SUMMARY AND CONCLUSIONS

The role of ACs in enhancing financial reporting quality has received much attention in the past decade. Therefore, research evidence on factors that may affect the effectiveness of ACs is of interest to regulators, boards, and investors. While Bruynseels and Cardinaels (2014) show that CEO-AC social ties resulting from other non-professional activities are associated with ineffective boards’

demand for low audit quality, the consequences of such social ties on auditors remain unclear. Because SOX has substantially increased the litigation risk auditors face, it is important to know whether auditors recognize this increased risk and how they react to different types of CEO-AC social ties in auditing different types of firms. This study takes a supply-side perspective to address these questions.

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Using a large dataset of US-listed firms during 2004 to 2012, we document three important findings. First, there is a sharp increase in social ties of all types, from 16% in 2004 to 21% in 2012.

Importantly, the proportion of employment ties changes from 8% in 2004 to 16% in 2012, a 100%

increase. We further find that the S&P 500 firms reduce the number of AC members who are socially tied with the CEOs due to other non-professional activities from 14% in 2004 to 9% in 2012. In contrast, the non-S&P 500 firms substantially increase the number of AC members who have employment ties with the CEOs from 8% in 2004 to 17% in 2012. These statistics imply that the S&P 500 and non-S&P 500 firms adopt different policies in hiring their AC members. Second, auditors only react to employment ties existed in non-S&P 500 firms by exerting more audit effort, becoming more conservative, and resigning more often if clients have higher fraud risk. These findings are robust to controlling for endogeneity and different sample periods. Third, we provide and test a possible explanation that may reconcile the inconsistency between Bruynseels and Cardinaels’ (2014) results and ours. Finally, we find that, whereas auditors consistently react to EMPLOY ties only, their reactions vary depending on firm types and whether firms’ ACs have accounting experts. .

Our empirical findings have important implications for regulators, boards of directors, investors, and others. First, we find that more than one-fifth of the AC members in our 2012 firm-year observations are socially tied with the CEOs. Because Westphal and Graebner (2010) show that CEOs may increase socially-tied directors that are formally independent simply to create the appearance of improved governance without actually increasing boards’ control capacity, our results may motivate regulators to seriously consider this problem and establish new rules, such as a mandatory disclosure of AC social ties with executives in firms’ proxy statements. Second, our audit fee analyses produce the same results as those in Bruynseels and Cardinaels (2014). If social ties between CEOs and AC members indeed impair AC independence, the auditors shall face a higher control risk. Following prior

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studies, the auditors should adjust audit fees upward to incorporate the increased audit risk. However, empirical evidence from the demand-side and supply-side shows that audit fees decrease when non-professional ties exit. Future research may explore the underlying reasons why the auditors view this type of social ties to be beneficial to ACs. Third, we find that Bruynseels and Cardinaels' (2014) results are mainly driven by non-S&P 500 firms. As a result, regulators and investors should pay more attention to the financial reporting quality of non-S&P 500 because these firms are more likely to hire non-industry expert auditors, giving rise to lower audit quality. Fourth, we show that auditors are more likely to resign from their S&P 500 clients if these firms have accounting experts on their audit committees. We posit that these experts may take advantage of their accounting expertise to cooperate with the CEOs in managing and hiding earnings manipulation. Our conjecture may be important to regulators because, when considering the existence of employment ties between the CEOs and accounting experts, audit committees with more “tied” experts may increase risk, leading to a higher likelihood that the auditors will resign. Future research may examine whether our conjecture is valid.

Finally, we focus on four common reactions the auditors may take to respond to clients’ CEO-AC social ties. Future research could explore how auditors use the combination of these reactions and test other reactions to examine whether these reactions are effective in improving AC oversight quality.

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APPENDIX