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 (Syracuse University)

David Harris (Syracuse University)

Linna Shi '11 Ph.D. (University of Cincinnati)

Nan Zhou (University of Cincinnati)

Year of Publication : Review of Accounting Studies (2020)

Summary of Findings : We find that members of the Audit Committees of public corporations' Boards of Directors communicate and act on manipulative accounting polices of other firms' Boards on which they also sit; that, like disease, abusive accounting polices move from infected firms to clean firms when a new member of the Board joins and has served on the Board of a contagious firm.

Research Questions : Are manipulative accounting policies transmitted between firms via the Audit Committee of the Board of Directors when a Director, who has served at another firm, newly joins another firm's Board?

What are the characteristics of such transmission: Does it start only after a new member joins the Board? Does it end when that member leaves? Does it move only from more influential, larger, firms to smaller firms? It it more intense when the two firms are both in the same industry?

We finds the answers, to all questions, to be, Yes.

What we know : Abusive accounting policies of publicly traded companies are very costly, and not just to the shareholders of that firm, but to society, at large.The best (worst) example, likely, is Enron. Given these enormous costs, it is very important to understand how these policies spread across firms, just like is very important to understand how dangerous diseases spread across countries. Documenting an important source of disease contagion allows investors, auditors, and regulators to better focus on this problem and effectively respond to it.

Novel Findings : These findings are original to our work. Some prior work has shown some connections across firms due to interlocked Boards of Directors, but have not focused on any of the details of what is going on.

Novel Methodology : We do introduce a number of new methodological refinements. We show that contagion only starts after a new Director, coming from an infected firm, joins an uninfected firm and that the infection is of the same type as at the old firm. We show that this connection stops when the interlocked Director leaves the infected firm. We also support the legitimacy of our findings by showing that the more influential the infected firm, the greater the impact - abusive policies of more important, larger firms, have substantial impact smaller firms in the same industry. We also show that this transmission of infection only goes one way - from infected to uninfected firms - the bad firms don't seem to get better.

Implications for Practice : On a practical basis, this suggests that if a firm is identified as having violated mandatory accounting rules and regulations, such as having to restate their earnings, that one should look to other firms associated with them by interlocked Directors; that interlocked firms, though not yet identified, are more likely also to have violated accounting rules and regulations.

Implications for Policy: There is, most likely, no particular policy implication, as it seems overly aggressive to forbid the creation of interlocked Boards of Directors. On the other hand, it does suggest that the Board of Directors of a company looking for a new member should carefully examine the accounting policies (and likely all of the important financial policies) of the firms where that Director currently sits, as it seems very likely that those policies will be suggested to the new firm by that Director.

Implications for Society: As noted above, societal costs of accounting manipulations can be enormous. It is widely accepted that the Great Depression arose from the lack of accounting regulation and the continued existence of effective accounting regulation since then has prevented another global financial disaster of that magnitude. Thus, identifying a vector of diseased accounting polices transmission can better arm society against its spread and concomitant damage.

Implications on Research: This research suggests a number of profitable future research ideas. For example, our paper can be extended by further refining the characteristics that, on the one hand, make firms more easily influenced and, on the other hand, make a firm more influential. Obviously, it suggests the possibility that many other firm operations, beyond accounting, can be examined to see how they change with changes in the Board of Directors, such as: debt policies, acquisitions and mergers, leveraged buyouts, etc.

Full Citations : Dharwadkar, R., Harris, D., Shi, L., Zhou, N. Rev Account Stud (2020). https://doi.org/10.1007/s11142-019-09516-w

Abstract : We examine how bad accounting policies are communicated between firms. We theorize that bad accounting, like disease, is transmitted from infected, contagious firms to other firms. The particular accounting policy we focus on is the accounting for special items; well known for being used to manipulate firms’ earnings. We find that this accounting policy is transmitted between firms across connections in their boards of directors; specifically, members of the audit committee. To isolate this vector of infection, we examine the setting in which the director of a diseased firm, who has served there for at least a year, joins another firm. We then examine how the newly joined firm’s accounting changes after becoming interconnected. We find that the newly joined firm adopts the infected firm’s manipulative accounting policy. Bolstering our conclusion that we have found a vector through which bad accounting policies are transmitted, we also show that: bad accounting only flows to the newly joined firm, and not the other way; it only flows from the larger, more important firm, to the smaller firm; that it is worst for firms in the same industry, where an infection from one firm is most likely to “fit” the newly joined firm; and, this similarity ends if the connecting director leaves.

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We find that members of the Audit Committees of public corporations’ Boards of Directors communicate and act on manipulative accounting polices of other firms’ Boards on which they also sit; that, like disease, abusive accounting polices move from infected firms to clean firms when a new member of the Board joins and has served on the Board of a contagious firm.

David Harris
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