New Study Offers Key to Understanding Insider Trading

Last Updated Aug 17, 2009 2:55 PM EDT

Plenty of academic and anecdotal evidence shows that corporate executives routinely break the law by trading their companies' stock based on inside information. But a new Harvard Business School study reveals that insiders rely on one particular kind of reporting item in deciding to sell shares before the broader markets discover the loss: goodwill impairment.

Accountants use goodwill to estimate the value of a company's intangible assets, such as its brand or industry reputation. Corporate insiders with companies that plan to disclose a decline in the value of those assets are more likely to unload stock than execs with businesses not facing a hit to goodwill, the authors found.

Indeed, knowing that a company must write down goodwill may be even more useful for insider trading than having advance notice of other business developments, such as a merger, earnings announcement or even bankruptcy. "Goodwill impairment charges represent a particularly promising earnings component that insiders could strategically trade ahead of," say Karl A. Muller III of Penn State, Monica Neamtiu of the University of Arizona and Edward J. Riedl of Harvard Business School.

Why? First, goodwill impairment charges tend to be big, averaging nearly 12 percent of the market value of a company's equity. In other words, disclosing such charges can significantly dent a company's stock price, especially if the news is a surprise. Second, goodwill impairment charges are calculated regularly using internal forecasts of earnings and other cash flows that aren't typically made public. Third, accounting rules only require companies to disclose impairments of specific assets, such as goodwill, when the entire reporting unit is impaired. In practice, that lets managers delay booking the writedown for months or even years. Finally, corporate managers have a lot of discretion in how they measure goodwill charges, which gives them more control over the size of an impairment.

Of particular relevance here is that goodwill impairment may not be revealed to the market for a long time. That lets insiders sell stock well before a charge is ever disclosed. How long? Up to two years, according to the study.

Of course, just because execs can dump stock ahead of an accounting-related shock to their stock doesn't mean they will, as the researchers note. The drop in goodwill may already be "priced in" to the company's shares, although that's less likely if few analysts cover a given firm. Not incidentally, insiders also know they risk getting caught by securities regulators or, more likely, internal auditors.

Still, there's reason to think this sort of insider trading is common. Preventing it is difficult, if not altogether impossible. And it takes a toll. The analysis "reveals that among firms reporting goodwill impairments, those with net selling among insiders exhibit significantly more negative abnormal stock returns relative to those not reporting net selling among insiders," the report authors conclude.
  • Alain Sherter On Twitter»

    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

Comments

Market Data

Market News

Stock Watchlist