The article by Beneish and Vargus examines the issue of insider trading and the possibility to use the information about it so as to assess the quality of earnings (i.e., to find out whether the chance of stable earnings in the future is high or low), as well the implications of accruals pertaining to the valuation (756).
In order to analyze the problem, the authors studied the sample comprising 21,678 firm-years of 3,906 various companies over a period of 1985-1996 (Beneish and Vargus 760). The investigation was conducted by employing three steps: 1) checking if the information related to insider trading can be meaningful in forecasting the quality of earnings (that is, their stability) of a company over the period of one year starting at the point at which the data was collected; 2) employing the market pricing tests, as well as the hedge portfolio tests, in order to find out if the scope of accrual mispricing varies significantly between enterprises that suffer from a low earnings quality, on the one hand, and the companies which enjoy a high earnings quality, on the other; 3) inspecting the degree to which the poor quality of earnings can be considered a consequence of the way in which the company’s earnings are managed. Thus, a number of tests were carried out in order to find out whether the data supports the six hypotheses related to the level of persistence of income-increasing accruals in a situation when there is abnormal insider buying; to the scope to which the earning expectations as reflected in the prices of shares can be used in order to forecast the level of persistence of accruals that boost the amount of incomes and are associated with either abnormal insider selling or abnormal insider buying; to the persistence of income-lowering accruals that are associated with abnormal insider buying or selling; and to the scope to which the earning expectations as reflected in the prices of shares can be employed so as to predict the level of persistence of accruals that lower the level of incomes and are associated with either abnormal insider selling or abnormal insider buying (Beneish and Vargus 759-760).
Upon conducting the tests, the authors were able to gain a number of results which demonstrate that: 1) the level of persistence of accruals that boost the incomes of a company over the period of one year from the point at which the data was collected is much lower when abnormal insider selling accompanies it, and is significantly higher in the situation when abnormal insider buying accompanies it; 2) the mispricing of accruals that was considered in previous studies actually results from the mispricing of accruals that boost incomes; 3) investors seem to create prices for the accruals that enhance the levels of income in a way which would be employed if these accruals were of high-quality; 4) the one-year-ahead hedge turns back to the trading policy which is grounded upon the direction of accruals, and the insider trading is much higher than that which is grounded only on accruals; 5) the small levels of persistence of accruals that positively affect the income and are accompanied by abnormal scope of insider selling can be at least partially explained by employing the data pertaining to the opportunistic earnings management (Beneish and Vargus 787-789).
Beneish, Messod D., and Mark E. Vargus. “Insider Trading, Earnings Quality, and Accrual Mispricing.” The Accounting Review 77.4 (2002): 755-791. JSTOR. Web.