Trust and Financial Reporting Quality

• Date: 01 December 2014
• DOI: http://doi.org/10.1111/1475-679X.12063
• Published date: 01 December 2014

DOI: 10.1111/1475-679X.12063

Journal of Accounting Research

Vol. 52 No. 5 December 2014

Printed in U.S.A.

Trust and Financial Reporting

Quality

JACE GARRETT,

∗RANI HOITASH,

∗

AND DOUGLAS F. PRAWITT

†

Received 25 August 2012; accepted 31 August 2014

ABSTRACT

Using unique survey data from Great Place to WorkRInstitute, we inves-

tigate the association of intraorganizational trust (i.e., employees’ trust in

management) with three aspects of financial reporting: accruals quality, mis-

statements, and internal control quality. We find that trust is associated with

better accrual quality, lower likelihood of financial statement misstatements,

and lower likelihood of internal control material weakness disclosures. How-

ever, these effects are not uniform across all companies. Consistent with trust

improving financial reporting quality through improved information produc-

tion and information sharing, we find that trust is significantly associated with

financial reporting quality in relatively decentralized firms, but not in firms

∗Department of Accountancy, Bentley University; †Marriott School of Management,

Brigham Young University.

Accepted by Christian Leuz. The authors thank Jean Bedard, Ted Christensen, Cynthia

Clark, Michael Drake, Steve Glover, Udi Hoitash, Kurt Schulzke, Jay Thibodeau, Jeff Wilks,

Mark Zimbelman, participants at the 17th Annual Symposium on Ethics Research in Account-

ing, and seminar participants at Bentley University and Brigham Young University for help-

ful comments. We are grateful to the anonymous reviewer for insightful and constructive re-

views, which greatly benefited the paper. We also thank Amy Lyman, Michael Burchell, and

Great Place to Work Institute for their data and support of this project. The authors are also

grateful for research support provided by a Lund Grant from the Marriott School. An online

appendix to this paper can be downloaded at http://research.chicagobooth.edu/arc/journal-

of-accounting-research/online-supplements.

1087

Copyright C, University of Chicago on behalf of the Accounting Research Center,2014

1088 J.GARRETT,R.HOITASH,AND D.F.PRAWITT

that are relatively centralized. Our results are robust to several analyses that

attempt to control for potential alternative explanations.

JEL codes: M14; M41; M54

Keywords: trust; information sharing; accruals; internal control;

misstatements

1. Introduction

Following misconduct by Solomon Brothers in the treasuries market in

1991, Warren Buffet said, “Trust is like the air we breathe. When it’s present,

nobody really notices. But when it’s absent, everybody notices” (Sand-

lund [2002, p. 70]). Business leaders and leadership consultants agree

that “trusted leadership is more important now than ever before . . . Cre-

ating organizations that are bound by strong, deep connections between

peers, across levels, and across functions may be the only recipe for sustain-

able success” (Galford and Drapeau [2003], p. xii). Despite its importance,

the role of trust has been relatively unexplored in the accounting litera-

ture, and even less so in the specific context of financial reporting quality

(FRQ).1However, there is reason to believe that trust, in particular, em-

ployees’ trust of their managers, might have a positive influence on FRQ,

because “managers who generate financial reports often rely on subordi-

nates who possess private information to provide inputs” (Jollineau, Vance,

and Webb [2012, p. 1]), and the level of trust between managers and sub-

ordinates can influence the extent to which private information is objec-

tively produced (Bart [1988]) and openly and accurately shared (Mayer

and Gavin [2005], Roberts and O’Reilly [1974], Zand [1972]).

In this study, we investigate whether employees’ trust in management, an

element of firm culture that is becoming increasingly important in both re-

search and practice, is associated with the quality of firms’ financial report-

ing. We argue that trust between employees and management contributes

positively to the financial reporting process because it is vital to informa-

tion production and communication. In the absence of trust between em-

ployees and management, it might be difficult, even for highly skilled man-

agers, to produce high FRQ. Trust enables individuals to reveal their lack of

knowledge, seek advice, and rely more on incoming advice and information

(Boss [1978], Butler [1999], McEvily, Perrone, and Zaheer [2003], Staples

and Webster [2008], Zand [1972]). 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 (Dirks

and Ferrin [2001]). In this way, trust leads to greater availability of accurate

1Consistent with the Financial Accounting Standards Board Statement of Financial Ac-

counting Concepts No. 8 [2010], we define FRQ to be the extent to which financial reporting

conveys information about the firm’s financial position that is complete, neutral, and free

from error.

TRUST AND FINANCIAL REPORTING QUALITY 1089

information across the organization and quicker identification of potential

problems. This, in turn, results in improved FRQ.2

Using a unique measure of employees’ trust in management that is based

on proprietary data collected by Great Place to Work Institute (GPTW),

we provide evidence that greater trust is associated with higher FRQ as in-

dicated by higher accruals quality, lower likelihood of financial statement

misstatements, and lower likelihood of disclosed material weaknesses in in-

ternal control. To provide support for the argument that trust plays a role

in improving FRQ through its effect on information production and in-

formation sharing, we test whether the effect of trust differs between rel-

atively centralized and decentralized firms. Objective information produc-

tion and open information sharing are more important in decentralized

firms (Gallemore and Labro [2013]), suggesting that trust may play a more

important role in more decentralized firms relative to less decentralized

firms. We find that trust is significantly associated with FRQ in relatively

decentralized firms, but not in relatively centralized firms.

We perform several additional analyses to provide support for the argu-

ment that trust plays a role in improving FRQ through its effect on informa-

tion production and information sharing. To mitigate the possibility of our

results being explained by correlated omitted firm-level variables, we per-

form a 2SLS regression analysis using instruments taken from a separate

GPTW survey.3Our results are robust to this analysis. We also find that trust

remains positively associated with FRQ after controlling for five proxies for

managerial ability previously identified in the literature. We test for reverse

causality by regressing lagged values of accruals quality (trust) on trust (ac-

cruals quality), and find that trust appears to precede accruals quality. Fi-

nally, the Heckman [1976] selection model yields some evidence that our

results are not driven by sample selection. Although directly ruling out the

possibility of alternative explanations for the relation we observe between

trust and FRQ may not be possible, the differential relation we find between

trust and FRQ in relatively centralized and decentralized firms supports our

theory.

As supplemental analyses, we examine trust measured at different em-

ployee 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. We find limited evidence that

the effect of upper level trust on FRQ is diminished for firms with low trust

2Standards for internal control over financial reporting also emphasize the role of infor-

mation sharing within the organization. “Internal communication facilitates the functioning

of internal control by sharing information up, down, and across the entity.. . . Information is

necessary for the organization to carry out its internal control responsibilities to support the

achievement of objectives” (COSO [2013, p. 148–49]).

3The GPTW Culture AuditCis a separate questionnaire completed by management that

includes information on employee demographics and benefits provided to employees by the

company.