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September 20, 2020 07:55 PM

The Impact of CEO/CFO Outside Directorships on Auditor Selection and Audit Quality

Posted by Jaeyoon Yu

In a recent study published in European Accounting Review, Byungjin Kwak, Myung Seok Park, Yoonseok Zang and I examine whether outside directorships of chief executive officer/chief financial officer (CEO/CFO) and resulting network ties to auditors affect auditor selection decisions and subsequent audit quality. While some studies suggest that executives’ outside board directorship is related to managerial opportunism and entrenchment (agency view) (Davis, 1991; Zajac & Westphal, 1996), others argue that it can enhance the home firm’s ability to obtain critical information and resources (embeddedness view) (Bacon & Brown, 1975; Fahlenbrach et al., 2010). Our study provides a unique setting to test these two different views in the context of audits.

We focus on a network tie that arises when the CEO/CFO of a firm (home firm) serves as an outside director of another firm (connected firm) that hires an auditor (connected auditor). We call this relationship CEO/CFO-auditor interlocks (or network ties). The CEO/CFO outside directorship provides an important opportunity to learn about an auditor and to build a connection, but the implications of such a connection for the home firm’s auditor appointment and subsequent audit outcome have been unexplored in prior studies.

Using a sample of US firms, this paper provides interesting results regarding auditor selection decisions. First, we find that home firms whose CEO/CFOs have network ties to auditors via outside directorships are more likely to appoint connected auditors. Second, a home firm’s tendency to hire a connected auditor is mitigated when its corporate governance is stronger. Third, a home firm is more likely to hire a connected auditor when such hiring leads to the home and connected firms being audited by the same audit office.

In the second part of this paper, we move our focus to audit quality consequences of hiring a connected auditor. Using a difference-in-differences research design, we show that hiring the connected auditors impairs the subsequent audit quality in home firms. Specifically, home firms hiring the connected auditors are more likely to misstate their financial statements, report greater absolute discretionary accruals, and are more likely to meet or just beat important earnings benchmarks, compared to those switching to non-connected auditors. Importantly, the decline in audit quality is more pronounced when such hiring leads to the home and connected firms being audited by the same audit office. Our findings collectively suggest that CEO/CFO outside directorships increase the likelihood of hiring a connected auditor and such hiring results in a deterioration of audit quality.

Our study contributes to the literature on the effects of top executives’ outside directorship on home firms. Prior literature offers conflicting theories and evidence for whether an executive’s outside board service will have a positive or negative impact on the home firm. While existing studies examine this issue in the areas of firm performance, corporate governance, CEO compensation, performance of mergers, and sensitivity of CEO turnover-to-performance, we contribute to this literature by examining an unexplored issue of the effect on auditor selection and audit quality.

Our study also contributes to the auditing literature. First, it adds to the auditor selection literature by documenting that CEO/CFO-auditor ties through outside directorships significantly affect auditor selections among Big 4 auditors, particularly when the tie is developed at the local audit office level. Second, we extend the literature on the effect of CEO/CFO-auditor ties on audit quality by examining a new type of ties via CEO/CFO outside directorships.

 

Discover more about our study: https://www.tandfonline.com/doi/full/10.1080/09638180.2020.1807381

To cite this article: Jaeyoon Yu, Byungjin Kwak, Myung Seok Park & Yoonseok Zang (2020) The Impact of CEO/CFO Outside Directorships on Auditor Selection and Audit Quality, European Accounting Review, DOI: 10.1080/09638180.2020.1807381

 

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About Jaeyoon Yu

Erasmus University Rotterdam
Assistant Professor

I am an Assistant Professor of Accounting at Erasmus University Rotterdam. My research interests are in the fields of auditing, regulation, and corporate governance.

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