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In the current economic environment, one of the crucial challenges is the fact that not all of the implications of accounting accruals and financial reporting are understood by stakeholders of the financial market. According to Beneish and Vargus, there is strong evidence that even the auditors can occasionally misinterpret the implications of pricing accruals and other elements that can lead to the incidence of accrual mispricing, as well as substantially lower the quality of financial accruals (756).
For that reason, it is important to analyze and evaluate all the implications of earnings persistence and valuation, which would help to improve not only the quality of financial accruals but also identify better the underpinning economic factors that lead to the incidence of earnings management in the first place. In order to do that Beneish and Vargus offer a number of tests aimed at revealing the association between the income-increasing accruals and earnings persistence associated with the cases of insider buying, accruals mispricing, and other cases of the earnings management.
The pricing tests suggested by Beneish and Vargus are to unveil the correlation between the accruals mispricing as the result of the earnings management with the income-increasing accruals (757). Secondly, it is also important to point out that one of the objectives of the test is to identify the associating between the appearance of the income-increasing accruals and the insider sales, particularly, if “income-increasing accruals appear to be overpriced when managers engage in abnormal selling and rationally priced when managers engage in abnormal buying” (Beneish and Vargus 757). Also, it is important to analyze the incentives why all the market participants treat such financial accruals as if they revealed the earnings of high quality.
In addition, Beneish and Vargus suggest that there is also a linkage between insider trading and the benefits and advantages that the executives and other insider participants have in knowing the company’s current performance during a fiscal year. However, on one hand, such actions can be considered a part of the managers’ earnings management activities if they are intended at liquidity rebalancing. Meanwhile, on the other hand, the disclosure of income-increasing accruals, as well as proper audit of the company’s portfolio can be a means to diminish the potential dangers of insider trading in terms of its effects on accruals mispricing.
In such a way, managers boost earnings persistent both for the purposes of increase in stock prices and personal executive benefits and advantages in insider trading. Thus, the hypothesis suggested by Beneish and Vargus is that “income-increasing unexpected accruals are more persistent when accompanied by abnormal insider buying” (759). It can be interpreted in a way that correlation with the insider selling and income-reducing accruals should also be positive.
The incentive, in this case, is that the market participants expect the managers to benefit “from increased proxy statement or Form 10-K disclosures about trading by firms’ top executives during the fiscal year” (Beneish and Vargus 758). One of the ways to dismantle the association between those misleading factors is to admit that the forecasts regarding the stock prices cannot fully anticipate the company’s performance, especially in the situation, when insider buying or selling is involved.
Method, Empirical Results, and Robustness Checks
The most of the data gathered by Beneish and Vargus was from a number of financial databases, including Compustat, Industrial Research, as well as the taped documentation from the Full Coverage database and it included the period from 1985 to 1997 collected among the sample of “21,678 firm-years from 3,906 firms” (760). It is important to point out the fact that the data was analyzed with consideration for several parameters.
Firstly, it involved the financial services including those of the auditors, as well as the variation of data before and after the end of a particular fiscal year. Secondly, American Depository Receipts (ADRs) were analyzed in order to establish the implications of adjustments in various accruals.
Among the result that confirmed the hypothesis, it was established that abnormality of financial accruals shows a positive correlation with the certain cases of the accruals mispricing. The specific area in which such phenomenon reveals itself is the income-increasing accruals. Moreover, it was also defined that insider trading among senior executives shows a correlation with the abnormality of income-increasing and income-decreasing accruals in the situation where such practice can affect the future stock prices.
The first implication of this result is that in the case of the company’s performance being unable to meet the earnings benchmark set by the auditors, insider buying can boost the stock prices. On the other hand, if the company substantially exceeds the set expectations, the insider selling along the abnormal income-decreasing accruals can be used for the purposes of stabilizing the company’s performance, liquidity, and stock prices.
Overall, cross-section results prove the correlation between intensity and persistence of earnings with the consequences of insider trading that manifests itself in the form of abnormal accruals. Moreover, the situation, when such abnormal insider trading takes places alongside low persistence of earnings, it can be associated with earnings management.
Beneish, Messod, and Mark Vargus. “Insider Trading, Earnings Quality, and Accrual Mispricing.” The Accounting Review 77.4 (2002): 755-791. Print.