The Effect of Top Executive Turnover and Local Market Characteristics on Financial Reporting Risk

Abstract

Upper echelon theory posits that defining, executing, and overseeing an organization’s strategy is a shared activity among top executives. Based upon this perspective, we expect turnover among the members of a firms’ top management team (TMT) other than the CEO and CFO to result in significant disruption to an organization’s operations, leading to greater uncertainty regarding its future performance, execution of operational strategies, and financial reporting decisions. In this study, we explore whether TMT turnover affects stakeholders’ perceptions of financial reporting risk. We find that TMT turnover is positively associated with audit fees which reflects auditors’ and audit committees’ assessments of financial reporting risk. Importantly, building upon labor economics literature, we find that TMT turnover’s effect on stakeholders’ perceptions of financial reporting risk is greater for companies headquartered where there are more limited local labor pools and companies that are market leaders in their local areas or industries. Further analyses suggest that increased audit fees offset deterioration in financial reporting quality as TMT turnover increases.