He that lies with dogs, shall rise up with ﬂeas. —Benjamin Franklin
here is ample evidence that social interactions affect human behavior. We see imitation in a wide range of situations, from teen activities to corporate decisions. Research on howbehavior spreads through social networks and affects outcomes has emerged in manyacademic ﬁelds, such as psychology, sociology, anthropology, biology, economics, and computer science, as well as various business disciplines, including accounting and ﬁnance (Rogers 2003;Jackson 2010).In the corporate world, behavior may spread through board of director networks.
A board linkexists between two ﬁrms whenever a director sits on both ﬁrms’ boards. A typical board in our sample has nine directors, and the median number of interlocks with other boards is approximatelyﬁve (see Table 1, Panel C). In this way, ﬁrms are widely connected by their board networks, whichpotentially serve as conduits for spreading behaviors from ﬁrm to ﬁrm.In this study, we investigate whether ﬁnancial reporting behavior spreads through interlockingcorporate boards. Our test design emphasizes contagion of
ﬁnancial reporting choices,speciﬁcally, earnings management that results in a subsequent earnings restatement, although it alsoallows for inferences about
reporting contagion. We use restatements to identify ﬁrms that have managed earnings and the period when the manipulation occurred. Timing issues areimportant when studying contagion and Figure 1 illustrates our timeline of events for contagion.We refer to a ﬁrm that later restates earnings as
. We deﬁne the
asstarting in the ﬁrst year for which earnings are restated and ending two years after. Any ﬁrm that shares an interlocked director with the contagious ﬁrm during the contagious period is therefore
to an earnings management infection via the board network. We consider a multiyear contagious period to allow the earnings management infection to incubate, which is analogous to anepidemiological setting for viral infections. Our key test investigates whether an exposed ﬁrm ismore likely to manage earnings during the contagious period as compared to an unexposed ﬁrm. If shared directors transmit earnings management practices, then the answer would be yes.Rogers (2003) suggests that opinion leaders are particularly inﬂuential in spreading behavior.High-prestige board positions and those more directly responsible for monitoring ﬁnancial reportingare more likely to be opinion leaders about ﬁnancial-reporting-related issues. Our second key test examines whether earnings management contagion varies in strength by board leadership positions,such as CEO, board chair, audit committee chair, audit committee member, and other boardpositions, in either the exposed or contagious ﬁrm.In testing for contagion, it is crucial to control carefully for alternative explanations for commonalities in linked ﬁrms’ behavior. A ﬁrm that intends to manage earnings may intentionallyrecruit a director who is earnings-management-friendly. Alternatively, ﬁrms facing similar economic environments may have preferences for similar director characteristics. These similaritiesor preferences could result in a common higher frequency of restatements in board-linked ﬁrms.Section V discusses how we control for such endogenous matching of directors and ﬁrms usingvariables that exploit the timing of the occurrence of earnings management and the timing of the
Our study concerns the behavior of individuals, and therefore networks in this study refer to social networksamong individuals (e.g., directors) or entities formed by individuals (ﬁrms), not networks of physical (e.g.,computer) objects. Speciﬁcally, we examine board networks formed from interlocked directors. In our tests inSections IV and V, we control for other networks, e.g., ﬁrms within a common industry, ﬁrms located in closegeographical proximity to other ﬁrms, and to accounting rule enforcers (auditors and SEC local ofﬁce). Footnote 3discusses other networks studied in the literature, e.g., between CEO and directors, and between CEO and market participants (analysts and investment fund managers).
Chiu, Teoh, and TianThe Accounting Review May 2013