Audit committee member contextual experiences and financial reporting outcomes

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2012-05

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Contextual experience with the practical application of accounting standards is important for independent audit committee members to effectively monitor managers’ financial reporting estimates and the audits of those estimates. Basic knowledge of accounting standards can be acquired by reading public documents and some degree of information regarding firm-specific application of standards can be obtained from public disclosures. However, real-world, contextual experience may best be obtained through performing or monitoring the reporting tasks themselves. This dissertation investigates how a firm’s (focal firm) financial reporting monitoring activities are affected by its audit committee members’ contextual experiences gained through connections, either as managers or audit committee members, with other firms (links or interlocks). I specifically estimate whether contextual experience with significant judgments and estimates, measured as interlocks with firms that likely performed extensive impairment analyses in the prior year (distressed firms), affects the likelihood of focal firm decisions to write off goodwill after controlling for economic indicators of impairment, managerial incentives to misreport, and ability of managers to exercise discretion. I find that the likelihood of write-off is significantly greater for firms with links to distressed firms than firms without links, consistent with audit committee contextual experience influencing financial reporting outcomes. The distressed firm interlock effect is significantly greater when the contextual experience at the linked firm is in the performance of estimates as a manager in contrast to the monitoring of estimates as an audit committee member. However, in a subset of large firms with ExecuComp data, I find that the overall probability of write-off is decreasing across quartiles of managerial incentives to misreport and received interlocks are only marginally significant in the second quartile, indicating that contextual experience may not be an effective monitoring mechanism when managerial incentives to misreport are high. Combined results suggest that contextual experiences obtained through audit committee network associations do affect focal firm financial reporting outcomes and are most influential when the contextual experience is as a manager, rather than a monitor. However, such monitoring mechanisms appear to be primarily imitative and may not be effective deterrents against managerial misreporting at large firms when managerial equity-based incentives are strong.

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