How Suspicions of the Method of Earnings Management and Its Underlying Motive Affect Investors’ Trust in Managers and Willingness to Invest in the Firm

Using an experiment we examine the effects of suspicions of the method of earnings management and its underlying motive on investors’ willingness to invest in the firm. We focus on the role of investors’ trust in managers, while controlling for investors’ assessments of the effects of earnings management on the firm’s future cash flows. Consistent with our trust-based hypotheses, we find that the method of earnings management only affects investors’ willingness to invest in the firm when the motive underlying the earnings management does not breach investors’ trust in managers. In this situation we find that investors view accruals-based earnings management more negatively than real earnings management. We also show that trust fully mediates the effect of the interaction of the method of earnings management and its underlying motive on investors’ willingness to invest in the firm.