Abstract
Higher past financial reporting quality (FRQ, as measured by less past earnings management, either in the prior year(s), or over a CEO’s tenure) is associated with stronger earnings responses. This effect is more pronounced where managers would have had more incentives and opportunities to misrepresent earnings – that is, where they passed a “litmus test” of trustworthiness. Analysts recognize that earnings of high-FRQ firms more reliably predict earnings. Overall, the results suggest that the trust investors put in a firm’s announcements depends on its reporting track record and on management’s resistance against temptations for misreporting.