Determinants of Voluntary Audit Committee Formation in a Two-Tier Board System of a Post-transitional Economy – The Case of Slovenia

Abstract

This paper investigates the determinants of voluntary audit committee (AC) formation in a setting characterized by: (i) a two-tier board system; (ii) a post-transitional economy. Both factors may affect the system of incentives that influences the decision to form an AC and both factors distinguish this paper from existing studies that are usually done under a unitary-board system in a developed capital market. Only a minority (17%) of companies in our sample had voluntarily established ACs by the time ACs had become mandatory by law. We find that larger firms, firms with larger supervisory boards and firms with less debt (rather than more) are more likely to have voluntarily established an AC. Although the inverse relationship between debt and AC formation contradicts the debt holder–manager conflict it can be explained in the context of a post-transitional economy, where the ownership structure appears not to have stabilized yet and where debt has been used as a means of achieving effective control of firms by insiders.

Acknowledgments

This research is part of the INTACCT programme – The European IFRS revolution (Contract No. MRTN-CT-2006-035850).

Notes

In their framework of expected AC effects, Turley and Zaman (2004) also point out reduction in director's legal liability in addition to factors associated with potential reduction in agency costs and links with other governance arrangements such as large audit firms.

Because of the mergers among the large audit firms (primarily referred to as the Big 8, then the Big 6, Big 5 and now the Big 4) we adopt the term used by Piot (2004) and use it throughout the text.

Vera-Muñoz (2005) maintains that ACs are perceived by market participants as providing effective oversight of the financial reporting process. This perception can only be expected in a framework of voluntary AC formation. The existence of an AC in an environment where the regulation enforces this type of monitoring, diminishes the information signal related to the quality of the monitoring process.

Other directions of AC research include approaches based on the financial economics literature (Adams, 1997) and institutional theory (Kalbers and Fogarty, 1998).

Collier and Gregory (1996) indicate that the two-tier board structures in Germany and the Netherlands may explain the weak development of ACs in these countries.

Collier (1993) emphasizes that ACs empower non-executive directors. The reason for such empowerment is that (in a one-tier board system) ACs are closely related with the role and duties of non-executive directors.

The directors' share of ownership can be used as a proxy for the separation between ownership and management function (Niehaus, 1989). According to Kalbers and Fogarty (1998), high levels of management ownership suggest a better alignment with the interests of owners. On the other hand, their low share of ownership can result in significant information asymmetries that can be diminished with particular forms of corporate governance.

Although the liability insurance problem exists independently from the formation of an AC (because AC members are at the same time members of either the board of directors or the supervisory board and are therefore likely to demand directors' and officers' liability insurance coverage independently from their role as AC members), Battle and Weitz (1981) point out that AC members are more likely to demand insurance protection because to the extent that an outside director serves on committees, he/she will have less of an opportunity to claim ignorance related to management wrongdoing.

A different reasoning for AC formation in larger insurance companies is proposed by Adams (1997). He relates the questions of AC formation in life insurance companies to information asymmetry and contends that ‘restricting firm size allows policy-holders to economize on monitoring expenditures and enables them to control more effectively managerial discretion over decision-making’ (Adams, 1997, p. 124).

This is supported by Piot (2004), who conveys that in addition to promoting audit quality, the big audit firms in France generally propose formation of ACs to support institutional compliance with corporate governance recommendations.

The study was based on 812 clients that dismissed Andersen during the sample period between 15 October 2001 and 31 August 2002. The study revealed that firms with more effective ACs and boards of directors responded quickly to the Andersen–Enron situation and were more likely to demand higher reputation auditors.

In one case, the debt exceeds book value of assets, indicating insolvency. The particular firm is under bankruptcy proceedings at the time of writing.