The control environment and financial reporting quality : does "tone at the top" matter?

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2017-08

Authors

Lord, Jeanmarie Marcelle

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Abstract

Are the attitudes and cognitive style of top management related to an entity’s financial reporting quality? The answer is important because the control environment, which includes management’s philosophy and operating style under COSO, is presumed to be the foundation of internal control necessary for effective transaction level processing and for management’s judgments implementing financial reporting and disclosure requirements. Yet empirical tests of the presumption are impaired by the inability to measure management’s attributes. In this study, I extract linguistic markers of top management’s attitudes and cognitive style from their response to financial reporting queries from the Securities and Exchange Commission staff and I relate the markers to concurrent material misstatements in the financial statements under scrutiny. To minimize the influence of outside professional advisors, I use responses to the initial mandated comment letters for small business issuers whose statements contained material misstatements and an industry- and size-matched sample of firms without misstatements. Using factor analysis, I find a factor composed of lower analytical thinking and higher clout significantly improves the explanatory power of a logistic regression of concurrent material misstatement and reduce the Type 1 and Type 2 classification error rates by 5% and 25%, respectively. Results are consistent with management’s attitudes and cognitive style being associated with financial reporting quality, either directly through management’s accounting judgments or indirectly through internal controls.

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