Misvaluation and Insider Trading Incentives for Accrual‐based and Real Earnings Management

• Published date: 01 September 2014
• Author: Julia Sawicki,Keshab Shrestha
• Date: 01 September 2014
• DOI: http://doi.org/10.1111/jbfa.12084

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 41(7) & (8), 926–949, September/October 2014, 0306-686X

doi: 10.1111/jbfa.12084

Misvaluation and Insider Trading

Incentives for Accrual-based and Real

Earnings Management

JULIA SAWICKI AND KESHAB SHRESTHA∗

Abstract: We investigate the incentives that misvaluation creates for: (1) insider trading; and

(2) concurrent earnings management through both accruals and real activities. Managers of

overvalued firms have an incentive to sustain overvaluation through income increasing earnings

management and, at the same time, to sell their shares (Jensen, 2005). Managers of undervalued

firms benefit from buying their firm’s shares, however the negative effects of downward earnings

management may offset incentives to enhance trading advantages. The results indicate that

managers of both over- and under-valued firms act opportunistically, managing earnings upward

(downward) with accruals while selling (buying) shares. The Sarbanes-Oxley Act of 2002 (SOX)

has been largely ineffective in eliminating trading motivated earnings management. Finally,

we do not find evidence of a relationship between managerial trading and real earnings

management.

Keywords: insider trading, earnings management, accruals, undervaluation, overvaluation,

SOX, managerial opportunism

1. INTRODUCTION

Earnings management has received considerable attention in the accounting litera-

ture. However, very few studies have analyzed the earnings management incentives

associated with insider trading. Beneish and Vargus (2002) highlight the importance

of the relationship between insider trading and earnings management. They suggest

that the opportunistic earnings management patterns they document are attributable,

in part, to insider trading incentives. Similarly, Piotroski and Roulstone (2005) con-

clude that managers “cash out” after revealing strong earnings news. Both studies call

for research into the incentives that insider trading creates for earnings management.

∗The first author is from the Rowe School of Business, Dalhousie University, Halifax, Nova Scotia, Canada.

The second author is from the Monash University Malaysia, Jalan Lagoon Selatan, 47500 Bandar Sunway,

Selangor Darul Ehsan, Malaysia. The authors would like to thank Joint-Editor Prof. Andrew W. Stark and the

anonymous referee for their comments and suggestions. The authors would also like to thank the seminar

participants at Nanyang Techological University and the 2011 annual meeting of the FMA for their helpful

comments. (Paper received March 2011, revised version accepted May 2014)

Address for correspondence: Keshab Shrestha, Monash University Malaysia, Jalan Lagoon Selatan, 47500

Bandar Sunway, Selangor Darul Ehsan, Malaysia.

e-mail: keshab.shrestha@monash.edu

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MISVALUATION AND INSIDER TRADING INCENTIVES 927

Therefore, we explore the relationship between managerial trading and both accrual-

based and real earnings management.

This study jointly investigates two important roles of regulators and policymakers

related to protecting investors and maintaining the integrity of capital markets: (1)

insuring the quality of financial information; and (2) enforcing laws prohibiting

illegal insider trading. These topics are the stated focus of the US Securities and

Exchange Commission (SEC)1and are of concern to other regulatory bodies (e.g.,

the Public Company Accounting Oversight Board (PCAOB), the Financial Accounting

Standards Board (FASB), and the International Accounting Standards Board (IASB)

etc.), lawmakers and private sector organizations. The credibility of financial reporting

is a foundation for investor confidence in the information firms disclose. Weakness

in disclosure quality, exacerbated by potential insider trading advantages, ultimately

increases the cost of capital and impedes capital formation. As Kothari (2000) points

out, credible financial information reduces the information asymmetry between

management and outside investors (thus lowering the cost of capital), motivating

regulators around the world to strive for high quality accounting standards.

Financial disclosure and the market’s reaction to public earnings announcements

have been the focus of one of the primary streams of research in accounting and

finance (Bailey et al., 2006). Verrecchia (2001) summarizes this broad research

area. He observes that disclosure spans three disciplines: accounting, finance and

economics. Thus, disclosure research inevitably takes on unique features of each of

these literatures. A long stream of research indicates the importance of the issue of

disclosure, especially its timing and quality. Earnings management is at the core of this

issue.

Prior research has posited numerous incentives for earnings management, includ-

ing those arising from managerial ownership, and has established an indirect link

between insider selling and income-increasing earnings management (Beneish and

Vargus, 2002; Cheng and Warfield, 2005; and McVay et al., 2006). Cheng and Lo

(2006) find evidence that managers use bad news forecasts to reduce the share price

when they are buying shares. Studies analyzing the information content of insider

trading have found that insiders trade on both temporary mispricing and future

performance (Rozeff and Zaman, 1998; Piotroski and Roulstone, 2005).

Other studies explore the association between insider trading and accrual-based

earnings management. For example, using a bivariate analysis, Kothari et al. (2006)

find evidence that insiders of the highest accrual decile firms are net sellers. However,

the insiders of the lowest accrual decile firms do not exhibit consistent buying or

selling behaviour. They also find that high accrual decile firms, in general, have higher

market-to-book ratios, implying that these firms are over-valued. Similarly, Sawicki

and Shrestha (2008) hypothesize a negative association between insider purchases

and discretionary earnings management. They find evidence suggesting that insiders

manage earnings downward (upward) when buying (selling) shares.

We contribute to this literature by extending the evidence previously documented

by Kothari et al. (2006) and Sawicki and Shrestha (2008) by incorporating insiders’

trading profit as an additional incentive for earnings management. Our hypotheses

1 The SEC identifies three areas of focus in its mission statement: investor protection, maintenance of

markets and facilitation of capital formation. The detection and prosecution of illegal insider trading is an

enforcement priority because it undermines investor confidence in the fairness and integrity of the securities

markets.

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