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    Audit Committee Director-Auditor Interlocking and...
    research summary posted March 2, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 13.0 Governance, 13.02 Board/Financial Experts, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
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    Title:
    Audit Committee Director-Auditor Interlocking and Perceptions of Earnings Quality
    Practical Implications:

    This study is important to provide an insight into the personal relationships and familiarity between audit committee directors and external auditors in terms of auditor independence. Furthermore, our examination of AC director-auditor interlocking provides a more complete basis for understanding the effectiveness of corporate governance in guarding earnings quality. The results not only support the view that AC director-auditor interlocking positively affects investors’ perception of earnings quality, but also support the regulatory requirement that audit committees include at least one financial expert.

    For more information on this study, please contact Jeng-Fang Chen.

    Citation:

    Chen, J.-F., Y.-Y. Chou, R.-R. Duh, and Y.-C. Lin. 2014. Audit committee director-auditor interlocking and perceptions of earnings quality. Auditing: A Journal of Practice and Theory 33 (4): 41-70

    Keywords:
    Audit committee director-auditor interlocking, investor perceptions, earnings response coefficients, financial expert
    Purpose of the Study:

    In response to Enron and subsequent financial reporting scandals, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 (SOX, hereafter), which put particular emphasis on the role of audit committees in ensuring financial reporting quality. Although existing regulations stipulate the composition and qualifications of audit committee directors, audit committee director interlocking that arises when an audit committee director serves on more than one audit committee is allowed. Therefore, we analyze how investors perceive reported earnings when companies with interlocking audit committee directors are audited by the same audit firm (hereafter, AC director-auditor interlocking), using earnings response coefficients (ERCs) as a proxy for investor perceptions of earnings quality. The tendency of AC director-auditor interlocking could have positive or negative implications for the audit committee’s effectiveness in guarding earnings quality.

    • A positive influence may result insofar as closer personal relationships enhance the audit committee’s understanding and trust of auditors, thereby making interlocking audit committee directors more likely to support the auditor in accounting and auditing disputes.
    • An opposing argument is that economic incentives may compromise auditor independence. Also, interlocking audit committee directors may be less critical of auditor performance due to personal relationships with the interlocking auditor.

    Besides the relationship between AC director-auditor interlocking and ERCs, this study investigates whether the potential positive impact of AC director-auditor interlocking in improving earnings quality would be outweigh the potential negative influence in the post-SOX period, when shareholders and regulators have higher expectations and heighten liability concerns for both interlocking audit committee directors and auditors. In particular, this study examines if earnings quality is higher when interlocking audit committee directors are financial experts who are better placed to recommend streamlining of audit committee procedures on the financial reporting process.

    Design/Method/ Approach:

    We collect director information through the RiskMetrics database, which covers S&P 1500 companies, from fiscal years 1998 to 2010, while the impact of financial experts is examined by a sample from fiscal years 2003 to 2010. This study uses ERCs from returns-earnings regressions and designs three measures for the degree of a firm’s AC director-auditor interlocking to examine its impact on earnings quality. 

    Findings:
    • This study finds that a greater extent of AC director-auditor interlocking is perceived as associated with higher earnings quality.
    • This study finds that investors’ perceptions of earnings quality are more affected by the extent of AC director-auditor interlocking in the post-SOX era than before it, whatever we use the pre- and post-SOX subsamples or the interaction item of SOX for the test.
    • This study finds that investors perceive AC director-auditor interlocking especially positively when interlocked audit committee directors are financial experts. That is, the results document that the positive impact of AC director-auditor interlocking on the ERCs is more pronounced when interlocking audit committee directors are financial experts.
    Category:
    Corporate Matters, Governance, Standard Setting
    Sub-category:
    Audit Committee Effectiveness, Board/Financial Experts, Impact of SOX