Welcome to the Gray Zone: Shades of Honesty and Financial Misreporting

We examine the influence of CFO/CEO honesty perceptions on earnings management for the largest publicly traded companies in America, and show that verbal and visual cues play a significant role. Specifically, after controlling for incentives (i.e. stock-based compensation, bonuses, leverage) and opportunities (i.e. auditor independence, internal control deficiencies), members of senior management perceived to be less honest engage in higher levels of both accruals management and real earnings management. Interestingly, the beneficial impact of perceived honesty on earnings quality is most pronounced when both the CFO and the CEO are perceived to be honest. Findings are consistent with our conjecture that both the CFO and CEO independently contribute to a firm’s reporting environment. The role played by visual cues in assessing perceived honesty is complementary to the role played by verbal cues, which are revealed more slowly over an executive's tenure.