Investors' Interpretations of Imprecise Standards and Their Perceptions of Earnings Management by Reputable Companies

Abstract

ABSTRACT Standards with imprecise guidelines require interpretation by users. In this study we investigate how investors' perceptions of earnings management vary with their interpretations of imprecise standards and the type of company reputation. We design a quasi-experiment that exploits the role of the press as a “watchdog” of corporate activities to focus the attention of investors on the financial reporting practices of companies. The results show that both factors interact to influence investors' perceptions. Investors, whose interpretations of the imprecise standard are inconsistent with that of the company, are more likely to suspect earnings management when the company has a financial rather than non-financial reputation. Investors in the inconsistent/financial reputation condition are also more likely to sell their investments than those in the inconsistent/non-financial reputation condition. The type of reputation does not show a significant effect on investors' perceptions when investors' interpretations are consistent with that of the company. JEL Classifications: M40; M41.