Does Earnings Quality Affect Information Asymmetry? Evidence from Trading Costs*

A fundamental role of accounting information in financial markets is to serve as a basis for capital allocation. An important attribute of the quality of accounting information is the extent to which earnings (accruals) map into cash flows. A poor mapping of accruals into cash flows reduces the information content of reported earnings and results in lower-quality earnings. If investors differ in their ability to process earnings related information, then poor earnings quality can result in differentially informed investors and thereby exacerbate the information asymmetry in financial markets (Diamond and Verrecchia 1991; Kim and Verrecchia 1994). Analytical models (e.g., Kyle 1985; Glosten and Milgrom 1985) predict that differential information among market participants increases the adverse selection risk for liquidity providers. In response, liquidity providers demand a larger compensation and widen the spread between the bid and the ask prices, thereby lowering liquidity and increasing the cost of capital. 1