The Downside of the Network Ties between CEO/CFOs and Auditors through External Directorships: Evidence from Auditor Selection and Subsequent Audit Quality

This study examines whether the professional ties of Chief Executive Officers/Chief Financial Officers (CEO/CFOs) to auditors through external directorships affect auditor selection and subsequent audit quality. Professional ties to auditors arise when the CEO/CFO of a firm (referred to as the home firm) serves as an outside director of another firm that hires an auditor (a connected auditor). Using a sample of firms with auditor switches over the period 2003-2012, we find that home firms are more likely to appoint connected auditors. Furthermore, utilizing a difference-in-differences approach, we find that home firms appointing connected auditors experience a significant decline in subsequent audit quality, compared with firms that appoint nonconnected auditors. Specifically, our results show that the likelihood of misstatements, the propensity to meet or just beat earnings benchmarks, and the magnitude of discretionary accruals increase after the home firms appoint connected auditors. We further provide some evidence that the negative effect on subsequent audit quality is more pronounced when the connection is via the same auditor office or audit committee membership. Collectively, our findings suggest that the network ties between the CEO/CFO and auditors through external directorship significantly influence the home firm’s auditor selection decisions and that the appointment of a connected auditor results in a downside of connections in terms of audit quality.