What Does Earnings Management Signal? The Role of Managerial Honesty in Investment Decisions

Abstract

Accounting earnings management elicits varying reactions: To some observers, it signals low managerial honesty. To others, it indicates that firm managers are sharing private information. Accordingly, different investors may respond differently to this managerial behavior. To assess these responses in ways not available in archival studies, we conduct two laboratory experiments simulating investment choices. Participants perceive a CEO to be more committed to honesty when they infer that the CEO engaged less in earnings management. For investment decisions, a one standard deviation increase in a CEO's perceived commitment to honesty compared to another CEO reduces the relevance of differences in the CEOs’ claimed future returns by 40%. This effect is prominent among investors with a proself value orientation. To prosocial investors, their own honesty values and those attributed to the CEO matter directly; returns play a secondary role. Overall, perceived CEO honesty matters to different investors for distinct reasons.

Keywords: earnings management, honesty, investor preferences, investor segmentation, protected values

JEL Classification: M41, G41, G11