219 1.00 1.000 0.992 0.978 1.05

-3 214 221 224 0.260 0.274 0.082 1.97** 0.981 0.999 0.656 1.64*

-2 225 217 201 0.172 0.238 0.162 0.11 0.956 0.980 0.913 0.26

-1 174 191 191 0.207 0.393 0.216 -0.10 0.985 1.000 0.999 0.36

0 157 200 201 -0.191 0.319 0.169 -3.59*** -1.000 1.000 0.959 -3.62***

1 141 187 204 -0.093 0.343 0.261 -3.41*** -0.857 1.000 1.000 -3.49***

2 156 189 209 0.103 0.360 0.332 -2.34** 0.873 1.000 1.000 -1.90**

3 152 197 172 0.170 0.348 0.259 -0.85 0.938 1.000 1.000 -0.80

4 144 186 186 0.069 0.439 0.333 -2.54** 0.701 1.000 1.000 -2.81***

40

TABLE 3 (continued) Net Insider Selling Conditional on Abnormal Return around Restatement Announcements

Panel B: Pre-Sarbanes-Oxley

Quarter N Mean t-test Median Wilcoxon test

Low Medium High Low Medium High Low Mediu High

-8 175 177 193 0.230 0.193 0.234 -0.04 0.973 0.951 0.968 -0.02

-7 182 166 183 0.300 0.180 0.170 1.34 1.000 0.898 0.882 1.77*

-6 164 190 171 0.201 0.145 0.115 0.83 0.978 0.922 0.832 0.95

-5 166 151 155 0.288 0.079 0.107 1.74* 0.999 0.663 0.818 1.75*

-4 161 147 161 0.271 0.182 0.190 0.78 0.991 0.981 0.928 0.97

-3 139 139 133 0.314 0.124 -0.063 3.33*** 1.000 0.845 -0.162 3.18***

-2 131 128 123 0.206 0.191 0.082 1.06 0.968 0.952 0.535 1.46

-1 104 87 103 0.181 0.103 0.164 0.13 0.906 0.830 0.984 0.05

0 81 98 102 -0.114 0.173 0.131 -1.74* -0.699 0.982 0.894 -1.66*

1 63 91 98 -0.080 0.125 0.188 -1.73* -0.663 0.890 0.975 -1.89*

2 65 70 94 -0.090 0.104 0.186 -1.81* -0.274 0.821 0.993 -1.64

3 55 62 64 -0.102 -0.043 0.151 -1.42 -0.852 -0.176 1.000 -1.51

4 43 61 60 -0.331 0.166 0.011 -1.80* -1.000 0.809 0.145 -2.01**

41

TABLE 3 (continued) Net Insider Selling Conditional on Abnormal Return around Restatement Announcements

Panel C: Post-Sarbanes-Oxley

Quarter N Mean t-test Median Wilcoxon test

Low Medium High Low Medium High Low Mediu High

-8 23 22 23 0.334 0.203 -0.250 2.08** 1.000 0.997 -1.000 1.94**

-7 27 32 28 0.180 0.050 0.042 0.53 0.958 0.476 0.617 0.44

-6 40 46 37 -0.072 0.356 -0.012 -0.27 -0.476 1.000 -0.306 -0.03

-5 49 52 41 0.317 0.441 0.189 0.67 1.000 1.000 0.941 1.00

-4 59 59 57 0.358 0.406 0.351 0.04 1.000 1.000 1.000 0.03

-3 58 73 74 0.294 0.488 0.226 0.41 1.000 1.000 0.996 0.64

-2 82 86 71 0.225 0.277 0.309 -0.55 1.000 1.000 1.000 -0.69

-1 62 92 72 0.411 0.589 0.291 0.76 1.000 1.000 1.000 0.57

0 74 100 89 -0.195 0.497 0.128 -2.15** -1.000 1.000 0.913 -2.15**

1 66 95 96 0.014 0.506 0.327 -2.08** 0.341 1.000 1.000 -2.08**

2 84 113 108 0.319 0.400 0.445 -0.98 1.000 1.000 1.000 -0.55

3 89 128 98 0.449 0.417 0.360 0.69 1.000 1.000 1.000 0.87

4 94 119 119 0.419 0.515 0.457 -0.31 1.000 1.000 1.000 -0.52

42

TABLE 4 Regression Analysis of Insider Trading around Financial Restatement Announcements

Dependent variable is scaled net insider selling based on number of shares traded. RACAR is calculated as the sum of daily return minus equal-weighted market return over calendar days [-7, 7] around restatement announcement date. RM is an indicator variable for revenue recognition related restatements. SEC is an indicator variable for SEC-initiated restatements. COM is an indicator variable for company-initiated restatements. PRERET is abnormal return from the start of the quarter to the last insider trading date during that quarter. POSTRET is abnormal return over 91 calendar days from the last insider trading date during that quarter. LCAP is the log of market capital and BM is book-to-market value, both measured at the end of the fiscal year when the restatement announcement is made. An insider trading quarter is classified as pre-Sarbanes-Oxley if it ends before the end of June 2002 and is classified as post-Sarbanes-Oxley if it starts after the end of June 2002. All t-statistics are based on White’s (1980) heteroskedasticity consistent variance-covariance matrix. *, **, and *** indicate significance at 0.10, 0.05 and 0.01 levels respectively (2-sided).

Panel A: All Observations

Quarter -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4

Intercept -0.530 -0.516 -0.419 -0.620 -0.486 -0.400 -0.477 -0.432 -0.472 -0.482 -0.429 -0.351 -0.414 (-4.83)*** (-4.37)*** (-3.67)*** (-5.03)*** (-4.18)*** (-3.54)*** (-4.13)*** (-3.07)*** (-3.72)*** (-3.80)*** (-3.04)*** (-2.20)** (-2.74)***

RACAR -0.443 -0.449 -0.493 -0.618 -0.459 -0.673 -0.354 0.304 -0.029 0.735 0.486 0.186 0.743 (-2.34)** (-2.27)** (-2.35)** (-2.83)*** (-2.65)*** (-3.69)*** (-2.21)** (1.19) (-0.11) (3.12)*** (2.11)** (0.72) (2.91)*** RM 0.158 0.102 0.003 0.006 0.110 0.014 0.038 -0.091 -0.074 -0.035 0.011 -0.005 -0.068 (2.20)** (1.39) (0.03) (0.08) (1.54) (0.19) (0.52) (-1.09) (-0.90) (-0.43) (0.14) (-0.06) (-0.82) SEC -0.011 0.025 0.146 0.163 0.041 -0.154 -0.150 -0.362 -0.211 -0.167 -0.179 -0.119 -0.253 (-0.09) (0.20) (1.23) (1.44) (0.32) (-1.23) (-1.29) (-2.67)** (-1.65)* (-1.36) (-1.45) (-0.87) (-1.91)* COM -0.014 0.006 -0.071 0.099 0.119 0.020 -0.090 -0.002 -0.107 -0.024 0.033 0.076 -0.041 (-0.18) (0.08) (-0.91) (1.24) (1.60) (0.26) (-1.22) (-0.02) (-1.31) (-0.29) (0.41) (0.93) (-0.50) PRERET 0.977 0.729 0.634 0.535 0.546 0.743 0.708 0.568 0.562 0.684 0.460 0.759 0.724 (7.27)*** (5.06)*** (4.98)*** (4.84)*** (4.25)*** (6.44)*** (6.12)*** (3.97)*** (3.19)*** (4.31)*** (5.00)*** (4.72)*** (4.60)*** POSTRET -0.377 -0.420 -0.380 -0.536 -0.501 -0.348 -0.565 -0.627 -0.546 -0.323 -0.271 -0.264 -0.442 (-2.85)*** -(3.54)*** (-3.10)*** (-4.36)*** (-4.74)*** (-3.00)*** (-6.16)*** (-4.10)*** (-4.53)*** (-2.71)*** (-2.18)** (-1.89)* (-3.06)*** LCAP 0.111 0.113 0.095 0.119 0.106 0.099 0.118 0.123 0.120 0.122 0.128 0.111 0.133 (7.21)*** (7.18)*** (5.77)*** (7.08)*** (6.41)*** (6.34)*** (7.53)*** (6.15)*** (6.80)*** (6.75)*** (6.95)*** (5.49)*** (6.39)*** BM -0.013 -0.015 -0.016 -0.020 -0.016 -0.050 -0.004 -0.011 -0.013 0.001 -0.057 -0.116 -0.026 (-1.09) (-0.96) (-1.61) (-1.71)* (-1.37) (-3.15)*** (-0.35) (-0.78) (-0.99) (0.05) (-1.62) (-2.41)** (-0.91)

# Obs. 582 602 608 585 615 613 600 527 534 517 535 499 477 Adj. R2 14.96 14.24 9.59 12.60 12.36 12.51 17.05 10.31 13.12 12.93 13.66 12.68 15.55

43

TABLE 4 (continued) Regression Analysis of Insider Trading around Financial Restatement Announcements

Panel B: Pre-Sarbanes-Oxley

Quarter -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 Intercept -0.448 -0.463 -0.380 -0.712 -0.519 -0.424 -0.405 -0.698 -0.586 -0.692 -0.672 -1.066 -1.178

(-3.76)*** (-3.54)*** (-2.96)*** (-5.07)*** (-3.96)*** (-3.06)*** (-2.77)*** (-3.58)*** (-3.26)*** (-3.96)*** (-3.11)*** (-4.72)*** (-4.45)*** RACAR -0.374 -0.462 -0.588 -0.779 -0.566 -0.954 -0.515 0.037 -0.438 0.766 0.325 0.232 0.586 (-1.94)* (-2.21)** (-2.70)*** (-3.43)*** (-3.02)*** (-4.75)*** (-2.99)*** (0.12) (-1.53) (2.54)** (1.11) (0.74) (1.64)* RM 0.152 0.098 0.008 -0.019 0.146 -0.002 0.049 -0.092 0.002 0.012 0.142 0.185 0.222 (1.97)** (1.23) (0.09) (-0.23) (1.70)* (-0.02) (0.51) (-0.78) (0.02) (0.10) (1.17) (1.35) (1.51) SEC -0.031 -0.016 0.130 0.176 0.232 -0.105 -0.014 -0.265 -0.260 -0.061 0.032 0.043 -0.145 (-0.26) (-0.13) (1.00) (1.39) (1.72)* (-0.69) (-0.09) (-1.55) (-1.60)* (-0.40) (0.20) (0.24) (-0.74) COM -0.019 -0.009 -0.053 0.145 0.057 -0.053 -0.137 0.117 -0.130 -0.083 0.069 0.024 -0.062 (-0.23) (-0.10) (-0.60) (1.57) (0.64) (-0.56) (-1.41) (0.97) (-1.12) (-0.67) (0.53) (0.17) (-0.40) PRERET 1.020 0.764 0.720 0.469 0.524 0.869 0.713 0.448 0.657 0.870 0.498 0.442 0.652 (7.36)*** (4.59)*** (5.10)*** (3.63)*** (3.78)*** (6.75)*** (4.91)*** (2.19)** (3.06)*** (3.93)*** (4.23)*** (2.40)** (3.29)*** POSTRET -0.314 -0.391 -0.323 -0.487 -0.487 -0.372 -0.544 -0.472 -0.415 -0.310 -0.281 -0.180 -0.450 (-2.27)** (-3.07)*** (-2.37)** (-3.64)*** (-4.01)*** (-2.82)*** (-5.39)*** (-2.45)** (-2.34)** (-1.87)* (-1.99)** (-1.08) (-2.34)** LCAP 0.103 0.113 0.088 0.132 0.105 0.096 0.097 0.137 0.130 0.146 0.131 0.184 0.204 (6.23)*** (6.58)*** (4.77)*** (6.99)*** (5.50)*** (4.77)*** (4.83)*** (4.94)*** (5.48)*** (6.10)*** (4.80)*** (6.45)*** (5.99)*** BM -0.012 -0.034 -0.019 -0.043 -0.025 -0.093 -0.009 0.016 -0.021 -0.002 -0.093 -0.079 0.066 (-1.00) (-1.16) (-1.29) (-1.68)* (-2.64)*** (-3.84)*** (-0.85) (0.50) (-0.49) (-0.07) (-1.54) (-1.32) (0.77) # Obs. 492 484 478 435 429 374 349 271 264 242 219 170 152 Adj. R2 14.65 14.70 10.10 15.28 13.93 18.27 17.81 8.95 15.11 19.59 17.91 23.73 22.10

44

TABLE 4 (continued) Regression Analysis of Insider Trading around Financial Restatement Announcements

Panel C: Post-Sarbanes-Oxley

Quarter -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 Intercept -1.358 -0.550 -0.728 -0.050 -0.071 0.045 -0.351 0.125 -0.340 -0.174 -0.197 0.129 0.003

(-3.21)*** (-1.44) (-2.59)*** (-0.16) (-0.28) (0.21) (-1.70)* (0.57) (-1.73)* (-0.85) (-1.02) (0.60) (0.02) RACAR -0.893 0.130 0.357 0.402 0.336 0.037 0.438 0.571 1.097 0.677 0.621 0.223 0.590 (-1.03) (0.17) (0.53) (0.55) (0.66) (0.08) (0.87) (1.09) (2.27)** (1.56) (1.57) (0.53) (1.64)* RM -0.014 0.239 -0.124 0.098 0.005 0.090 0.084 0.061 -0.189 -0.107 -0.042 -0.077 -0.189 (-0.06) (0.94) (-0.61) (0.62) (0.04) (0.63) (0.65) (0.50) (-1.49) (-0.85) (-0.37) (-0.73) (-1.82)* SEC -0.254 -0.161 0.396 0.191 -0.423 -0.290 -0.374 -0.613 -0.162 -0.285 -0.290 -0.213 -0.219 (-0.77) (-0.38) (1.20) (0.63) (-1.27) (-1.25) (-1.86)* (-2.38)** (-0.75) (-1.29) (-1.43) (-0.90) (-1.11) COM 0.011 0.078 0.081 0.026 0.139 -0.069 -0.070 -0.275 -0.142 -0.009 -0.013 0.085 -0.045 (0.03) (0.34) (0.45) (0.16) (0.94) (-0.48) (-0.52) (-2.33)** (-1.16) (-0.07) (-0.12) (0.86) (-0.46) PRERET 0.213 0.183 0.367 0.550 0.870 0.526 0.780 0.269 0.478 0.422 0.404 1.062 0.769 (0.31) (0.40) (1.23) (2.50)** (3.26)*** (1.68)* (4.10)*** (0.90) (1.41) (2.43)** (2.74)*** (3.79)*** (2.95)*** POSTRET -0.994 -1.175 -0.634 -0.735 -0.530 -0.403 -0.722 -0.843 -0.790 -0.305 -0.161 -0.551 -0.397 (-2.41)** (-3.80)*** (-1.95)* (-2.50)** (-2.29)** (-1.41) (-3.27)*** (-3.16)*** (-4.72)*** (-1.52) (-0.56) (-2.36)** (-1.82)* LCAP 0.225 0.098 0.126 0.047 0.067 0.058 0.115 0.079 0.115 0.089 0.110 0.048 0.089 (4.55)*** (1.69)* (3.18)*** (1.10) (2.01)** (1.90)* (4.03)*** (2.64)*** (4.29)*** (2.88)*** (4.20)*** (1.75)* (3.22)*** BM -0.038 0.031 -0.017 0.007 -0.004 -0.024 0.006 -0.029 -0.008 0.011 -0.032 -0.049 -0.035 (-0.17) (0.20) (-1.63)* (0.30) (-0.27) (-3.00)*** (0.41) (-3.52)*** (-0.57) (0.91) (-0.81) (-0.59) (-1.08) # Obs. 62 78 113 135 163 197 229 220 257 253 296 305 305 Adj. R2 12.17 15.00 8.09 1.86 7.39 2.61 12.57 6.33 11.74 6.48 7.45 7.36 8.53

45

TABLE