The spillover effects of financial misconduct on director-interlocked firms: Evidence from auditor scrutiny

Abstract

This paper examines the impact of firm financial misconduct on its director-interlocked firms from the perspective of auditors. We argue that when a firm engages in financial misconduct, auditors tend to perceive its director-interlocked firms as having higher audit risks. This is because accounting policies, procedures and corporate governance can propagate via common directors. Using a sample of listed US firms from 1999 to 2018, we find that auditors charge higher fees for firms whose director-interlocked firms engage in financial misconduct. Further analyses show that this spillover effect is stronger when focal firms are riskier (when they are financially distressed or have worse earnings quality) or they have weaker alternative monitoring mechanisms (as evidenced by lower institutional shareholding). The effect is also more prominent when the tainted directors hold important positions or the financial misconduct is more severe. We also find that the higher auditor fees arise from not only risk premium but also greater audit effort. Our results are still valid after conducting a series of robustness tests.