Plenty of friends and strong social ties keep companies honest

Businesses that operate in societies with strong social bonds are far less likely to manipulate their financial results, according to new research from the University of Portsmouth, suggesting that “having good friends” may be just as important as formal corporate rules in keeping companies honest. 

The international study, based on data from more than 1,200 companies across 14 countries, finds that higher levels of social capital - the strength and breadth of social ties, trust and shared norms within a society - significantly reduce the use of earnings management, a practice in which firms legally stretch or manipulate accounting judgments to make their performance look better than it really is. 

The research shows that companies behave better when they know their reputation is on the line in tightly connected communities. 

“Social pressure and the risk of reputational damage appear to act as powerful informal controls on corporate behaviour,” explained Dr Sonia Brandon, Associate Head of the Accounting and Financial Management at the University of Portsmouth. “Where firms are more socially embedded, the cost of being seen to ‘bend the rules’ is much higher.”

While earlier research focused mainly on national culture, this study shows that social trust and strong community ties matter even more. Even after accounting for cultural differences such as how independent people are and how much inequality in power people accept (known as “power distance”), firms in high-trust, well-connected societies were far less likely to manipulate their financial results. 

The research shows the effect is strongest in countries with: 

• Lower individualism 

• Lower tolerance of power imbalances 

• Lower emphasis on indulgence 

• Strong disclosure standards 

• Legal systems based on code law traditions 

In these environments, strong social networks appear to reinforce ethical norms and create real-world consequences for firms that step out of line. 

The study also finds that social capital matters most where corporate governance is weakest. In companies with poor internal controls or weaker boards, strong external social pressure acts as a substitute form of regulation, constraining bad behaviour that might otherwise go unchecked. 

This suggests that informal institutions like trust, reputation and networked communities can compensate for weak formal governance structures, challenging the idea that only laws and regulations keep firms accountable. 

The researchers believe the findings carry significant implications for regulators, investors and policymakers worldwide. 

In countries with lower levels of social trust, the study suggests there is a much greater need for strong, enforceable corporate governance rules to prevent financial manipulation. In high-trust societies, reputation and community scrutiny act as powerful, low-cost enforcement mechanisms. 

The research also helps explain why corporate scandals and financial reporting quality can vary widely across countries, even where formal accounting rules look similar on paper.