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Keep stricter audit committee standards flexible, argues new study from the University of Toronto

August 28, 2013

Study validates controversial OSC 2003 decision

TORONTO, ON — Inde­pen­dent, finan­cial­ly-lit­er­ate audit com­mit­tees lead to high­er firm val­ues and less diver­sion of resources by man­age­ment, shows a new study by researchers at the Uni­ver­si­ty of Toron­to.

But the paper, which looked at small com­pa­nies that vol­un­tar­i­ly adopt­ed stan­dards required of larg­er com­pa­nies, also says it’s impor­tant for reg­u­la­tors to stay flex­i­ble around rules requir­ing high-qual­i­ty audit com­mit­tees, par­tic­u­lar­ly for small­er firms that may be hurt by expen­sive direc­tor com­pen­sa­tion costs.

The study was moti­vat­ed by con­tro­ver­sy sur­round­ing a 2003 deci­sion by the Ontario Secu­ri­ties Com­mis­sion (OSC). The OSC exempt­ed small­er firms from a new pol­i­cy requir­ing high­er audit com­mit­tee stan­dards for TSX-list­ed secu­ri­ties issuers, argu­ing for a bal­ance between investor pro­tec­tion and main­tain­ing a com­pet­i­tive envi­ron­ment for Cana­di­an com­pa­nies.

“Our evi­dence is con­sis­tent with OSC’s stand,” said Feng Chen, a pro­fes­sor at the Uni­ver­si­ty of Toron­to Mis­sis­sauga and the Uni­ver­si­ty’s Rot­man School of Man­age­ment who wrote the paper with Yue Li, also an account­ing pro­fes­sor at UTM and the Rot­man School. The researchers wrote that crit­ics of vol­un­tary stan­dards may “under­es­ti­mate the eco­nom­ic incen­tives for small­er firms to vol­un­tar­i­ly adopt the new pol­i­cy.”

The researchers exam­ined data for com­pa­nies list­ed on the Toron­to Ven­ture Exchange, which were exempt from the pol­i­cy, as well as for a group of TSX-list­ed com­pa­nies, which were not. Out of 376 TSX Ven­ture firms, some 101 of them had vol­un­tar­i­ly adopt­ed the OSC pol­i­cy by 2005, some­thing the researchers called “a pleas­ant sur­prise.” The pol­i­cy requires audit com­mit­tees to have at least three inde­pen­dent and finan­cial­ly-lit­er­ate mem­bers.

The study found that TSX Ven­ture com­pa­nies with low­er com­pli­ance costs and a greater need to raise exter­nal financ­ing were more like­ly to adopt the high­er stan­dards. All com­pa­nies oper­at­ing under the high­er stan­dards, includ­ing those that were required to, gen­er­al­ly saw high­er firm val­ue, improved invest­ment effi­cien­cy, and sig­nif­i­cant­ly low­er bor­row­ing costs.

Pre­vi­ous research has found that com­pa­nies that have finan­cial experts on their audit com­mit­tees are less like­ly to restate earn­ings, dis­miss their audi­tors if they receive a neg­a­tive report, and are less like­ly to out­source rou­tine inter­nal audit­ing jobs to exter­nal audi­tors.

The OSC pol­i­cy was devel­oped fol­low­ing tougher account­ing and finan­cial rules draft­ed in the U.S. under the Sar­banes-Oxley Act. Crit­ics of the OSC’s deci­sion to exempt small­er com­pa­nies called it unfair and said that it was small start-ups where investors faced the biggest risks.

But the researchers’ study shows that the OSC pol­i­cy “is effec­tive,” says Prof. Li. “It pro­vides the flex­i­bil­i­ty for small­er firms to assess for them­selves the costs ver­sus the ben­e­fits of stronger gov­er­nance. A more strict pol­i­cy on manda­to­ry adop­tion prob­a­bly would not work well in the Cana­di­an con­text where we have a large num­ber of firms on the ven­ture stock exchange.”

The study is forth­com­ing in the Account­ing Review.

For the lat­est think­ing on busi­ness, man­age­ment and eco­nom­ics from the Rot­man School of Man­age­ment, vis­it

The Rot­man School of Man­age­ment at the Uni­ver­si­ty of Toron­to is redesign­ing busi­ness edu­ca­tion for the 21st cen­tu­ry with a cur­ricu­lum based on Inte­gra­tive Think­ing. Locat­ed in the world’s most diverse city, the Rot­man School fos­ters a new way to think that enables the design of cre­ative busi­ness solu­tions. The School is cur­rent­ly rais­ing $200 mil­lion to ensure Cana­da has the world-class busi­ness school it deserves. For more Infor­ma­tion, vis­it


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Rot­man School of Man­age­ment
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