LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT 1 Social Ties Research in the Finance Literature

Social ties have received much attention from accounting and finance academics because they are nonfamilial and informal connections that may be a potential source of a person’s dependence on other people. Prior finance research examines whether CEOs’ social ties with board directors and other outside professionals bring negative consequences to the firms. However, the results are mixed. For example, in a smaller cross-section of Fortune 100 firms drawn from 1996-2005, Hwang and Kim (2009) find that firms whose board members are tied with their CEOs through education and non-professional connectedness award a significantly higher level of CEO compensation and exhibit weaker pay-performance sensitivity. Fracassi and Tate (2012) examine whether social ties between CEOs and board directors jeopardize firms’ governance. They find that CEO-director’s education, employment, and other activities ties reduce firm value, particularly when firms have no other governance mechanisms to substitute for board oversight. In addition, firms with more CEO-director ties engage in more value-destroying merger and acquisitions (M&A) activities.

In contrast, Cohen et al. (2008) focus on education ties between CEOs and mutual fund managers. They find that portfolio managers put larger bets on connected firms and perform significantly better on these holdings. Cohen et al. (2010) also use education ties between CEOs and analysts to show that connected analysts outperform by up to 6.60% per year on their stock recommendations. The above two studies suggest that social ties facilitate information flows. Schmidt (2015) explores the effect of education and non-professional ties between CEOs and board members on firms’ M&A decisions. The empirical results indicate that bidder announcement returns are higher

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when board advice is more important than monitoring. The author concludes that, in the M&A situation, board independence is not always in the shareholders’ best interest.

Overall, given the mixed results reported in the finance literature, whether CEO-director social ties are detrimental or beneficial to firms is still an empirical question. Instead of focusing on the consequences of social ties among board members, our study focuses on what actions the auditors can take to respond to the existence of three types of social ties in their clients’ boards. We argue that different types of social ties between CEOs and people other than board directors who are not responsible for overseeing financial reporting will have different effects on the firms.

2.2 Social Ties Research in the Accounting Literature

Recently, accounting researchers have also begun to investigate the effects of social ties on firms’ earnings quality and governance effectiveness. Not surprisingly, the results are mixed. For example, Naiker and Sharma (2009) examine whether the presence of former audit partners on ACs harms the committees’ independence, leading to oversight failure in internal control weaknesses. They find that AC members who are former audit partners and affiliated with current auditors enhance AC oversight quality, which in turn improves internal controls and financial reporting quality. In a related study in a similar setting, Naiker et al. (2013) further show that the presence of former audit partners on ACs is negatively associated with the procurement of non-audit services from the current auditors.

Both studies suggest that past audit firm employment ties will not reduce current AC oversight quality.

In contrast, Krishnan et al. (2011) combine social ties resulting from education, employment, and non-professional activities into one measure and test whether these ties between the CEOs/CFOs and board directors motivate firms’ earnings management. They first show that CEOs/CFOs are more likely to appoint socially-connected directors to boards after SOX. They then show that these social ties are positively associated with firms’ avoidance of a loss, an earnings decline, and failure to meet or

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beat analysts’ earnings forecasts. However, the negative effect of social ties seems to be offset by the increase in board risk aversion due to SOX.

Two more recent studies turn attention to two monitoring bodies that are mandated to be independent. Bruynseels and Cardinaels (2014) document that social ties between AC members and CEOs have a negative effect on the quality of AC oversight. Particularly, they find that ACs that have non-professional activities ties with CEOs tend to pay lower audit fees to buy less audit effort, leading to larger discretionary accruals. In addition, because ACs become ineffective, they cannot sufficiently mitigate management pressure on the auditors when there are disputes about firms’ going-concern and internal control weaknesses. However, social ties resulting from AC members' past education and employment with the CEOs do not have adverse effects on AC oversight effectiveness. In another study, Guan et al. (2016) use China data to show that auditors who have school ties with clients’

executives are more likely to issue favorable audit opinions, especially for financially distressed clients.

Also, firms audited by these connected auditors are more likely to have larger discretionary accruals, subsequent downward earnings restatements, and lower information content of earnings. The authors conclude that school ties between auditors and clients’ executives impair audit quality.

Different from the above two studies, Westphal and Graebner (2010) adopt impression management theory to test whether powerful firm leaders change board composition so that they appear to be more independent but actually do not enhance monitoring capacity, especially when analysts make negative appraisals of firm value. The results show that CEOs tend to increase socially-tied directors that are formally independent to induce analysts to issue more optimistic earnings forecasts and more positive stock recommendations. This finding suggests that, even though regulators believe that an increase in formal board independence can improve board governance, such changes in board composition are made simply to create the appearance of improved governance

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without actually increasing board control.

Our study differs from prior accounting studies in two aspects. First, Bruynseels and Cardinaels (2014) take a demand-side perspective and show that it is other non-professional ties that harm AC independence. We take a supply-side perspective and report that auditors regard employment ties to be their major concern and react accordingly. Importantly, Bruynseels and Cardinaels (2014) do not separate their sample into S&P 500 vs. non-S&P 500 firms and do not investigate whether AC members’ accounting expertise mitigates the adverse effect of social ties on AC quality. Because they do not examine whether different types of firms will use different types of social ties to influence their AC members, it is possible that their empirical results may be jointly driven by social tie type and firm type. We conduct our analyses using S&P 500 vs. non-S&P 500 samples and find that auditors do not perceive any type of social ties to be severe and do not react when their clients are S&P 500 firms or when firms have at least one accounting expert on their ACs. We focus on the auditors’ reactions because accepting low audit fees from ineffective ACs and exerting less audit effort exposes auditors to much higher litigation risk. In auditing practice, the auditors will not compromise their audit quality simply because clients’ CEOs and AC members are socially tied by non-professional activities.

Second, our study and Westphal and Graebner (2010) examine entirely different incentive problems. In Westphal and Graebner's (2010) setting, the corporate leaders react to analysts’ negative firm valuation by appointing more socially-tied directors with an aim to convince the analysts that firms' governance has improved. However, the actual board control capacity does not increase. In other words, social ties serve as a means to “cheat” the analysts. In contrast, auditors in our setting react to social ties between CEOs and AC members by taking certain actions to protect themselves from litigation. Therefore, social ties serve as a “warning sign” that clients’ control risk may be higher.

2.3 Hypotheses:

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First, because social ties may harm AC independence and facilitate earnings management, which increases the likelihood of restatements and in turn audit risk, we expect CEO-AC social ties will lead to reduced AC oversight quality. We thus test whether auditors regard the existence of social ties as a signal of increased audit risk and react accordingly.

H1: The auditor’s reaction increases with the proportion of social ties between the CEO and audit committee members.

Second, Bruynseels and Cardinaels (2014) show that, from a demand-side perspective, only other non-professional ties impair AC oversight quality. Because we do not know which type of social ties the auditors will perceive to jeopardize ACs' monitoring effectiveness from a supply-side perspective, we predict that the auditors will regard different types of social ties to have different effects on AC and, therefore, react differently:

H2: The auditor’s reaction differs across education, employment, and non-professional ties between the CEO and audit committee members.

Finally, because larger firms are more likely to attract the attention of the public (Watts and Zimmerman 1986) and their shares are highly preferred by institutional investors due to their stronger governance (Ferreira and Matos 2008), larger firms are subjected to higher external monitoring pressure. Therefore, even though there are social ties between CEOs and AC members, larger firms’

ACs are more likely to remain effective than smaller firms. Because firms with different sizes may have different incentives to use different types of social ties to influence their ACs, we predict that the auditors will perceive the social ties problem to be less severe for larger firms than for smaller firms and react differently.

H3: The auditor’s reaction to social ties between the CEO and audit committee members differs between large and small firms.

To test the above hypotheses, we focus on the following three common proxies for auditors’

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reactions: audit effort, conservatism, and auditor change. Also, we use S&P 500 and non-S&P 500 (including Mid-cap S&P 400 and small-cap S&P 600) to distinguish large and small firms. We use S&P 500 membership to define firm types mainly because S&P 500 and non-S&P 500 firms have substantial differences in stock returns, risk exposure to the market, media attention, industry concentration, market capitalization, and the adoption of social ties in appointing AC members (to be discussed in Section 3.2). Since global investors may include both types of firms in their portfolios, it is necessary to examine whether different social ties affect ACs’ oversight quality and whether auditors react to different social ties in different ways for different types of firms.

3. DATA DESCRIPTIONS