Review of Quantitative Finance and Accounting, 15 (2000): 325±347
# 2000 Kluwer Academic Publishers. Manufactured in The Netherlands.
Information Asymmetry and Earnings Management:
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 suf®cient resources, incentives, or access to relevant information to
monitor manager's actions, which gives rise to the practice of earnings management (Schipper, 1989; War®eld
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 Classi®cation: M41, G14, G34
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.
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''