Among Boards of Directors Abusive Accounting Policies Can Be Contagious

A study published in Review of Accounting Studies finds that it’s possible for manipulative accounting policies to be transmitted between firms. The common denominator is found within the Audit Committee of a company’s board of directors. 

“We find that members of the Audit Committees of public corporations’ boards of directors communicate and act on manipulative accounting policies of other firms’ boards on which they also sit,” says David Harris, professor of accounting, and co-author of the study. “Like disease, abusive accounting polices move from infected firms to clean firms when a new member of the board joins who has served on the board of a contagious firm.”

Harris and his co-authors, Ravi Dharwadkar (Syracuse University), Linna Shi ’11 Ph.D. (University of Cincinnati), and Nan Zhou (University of Cincinnati), focused on the accounting for special items accounting policy, one that is well known for being used to manipulate firms’ earnings. They find that this accounting policy is transmitted between firms across connections in their boards of directors; specifically, members of the audit committee. To isolate this vector of infection, the researchers examine the setting in which the director of a diseased firm, who has served there for at least a year, joins another firm. They then examine how the newly joined firm’s accounting changes after becoming interconnected. 

“We find that the newly joined firm adopts the infected firm’s manipulative accounting policy,” says Harris. “Bolstering our conclusion that we have found a vector through which bad accounting policies are transmitted, we also show that: bad accounting only flows to the newly joined firm, and not the other way; it only flows from the larger, more important firm, to the smaller firm; that it is worse for firms in the same industry, where an infection from one firm is most likely to ‘fit’ the newly joined firm; and, this similarity ends if the connecting director leaves.”

This study is the first to focus on the intricacies of the connections across firms due to interlocked boards of directors. Prior work has shown that there are connections but this research provides a concrete example of just how far-reaching the connections can be.

“The more influential the infected firm, the great the impact,” says Harris. “Abusive policies of more important, larger firms, have substantial impact smaller firms in the same industry.”

He adds that this research is critically important, given the enormous costs to society that can result from abusive accounting policies of publicly-traded companies. It documents an important source of the disease contagion and allows investors, auditors and regulators to better focus on the problem and effectively respond to it.

Harris suggests that if a firm is identified as having violated mandatory accounting rules and regulations, such as having to restate their earnings, one should look to other firms associated with that company by interlocked directors. Interlocked firms are more likely to also have violated accounting rules and regulations.

Ravi Dharwadkar and David Harris, “The initiation of audit committee interlocks and the contagion of accounting policy choices: Evidence from special items” (with Shi, L ’11 Ph.D. and Zhou, N.), Review of Accounting Studies.