Voluntary Adoption of More Stringent Governance Policy on Audit Committees: Theory and Empirical Evidence

Abstract

This study exploits an exogenous change to audit committee policy in Canada and presents new evidence on how high-quality corporate governance mitigates managerial resource diversion and improves firm values. We first examine why some Toronto Venture Exchange (TSX Venture)-listed firms voluntarily adopted the more stringent governance policy in 2004 that requires all audit committee members to be independent and financially literate. We develop a parsimonious analytical model that shows that both compliance costs and financing needs have an impact on firms’ adoption decisions. Confirming the model’s predictions, we find that TSX Venture firms with low compliance costs and greater future financing needs are more likely to adopt the new policy voluntarily. The analytical model also shows that high-quality audit committees enhance firm values by reducing the likelihood of managerial resource diversion. Consistent with the predictions of our analytical model, we find that the adoption decision has a positive impact on firm value and a negative impact on firms’ cost of equity capital for both Toronto Stock Exchange (TSX) and TSX Venture firms. As corroborating evidence of the economic impact of the more stringent governance policy, we also show that both TSX and TSX Venture firms have improved investment efficiency following the adoption decisions.

Keywords: Audit committees, voluntary compliance, compliance costs, Tobin’s Q, investment efficiency

JEL Classification: M41, G38, G30