Voluntary Adoption of More Stringent Governance Policy on Audit Committees: Theory
and Empirical Evidence
Feng Chen
Rotman School of Management
University of Toronto
105 St. George Street
Toronto, ON
M5S 3E6, Canada
feng.chen@rotman.utoronto.ca
Yue Li
Rotman School of Management
University of Toronto
105 St. George Street
Toronto, ON
M5S 3E6, Canada
yueli@rotman.utoronto.ca
October 1, 2010
We thank the CICA/CMA Research Grant Program for financial support and David Song for statistical programming assistance.  We acknowledge the following students for collecting the data used in this study: Zohair Akhtar, Dada Olusegun, Nishit Pathak, Sonia Singh, Fahad Tariq, Cindy Wang, Yuanyuan Wei, and Zheng Zhao.  We thank Jeff Callen, Gus De Franco, Ole-Kristian Hope, Soo Young Kwon (discussant), Eric Mak, Michael Maier (discussant), Konari Uchida (discussant), participants at University of Toronto and McMaster University workshop, the 5th International Conference on Asian Financial Markets, 2010 AAA International Accounting Section mid-year meeting, 2010 EAA annual conference, 2010 CAAA Annual Conference, and 2010 AAA Annual Meeti
ng for their comments.  Feng Chen acknowledges the financial support from the EASSH program at University of Toronto.
Voluntary Adoption of More Stringent Governance Policy on Audit Committees: Theory
and Empirical Evidence
Abstract: This study examines why the Toronto Venture Exchange (TSX Venture) listed firms chose to voluntarily adopt the more stringent governance policy that requires all audit committee members being independent and financially literate.  We develop a parsimonious analytical model that shows both compliance costs and financing needs have an impact on firms’ adoption decision.  The model also shows that high quality audit committees enhance firm value by reducing the likelihood of diversion.  We test the predictions of our analytical model using a sample of 376 TSX venture firms from the 2003 to 2005 period.  The results confirm that venture firms with low compliance costs and future financing needs are more likely to adopt the new policy voluntarily.  Further analyses show that the adoption decision has a positive impact on firm value and negative impact on firms’ cost of capital.  The overall evidence is consistent with the argument that firms consider both the cost and benefit factors when deciding whether to establish an audit committee with all independent and finan
cially literate members.  Keywords: Audit Committees, Venture Firms, Voluntary Compliance, Cost and Benefit Analysis, Financing Needs, Tobin’s Q
Voluntary Adoption of More Stringent Governance Policy on Audit Committees:
Theory and Empirical Evidence
I. Introduction
Audit committees oversee the internal control process and relations with external auditors, monitor the choice of accounting policies and principles, as well as guiding the financial reporting and disclosure process.  By performing these functions, financially literate and independent audit committees may reduce the probability of financial fraud and mitigate management capability to divert corporate resources for personal gain (Wild 1994; Beasley 1996; Krishnan 2005).  There is a consensus in the literature that strong and independent audit committees strengthen internal controls and enhance the quality of financial reporting (DeFond and Francis 2006).
Securities regulators in Canada take a similar view on the role of audit committees.  The Ontario Securities Commission (OSC hereafter) in Canada issued a policy, Multilateral Instrument 52-110 (MI
52-110 hereafter), in June 2003 (OSC 2003a).  The policy, effective January 1, 2004, requires securities issuers in Canada to set up an audit committee of at least three independent and financially literate board members.  An interesting and yet controversial feature of the policy is that it exempts small issuers such as companies listed on the TSX Venture Exchange.  For these companies, the policy requires them only to disclose whether they have an audit committee, who sits on it, and whether its members are independent.
The new policy on audit committees creates a unique regulatory environment to study the role of independent audit committees in the capital market setting because it allows small firms to adopt the more stringent governance policy voluntarily.  The heightened awareness of corporate governance in recent years creates a demand for increased scrutiny of the corporate
financial reporting process.  Because of the lack of institutional investors and financial analysts following for TSX Venture listed firms, voluntarily adopting more stringent governance policies can be a cost-effective mechanism for small firms to enhance and signal the quality of their financial statements.
This study examines the following questions in the Canadian regulatory setting: (1) To what extent do
the TSX Venture listed firms choose to comply voluntarily with the audit committee policy?  (2) What factors affect firms’ decisions to adopt the more stringent policy voluntarily?  (3) Will the firms that voluntarily adopt the policy be rewarded by the capital market in the form of reduced costs of capital and higher firm values?
We develop a parsimonious model to analyze controlling shareholders’ (or management) incentive to adopt the more stringent audit committee policy voluntarily.  We then test the predictions of the model empirically by using a sample of 376 largest firms listed in the Toronto Venture Exchange in 2004.  We find that about 33% of the sample firms voluntarily adopted MI 52-110 by 2005.  Consistent with the prediction of the model, our Logit regression shows that compliance costs negatively affect the firms’ decision to adopt the audit committee policy, while the incentives for external financing have a positive impact on the firms’ adopting decision.  Our further empirical analyses indicate that adopting firms experienced higher firm values (proxied by Tobin’s Q) and lower costs of equity capital.
The findings of this study contribute to the literature in several ways.  First, independent audit committees are mandatory for U.S. public firms under current U.S. regulatory regime, thereby lacking cross-sectional variations.  In contrast, the Canadian regulatory setting allows us to triangulate the co
st and benefit factors that affect management’s adoption decision.  More generally, our study contributes to the debate concerning net effects of recent regulatory
requirements that increase accounting, audit, and other compliance costs.  To us, the more germane question is whether these costs are justified by attendant benefits to public shareholders.  While this question applies to all firms, it is especially salient for smaller public firms.  Because small firms have fewer resources, enjoy less economies of scale, and generally receive little investor attention, they likely face higher incremental compliance costs relative to their firm size (Kamar, Karaca-Mandic and Talley 2007; Linck, Netter and Yang 2009).  On the other hand, small firms (or at least their outside investors) may benefit more from the enhanced corporate governance mechanisms required by the new regulation since small companies have historically been more prone to financial fraud than large firms (Doyle, Ge and McVay 2007). Whether small firms take advantage of the flexibility in the new regulation and voluntarily adopt the more stringent audit committee policy is an empirical issue.  Gao, Wu and Zimmerman (2009) show that some U.S. public firms chose to stay small following the Sarbanes-Oxley Act in order to avoid costs of more stringent regulations.  Our study complements Gao et al. (2009) by showing that when benefits outweigh costs, small firms may voluntarily choose to adopt more stringent governance mechanisms.  In particular, we show that firms’ future financing n
governance
eeds are an important factor for the TSX venture listed firms to voluntarily adopt the more stringent audit committee policy.
Secondly, although extensive research exists that examines the relation between audit committee independence and audit quality (and financial reporting quality in particular; see Bushman and Smith 2001; Pomeroy and Thornton 2008), there has been limited research in the corporate governance literature on whether high-quality audit committees provide tangible economic benefits and enhance firm value.  The existing research has not provided conclusive evidence on this issue.  An underlying assumption of the new OSC’s policy is that independent

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