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The initiation of audit committee interlocks and the contagion of accounting policy choices: evidence from special items

Review of Accounting Studies volume 25, pages 120–158 (2020)Cite this article

Abstract

We document that the initiation of audit committee interlocks is associated with contagion in reported special items. We argue that this is, in part, attributable to contagion of accounting policy choices. We find that the special items of newly interlocked firms, unrelated before interlock, become positively correlated afterward, suggesting information transfer starts with interlock formation. This result holds for negative special items, key components of special items (asset impairments, restructuring costs, and gains/losses from asset sales), and is stronger for larger firms and for firms within the same industry.

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Notes

  1. For example, an audit committee chair of a NASDAQ firm stated that “The audit committee is absolutely involved. We focus on any prior year restructuring reserves, particularly focusing on where we put the reversal of any reserves. We focus on the allowance for doubtful accounts, inventory reserves, and income/deferred income estimates. We also look at impairment of intangibles” (Beasley et al. 2009, p. 95).

  2. Classified boards are common in US firms (Yerak 2012). Since a director may be removed from the audit committee without being removed from the classified board (Arthaud-Day et al. 2006), our focus on audit committees could help mitigate the entrenchment effect associated with directors on a staggered board (Bebchuk and Cohen 2005).

  3. Our definition of an audit committee interlock considers the situation where an inside director of one firm joins the audit committee of another firm. Supported by the empirical evidence that executives have greater access to inside information than audit committee members do (Ravina and Sapienza 2010), this research design considers all cases in which a new director uses information obtained from the contagious firm to influence audit committee decisions of the suspect firm. As the initiation of an audit committee interlock is a one-time event, we adopt this broader definition to increase the size of our sample and the power of our study.

  4. Han et al. (2017) find that Chinese firms with interlocked directors have similar inventory and depreciation methods. As a choice between FIFO and weighted average cost, the inventory cost method in China exhibits little variation, as 71.92% of the firms use the weighted average cost method as of December 31, 2009 (http://www.atlantis-press.com/php/download_paper.php?id=9403). Given the stickiness of inventory methods, their findings are likely driven by endogenous ex-ante similarities between interlocked firms rather than by the asserted information transfer.

  5. This one-year requirement helps us establish the sequence of events without ambiguity.

  6. Since special items are expenses reported in the income statement, we scale special items, negative special items, and special items components by sales in our paper (McVay 2006; Fan et al. 2010). Our main results in Tables 3, 4, 5, 6 and 7 are robust when, alternatively, we deflate special items, negative special items, and special items components by average total assets.

  7. Consistent with Elliott and Hanna (1996), we assign a zero to special items if this data item is missing in Compustat.

  8. Bebchuk et al. (2009) track six provisions: staggered boards, limits to shareholder amendments of the bylaws, supermajority requirements for mergers, supermajority requirements for charter amendments, poison pills, and golden parachute arrangements. They construct an entrenchment index (E-Index) by assigning a score from zero to six based on the number of these provisions that the company has in a given year.

  9. We follow the Fama-French 12 industry classification (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/det_12_ind_port.html).

  10. As reported in Johnson et al. (2011), the SI distribution is skewed because the number of firms reporting negative special items is significantly greater than the number of firms reporting positive special items. This is most likely driven by managerial incentives to classify expenses or losses into SI, which is often excluded in executive compensation contracts and analyst forecasts (e.g., McVay 2006). Per the central limit theorem, OLS estimates are asymptotically normally distributed in large enough samples (Wooldridge 2013), which our sample is. Thus, a strictly normal distribution of the error is not necessary for the validity of our OLS regressions. Nonetheless, in untabulated analyses, we find that our main results in Tables 3, 4, 5, 6 and 7 are robust with bootstrapped standard errors.

  11. Restructuring costs include “a write-down of assets to their estimated realizable value; operating losses to be incurred prior to the sales; a provision for severance and other employee termination costs; and a provision for the cost of redeployment of assets” (Elliott and Shaw 1988, p. 117).

  12. Note that our asset impairment measure includes write-downs for tangible assets and impairment of goodwill for intangible assets, as Cready et al. (2012) find that earnings increases are greater for restructuring charges than for asset write-downs or goodwill impairment charges.

  13. The other four special items components – extinguishment of debt, acquisition/merger, settlement (litigation/merger), and in-process research & development – are less likely to be discretionary accounting choices. While the timing of extinguishment of debt is under management’s control, the amount is less likely to be manipulated because the extinguishment payment by cash or by a new debt is objective. Representing the portion of R&D considered to be “purchased,” the in-process research & development item is written off immediately upon acquisition if the R&D items are deemed not to have an alternative use.

  14. We find that the correlation of restructuring costs between suspect firms and contagious firms is significant before the new interlock formation, which may be because firms with similar restructuring activities tend to select similar directors; i.e., ex-ante similarities exist. However, the significant increase in the correlation (β2 is significant for all models in Table 7) due to interlock formation clearly shows that information also is transferred via interlocks. Therefore, the significant correlation post interlock formation between restructuring costs of interlocked firms is a result of both ex-ante similarities and information transfer.

  15. Note that the joint probability of independent events is their product.

  16. “A falsification hypothesis is a claim, distinct from the one being tested, that researchers believe is highly unlikely to be causally related to the intervention in question” (Prasad and Jena 2013, p. 241).

  17. Our results are robust if we define new audit committee interlocks in their first 2 years of existence.

  18. Hiring and firing directors is a significant corporate decision that requires voting by shareholders. It seems rather unlikely that firms hire and fire directors in sync with their desires for a single, specific accounting policy, as accounting expertise should, in general, fall across a much larger spectrum.

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Acknowledgements

We thank Scott Richardson (editor) and an anonymous referee for their valuable suggestions, which have significantly improved our paper. We also thank Pamela Brandes, Joseph Comprix, Parthiban David, Gerry Davis, Hui Guo, Sangsoo Kim, Mark Mizruchi, Paul Ordyna, Chen Xue, and workshop participants at American University, SUNY–Binghamton, Syracuse University, University of Cincinnati, University of International Business and Economics, Zhejiang University, and the Conference on the Convergence of Financial and Managerial Accounting Research in Lake Louise for their helpful comments.

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  1. Whitman School of Management, Syracuse University, Syracuse, NY, USA

    Ravi Dharwadkar & David Harris

  2. Lindner College of Business, University of Cincinnati, Cincinnati, OH, USA

    Linna Shi & Nan Zhou

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  1. Ravi Dharwadkar
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Appendices

Appendices

Appendix 1: Examples for Contagion of Special Items Reporting Between Interlocked Firms

In this appendix, we present three cases of information contagion obtained by reading interlocked firms’ DEF 14A filings for director information and 10-K filings for reported special items, including asset impairments, restructuring costs, and gains/losses from asset sales.

  • Case 1: Interlock between Weyerhaeuser Company and E. W. Scripps Company in 2008.

Kim Williams had been an audit committee member at Weyerhaeuser Company since 2006. She joined the audit committee of the E. W. Scripps Company in 2008. In Form 10-K for the fiscal year ended December 30, 2007, Weyerhaeuser reported an impairment of goodwill for $30 million (associated with its Canadian and certain US building materials distribution centers) and an impairment of long-lived assets of $128 million (associated with its segment of real estate). The total amount of write-downs was $158 million. In Form 10-K for the fiscal year ended December 31, 2008, Scripps started to report impairments of goodwill and long-lived assets totaling $810 million for the fiscal year, including a write-down of goodwill totaling $779 million, an $11.4 million non-cash charge to write down the FCC license, and a $19.6 million non-cash charge to write down long-lived assets to fair value.

  • Case 2: Interlock between Sybase Inc. and Portal Software Inc. in 2000.

Robert P. Wayman had served on the board of Sybase Inc. since 1995 and was an audit committee member of the company as of 2000. He joined Portal Software Inc. as an audit committee member in September 2000. In February 1998, Sybase announced and began to implement a restructuring plan aimed at improving productivity per employee. The company reported restructuring cost (reversal) of ($791), ($8528), and $74,167 thousands for the 2000, 1999, and 1998 fiscal years, respectively. In April 2001, Sybase initiated another restructuring program in connection with its acquisition of New Era of Networks. In Form 10-K for the fiscal year ended December 31, 2001, Sybase disclosed that it recorded significant accruals in connection with its restructuring program, and reported the estimated cost of restructuring in the amount of $48,751 thousands. During the fiscal year ended January 31, 2002, Portal Software announced plans to restructure the company through a combination of a reduction in workforce, consolidation of facilities, and the write-off of assets. In Form 10-K for the fiscal year ended January 31, 2002, Portal Software started to report $71,020 thousands in estimated accrued restructuring expenses.

  • Case 3: Interlock between Parexel International Corporation and Brooks Automation Inc. in 2012.

Ellen M. Zane had served as a director of Parexel International Corporation since July 2006. She joined Brooks Automation Inc. as an audit committee member in 2012. In Form 10-K for the fiscal year ended June 30, 2013, Parexel reported $884 thousands for gain on disposal of assets in its Consolidated Statements of Cash Flows. In Form 10-K for the fiscal year ended September 30, 2013, Brooks Automation reported $1394 thousands for gain on disposal of long-lived assets in its Consolidated Statements of Cash Flows. In a footnote to financial statements, Brooks Automation disclosed that the gain was from the sale of certain underutilized buildings in Chelmsford, Massachusetts, and Oberdiessbach, Switzerland.

Appendix 2: Variable Definitions

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Dharwadkar, R., Harris, D., Shi, L. et al. The initiation of audit committee interlocks and the contagion of accounting policy choices: evidence from special items. Rev Account Stud 25, 120–158 (2020). https://doi.org/10.1007/s11142-019-09516-w

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Keywords

  • Audit committee interlock
  • Information transfer
  • Special items
  • Restructuring charges
  • SFAS 146

JEL classification

  • M41
  • M42
  • M48
  • G34
  • D83