How Do Accounting Practices Spread? An Examination of Law Firm Networks and Stock Option Backdating

Abstract

We hypothesize that one way accounting practices spread is through law firm connections. We investigate this prediction by examining companies that avoided reporting compensation expense by engaging in stock option backdating. We hypothesize that executives engaged in backdating because they were desensitized to its inappropriateness when they learned through their legal counsel that other companies were engaging in this practice. We identify backdating companies through backdating-related restatements of earnings. Using network analysis, we find backdating companies are highly connected with other backdating companies via shared law firms. Logistic regressions reveal that the odds of a company backdating are 53 to 88 percent higher when its law firm has another client that backdates, and that law firm connections are incremental to board interlocks and geographic location. Finally, law firms with backdating clients have more other clients with “lucky” grants, suggesting backdating spread to other companies but only some restated.

Keywords: accounting practices, stock options, backdating, law firms, directors, geographic location, network analysis

JEL Classification: J33, K22, K42, L14, M41, M43, M45