Private Signals of Misreporting and Executive Dismissal

Executive dismissal following low reporting quality events is well documented. However, prior research examines public signals of low reporting quality (e.g., restatements), which also have implications for the board’s own reputation due to the public nature of the signal. To investigate the board’s demand for reporting quality in the absence of a public signal, we exploit a private signal of low reporting quality: audit adjustments communicated to the board by the external auditor. We find an increased likelihood of CEO dismissal following adjustments required by auditors. This association is driven by adjustments that reduce income, by firms that have lower operating performance, and by firms with higher-quality board oversight. We find a similar dismissal effect for CFOs. These findings suggest that (1) boards act proactively following private signals of low reporting quality, and (2) boards incorporate information from the external auditors into their governance processes.