Insider trading and the early adoption of SFAS 96: A test of the signaling hypothesis

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Advances in Accounting







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This paper examines the insider trades of officers and directors of firms that adopted Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes" (SFAS 96) to test whether managers' expectations are consistent with signaling theory. One theory of signaling suggests that high quality firms may signal their quality by using the "best" accounting policies advocated by the accounting profession. A second theory suggests that a one time earnings management opportunity may be used to smooth a transitory increase or decrease in earnings as "an effective way for a firm to provide the stock market with information as to the degree of future persistence in the unexpected component of current earnings." Our results show that in the six-month interval preceding SFAS 96 adoption, managers of firms that increase net income by more than 20 percent from the adoption nearly doubled their normal number of purchases relative to other intervals examined, and made significantly more purchases of their firms' stock than did a control sample of nonadopters. This result is consistent with the theory that managers may have used the positive income effects from SFAS 96 adoption to signal their positive long-term expectations. However, when all adopting firms are pooled together regardless of the magnitude or direction of the income effect from SFAS 96 adoption, our results suggest that managers of adopting firms may have had an unfavorable outlook. Insiders of firms that adopted in 1987 engaged in significantly more selling in the last six months of 1987 than did a control sample of firms that did not adopt SFAS 96. Of the four time periods examined, this was the only one in which selling was significantly different for adopting firms. Insiders of firms adopting in 1988 also engaged in significantly more selling, and in significantly less buying in the last six months of 1988 than nonadopters. These results suggest that managers of adopting firms may have had an unfavorable outlook, and, as such, are not consistent with the theory that firms choose accounting methods as a way to signal higher quality. © 2000.