Review of Quantitative Finance and Accounting, 15 (2000): 325347

# 2000 Kluwer Academic Publishers. Manufactured in The Netherlands.

Information Asymmetry and Earnings Management:

Some Evidence
VERNON J. RICHARDSON
Division of Accounting and Information Systems, University of Kansas, Lawrence, KS 66045
E-mail: vrichardson@ukans edu

Abstract. This paper conducts an empirical investigation of the relationship between information asymmetry
and earnings management predicted by Dye (1988) and Trueman and Titman (1988). When information
asymmetry is high, stakeholders do not have sufcient resources, incentives, or access to relevant information to
monitor manager's actions, which gives rise to the practice of earnings management (Schipper, 1989; Wareld
et al., 1995). Empirical results suggest a systematic relationship between the magnitude of information
asymmetry and the level of earnings management in two different settings.

Key words: earnings management, information asymmetry, monitoring, seasoned equity offerings

JEL Classication: M41, G14, G34

I. Introduction

Accounting standards allow for managerial discretion in the application of accounting

methods used to report rm performance. When this discretion is used with the intent to
manipulate reported results, it is called earnings management. Growing anecdotal and
systematic evidence supports the argument that earnings management is a common
practice in rms.1 This study attempts to identify the environmental conditions that give
rise to the practice of earnings management. Managers possess private information about
the rm and its current and prospective earnings streams that current and potential
shareholders do not have (i.e., information asymmetry exists between managers and
shareholders) which may allow manage them to manage earnings. In this paper I
investigate the relationship between information asymmetry and earnings management.
Analytical models have demonstrated that the existence of information asymmetry
between rm management and rm shareholders is a necessary condition for the practice
of earnings management (Trueman and Titman, 1988; Dye, 1988). However, there has
been little, if any, empirical work investigating this relationship. Schipper (1989) argues
that this lack of empirical testing of the information environment surrounding earnings
management represents a slippage between analytical models and empirical tests of
earnings management. Schipper also suggests the need for empirical work that addresses
the environmental conditions surrounding the practice of earnings management.
This paper hypothesizes that the magnitude of information asymmetry affects the
magnitude of earnings management practiced by rm managers. When information
asymmetry is high, stakeholders do not have the necessary information to ``see through''
326 RICHARDSON

the managed earnings. When shareholders have insufcient resources, incentives, or

access to relevant information to monitor manager's actions, earnings management can
also occur (Schipper, 1989; Wareld, Wild, and Wild, 1995). This hypothesis is tested in a
broad sample setting as well as around a seasoned equity offering.
Test results in the broad sample setting suggest a signicant, positive relation between
measures of information asymmetry (bid-ask spreads and analysts forecast dispersion) and
earnings management, after controlling for other previously documented determinants of
earnings management. These ndings are consistent with analytical evidence that the
greater the information asymmetry between management and its shareholders, the more
likely the rm is to manage accruals and earnings.
Earnings management around seasoned equity offerings serves as a second setting to
test the relation between information asymmetry and earnings management. Shivakumar
(1996) and Rangan (1998) provide evidence of earnings management around seasoned
equity offerings. They indicate that management faces the incentive to manage earnings
upwards around a seasoned equity offering to maximize the offer price for its shares of
stock. I test whether the presence of information asymmetry affects the extent of earnings
management in a setting where management faces a strong incentive to manage earnings
Results suggest a systematic relationship between information asymmetry and earnings
management around seasoned equity offerings.
The remainder of this paper is organized in the following manner. Section II develops
the hypothesized relationship between information asymmetry and earnings management
Empirical measures that proxy for information asymmetry and earnings management are
developed in Section III. The sample data, research design and empirical results for the
broad sample setting are described in Section IV. Empirical results from the seasoned
equity offering sample are discussed in Section V. The nal section includes the summary
and conclusions.

II. Hypothesis development

Setting for earnings management

Figure 1 is a graphical representation of the process of communicating information about a

rm's underlying earnings process to the investor. Assume that the manager of the rm
views the earnings gure X~it , which is earnings measured before any incremental
manipulation.2 Managers then choose their level of earnings management MAAit , subject
to the different incentives and constraints that they face, and report accounting earnings
Ait to investors. The relation between earnings before incremental manipulation X~it
and the reported accounting earnings Ait is

Ait X~it MAAit 1

where,
INFORMATION ASYMMETRY 327

Figure 1. Simplied setting for earnings management: Information ows to investors.

Ait accounting earnings reported to investors by rm i at time t;

MAAit managed accounting accrual by rm i at time t;
X~it earnings before incremental manipulation.

Assuming no fraudulent reporting, at least two factors limit the extent of earnings
management MAAit . First, GAAP denes limits within which reported earnings can
deviate from earnings before incremental manipulation (Chaney and Lewis, 1995) GAAP
requires that reported earnings be a function of the earnings viewed by managers
Ait f X~it . GAAP also serves as a disciplining mechanism by restricting managers
from consistently P over- orPunder-reporting earnings, since over the long term
EMAAit 0 and X~it Ait .
A second factor that affects the level of earnings management MAAit is the extent of
information known by outsiders about rm performance (consider gure 1). Investors
have access to the amount of earnings reported by management Ait , but investors also
have access to other publicly reported information about the rm. Financial analysts, labor
unions, large shareholders, industry trade journals and outside board members monitor and
report information about the protability and status of the rm. To the extent that such
outside sources are successful in monitoring the protability and performance of the rm,
information asymmetry between management and shareholders will be reduced. But when
information asymmetry is high, outside stakeholders do not have the necessary
information to monitor management or their accounting choices.
In analytical models of earnings management, Dye (1988) and Trueman and Titman
(1988), rely on persistent information asymmetry as a condition for earnings management.
For example, Dye (1988) assumes an overlapping generation of owners. Selling
shareholders instruct management to follow a certain earnings management strategy to
create a favorable impression on the buying group. In this model, the manager knows
something about earnings that shareholders do not. A condition that must be met for
328 RICHARDSON

earnings management to exist in such a model is that the information asymmetry must
persist throughout the transaction. Assumptions about proprietary costs of disclosure,
accounting rules and other institutional and contractual constraints suggest there is a
restriction on total communication between management and shareholders. Information
asymmetry does not dissipate over time because a form of blocked communication cannot
be eliminated by changing the contractual arrangements (Schipper, 1989).3
High levels of information asymmetry between managers and shareholders is evidence
of shareholders lacking sufcient resources, incentives or access to relevant information to
monitor manager's actions (Schipper, 1989; Wareld, Wild and Wild 1995). For example,
management of rms with debt contracts may have incentives to manage earnings over
time to avoid debt covenant violations. When information asymmetry is high, such rms
may be able to manage earnings around those debt contracts without being detected.
Therefore, the greater the information asymmetry, the more likely the rm will not be
monitored as effectively as rms with less information asymmetry between rm
management and shareholders. Figure 2 gives an example of the relationship between
incentives, constraints and potential costs of earnings management.

III. Measurement of information asymmetry and earnings management

Measuring information asymmetry

Bhattacharya and Spiegel (1991) suggest that information asymmetry causes an

unwillingness to trade and increases the cost of capital as investors ``price protect''
themselves against potential losses from trading with better informed market participants.
Lev (1988) argues that observable measures of market liquidity can be used to identify the
perceived level of information asymmetry facing participants in equity markets. Bid-ask
spreads are one such measure of market liquidity that have been used extensively in
previous research as a measure of information asymmetry between management and rm
shareholders. Evidence of the ability of bid-ask spreads to capture the information
environment of the rm is provided by Healy, Palepu, and Sweeney (1995) and Welker
(1995) who report evidence of a negative relationship between bid-ask spreads and rms'
disclosure policies.
Market microstructure theory suggests that one persistent adverse selection problem
facing market makers is the possibility that material rm-specic information has not been
publicly disclosed by the rm (Glosten and Milgrom, 1985; Welker, 1995). Withheld
information may be privately available to select traders who invest in costly information
acquisition, creating an ongoing adverse selection problem. When uncertainty about the
occurrence of information events exists and rms consistently provide incomplete
disclosures with respect to such events (see gure 1), the market maker increases the bid-
ask spread to offset the potential losses of trading with informed traders with gains from
trading with liquidity traders. Therefore, over the long time horizon, when the possibility
that material rm-specic information is not completely disclosed, bid-ask spreads proxy
for the information asymmetry between the manager and the shareholders. In this paper,
INFORMATION ASYMMETRY 329

Figure 2. The effect of incentives, constraints and costs on the level of earnings management (adapted from
Jiambalvo, 1996).

the closing bid and ask quotes for the last trading day of June for each year of the sample
are used as a proxy for baseline market liquidity.
A second measure of information asymmetry between management and shareholders
used in the literature is the dispersion in analysts' forecasts (e.g., Healy, Palepu, and
Sweeney, 1995). Brown and Han (1992) argue that as the amount of information
330 RICHARDSON

asymmetry decreases, there is likely to be a higher consensus among nancial analysts

about the future performance of the rm. Therefore, a measure of the dispersion in
analysts' forecasts is used as a second measure of information asymmetry in this paper.
Using the I/B/E/S database of analysts' forecasts, I estimate the dispersion in analysts'
forecasts as follows:

Std. dev. of analysts' forecasts4

Dispersion in analysts' forecasts (DISP) :
jMedian forecastj

Measuring earnings management

Jones (1991) offers a model to help identify rms that manage earnings. The object of the
Jones model is to segregate expected (nondiscretionary) accruals EACi from the
managed (discretionary) accruals (MAA). Measures of the managed accounting accrual
used in this paper are estimated using Dechow, Sloan and Sweeney's (1995) suggested
modication of the Jones (1991) model.5 This modied Jones model estimates the level of
expected accruals as a function of the difference between the change in revenues and the
change in receivables and the level of property, plant and equipment. Therefore, the model
employed in this paper is expressed as follows:

EACt a0 a1 DREV t DRECt a2 PPEt 2

where

EACt expected normal accrual;

DREV t net revenues in year t less net revenues in year t1;
DRECt net receivables in year t less net receivables in year t1;
PPEt property plant and equipment at time t.

All variables are deated by the beginning-of-period total assets. Both time-series and
cross-sectional methods are used to estimate two alternative measures of earnings
management.
The rst measure of earnings management, jMAA1i j, is estimated using a time-series
approach.6 Estimates of a0 ; a1 , a2 and a3 and expected normal accruals are made using
data from 19761987. These parameters then are used to predict the level of expected
accruals, EAC. Consistent with previous studies of earnings management (Healy, 1985;
Jones, 1991), the accounting accrual ACt is computed as:

ACt DCAt DCLt DCasht DSTDt Dept 3

where
INFORMATION ASYMMETRY 331

DCAt change in current assets;

DCLt change in current liabilities;
DCasht change in cash and cash equivalents;
DSTDt change in debt included in current liabilities;
Dept depreciation and amortization expense.

All variables are deated by the beginning-of-period total assets.

Since the hypothesis does not rely on the direction of the managed accrual, but rather on
the magnitude of the accrual adjustments, test statistics are based on the absolute value of
the managed accrual jMAAi j. Specically, jMAA1i j is estimated in the following fashion

jMAA1i j jACi EAC1i j: 4

A benet to estimating expected accruals using the time-series approach is that,

presumably, the accruals generating process is captured. However, this rm-specic
approach requires a long time-series of data and assumes that the accruals generating
process is constant over time. This assumption may not hold in periods of changing
economic conditions. As an alternative to the time-series estimation, a cross-sectional
approach is used which compares the expected level of accruals for the rms in the sample
with others in the same 2-digit SIC code each year of the test period.7 A cross-sectional
regression employing model (1) is estimated over all rms in the same industry and then is
used to predict the level of expected accruals EAC2 for the test rms The absolute
value of the level of managed accruals, jMAA2i j, is estimated as follows

jMAA2i j jACi EAC2i j: 5

AC is dened in the same manner as in equation (4).

Since both the time-series and the cross-sectional models have advantages and
disadvantages, robustness across models increases our condence in the results obtained
jMAA1i j and jMAA2i j are thus measures of the extent to which accruals and earnings are
managed each year.
Depending on the realization of X e it (earnings before incremental manipulation) each
period, management will determine the sign and the magnitude of the needed
manipulation (see example in gure 1). In some periods, the realized X e it may be exactly
the amount that management needs to meet its objectives In other periods, X e it may be such
that a signicant level of earnings management is not needed for management to meet its
goals. Therefore, a prediction for any single year may not capture the level of earnings
management practiced by the rm. This study attempts to capture the long-run propensity
of rms to manage earnings. For this reason, mean values for each rm-variable are
computed over the test period and used in this study. Similar results are obtained when the
jMAA1i j and jMAA2i j are calculated yearly.
332 RICHARDSON

IV. Research design, sample data and empirical results

Research design

Obviously, information asymmetry between rm managers and shareholders is not the sole
determinant of managers' accounting choices. Figure 2 provides a graphical depiction of
the incentives, constraints and costs of managing earnings. Two incentives for managing
earnings are to reduce political costs and to avoid violating debt covenants. Past research
indicates that political process theory has implications for the determination of accounting
choices (Watts and Zimmerman, 1978). For example, Zmijewski and Hagerman (1981)
suggest that political costs increase with rm size and with rm risk. Managers of large
and/or high-risk rms, therefore, have greater incentives to exploit the latitude in
accounting to reduce these political costs. Firm size, the rm's market-to-book ratio, sales
growth, and the volatility of underlying cash ows are used as proxies for a rm's size and
risk. Given past research, I hypothesize that earnings management is increasing with
respect to the level of rm risk and the volatility of underlying cash ows. Besides the
positive theory implications of rm size, the size of the rm may also be capturing the
rm's information environment and could thus have a negative relationship with the level
of managed accruals. Therefore, I do not predict the sign of the relationship between rm
size and the level of earnings management.
To test the hypothesis, two measures of information asymmetry (bid-ask spreads
BIDASK i and dispersion in analyst forecastDISPi ) and two measures of earnings
management (developed using time-series MAA1i and cross-sectional methods MAA2i
are used). To test all possible combinations four empirical models are derived below:

jMAA1i j a0 ai BIDASK i a2 CFVARi a3 MKTBV i a4 SIZEi a5 GROWTH i ei 6a

jMAA1i j a0 a1 DISPi a2 CFVARi a3 MKTBV i a4 SIZEi a5 GROWTH i ei 6b

jMAA2i j a0 ai BIDASK i a2 CFVARi a3 MKTBV i a4 SIZEi a5 GROWTH i ei 6c
jMAA2i j a0 ai DISPi a2 CFVARi a3 MKTBV i a4 SIZEi a5 GROWTH i ei 6d

where:

jMAA1i j the mean managed accounting accrual under the modied Jones
(1991) model using the time-series estimation approach (see
derivation in Section III);
jMAA2i j the mean managed accounting accrual under the modied Jones
(1991) model using the cross-sectional estimation approach (see
derivation in Section III);
BIDASK i the mean bid-ask spread at the close of trade on the last trading day
of June, scaled by the average of the bid and ask prices;
DISPi the mean standard deviation in analysts' forecasts during the month
of June, scaled by the median forecast of year-ahead earnings for
rm i over the test period.
INFORMATION ASYMMETRY 333

CFVARi the standard deviation of operating cash ows over the test period
divided by the average operating cash ows over the test period;
MKTBV i the mean market capitalization divided by the book value of equity
for rm 1 over the test period;
SIZEi natural log of the mean market capitalization for rm i over the test
period;
GROWTH i net revenues at the end of the test period less net revenues at the
beginning of the test period scaled by net revenues at the beginning
of the test period.

The hypothesis will be tested by estimating a1 . An a1 that is signicantly greater than

zero would provide evidence of a positive relationship between the level of information
asymmetry and earnings management.

Bid-Ask spread sample

The bid-ask spread sample of rms used in testing models (6a) and (6c) is identied from
the Fitch Data sheets and the NYSE Daily Sales Report which provide the closing bid-ask
spreads for all NYSE rms on the last day of June for the years 19881992. For simplicity
and homogeneity, I require that all rms have calendar year-ends. For the time-series
estimation of the modied Jones model, rms must have the full 17 years (19761992) of
Compustat data necessary to estimate the parameters of the modied Jones model. In
addition, both models require Compustat information over the 198892 sample period.
The sample rms also must have price and returns information available on CRSP. After
the data constraints are applied, the sample includes 355 (641) rms over the period 1988
1992 to measure jMAA1i jjMAA2i j.
The jMAA1i j and jMAA2i j variables are derived from the time-series and from the
cross-sectional models, respectively. The jMAA1i j and jMAA2i j samples include rms
from a wide cross-section of industries (41 and 46 industries respectively). In both
samples the electric and gas utilities (84 and 95 rms), chemicals and allied products (35
and 51 rms), and electrical equipment industries (25 and 41 rms) are the industries
with highest representation. Due to the use of NYSE bid-ask information and the
stringent data requirements, the average total assets for both samples are above the 75th
percentile of all Compustat observations. Therefore, the results apply primarily to large
rms.
Some descriptive statistics and a correlation table are provided in Panel A of Table 1.
The average bid-ask spread, BIDASK i , is approximately 11% of share price and ranges
between 0.24% and 7.17%. Welker (1995) reports a comparable average and range in his
sample of bid-ask spreads. It is also interesting to note that the correlation between
jMAA1i j and jMAA2i j is 0.46 and is signicant at a 0.01 level of signicance. This suggests
that the cross-sectional and time-series estimation of the level of abnormal accruals are
capturing a similar phenomena. Other variables appearing in Panel A of Table 1 are
introduced and described in Section V.
334 RICHARDSON

Dispersion in analysts' forecasts (DISP) sample

The dispersion in analysts' forecasts sample used in testing models (6b) and (6d) is
gathered from the I/B/E/S tapes. To be included in this sample, each rm must have
analysts' forecasts from at least ve analysts during the month of June. Data constraints
are similar to those imposed on the bid-ask spread sample. The sample rms are also

Table 1. Descriptive statistics of the bid-ask spread and dispersion in analyst forecast samples

Panel A: Bid-ask spread sample N 355

Descriptive statistics

Variable N Mean Median Maximum Minimum Std. Dev.

jMAA1i j 355 0.0575 0.0396 0.3340 0.0037 0.051

jMAA2i j 641 0.0442 0.0348 0.1737 0.0071 0.033
BIDASKi 355 0.0110 0.0081 0.0717 0.0024 0.014
CFVARi 355 0.7223 0.5536 6.1962 0.0156 0.759
MKTBVi 355 2.0349 1.5674 13.695 0.4687 1.507
SIZEi 355 7.0846 7.1644 11.113 2.0731 1.603
GROWTHi 355 0.2160 0.1073 3.4289 1.0103 0.470

Correlation table

jMAA1i j jMAA2i j BIDASKi CFVARi MKTBVi SIZEi GROWTHi

jMAA1i j 0.541 0.236 0.472 0.028 0.285 0.075

jMAA2i j 0.467 0.235 0.407 0.080 0.235 0.015
BIDASKi 0.262 0.293 0.322 0.362 0.802 0.214
CFVARi 0.257 0.199 0.209 0.161 0.340 0.112
MKTBVi 0.001 0.099 0.205 0.115 0.408 0.461
SIZEi 0.283 0.244 0.597 0.240 0.363 0.216
GROWTHi 0.099 0.024 0.105 0.184 0.360 0.363

Note: All of the descriptive statistics above reect the jMAA1i j sample (with 355 observations) except for the
statistics for the variable, jMAA2i j. All correlation coefcients with an absolute value above 0.10 or greater
are signicant at a 0.05 level of signicance (two-tailed). The Pearson correlation coefcients appear in the
lower diagonal, the Spearman rank correlation coefcients appears in the upper diagonal.

Panel B: Dispersion in analysts' forecasts sample N 422

Descriptive statistics

Variable N Mean Median Maximum Minimum Std. Dev.

jMAA1i j 422 0.0354 0.0291 0.1481 0.0034 0.032

jMAA2i j 539 0.0377 0.0305 0.1433 0.0001 0.034
DISPi 422 0.0974 0.0561 0.4942 0.0077 0.097
CFVARi 422 0.4124 0.2932 5.7266 0.0243 0.587
MKTBVi 422 2.2228 1.7046 12.934 0.1667 1.629
SIZEi 422 7.2652 7.2431 11.154 3.2626 1.413
GROWTHi 422 0.4613 0.2570 4.9003 1.1363 0.658
INFORMATION ASYMMETRY 335

Table 1. (Continued)

Correlation table

jMAA1i j jMAA2i j DISPi CFVARi MKTBVi SIZEi GROWTHi

jMAA1i j 0.540 0.175 0.531 0.104 0.254 0.249

jMAA2i j 0.461 0.228 0.496 0.168 0.219 0.336
DISPi 0.133 0.174 0.399 0.358 0.252 0.111
CFVARi 0.357 0.230 0.195 0.054 0.454 0.281
MKTBVi 0.003 0.071 0.092 0.031 0.322 0.356
SIZEi 0.242 0.218 0.126 0.250 0.310 0.188
GROWTHi 0.264 0.335 0.167 0.039 0.214 0.022

Notes: All of the descriptive statistics above reect the jMAA1i j sample (with 422 observations) except for
the statistics for the variable, jMAA2i j: All correlation coefcients with an absolute value above 0.10 or
greater are signicant at a 0.05 level of signicance (two-tailed). The Pearson correlation coefcients appear
in the lower diagonal, the Spearman rank correlation coefcients appear in the upper diagonal.
Variable Denitions
MAA1i the mean managed accounting accrual under the modied Jones (1991) model using the
time-series estimation approach (see derivation in Section III in the text);
MAA2M i the mean managed accounting accrual under the modied Jones (1991) model using the
cross-sectional estimation approach (see derivation in Section III in the text);
BIDASKi the mean bid-ask spread at the close of trade on the last trading day of June, scaled by the
average of the bid and ask prices;
DISPi the mean standard deviation in analysts' forecasts during the month of June, scaled by the
median forecast of year-ahead earnings for rm i over the test period;
CFVARi the standard deviation of operating cash ows over the test period divided by the average
operating cash ows over the test period;
MKTBVi the mean market capitalization divided by the book value of equity for rm i over the test
period;
SIZEi natural log of the mean market capitalization for rm i over the test period;
GROWTHi net revenues at the end of the test period less net revenues at the beginning of the test
period scaled by net revenues at the beginning of the test period.

required to have price and returns information available on CRSP. After data constraints
are applied, the sample includes 422 (539) rms over the period 19881994 to measure
jMAA1i jjMAA2i j
The jMAA1i j and jMAA2i j samples represent rms from a wide cross-section of
industries (48 and 53 industries, respectively). Similar to the bid-ask sample, the utility,
chemicals and allied products, and electrical equipment industries have the highest
representation. Also, due to the requirement of at least ve analysts providing earnings
forecasts and the stringent data requirements, the average total assets for both samples is
above the 70th percentile of all Compustat observations. Therefore, the results presented
here should be interpreted as applying to large rms.
Some descriptive statistics and a correlation table are provided in Panel B of Table 1.
The average dispersion in analysts' forecasts, DISPi , is 9.74% and ranges from 0.77% to
49.42%. Similar to the bid-ask spread sample, it is also interesting to note that the
correlation between jMAA1i j and jMAA2i j is 0.46 and is signicant at a 0.01 level of
signicance. This suggests that both the cross-sectional and time-series estimation of the
336 RICHARDSON

level of abnormal accruals are capturing the same phenomena. Other descriptive statistics
and a correlation table appear in Panel B of Table 1.
For both the bid-ask sample and the dispersion in analysts forecasts sample, I winsorized
all observations below the 1st and above the 99th percentile of observations to control for
the possible inuence of extreme observations.8
The correlations presented in Panel A of Table 1 indicate a correlation between bid-ask
spreads and the earnings management measures jMAA1i j and jMAA2i j of 0.262 and 0.293,
respectively. Panel B of Table 1 shows the correlation between the dispersion in analysts
forecasts DISPi and the earnings management measures jMAA1i j and jMAA2i j of 0.133
and 0.174, respectively. Each of these correlations between the measures of earnings
management and the measures of information asymmetry is signicantly greater than zero
at a 0.01 level of signicance.

Estimation results

Table 2 shows the results of the OLS regression of the relation between information
asymmetry and earnings management under both methods of estimating the level of
earnings management (jMAA1i j and jMAA2i j) examined in this paper for the bid-ask
spread sample. When jMAA1i j is the dependent variable in Panel A, the coefcients on the
control variables CFVARi and GROWTHi take on the expected sign and are signicantly
greater than zero. The coefcient on SIZEi is negative and signicant, which may suggest
that size is a proxy for information environment surrounding the rm. The coefcient on
the bid-ask spreads is 0.620 with a t-statistic of 2.086, which is signicantly greater than
zero at a 0.01 level of signicance. The overall t of the regression equation is
demonstrated by the adjusted R2 , which is reasonable at 14.8%. The overall t of each of
these regression models) compares favorably to those of Wareld, Wild and Wild's (1995)
adjusted R2 of between 8.34% and 12.48%.
When jMAA2i j is the dependent variable (see Panel B), the coefcients of the control
variables CFVARi and MKTBVi take on the expected sign and are signicantly greater than
zero. Once again, the coefcient on size is negative and signicant. The coefcient on bid-
ask spreads is 0.372 with a t-statistic of 3.592, which is signicantly greater than zero at a
0.01 level of signicance. The overall t of the regression equation is reasonable with an
adjusted R2 of 14.0%. After controlling for other determinants of earnings management,
the results indicate that bid-ask spreads are systematically associated with the level of
earnings management practiced by managers.
Table 3 shows the results of the estimation of model 6 for both jMAA1i j and jMAA2i j
using the dispersion in analysts' forecast samples. In both samples, the control variables
CFVARi and GROWTHi take on the expected sign and are signicantly greater than zero,
and the coefcient on SIZEi is negative and signicant. The coefcient on DISPi
(dispersion in analysts forecasts) is 0.026 (0.049) with a t-statistic of 2.182 (4.475), which
is signicantly greater than zero at a 0.01 level of signicance in the estimation of
jMAA1i jjMAA2i j. The overall t of the regression equation in explaining the variation in
jMAA1i j and jMAA2i j is indicated by adjusted R2 of 21.3% and 19.4%, respectively.9
Therefore, under two different measures of earnings management (jMAA1i j and
INFORMATION ASYMMETRY 337

Table 2. Regression results of the relationship between information asymmetry BIDASKi and earnings
management

Panel A: Multivariate regression with jMAA1i j as dependent variable

jMAA1i j a0 a1 BIDASKi a2 CFVARi a3 MKTBVi a4 SIZEi a5 GROWTHi ei 6a

a0 a1 a2 a3 a4 a5 R2 N

Predicted sign ?
Coef. 0.077 0.620 0.015 0.0024 0.0065 0.017 14.8% 355
(t-statistic) (4.349)** (2.086)* (4.187)** (1.188) ( 2.957)** (2.776)**

Panel B: Multivariate regression with jMAA2i j as dependent variable

jMAA2i j a0 a1 BIDASKi a2 CFVARi a3 MKTBVi a4 SIZEi a5 GROWTHi ei 6c

a0 a1 a2 a3 a4 a5 R2 N

Predicted sign ?
Coef. 0.052 0.372 0.005 0.0038 0.0035 0.0002 14.0% 641
(t-statistic) (6.944)** (3.592)** (3.499)** (4.174)** ( 3.577)** (0.099)

Notes: The listed R2 are the adjusted R2 .

**Signicant at the 0.01 level.
*Signicant at the 0.10 level (one-sided tests).
Variable Denitions
MAA1i the mean managed accounting accrual under the modied Jones (1991) model using the
time-series estimation approach (see derivation in Section III in the text);
MAA2i the mean managed accounting accrual under the modied Jones (1991) model using the
cross-sectional estimation approach (see derivation in Section III in the text);
BIDASKi the predicted bid-ask spread estimated from model 7 in Table 2 above;
CFVARi the standard deviation of operating cash ows over the test period divided by the average
operating cash ows over the test period;
MKTBVi the mean market capitalization divided by the book value of equity for rm i over the test
period;
SIZEi natural log of the mean market capitalization for rm i over the test period;
GROWTHi net revenues at the end of the test period less net revenues at the beginning of the test
period scaled by net revenues at the beginning of the test period.

jMAA2i j) and two different measures of information asymmetry, BIDASKi and DISPi ,
there is evidence of a systematic relation between earnings management and information
asymmetry.
The analysis was also conducted without the regulated rms (rms with SIC codes
between 4,000 and 4,999 or between 6,000 and 6,299) since Wareld, Wild, and Wild
(1995) suggest that regulated rms may be subject to different incentives than non-
regulated rms. The analysis (not reported here) reveals similar inferences regarding
information asymmetry and earnings management for the non-regulated rms. In addition,
to control for different levels of earnings management across different industries, industry
dummies were included in the model. The inclusion of industry dummies (not reported
here) caused no changes in inferences regarding information asymmetry and earnings
management.10
338 RICHARDSON

Table 3. Regression results of the relationship between information asymmetry DISPi and earnings
management

Panel A: Multivariate regression with jMAA1i j as dependent variable

jMAA1i j a0 a1 DISP a2 CFVARi a3 MKTBVi a4 SIZEi a5 GROWTHi ei 6b

a0 a1 a2 a3 a4 a5 R2 N

Predicted sign ?
Coef (t-statistic) 0.043 0.026 0.013 0.0002 0:003 0.010 21.3% 422
(6.260)** (2.182)* (6.067)** (0.255) ( 3.122)** (5.648)**

Panel B: Multivariate regression with jMAA2i j as dependent variable

jMAA2i j a0 a1 DISPi a2 CFVARi a3 MKTBVi a4 SIZEi a5 GROWTHi ei 6d

a0 a1 a2 a3 a4 a5 R2 N

Predicted sign ?
Coef (t-statistic) 0.036 0.049 0.0027 0.0011 0:0019 0.009 19.4% 539
(5.879)** (4.475)** (4.105)** (1.606) ( 2.377)* (6.705)**

Notes: The listed R2 are the adjusted R2 .

**Signicant at the 01 level.
Variable denitions
MAA1i the mean managed accounting accrual under the modied Jones (1991) model using the
time-series estimation approach (see derivation in Section III in the text);
MAA2i the mean managed accounting accrual under the modied Jones (1991) model using the
cross-sectional estimation approach (see derivation in Section III in the text);
DISPi the predicted dispersion in analysts' forecasts as estimated from model 7 in Table 3 above
CFVARi the standard deviation of operating cash ows over the test period divided by the average
operating cash ows over the test period;
MKTBVi the mean market capitalization divided by the book value of equity for rm i over the test
period;
SIZEi natural log of the mean market capitalization for rm i over the test period;
GROWTHi net revenues at the end of the test period less net revenues at the beginning of the test
period scaled by net revenues at the beginning of the test period.

V. Tests of the relationship between information asymmetry and earnings

management around seasoned equity offerings

The testing performed using the broad sample suggests that, in the presence of a high level
of information asymmetry, managers will manipulate earnings. As a test of robustness, the
relationship between information asymmetry and earnings management is tested around
the period of a seasoned equity offering.
Shivakumar (1996) argues that the need to raise capital at the lowest cost provides
managers with incentives to manage earnings upwards before an equity offering.
Likewise, managers have incentives to manage earnings after an equity offering due to the
prospect of litigation if the managers fail to meet favorable forecasts made before the
offering. Shivakumar (1996) and Rangan (1998) nd evidence of income-increasing
INFORMATION ASYMMETRY 339

accruals management for the two quarters before, the quarter of, and three quarters
following a seasoned equity offering. Therefore, the time period surrounding a seasoned
equity offering appears to be a reasonable setting for testing the relationship between
information asymmetry and earnings management.
In a seasoned equity offering setting, potential shareholders are keenly interested in
knowing the degree of earnings management performed by management before
purchasing stock. When information asymmetry is high, shareholders lack the necessary
information to monitor manager's actions. In the presence of high information asymmetry
between management and shareholders, management is able to manage earnings to a
higher degree than in the presence of low information asymmetry. Therefore, I
hypothesize a positive relation between the level of information asymmetry and the
extent of earnings management in a seasoned equity offering setting.

Research design

The rst test performed is to replicate the results of Shivakumar (1996) and Rangan
(1998). Using a cross-sectional estimation approach as dened in Section III, the managed
abnormal accruals, MAAi , are identied by comparing the accruals of the rms making
seasoned equity offerings with the accruals of all other rms in the same industry in the
scal year of the offering. If the accruals of the rms making seasoned equity offerings are,
on average, more income increasing than the accruals of all other rms in the same
industry, it would suggest that rms have managed earnings upwards in the scal year of
the seasoned equity offering.
I then test to see if information asymmetry affected the level of earnings management in
the following model.

MAA2i a0 ai BIDASKi a2 VARi a3 DEBTi a4 MKTBVi a5 SIZEi a6 OFFSIZEi

a7 OWNi a8 GROWTHi ei 7

where

MAA2i the managed accounting accrual under the modied Jones (1991)
model using the cross-sectional estimation approach in the year of the
offering (see derivation in Section III);
BIDASKi the bid-ask spread at the close of trade on the last trading day of June
for the year before the seasoned equity offering, scaled by the average
of the bid and ask prices;
VARi the standard deviation of earnings divided by the average operating
cash ows over the period ve years before the offering until the year
before the offering;
DEBTi long-term debt divided by total assets (both from year t 1);
MKTBVi the market capitalization divided by the book value of equity for rm
1 in year t 1;
340 RICHARDSON

SIZEi natural log of the market capitalization for rm i in year t 1;

OFFSIZEi relative size of seasoned equity offering dened as of gross offer
proceeds divided by the market capitalization in year t 1;
OWNi stock ownership of the offering rm's directors and ofcers as a
percentage of the total outstanding shares;
GROWTHi net revenues at the end of the test period less net revenues at the
beginning of the test period scaled by net revenues at the beginning of
the test period.

The model predicting earnings management around a seasoned equity offering is

derived from equation (6) above as well as a model used by Shivakumar (1996) to analyze
earnings management. The rst modication to equation (6) is that, since we would expect
income-increasing accruals in the period around a seasoned equity offering, MAA2i is used
as a measure of earnings management (as opposed to the absolute value of managed
accounting accruals, jMAA2i j). In addition, Shivakumar suggests that when the stock
owned by management OWNi is high, management has greater incentives to maximize
the proceeds from the offering through earnings management.
A third modication to equation (6) is the use of offer size as a determinant of earnings
management. Firms that expect to make a large offering relative to rm size, OFFSIZEi ,
stand to gain more from overstating earnings than rms that expect relatively smaller
offerings. VARi is the variability in earnings over the past ve years, used as a measure of
the propensity of rms to opportunistically manage earnings. On the one hand, the higher
the level of earnings management that was done in the past may adversely affect the level
of earnings management that can be performed in the future since the rm may have used
up its earnings management exibility. On the other hand, high earnings management in
the past may simply suggest that managers have great exibility in managing earnings and
will continue to manage earnings in the future. Therefore, I cannot predict the sign of the
relationship between VARi and the level of earnings management MAA2i .
Under the pecking order theory of corporate nancing (Myers, 1993), rms will rst use
internally-generated funds and then obtain debt nancing. These rms will issue new
shares only as a last resort. Myers (1993) argues that an equity issue becomes feasible in
the pecking order only when leverage is already high enough to make additional debt
materially expensive, e.g. because of the threat of costs of nancial distress. Therefore, it
may be the case that the rms that seek equity nancing are rms that are highly leveraged
and close to debt covenant violations. Shivakumar suggests that these highly levered rms.
may have overstated earnings in the quarters before the decision to issue equity was made
to avoid debt covenant violations. This may restrict their ability to manage earnings
around a seasoned equity offering. Therefore, a negative relationship is predicted between
leverage, DEBTi , and the level of earnings management. As theorized above, the market-
to-book ratio, MKTBVi , sales growth, GROWTHi , and SIZEi are motivated by the presence
of political and contracting costs, rms of larger size and risk are expected to manage
earnings more. However, to the extent that SIZEi proxies for the information environment
facing the rm, a negative sign is predicted. Therefore, no sign is predicted for the
relationship between SIZEi and the level of managed accruals, MAA2i .
Similar to the testing performed in the broad sample, the bid-ask spread, BIDASKi , is
INFORMATION ASYMMETRY 341

used as a proxy for the information asymmetry between management and shareholders.
The bid-ask spread is measured on the last June 30 date before the equity offering takes
place. The test of the hypothesis is based on the sign of a1 in a regression of equation (7). A
positive sign of a1 is consistent with a systematic relationship between information
asymmetry and earnings management.

Data

The sample of seasoned equity offerings during the period June 30, 1986 to June 30, 1993
was obtained from the Securities Data Corporation. This sample includes all registered
rm-commitment offerings of stock made by NYSE rms in that period.11 Following
Rangan (1998), only offerings that met the following criteria were retained:

(1) The offering was not made in combination with any other securities (e.g. debt,
preferred stock) of the rm.
(2) The offering was not an offering of common shares with warrants attached.
(3) The rm offering shares had the necessary SEC proxy statements available on the
Corporate Text database in the year of the offering.
(4) The offering was not made consequent to a shelf registration.
(5) If there was more than one offering during the sample period, only the rst offering
was used in this sample.
(6) The rm was not a nancial services or utility rm.

In addition, the rm had to have the necessary Compustat information available as well as
at least ten other rms in the same 2-digit SIC code with the necessary data.
Some statistics describing the remaining sample of 150 rms are included in Table 4.
Panel A shows the distribution over the sample period of the seasoned equity offerings. As
would be expected, there is a decrease in the number of seasoned equity offerings around
the October 1987 stock market crash. Panel B of Table 4 details that the mean market value
of equity of the offering rms is $829.3 million, which is signicantly larger in size than
Shivakumar (1996). This is primarily due to the requirement of bid-ask spreads from
NYSE rms. Therefore, the results obtained should only be generalized to large rms.
Also, Panel B shows that the mean offering in this sample is $82.5 million, or 23.4% of the
pre-offering market value of equity.

Results

The rst issue is to determine if earnings management was performed in the period
surrounding the seasoned equity offering. Using a cross-sectional Jones model (MAA2) as
derived in Section III, the level of accruals of the offering rm is compared with the level
of expected accruals. The level of expected accruals is derived from other rms in the
same industry (2-digit SIC code). After this test is performed, I nd evidence that income
increasing accruals were used in the scal year of the seasoned equity offering
342 RICHARDSON

Table 4. Descriptive statistics on seasoned equity offerings and offering rms

Panel A: Distribution of seasoned equity offerings by half-year

Period No. of Offerings

1986Q3 & Q4 10
1987Q1 & Q2 27
1987Q3 & Q4 6
1988Q1 & Q2 3
1988Q3 & Q4 6
1989Q1 & Q2 2
1989Q3 & Q4 9
1990Q1 & Q2 12
1990Q3 & Q4 2
1991Q1 & Q2 15
1991Q3 & Q4 18
1992Q1 & Q2 20
1992Q3 & Q4 7
1993Q1 & Q2 13

Panel B: Descriptive statistics on offering rms and offerings

Mean Median Maximum Minimum

a
Market value of equity ($millions) 829.3 351.2 10050.9 12.4
Leverageb 0.271 0.260 0.916 0.0001
Amount offered in seasoned equity offering 82.5 57.0 517.5 3.470
($ millions)
Amount offered/market value of equity 0.234 0.162 2.221 0.007
Bid-ask spreads BIDASKi 0.004 0.003 0.001 0.020
Earnings variability VARi 1.353 0.588 0.062 14.586
Market-to-book ratio MKTBVi 1.503 1.207 0.291 6.899
Stock ownership by directors and ofcers 12.8% 5.1% 0.0% 76.7%
OWNi
Sales growth for the year prior to the IPO 154.3% 64.0% 82.3% 3,727.8%
GROWTHi

Notes: aThe market value of equity is the market capitalization of equity at the end of scal year t 1.
b
Leverage is measured as long-term debt divided by total assets (both measured at the end of scal year
t 1).
Variable denitions
BIDASKi the bid-ask spread at the close of trade on the last trading day of June for the year before
the seasoned equity offering, scaled by the average of the bid and ask prices;
VARi the standard deviation of earnings divided by the average operating cash ows over the
period ve years before the offering until the year before the offering;
DEBTi long-term debt divided by assets (both from year t 1);
MKTBVi the market capitalization divided by the book value of equity for rm i in year t 1;
SIZEi Natural log of the market capitalization for rm i in year t 1;
OFFSIZEi Relative size of seasoned equity offering dened as of gross offer proceeds divided by the
market capitalization in year t 1;
OWNi Stock ownership of the offering rm's directors and ofcers as a percentage of the total
outstanding shares;
GROWTHi Net revenues at the end of the test period less net revenues at the beginning of the test
period scaled by net revenues at the beginning of the test period.
INFORMATION ASYMMETRY 343

MAA2 0:011; p50:05. That is, income increasing accruals were, on average, 1.1% of
year t 1 assets for the offering rms. This gives additional evidence of earnings
management around seasoned equity offerings and supports the ndings of earnings
management in this setting by Shivakumar (1996) and Rangan (1998).
Table 5 provides the results of a regression estimating the level of income-increasing
accruals used by the rm to opportunistically manage earnings.12 The model explains
approximately 11.1% of the variation in managed accruals which is comparable to
Shivakumar (1996) who achieved adjusted R2 between 9.89% and 11.89%. The signicant
coefcient on the BIDASKi variable provides evidence of a positive relationship between

Table 5. Regression results of the relationship between information asymmetry and earnings management around
seasoned equity offerings
MAA2i a0 a1 BIDASK i a2 VARi a3 DEBT i a4 MKTBV i a5 SIZEi a6 OFFSIZEi a7 OWN i
a8 GROWTHi ei 7

Regression

Variable Predicted Sign Parameter Estimate T-stat

Intercept 0.067 1.803

BIDASK i 3.721 2.216
VARi ? 0.006 2.404
DEBT i 0.077 2.103
MKTBV i 0.005 1.037
SIZEi ? 0.010 1.458
OFFSIZEi 0.0043 0.488
OWN i 0.0002 0.455
GROWTHi 0.0044 2.327
No. of Obs. 150
Adj. R-Squared 11.1%

Notes: The t-statistics are corrected for heteroskedasticity using White's consistent estimator for standard
error.
Variable denitions
MAA2i the managed accounting accrual under the modied Jones (1991) model using the cross-
sectional estimation approach in the year of the offering (see derivation in Section III);
BIDASK i the bid-ask spread at the close of trade on the last trading day of June for the year before
the seasoned equity offering, scaled by the average of the bid and ask prices;
VARi the standard deviation of earnings divided by the average operating cash ows over the
period ve years before the offering until the year before the offering;
DEBT i long-term debt divided by assets (both from year t 1);
MKTBV i the market capitalization divided by the book value of equity for rm 1 in year t 1
SIZEi Natural log of the market capitalization for rm 1 in year t 1;
OFFSIZEi relative size of seasoned equity offering dened as of gross offer proceeds divided by the
market capitalization in year t 1;
OWN i stock ownership of the offering rm's directors and ofcers as a percentage of the total
outstanding shares;
GROWTHi net revenues at the end of the test period less net revenues at the beginning of the test
period scaled by net revenues at the beginning of the test period.
344 RICHARDSON

the extent of information asymmetry and the level of earnings management conducted by
the rm. The control variables, earnings variability, the debt-equity ratio, and earnings
growth are also statistically signicant in explaining the level of earnings management.
Therefore, this second test lends credence to the hypothesized relation between
information asymmetry and earnings management in a setting where management has
the incentive to manage earnings opportunistically.

VI. Summary and conclusions

This paper develops and tests hypotheses of how the presence of information asymmetry
affects management incentives to manage earnings. This is a direct test of Dye (1988) and
Trueman and Titman's (1988) theory that the presence of information asymmetry is a
necessary condition for earnings management. I extend that argument by suggesting that
the level of earnings management increases as the level of information asymmetry
increases. When information asymmetry is high, stakeholders may not have the necessary
information to undo the manipulated earnings. Another possible explanation is that the
existence of rms with high levels of information asymmetry is evidence of shareholders
without sufcient resources, incentives, or access to relevant information to monitor
manager's actions, which may give rise to the practice of earnings management.
The hypothesis is tested in both a general and a time-specic setting. Using a broad
sample of rms, multivariate tests are used to test the relation between information
asymmetry and earnings management. Tests of the hypothesis provide evidence of the
predicted positive relation between information asymmetry and earnings management
using two different measures of earnings management and two different measures of
information asymmetry. In addition, the relation between information asymmetry and
earnings management is tested around a seasoned equity offering. This allows a test of the
effect of information asymmetry on earnings management in a setting where signicant
incentives exist for managers to opportunistically manipulate earnings in a predictable
direction. After replicating the analysis performed by Shivakumar (1996) and Rangan
(1998), and nding evidence of earnings management around seasoned equity offerings, I
analyze the extent of earnings management and the extent of information asymmetry. I
nd a statistically signicant relationship between the extent of income-increasing
accruals manipulation and the level of information asymmetry.
Evidence from this paper suggests that information known about the rm and its
earnings may limit the extent of earnings management performed by rm managers.
Outside monitors might also curtail management action and management's accounting
choices. Evidence of such monitoring within a particular rm may be the proportion and
strength of outside members of the board of directors, the strength of the audit committee,
focused rm stakeholders (e.g., labor unions, rm suppliers, etc.), and shareholders that
hold a large proportion of the company shares. Research which helps us understand the
information and monitoring environments faced by rm management will enhance our
understanding of why and how management makes accounting choices.
INFORMATION ASYMMETRY 345

Acknowledgments

I wish to thank members of my dissertation committee at the University of Illinois for

insightful comments and suggestions. Dick Dietrich (chairman), Don Kleinmuntz, Tom
Linsmeier, Theodore Sougiannis, Dave Ziebart and Shane Greenstein. I also thank an
anonymous referee, Mike Euredge, Mark Hirschey, Susan Scholz, Joe Comprix, Connie
Richardson and workshop participants at University of Arizona, University of Arkansas,
Brigham Young University, Georgia State University, University of Illinois, University of
Kansas, London Business School, University of North Carolina, Purdue University,
SUNY-Buffalo, Syracuse University, Thunderbird and Tulane University. I gratefully
acknowledge funding from the Deloitte and Touche Foundation, the State Farm
Companies Foundation and the Richard D. and Anne Maric Irwin Foundation.

Notes

1. Healy (1985), Perry and Williams (1994), and DeFond and Jiambalvo (1994) are examples of empirical
research suggesting that earnings management is common among rms. Some anecdotal evidence comes
from an American Express attorney, ``If you tell me that it's improper under all circumstances for
management to want to smooth out their results, adjust the level of risk, or to smooth out reserves, or to move
gures from one period to another. . . I'll tell you, you don't understand the way American business is
conducted.'' (Fortune, June 25, 1984 5861).
2. The earnings management examined in this paper is the measure of the period-to-period (or incremental)
manipulation of accruals. The paper does not deal with longer-term accounting policy choices (e.g. FIFO vs.
LIFO) that are made by management.
3. Blocked communication is dened to mean that managers cannot communicate all of their private
information but some communication is permitted.
4. Deating the standard deviation of analysts' forecasts by year t 1 price or by actual earnings causes no
changes in inferences throughout the paper.
5. Dechow, Sloan and Sweeney (1995) test various models proposed in the literature and nd the modied
version of the Jones model to provide the most powerful tests for detecting earnings management Guay,
Kothari and Watts (1996) also nd some support for the validity of the Jones and modied Jones models over
the other proposed models.
6. This time series approach is used in Jones (1991), DeChow, Sloan, and Sweeney (1995), and Guay, Kothari,
and Watts (1996).
7. A similar cross-sectional approach is implemented in DeFond and Jiambalvo (1994).
8. Inuential observations excluded using Belsey, Kuh, and Welsch (1980) criteria (not reported here) had no
affect on the inferences made.
9. Table 1 suggests there may be some outliers in the CFVAR, MKTBV and GROWTH variables. Therefore, to
control for inuence these outhers may have on the sample results, all observations below the 1st and above
the 99th percentile of observations were winsorized to control the possible inuence of extreme observations.
Separately, inuential observations were identied and excluded using Belsey, Kuh, and Welsch (1980)
criteria (not reported here). Qualitatively similar results are obtained with no effect on the inferences made.
10. Past research (Schipper, 1989; Kasznik, 1999) suggests that simultaneity may exist in the determination of
earnings management and information asymmetry. Therefore, an issue which must be addressed is the
possibility of endogeneity between information asymmetry and earnings management. An approach to
establishing the direction of causality is the use of simultaneous equations. Qualititatively similar results (not
reported here) are found when using two-stage least squares.
11. Firms that are listed on NASDAQ are not included in the sample since there is some evidence of collusion
among market makers in setting the bid and offer prices (Christie and Schultz, 1994).
346 RICHARDSON

12. To control for outliers, all observations below the 1st and above the 99th percentile of observations were
winsorized to control the possible inuence of extreme observations. Separately inuential observations were
identied and excluded using Belsey, Kuh, and Welsch (1980) criteria (not reported here). There is no effect
on the inferences made.

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