Audit Committee Interlocking and Internal Controls over Financial Reporting

• In Event: Audit Committee Relationships

Abstract

We investigate the relationship between audit committee interlocking and the effectiveness of internal controls over financial reporting (ICFR). Agency theory (Fama and Jensen, 1983) suggests that external directors improve the board of directors’ monitoring of the firms they serve. Interlocked audit committee members are directors that serve on multiple firms’ audit committees, and thus are able to transfer their experience and knowledge. However, currently we do not know whether this common practice is beneficial. Using public U.S. firms, we contribute to the corporate governance literature by showing that companies that are interlocked at the audit committee level with other companies that have effective ICFR, are more likely to have effective controls themselves. We relate our results to the transfer of interlocked members’ positive knowledge and expertise across the firms they serve, hence a “positive contagion” effect. Furthermore, we do not find a significant relationship between interlocking with companies with ineffective controls and control effectiveness. As such we do not observe a “negative contagion” effect of being connected to a company with ICFR problems. We attribute this to the fact that audit committee members do not have an incentive to allow and spread control weaknesses across the firms they serve, as well as the fact that internal controls weaknesses are easily visible to the public from the 10-k, which would damage the reputation of the director. Overall, our results provide evidence that interlocked audit committee members are important elements in improving certain aspects of firms’ corporate governance.

Authors

• Ahmad Hammami, Concordia University

• Alexey Lyubimov, Concordia University