{"id":633887,"date":"2018-09-18T00:00:00","date_gmt":"2018-09-17T22:00:00","guid":{"rendered":"https:\/\/www.ie.edu\/insights\/latest-news\/articles\/good-governance-and-audit-committees-social-capital\/"},"modified":"2019-11-25T11:15:00","modified_gmt":"2019-11-25T10:15:00","slug":"good-governance-and-audit-committees-social-capital","status":"publish","type":"articles","link":"https:\/\/www.ie.edu\/insights\/articles\/good-governance-and-audit-committees-social-capital\/","title":{"rendered":"Good Governance and Audit Committees\u2019 Social Capital"},"featured_media":636286,"template":"","meta":{"_has_post_settings":[]},"schools":[32],"areas":[18,19,20],"subjects":[],"class_list":["post-633887","articles","type-articles","status-publish","has-post-thumbnail","hentry","schools-global-and-public-affairs","areas-finance-control","areas-global-affairs-law","areas-human-behavior"],"custom-fields":{"wpcf-article-leadin":["Contact networks (social capital) can be beneficial in any professional activity. In the specific case of audit committee members, what sort of influence do contact networks have? Could the social capital of audit committee members have a negative impact on the quality of financial reporting?"],"wpcf-article-body":["The audit committee plays a fundamental role in the good governance of any organization. A company\u2019s ethics and transparency are perhaps the best indicators of its reputation. The composition\u2014and, in particular, the experience\u2014of a company\u2019s audit committee therefore plays a crucial role in ensuring efficient and reliable oversight of financial<\/a> reporting processes. As various studies have demonstrated, the profile of an audit committee\u2019s members\u2014including their social capital\u2014can affect the quality of the company\u2019s financial reporting.\r\n\r\n \r\n\r\nThe social capital factor<\/strong>\r\n\r\nIndividuals generate social capital by interacting with other members of their social network. Social capital can be defined as the advantage created by a person\u2019s position within the structure of her social network. As previous studies have shown, social capital arises from the information-transmitting potential of an individual\u2019s networks and the links of dependence created through these trust-based relationships. The set of resources derived from a person\u2019s contacts and social relationships would theoretically be expected have a positive effect on that individual.\r\n\r\nEmpirical studies on corporate governance have mainly focused on the benefits derived from social networks. One such benefit is the positive effect that information transfer among audit committee members can potentially have on financial<\/a> reporting quality. However, interaction with the members of one\u2019s social network can also have negative effects, suggesting a \u201cdark side\u201d of social capital that could potentially worsen the performance of board members in general and audit committee members in particular.\r\n
Social capital arises from the information-transmitting potential of an individual\u2019s networks and the links of dependence created through these trust-based relationships.<\/blockquote>\r\nTies that bind, ties that blind<\/strong>\r\n\r\nLet us consider the case of audit committee members specifically. When these individuals are \u201ccross-appointed\u201d\u2014i.e. when they sit on multiple committees at the same time\u2014they develop connections with other directors in the same situation, and this can have a negative effect on their performance at each of the companies they serve. This effect can be attributed to a lower degree of decision-making autonomy and independence as well as the potential \u201ccontagion\u201d effect of questionable accounting practices. From this perspective, an audit committee\u2019s social capital could have a negative impact on financial<\/a> reporting quality.\r\n\r\n \r\n\r\nInfluential indicators<\/strong>\r\n\r\nSocial capital is not easy to measure. Drawing on the work of contemporary researchers, we can identify four main indicators:\r\n
    \r\n \t
  1. Degree centrality.<\/span> This indicator considers the number of connections that an individual has with other people in her network. An individual is said to be central if her ties make her visible to other people in the network. Thus, audit committee members with a high degree of centrality can gather information about accounting practices from a larger number of sources, thanks to their position within the network.<\/li>\r\n \t
  2. Connectivity.<\/span> This indicator has to do with the quality of a person\u2019s connections. Specifically, it measures an individual\u2019s position within a network structure in terms of the quality\u2014as opposed to the quantity\u2014of his contacts. Like degree centrality, connectivity can influence the quality of the information that individuals obtain through their connections.<\/li>\r\n \t
  3. Brokerage.<\/span> This indicator shows how often an individual acts as an intermediary within her network, thus providing an indirect measure of the power she enjoys as a consequence of her location in the network. The work of audit committee members can be affected by their brokerage position within the network.<\/li>\r\n \t
  4. Strong ties.<\/span> This indicator measures the number of three-way relationships among individuals in the same network. Strong ties inculcate commitment and constitute a source of information, which in turn can affect an individual\u2019s attitudes, opinions, and decisions.<\/li>\r\n<\/ol>\r\nUsing these indicators, we studied the effect of audit committees\u2019 social capital on financial<\/a> reporting quality. To do this, we gathered data from a sample of listed companies in the United States. We examined the social networks of the sample companies\u2019 board members, analyzing four subgroups in particular: audit committee members, non-audit committee members, audit committee members designated as financial experts, and audit committee members not designated as financial experts. The four indicators described above were calculated at the director level for each subgroup and later aggregated at the company level. Financial reporting quality was measured using accruals-based quality models (a method widely used in previous research).\r\n\r\nOur empirical analysis showed that the social capital of audit committee members does indeed have an effect on financial<\/a> reporting quality. However, the same does not hold for non-audit committee members, whose social capital does not appear to exert a significant influence on financial reporting quality. Specifically, our findings suggest that the social capital of audit committee members has a negative influence on financial reporting quality, supporting the hypothesis that social capital has a \u201cdark side.\u201d\r\n\r\nWhen audit committee members with and without financial<\/a> experience were analyzed separately, the results varied depending on the social capital indicator considered. For the degree centrality indicator, we observed a negative effect on reporting, but only in the case of audit committee members designated as financial experts. That is, when board members are cross-appointed\u2014i.e. they serve on multiple committees\u2014and have a larger number of connections, the quality of their performance appears to suffer. However, for the other indicators\u2014connectivity, brokerage, and strong ties\u2014the negative relationship between social capital and financial reporting quality was found only for non-experts. In other words, the quality and power of an individual\u2019s contacts appear to exert an influence only in the case of audit committee members without financial experience. In conclusion, the divergence between the results for experts and non-experts for some indicators suggests that further reflection on social capital measures is warranted.\r\n
    Our findings suggest that the social capital of audit committee members has a negative influence on financial reporting quality.<\/blockquote>\r\nImplications for regulators<\/strong>\r\n\r\nRegulators have long expressed concerns about cross-appointments at publicly traded companies. In Spain, the authors of the Olivencia Report argued that the cross-appointment of directors to the board of more than one company should be avoided. Our findings suggest that ties among audit committee members are especially important. Specifically, both financial<\/a> experts and their non-expert counterparts on the audit committee could be compromising the quality of their firm\u2019s financial reporting as a result of their links to other board members\u2014a phenomenon that could be called \u201ccross-appointment of audit committee members.\u201d\r\n\r\nOur findings underscore the need for rules that limit financial<\/a> experts\u2019 ability to hold multiple executive posts and suggest that the real contribution of non-financial experts on audit committees should be assessed in greater depth.\r\n\r\n \r\n\r\n\u00a9 IE Insights."],"wpcf-article-extract-enable":["1"],"wpcf-article-extract":["By Nieves Carrera, Tashfeen Sohail and Salvador Carmona<\/strong>. Contact networks (social capital) can be beneficial in any professional activity. In the specific case of audit committee members, what sort of influence do contact networks have? Could the social capital of audit committee members have a negative impact on the quality of financial reporting?"],"wpcf-article-summary-enable":["1"],"wpcf-article-summary":["The financial reports prepared by a company\u2019s audit committee play a key role in establishing the organization\u2019s reputation for ethics and transparency. The social capital of this committee\u2019s members\u2014that is, their interactions with other members of their social network\u2014can lead to a lower degree of decision-making autonomy and independence, to the detriment of financial reporting quality. A recent study showed that one individual\u2019s position in the social network, the quality of her contacts, and the power she enjoys as a consequence of her connections can affect the work of other audit committee members. These findings underscore the need for rules that limit the number of executive posts that can be held by board members and financial experts."]},"_links":{"self":[{"href":"https:\/\/www.ie.edu\/insights\/wp-json\/wp\/v2\/articles\/633887","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.ie.edu\/insights\/wp-json\/wp\/v2\/articles"}],"about":[{"href":"https:\/\/www.ie.edu\/insights\/wp-json\/wp\/v2\/types\/articles"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.ie.edu\/insights\/wp-json\/wp\/v2\/media\/636286"}],"wp:attachment":[{"href":"https:\/\/www.ie.edu\/insights\/wp-json\/wp\/v2\/media?parent=633887"}],"wp:term":[{"taxonomy":"schools","embeddable":true,"href":"https:\/\/www.ie.edu\/insights\/wp-json\/wp\/v2\/schools?post=633887"},{"taxonomy":"areas","embeddable":true,"href":"https:\/\/www.ie.edu\/insights\/wp-json\/wp\/v2\/areas?post=633887"},{"taxonomy":"subjects","embeddable":true,"href":"https:\/\/www.ie.edu\/insights\/wp-json\/wp\/v2\/subjects?post=633887"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}