The Effect of Top Management Team Turnover and Local Market Characteristics on Financial Reporting Risk

Abstract

Upper echelon theory posits that defining, executing, and overseeing an organization’s strategy is a shared activity among top executive teams. Prior research has applied this theory to improve our understanding of firm performance and strategy. In this study, we explore the boundaries of upper echelon theory by examining its application to managements’ financial reporting oversight function. Specifically, we examine whether greater turnover among the members of a firms’ top executive group other than those with direct financial reporting oversight responsibilities (i.e., the CEO and CFO) influences key stakeholders’ concerns about financial reporting risk or whether consistency in the CEO and CFO positions is sufficient to alleviate any such concerns. Consistent with upper echelon theory, we find that turnover among top executives other than the CEO and CFO is positively associated with increased perceptions of financial reporting risk among auditors and audit committees. Building upon labor economics literature, we then explore whether local market characteristics that should affect firms’ ability to replace top executive talent moderates this effect. We find that the positive association between executive team turnover and perceptions of financial reporting risk is greater for companies headquartered in areas with more limited local labor pools and companies that are market leaders in their local areas or industries. Further analyses suggest that the perceptions of financial reporting risk in response to executive team turnover offsets deterioration in financial reporting quality.