Social capital and earnings management in small and medium firms

ABSTRACT In this study we examine the association between social capital and earnings management in small and medium firms (SMEs). Social capital, i.e. the community’s norms and networks, may play a role as an informal and external disciplining mechanism of managers and, therefore, affect earnings management practises in small and medium firms, less subject to formal internal and external monitoring than larger firms. We implement a cross-region analysis by using a sample of Spanish SMEs and employ three measures that consider sociological and economic dimensions of social capital: an index of social capital based on economic relationships and proxies for trust and civic engagement. We find a negative association between the proxies for social capital and earnings management. Hence, our findings suggest that managers of small and medium firms headquartered in regions of higher social capital are less likely to manage reported earnings. However, our findings also reveal that the relationship between social capital and earnings management practises in private SMEs depends on firm size.