Audit Committee Director-Auditor Interlocking and Perceptions of Earnings Quality

Abstract

SUMMARY: Using earnings response coefficients (ERCs) from returns-earnings regressions as a proxy for investor perceptions of earnings quality, we analyze how investors perceive reported earnings when companies with interlocking audit committee directors are audited by the same audit firm (hereafter, AC director-auditor interlocking). Our empirical results show that the extent of AC director-auditor interlocking is significantly and positively associated with ERCs. By dividing the sample period into pre-Sarbanes-Oxley Act (pre-SOX, 1998 through 2001) and post-SOX (2002 through 2010) periods, we find that the significantly positive effect of AC director-auditor interlocking on ERCs only exists in the post-SOX period, indicating that investors have reacted more positively to AC director-auditor interlocking after the implementation of SOX, which requires that audit committee members be independent. Finally, using financial expertise data for the period 2003 to 2010, we find that the positive relationship between the extent of AC director-auditor interlocking and ERCs is more pronounced when interlocking audit committee directors are financial experts than when they are not financial experts.