Financial Reporting Quality and Auditor Dismissal Decisions at Companies with Common Directors and Auditors*

Abstract

ABSTRACTWe examine the effects of corporate networks involving common directors and auditors (i.e., connections creating single or double ties between companies) on two important monitoring roles: financial reporting quality and auditor dismissal decisions. We also investigate how shocks to the networks, in the form of the audit failing to detect misstatements, affect these networks' structure. The investigations are important because these networks can have significant effects on firm governance and may have different effects when they overlap. We have three primary findings about double‐tie networks: (i) there is no evidence that they improve overall financial reporting quality beyond the effect of single‐tie networks; (ii) they lower directors' willingness to dismiss the auditor, even when there is a signal of an audit failure within the network; and (iii) they allow audit‐quality problems to spread between companies. Our results demonstrate the importance of investigating multiple types of networks and how shocks travel through them. Our findings also lend credence to concerns that “cozy” relationships between directors and auditors diminish the link between poor audit quality and market‐imposed reputation penalties—specifically, auditor dismissals.