Board interlocks and earnings management contagion

Abstract

We examine whether earnings management spreads from firm to firm via board connections of shared directors. A firm has a higher likelihood of restating earnings in a given year if it shares a director with another firm that restated earnings either in that same year or within the past two years. We also find evidence of earning management contagion at the earlier restating period when the accounting violated GAAP. In this case, a firm has a higher probability of later restating earnings reported in the current year if it shares a director with other firms that have to restate earnings for the current or past two years. Furthermore, we find that earnings management contagion is stronger when it’s the shared director has a more important relevant position. A board chairman, audit committee member or especially audit committee chairman who is also a director at another firm is associated with stronger contagion relative to other board positions of shared directors. This finding is consistent with the importance of the role of board monitoring to ensure high quality financial reporting. Board network contagion effects are not due to reverse causality, endogenous matching of firm characteristics or common industry shocks, but are weakened by endogenous matching of director characteristics. Board network contagion effects also subsume contagion from geographical proximity of firms, and are incremental to other sources of earnings management incentives, such as M&A and new issue activities. Overall, the evidence supports the idea that economic behaviors such as earnings manipulation spread through social networks.