The Relation between Information Asymmetry and Earnings Management: A Revisit using Adjusted Trading Volume and Unexpected Core Earnings

Since the level of information asymmetry between managers and outsiders of a company such as shareholders, investors, or creditors cannot be observed directly, prior studies use proxies to measure information asymmetry. In particular, bid-ask spread has been commonly used as a proxy for information asymmetry in prior research. Bartov and Bodnar (1996), however, argue that using bid-ask spread as the proxy of information asymmetry has some deficiencies in practice, and suggest an adjusted trading volume as a better proxy for information asymmetry. In this study, therefore, we empirically re-examine the association between information asymmetry and earnings management by utilizing the adjusted trading volume (Bartov and Bodnar 1996) as a proxy for information asymmetry. Furthermore, we adopt the unexpected core earnings from McVay (2006) as a new proxy for earnings management to revisit the relation between information asymmetry and earnings management. Using data for firms traded in NYSE, AMEX, or NASDAQ from 1993 and 2013 fiscal years, we find empirical evidence that the level of adjusted trading volume is positively and significantly associated with the magnitude of unexpected core earnings, confirming the results documented by prior analytical and empirical research. Furthermore, in the robustness test using the residual volatility of stock returns as a proxy for information asymmetry, we also find that the unexpected core earnings positively relate to the residual volatility of stock returns, implying that managers are more likely engage in earnings management due to greater information asymmetry.