The Impact of Board Interlocks on Auditor Choice and Audit Fees

• Author: Thomas Riise Johansen,Kim Pettersson
• Date: 01 May 2013
• Published date: 01 May 2013
• DOI: http://doi.org/10.1111/corg.12013

The Impact of Board Interlocks on Auditor

Choice and Audit Fees

Thomas Riise Johansen* and Kim Pettersson

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paper uses unique Danish data to examine whether non-executive directors draw on both

direct and indirect ties in the network of interlocking directorates to impact auditor choice, and whether this impact has

consequences for audit fees.

Research Findings/Insight: The paper f‌inds clear evidence that non-executive directors draw on their networks to impact

auditor choice, and evidence that clients pay an audit fee premium when non-executive directors are connected to audit

f‌irms outside the focal company. The relationship between non-executive directors and auditors is well established in

Denmark and exhibits features that currently emerge in international debates and regulations. Therefore, the national

context offers an interesting setting for empirical evidence of whether international aspirations are likely to be realized.

Theoretical/Academic Implications: Audit-related corporate governance research has predominantly adopted the agency

theory paradigm and has only drawn on alternative theoretical perspectives to a limited extent. We draw on the literature

about board interlocks and social network theory in order to develop a study thataims to increase our understanding of the

non-executive director–auditor relationship and the role that board networks have in governing auditor choice decisions.

The study identif‌ies interlocks as an infrastructure for differentiation in the audit market and determines that such

differentiation is associated with an audit fee premium for audit f‌irms. The f‌indings indicate that personal experiences with

auditors are shared among non-executive directors and that audit attributes other than low cost audit, auditor size, and

industry specialism, are important in the audit market.

Practitioner/Policy Implications: Our f‌indings support continued efforts to strengthen the relationship between non-

executive directors and auditors. Our f‌indings also indicate that board interlocks mayconstitute a mechanism that mitigates

the audit market failure that arises because of a lack of auditor differentiation.

Keywords: Corporate Governance, Board Interlocks, Auditor Choice, Social Network Theory, Non-executive Directors

INTRODUCTION

This paper examines the impact of board interlocks

on auditor choice and audit fees. Board interlocks

are def‌ined as overlapping board memberships, and they

create a network structure that may inf‌luence board-level

decisions through the sharing of knowledge and experi-

ences (Beckman, 2010; Shropshire, 2010). We propose that

board interlocks may enable the sharing of knowledge and

experience related to auditors and that interlocks impact

auditor choice and audit fees when two conditions are met.

The f‌irst condition is that interlocks connect individuals

involved in auditor choice, and the second is that those

involved in auditor choice are receptive to information dis-

seminated via interlocks (Shropshire, 2010).

Regarding the f‌irst condition, regulators increasingly

emphasize that boards should make informed choice and an

assessment of auditors, and that non-executive directors

should be involved in this. In Denmark, which provides

the setting for our study, supervisory boards are primarily

composed of non-executive directors and the relationship

between boards and auditors is established both by law and

in practice. Thus, board networks created by overlapping

non-executive directors should connect individuals

involved in auditor choice.

The second condition depends on the nature of the deci-

sion being made. The auditor choice decision is shaped by

the fact that an audit is an “experience good” (Craswell &

Francis, 1999; Houghton & Jubb, 2003), the qualities and

output of which are only actually visible after the audit has

*Address for correspondence: Thomas Riise Johansen, Department of Accounting

and Auditing, Copenhagen Business School, Solbjerg Plads 3, 2000 Frederiksberg,

Denmark. Tel: +45-38152320; Fax:+45-38152321; E-mail: trj.acc@cbs.dk

287

Corporate Governance: An International Review, 2013, 21(3): 287–310

© 2013 Blackwell Publishing Ltd

doi:10.1111/corg.12013

been conducted, and then only by insiders (see also Moizer,

1992; Power, 1997). This means that each auditor choice will

involve uncertainty (Craswell & Francis, 1999) regarding,

for example, audit quality, auditor quality, and the relevance

and completeness of the auditor’s reporting. There may be

diverse ways of dealing with this uncertainty. One is not to

differentiate between auditorsand audits and to focus exclu-

sively on minimizing the audit fee. Two other ways exten-

sively covered in prior research include choosing a large

auditor or choosing an industry specialist as auditor

(Francis, 2004).

However, a notably different way of dealing with uncer-

tainty is observed within the social network literature,

which suggests that decision makers are likely to draw on

recommendations from their personal networks (e.g.,

Nelson, 1970; Powell, 1990). These include the networks

created by board interlocks that provide connected directors

with access to information from personalconnections. Using

information from such connections may reduce uncertainty

in decision making, and thus interlocks as a network struc-

ture may affect f‌inancial outcomes, such as hiring and

pricing (Granovetter, 2005). Accordingly, we expect boards

to be receptive to information related to auditors and aim to

study the impact of board interlocks on auditor choice and

the impact of board-auditor connections on audit fees.

We apply a discrete choice model to test the impact of

board interlocks on auditor choice. Our results are based on

Danish listed company data from 4,640 f‌irm-years and show

evidence of such impacts at the audit f‌irm, and especially at

the audit partner, level. Using social network analysis, we

f‌ind evidence that directors not only utilize their own expe-

rience with auditors, but also draw on the experience of the

members of other boards. In a second analysis, we apply a

standard auditfee model to test whether board-auditor con-

nections have an impact on audit fees. The results show that

companies whose non-executive directors have connections

to audit f‌irms outside the focal company pay, on average, a

fee premium.

This study makes several contributions to the existing

literature and to current regulatory developments. First, we

respond to general calls for research on the effects of net-

works as informal governance mechanisms (e.g., Larcker,

Richardson, Seary, & Tuna, 2005; Stafsudd, 2009) and the

eff‌icacy of non-management involvement in auditor choice

(Fiolleau, Hoang, Jamal, & Sunder, 2010). This is important

as the changing regulatory environment is expected to

increase the inf‌luence of non-executive directors and expand

the role of interlocking directors (Shropshire, 2010). Sec-

ondly, we seek to contribute by adopting non-agency theory

perspectives as we draw on the boardnetwork literature and

social network theory. While agency theory-based studies

have focused on director independence as the main attribute

of directors (Carcello, Hermanson, & Ye, 2011; Cohen, Krish-

namoorthy, & Wright, 2008; Cravens & Wallace, 2001), we

show that directors’ direct and indirect ties to external net-

works are both attributes that impact auditor choice. Thirdly,

this study contributes by providing insights that can be

used by policy makers. Much concern has recently been

expressed regarding the effectiveness of audit markets and

the market failure that arises because of limited ex ante

differentiation in the audit market (e.g., Department of the

Treasury, 2008; European Commission, 2008; OECD, 2009;

Oxera, 2006). Our study suggests that board networks have

economic consequences for the audit market, and this study

contributes to a small number of studies on how and to what

extent market players differentiate among auditors beyond

using audit f‌irm size and industry expertise as differentia-

tion sources (Francis, 2004). Fourthly, this paper responds to

calls for research in non-Anglo-American settings (Carcello

et al., 2011).

BOARD INTERLOCKS, AUDITOR CHOICE,

AND AUDIT FEES

The fact that audits are experience goods makes differentia-

tion in the audit market problematic due to the asymmetry

of information about audit/auditor quality between the

buyer and the seller (OECD, 2009). Social network research

identif‌ies two demand side mechanisms that assist buyers in

differentiating experience goods: (1) using reputation as a

surrogate for direct experience with quality, and (2) drawing

on recommendations from others to obtain experience with

quality (Davis & Robbins, 2004; Granovetter, 1973; Nelson,

1970; Podolny, 2001; Powell, 1990; Saxton, 1997). We focus on

the latter mechanism. Podolny (2001:33–37) argues that net-

works can be the “pipes of the market,” as they work as

“the channels or conduits through which ‘market stuff’

f‌lows, where ‘market stuff’ encompasses information about

exchange opportunities.” This suggests that information

related to experience with auditors may spread throughout

networks. One type of network is created by the board inter-

locks that occur when directors sit on multiple boards.

Empirical studies have documented that board interlocks

are important for interpersonal information f‌lows and

knowledge sharing that may lead to the spread of ideas,

practices, and potentially impact high-level decisions

(Bizjak, Lemmon, & Whitby, 2009; Bouwman, 2011; Chiu,

Teoh, & Tian, 2009; Davis & Greve, 1997; Gulati & Westphal,

1999; Haunschild, 1993; Haunschild & Beckman, 1998;

Horton, Millo, & Serafeim, 2012; Larcker et al., 2005;

Ortiz-de-Mandojana, Aragón-Correa, Delgado-Ceballos, &

Ferrón-Vílchez, 2012; Rao, Davis, & Ward, 2000). We draw on

social network theory and specif‌ically on work that focuses

on the effects of connections and distance in board networks

and on more conceptual ideas of how uncertainty is reduced

in markets for experience goods.1

The four hypotheses developed below address the pos-

sible knowledge-sharing facilitated by board interlocks. We

focus on the interlocks created by non-executive directors as

they are expected to be involved in auditor choice. Our f‌irst

two hypotheses relate to auditor switches and question

whether the network created by boardinterlocks impacts the

choice of incoming auditors. We suggest that there are two

ways by which board interlocks bring experience with audi-

tors to the board that makes the auditor choice (focal board).

We distinguish between situations where experiences with

incoming auditors are obtaineddirectly from other boards to

which the focal board is connected via an overlapping non-

executive director (hypothesis 1) and situations where expe-

riences with incoming auditors can be obtained over distance

as they become reachable to the focal board via an exchange

288 CORPORATE GOVERNANCE

Volume 21 Number 3 May 2013 © 2013 Blackwell Publishing Ltd