The initiation of audit committee interlocks and the contagion of accounting policy choices: Evidence from special items

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Author Information : Ravi Dharwadkar (Whitman School, Syracuse University)
David Harris (Whitman School, Syracuse University)
Linna Shi 'XX (University of Cincinnati)
Nan Zhou (University of Cincinnati)

Year of Publication : Review of Accounting Studies (2019, forthcoming)

Summary of Findings : We find that manipulative accounting methods are transmitted between firms by common members on the Audit Committees of the Boards of Directors.

Research Questions : We examine how corporate governance is affected by common connections between firms on the Boards of Directors.

What we know : It is important to understand how manipulative accounting methods arise and propagate across firms over time.

Novel Findings : We are the first paper to study this and to find this result.

Abstract : We examine whether a member of the Board of Directors of a firm committing accounting manipulations (the transmitting firm) joining the Audit Committee of the Board of Directors of another firm which has not been doing this (the receiving firm) leads the receiving firm to adopt those manipulations. The Audit Committee has considerable expertise in how financial information should be prepared and has oversight of a firm’s financial accounting; if influence were to be exerted this is where it most effectively could be done. We find strong evidence that earnings manipulations are transmitted between firms within the Audit Committee. We examine discretionary earnings manipulations, generally, and several specific examples such as strategic asset sales, charging off “special” losses, and writing down asset values. We also conduct several tests that validate our results. For example, we find that “transmitting” firms infect "receiving" firms and that transmitting firms don’t get better for associating with receiving firms not involved in accounting manipulations; the good firms just get worse due to the one-way transmission of information. We also find that if a Director comes from a larger firm, then they have more influence over a receiving firm than if they had come from a small firm. In summary, we document an important channel of communication and influence by which manipulative accounting policies migrate between firms.

This research finds that manipulative accounting methods are transmitted between firms by common members on the Audit Committees of the Boards of Directors.

Ravi Dharwadkar

Professor Dharwadkar is a professor of management. His research interests include organization theory and organizational behavior. He is currently working in the area of corporate governance.
Ravi Dharwadkar
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