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    Voluntary Adoption of More Stringent Governance Policy on...
    research summary posted November 12, 2014 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
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    Title:
    Voluntary Adoption of More Stringent Governance Policy on Audit Committees: Theory and Empirical Evidence
    Practical Implications:

    The findings in this study have important policy and practical implications. First, the study provides empirical evidence that firms have incentives to adopt more stringent governance mechanisms voluntarily if doing so is beneficial. The OSC Policy to exempt smaller issues is both effective and efficient in that it encourages the voluntary adoption and it avoids imposing unnecessary compliance costs associated with a one-size-fits-all mandatory compliance policy. Second, the findings in this study provide strong evidence that adopting more stringent audit committees can generate tangible economic benefits in the form of increased firm valuation, lower cost of capital, and improved investment efficiency. It appears that managers in some TSX listed firms may have overlooked these benefits and did not adopt the more stringent audit committee voluntarily before the mandatory adoption date. Finally, the findings in this study provide corroborating evidence that fully independent and financially literature audit committees are more effective than the less stringent ones in monitoring firm investments and in enhancing the quality of accounting information, as implied in our findings. Investors and policy makers should advocate the adoption of more stringent audit committees.

    For more information on this study, please contact either Feng Chen or Yue Li.

    Citation:

    Chen, F., and Y. Li. 2013. Voluntary Adoption of More Stringent Governance Policy on Audit Committees: Theory and Empirical Evidence. The Accounting Review 88 (6): 1939-1969.

    Keywords:
    Independent audit committees; corporate governance; voluntary compliance; investment efficiency; firm valuation; cost of capital
    Purpose of the Study:

    The Ontario Securities Commission (OSC) issued Multilateral Instrument 52-110 (MI 52-110) policy in June 2003. This policy, which became effective on January 1, 2004, requires securities issuers listed in the Toronto Stock Exchange (TSX) to set up an audit committee with at least three independent and financially literate board members. One unique feature of this policy is that it exempts small issuers such as companies listed on the TSX Venture Exchange in favor of voluntary compliance by these firms due to concerns about compliance costs. . The policy only requires small issuers to disclose whether they have an audit committee, the names of its members, and whether the members are independent.

    The OSC’s policy on audit committees is unique in that it allows TSX Venture-listed firms to adopt a more stringent governance mechanism voluntarily. This policy creates a desirable regulatory setting to investigate the costs and benefits associated with voluntary adoption of a more stringent audit committee.  Within this Canadian regulatory setting, we examine the following research questions: (1) What economic factors would affect TSX Venture firms’ decisions to adopt the more stringent audit committee voluntarily? (2) What are the likely economic benefits from adopting more stringent audit committees by TSX Venture firms and from mandatory compliance by TSX listed firms? 

    Design/Method/ Approach:

    The researchers first develop a parsimonious analytical model to analyze controlling shareholders’ (or management) incentives to adopt the more stringent audit committee policy voluntarily. The model provides interesting and intuitive predictions. First, firms with low compliance costs will be more likely to adopt the more stringent audit committee voluntarily. Second, firms with high future financing needs will also be more likely to adopt the more stringent audit committee voluntarily. Finally, the adoption of the more stringent audit committee will lead to higher firm valuation due to improvement in investment efficiency.           

    They then test the predictions of the model empirically by using archival data from a sample of 376 firms listed on the TSX Venture Exchange during the 2003-2004 period. They also analyzed whether the adoption of the more stringent audit committee would lower the cost of capital and improve the investment efficiency for both the TSX Venture firms and TSX listed firms. 

    Findings:
    • Consistent with the predictions of the model, the researchers find that compliance costs negatively affect the TSX Venture firms’ decisions to adopt the more stringent audit committee policy voluntarily.
    • They also find that firms that adopted the more stringent audit committees voluntarily were more likely to raise capitals and to migrate to the Toronto Stock Exchanges during the three year period immediately following the adoption decision.
    • The study also finds that companies that adopted the audit committee policy voluntarily experienced a high firm valuation measured in Tobin's Q, lower costs of capital, improved investment efficiency after the voluntary adoption.
    • Finally, the study finds that TSX listed firms also experienced increased firm valuation, lower cost of capital, and improved investment efficiency immediately following the mandatory adoption of more stringent audit committees.
    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Board/Audit Committee Composition