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  • Jennifer M Mueller-Phillips
    Trust and Financial Reporting Quality.
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses 
    Title:
    Trust and Financial Reporting Quality.
    Practical Implications:

    The authors provide evidence of a firm-level benefit of interpersonal trust. The findings have important practical implications that highlight the influence of firm culture on financial reporting. Whether by improving the decision making, facilitating the discovery and remediation of problems, or increasing the accuracy of the underlying information, a strong culture of trust may serve as an effective means of reducing the likelihood of costly financial reporting failures. This may be especially true for decentralized firms in which the aggregation of accurate information for financial reporting is particularly challenging. Managers may benefit from a better understanding of the level of trust within their firms. The findings suggest that trust is a potential correlate of FRQ that could be useful for stakeholders to monitor.

    Citation:

    Garrett, J., Hoitash, R., & Prawitt, D. F. 2014. Trust and Financial Reporting Quality. Journal Of Accounting Research 52 (5): 1087-1125. 

    Keywords:
    truth, information sharing, accruals, internal control, misstatements, material weakness
    Purpose of the Study:

    There is reason to believe that trust, in particular, employees’ trust of their managers, might have a positive influence on high financial reporting quality (FRQ), because managers who generate financial reports often rely on subordinates who possess private information to provide inputs, and the level of trust between managers and subordinates can influence the extent to which private information is objectively produced and openly and accurately shared.

    In this study, the authors investigate whether employees’ trust in management, an element of firm culture that is becoming increasingly important in both research and practice, is associated with the quality of firms’ financial reporting. The authors argue that trust between employees and management contributes positively to the financial reporting process because it is vital to information production and communication. In the absence of trust between employees and management, it might be difficult, even for highly skilled managers, to produce FRQ. Trust enables individuals to reveal their lack of knowledge, seek advice, and rely more on incoming advice and information. Similarly, lower level employees who have private information necessary for the production of accurate financial reports are more likely to share what they know when trust is greater. In this way, trust leads to greater availability of accurate information across the organization and quicker identification of potential problems. This, in turn, results in improved FRQ.

    Design/Method/ Approach:

    The sample is derived from a database of companies that were surveyed by GPTW for inclusion in Fortune magazine’s annual list of the 100 Best Companies to Work for in America. The GPTW database includes data for 2,368 public and private firms-years from 2005 to 2010. Using Compustat the authors develop a preliminary sample of 1,005 firm-year observations, comprising 475 distinct firms.

    Findings:
    • Trust is significantly associated with FRQ in relatively decentralized firms, but not in relatively centralized firms.
    • Trust remains positively associated with FRQ after controlling for five proxies for managerial ability previously identified in the literature.
    • The authors test for reverse causality by regressing lagged values of accruals quality (trust) on trust (accruals quality), and find that trust appears to precede accruals quality.
    • As supplemental analyses, the authors examine trust measured at different employee ranks. The results indicate that upper level employees tend to have greater trust in management; however, trust measured at both higher and lower ranks is associated with greater FRQ.
    • The authors find limited evidence that the effect of upper level trust on FRQ is diminished for firms with low trust cohesion, measured as a large difference between trust at upper and lower levels.
    • The authors also investigate whether very high levels of trust have adverse effects on FRQ.  The results suggest this is not the case within the data set. Investigating whether the relationship between trust and FRQ varies between high versus low agency-cost settings.
    • The findings generally suggest that trust is important both when incentives to manage earnings are high and when they are low.
    Category:
    Internal Control
    Sub-category:
    Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Was Dodd-Frank Justified in Exempting Small Firms from...
    research summary posted November 26, 2014 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.08 Impact of SEC Rules Changes/SarbOx, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.05 Evaluating Accruals/Detection of Abnormal Accruals, 08.06 Earnings Management – Detection and Response, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance?
    Practical Implications:

    Our study evaluates a provision of Dodd-Frank which provided permanent exemption from Section 404b compliance to non-accelerated filers. Our results show that these small firms did not improve their reporting quality to the same extent as large firms implying that the Dodd-Frank exemption will probably serve to keep the reporting quality of the exempted firms at lower than achievable levels.

    We also note that as part of the Dodd-Frank legislation, the SEC was given a mandate to investigate raising the Section 404b exemption requirements from $75 million to $250 million in market capitalization (Dodd Frank 2010). While the SEC eventually decided to leave the exemption criterion at $75 million, this matter is still considered to be an open topic (SEC 2011). Our study informs this ongoing debate.

    For more information on this study, please contact

    Anthony D. Holder, PhD, CPA

    Assistant Professor, Department of Accounting - MS 103

    University of Toledo

    Toledo, OH 43606-3390

    Email: Anthony.Holder@utoledo.edu

    Web:    http://homepages.utoledo.edu/aholder4/

    Phone: 1.419.530.2560

    Fax: 1.419.530.2873 

    Citation:

    Holder, A., K. Karim, and A. Robin. 2013. Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance? Accounting Horizons 27 (1): 1-22.

    Keywords:
    Sarbanes-Oxley; Dodd-Frank; earnings management; exempt filers
    Purpose of the Study:

    A major component of the Sarbanes-Oxley Act of 2002 (SOX) is Section 404b, which requires auditor certification of internal controls. However, not all firms were required to comply with this section. Fearing that compliance costs may be prohibitive, SOX allowed a temporary exemption to small firms called non-accelerated filers (typically those firms with market capitalizations under $75 million). Later, the Dodd-Frank Act of 2010 made this exemption permanent.

    Needless to say, both 404b itself and the small-firm exemption, remain controversial. At the heart of the issue, as with any regulation, is the cost-benefit tradeoff. In this particular instance, what are the potential benefits small firms would have obtained had they been subject to SOX Section 404b? By focusing just on the costs of compliance, we may be overlooking these benefits. We consider these foregone benefits an opportunity cost.

    The purpose of our study is to estimate this opportunity cost. We estimate the benefits lost by small firms, because they were not subject to SOX Section 404b.

    Design/Method/ Approach:

    Our sample contains listed firms (subject to SOX), divided into the large (accelerated) and small (non-accelerated) categories. Our data span the SOX period and are from 1995-2009. We measure reporting gains using two standard approaches, one measuring the extent of earnings management and the other measuring accrual quality.

    The reporting benefits foregone by small-firms can be understood by comparing the following two quantities:

    • Post-SOX reporting gains achieved by large firms (accelerated filers).
    • Post-SOX reporting gains achieved by small firms (non-accelerated filers). If these gains (or losses) are smaller than those achieved by large firms, we know there is an opportunity cost.
    Findings:

    We detect a significant deterioration in reporting quality for non-accelerated filers but not for accelerated filers. The result is invariant to whether we compare non-accelerated filers with all accelerated filers or only with small accelerated filers.  Our findings suggest a significant opportunity cost for the exemption. Although the consideration of the cost of Section 404b compliance is outside the scope of our study, our result concerning the opportunity cost suggests that it may have been premature to grant permanent exemption to the non-accelerated filers. This result is especially important, considering contemporaneous discussions to grant Section 404b exemption to even larger firms (up to a market capitalization of $500 million).

    Category:
    Auditing Procedures - Nature - Timing and Extent, Corporate Matters, Independence & Ethics, Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management – Detection and Response, Earnings Management, Evaluating Accruals/Detection of Abnormal Accruals, Impact of 404 on Fees and Financial Reporting Quality, Impact of SEC Rules Changes/SarBox

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