Board Interlocks and Earnings Management Contagion

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday January 21, 2011 at 9:33 am
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Editor’s Note: The following post comes to us from Peng-Chia Chiu, Merage School of Business, University of California, Irvine; Siew Hong Teoh, Dean’s Professor of Accounting, Merage School of Business, University of California, Irvine; and Feng Tian, School of Business, University of Hong Kong.

In the paper, Board Interlocks and Earnings Management Contagion, which was recently made publicly available on SSRN, we test whether earnings management (like a virus) spreads from firm to firm via board connections of shared directors (virus carriers).

We use earnings restatements to identify firms that managed earnings and to identify the period when these firms manipulated earnings. We consider firms as infectious in the period when they manipulated earnings. We test whether the directors of the infected firms carry these earnings management behaviors to susceptible firms on whose boards they also sit on.

We find evidence of earnings management contagion in firms with interlocked boards. A firm sharing a common director with an earnings manipulator is more likely to manage earnings. The contagion is stronger when the shared director has a leadership position (e.g. board chair or audit committee chair) or an accounting-relevant position (audit committee member) in the susceptible firm. Contagion effects are not due to reverse causality effects, common industry shocks, geographical proximity, or common auditor firm. Contagion effects exacerbate earnings management incentives, such as M&A activities or situations associated with accounting fraud. Overall, the evidence supports the idea that economic behaviors such as earnings manipulation also spread through private social networks, and not just through public information channels.

The full paper is available for download here.


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