Spillover Effects of Internal Control Weakness Disclosures: The Role of Audit Committees and Board Connections

Abstract

ABSTRACT We find that firms are less likely to report an internal control material weakness (as mandated by the Sarbanes‐Oxley Act) in a given year if one of their audit committee members is concurrently on the board of a firm that disclosed a material weakness within the prior three years. We find a similar spillover effect for financial restatement disclosures. The spillover from material weakness disclosures is evident only if a shared director has more experience with the disclosing firm or can channel more information about the disclosed material weakness. Our findings suggest that prior director experiences outside the firm influence the work of audit committees inside the firm. One rationale is that a director's prior experience with an adverse disclosure helps diffuse important insights and serves as a catalyst for improvements in a firm's internal control and financial reporting practices. An alternative explanation, which we cannot dismiss, holds that a director's prior experience helps a firm to underreport material weaknesses and financial restatements without any attendant improvements in the underlying practices.