An empirical investigation of the relationship between information asymmetry and earnings managemen

Accounting standards allow for managerial discretion in the choice and application of accounting methods (commonly referred to as "earnings management"). A growing body of empirical evidence and anecdotal evidence supports the argument that earnings management is a common practice in firms. A fundamental question posed for accounting research is to identify the environmental conditions under which accounting choices are made by managers. Moreover, managers possess private information about the firm and its earnings stream that shareholders do not have (i.e. information asymmetry between managers and shareholders). The purpose of this thesis is to investigate the relationship between information asymmetry and earnings management.;Dye (1988) and Trueman and Titman (1988) suggest that information asymmetry is a necessary condition for the practice of earnings management. I extend their argument by hypothesizing that the level of information asymmetry is positively related to the level of earnings management. One explanation is that when information asymmetry is high, shareholders do not have the necessary information to undo the manipulated earnings. This information asymmetry gives management additional flexibility to manage earnings.;The hypothesized relationship is tested using a broad sample of firms. The results of the analysis support the argument that the magnitude of information asymmetry, as measured by bid-ask spreads and the dispersion in analysts' forecasts, is systematically related to the magnitude of earnings management. The results appear to be robust across different methods of estimating the level of earnings management. Various sensitivity tests provide support for the robustness of the results obtained. In addition, the possibility of endogeneity is dealt with using a simultaneous equations approach.;In an attempt to triangulate the results obtained in the broad sample, two additional settings are considered: earnings management around seasoned equity offerings and earnings management using R&D expenditures. Tests reveal a similar systematic relationship between information asymmetry and earnings management in these additional settings.