The Effects of Board Interlocks With an Allegedly Fraudulent Company on Audit Fees

Mariya N Ivanova,Annalisa Prencipe

doi:10.1177/0148558x20971947

Mariya N Ivanova, Annalisa Prencipe

Open Access

https://doi.org/10.1177/0148558x20971947

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Abstract

Drawing on prior literature on audit fees, client reputation, and corporate governance, we posit that a material adverse event at a firm, such as a financial fraud allegation, leads to an increase in the audit fees of firms connected to the former by a board interlock. We propose two possible mechanisms to explain the upward pressure on audit fees: a client-side effect, where the client demands additional audit services, and an auditor-side effect, where the auditor raises its audit fees due to a perceived increase in audit engagement risk. The results indicate an average marginal increase of 12.86% in audit fees in the year following the public revelation of financial fraud. Additional analyses suggest that an auditor-side effect is in place, while we cannot find clear evidence supporting the client-side effect. Furthermore, we document that the positive effect on audit fees persists for up to at least 2 years after public disclosure of the event when the interlocked director serves as a member of the audit committee. JEL Descriptors: G34, M40, M42

Highlights

Board interlocks occur when the same director sits simultaneously on the boards of two firms.1 This study addresses whether audit fees increase following financial fraud allegations at firms to which the audit client is connected by a board interlock
After we add the full set of control variables and industry and year fixed effects to the model, the coefficient of Y1 is positive and significant at the 1% level for a two-tailed test (b1 = 0.121; t-statistic = 2.63), suggesting that, on average, the revelation of financial fraud is positively associated with the audit fees of interlocked firms, in support of our prediction
This study examines whether material adverse events such as egregious Generally Accepted Accounting Principles (GAAP) violations at a firm have an effect on the audit fees of firms connected to the former by a board interlock

Summary

Introduction

Board interlocks occur when the same director sits simultaneously on the boards of two firms. This study addresses whether audit fees increase following financial fraud allegations at firms to which the audit client is connected by a board interlock. We argue that the reputational concerns of interlocking directors will motivate them to demand additional audit services to reduce the risk of fraudulent behavior and protect their own and the connected firm’s reputation (Carcello et al, 2002; Hay et al, 2008; Knechel & Willekens, 2006; Zaman et al, 2011) Taking into account both the auditor- and the client-side mechanisms, we expect a firm connected to an allegedly fraudulent firm to pay higher audit fees after the revelation of accounting fraud at a connected firm. Our main hypothesis predicts that b1 is positive and significant

Empirical Results

Main Results

Conclusion