Abstract
The purpose of this paper is to analyse whether the independence of audit committees is affected by the degree of control exerted by managers over the board of directors. Results from a sample of 75 listed Spanish companies show that the majority of firms that voluntarily adopted an audit committee between 1998 and 2001, made an effort to guarantee their independence from management. The degree of independence is shown to be determined by the proportion of inside directors on the board, the same person holding both the CEO and board chairperson positions, and the level of management ownership. These findings may have political implications because existing regulations do not limit the presence of inside directors on audit committees. The presence of inside directors may compromise effectiveness, turning audit committees into instruments of management to provide the appearance of monitoring.
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Notes
In Europe, member states have echoed these initiatives through the development of national corporate governance codes, for example, see Cadbury (1992), Greenbury (1995) and Hampell (1998), Reports and the Combined Code (1998) in the United Kingdom, the Cardon Report (1998) in Belgium, the Peters Report (1996) in Holland, the Viénot I and II Reports (1995 and 1999) in France, the Preda Code (1999) in Italy, the Olivencia Report in Spain (1998), the Corporate Governance Rules for German Quoted Companies (2000) in Germany, the Corporate Governance Statements by major ASX Listed Companies (1995) in Australia, and the Toronto Report (1994) in Canada. For more information about different codes in the world, see http://www.ecgi.org/codes/all_codes.php (18/01/2007).
Following most of the common classifications for board members within one-tier corporate governance systems, we distinguish between inside directors or insiders (those who are employees of the company) and outside directors or outsiders (those who are not employees of the company). We will also use the terms “executive” and “non-executive” directors (NED) to denote insiders and outsiders. We will also refer to “independent directors”, consistent with the usage in numerous studies and by different regulatory bodies, such as the Blue Ribbon Report (1999). Independent directors are those who are not employees of the company or their relatives, employees of subsidiaries, retired company employees, or grey directors. Grey directors (management consultants, lawyers, and executives in financial companies) are not classified as independent as they may be involved with managerial business.
Particularly, Cuervo (2002) argues that the legal system establishes norms that regulate the behaviour of the company, offering different levels of protection of the rights of minority shareholders and influencing the development of the capital market. In line with previous literature, he differentiates two main institutional contexts according to their legal system: common law (in the Anglo-Saxon tradition) and civil law countries (in the Continental European tradition). He states that ‘the type of legal system limits the efficiency in the application of the codes of good governance’ (p. 85). Firms within common law countries are expected to have more incentives to comply with the codes of good governance, because judges can enforce the application of these codes. However, firms within civil law countries could apply these codes “following the letter but not the spirit” (p. 85). In the same sense, these expected divergences in companies’ behaviour might lead to different motivations regarding audit committee adoption.
Among the dimensions examined in the literature we can mention audit committee independence and expertise, financial literacy, diligence, size, number of meetings, length of meetings, conformity with prescribed standards, and management cooperation (see DeZoort et al. 2002, for a review).
The empirical evidence provides strong support for these arguments, finding that an audit committee comprising solely independent directors is positively related to a higher quality of financial reporting (McMullen and Raghunandan 1996; Beasley et al. 2000; Klein 2002b; Xie et al. 2003; Abbott el al. 2004 Davidson et al. 2005) and to a better discharge of its functions related to external and internal auditors (Scarborough et al. 1998; Abbott and Parker 2000; Carcello and Neal 2000, 2003; Archambeault and DeZoort 2001; Abbott et al. 2003; Ng and Tan 2003; Lee et al. 2004; Chen et al. 2005; Lee and Mande 2005).
For instance, inside directors are considered to be less likely or even less able to exercise independent judgement in matters regarding the control of management, because they are subordinate to the CEO, on whom their careers may depend (Patton and Baker 1987). Therefore, there is a lack of faith in their ability to review their own performance and that of their colleagues with whom they must continue to live and do business with in an operating capacity.
However, some authors state that firms with CEO duality “are likely to be perceived as needing more stringent monitoring mechanisms” (Collier and Gregory 1999, p. 315) because a CEO–chairperson may impair the board’s monitoring role (Chau and Leung 2006, p.6). Following this argument, companies with CEO duality will have more incentives to have a totally independent audit committee.
However, Klein (2002a) argues that “if the firm limits board size, then the number of directors available to serve on the audit committee also will be limited” (p. 438). In this sense, previous studies show that larger boards are likely to have more independent audit committees (Beasley and Salterio 2001; Klein, 2002a; Piot 2004).
Audit committee adoption among listed companies has been mandatory since 2002, as a result of the enactment of the law “Ley 44/2002, de 22 de noviembre, de Medidas de Reforma del Sistema Financiero” (better known as Financial Law).
On the contrary, the composition of the audit committee in subsequent years could be guided by their previous experience on stock market preferences or just be a consequence of the previous decision.
Accounting for the possible presence of grey directors among these non-executive directors, it would be appropriate to consider solely independent outside directors (Menon and Williams 1994; Beasley et al. 2000; Deli and Gillan 2000; Klein 2000 and 2002a; Ng and Tan, 2003; Lee et al. 2004; Piot 2004). However, we do not have enough observations in the sample to compose this alternative variable.
Other authors use the proportion of voting control (Beasley and Salterio 2001), but in Spain the only information publicly available is the proportion of shares held by investors who own more than 5%.
However, the level of debt may act as a control mechanism itself, in that the higher the level of debt and its concentration among creditors, the greater the scrutiny these creditors will apply to management behaviour. Following this reasoning, creditors exercise control, thus reducing the need to improve audit committee effectiveness.
This pressure may increase the likelihood that management will engage in fraudulent practices to maintain the appearance of rapid company growth. Deli and Gillan (2000) suggest that companies with growth opportunities tend to avoid “contracts based on accounting numbers because of the poor quality of such numbers” (p. 431). They will have less incentive to have effective monitoring mechanisms.
These costs represent a greater burden for smaller companies than for larger companies, which obtain additional benefits because of economies of scale, thereby giving the latter extra motivation to maintain effective audit committees.
This variable is especially important in the Spanish context, where in 43.9 of companies, the main shareholders own more than 50 of the shares and only in 9% of companies is the main shareholders’ stake less than 10 (Lopez-Iturriaga and Rodríguez-Sanz 2001). This situation differs greatly from the US scene where the main shareholders own more than 50% of the shares in only 9 of companies, and in 52% of companies the main shareholders’ stake is less than 10%.
Given these results, we include HIGH-TECH as a control variable; it is a dummy variable that takes the value 1 if the firm is in a high-tech industry and 0 otherwise.
As a complementary test this process was inverted. The estimated OLS regression is FIRMSIZE = 17.048 + 0.241BOARDSIZE (adjusted R2 = 0.449 and F-stat. is significant at P < 0.0001). We replicated model 1 substituting FIRMSIZE by RES_FIRMSIZE and RES_BOARDSIZE by BOARDSIZE. BOARDSIZE becomes significant and positive at P < 0.05 and RES_FIRMSIZE becomes insignificant. This confirms that both BOARDSIZE and FIRMSIZE are capturing the SIZE effect for audit committee independence.
The inclusion of dummy variables for each industry does not make any contribution to the explanation of audit committee independence, other than for high-tech industries.
For the multivariate analysis, YEAR_2000 also includes an observation for the only two firms that formed an audit committee in 2001.
This lack of significance may be because only three firms suffered from consecutive losses.
As with the OLS regressions, both BOARDSIZE and FIRMSIZE are significant at the 5% level when we alternatively capture the marginal effects of the other variable using the residuals from a regression between the two variables.
This is consistent after controlling for correlation between BOARDSIZE and FIRMSIZE.
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Acknowledgements
The paper has benefited greatly from the suggestions of Mahbub Zaman, three anonymous referees and the journal’s editor. We gratefully acknowledge the financial support provided by the Spanish Ministry of Science and Technology (BEC2002–03043). We acknowledge helpful suggestions from Roberto Di Pietra and three anonymous reviewers. We gratefully acknowledge the financial support provided by the Spanish Ministry of Education and Science (SEJ2006–14021).
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Ruiz-Barbadillo, E., Biedma-López, E. & Gómez-Aguilar, N. Managerial dominance and audit committee independence in Spanish corporate governance. J Manage Governance 11, 311–352 (2007). https://doi.org/10.1007/s10997-007-9035-4
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DOI: https://doi.org/10.1007/s10997-007-9035-4