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    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 
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    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