Earnings Quality, Insider Trading, and Cost of Capital

Abstract

Previous research argues that earnings quality, measured as the unsigned abnormal accruals, proxies for information asymmetries that affect cost of capital. We examine this argument directly in two stages. In the first stage, we estimate the firm's exposure to an earnings quality factor in the context of a Fama-French three factor model augmented by the return on a factor-mimicking portfolio that is long in low earnings quality firms and short in high earnings quality firm. In the second stage, we examine whether the earnings quality factor is priced and whether insider trading is more profitable for firms with higher exposure to that factor. Generally speaking, we find evidence consistent with pricing of the earnings quality factor and insiders trading more profitably in firms with higher exposure to that factor.

JEL Classification: G12, G29, D82, M41, M45