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Board Interlocking and EM Contagion AR 2013

Board Interlocking and EM Contagion AR 2013

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Published by: Mira Amirrudin on Jul 06, 2014
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THE ACCOUNTING REVIEW 
 American Accounting AssociationVol. 88, No. 3 DOI: 10.2308/accr-503692013pp. 915–944
Board Interlocks and Earnings ManagementContagion
 Peng-Chia ChiuSiew Hong Teoh
University of California, Irvine
 Feng Tian
The University of Hong Kong
ABSTRACT:
 We test whether earnings management spreads between firms viashared directors. We find that a firm is more likely to manage earnings when it sharesa common director with a firm that is currently managing earnings and is less likely tomanage earnings when it shares a common director with a non-manipulator. Earningsmanagement contagion is stronger when the shared director has a leadership or accounting-relevant position (e.g., audit committee chair or member) on its board or the contagious firm’s board. Irregularity contagion is stronger than error contagion.The board contagion effect is robust to controlling for endogenous matching of firmswith directors, fixed firm/director effects, incidence of M&A, industry, and contagion viaa common auditor or geographical proximity. These findings support the view thatboard monitoring plays a key role in the contagion and quality of firmsfinancialreports.
Keywords:
 earnings management 
;
 restatements
;
 board interlocks
;
 board networks
;
social networks
;
 contagion
;
 governance
.
JEL Classifications:
 M40 
;
 M41
;
 M49
;
 G34
;
 G39
;
 D83 
.
Data Availability:
 Data are available from sources identified in the text 
.
We thank Steve Kachelmeier and Harry Evans (editors) and two anonymous referees; conference and workshopparticipants at the 20th Financial Economics and Accounting Conference (Rutgers, The State University of New Jersey),Annual Academic Corporate Reporting and Governance Conference (California State University, Fullerton), 2011 AAAWestern Region Conference (Lucile Faurel, discussant), 2011 AAA Annual Meeting (Rosemond Desir, discussant),Santa Clara University, Southern Methodist University, University of California, Irvine, and University of Toronto, andYe Cai, David Hirshleifer, Haidan Li, Hai Lu, Partha Mohanram, Carrie Pan, Mort Pincus, Devin Shanthikumar, and IvoWelch for very helpful comments.Editor’s note: Accepted by John Harry Evans III, with thanks to Steven Kachelmeier for serving as editor on a previousversion.
Submitted: February 2011 Accepted: November 2012 Published Online: December 2012
915
 
He that lies with dogs, shall rise up with fleas. —Benjamin Franklin
I. INTRODUCTION
T
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.
1
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 
 ‘‘
bad
’’
 financial reporting choices,specifically, earnings management that results in a subsequent earnings restatement, although it alsoallows for inferences about 
 ‘‘
good
’’
 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
 contagious
. We define the
 contagious period 
 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
exposed 
 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 similaeconomic 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
1
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).
916
 Chiu, Teoh, and TianThe Accounting Review May 2013
 
creation of board linkages to contagious firms. Furthermore, we control for other channels for spreading financial reporting behavior, such as networks formed within an industry, sharing common auditor, and geographical proximity to contagious firms and to the local Securities andExchange Commission (SEC) office. Finally, we control for situations for which previous studiesdocument an increased incentive to manage earnings, such as during mergers and acquisitions(M&A) or new equity offerings and in high fraud-score firms.The core question motivating our research is whether board networks spread financial reportingbehavior, and we focus on earnings management because regulators, market participants, and theacademic literature are concerned about bad financial reporting practices. Our test design choicenarrows the focus further on extreme forms of earnings management that are detected withrestatements. Whether our results generalize to undetected milder forms of earnings management bears further study. For some insight into the effects of earnings management severity on boardcontagion strength, in Section V we test whether board contagion differs between irregularityrestatements, which are more egregious forms of misreporting, and error restatements, which areless serious violations.In the 1997–2001 sample period, we find strong evidence that a firm is more likely to manageearnings when exposed within a three-year period to earnings management from a common director with an earnings manipulator. The contagion effect is economically substantial. The regression oddsratio suggests that a board link to a manipulator doubles the likelihood that the firm will manageearnings. Interestingly, we also find evidence for 
 good 
 financial reporting contagion. A board linkto
 non
-manipulator significantly decreases the likelihood of the firm being a manipulator. In sum,both bad and good accounting behaviors are contagious across board networks.
FIGURE 1Illustration of Earnings Management Contagion
 Board Interlocks and Earnings Management Contagion
 917
The Accounting Review May 2013

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