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

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 41(7) & (8), 926–949, September/October 2014, 0306-686Xdoi: 10.1111/jbfa.12084

Misvaluation and Insider TradingIncentives 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 ofovervalued firms have an incentive to sustain overvaluation through income increasing earningsmanagement and, at the same time, to sell their shares (Jensen, 2005). Managers of undervaluedfirms benefit from buying their firm’s shares, however the negative effects of downward earningsmanagement may offset incentives to enhance trading advantages. The results indicate thatmanagers 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 earningsmanagement.

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 incentivesassociated with insider trading. Beneish and Vargus (2002) highlight the importanceof the relationship between insider trading and earnings management. They suggestthat 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 callfor 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 theanonymous referee for their comments and suggestions. The authors would also like to thank the seminarparticipants at Nanyang Techological University and the 2011 annual meeting of the FMA for their helpfulcomments. (Paper received March 2011, revised version accepted May 2014)

Address for correspondence: Keshab Shrestha, Monash University Malaysia, Jalan Lagoon Selatan, 47500Bandar Sunway, Selangor Darul Ehsan, Malaysia.e-mail: [email protected]

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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 policymakersrelated to protecting investors and maintaining the integrity of capital markets: (1)insuring the quality of financial information; and (2) enforcing laws prohibitingillegal insider trading. These topics are the stated focus of the US Securities andExchange Commission (SEC)1 and are of concern to other regulatory bodies (e.g.,the Public Company Accounting Oversight Board (PCAOB), the Financial AccountingStandards Board (FASB), and the International Accounting Standards Board (IASB)etc.), lawmakers and private sector organizations. The credibility of financial reportingis a foundation for investor confidence in the information firms disclose. Weaknessin disclosure quality, exacerbated by potential insider trading advantages, ultimatelyincreases the cost of capital and impedes capital formation. As Kothari (2000) pointsout, credible financial information reduces the information asymmetry betweenmanagement and outside investors (thus lowering the cost of capital), motivatingregulators around the world to strive for high quality accounting standards.

Financial disclosure and the market’s reaction to public earnings announcementshave been the focus of one of the primary streams of research in accounting andfinance (Bailey et al., 2006). Verrecchia (2001) summarizes this broad researcharea. He observes that disclosure spans three disciplines: accounting, finance andeconomics. Thus, disclosure research inevitably takes on unique features of each ofthese literatures. A long stream of research indicates the importance of the issue ofdisclosure, especially its timing and quality. Earnings management is at the core of thisissue.

Prior research has posited numerous incentives for earnings management, includ-ing those arising from managerial ownership, and has established an indirect linkbetween insider selling and income-increasing earnings management (Beneish andVargus, 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 pricewhen they are buying shares. Studies analyzing the information content of insidertrading have found that insiders trade on both temporary mispricing and futureperformance (Rozeff and Zaman, 1998; Piotroski and Roulstone, 2005).

Other studies explore the association between insider trading and accrual-basedearnings 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 orselling behaviour. They also find that high accrual decile firms, in general, have highermarket-to-book ratios, implying that these firms are over-valued. Similarly, Sawickiand Shrestha (2008) hypothesize a negative association between insider purchasesand discretionary earnings management. They find evidence suggesting that insidersmanage earnings downward (upward) when buying (selling) shares.

We contribute to this literature by extending the evidence previously documentedby 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 ofmarkets and facilitation of capital formation. The detection and prosecution of illegal insider trading is anenforcement priority because it undermines investor confidence in the fairness and integrity of the securitiesmarkets.

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are based on agency theory and related to the incentives that misvaluation createsfor insider trading and earnings management. According to the agency theory ofovervalued equity (Jensen, 2005), when a firm’s shares become overvalued, managersact to prolong the overvaluation (using various tools, including income increasingearnings management) and at the same time, sell their shares to benefit fromovervaluation. However, when their stock is undervalued, managers face conflictingincentives. The first incentive is to prolong the undervaluation by using incomedecreasing earnings management and, concurrently, buy the shares to benefit fromthe undervaluation. However, there are negative consequences of downward earningsmanagement, such as potential job loss, decreased compensation, and a diminishedpersonal reputation. Managers may, therefore, choose to forego the benefit frominsider trading and use income increasing earnings management to signal theundervaluation. Therefore, managers have competing incentives to manage earningsupward, instead of downward, when their firms are undervalued. These two incentiveshave opposite implications for the direction of earnings management. Determiningwhich one dominates is an empirical question. In any case, we posit that the useof income decreasing accruals and insider buying will be significantly lower forundervalued firms, which will result in asymmetry in the relationship between accrualsand insider trading.

Our hypotheses thus far apply to accrual-based earnings management. We also testhypotheses concerning the relationship between insider trading and earnings man-agement through real activities (i.e., real earnings management). Several studies findevidence that executives employ various real decisions, such as cutting discretionaryexpenditures (Bushee, 1998; Cheng, 2004) or selling assets (Herrmann et al., 2003),to increase reported earnings. An important side effect of real earnings managementis the economic consequence of lost competitiveness and value. Does the loss infirm value negate the incentive to enhance trading advantages through real earningsmanagement? We conjecture that transitory trading gains are unlikely to offset thepermanent, detrimental effect that real earnings management has on firm value.Therefore, we do not predict that there is a relationship between trading and earningsmanagement through real activities.

Finally, we consider the effect of the implementation of the Sarbanes-Oxley Act of2002 (SOX) on the association between insider trading and opportunistic earningsmanagement. We predict that increased scrutiny and the possibility of litigation inthe post-SOX period will reduce the incentive that managers have to enhance tradingadvantages. Furthermore, the difficulty of distinguishing real earnings managementfrom normal business activities raises the possibility that managers will switch fromaccrual-based to “real methods” in manipulating reported earnings in the post-SOXperiod (Cohen et al., 2008). We test for a switching of methods by comparing bothaccrual-based and real earnings management in the pre- and post-SOX periods.

Our results provide strong evidence of opportunistic accrual-based earnings man-agement for both over- and under-valued firms. Specifically, we find evidence of asignificantly positive relationship between insider trading and discretionary accrualswhere selling (buying) is related to income increasing (decreasing) earnings manage-ment. The relationship between insider trading and accruals is stronger for overvaluedfirms, but it is not statistically different from that between accruals and insider tradingfor the undervalued firms. We find that this relationship is present in both the pre- andpost-SOX periods, indicating that SOX has not been successful in attenuating such



opportunistic behaviour. Finally, we do not find evidence of insider trading relatedreal earnings management for the full sample (or either the pre- or post-SOX sub-samples). It appears that insider trading advantages are not sufficient to offset thepermanent negative effects of real earnings management, and that managers have notsubstituted real activity management for insider trading related accruals managementin the post-SOX era.

This paper contributes to the literature on earnings management in the followingways. First, we present agency-based hypotheses and perform empirical tests relatedto the accrual-based earnings management motivated by profits from insider trading.In this regard, we extend Kothari et al.’s (2006) bivariate analysis using multivariateanalyses and explicitly incorporating the over- and under-valuation using two differentcriteria: book-to-market ratio and historical sales growth (Lakonishok et al., 1994).We also extend Sawicki and Shrestha’s (2008) results by explicitly testing for a possibleasymmetric relationship, contrary to their tests, which involve a symmetric relationshipbetween insider trading and accrual based earnings management. Second, we test theeffectiveness of SOX in eliminating or reducing accrual-based earnings management.The evidence of opportunistic earnings management reported here, and the ineffec-tiveness of SOX in curtailing it, has important implications for investor confidence andmarket integrity, which ultimately translates into a misallocation of resources and awelfare loss to society. Finally, we test hypotheses related to real earnings managementand insider trading, investigating the possibility that managers respond to post-SOXscrutiny by shifting to a “more disguised” form of earnings management through realactivities.

2. BACKGROUND AND HYPOTHESES

Disclosure quality plays an important role in the efficient allocation of capital. More-over, the harmful effects of accounting manipulation have long been recognized.2

Thus, the link between disclosure quality and earnings management is important.Concerns about the quality of information provided to the market and earningsmanagement have intensified over the last decade, partly due to the huge lossesincurred by investors in well-publicized financial reporting frauds committed by highprofile firms such as Enron, WorldCom, Adelphia, Parmalat and Tyco International.In response to accounting fraud and a concern over reporting misconduct, the UnitedStates Congress enacted the Sarbanes-Oxley Act in 2002 with a goal of improvingdisclosure and financial reporting.3

Earnings management is not necessarily misleading or fraudulent. Generally ac-cepted accounting principles (GAAP) guide the financial reporting process. Estimatesand managerial discretion are often required in applying GAAP, the goal of which is toproduce an earnings number that better represents the firm’s economic performancethan a pure cash flow estimate of earnings. Whether these estimates and discretion areused to: (1) provide investors with an accurate reflection of economic performance,or (2) in response to other incentives, is an empirical issue.

2 The report to the Chairman, Committee on Banking, Housing and Urban Affairs, US Senate by GeneralAccounting Office (GAO, 2002) estimates that, between January 1997 and March 2002, the restatementannouncements caused market capitalization losses of about US$ 100 billion.3 One of the objectives of this research is to test whether SOX has been successful in eliminatingopportunistic earnings management motivated by insider trading profits.



Earnings management has been investigated in the context of two hypotheses: (1)signaling, and (2) opportunism. Under the signaling theory, earnings management isused to improve the information content of financial statements and convey the com-pany’s true performance to outsiders (Watts and Zimmerman, 1986; Subramanyam,1996; Guay et al., 1996; Demski, 1998; Kothari, 2001; Arya et al., 2003; Louis andRobinson, 2005).4 On the other hand, the opportunistic hypothesis argues thatsome managers may artificially enhance the performance of the firm or hide poorperformance (Healy, 1985; Burgstahler and Dichev, 1997; Beneish and Vargus, 2002;Marquardt and Wiedman, 2004; Cheng and Warfield, 2005; Burgstahler and Eames,2006; Efendi et al., 2007).

The insider trading literature has evolved into three main streams: (1) welfareeffects, (2) profits and sources of profits, and (3) market efficiency effects.5 Wefocus on the second broad topic and argue that some managers may use earningsmanagement techniques to profit from insider trades. Several laws prohibit insidersfrom trading on material, non-public information.6 However, there are no legalrestrictions on insider trading based on perceived over- or under-valuation.

Numerous techniques can be employed in managing earnings and they are gener-ally characterized as either accrual-based or real earnings management. Prior researchhas generally concentrated on the former, using accruals (accounting adjustmentsto cash flows that modify the measurement and timing of the resulting revenuesand expenses) to estimate the level of earnings management through discretion inmaking estimates and the inherent assumptions allowed under generally acceptedaccounting principles. Prior research finds ample evidence of accrual-based earningsmanagement, as discussed in Healy and Whalen’s (1999) survey of this literature.

Real earnings management affects reported earnings through cash flows. Shipper’s(1989) definition of real earnings management identifies it as the timing of financingor investment activities in order to alter reported income. Examples and evidence ofreal earnings management include: changes in discretionary spending on researchand development (Bushee, 1998; Cheng, 2004), asset sales (Bartov, 1993; Hermannet al., 2003) and stock repurchases (Hribar et al., 2006).

Several studies investigate the incentives that managerial equity ownership createsfor earnings management. Cheng and Warfield (2005) argue that equity incentives(stock ownership and stock-based compensation, such as option grants) are linked tofuture managerial trading, which thus creates an incentive to manage earnings. Theirevidence suggests that over-priced equity is related to share sales following earningsannouncements. They find that insider trading is indirectly associated with earningsmanagement. Specifically, they find evidence of: (1) a positive relationship betweenequity incentives and the incentive of just meeting or beating analysts’ forecasts,

4 See Dye and Verrecchia (1995) and Evans and Sridhar (1996) for an optimal contracting justification ofallowing reporting flexibility (earnings management). In some cases, manipulation of accruals may resultin lower wealth losses to shareholders than the alternative manipulation of real activity (Fields et al., 2001).Finally, too much disclosure may not be in the interest of the firm if it reveals private information thatcompetitors may use (Graham et al., 2005).5 See Roulstone (2003) for a discussion of these issues. Furthermore, it is important to note that insiderstrade for reasons other than profiting from private information, including: taxes, portfolio re-balancing(diversification) and liquidity (Kallunki et al., 2009).6 The original legislation, The Securities and Exchange Act of 1934 and the 1968 Williams Act Amend-ments, regulate insider trading. These are supplemented by the Insider Trading Sanction Act of 1984(ITSA) and the Insider Trading and Securities Fraud Enforcement Act of 1988. See Meulbroek (1992)for a discussion of these acts. A more timely disclosure regime was introduced by Section 403 of SOX, 2002.



and (2) a negative relationship between equity incentives and large positive earningssurprises (indicative of smoothing earnings). Overall, they conclude that while stock-based compensation and ownership can have positive incentive effects, a side effectmay be opportunistic earnings management. Efendi et al. (2007) find evidenceconsistent with this conclusion. They find a significant increase in the likelihoodof misstated financial statements when the CEO has significant in-the-money stockoptions.

In a more direct test of the relationship between managerial trading and earningsmanagement, McVay et al. (2006) report a strong association between managerialstock sales and the likelihood of just meeting or beating analysts’ forecasts. Theyprovide further evidence of earnings management through discretionary accruals justprior to meeting the analyst threshold and selling shares, thus establishing a direct linkbetween managerial trading and earnings management

Richardson et al. (2004) argue that another method for meeting analysts’ expec-tations is to manage the forecast (i.e., managers guide the forecast down to beatablelevels). They report systematically optimistic forecasts early in the fiscal year, followedby systematically more pessimistic forecasts later in the year. They link this patternto managerial and firm incentives to sell shares in the post-earnings announcementperiod. Their overall conclusion is that managers opportunistically guide analysts’expectations leading up to earnings announcements to facilitate favorable insidertrades after earnings announcements.

Disclosures have also been investigated in the context of trading incentives. Chengand Lo (2006) find that insiders strategically choose disclosures and the timing oftheir equity trades, using bad news forecasts to reduce the share price before managers(especially the CEO) buy shares. They find that forecasting activities and sales are notrelated, which they explain with higher litigation concerns related to sales.7 Rogers’(2008) results corroborate the impact of litigation threats with evidence that managersprovide higher quality disclosures before selling shares than when they do not trade.They also find some evidence of lower quality disclosures prior to insider purchases ofshares than when they do not trade.

Furthermore, extant research finds evidence that once the firm’s stock becomesunder- or over-valued, some insiders benefit by buying the shares when the firm isundervalued or selling the shares when the firm is overvalued.8 We do not argue thatinsiders intentionally manage earnings in order to generate misvaluation in order tosubordinate trade to benefit from the misvaluation. However, we posit that once thefirm’s stock becomes under- or over-valued, in addition to simply buying undervaluedstock and selling overvalued stock, managers can engage in opportunistic earningsmanagement to enhance the profits from their trades. We hypothesize a trigger process,where the under- or over-valuation becomes the trigger point which sets off the tradingand earnings management. We further argue that managers react more readily to

7 On the other hand, many studies find evidence of a link between selling and earnings management. Theconflicting results may be explained by the fact that evidence of opportunistic trading related to forecastsand disclosures is more salient and perhaps a stronger basis upon which to prosecute than other types ofmanagerial actions.8 We can consider such insider trading behavior as a signaling behavior. For example, Udpa (1996) findsevidence that insider trading prior to the earnings announcement increases the amount of pre-disclosureinformation. Gregory et al. (1997) find that insider purchases lead to positive abnormal returns and saleslead to negative abnormal returns. Finally, Zhang (2001) discusses insider trading as an alternative way ofreducing information asymmetry.



over- than under-valuation, resulting in an asymmetric relationship between tradingand earnings management. Specifically, we predict that selling and income increasingearnings management are more strongly related than buying and income decreasingearnings management.

We develop our hypotheses in the context of the agency theory of overvaluedequity (Jensen, 2005; Kothari et al., 2006). When managers perceive their firm’sshares to be overvalued, they can take actions to prolong the overvaluation and,even, exasperate it. Prior research has argued various incentives for prolonging theovervaluation. First, managers’ compensation as well as overall wealth increases withthe stock price when part of the compensation is paid in shares or options (Cheng andWarfield, 2005; Bergstresser and Philippon, 2006; Burns and Kedia, 2006; Efendi et al.,2007). Second, managers are less likely to lose their jobs when the stock is overvalued(Weisbach, 1988). Third, managers have incentives to maintain overvaluation if theirfirm is constrained by an interest-coverage debt covenant (Efendi et al., 2007).Finally, a strong stock price performance increases managers’ reputation and valuein the executive labor market. We introduce an additional incentive for maintainingovervaluation: the potential to profit from insider selling. In other words, managerscan opportunistically benefit by managing earnings upward (using income-increasingaccruals) and selling their shares.9 These arguments lead to our first hypothesis, thatwhen the firm is overvalued, managers engage in accrual-based income-increasingearnings management and substantially sell their shares. We state the empiricalprediction as follows (in the alternative form):10

H1: There is a positive association between insider selling and accrual-based, income-increasing earnings management for overvalued firms.

When the firm is undervalued, managers can act in a similar opportunistic manner,using income-decreasing earnings management to prolong the undervaluation andexploiting the misvaluation by purchasing shares. However, buying when the firm isundervalued may not be very attractive to some managers due to fact that it wouldresult in the manager holding an under-diversified portfolio. In addition, prolongingthe undervaluation of the firm can result in adverse individual effects in terms of lowercompensation, lower bonuses and reputation loss and an incremental threat of takeover. Thus, we argue that there is an offsetting incentive for managers to use income-increasing earnings management to provide a signal to investors that would help correctundervaluation (i.e., engage in informative earnings management). This tension leadsto two potential strategic possibilities. The first (the opportunistic strategy) wouldlead to the use of income-decreasing earnings management and the second (thesignaling strategy) would lead to the use of income-increasing earnings management.

9 The threat of litigation may counteract this incentive. The empirical evidence is mixed and there isdisagreement about the effect of litigation on equity incentives for earnings management (Beneish andVargus, 2002; Ke et al., 2003; Cheng and Warfield, 2005; McVay et al., 2006).10 This hypothesis is the same as Sawicki and Shrestha’s (2008) hypothesis H2A for growth or glamour (over-valued) firms except in our research we estimate the association using subsamples of value and growth firmsand we use double-sorts to determine over- and under-valuation. We also analyze the impact of SOX on suchan association. It is the next hypothesis that distinguishes our research from that of Sawicki and Shrestha(2008). Also, based on our argument, the earnings management should precede the insider trading. Weassume that a year is long enough so that the earnings management and insider trading occur within a year.For robustness, we also analyze the earnings management in year t and insider trading in year t+1. Thenature of our results does not change.



Which strategy dominates is an empirical question. Therefore, we express our secondhypothesis in the null form as follows:

H2: When the firm is undervalued, there is no association between trading and accrual-based earnings management.

Under hypothesis H1, we expect managers to engage in opportunistic earningsmanagement. Under hypothesis H2, conflicting incentives result in the possibility of:(1) opportunistic earnings management, or (2) informative earnings management,or (3) no earnings management. The difference in incentives for over- and under-valued firms leads to the expectation of an asymmetric association between earningsmanagement and trading, with a stronger association between trading and accruals forover-valued firms.

Existing research finds some evidence related to our two hypotheses. For example,Sawicki and Shrestha (2008) find a significantly negative association between discre-tionary accruals and insiders’ purchase ratio, implying that managers manage earningsdownward (upward) when buying (selling). However, they do not test the asymmetricassociation between managers’ purchasing behavior and earnings management, whichdepends on the over- and under-valuation conditions. Kothari et al. (2006), basedon the agency hypothesis, predict asymmetry in the insider trading activity acrossaccrual deciles. They predict that insiders among the high accrual decile firms arenet sellers because these firms are overvalued. However, they do not expect insiders oflow accrual-decile firms to exhibit abnormal buying. Using accrual deciles, they findempirical evidence consistent with their hypotheses. Our study differs from Kothariet al. (2006) in two ways. First, we recognize the possible insider trading profit asan additional motive for earnings management. For example, even for under-valuedfirms, managers have an incentive to use income-decreasing earnings managementand profit from purchasing shares. Second, their analysis is bivariate in nature. Wetest our hypotheses by explicitly analyzing the over- and under-valued firms in amultivariate regression setup.

Following several high-profile financial reporting frauds, the US Congress imple-mented the Sarbanes-Oxley Act of 2002 designed to improve accountability, reducefinancial deception and protect investors.11 The emerging evidence on the effective-ness of SOX in curtailing opportunistic earnings management provides some evidenceindicating that it has been successful but the evidence is not unequivocal. Both Liet al. (2008) and Zhang (2007b) conduct event studies, estimating stock pricereactions to SOX legislation to infer investors’ expectations about the costs andbenefits of the reforms. Li et al. (2008) find that returns are positively related tothe level of earnings management in the pre-SOX period, which is consistent withthe anticipation that SOX would be effective in curtailing opportunistic earningsmanagement. On the other hand, Zhang (2007b) finds statistically significant negative

11 The establishment of PCAOB, requirement of certification by CEOs and CFOs of financial statementssubject to criminal liability, requirement of financial disclosure, including material off-balance sheettransactions, on a rapid and timely basis etc. are a few of the specific provisions of SOX that could reduceopportunistic earnings management.



abnormal returns, which she attributes to the net effect of costs related to non-auditservices and governance provisions.12

Cohen et al. (2008) investigate the influence of SOX on earnings management.They find evidence of an increase in earnings management leading up to SOX thatis concurrent with an increase in equity-based compensation. In the post-SOX period,they find a decrease in accrual-based earnings management. However, they find anincrease in real earnings management. The increase in real earnings managementmay imply that the firms are substituting accrual-based earnings management withreal earnings management. The net effect is not clear. Given the potentially highercosts of real earnings management, these results may suggest that the costs of earningsmanagement have increased in the post-SOX period.

Several studies report evidence of a decline in earnings management in the post-SOX period. Lobo and Zhou (2010) use a matched sample of dual- and domestically-listed Canadian counterpart firms and find that firms subject to SOX have lowerdiscretionary accruals and follow more conservative accounting practices in the post-SOX period. This result is more pronounced for firms that were aggressive in the pre-SOX period. Mitra et al. (2009) also report lower discretionary accruals in the post-SOX period, which they relate to auditor effort in mitigating reporting bias. Koh et al.(2008) find that the incidence of meeting or just beating analyst forecasts declines andits relationship to future cash flows strengthens following SOX, consistent with lowerearnings management.

Brochet (2010) provides evidence of the impact of SOX on insider trading. Heinvestigates the effect of the insider trading disclosure regime under SOX, whichreduced insiders’ reporting window from 10 days (1934 Exchange Act) to 2 days. Hisresults suggest an improvement in transparency, including the increase in abnormalreturns following purchases and a reduction in incentives to sell ahead of privatelyknown negative news.

We investigate the effect of SOX on opportunistic earnings management motivatedby insider trading by testing the following hypothesis:

H3: Trading and accrual-based earnings management are related during the pre-SOX period, but there is no association between trading and accrual-based earningsmanagement in the post-SOX period.

We next consider the relationship between insider trading and real earnings man-agement. Managers can manipulate reported earnings through business operationsthat deviate from normal practices, such as: increasing sales through pricing and creditpolicies, managing discretionary expenditures, selling profitable assets and engagingin over- or under-production. In a survey by Graham et al. (2005), managers identifystrategies, like decreasing discretionary expenditures or delaying a project, whichare employed in order to achieve desired earnings numbers. Studies using archivalempirical methods indicate that executives manage earnings through sales (Bartov,1993; Roychowdhury, 2006), research and development expenditures (Dechow andSloan, 1991; Barber et al., 1991) and other discretionary expenditures (Roychowdhury,2006).

12 Zhang (2007) uses non-US-traded foreign firms as the benchmark in estimating abnormal returns. Leuz(2007) acknowledges the quality and importance of the work, but questions the conclusion that the resultsare due to SOX pointing to a problem of confounding events.



Real earnings management results in permanent economic consequences. Alteringnormal operations in order to meet a particular accounting target is sub-optimal andultimately erodes firm value. Managers face a choice in trading off the perceivedbenefits of achieving their desired earnings target relative to the costs of deviatingfrom optimal operating, financing or investing choices. Empirical evidence thatmanagers engage in real earnings management suggests that incentives to meetearnings expectations or reduce earnings volatility are sufficiently high to offset theeconomic costs.

In investigating the relationship between insider trading and real earnings man-agement, we consider the interrelation between managerial trading incentives, per-manent negative effects of real earnings management, and litigation risk. Althoughthe costs of real earnings management, due to sub-optimal decisions, exceed those ofaccruals-based earnings management, prior research provides little empirical evidenceconsistent with this conjecture.13 If managers deem the trading gains insufficient tooffset the erosion in future performance, notwithstanding litigation risk, we wouldnot expect to find an association between real earnings management and trading.On the other hand, extant research finds evidence that managers consider the threatof litigation in choosing their trading strategy (Ke et al., 2003; Beneish et al., 2005).Abnormal accruals may attract scrutiny, whereas real earnings management is moredifficult to detect and may be a preferred method of sustaining misvaluation. Also,Zang (2007) and Cohen et al. (2008) argue that accrual-based earnings managementand real earnings management act as substitutes. If managers choose real activitiesover accruals to sustain misevaluation, the adverse effect of real earnings managementon future performance further enhances the incentive to sell.

Thus, the association between real earnings management and insider trading is anempirical issue. Therefore, we state this hypothesis non-directionally as follows:

H4: There is no association between real earnings management and insider trading.

Finally, we investigate an important question raised by Cohen et al. (2008): did man-agers switch from accrual-based earnings management to real earnings managementafter the implementation of SOX? This question is motivated in part by Graham et al.’s(2005) survey evidence which suggests that executives alter operating and investingactivity in order to achieve short-term earnings targets. Furthermore, the respondentsexpress a preference for these mechanisms over accruals management. The authorsspeculate that this may be “ . . . a consequence of the stigma attached to accountingfraud in the post-Enron and post-Sarbanes-Oxley world.”14

Researchers are just beginning to document the interaction between, and costs of,real and accrual-based earnings management. Zang’s (2007) results suggest that theyact as substitutes. Cohen and Zarowin (2010) find consistent evidence in the contextof SEOs. Cohen et al. (2008) find that the use of accrual-based earnings managementincreased in the pre-SOX period (which they link to the increase in equity-basedcompensation) while real earnings management declined. After the passage of SOX,they find that the pattern reverses, thus leading to the conclusion that managers, onaverage, switched methods. We investigate whether SOX prompted a change in the

13 Gunny (2010) finds a negative relationship between opportunistic real earnings management and futureperformance. Cohen and Zarowin (2010) report evidence that costs of real earnings management exceedthe costs of accrual earnings management in the case of SEOs.14 See Graham et al. (2005) for detail.



form of insider trading motivated earnings management by measuring the relationshipin the pre- and post-SOX periods.

3. EMPIRICAL RESULTS

(i) Data and Methodology

Our sample spans the 1992 to 2006 period.15 We collect insider trade data fromThomson Financial. Like most studies examining the association between insidertrading and earnings-related events, we narrow the definition of insiders to directorsand officers (Ke, Huddart and Petroni, 2003; Roulstone, 2003; Sawicki and Shrestha,2008). We only consider open market purchases and open market sales. We obtain allof the accounting data from COMPUSTAT. We exclude firms in regulated industries(Zhang, 2007a),16 those with a negative book value of equity, and book value of assetsless than US$ 10 million (Hribar and Collins, 2002). After matching the insider datawith the COMPUSTAT data, the sample comprises 33,946 firm–year observations.17 Wewinsorize all continuous variables at the 1st and 99th percentiles.

(a) Insider Trading Measure

Prior research has employed various indices and ratios to measure insider tradingbehavior (see Beneish, 1999). We use the following net purchase ratio (NPR):

NPRi,t = Buyi.t − Sell i,t

(Buyi,t + Sell i,t), (1)

where Buyi,t (Selli,t) equals the number of shares purchased (sold) by registered insidersof firm i during fiscal year, t. We compute annual insider purchases and sales for eachfiscal year. Even though NPR is a continuous variable that takes values between –1 to 1,for bivariate analysis, we categorize it into five discrete groups as “All Buy”, “Buy”, “Buyequal Sell”, “Sell” and “All Sell” (see Figure 1).

(b) Accrual-based Earnings Management

Accounting accruals are commonly used to measure the level of earnings man-agement.18 Total accruals can be decomposed into non-discretionary (NDA) anddiscretionary accruals (DA) which measure the level of earnings management. Wecalculate total accruals using the following equation:

TAi,t = NDAi,t + DAi,t , (2)

15 The sample begins in 1992 because the Thomson Financial database covers very few firms for earlieryears.16 That is, firms with SIC code greater than or equal to 4900 and less than or equal to 4999 and firms withSIC code greater than or equal to 6000 and less than or equal to 6999.17 We use insider trading during the fiscal year. To increase the sample size, we do not restrict our sampleto the firms with December fiscal year ends.18 See Beneish (2001) for a discussion of earnings management: definition, pervasiveness and measure-ment.



Figure 1Transaction Groups based on Net Purchase Ratio (NPR)

Note:“All Buy” and “All Sell” represent firm–year data with NPR = 1 and NPR = –1,

respectively. Firm–year data with NPR less than 1 and greater than or equal to 0.5belong to the “Buy” group. Firm–year data with NPR greater than –1 and less than

–0.5 belong to the “Sell” group. Remaining firm–year data belong to “BuyeqSell” or“Buy equal Sell” group.

All Sell, NPR = -1 All Buy, NPR = 1Sell

-1 < NPR < -0.50Buy = Sell

-0.50 ≤ NPR < 0.50Buy

0.5 ≤ NPR < 1

where:

TAi,t = total accruals for firm i in year t,NDAit = non-discretionary accruals for firm i in year t, andDAit = discretionary accruals for firm i in year t.

Hribar and Collins (2002) argue that the balance sheet based measurement oftotal accruals is contaminated by measurement error. Therefore, following Hribar andCollins (2002) we use cash flow statement data to compute total accruals19 and definetotal accruals (TA) as earnings before extraordinary items (data #123) less cash flowfrom operations (data #308 – data #124). We use the cross-sectional modified Jonesmodel proposed by Dechow et al. (1995) to decompose total accruals into the non-discretionary and discretionary accrual (DA) components (Defond and Jiambalvo,1994; Defond and Subramanyam, 1998).20 We estimate the following cross-sectionalModified Jones model by industry and year using two-digit SIC code peers with at least10 observations:21

TAi,t

Ai,t−1= α0 + α1

(1

Ai,t−1

)+ α1

(�REV i,t − �RECi,t

Ai,t−1

)+ α2

(PPEi,t

Ai,t−1

)+ εi,t , (3)

where:

Ai,t = Total assets for firm i in year t (data #6),�RECi,t = change in receivables firm i in year t (data #2),�REVi,t = change in revenue for firm i in year t (data #12), andPPEi,t = gross property, plant and equipment for firm i in year t (data #7).

Then, we use the residual from the regression as the measure of discretionaryaccruals and denote it as MDA.

To determine misvaluation, we identify value and growth firms following a methodsimilar to that used by Lakonishok et al. (1994) and double-sorts using the book-to-market ratios and sales growth rates, where undervalued firms are “value” firms andovervalued firms are “growth” firms. Specifically, we sort the firms by book-to-market

19 See also, Xie (2001) and Armstrong et al. (2008).20 We find similar results using the basic Jones (1991) model.21 In the model, we include the intercept. We follow Kothari et al. (2005) who identify improvements fromusing this specification.



value of equity (BM) with the highest 30% considered “BM value” and the lowest 30%“BM growth”. We also rank firms based on the past 5 years’ weighted sales growth(SG). We begin by sorting the firms into the highest 30, middle 40, and the lowest30% in sales growth for each of Years –1, –2, –3, –4 and –5. Then, we compute theweighted average rank, giving the weight of 5 to its growth rank in Year –1, the weightof 4 to its growth rank in Year –2, etc. “SR growth” and “SR value” firms are the highest30% and the lowest 30% of the firms in terms of weighted average sales growth rank,respectively. Finally, we compute the combined classification where, the firms which areboth “BM value” and “SG value” are considered “value” firms. Similarly, the firms whichare classified as both “BM growth” and “SG growth” are considered “growth” firms.

Using bivariate tests, we investigate the association between insider trades andmisvaluation, where insiders buy value (undervalued) firms and sell overvalued(growth) firms. However, a simple bivariate analysis of discretionary accruals (earningsmanagement) may not provide a clear picture because discretionary accruals maydepend on various factors in addition to insider trading.22 Therefore, we test ourhypotheses using multivariate analysis, estimating the following equation:

DAi,t =β1+β2NPRi,t +β3OCF i,t +β3EMPGRi,t +β4Sizei,t +β6Levi,t +α7Liti,t +e i,t . (4)

where:

OCFi,t = cash flow from operations excluding extraordinary items (data #18 – TA)divided by lagged total assets,

EMPGRi,t = employee growth rate ((data #29 – lagged data #29)/lagged data #29),Sizei,t = natural logarithm of the market value of equity,Levi,t = leverage (data #9/data#6), andLiti,t = litigation risk industry dummy equal to 1 if the firm is in pharmaceutical,

biotechnology, computer, electronics or retail industries, and 0 otherwise (Chengand Warfield, 2005).

We test our hypotheses based on the significance of the coefficient on NPR, β2. Ifmanagers act opportunistically, the coefficient β2 should be negative, which indicatesthat when managers purchase shares (i.e., NPR is positive), they use income-decreasingearnings management and when they sell (i.e., NPR is negative), they use income-increasing earnings management. In order to test hypotheses H1 and H2, we dividethe sample into subsamples of “value” firms and “growth” firms. Using these two sub-samples, we estimate two values of β2 and compare: β2

Growth and β2Value.

A significantly negative β2 estimate is consistent with opportunistic earningsmanagement. We expect to find opportunistic earnings management in the case ofovervalued firms (H1) where managers respond to incentives to prolong overvaluationand sell their shares. We posit a significantly negative coefficient for the growthsample, β2

Growth. The conflicting incentives faced by managers of undervalued firmsleave the sign of the association an empirical question. We test the null hypothesisof no association for the value sample (H2), which predicts an insignificant β2

Value

coefficient.

22 Several studies establish a negative relationship between operating cash flow and accruals (for example,Dechow et al., 1998). EMPGR proxies for investment-related growth and is included to control for the effectof investment activities which co-vary with accruals (Zhang, 2007). Other variables which have been shownto affect discretionary accruals are: firm size, leverage and litigation (Cheng and Warfield, 2005).



In addition, we expect asymmetry in the relationship because of the differentincentives created by over- versus under-valuation. If the association between earningsmanagement and insider trading is asymmetric with managers responding more read-ily to overvaluation than to under-valuation, we should find β2

Growth to be significantlylower than β2

Value (note that since beta is negative, a lower value for the βestimateindicates a stronger association between trading and earnings management becauseas the magnitude of selling increases, our measure of insider trading, purchase ratio,falls). An insignificant β2

Value is also consistent with the asymmetric expectation.We perform subsample analysis, estimating the regression for the whole sample, as

well as the pre- and post-SOX sub-samples. We test the effectiveness of SOX in curtail-ing insider-trading-based opportunistic earnings management (H3) by comparing thepre-SOX β2

Growth and β2Value estimates to the post-SOX estimates. In order to get clearer

results, we exclude the year 2002 from both pre- and post-SOX period because SOXwas enacted midway through this year.

(c) Real Earnings Management

Next, we turn to the real earnings management tests. We use the three measuresof real earnings management, overproduction and discretionary expenditure, closelyfollowing the method used by Cohen et al. (2008) and Roychowdhury (2006). Weestimate the normal level of production costs as follows:

Pr odi,t

Ai,t−1= k1

(1

Ai,t−1

)+ k2

(REV i,t

Ai,t−1

)+ k3

(�REV i,t

Ai,t−1

)+ k4

(�REV i,t−1

Ai,t−1

)+ εi,t , (5)

where the production costs (Prodi,t) is defined as the sum of COGS (data#41) and thechange in inventories (data#3). Similarly, the normal level of discretionary expenses isestimated as:

DiscExpi,t

Ai,t−1= k1

(1

Ai,t−1

)+ k2

(REV i,t−1

Ai,t−1

)+ εi,t , (6)

where discretionary expenditures (Disc E xp i,t) are the sum of advertising expense(data#45), R&D expense (data#46) and SG&A expense (data#189). Finally, we esti-mate the normal level of cash flow from operations (CFO, data#308 – data#124) as:

CFOi,t

Ai,t−1= k1

(1

Ai,t−1

)+ k2

(REV i,t

Ai,t−1

)+ k3

(�REV i,t

Ai,t−1

)+ εi t (7)

We estimate these regressions for each two-digit SIC code and year with at least eightobservations (Cohen et al., 2008). We then use the residuals from these regressionsas the abnormal production cost, abnormal discretionary expenses and abnormalcash flow from operations. Finally, we use abnormal production cost minus abnormaldiscretionary expenses minus abnormal cash flow from operations as a single measureof real earnings management (REM) (Badertscher, 2011). Therefore, higher REMmeans income-increasing real earnings management.

In order to test the real earnings management hypotheses, we test the associationbetween insider trading and real earnings management using REM as the dependent



Table 1Summary Statistics on Net Purchase Ratio (NPR) based on Valuation

‘value’ minusBM Mean Std. Dev N ‘growth’ T-ratio

BM Growth 1 −0.475 0.8000 9,217 0.505 39.734BM Mid Value 2 −0.323 0.8652 12,379 . .BM Value 3 0.030 0.9231 9,254 . .

SalesSG Growth 3 −0.395 0.8419 6,849 0.286 19.989SG Mid Value 2 −0.342 0.8617 9,766 . .SG Value 1 −0.109 0.9153 8,233 . .

Double Sort

Value MinusBM Sales Mean Std. Dev. N growth T-ratio

Growth 1 3 −0.582 0.7360 2,567 0.653 29.658Value 3 1 0.071 0.9213 3,522 . .

Notes:This table reports and compares the Net Purchase Ratio (NPR) of firms sorted into groups based on book-to-market ratio (BM) and past sales growth (SG) where the sample covers a period from 1992 to 2006. BMgrowth (BM = 1) and BM value (BM = 3) firms are the lowest 30% and the highest 30% of the firms basedon BM, respectively. Similarly, SG growth (Sales = 3) and SG value (Sales = 1) firms are the highest 30%and the lowest 30% of the firms based on weighted average sales, respectively. The double sort groups are:growth (BM = 1 & Sales = 3) and value (BM = 3 & Sales = 1). We consider value firms to be undervaluedand growth firms to be overvalued.

variable in the equation (4). As before, if managers act opportunistically, the coeffi-cient β2 should be negative.

(ii) Results

We report the relationship between misvaluation and the insider purchase ratio (NPR)in Table 1. Firms are categorized into value and growth firms based on book-to-marketratio (BM) and past sales growth (SG) where the value group includes the highest30% of firms in terms of BM and the lowest 30% of the firms in terms of SG. Similarly,the growth group includes the lowest 30% of firms in terms of BM and the highest30% of the firms in terms of SG. In all cases, the results indicate that insiders sell(negative NPR) when firms are overvalued (growth) and insiders buy when the firmsare undervalued (value), except for the misvaluation based solely on sales growth.For sales-based misvaluation, although the results are consistent (in that they indicateinsiders are selling more for SG growth firms compared to the SG value firms), theNPR is negative (indicating net selling) for all valuation groups. This result could beattributable to the fact that insiders, in general, sell for diversification purposes.

Table 2 presents the associations between insider trading and both: (1) accrual-based, and (2) real earnings management. The relationship between accrual-basedearnings management and trading is consistent with opportunistic behavior. A com-parison of the two extremes of inside purchase ratio: all buy (NPR = +1.0) and all sell(NPR = –1.0) indicates that all buy firms manage their earnings downward and all sellfirms manage their earnings upward based on the average discretionary accruals.



Table 2Accrual-based and Real Earnings Management for different Transaction Groups

MDA

Mean Std. Dev. Median N

All Buy −0.0057 0.1229 0.0063 9,459Buy −0.0134 0.1311 0.0068 1,698BuyeqSell −0.0031 0.1220 0.0097 3,009Sell 0.0039 0.1094 0.0085 7,191All Sell 0.0050 0.1130 0.0118 12,589

REM

Mean Std. Dev. Median N

All Buy −0.0473 0.4610 −0.0311 8,014Buy −0.0689 0.4822 −0.0447 1,402BuyeqSell −0.1002 0.4797 −0.0876 2,585Sell −0.1791 0.5059 −0.1365 6,262All Sell −0.1816 0.5219 −0.1486 11,000

Notes:MDA represents discretionary accruals estimated with the Modified Jones Model and REM represents realearnings management which is equal to Abnormal Production minus Abnormal Discretionary Expenditureminus Abnormal CFO. Higher values of MDA and REM indicate income enhancing earnings management.The transaction group variables, ‘All Buy’, ‘Buy’, ‘BuyeqSell’, ‘Sell’ and ‘All Sell’ are defined under Figure 1.

The results for real earnings management are contrary to that which would beexpected in an opportunistic scenario. If selling (buying) is associated with incomeincreasing (decreasing) earnings management, we would expect to observe high realearnings management for selling firms relative to buying firms. However, the resultsindicate the opposite: real earnings management (income increasing real earningsmanagement) for all sell is lower than the all buy group.

We estimate a multivariate regression, equation (4), to analyze the relationshipbetween the insider trading and earnings management while controlling for multipleeffects. Also, since we investigate the impact of SOX on the relationship betweeninsider trading and earnings management, we estimate the relationship over sub-periods.

Table 3 presents the regression estimates using data covering the entire sample pe-riod, 1992–2006. The NPR coefficients for both growth and value firms are significantlynegative in all regressions. Selling is associated with upward earnings management andbuying is associated with downward earnings management, regardless of whether thefirm is over- or under-valued. The evidence for growth firms is consistent with the firsthypothesis (H1), which predicts that the managers of overvalued firms respond to theincentive to prolong overvaluation by managing earnings upward, and at the sametime selling their shares. This interpretation is consistent with Chan et al.’s (2006)results, which indicate that firms with high accruals are at a turning point whereprior stellar performance (high returns and earnings in the years prior to the risein accruals) starts to fade. The performance patterns they report suggest that growthis slowing but accruals are used to delay reporting the bad news. An intriguing aspectof their evidence is that in the year that accruals are high and possibly signaling pastgrowth has faded, earnings remain strong. In this context, our evidence linking selling



Table 3Regression of Abnormal Accruals on Insider Trading

Value Growth Value minus Growth

NPR −0.010*** −0.017***

(−5.39) (−3.83)EMPGR 0.034*** −0.005

(4.00) (−0.52)Size 0.007*** 0.005***

(6.45) (2.71)Lev −0.004 −0.055***

(−0.39) (−3.45)Lit −0.018** −0.069***

(−2.41) (−6.54)OCF −0.352*** −0.161***

(−14.46) (−7.20)Constant 0.020 −0.044

(0.61) (−1.16)Difference Between Value and Growth NPR Coefficient 0.007

(1.43)Adjusted R 2 0.160 0.087 0.121Sample size 3,522 2,567 6,089

Notes:The sample comprises firm–year observations for the period 1992 to 2006. Abnormal accruals are estimatedwith Modified Jones Model. Net Purchase Ratio (NPR) represents the insider trading. The control variablesare: operating cash flows (OCF), employee growth (EMPGR), Size (the natural log of the market value ofequity), leverage (LEV), and litigation risk (Lit, industry dummy equal to 1 if the firm is in pharmaceutical,biotechnology, computer, electronics or retail industries, and 0 otherwise). Growth and value firms aredefined in Table 1. All regressions include industry and year dummy variables. t-values are in parentheseswhere the standard errors are corrected for the firm-level clustering. *, ** and *** denote significance at0.10, 0.05 and 0.01, respectively.

and high accruals seems to confirm that managers of growth firms “cash out” at theright time.

Our second hypothesis regarding opportunistic behavior of value firms stems fromthe conflicting incentives that the managers of undervalued firms face, given thenegative consequences of lowering the earnings of these firms. Our evidence indicatesthat the association between trading and accruals is also significant for value firms,leading to a rejection of the null hypothesis which predicts no trading related earningsmanagement for undervalued firms.

Chan et al.’s (2006) operating performance patterns are also helpful in interpretingthis result. They document that low accrual firms are poor performers with decliningprior-year sales and earnings. Low accruals coincide with a trough in operatingperformance where earnings and sales subsequently improve. They speculate that thepatterns they document could indicate that managers, who anticipate an improvementin operating performance following a period of poor performance, reduce currentearnings in order to strengthen the signal of the reversal in their future performance.Bagnoli and Watts (2000) argue that although the literature indicates that currentperformance is a deciding factor in earnings smoothing, expectations may makefuture performance sufficiently important for managers to create hidden reserves andengage in other income smoothing tactics. Our evidence relating insider buying to



Table 4Regression of Abnormal Accruals on Insider Trading: Pre- and Post-SOX Periods

Panel A: Pre-SOX (1992–2002) Panel B: Post-SOX (2003–2006)

Value ValueValue Growth minus Growth Value Growth minus Growth

NPR −0.006** −0.015** −0.017*** −0.024***

(−2.29) (−2.49) (−4.88) (−3.22)EMPGR 0.050*** 0.008 0.010 −0.037**

(3.91) (0.66) (0.88) (−2.29)Size 0.008*** 0.007** 0.004** 0.003

(5.73) (2.43) (2.00) (0.90)Lev −0.010 −0.077*** 0.002 −0.036*

(−0.69) (−3.11) (0.08) (−1.67)Lit −0.018 −0.080*** −0.016* −0.048***

(−1.51) (−5.36) (−1.67) (−3.05)OCF −0.440*** −0.183*** −0.233*** −0.129***

(−13.77) (−6.36) (−5.49) (−3.21)Constant 0.034 −0.034 −0.012 0.005

(0.90) (−0.80) (−0.71) (0.18)Diff. bet. Value

and GrowthNPR coeff.

0.010 0.007

(1.46) (0.88)Adj. R 2 0.237 0.117 0.106 0.094Sample Size 1,991 1,347 1,196 988

Notes:The sample comprises firm–year observations for sub-periods 1992 to 2001 (Pre-SOX) and 2003 to 2006(Post-SOX). Abnormal accruals are estimated with Modified Jones Model. The Net Purchase Ratio (NPR)represents the insider trading. The control variables are: operating cash flows (OCF), employee growth(EMPGR), Size (the natural log of the market value of equity), leverage (LEV), and litigation risk (Lit,industry dummy equal to 1 if the firm is in pharmaceutical, biotechnology, computer, electronics or retailindustries, and 0 otherwise). Growth and value firms are defined in Table 1. All regressions include industryand year dummy variables. t-values are in parentheses where the standard errors are corrected for the firmlevel clustering. *, ** and *** denote significance at 0.10, 0.05 and 0.01, respectively.

low accruals for undervalued firms is consistent with this sort of scenario, where priorbad performance is made even worse through accounting manipulations in order to“clear the decks” today and send a strong signal of improved performance in thefuture.

We further hypothesize that because of the difference in the incentives thatmisvaluation creates for trading and earnings management for overvalued ver-sus undervalued firms, the association should be stronger for the growth firms.The evidence is not consistent with this prediction. Although the NPR coeffi-cient for the growth firms is higher (in absolute magnitude) than that of thevalue firms (0.017 versus 0.010), the difference is insignificant (Table 3, the lastcolumn).

We estimate equation (4) to analyze the impact of SOX on this relationship. Table 4,Panel A presents the results for the pre-SOX sample (where we exclude the year2002). The results are similar to those discussed previously. There is a significantassociation between earnings management and insider trading for both growth and



Table 5The Association between Real Earnings Management and Insider Trading

Value Growth

NPR 0.009 0.024(0.92) (1.38)

ROA 0.013 −0.175***

(0.34) (−4.08)EMPGR −0.032 −0.132***

(−1.10) (−3.21)Size −0.023*** −0.024**

(−3.69) (−2.35)Lev 0.185*** 0.407***

(3.06) (4.42)Lit −0.308*** −0.419***

(−6.07) (−6.31)Constant −0.085 −0.518**

(−0.47) (−2.50)Adj. R 2 0.096 0.195N 3,345 2,309

Notes:The sample comprises firm–year observations for sub-periods 1992 to 2006. The real earnings management(REM), the dependent variable, is equal to Abnormal Production minus Abnormal Discretionary Expendi-ture minus abnormal CFO. Higher value of REM means income increasing real earnings management.The insider trading is represented by Net Purchase Ratio (NPR). The control variables are: return onassets (ROA), employee growth (EMPGR), Size (the natural log of the market value of equity), leverage(LEV), and litigation risk (Lit, industry dummy equal to 1 if the firm is in pharmaceutical, biotechnology,computer, electronics or retail industries, and 0 otherwise). Growth and value firms are defined in Table 1.All regressions include industry and year dummy variables. t-values are in parentheses where the standarderrors are corrected for the firm level clustering. *, ** and *** denote significance at 0.10, 0.05 and 0.01,respectively.

value firms. Also, the NPR coefficient is higher for the growth than the value firms(in absolute magnitude) but, again, the difference is insignificant. Table 4, PanelB summarizes the results for the post-SOX period (which also excludes year 2002).Again, the regression results for the post-SOX period indicate that opportunisticearnings management is similar for value and growth firms, with selling (buying)related to income increasing (decreasing) discretionary accruals. Therefore, weconclude that SOX has not been effective in curtailing insider trading related earningsmanagement.

(iii) Real Earnings Management

Tables 5 and 6 present the regression results related to the association between realearnings management and insider trading. Consistent with the null hypotheses thatthere is no association between real earnings management and insider trading, theNPR coefficient is insignificant, regardless of whether the tests are conducted acrossthe entire period (Table 5) or sub-periods (Table 6). One interpretation of theseresults is that the trading profit incentives are not sufficient to offset the detrimentaleffects real earnings management has on firm value.



Table 6The Association between Real Eearnings Management and Insider Trading

Panel A: Pre-SOX (1992–2001) Panel B: Post-SOX (2003–2006)

Value Growth Value Growth

NPR 0.009 0.010 0.005 0.031(0.78) (0.42) (0.33) (1.00)

ROA −0.027 −0.168*** 0.073 −0.344***

(−0.55) (−3.55) (0.98) (−3.10)Employee Growth −0.042 −0.108* 0.008 −0.146**

(−1.06) (−1.92) (0.17) (−2.46)Log MV equity −0.032*** −0.044*** −0.019* 0.004

(−4.08) (−3.22) (−1.91) (0.28)Leverage 0.294*** 0.357*** 0.043 0.466***

(4.19) (2.61) (0.37) (3.72)Litigation −0.239*** −0.419*** −0.373*** −0.410***

(−4.77) (−5.09) (−4.97) (−4.45)Constant −0.123 −0.407* 0.144** −0.015

(−0.54) (−1.84) (1.97) (−0.17)R 2 0.131 0.203 0.110 0.241N 1,886 1,192 1,140 912

Notes:The sample comprises firm–year observations for sub-periods 1992 to 2001 (Pre-SOX) and 2003 to2006 (Post-SOX). The real earnings management (REM), the dependent variable, is equal to AbnormalProduction minus Abnormal Discretionary Expenditure minus abnormal CFO. Higher value of REM meansincome increasing real earnings management. The insider trading is represented by Net Purchase Ratio(NPR). The control variables are: return on assets (ROA), employee growth (EMPGR), Size (the natural logof the market value of equity), leverage (LEV), and litigation risk (Lit, industry dummy equal to 1 if the firmis in pharmaceutical, biotechnology, computer, electronics or retail industries, and 0 otherwise). Growthand value firms are defined in Table 1. All regressions include industry and year dummy variables. t-valuesare in parentheses where the standard errors are corrected for the firm level clustering. *, ** and *** denotesignificance at 0.10, 0.05 and 0.01, respectively.

4. CONCLUSION

We present and test agency-based hypotheses stemming from the incentives thatmisvaluation and insider trading creates for both accrual-based and real earningsmanagement. We also analyze the effect of SOX in eliminating accrual-based earningsmanagement. If SOX has been successful in eliminating accrual-based earningsmanagement, then it is possible that managers may have moved from accrual-basedearnings management to real earnings management in the post-SOX period. Althoughthere is a large body of literature on earnings management, the insider tradingmotive for earnings management has been largely overlooked. Prior evidence onthe effectiveness of SOX in curtailing opportunistic earnings management provides amixed picture, including the possibility that real methods have substituted for accrualsin the post-SOX era.

The theory of overvalued equity predicts that managers of overvalued firms havean incentive to prolong the overvaluation. We argue that profits from insider tradingcreate an additional incentive to prolong the overvaluation using accrual-basedearnings management. The profits from insider trading also create an incentive formanagers of undervalued firms to prolong the undervaluation. However, prolongedundervaluation has several negative effects on the managers of the undervalued



firms. Therefore, we predict the existence of insider trading motivated accrual-based earnings management for the overvalued firms. As with the under-valuedfirms, we predict the extent of the insider trading motivated accrual-based earningsmanagement to be lower compared to the overvalued firms.

We find evidence that managers of value (undervalued) firms are net buyersand managers of growth (overvalued) firms are net sellers of the firms’ shares. Wealso find insider trading motivated accrual-based earnings management for boththe over- and under-valued firms. Even though the extent of earnings managementfor overvalued firms is higher relative to undervalued firms, the difference is notstatistically significant.

Regarding the effectiveness of SOX in eliminating accrual-based earnings manage-ment, we find similar evidence of insider trading motivated accrual-based earningsmanagement for both the pre-SOX and post-SOX periods. Therefore, we concludethat SOX seems to have been largely ineffective in eliminating insider trading relatedaccrual-based earnings management.

We do not find evidence of insider trading motivated real earnings management forthe entire period or for the pre- and post-SOX sub-periods. This result could be dueto the fact that the costs associated with real earnings management are high enoughto offset any benefits from insider trading.

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Documents

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