Insider Trading and Earnings Management in Distressed Firms*

This paper shows that the threat of litigation impacts managers' accounting and stock-trading decisions in periods preceding technical default. We analyze managers' pre-default accrual strategies separately and jointly with their pre-default insider trading activity in a sample of 462 firms that experienced technical default in the period 1983-1997. We find that pre-default abnormal insider selling provides incentives for upward earnings management independent of debt contracts. Our evidence that insider trading incentives complement debt contract incentives suggests that researchers investigating earnings management among distressed firms can exploit managers' trading patterns to increase the power of their tests. We also propose and find that abnormal selling occurs before rather than after earnings management. This suggests that earnings management in distressed firms is more likely to reflect a desire to avoid litigation (`` dump and pump'') rather than to sell at higher prices (`` pump and dump''). Indeed, evidence that earnings management can distance managers' selling from the revelation of bad news suggests that investors and those with oversight authority (e. g., boards of directors, auditors, and regulators) consider monitoring insider trading activity prior to, rather than subsequent to, earnings management.