Earning Investor Trust: The Role of Past Earnings Management

Does earnings management, even though legal, hinder investor trust in reported earnings? Or do investors regard earnings management as a way for firms to convey private information, or simply as a neutral feature of financial reporting? We find that past abstinence from earnings management increases investor responses to future earnings surprises. Importantly, this effect occurs in industries where investor trust has recently been violated, and where managers would in the past have had incentives and opportunities to misrepresent earnings. Overall, investors seem to interpret the extent to which management resists temptations for misreporting as a “litmus test” of trustworthiness.