Overvalued Equity and the Accruals Anomaly: Evidence from Insider Trades

Abstract

This paper examines the accruals anomaly in an agency context where managers of overvalued firms engage in various activities, including accruals-based earnings management, to sustain overvaluation. We use managerial trading to operationalize the empirical investigation, hypothesizing that mangers anticipate the ultimate share price reversals, and use high accruals to temporarily sustain overvaluation while at the same time sell their shares. There is no incentive to deflate earnings of undervalued firms, leading to the prediction of an asymmetric relationship between trading and accruals. We contrast this to the fixation hypothesis where high (low) accruals are associated with negative (positive) returns. Although investor errors are operative in both agency and fixation, the causes, mechanisms and implications are very different. Our results, which are important to the distinction, support an agency explanation for the anomaly. Quadratic and binary regressions confirm an asymmetric relationship between trades and accruals concentrated on the selling side. The relationship between accruals and trading is only significant within the overvalued, low book-to-market (BM) firms. There is also evidence that low BM firms manage their earnings upward compared to high BM firms. Tests using a subset of firms sorted on valuation ratios and past growth provide evidence of a strong relationship between insider sales and income increasing accruals for the glamour firms while buying and accruals are not related for the value firms.