Accounting conservatism and the profitability of corporate insiders

• Published date: 01 March 2020
• DOI: http://doi.org/10.1111/jbfa.12438
• Author: Akram Khalilov,Beatriz Garcia Osma
• Date: 01 March 2020

DOI: 10.1111/jbfa.12438

Accounting conservatism and the profitability

of corporate insiders

Akram Khalilov1Beatriz Garcia Osma2

1UniversidadCarlos III de Madrid, Department of

Business Administrationand BI Norwegian

Business School, Department of Accounting,

Auditing and Business Analytics

2UniversidadCarlos III de Madrid, Department of

Business Administration

Correspondence

UniversidadCarlos III de Madrid, Department

ofBusiness Administration, Madrid 126, 28903

Getafe,Madrid, Spain.

Email:akhalilo@emp.uc3m.es

Fundinginformation

CAM,Grant/Award Number: H2015/HUM-3353;

Ministeriode Ciencia e Innovación, Grant/Award

Number:ECO2016-77579; European Regional

DevelopmentFund, Grant/AwardNumber:

UNC315-EE-3636

Abstract

We predict that accounting conservatism influences insiders’ oppor-

tunities to speculate on good and bad news, and thus, insider trad-

ing profitability. We find that greater conditional (unconditional)

conservatism is associated with lower (higher) insiders’ profitability

from sales. We find limited evidence that conservatism influences

profitability from purchases. These findings are consistent with our

hypotheses on the different informational roles of conditional and

unconditional conservatism, and on the asymmetric influence of con-

servatism over the opportunities to speculate on good versus bad

news. Our research design takes into consideration the endoge-

nous nature of insiders’ trading and conservatism. The results are

robust to different measures of conservatism and a number of addi-

tional analyses.

KEYWORDS

conditional conservatism, insider trading sales and purchases, prof-

itability from insider trading, unconditional conservatism

JEL CLASSIFICATION

G30, M41

1INTRODUCTION

We examine the association between conservatism and insider-trading profitability from sales and purchases. We

argue that firm-level accounting conservatism influences transparency and thus, the opportunities availablefor insid-

ers to speculate on good and bad news. Our main focus is on conditional conservatism as it systematically affects

the timeliness of good and bad news recognition.1Conditional conservatism refers to the asymmetric verifiability

requirements for the recognition of economic gains versus losses, which results in earnings that capture unfavourable

1Conservatism can be classified as conditional or unconditional (Ball & Shivakumar,2005; Beaver & Ryan, 2005). Unconditional conservatism refers tothe

persistent understatement of net assets which results in unrecognised goodwill (of unknown magnitude). It is the result of news-independent conservative

accounting at the inception of assets and liabilities (Basu, 2005; Ryan, 2006). In addition, and somewhat orthogonally to these notions, the most recent con-

ceptual frameworks refer to “cautious prudence,” and prior work also identifies balance sheet conservatism (Basu, 1997, 2001; Sunder,Sunder, & Zhang,

2018).

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2020 John Wiley & Sons Ltd 333

334 KHALILOVAND GARCIA OSMA

economic events more quickly and completely than favourableevents (Basu, 1997), leading to asymmetric persistence

of good and bad news.

Prior literature usually regards conditional conservatism as a desirable property of accounting numbers, which

results in high quality information useful to monitor management (Beekes, Pope, & Young,2004; Ahmed & Duellman,

2007; Ahmed & Duellman, 2011; Louis, Sun, & Urcan, 2012; Mora & Walker, 2015). We build on this literature and

argue that conditional conservatism reduces insiders’ trading profitability.Two key assumptions underpin our predic-

tion. First, that insiders can earn abnormal returns byexploiting private information (Seyhun, 1986; Jagolinzer, Larcker,

& Taylor, 2011). Second, that conditional conservatism is positively associated with decreases in information asymme-

try (LaFond & Watts, 2008; Francis,Hasan, & Wu, 2013) and that it acts as a corporate governance mechanism that

disciplines opportunistic decision-making, offsetting managerial tendency to hide bad news and accelerate good news

recognition (Watts,2003).

In particular, given that conditional conservatism leads to timely and complete bad news recognition, when con-

servatism is high, we expect a reduction in insiders’ opportunities to speculate on negative news. This should result in

lower insiders’ profitability from sales. In contrast, the prediction on the effect over the profitability from purchases is

not as straightforward.On the one hand, conditional conservatism imposes higher verification standards for the recog-

nition of economic gains (Basu, 1997). This means that gains are recognised as the associated cash flows are realised

(thus, often with a lag), and could lead investors to makeincorrect inferences regarding firm’s prospects. Then, conser-

vatism would create opportunities for insiders to speculate on positive news, increasing profitability from purchases.

On the other hand, prior work shows that conditional conservatism ameliorates the firm information environment,

improving transparency.Conditional conservatism is associated with improvements in corporate governance, lower-

ing the incentives for opportunistic managerial behaviour (Watts, 2003; Gao, 2013),and enhancing the confirmatory

role of accounting, disciplining good news disclosure and increasing its credibility (Ball, 2001; Garcia Osma, Guillamon-

Saorin, & Mercado, 2018). Then, conditional conservatism would act as a disciplining mechanism that leads to truthful

disclosure of good news (Guay& Verrecchia, 2018; LaFond & Watts, 2008), reducing the opportunities to speculate on

good news.

Wetest our predictions on a large sample of US firms over the period 2003–2014. To measure insiders’ profitability,

we focus on opportunistic insiders’ sale and purchase transactions aggregated at a firm-day level,following Jagolinzer

et al. (2011). We classify firms as having high (low) profitability if they earn (do not earn) abnormal returns from their

transactions. Toensure the robustness of our results, we measure conservatism using two different proxies. The first

is market-based in cross-section (Basu, 1997), and the second is firm-specific (Khan & Watts, 2009).Both of the mea-

sures are modified following Banker, Basu, Byzalov, and Chen (2016). In addition, to address potential endogeneity

issues, we run changes analyses and study the effect of an exogenousshock to conservatism: the mandatory adoption

of SFAS 142. Forrobustness, we examine whether our results are robust to different categories of insiders (CEO and

CFO,Top-5 insiders, and all other officers and directors). Finally,we study the impact of unconditional conservatism on

insiders’ profitability.

We report the following key findings. First, our results indicate timelier recognition of bad news in firms where

insiders have lower profitability from sales. We find no systematic evidence of an effect over the profitability from

purchases. This reduces the concerns that conditional conservatism delays the recognition of good news resulting in

higher information asymmetry.In contrast, we find unconditional conservatism is associated with greater profitability

from insiders’ sales. Unconditional conservatism results in an understatement of net assets that is news-independent

(Beaver & Ryan, 2005), and mayprevent the recognition of future negative news in a timely manner (Basu, 2001). Our

finding is consistent with the view in Ball and Shivakumar (2005) and Basu (2005) that unconditional conservatism is

uninformative and largely exists to circumvent taxesand regulation. Finally, we show that the relation between con-

ditional conservatism and insiders’ profitability is sensitive to the constraining effect of unconditional conservatism

(Sunder et al., 2018). Because unconditional conservatism pre-empts the recognition of future bad news, it lowers

the negative effect of conditional conservatism on insiders’ profitability.Our results are robust to the use of different

KHALILOVAND GARCIA OSMA 335

measures for insider trading and conditional and unconditional conservatism, to the inclusion of additional control

variables and to a battery of robustness tests.

Put together, our results contribute to severalstreams of the literature. We contribute to the literature on insider

trading by showing that conditional conservatism reduces the ability of insiders to speculate on private information.

Thisadds to the work that evidences negative effects associated with insider trading (e.g., Ausubel, 1990; Easley, Kiefer,

Ohara, & Paperman, 1996; Bernardo, 2001; Cheng & Lo, 2006; Ellul & Panayides, 2018) and suggests conservatism

may act as a mechanism against insiders’ opportunistic behaviour,limiting speculation on negative news. In contrast,

we show that unconditional conservatism triggers greater insiders’ profitability from sales, consistent with the view

that it increases information asymmetry. Our evidence has policy implications, as it suggests that greater conditional

conservatism may increase price informativeness and lower information asymmetry.Ultimately, more efficient prices

benefit society as they lead to a more efficient allocation of resources. Therefore, we also add to the literature on the

positive economic consequences of conditional conservatism (e.g., Ahmed, Billings, Morton, & Stanford-Harris, 2002;

Ahmed & Duellman, 2007, 2011; Zhang, 2008; Francis & Martin, 2010; Louis et al., 2012; Franciset al., 2013; Garcia

Lara, Garcia Osma, & Penalva, 2014;Kim & Zhang, 2016).

2LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

Insiders often earn abnormal returns when trading on theirown firmsby exploiting private information (Seyhun, 1986;

Rozeff & Zaman, 1988; Lakonishok & Lee, 2001; Marin & Olivier, 2008; Jagolinzer et al., 2011). While insider trad-

ing may accelerate the resolution of uncertainty,increasing stock price informativeness (Manne, 1966; Leland, 1992),

and spurning the generation, processing, and communication of private information (Ronen, 1977), recent work gen-

erally highlights its negative effects. This research suggests that insider trading may not be Pareto optimal (Ausubel,

1990), that it increases cost of capital (Easley & O’ Hara, 2004), and lowers liquidity and firm value (Masson & Madha-

van, 1991; Easley et al., 1996). We add to this literature by examiningthe role of conservatism in influencing insiders’

opportunities to speculate on good and bad news and by proposing conditional conservatism as a plausible mechanism

that limits the negative effects of insider trading.

Conservatism is partly non-discretionary and determined by accounting regulation (Lawrence, Richard, & Yuan,

2013), taxation, litigation risk, and innate firm characteristics, such as firm size, capital structure or growth opportuni-

ties (Watts,2003; Roychowdhury & Watts, 2007; Qiang, 2007; Khan & Watts, 2009), making it fairly exogenous to the

current generation of managers.2Concerns existthat conservatism may lead to inefficient decision-making because of

the bias it introduces in financial reporting (Guay & Verrecchia,2006; Gigler, Kanodia, Sapra, & Venugopalan, 2009).3

However,most of the existing work concludes that conditional conservatism is an efficient mechanism associated with

anumber of positive economic consequences (Watts, 2003; Mora & Walker,2015; Ruch & Taylor,2015). In line with this

latter literature, we present a bright side of conditional conservatism, acting as a tool against opportunistic behaviour

of insiders in exploiting private information to trade on negative economic news. In particular, we argue that condi-

tional conservatism mitigates information asymmetries between outsiders and insiders through timelier recognition of

losses and increasing price informativeness that lowers information asymmetry.Timely loss recognition also enhances

the confirmatory role of accounting, disciplining good news disclosure. In contrast, we expect that unconditional con-

servatism introduces a bias into financial statements that results in higher information asymmetry and higher insiders’

profitability.We develop our arguments next.

2Discretionalso exists in conservatism. An ample literature provides evidence of cross-sectional variation in conservatism, driven by changes in regulation and

firm determinants, as well as by firm-level choices linkedboth to managerial decision-making and to pressures from boards of directors, auditors, creditors

andother stakeholders (see, e.g. Watts, 2003; Mora & Walker,2015; Ruch & Taylor,2015).

3Thesecriticisms are usually focused on unconditional conservatism (Ball & Shivakumar, 2005).