Corporate executives and directors are trading on inside information about potential audit findings in the window between year-end earnings announcements and when companies file annual reports and audit opinions with the Securities and Exchange Commission, according to new research.
Companies didn’t use to announce fourth-quarter earnings until the auditors’ work was done and the annual report with its opinion was issued. Since 2004, however, after new audit requirements were mandated by the Sarbanes-Oxley Act as a result of the failure of Enron and the dissolution of its audit firm Arthur Andersen, audits are taking longer to finish.
As a result, recent studies say nearly 70% of companies now announce unaudited fourth quarter and year-end earnings well before the completion of the audit, on average at least 15 days later.
Read: Many annual earnings are arriving without an audit, and that could be a problem
See also: Only a few companies are reporting earnings that are fully audited
Most publicly traded companies receive a clean audit opinion on their financial reports, but not all. Auditors occasionally add additional language to the report to highlight material internal control weaknesses, going concern issues, and restatements of prior financial statements for errors or material misstatements.
The new working paper, “Audit Process, Private Information, and Insider Trading,” by accounting professors Salman Arif and Joseph Schroeder of the Kelley School of Business at Indiana University and John Kepler and Daniel Taylor of The Wharton School at the University of Pennsylvania, provides evidence that corporate insiders in some companies exploit the window between the earnings announcement and the 10-K filing for personal gain by trading based on material private information about any audit findings. The working paper has not yet been peer reviewed.
The researchers say that any increase in the information content of the audit report, such as a seemingly innocuous explanatory paragraph, increases the value of insiders’ information advantage and potentially increases the incentive to trade during the gap between the earnings release and the publication of the auditors’ annual report.
Taylor, Arif, Schroeder and Kepler conclude that advanced knowledge of audit findings provides corporate insiders with a “temporary information advantage.” The simple solution, they told MarketWatch, is to align the announcement of earnings with the filing of the 10-K and audit report. They recommend in the paper that companies could also further limit trading for key personnel involved with the audit and that companies could consider extending trading blackout windows until the 10-K and auditor’s opinion is issued.
Beginning with the 2019 annual reporting season, requirements for auditors to say more about critical audit matters, or CAMs, will be phased into the audit report. “Any increase in the information content of the audit report will increase the incentive to engage in opportunistic insider trading,” Taylor told MarketWatch.
Schroeder added, “This is an important thing for regulators and company counsels to monitor as we implement the new CAM disclosures.”
Corporate executives and board members will know well in advance of the filing of the annual report if the auditor has raised issues with the financials or the internal controls and whether that information will show up in the annual report. That’s because a typical large public company audit is now a year-long effort, beginning with scoping and scheduling the work effort and then performing interim audit procedures at the end of each quarter.
When the audit report is almost ready, the lead auditor briefs the audit committee of the board. The company subsequently files its 10-K that includes the audit report and any findings to the SEC and the public.
It is illegal for corporate insiders to trade while in possession of material non-public information. Companies monitor compliance with the insider trading law based on company-specific policies that establish restricted trading windows. Earlier research based on actual insider trading policies at 260 companies found that the average length of trading restrictions is 48 days, or 46 days before and 1 day after an information event such as the fourth-quarter and year-end earnings announcement.
There is no formal requirement for companies to file insider trading policies with the SEC.
To read: SEC’s Jackson says research he’s conducted shows corporate insiders are using buybacks to cash out
More info: What exactly is insider trading—and how do you avoid it?
The earlier researchers also found that about 24% of all insider trades still occur within these restricted trade windows, which vary by company and where enforcement varies by company.
Restricted trading windows alone are not effective at reducing insider trading, according to the earlier research co-authored by Taylor of Wharton with Alan D. Jagolinzer of the University of Cambridge Judge Business School and David F. Larcker of the Stanford University Graduate School of Business.
The effectiveness of restricted trade windows in deterring insider trading depends, instead, on whether individual transactions require corporate legal officer approval.