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Directors network centrality and earnings quality

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ISSN: 0003-6846 (Print) 1466-4283 (Online) Journal homepage: http://www.tandfonline.com/loi/raec20

Directors network centrality and earnings quality

Bright Gershion Godigbe, Chin Man Chui & Chih-Liang Liu

To cite this article: Bright Gershion Godigbe, Chin Man Chui & Chih-Liang Liu (2018)
Directors network centrality and earnings quality, Applied Economics, 50:50, 5381-5400, DOI:
10.1080/00036846.2018.1486992

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APPLIED ECONOMICS
2018, VOL. 50, NO. 50, 5381–5400
https://doi.org/10.1080/00036846.2018.1486992

Directors network centrality and earnings quality

Bright Gershion Godigbea, Chin Man Chuib and Chih-Liang Liub
a
Department of Accountancy, City University of Hong Kong, Hong Kong, China; bInstitute for Financial and Accounting Studies, Xiamen
University, Xiamen, China

ABSTRACT KEYWORDS
This study examines whether firms with network central boards of directors behave differently Earnings quality; financial
from other firms in terms of financial reporting quality. We find that earnings quality among firms reporting quality; director
is low when board networks are channels of incorrect information transmission (including earn- network centrality;
ings management information) and for firms whose directors are awarded equity-based com- discretionary accruals
pensation have connections through boardroom networks, but earnings quality is better for firms JEL CLASSIFICATION
with good performance in spite of their networks. These results are robust to controlling for firm M40; M41; G34
information environment, growth, size, age, leverage, performance, volatility in firm operations,
and corporate governance.

I. Introduction managing earnings and institutional setup within

which firms report low-quality earnings (Leuz,
Recent accounting and finance literature on social
Nanda, and Wysocki 2003; Cohen, Dey, and Lys
network theory explains how information flow,
2008). However, the social structure within which
resource exchange and diffusion of corporate prac-
financial reporting occurs has largely been ignored.
tices occur through corporate networks1 with
Firms have similar behaviour patterns as a result of
Larcker, So, and Wang (2013) demonstrating possi-
information exchange among them.2 The observed
ble increase in firm value for highly connected firms.
herding behaviour of firms can be explained by social
Financial reporting quality however has been scant
network theory which predicts firms to imitate others
in the context of social networks. The influence of
with perceived superior information (Lieberman and
networks of firm executives (e.g. directors) on finan-
Asaba 2006).
cial reporting quality is very important because cur-
The networks of corporate directors are natural
rent regulations provide much reporting discretion
channels for diffusion of corporate practices, includ-
to managers (ultimately directors) and this is likely
ing undesirable practices. There is a likelihood of
to induce opportunistic manipulation of financial
imitating a bad act when those engaged in the act
reports; a behaviour that can easily spread among
remain unnoticed/unpunished after a long time, as
related firms (Milgram 1963). There are few studies
the initial observers subsequently discount the cost
on the possibility of corporate networks affecting the
of being caught and are enticed to actively engage in
quality of financial reports such as fraudulent
the act (Lieberman and Asaba, 2006). Davis (1991)
accounting restatements and options-backdating
documents the diffusion of poison pills adoption
(e.g. Bizjak, Lemmon, and Whitby 2009).
among U.S. firms in the late 1980s where directors’
The quality of financial reports has been exten-
network was identified as the transmission channel.
sively studied with focus on the incentives for
Similarly, options backdating was reportedly

CONTACT Chin Man Chui cmchui@xmu.edu.cn Institute for Financial and Accounting Studies, Xiamen University, 422 Siming Road South, Xiamen,
China
Present affiliation for Chin Man Chui is School of Business, Macau University of Science and Technology, Avenida Wai Long, Taipa, Macau, China. Tel: +853
8897-2857, Fax:+853 2882-3281.
Part of work was done when Bright Gershion Godigbe was in Xiamen Univesity.
1
The influence of corporate executives’ networks on investment decisions (Renneboog and Zhao 2014; El-Khatib, Fogel, and Jandik 2015), tax planning
(Brown and Drake 2014), firm performance and firm value (Larcker, So, and Wang 2013; Chuluun, Prevost, and Puthenpurackal 2014; Akbas, Meschke, and
Wintoki 2016), and executive compensation (Renneboog and Zhao 2011).
2
Firm networks serve as channels of information transfer. More connections mean more access to information including undesirable information.
© 2018 Informa UK Limited, trading as Taylor & Francis Group
5382 B. G. GODIGBE ET AL.
imitated by firms who shared directors with firms
that engaged in the practice (Bizjak, Lemmon, and
Whitby 2009). Directors carry information about
such and other bad corporate practices to their
firms. We therefore contend that firms manage
earnings if they are linked with other firms engaged
in the act.
The objective of this study is to explore the effect of
directors’ networks on the quality of financial reports.
It is likely that the possible effect of director networks
on the quality of financial statements change under
different situations. Firms with good operational out-
comes have little incentive to manage their earnings
compared to those with poor performance. The adop-
tion of desirable and undesirable financial reporting
practices from the network of directors will be differ-
ent for these firms. For firms with good (poor) finan-
cial performance, we maintain that the possibility of
adopting the behaviour of intentionally misreporting
financial outcomes from their networks is lower
(higher).
Newman (2010) indicates that complete informa-
tion exchange extends beyond direct interaction
between two individuals or firms, which has been
represented by board interlocks.3 The board of direc-
tors form the highest representation of firms and the
power of a director’s information access from his/her
network also depends on the link with other con-
nected directors and the position of the director on
the information path linking others. Network central-
ity captures these other dimensions of social networks
not represented by board interlocks making network
centrality measures more comprehensive proxies for
social network analysis. We use various aspects of
directors’ networks (culminating into firm-level net-
work measures) to proxy for firm network.
Earnings quality has been proxied by discretionary
accruals in prior literature. Discretionary accruals is a
subtle earnings management tool rarely noticed by
stakeholders. It is usually the first choice for firms
that manage earnings. Managers use real earnings
management and accounting misstatements to sup-
plement the results of managing earnings through
accruals (Zang 2011). In order not to constrain our
study sample size on egregious earnings management
(e.g. intentional misstatements/restatements), we fol-
low prior literature to adopt the popular discretionary
3
See Davis (1991), Bizjak, Lemmon, and Whitby (2009) and Chiu, Teoh, and Tian (2013).
accruals as a proxy for financial reporting and earn-
ings quality in this study.
Using a sample of 1803 U.S. firms during the period
of 1996–2013, we document that earnings quality is
low among linked firms. Director networks serve as
transmission channels for poor quality earnings
reporting, more so when directors have equity stake
in their firms. Another very important finding of this
study is that firms with good financial performance
are less likely to adopt poor earnings reporting beha-
viour from their networks. These findings are robust
to the inclusion of governance controls that influence
managerial behaviour (Jensen and Meckling 1976). In
additional tests, we find that the role of director net-
works in transmitting financial reporting misbeha-
viour has declined in the post-Sarbanes-Oxley (SOX)
period, suggesting that directors care about their repu-
tation. Our results are robust to tests for the endo-
geneity of the network measures.
Our study contributes to the literature in several
ways. Our study is the first to reconcile the competing
evidence in prior literature on the effect of firm net-
works on financial reporting quality. Omer, Shelley,
and Tice (2015) evidence of a decline in restatements
in the face of increased directors connectedness con-
trasts Bizjak, Lemmon, and Whitby (2009) report of
board interlocks serving as moderates for the popu-
larizing options backdating in the United States. Our
article provides evidence that in the context of finan-
cial reporting quality, firm networks propagate finan-
cial reporting misbehaviour mainly for firms with
poor financial performance.
Secondly financial reporting quality has been
widely studied in prior literature with little focus on
the social structure within which the practice occurs.
To the best of our knowledge, our study is the first to
document a comprehensive effect of directors’ net-
work on the quality of financial reports using discre-
tionary accruals. Our study highlights the role
directors’ networks play to propagate earnings man-
agement among firms. Perhaps the closest attempt
which previous studies have made is to relate account-
ing restatements and options accounting to board
interlocks (Bizjak, Lemmon, and Whitby 2009;
Omer, Shelley, and Tice 2015) but Karpoff et al.
(2014) indicate the limitations in using restatement
as proxies for financial report manipulation especially

when a researcher relies more on available databases.
They showed that current available databases are not
timely and do not capture real financial manipulators.
We choose discretionary accruals as our proxy for
financial reporting quality because this measure is a
more subtle tool to manage earnings and widely used
in accounting research as a proxy for earnings quality.
The third contribution of this study is to the
corporate governance literature. Findings in this
study point to how the monitoring role of directors
may be undermined when they are highly net-
worked with other directors who may be CEOs in
other firms. Increased networking offer directors
access to more complete information to help their
decision making. The ease of information access
improves the independence of directors and they
can better play their monitoring role. However,
increased director networking also comes with
potentially increased familiarity with other directors
who may be linked with the managers they oversee.
Such familiarity undermines the independence of
directors who are unable to fully play their roles as
independent monitors.
The fourth contribution of this study is that gov-
ernance problems still exist when equity incentives
are been used to align director and shareholders’
interests. Through their networks, directors identify
with other directors and possibly CEOs whose firms
manage earnings to maximize the value of their
(directors) equity in the short-term (Cheng and
Warfield 2005). This common identification makes
directors to superintend over misleading financial
reporting behaviour in their firms. Finally, this study
demonstrates to investors how directors’ networks
relate to the financial transparency of their firms and
the implications on the values of their investments.
From their networks, directors learn to aid obscur-
ing the true economic fundamentals of their firms at
least for the short term. The long-term implication is
a discount of firm value.
The remainder of this paper is organized as fol-
lows. In the next section, we present a description of
network centrality of directors and firms as well as a
review of prior literature on financial reporting qual-
ity leading to our hypotheses. Section three discusses
our empirical design, sampling procedure and mea-
surement of variables. Section four reports results of
empirical analysis. Section five discusses additional
tests and conclusion is presented in Section six.
APPLIED ECONOMICS 5383
II. Literature review and hypotheses
development
This section reviews literature on social networks
related to corporate directors and economic conse-
quences of their connections for the firm. We also
develop our hypotheses based on the linkage
between social networks and financial reporting
quality.
Director networks
Social network theory suggests that individual
behaviour is an outcome of social interactions
and this extends to corporate behaviour as well
(Jackson 2008; Newman 2010). Individuals and
their common social interactions or links form a
network across which they share information and
other resources useful for their decision making.
Under conditions of uncertainty (which is typical
of firms), it is useful to observe behaviours of
others, especially those perceived to have superior
or more complete information (Lieberman and
Asaba, 2006). Social networks serve as conduits
for the transmission of information about corpo-
rate practices culminating into herding behaviour
(Bikhchandani, Hirshleifer, and Welch 1998;
Hirshleifer and Teoh 2003).
A direct link between two firms (e.g. through
shared directorates, trade partners, etc.) serves as a
natural channel for information sharing. Prior
literature uses board interlocks to represent inter-
action between firms. The power of this proxy is
that it focuses on direct connection between firms
and as such resource exchange between linked
firms is observable. Also, firm level network stu-
dies can conveniently use board interlocks as firm
level measures since firms have only one board.
However, the source or access to a complete infor-
mation extends beyond direct connections
between two firms. Newman (2010) provides
how two individuals who are not directly linked
can assess information from each through a third
individual to which they are both linked. A direc-
tor who is positioned between two other directors
controls information flow between them and
serves as an information hub making him/her
very indispensable or powerful in the network.
Such power or indispensability referred to as
5384 B. G. GODIGBE ET AL.
network centrality (Jackson 2008) is not captured
by a simple board interlock proxy. A direct link to
an information hub increases access to more com-
plete information. Also, a director with links to
many other directors increases the network cen-
trality or information access of the whole board on
which he/she sits. Network centrality is therefore a
more comprehensive proxy for social networks/
connections. Appendix A4 illustrates two firms
with same number of board interlocks can have
different power or access to information repre-
sented by network centrality.
In an attempt to represent the different but related
dimensions of networks, we use four popular mea-
sures that have been adopted in social network studies
– Degree, Eigen-vector, Betweenness and Closeness
centralities. Degree centrality is a comprehensive
measure of the number of direct ties an individual
has with others. Information access is expected to
increase with degree centrality, and therefore one
with many direct connections is more central (power-
ful) in the network. An individual’s connection to a
more powerful member of a network increases his
information access. The indirect connection and
information retrieval from a bunch of others through
ones link with a powerful member with numerous
links is represented by eigen-vector centrality.
Betweenness centrality indicates a network member’s
control of information flow. In a network, an indivi-
dual positioned between two others serving as the
medium of information exchange between them is
viewed as one controlling information flow.
Closeness centrality refers to the shortest possible
path or link on which information access is optimal.
Closeness centrality measures how quick information
from other members of a network gets to an indivi-
dual. The closer an individual is to a source of infor-
mation, the more efficient and easier it is to access the
information (Jackson 2008; Newman 2010).
Prior corporate network studies focused largely on
board interlocks, which is akin to degree centrality
(Bizjak, Lemmon, and Whitby 2009). However, a
firm’s complete information access from a network
extends beyond shared directorates. Appendix A4
illustrates if two firms have the same number of
board interlocks, firm level aggregate director net-
works measures can be different. This demonstrates
that director networks measures provide extra infor-
mation beyond the board interlocks and capture
different aspects of information on the relative posi-
tion of directors in their networks. Corporate practi-
tioners such as board of directors are experts at their
jobs (Jensen and Meckling 1976) and do not merely
imitate others; one can appreciate the need for com-
plete information access. From his/her network, a
director actively gathers relevant information which
is optimal to the decision making process of the board
he/she sits on. Incorrect information gathered from a
member of a network can be corrected by more
precise information from other links in the network,
leading to an active decision-making process.
Director networks and financial reporting quality
Financial reports provide information about a firm’s
economic performance. Accounting numbers espe-
cially earnings are crucial for economic decisions
(e.g. capital provision, managerial compensation,
tax obligations, etc.) of a firm’s stakeholders. Firm
insiders reserve some level of discretion or judgment
in reporting economic outcomes of their firms.
Managers have incentives to opportunistically influ-
ence contractual outcomes (Healy and Wahlen
1999) or use a disclosure strategy to obscure the
information environment of their firms
(Verrecchia 1983; Cheng, Man, and Yi 2013).
Extant literature documents the motives for low-
quality financial reports – from personal gain and
self-preservation to reduction of loss. Bergstresser
and Philippon (2006) and Cheng and Warfield
(2005) indicate financial gains (through equity
sales) of managers who manipulate earnings suc-
cessfully. Managers sometimes manipulate earnings
to maintain their jobs especially in more competitive
environments (Datta, Iskandar-Datta, and Singh
2013). Other reasons for reporting misleading earn-
ings information are to avoid capital markets dis-
counting firm value (Hong, Huseynov, and Zhang
2014) and limit information asymmetry by smooth-
ing out earnings (Soon and Wee 2011).
Prior research documents events and environment
which influence the extent of financial reporting qual-
ity. Earnings management occurs around initial pub-
lic offers, seasoned equity offerings and acquisitions
(DuCharme, Malatesta, and Sefcik 2001; Cohen and
Zarowin 2010). Cheng, Man, and Yi (2013) and
Datta, Iskandar-Datta, and Singh (2013) also investi-
gate the influence of industry competition on a firm’s

decision to manage earnings. The level of discretion-
ary accruals and the disappearance of zero-earnings
discontinuity decline after the passage of the SOX
(Cohen, Dey, and Lys 2008; Gilliam, Heflin, and
Paterson 2015) highlight the influence of institutional
environment on the quality of financial reports.
To date, little is known about whether the ubiqui-
tous low-quality earnings is a herding behaviour of
firms, similar to the popular poison pill adoption
and options backdating by firms (Davis 1991; Bizjak,
Lemmon, and Whitby 2009). Also, there is a need to
test whether timely information access and exchange
by boards of directors can counter or not the level of
financial sophistication exhibited by managers who
manage earnings.
Boards of directors have two major roles in pro-
tecting the interest of shareholders – monitoring and
advising (Jensen and Meckling 1976; Fama 1980).
Agency theory literature provides the effect of board
independence, female inclusion and financial
sophistication among others on the monitoring
effectiveness of directors (Xie, Davidson, and
DaDalt 2003; Srinidhi, Gul, and Tsui 2011). And
firm performance has generally been linked to the
structure and features of the board of directors.
Directors provide knowledge and resources to the
firm. Prior experience, financial expertise and con-
nections of directors can be leveraged by a firm to
create value (Coles, Daniel, and Naveen 2012;
Chuluun, Prevost, and Puthenpurackal 2014).
The literature on board network however
diverges the effect of board connectedness on firm
value. Board connectedness can enhance or destroy
firm value. The effectiveness of directors depends on
their skills or knowledge and their access to timely
and correct information (Nowak and McCabe
2003). Through their links with other directors on
other boards, directors of a firm gain access to
information about suppliers, customers and other
business associates. Directors with good connections
are critical in the value creation of a firm (Larcker,
So, and Wang 2013; Chuluun, Prevost, and
Puthenpurackal 2014). However, by sitting on mul-
tiple boards, directors become too busy to monitor
managers in their firms (Cashman, Gillan, and Jun
2012). Prior evidence document the diffusion of
value destroying or bad corporate practices among
firms who share directors, implying that directors
become carriers of information about ‘bad’
APPLIED ECONOMICS 5385
corporate practices. Davis (1991) shows how firms
that are inter-connected through interlocking
boards of directors quickly adopted poison pills
which was the corporate norm in the 1980s to limit
takeover threats. In the United States, backdating
options became more common among firms at
least until 2002 with research pointing to board
interlocks channels though which the act was dif-
fused (Bizjak, Lemmon, and Whitby 2009). In terms
of financial reporting, goodwill write-offs, tax
accounting and financial restatements have been
shown to be common among related firms (Brown
and Drake 2014). Financial reporting practice, like
any other herding behaviour can be the outcome of
imitation behaviour of firms. A firm’s desire to mis-
represent earnings heightens when other firms
engaged in the act remain unnoticed. To keep the
competitive parity between rivals and themselves or
even the perception that firms that manage earnings
have superior information, a non-earnings mana-
ging firm is likely to adopt earnings management
behaviour (Bikhchandani, Hirshleifer, and Welch
1998; Hirshleifer and Teoh 2003; Lieberman and
Asaba, 2006). Board of director networks serve as
natural mediums through which information about
earnings reporting and how to skilfully manage
earnings is transmitted among firms. Based on the
above arguments, we expect board networks to pro-
pagate earnings management among connected
firms through a contagion effect. We therefore pro-
vide our hypotheses as follows.
H1. Firms with more director networks are asso-
ciated with higher earnings management (lower
earnings quality).
Firm performance, director networks and financial
reporting quality
The need for managing earnings arises when earn-
ings are inconsistent with desired thresholds.
Managers are pressured to misreport the true eco-
nomic fundamentals of their firms especially when
profit levels are lower than expected. Prior literature
presents evidence of firms reporting profits just
above zero to avoid reporting losses (Burgstahler
and Dichev 1997; Gilliam, Heflin, and Paterson
2015; Roychowdhury 2006). Firm networks offer
5386 B. G. GODIGBE ET AL.
platforms on which corporate executives can learn
or gain access to resources to enhance true perfor-
mance of their firms. Similarly, information about
various methods of managing earnings and other
undesirable corporate practices that can disguise
true firm performance can be transmitted through
the network of firms.
Like disease versus health, the practice of bad finan-
cial reporting aimed at managing earnings are con-
tagious and easily transmitted through firm networks.
However, we maintain that firms with good or healthy
operating performance are less likely to adopt earn-
ings management (Burgstahler and Dichev 1997). We
expect that the contagion effect of firm networks
dominates for poor performing firms and that firms
with good operating performance are less likely to
adopt low quality financial reporting behaviour from
their networks. Our hypothesis is as follows.
H2. Relative to firms with poor performance, firms
with good financial performance are less likely to
adopt earnings management behaviour from the
network of directors.
Directors’ equity compensation, networks and the
quality of financial reports
The need for interest alignment in the management-
ownership relationship (Jensen and Meckling 1976)
gave birth to equity compensation, which takes the
form of stock ownership, options grants and other
similar assets. In spite of the mixed evidence of the
effects of executive shareholding on firm value, the
literature suggests that equity compensation does
motivate firm executives. Coles, Daniel, and
Naveen (2006) and Armstrong and Vashishtha
(2012) among others present evidence in support
of the argument that equity compensation provides
incentives for firm executives to increase firm value.
There is also evidence of managers motivated by
stock compensations to increase short-term stock
prices (Cheng and Warfield 2005; Bergstresser and
Philippon 2006). The latter evidence is supported by
the argument that managers try to diversify away
from their firms through the sale of their holdings.
Maximizing stock prices before the sale is a reason
why firm managers with equity ownerships in their
firms are likely to engage in actions including earn-
ings manipulation to help them achieve their goal.
Directors’ incentives to reap maximum benefit
from their equity holdings/compensation are not
different from that of CEOs. The increased and
common practice of compensating firm executives
(including directors) with equity (Bergstresser and
Philippon 2006) gives a common identification to
directors and CEOs. Directors’ common interest
of maximizing their wealth comes along with the
opportunity of sharing information on how to
maximize short-term stock prices. Based on the
above arguments, we expect the contagious effect
of earnings manipulation among connected firms
to increase when directors enjoy equity compensa-
tions. We present this hypothesis as follows.
H3. The association between directors network and
earnings management increases when directors
earn equity compensation.
III. Empirical design
Data and sample selection
We obtain our data from multiple sources. To con-
struct director network measures we require infor-
mation on companies’ board of directors, which is
available from ISS database (formerly Riskmetrics).
This database provides data on directors of S&P1500
firms from 1996 through 2013. Firm-level financial
information are obtained from COMPUSTAT. We
require firms in the ISS sample to have non-missing
financial data required for the estimation of discre-
tionary accruals. Data for control variables are from
Execucomp, IBES and Thomson Reuters Financial
databases. Appendix A3 provides details on how to
merge dataset from different databases. Consistent
with prior research, we exclude financial and regu-
lated firms from our final sample, which results in
14,593 firm-year observations in our final sample
(see Appendix A2).
Measuring earnings management


TAi;t =Ai;t
1 ¼ β0 1=Ai;t
1
þ β1 ðΔSALESit

ΔRECEIVABLESit Þ=Ai;t
1
þ β2 PPEi;t =Ai;t
1
þ β3 ROAi;t
1 þ εi;t (1)

DAi;t ¼ TAi;t =Ai;t
1



½β0 1=Ai;t
1
þ β1 ðΔSALESit

ΔRECEIVABLESit Þ=Ai;t
1
þ β2 PPEi;t =Ai;t
1 þ β3 ROAi;t
1 
We use discretionary accruals to proxy for earn-
ings management. Nondiscretionary accruals are
associated with the normal operations of firms
and discretionary accruals is at the discretion of
firm executives and usually subject to opportunis-
tic manipulation. We use modified Jones model to
estimate discretionary accruals which has largely
been interpreted as earnings management/finan-
cial reporting quality (Cohen and Zarowin 2010;
Hong, Huseynov, and Zhang 2014).
The modified Jones model estimates discretion-
ary accruals in two stages. First, total accruals are
estimated by subtracting net operating cash flows
from net income. Total accruals are then regressed
on change in sales revenue, change in accounts
receivable, property plant and equipment, and
return on assets. Changes in sales revenue and
account receivables reflect the short-term opera-
tions of the firm. Property plant and equipment
proxy for fluctuations in long-term operations of
the firm. Prior year return on assets is included to
control for the effect of a firm’s prior performance
on its level of total accruals (Kothari, Leone, and
Wasley 2005). This is a cross-sectional regression
for each two-digit SIC industry classification with
15 minimum observations for each year. All vari-
ables are scaled with 1-year lag total assets.
Where a firm’s total accruals (net income minus
net operating cash flow) in a year is TAit. ΔSALESit
and ΔRECEIVABLESit represent changes in a firm’s
sales and trade receivables over their prior year levels.
Gross property, plant, and equipment of a firm in a
year is represented by PPEit while ROAit−1 represent
1-year lag return on assets, which is calculated as net
income divided by total assets. All variables are scaled
by 1-year lag total assets, Ait−1. Details of variables
construction are shown in Appendix A1.
In the second stage, discretionary accruals
represented by DAit in equation (2) are estimated
as the residuals of fitted values from the first stage
4
We used UCINET, a network analysis software to compute the various measures of director connectedness.
5
An adjacency matrix is a symmetric matrix, where Aij = 1 if node i is adjacent to node j, and Aij = 0 otherwise.
APPLIED ECONOMICS 5387
regressions. The deviation of total accruals from
predicted values in the first stage regressions are
discretionary accruals, which is also interpreted as
the level of earnings management. Positive values
of discretionary accruals indicate increasing earn-
(2)
ings whereas negative values indicate firms deflat-
ing current earnings to protect against possible
future low earnings level or simply to smooth
out earnings (Cheng, Man, and Yi 2013). Since
the objective of our study is not to classify discre-
tionary accruals into income increasing and
income decreasing earnings management, we use
absolute values of discretionary accruals, winsor-
ized at 1% and 99% for our analysis.
Measuring firm network
We use director data from Riskmetrics to map out
firms network. Two firms are connected when
they share a common director in the same year
otherwise; they are not connected at least directly.
Data from Riskmetrics is at the director level. Four
network measures are computed mechanically for
each director-year.4 First, we estimate Degree cen-
trality, which is the number of direct connections
between two directors who sit on same board in a
year using the following model;
P
xij
j
Degreei ¼
n
1
Where Degreei represents the degree centrality of
director i, xij represents the direct link between
two directors by virtue of sitting on same board in
a particular year and n is equal to the number of
all directors in the network.
Second, we model directors’ network centrality
resulting from their connection with other well-
connected members of the network. This concept
is called Eigen-vector.
1X
Eigenveci ¼ Aij eυj
λ j
Eigenveci represents the derived network centrality
of director i. λ is a constant that provides a non-
trivial solution and Aij is an adjacency matrix,5
5388 B. G. GODIGBE ET AL.
divided by the maximum possible eigen-vector
centrality in the network.
Our third measure, Betweenness which proxies
for the amount of information controlled by a
director as a result of his/her position between
other members of a network is modelled as,
X other highly connected directors.
Betweennessi ¼ njik
jk
Betweennessi represents the betweenness network
centrality of director i.njik is an indicator of direc-
tor i on the path between directors j and k.
The fourth measure, Closeness measures the
mean information distance between two directors.
The shorter the distance between two connected
directors, the easier and prompt information is
transferred. This is modelled as,
n
1
Closenessi ¼ P
lði; jÞ
jÞi
Closenessi is the distance between director i and
other directors in the network. lði; jÞ is the length
of the information path between directors i and j.
In the next step, we averaged the connectedness
of directors sitting on each board to estimate firm
level connectedness for each year resulting in four
measures of firm network for each year.6 These
measures are correlated and therefore using prin-
cipal component analysis, we compute a fifth mea-
sure, which is a composite measure of the four
individual measures based on the first principal
component.
In computing directors network, we follow
prior literature using the largest components of
the network (Larcker, So, and Wang 2013; Omer,
Shelley, and Tice 2015). The values are normalized
to make inter-firm comparison of each measure
easy to understand. Table 1 shows that the largest
component of the network is generally 80% for
each year. Our sample covers S&P1500 firms,
which are public firms, and therefore has a higher
proportion of firms connected in the largest
component.7 The maximum number of directors
is 13,286, representing 1803 unique firms. In our
sample, a director is linked to about 15 other
6
We also consider the median of the director measures as the firms network measures in the subsequent analysis, the results are qualitatively the same.
7
Larcker, So, and Wang (2013) document the largest network component among public and private firms to be 70% in their 2000–2007 sample.
directors on average and the index representing
the shortest (optimal) path for information and
resource access for directors is about 20. The
maximum network centrality based on Eigen-vec-
tor is about 1. Eigen-vector measures the level of
connectedness based a director’s connection with
Sample description
In Table 2, we present summary statistics of the
variables. The variables are classified into net-
work measures, discretionary accruals and firm
characteristics. On average, each firm in our sam-
ple has 0.15 direct link to other firms through
their shared boards of directors. In our sample,
the maximum optimal paths on which firms can
assess information – closeness is indexed at 27%.
Overall, the firms have a maximum network cen-
trality indexed at 11%. On average, the level of
discretionary accruals in our sample is about 70%
of prior year’s total assets. Firms in our sample
grew by 47% from 1996 to 2013 with a maximum
capitalization of $24billion. The mean sharehold-
ings of institutional investors account for more
than 70% of the ownership in the firms studied.
There is high institutional shareholding in the
United States (Harford, Mansi, and Maxwell
2008).
Table 3 shows the correlations between the
variables used for the study. Our measures of
firm connectedness are highly correlated; how-
ever, the less than perfect correlation highlights
the different aspects of firm networks. Our com-
posite measure is highly correlated with the indi-
vidual measures. Generally, we observe weak
relation between our independent variables. The
positive correlations between growth measure
(Growth) and our financial reporting quality
proxy support the argument that growing firms
are more likely to manage earnings. Size and
leverage are negatively related to the level of dis-
cretionary accruals. These preliminary results are
consistent with big firms facing high political cost
of earnings management and increased monitor-
ing by debt providers (Lin et al. 2013).
 APPLIED ECONOMICS 5389

Table 1. Summary statistics for centrality measures.

Number of Number of Largest component Largest component Average centrality
Year firms directors (size) (%) Degree Closeness Betweenness Eigen-vector
1996 1444 11,461 9701 85 0.195 (18.917) 21.077 0.106 0.112
1997 1584 11,919 9937 83 0.188 (18.647) 20.922 0.103 0.660
1998 1770 12,902 10,930 85 0.166 (18.191) 20.722 0.094 0.945
1999 1803 13,286 13,286 100 0.111 (14.720) 23.236 0.038 0.837
2000 1755 12,899 10,902 85 0.101 (10.976) 21.348 0.034 0.751
2001 1797 12,977 10,668 82 0.155 (16.495) 19.592 0.100 0.914
2002 1439 10,667 8457 79 0.195 (16.481) 20.028 0.121 1.088
2003 1472 10,943 8653 79 0.185 (15.994) 19.823 0.118 0.908
2004 1477 11,033 8861 80 0.175 (15.475) 19.219 0.116 0.096
2005 1455 10,989 8778 80 0.170 (14.899) 18.783 0.117 0.108
2006 1413 10,811 8783 81 0.168 (14.790) 18.804 0.114 1.025
2007 1429 10,902 8792 81 0.163 (14.335) 18.110 0.118 0.076
2008 1442 11,287 9082 80 0.170 (15.447) 18.582 0.104 0.088
2009 1476 11,415 9139 80 0.154 (14.039) 17.753 0.112 0.081
2010 1481 11,435 9112 80 0.153 (13.980) 17.876 0.111 0.081
2011 1470 11,313 9076 80 0.153 (13.869) 17.611 0.113 0.083
2012 1495 11,482 9301 81 0.149 (13.865) 17.647 0.107 0.078
2013 1515 11,632 9473 81 0.148 (13.989) 17.806 0.105 0.079
This table presents summary statistics on four network centrality measures in this study. A component is the subset of a network that is connected.
Connected directors can reach other directors in a network for information/resource access. Degree measures the number of direct links a director has with
other directors. The number in parenthesis is the raw degree measures. Those without parenthesis are normalized. Closeness represents the average
shortest possible path on which information can be assessed. Betweenness measures the extent of information control a director holds. Eigen-vector refers
to the level of network centrality based on a director’s link to other connected directors.

Table 2. Descriptive statistics.

Variable Obs. Mean Std. Dev. Min Max
Firm network centrality
Degree 14,593 0.147 0.062 0.029 0.673
Betweenness 14,593 0.095 0.095 0.001 0.908
Closeness 14,593 19.228 2.877 9.449 26.711
Eigen-vector 14,593 0.003 0.006 0.000 0.111
PCA measure12 14,593 −0.033 1.557 −2.885 11.470
Earnings management
Absolute discretionary accruals 13,374 0.704 1.806 0.001 20.004
Real earnings management 12,684 −0.023 0.014 −0.027 0.333
Firm characteristics
Firm age 14,593 26.580 17.270 0 63
Growth 13,319 0.472 3.511 −0.498 69.350
Size 13,054 7.291 1.259 3.091 10.056
Leverage 12,663 0.465 0.201 0.006 0.999
Volatility in performance 12,863 0.047 0.093 0.002 3.409
Market-to-book ratio 14,107 0.013 0.006 0.000 0.086
Institutional holdings (%) 13,790 0.708 0.180 0.000 1.000
Number of analysts following 13,542 10.680 6.9151 1.000 30.000
Market capitalization ($’millions) 14,123 1901 3220 0.527 23,944
Total assets ($’millions) 13,657 3242.114 4277.645 6.268 23,296.420
This table reports summary statistics of the sample and variables used in our study. We categorize variables into firm network connectivity, earnings
management and firm characteristics. The statistics are based on a maximum of 14,593 firm-year observations covering 1899 unique firms for the period of
1996–2013. The sample has been drawn from S&P1500 firms in RISMETRICS with matching data from COMPUSTAT, Thomson Financials and IBES. Variables
are defined in Appendix A1.

IV. Empirical results our measure of firm connectedness. First quintile

Univariate analysis
In a univariate test, we find evidence that supports
the basic assumption that firms with different
levels of connection (network) manage earnings
differently. We sort firms into quintiles based on
represents firms with the least connectedness in
our sample while fifth quintile represents those
with the highest connectedness. We estimate
mean discretionary accruals for each quintile.
Table 4 reports a statistically significant difference
between lower and upper quintiles of firm

12
We generated PCA measure based on correlation PCA score of the four network measures. Covariance PCA score returns positive values of our PCA
measure. Regression results using either correlation or covariance score are similar.
5390 B. G. GODIGBE ET AL.

Table 4. Univariate analysis of firm network and earnings

*** represents p < 0.01, ** represents p < 0.05 and * represents p < 0.1. The sample has been drawn from S&P1500 firms in RISMETRICS with matching data from COMPUSTAT, Thomson Financials and IBES.
This table reports correlation statistics between variables used in our sample. The statistics are based on a maximum of 14,593 firm-year observations covering 1899 unique firms for the period of 1996–2013.
1.000
12
management.
Quintiles based on firm network t-
centrality Obs. Mean statistic Min Max

−0.092***
Quintile 1 2712 0.608 20.498 0.002 19.504

1.000
11
Quintile 2 2683 0.673 20.1411 0.001 20.004
Quintile 3 2684 0.704 19.641 0.001 19.584
Quintile 4 2656 0.732 19.710 0.001 19.956
Quintile 5 2639 0.806 21.206 0.001 19.722

−0.026**
p Value for difference in means of Q1 0.000

1.000
0.016
10

and Q5
This table reports a univariate analysis of the relation between firm net-
work and absolute discretionary accruals. We sort firms into quintiles
based on our measure of firm connectedness. Quintile 1 represents firms

−0.030**
with the least connectedness in our sample while Quintile 5 represents
1.000
−0.019
−0.013
9

those with the highest connectedness in our sample. We estimate mean

discretionary accruals for each quintile. The last row indicates the differ-
ence in mean discretionary accruals of the first and last quintiles.
−0.230***

0.057***
connection. The mean level of discretionary
1.000

−0.007
−0.014
8

accruals rises monotonically (from 0.608 to 0.806

for lowest and highest quintile respectively) with
firm connectedness. This is prima facie evidence
−0.081***
0.426***
−0.124***
−0.091***
0.539***
1.000
7

of earnings manipulation behaviour being trans-

mitted through the network of directors of firms.
0.428***

0.299***
−0.073***
−0.040***
0.155***
−0.025*
1.000
6

Multivariate analysis
In this section, we investigate the relation between
0.626***
0.153***

0.129***

0.064***

absolute discretionary accruals and firm network cen-

−0.026*
−0.020*
1.000

0.006
5

trality in a multiple regression. After including con-

trol variables, we estimate the following regression:
0.521***
0.761***
0.265***

0.247***
−0.040***

0.100***
0.027**

−0.026**

DiscAccruals ¼ β0 þ β1 FirmNetwork
1.000
4

þ β2 Growth þ β3 MB ratio
þ β4 Firm age þ β5 Size
0.390***
0.273***
0.830***
0.374***
−0.047***
0.230***
−0.058***

0.138***

þ β6 Leverage þ β7 Volatility
−0.033**
1.000
3

þ β8 ROA
X
þ β INDUSTRY
X i
0.805***
0.491***
0.416***
0.895***
0.488***
−0.051***
0.300***
−0.093***
−0.042***
0.165***

þ βi YEAR þ ν (3)
1.000
2

In the regression, the dependent variable is absolute

discretionary accruals (DiscAccruals), which captures
0.058***
0.041***

−0.042***

0.047***

the quality of a firm’s reported earnings. The main

0.020*

0.023*

−0.022*
1.000

−0.018

0.001

−0.017

−0.006
1

variable is firm network centrality (FirmNetwork),

Table 3. Correlation matrix.

which we specify as Degree, Betweenness, Closeness,

Eigen-vector or the first principal component (PCA)
11.Institutional holding
12. Analyst following

measure.8 These measure the centrality or extent of a

1. Disc. accruals

6. PCA measure
3. Betweenness

5. Eigen-vector

firm’s connectedness with others and the possible

10. Volatility
4. Closeness

9. Leverage

information and resource exchange. Following prior

8. Growth
2. Degree

7. Size

literature, we include control variables such as growth

(Growth), market-to-book ratio (MB ratio), firm age,
8
The first PCA explains 64% of proportion of variance of the data with eigenvalue equals 2.596 and the loading of the first PCA from the four measures are
0.565, 0.511, 0.492 and 0.422 respectively. We also consider the measure N-SCORE in Larcker, So, and Wang (2013), the results are qualitatively similar.

firm size (Size), leverage (Leverage), performance
(ROA) and performance volatility (Volatility).9
Details of all variables construction are included in
Appendix A1. In addition, we also include year and
industry dummies in our regressions and cluster stan-
dard errors at the firm level.
Pressure from the capital market induces growing
firms to manipulate their earnings, either by over-
investing in current assets such as receivables in
anticipation of future sales or intentionally manipu-
lating earnings due to the lesser transparency of fast
growing firms (Park and Shin 2004; Lee, Li, and Yue
2006). We therefore include a proxy for firm growth
(Growth). We expect a positive relation between firm
growth and the level of discretionary accruals.
Information asymmetry gives room for earnings
manipulation, we therefore control for the informa-
tion environment of firms using MB ratio and Firm
age. We expect that firms with opaque information
environment manage earnings more. The cost asso-
ciated with low quality financial reports is relatively
higher for large firms that usually have more press
coverage and active investor scrutiny (Zang 2011).
Also, larger firms face more political cost and are
less likely to misrepresent their earnings. We expect
firm size to discourage the level of discretionary
accruals. We use natural logarithmic transformation
of total assets to proxy for firm size. Firms with high
financial leverage are likely to manage earnings
because violating debt covenants may be high risk
(Roychowdhury 2006).
Firms which rely more on bank debts need intense
monitoring and are less likely to manipulate their
financial reports (Lin et al. 2013). We determine
Leverage by the ratio of a firm’s total debt to total
asset. We are unable to predict the effect of a firm’s
leverage on its level of earnings manipulation. We use
Volatility estimated by standard deviation in preced-
ing three-year return on assets as a proxy for fluctua-
tions in firm performance. Firms with good
operational outcomes have little motivation to man-
age earnings. We therefore include ROA to control
for firm performance.
Our results are reported in Table 5. The results
show that earnings quality declines with firm network.
In Panel A, we regress absolute discretionary accruals
on five different but related measures of firm
9
We use alternative measures of volatility such as sales volatility and cash flow volatility. Our results are still similar.
APPLIED ECONOMICS 5391
connectedness and control variables in our equation
(3). The coefficient of our principal firm network
measure (which is a composite measure of four dif-
ferent network measures) is positive and statistically
significant at 5% level. The economic significance
indicates that a one standard deviation increase in
firm network will lower earnings quality by about
7%. The mean ratio of discretionary accruals in our
sample is 70%. For our control variables, the results
show that firm size inhibits earnings management.
Firms with high growth and leverage are more likely
to manage earnings. These estimates are consistent
with the literature (Cohen and Zarowin 2010; Datta,
Iskandar-Datta, and Singh 2013). Firms with more
transparent information environments manage earn-
ings less indicated by the inverse relation between
market-to-book ratio and discretionary accruals.
Controlling for corporate governance
We include potential corporate governance variables,
which can affect the level of discretionary accruals in
the regressions. Institutional shareholders are sophis-
ticated investors who play a monitoring role in the
firm. They usually engage in private information
search about firms to inform their economic deci-
sions. The governance pressure exerted by institu-
tional investors tends to reduce the level of
information asymmetry as well as the likelihood of
misrepresenting earnings. Roychowdhury (2006)
document an increase in financial reporting quality
when firms have institutional investors. Independent
directors are good monitors of management. We con-
trol for the independence on the board in relation to
earnings quality.
Financial analyst are also important information
intermediaries who play key roles in disseminating
information. They sometimes engage in private infor-
mation search about firms and exert some level of
monitoring pressure on firms. Hong, Huseynov, and
Zhang (2014) find that the number of analyst follow-
ing reduces the extent of earnings manipulation.
Auditor quality (measured by Big 4 audit firms) has
been documented to influence the level of earnings
quality (Becker et al. 1998; Chen et al. 2011) because
auditing provides a monitoring mechanism that con-
strains the propensity of financial improprieties by
managers.
5392 B. G. GODIGBE ET AL.

Table 5. Firm network and earnings management.

Panel A
Discretionary accruals
Dependent variable = 1 2 3 4 5
Degree 0.982***
(0.351)
Betweenness 0.339
(0.216)
Closeness 0.023***
(0.009)
Eigen-vector 1.536
(2.823)
PCA measure 0.381**
(0.190)
Growth 0.137*** 0.138*** 0.137*** 0.139*** 0.138***
(0.017) (0.017) (0.017) (0.017) (0.017)
MB ratio −0.090** −0.086** −0.091** −0.084** −0.087**
(0.038) (0.038) (0.038) (0.038) (0.038)
Firm age 0.002** 0.003** 0.002** 0.003** 0.003**
(0.001) (0.001) (0.001) (0.001) (0.001)
Size −0.048** −0.038** −0.048** −0.032* −0.041**
(0.019) (0.019) (0.019) (0.019) (0.019)
Leverage 0.163 0.174* 0.162 0.185* 0.169
(0.104) (0.105) (0.105) (0.104) (0.104)
Volatility 0.228 0.226 0.222 0.225 0.227
(0.265) (0.266) (0.265) (0.266) (0.266)
ROA −0.034 −0.026 −0.034 −0.027 −0.027
(0.285) (0.286) (0.284) (0.287) (0.286)
Constant 0.775*** 0.789*** 0.054 0.775*** 0.785***
(0.152) (0.153) (0.175) (0.159) (0.152)
Year dummies Yes Yes Yes Yes Yes
Industry dummies Yes Yes Yes Yes Yes
Observations 11,252 11,252 11,252 11,252 11,252
Adjusted R2 0.222 0.221 0.222 0.221 0.221
Panel B
Model 1 Model 2 Model 3 Model 4 Model 5
PCA measure 0.388** 0.400** 0.522** 0.381** 0.527**
(0.191) (0.192) (0.256) (0.190) (0.257)
Growth 0.140*** 0.138*** 0.150*** 0.138*** 0.150***
(0.016) (0.017) (0.014) (0.017) (0.014)
MB ratio −0.082** −0.086** −0.081 −0.087** −0.081
(0.038) (0.038) (0.050) (0.037) (0.050)
Firm age 0.002** 0.003** 0.001 0.003** 0.001
(0.001) (0.001) (0.002) (0.001) (0.002)
Size −0.039** −0.041** 0.036 −0.040** 0.035
(0.019) (0.019) (0.032) (0.019) (0.032)
Leverage 0.158 0.180* 0.128 0.169 0.136
(0.105) (0.104) (0.150) (0.104) (0.149)
Volatility 0.214 0.244 0.197 0.226 0.190
(0.267) (0.265) (0.361) (0.265) (0.364)
ROA −0.017 −0.022 −0.128 −0.028 −0.128
(0.286) (0.286) (0.380) (0.286) (0.382)
Institutional holding −0.226** −0.078
(0.114) (0.175)
Board independence −0.124 −0.052
(0.110) (0.159)
Analyst following −0.156*** −0.153***
(0.048) (0.049)
Auditor −0.017 0.049
(0.052) (0.053)
Constant 0.525*** 1.110*** 0.111 0.801*** 0.929***
(0.185) (0.185) (0.209) (0.159) (0.281)
Year dummies Yes Yes Yes Yes Yes
Industry dummies Yes Yes Yes Yes Yes
Observations 11,193 11,226 6,066 11,252 6,058
Adjusted R2 0.222 0.221 0.217 0.221 0.217
This table presents statistics of regressions of absolute discretionary accruals on various measures of firm network. Degree represents a firm’s number of
direct links it has with other firms. Betwenness represents a firm’s location between two other connected firms, making the firm an information/resource
hub. Closeness measures the shortest possible path connecting two firms. Eigen-vector represents a firm’s network that results from its connection with
other well-connected firms. PCA is a weighted average of the four measures based on the principal component analysis and this represents the firm’s
overall network. All other variables are defined in Appendix A1. The figures in parentheses are robust standard errors. *** represents p < 0.01, ** represents
p < 0.05 and * represents p < 0.1.

In Table 5, panel B reports regressions in which we
include various corporate governance variables. In
Model 1 through Model 5, we report that the firm
network measures still has significant influence on the
level of earnings management after the inclusion of
various corporate governance variables. Specifically,
the coefficient on our PCA measure is consistently
positive and statistically significant at 5% significance
level. This result is robust to controlling for the effect
of institutional investors, board independence, finan-
cial analysts and auditors. Institutional holdings have
a strong negative relation (−0.226) with discretionary
accruals and the more analysts following a firm, the
better the quality of reported earnings.
Conditions under which director networks transmit
earnings management more
Firm networks serve as information channels through
which knowledge about desirable and undesirable cor-
porate practices is transmitted. The adoption of good
and bad corporate practices from the networks of
directors networks are not equally likely. There are
instances where good dominates the bad effect of net-
works (Omer, Shelley, and Tice 2015). The bad effect
of networks may prevail when the pressure to manage
earnings heightens under circumstances such as poor
performance (Zang 2011), and competition and capital
market pressures (Cohen and Zarowin 2010; Datta,
Iskandar-Datta, and Singh 2013). We expect the trans-
mission of earnings management behaviour through
firm networks to be constrained when the performance
of firms in the network is good.
In Table 6, we test for how director networks
affect the quality of earnings under circumstances
of good and poor financial performance. We clas-
sify firm-years with return on assets between zero
and 0.05 as poor performing firm-years and are
suspects of low quality earnings.10 Firm-years with
return on assets outside this range are classified as
those with good performance or those with genu-
ine earnings figures. In our analysis, we include
GOOD which is an indicator variable that equals 1
if a firm-year is classified as good performance,
and zero otherwise. GOOD is then interacted with
our network measures in the regression. We
report evidence consistent with the hypothesis
that poor performing firms are more likely to
10
Similar cut-off point is used in Coles, Daniel, and Naveen (2006), Roychowdhury (2006) and Gilliam, Heflin, and Paterson (2015).
APPLIED ECONOMICS 5393
report low quality earnings (Burgstahler and
Dichev 1997; Roychowdhury 2006) and that earn-
ings management behaviour is transmitted more
through the network of directors of poor perform-
ing firms. Specifically, the interaction term (our
network proxies*GOOD) is negative and signifi-
cant at 5% level for all of our network measures.
The coefficient on PCA measure*GOOD is signif-
icant and negative, implying that the likelihood of
earnings manipulation practice being transmitted
into a firm through director network is lower
firms with good performance. This supports the
hypothesis that firms with good performance are
less likely to adopt undesirable financial reporting
behaviour from their networks.
Directors equity compensation and earnings
quality
In order to align the interest of corporate insiders
with that of shareholders, equity compensation has
been commonly used to incentivize managers. The
effects of managerial equity compensation on miti-
gating agency conflict have been mixed in the litera-
ture. Equity compensation can provide managers
with the incentive to create firm value (Coles,
Daniel, and Naveen 2006; Rego and Wilson 2012).
However, opportunistic earnings manipulation of
firm insiders increases with managerial equity com-
pensation (Cheng and Warfield 2005). If director
network serves as a platform to spread opportunistic
earnings reporting, we expect the propagation to be
more severe if directors are individual beneficiaries
of equity compensation.
In Table 7, we predict that when directors are
compensated with equity, the contagion of misre-
porting earnings increases. We interact the log
transformation of directors’ equity compensation
with our overall firm network measure. The regres-
sion coefficient of this interaction term is positive
(0.264) and significant at 1% level after the inclusion
of control variables. A change in discretionary
accruals level with respect to director network is
positively associated with director equity compensa-
tion. Our results show that an increase in directors’
equity compensation results in a decreasing effect of
director networks on earnings quality. These results
5394 B. G. GODIGBE ET AL.

Table 6. The effect of director networks on earnings management when firms in the network have good financial performance.
Discretionary accruals
Dependent variable = Model 1 Model 2 Model 3 Model 4 Model 5
Degree 2.784***
(0.896)
Betweenness 1.334**
(0.563)
Closeness 0.036**
(0.015)
Eigen-vector 24.814**
(10.300)
PCA measure 1.322***
(0.498)
GOOD 0.382*** 0.200*** 0.415 0.163*** 0.285***
(0.124) (0.066) (0.288) (0.053) (0.094)
Degree × GOOD −2.119**
(0.898)
Betweenness × GOOD −1.176**
(0.575)
Closeness × GOOD −0.017
(0.015)
Eigen-vector × GOOD −26.398**
(10.381)
PCA measure × GOOD −1.112**
(0.505)
Growth 0.138*** 0.139*** 0.136*** 0.138*** 0.139***
(0.017) (0.017) (0.017) (0.017) (0.017)
MB ratio −0.105*** −0.102*** −0.107*** −0.099*** −0.104***
(0.033) (0.033) (0.033) (0.033) (0.033)
Firm age 0.002* 0.003** 0.002** 0.003** 0.003**
(0.001) (0.001) (0.001) (0.001) (0.001)
Size −0.050*** −0.040** −0.050*** −0.036* −0.044**
(0.019) (0.019) (0.019) (0.019) (0.019)
Leverage 0.202** 0.212** 0.203** 0.232** 0.208**
(0.098) (0.099) (0.099) (0.099) (0.099)
Volatility 0.435 0.411 0.393 0.402 0.419
(0.291) (0.295) (0.295) (0.294) (0.294)
Constant 3.037** 3.210** 2.746** 3.205** 3.136**
(1.354) (1.348) (1.378) (1.350) (1.349)
Year dummies Yes Yes Yes Yes Yes
Industry dummies Yes Yes Yes Yes Yes
Observations 11,252 11,252 11,252 11,252 11,252
R2 0.223 0.222 0.222 0.222 0.222
This table presents statistics of regressions of absolute discretionary accruals on various measures of firm network interacted with GOOD which is an
indicator of good firm performance. GOOD is equal to one if ROA in a firm-year is outside the range between 0 and 0.05 otherwise zero. Degree represents
a firm’s number of direct links it has with other firms. Betwenness represents a firm’s location between two other connected firms, making the firm an
information/resource hub. Closeness measures the shortest possible path connecting two firms. Eigen-vector represents a firm’s network that results from
its connection with other well-connected firms. PCA is a weighted average of the four measures based on the principal component analysis and this
represents the firm’s overall network. All other variables are defined in Appendix A1. The figures in parentheses are robust standard errors. *** represents
p < 0.01, ** represents p < 0.05 and * represents p < 0.1.

are consistent with Jiang, Petroni, and Wang (2010)
in which earnings manipulation increased with
equity incentives of chief financial officers and
chief executive officers of U.S. firms.
V. Additional tests
The effect of SOX
The main finding that director networks increase
the incidence of earnings manipulation implies
that directors care less about loss of their reputa-
tion due to poor quality financial reports. We
provide further test to see if directors indeed
care less about their integrity using the SOX reg-
ulation of 2002.
As Cohen, Dey, and Lys (2008) show, there is a
change in the earnings management behaviour of
firms after the SOX in 2002. The Act streamlined
existing corporate governance practices and limited
financial malfeasance by firm executives. The trans-
mission of earnings misrepresentation behaviour
through firm networks is constrained by the Act as
well. As Zang (2011) highlights increased scrutiny
from regulators and auditors after the passage of
SOX has increased the costs associated with manip-
ulating earnings. Directors have developed a reputa-
tion as monitoring specialists (Fama and Jensen 1983)
 APPLIED ECONOMICS 5395

Table 7. Directors equity compensation and network and earn- negatively associated with discretionary accruals
ings management. and significant at 10% level. This indicates the
Discretionary
Accruals effectiveness of SOX in sanitizing the financial
PCA measure −1.220* information environment and especially con-
(0.658) straining the extent to which directors can influ-
Directors equity compensation −0.073***
(0.022) ence each other to misreport earnings.
PCA measure × Directors equity compensation 0.264***
(0.102)
Growth 0.148***
(0.016) Endogeneity of director networks
MB ratio −0.043
(0.044) We findOne concern for our results is that
Firm age 0.001
(0.001) firms with higher tendency to report low qual-
Size −0.023 ity earnings attract directors with stronger net-
(0.025)
Leverage 0.340*** work connection who are in high demand
(0.127) because of the strong tendency of the herd
Volatility 0.081
(0.271) behaviour. We rely on a conventional approach
ROA −0.295
(0.311)
to ensure the robustness of our results to this
Constant 5.052*** endogeneity concern. We employ the instru-
(1.137)
Year dummies Yes mental variables estimation method and exam-
Industry dummies Yes ine the average industry PCA measure by year
Observations 6,122
R-squared 0.270 as the instrumental variable because it is cor-
This table presents statistics of regression of absolute discretionary accruals related with firm network centrality but uncor-
on firm network. PCA is the first principal component analysis measure related with the error term. The average
that represents a firm’s overall network. Equity compensation is the log
transformation of shares and option payment to directors in a year. PCA industry PCA measure may determine the
× Equity compensation is an interaction term that captures the interac-
tion between directors’ equity compensation and director (firm) network.
extent to which the industry has well-con-
All other variables are defined in Appendix A1. The figures in parentheses nected firms, but this average industry measure
are robust standard errors. *** represents p < 0.01, ** represents p < 0.05
and * represents p < 0.1. should be unrelated to the firm’s earnings
quality. Results of this analysis are similar to
those reported in Table 5 (not tabulated here).
and this reputation increases with the multiple boards We find that the PCA measure continues to
on which they sit. In order to safeguard this reputa- load positively at the 5% level or better, rein-
tion, we expect a decline in the transmission of earn- forcing our previous findings of a positive
ings manipulation behaviour among networked association between PCA measure and the
directors and thus connected firms in the post-SOX earnings management. The results indicate
period. that endogeneity concern is not likely to be
We find evidence in support of decline in earn- driving our core evidence.
ings management and the transmission of the act
though the networks of firms after the passage of
Robustness tests
SOX in 2002. We report in Table 8, and find a
negative association between discretionary We findIt is possible that our results are driven by the
accruals and SOX indicator. The linear summa- proxy used to measure earnings quality. We test for
tion of the estimates of the SOX indicator and the the relation in Table 5 using two alternative measures
interaction terms provide a strong evidence of an of financial reporting quality. In the post-SOX period,
increase in earnings quality after 2002, consistent firms have shifted away from managing earnings
with Zang (2011). More importantly, we report in through accruals to managing earnings through real
Table 8 evidence consistent with our prediction activities (Zang 2011). Since our data period extends
that SOX constrained the extent to which director through 2002 when SOX became effective, we follow
networks can propagate earnings manipulation Cohen and Zarowin (2010) to estimate real earnings
among firms. The interaction terms between management proxies to test the validity of our find-
SOX indicator and the network measures are ings. Using principal component analysis, we estimate
5396 B. G. GODIGBE ET AL.

Table 8. The effect of SOX on earnings management.

Discretionary accruals
Model 1 Model 2 Model 3 Model 4 Model 5
Degree 1.035**
(0.446)
Betweenness 0.609*
(0.365)
Closeness 0.017
(0.010)
Eigen-vector 4.466
(3.804)
PCA measure 0.558*
(0.295)
SOX 0.143 0.130* −0.043 0.110* 0.151*
(0.114) (0.072) (0.275) (0.064) (0.091)
Degree × SOX −0.084
(0.663)
Betweenness × SOX −0.356
(0.457)
Closeness × SOX 0.010
(0.015)
Eigen-vector × SOX −7.254*
(4.033)
PCA measure × SOX −0.244
(0.385)
Growth 0.137*** 0.138*** 0.137*** 0.139*** 0.138***
(0.017) (0.017) (0.017) (0.017) (0.017)
MB ratio −0.090** −0.086** −0.091** −0.084** −0.087**
(0.038) (0.038) (0.038) (0.038) (0.038)
Firm age 0.002** 0.003** 0.002** 0.003** 0.003**
(0.001) (0.001) (0.001) (0.001) (0.001)
Size −0.047** −0.038** −0.048** −0.033* −0.041**
(0.019) (0.019) (0.019) (0.019) (0.019)
Leverage 0.164 0.176* 0.161 0.187* 0.171
(0.104) (0.105) (0.105) (0.104) (0.104)
Volatility 0.229 0.228 0.216 0.228 0.230
(0.265) (0.266) (0.265) (0.266) (0.265)
ROA −0.034 −0.024 −0.035 −0.028 −0.026
(0.285) (0.286) (0.285) (0.286) (0.285)
Constant 3.169** 3.200** 3.033** 3.192** 3.180**
(1.352) (1.353) (1.348) (1.356) (1.352)
Year dummies Yes Yes Yes Yes Yes
Industry dummies Yes Yes Yes Yes Yes
Observations 11,252 11,252 11,252 11,252
Adjusted R2 0.222 0.222 0.221 0.222
This table presents statistics of regressions of absolute discretionary accruals on various measures of firm network after the coming into effect of the
Sarbanes-Oxley Act (SOX) in 2002. SOX is an indicator variable that equals one if firm year is after 2002, otherwise zero. Interaction between various firm
network measures (Degree, Betweennes, Closeness, Eigen-vector and PCA measure) have been included in the regression. All other variables are defined in
Appendix A1. The figures in parentheses are robust standard errors. *** represents p < 0.01, ** represents p < 0.05 and * represents p < 0.1.

a composite measure of real earnings management
using the three proxies in prior literature.11 We
regress our composite real earnings management
measure on our network measures and other controls.
The results (not tabulated here) are qualitatively simi-
lar to those reported in Table 5. We also find similar
results using accruals quality measure of Francis et al.
2005).
VI. Conclusion
In this study, we explored the effect of director
networks on the quality of financial reports. Low
11
See (Roychowdhury 2006) for three measures of real earnings management – abnormal levels of production costs, cash flow and discretionary expenses.
quality financial reporting can either be the result
of opportunistic behaviour of firm executives or it
can be a strategic tool to optimize firm value
(Cheng, Man, and Yi 2013). We tested the con-
tagion effect of director networks on financial
reporting behaviour of firms. While Larcker, So,
and Wang (2013) posit that directors of connected
firms assess more complete information regards
optimal corporate practices and also learn from
their networked peers, other studies however show
that connection among firms serve as conduits for
the diffusion of ‘bad’ corporate practices among
related firms (Bizjak, Lemmon, and Whitby 2009).

The main findings in our study support our
hypothesis that director networks spread finan-
cial reporting misbehaviour among connected
firms. Directors of firms with good financial
performance are however, less likely to adopt
earnings manipulation behaviour from their
networks. Also, the diffusion of low-quality
earnings reports among related firms increase
more when directors have equity stake in their
firms.
Overall, we find that firm behaviour of mis-
reporting financial statements especially earn-
ings like other corporate practices spreads
among connected firms with directors serving
as conduits for the transfer of information
about the practice. This suggests that a direc-
tor’s centrality in their networks provides
potential costs that are reflected in board over-
sight over the quality of financial reporting
through the contagion effect of director
networks.
Disclosure statement
No potential conflict of interest was reported by the author.
Funding
Liu acknowledges the research grant support from the
Fundamental Research Funds for the Central Universities
in China [grant number 20720151044];the Fundamental
Research Funds for the Central Universities in China [grant
number 20720151044].
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Appendices
Appendix A1. Definition of variables

Variable name Description and source

Absolute discretionary Absolute discretionary accruals refer to the absolute value of discretionary accruals. We use absolute discretionary accruals
accruals in our regressions.
Discretionary accruals (DA) We estimate DA as the difference between actual total accruals and predicted level of total accruals.
Betweenness centrality Betweenness centrality relates to the position of a director between two other linked directors. A director positioned on
the information path linking two other directors controls the flow of information between them.
Closeness centrality Closeness centrality measures the average shortest distance between two linked directors.
Degree centrality Degree centrality measures the number of direct links of a director to other directors through common board membership.
Directors data is retrieved from RISKMETRICS
Eigen-vector centrality Eigen-vector centrality measures the network power of a director who is linked to other powerful directors.
PCA measure PCA measures are the first principal component of the four network centrality measures.
Firm network Firm network is the average value of a firm’s director network.
Growth Growth equals to the annual change in total assets of a firm.
Market-to-book ratio Market_to-book (MB ratio) equals to log of (1+ ratio of market value to book value of equity. Market value of equity
(mkvalt) and book value of equity (ceq) are both COMPUSTAT variables.
Firm age Firm age is the total number of fiscal years that a firm has operated. We use current fiscal year minus IPO year or first year
appearing on COMPUSTAT.
Leverage Leverage equals to total liabilities (a COMPUSTAT variable) divided by total assets. We use 1-year lag total liabilities divided
by total asset in our regressions.
Size Size is the log transformation of total assets. In our regressions, we use log (1+ lag total assets).
Volatility We use three volatility measures. ROA volatility is equal to a 3-year rolling standard deviation of return on assets. CFO and
Sales volatility are estimated similarly.
Return on asset Return on asset (ROA) is a firm’s net income divided by it total assets.
Institutional holding Institutional shareholding is equal to shares held by institutional investors divided by total shares outstanding. Institutional
shareholding data is retrieved from Thomson Financial database.
Board independence The percentage of independent directors to the total number of directors on the board. We adopt the independence
indicator RISKMETRICS.
Number of analysts following The number of analysts following refers to the number of analysts who make periodic estimates about a firm’s financials.
numest is a variable on the summary file of IBES database representing the number of analysts following a firm. In our
regressions, we use log(1+numest)/100.
Directors equity Equity compensation of directors is the sum of stock and option payments made to directors in a fiscal year. We use log (1
compensation +value of shares and options) in our regressions. Directors’ compensation data was retrieved from EXECUCOMP.
Market capitalization Market capitalization is equal to log of COMPUSTAT variable mkvalt. We calculate market capitalization as COMPUSTAT
common shares outstanding multiplied by share price at the end of the fiscal year, when COMPUSTAT variable, mkvalt is
missing.
Property, plant and We use gross amounts of property, plant and equipment retrieved from COMPUSTAT
equipment (PPE)
Receivables Receivables refer to trade receivables. Data source is COMPUSTAT
Return on assets (ROA) Return on assets equals net income divided by total assets
Sales Sales refer to net turnover represented as sale in COMPUSTAT. We estimated annual changes in sales, which is used as an
explanatory variable in equation 1 and 2.
Total accruals (TA) TA is net income minus net operating cash flow. Data source is COMPUSTAT.
Total assets (A) A refers to the COMPUSTAT data variable total assets. We scale all variables used in estimating normal level of total
accruals with total assets.

Appendix A2. Sample selection

Panel A: Directors’ network sample construction Director-Years

Directors with firm identifiers from Riskmetrics (1996–2013) 209,353
Less directors who are not in the largest component 36,422
Sample directors used for network construction 172,931
Panel B: Final sample construction Firm-Years
Number of firms with corresponding director network measures 24,906
Less firms without required data from Compustat for the main model 10,313
Sample firms for panel data regressions 14,593
 5400 B. G. GODIGBE ET AL.

Appendix A3. Merging RISMETRICS and
COMPUSTAT databases
In this study, we merge data from five databases – RISKM
ETRICS, COMPUSTAT, IBES, THOMSON FINANCIAL and
EXECUCOMP. The last three databases share identifiers with
either RISKMETRICS or COMPUSTAT. There is however a
challenge in merging data from RISKMETRICS with that from
COMPUSTAT. Data from both databases have cusip and ticker in
common however the cusip in COMPUSTAT is a 10-digit header
cusip whereas that in RISKMETRICS is a 6-digit historical cusip
for a legacy file for the period of 1996–2006 and an 8-digit
historical cusip for the 2007 onwards period. Usually, ticker
does not produce satisfactory merging results.
We follow Cashman, Gillan, and Jun (2012) in merging
data from RISKMETRICS and COMPUSTAT through the
following steps:
(1) Match observations based on six-digit cusip,
ticker, and year.
(2) Match remaining observations based on six-
digit cusip and year.
(3) Match remaining observations based on ticker
and year.
Appendix A4. Example to illustrate how to
calculate the four network measures
The diagram and table in the following text demonstrate board
network among four unique firms. In the diagram, A, B, C,. . .,K
represents directors sitting on the boards of Firms 1, 2, 3, and 4.
Directors B, D and G through their simultaneous representation
on the boards of two firms creates a board interlock between the
firms. Firms 1 and 2 have two board interlocks each while Firms
3 and 4 have one each. As shown in Panel A, network centrality
(or access to a more complete information) of each of Directors
B, D and G differ because the firms have different board sizes
and different number of interlocks. Panel B shows that aggre-
gate firm network centrality differs for each firm despite having
same number of board interlocks.

Panel A: Director-level network centrality

Director Firm Number of boards Degree centrality Closeness centrality Eigenvector centrality Betweenness centrality
A 1 1 3 0.500 0.259 0
B 1,4 2 5 0.550 0.300 18
C 1 1 3 0.500 0.259 0
D 1,2 2 6 0.688 0.471 30
E 2 1 3 0.524 0.307 0
F 2 1 3 0.524 0.307 0
G 2,3 2 6 0.611 0.442 24
H 3 1 3 0.423 0.224 0
I 3 1 3 0.423 0.224 0
J 3 1 3 0.423 0.224 0
K 4 1 2 0.379 0.101 0
L 4 1 2 0.379 0.101 0
Panel B: Firm-level network centrality
Firm aggregate measures
Firm Director Number of board interlocks Degree centrality Closeness centrality Eigenvector centrality Betweenness centrality
1 A, B, C, D 2 4.250 0.560 0.322 12.000
2 D, E, F, G 2 4.500 0.587 0.382 13.500
3 G, H, I, J 1 3.750 0.470 0.279 6.000
4 B, K, L 1 3.000 0.436 0.167 6.000

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