Factors Associated with the Development of ... - Wiley Online Library

CORPORATE GOVERNANCE

4

Factors Associated with the Development of Board Sub-committees Elizabeth Carson* This study examines the factors associated with the presence of board sub-committees, specifically audit, remuneration and nomination committees. Factors which are hypothesised in this study to affect sub-committee presence are Big 6 auditors, non-executive directors, non-executive chairmen, number of intercorporate relationships of the board and shareholder type. Company size, number of board members and leverage are employed as control variables as suggested by earlier research. An analysis of board sub-committees in the Australian corporate environment is relevant to other jurisdictions as there are no mandatory requirements on either board composition or board sub-committees. There is, however, a mandatory requirement to disclose corporate governance practices which allows for a study of this type to be reliably conducted. A sample of 361 Australian companies drawn from the largest 500 public companies is employed. Audit committee presence is found to be positively associated with Big 6 auditors and the number of intercorporate relationships of the directors of the board. Remuneration committees are also found to be associated with Big 6 auditors and intercorporate relationships and also higher levels of institutional investment. The presence of nomination committees is not associated with auditors, directors or investors, but is associated with board size and leverage. The study concludes that audit committees are a highly developed and mature governance mechanism, and that remuneration committees can be classed as a developing and maturing structure whilst nomination committees are relatively immature. Keywords: Audit committees, remuneration committees, nomination committees, intercorporate relationships

Introduction

* Address for correspondence: School of Accounting, University of New South Wales, Sydney NSW 2052. Tel: 61 2 9385 5822; Fax: 61 2 9385 5925; E-mail: [email protected]

Volume 10

Boards are free to select their corporate governance structure from a range of possible structures. Possible decisions which relate to board structure include forming subcommittees of the board; separating the role of chairman and CEO; the number of directors on the board and the ratio of executive directors to non-executive directors. This study examines the factors associated with the presence of board sub-committees, with a focus on audit, remuneration and nomination committees.

Number 1 January 2002

If effective corporate governance practices are of value to investors then we would expect to see the adoption of these practices even in the absence of mandated requirements. Australian listed companies have no restrictions on corporate governance practices or board structure other than a minimum of three directors. However, the Australian Stock Exchange requires listed companies to disclose their corporate governance practices in their annual reports. This disclosure enables an examination of actual corporate governance practices to be undertaken without being confounded by the issue of voluntary disclosure.

# Blackwell Publishers Ltd 2002. 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA.

DEVELOPMENT OF BOARD SUB-COMMITTEES

This study has three key aims. Firstly, to reconcile differences in the audit committee literature, and secondly, to extend this literature by considering both remuneration and nomination committees. Finally, this study aims to investigate the role of intercorporate relationships on the development of subcommittees by comparing its significance cross-sectionally on committee presence. This study finds that differences found in previous studies on audit committees can be attributed to the institutional environment in which each study was conducted. The results suggest that, depending on the stage of development of a particular committee type, different influences will prevail. For emerging corporate governance structures, the larger the number of directors, the more likely that a sub-committee will be formed for reasons of board efficiency only. In this study, nomination committees are found to be in this category. For well-developed corporate governance structures, such as audit and remuneration committees in this study, additional factors such as auditors, directors and investors become more relevant in assessing the need for a particular structure.

Literature review Audit committees The rise of audit committees is an international phenomenon. In the US, audit committees have been mandatory for companies listed on NYSE since 1977 and encouraged by the SEC since the 1940s.1 Audit committees have also been mandatory practice in both Canada and Malaysia and heavily advocated in the United Kingdom2 (Cadbury Committee, 1992; Auditing Practices Board, 1992; Institute of Chartered Accountants in England and Wales, 1997), and Ireland (Ryan Commission, 1992). Whilst the key corporate governance reports consistently recommend that audit committees should comprise non-executive directors only (Treadway Commission, 1987; McDonald Commission, 1988; Cadbury Committee, 1992; Hilmer, 1993; Toronto Stock Exchange, 1994; Australian Investment Managers’ Association, 1995), some studies have modified this suggestion to a majority of nonexecutive directors (Price Waterhouse and ASCPA, 1990; ASCPA and ICAA, 1993; Bosch, 1995b). The New York Stock Exchange requires all listed companies to have an audit committee that consists of independent directors only.3 Research into audit committees in Australia is likely to be of relevance to other jurisdictions, particularly where the com-

# Blackwell Publishers Ltd 2002

5

pulsory formation of sub-committees may be considered by regulators. Committees may be formed to promote the appearance of good corporate governance without serving any useful purpose to the organisation (Menon and Williams, 1994).4 Bosch (1995a) acknowledges that audit committees may impose an additional layer of bureaucracy in an organisation which may lead to duplication, wasted effort and unbeneficial additional monitoring. As noted by Rutteman (1993) ‘‘many companies already have audit committees, but the quality and effectiveness of such committees is variable’’. One situation in which audit committees may be formed, without regard for quality or effectiveness, is in a highly litigious environment where the mere existence of an audit committee could be used as evidence that directors took due care in performing their duties. Further evidence to suggest that audit committees may be ineffective monitoring mechanisms is provided by Beasley (1996). He found that the composition of the board itself is more effective than the presence of an audit committee in reducing the likelihood of financial statement fraud. The prior literature has focused largely on audit committee formation. Eichenseher and Shields (1985) found that a firm is more likely to form an audit committee when it had recently switched to a large auditor. Pincus, Rusbarsky and Wong (1989) examine the voluntary formation of audit committees (NASDAQ firms in 1986). Their results indicate that lower managerial ownership, higher leverage, larger size, Big 8 auditors and higher proportions of non-executive directors were all positively related to audit committee formation. Bradbury’s (1990) findings contradict this earlier literature, finding no significance for these types of variables in the unregulated environment in New Zealand. Bradbury found that number of board members and intercorporate ownership were the most significant determinants of voluntary audit committee formation (levels of which were extremely low at 15 per cent compared to 68 per cent observed by Pincus, Rusbarsky and Wong). Collier (1993) attempts to reconcile the inconsistent results of these studies by examining UK audit committees. However, the samples, institutional environment and time periods were not comparable. Accordingly, it is not unexpected that the inconsistencies in the audit committee literature remain unresolved. Collier found that lower shareholdings by directors, higher gearing and higher numbers of non-executive directors were positively associated with audit committee formation. A recent Australian study on audit

Volume 10

Number 1

January 2002


6

committees is Arkley-Smith (1997). She finds that audit committee formation is positively associated with leverage, size and chairman independence. Menon and Williams (1994) introduced the concept of audit committee effectiveness into the literature by using audit committee composition and frequency of meetings to proxy for effectiveness. They found that when board composition is aligned with reliance on audit committees, i.e. as the proportion of nonexecutive directors increases, the firm is more likely to have an audit committee which is composed of all non-executive directors. Spira (1998) examines the effectiveness of audit committees over time, finding that audit committees tend to mature by becoming more active in their involvement in the governance of the company. This is subject to the influence of various catalysts in the life and evolution of the audit committee. The framework from this study can be extended to examine remuneration committees and nomination committees.

Remuneration committees Remuneration committees are designed to review the terms and conditions of employment of senior management. This is an area in which the interests of the shareholders clearly conflict with the interests of management. According to the Australian Investment Managers’ Association Corporate Governance Guidelines (AIMA, 1995), remuneration committees should comprise primarily nonexecutive members. This is a less independent composition than that advocated by AIMA for audit committees, where all members are non-executives. Shareholder/management conflicts may be more evident in remuneration disputes than in audit issues. A remuneration committee comprised of non-executive directors only minimises the risk of management determining their own remuneration. Vafeas (2000) found that remuneration committee composition is associated with outside directors, number of additional board seats held by directors, director tenure and age. To date, there has been little research into the role of remuneration committees5 or factors associated with the presence of remuneration committees. O’Sullivan and Diacon (1999) found that mutual insurance companies, which are not subjected to the external corporate governance mechanism of threat of takeover, are more likely to have formed remuneration committees than proprietary insurance companies. This may suggest that mutual insurance companies seek to compensate for low external corporate governance by using

Volume 10


stronger systems of internal corporate governance, consistent with the substitution hypothesis.

Nomination committees The role of the nomination committee is twofold. As the name of the committee suggests, one of its functions is to establish what skills are required of a replacement or additional director and to approach potential candidates. The second, and more critical, role of the committee is to review the performance of the board on a regular basis. The chairman of the board or the chief executive plays a key role in the selection of new directors in the absence of a nomination committee. As the AICD (1993) document on nomination procedures commented: ‘‘The selection process has been largely ad hoc’’. This may give management influence over the nomination process which, in turn, may make the new director feel obligated toward those who encouraged and supported his nomination. Lee, Rosenstein, Rangan and Davidson (1992, p. 58) note that ‘‘although the board is legally authorized to ratify and monitor managerial decisions, critics have argued strongly that management generally dominates the board by its influence over the selection of outside directors, and by its control over the agenda of board meetings and the information provided to outside board members.’’ The use of a nomination committee, dominated by non-executive directors, may reduce this problem.

Hypothesis development The three key stakeholders in the corporate governance process are the board of directors, shareholders (in particular, institutions) and auditors. For this reason, the approach taken has been to examine the impact of their influences on each of the committees at a common point in time (30 June 1996).6 It is anticipated that each stakeholder will have different influences over board sub-committee presence, depending on the stage of development of the committee type.

Auditor hypothesis Auditors are vitally interested in corporate governance related issues because any improvements in the governance of a company can improve financial statement quality impact on audit quality, and therefore, reduce litigation risk. It is anticipated that Big 6



auditors will encourage their clients to adopt higher levels of corporate governance, and vice versa. It is expected that this encouragement of best practice by auditors may be evident for remuneration and nomination committees as well. However, from the auditor’s point of view, the benefits arising from the formation of these committees are unclear. In examining the association between auditor characteristics and audit committee presence, there appears to be little or no increase in costs for the auditor to deal with an audit committee. However, there are clear incentives for auditors to encourage firms to adopt audit committees. For example, the auditor is less likely to depend on management because reliance on an independent group of nonexecutive directors is increased. Audit firms with reputational capital at stake, such as the Big 6 firms, are more likely to be associated with clients who are in good standing in the business community. Watts and Zimmerman (1986) and DeAngelo (1981) suggest Big 6 auditors will influence clients toward best practice. The prescriptive literature would suggest that the formation of board committees is considered ‘‘best practice’’ in the governance of companies. Evidence that the Big 6 actively support the formation of board committees can be found in the publications of the Australian offices of the Big 6 accounting firms.7 Additionally, the decision to purchase audit services from a Big 6 auditor is a more conservative strategy for directors than a lower cost and potentially, lower quality, non-Big 6 audit. Empirical testing of this Big 6 auditor effect has produced mixed results. Bradbury (1990) found no relationship between auditor size and committee presence in New Zealand. In Australia, Arkley-Smith (1997) found no relationship between Big 6 auditors and audit committee formation. However, in the US, Pincus, Rusbarsky and Wong (1989) found a significant relationship between audit committee formation and auditor size. In the UK, Collier and Gregory (1999) found a positive relationship between audit committee activity and auditor size. The following hypothesis is therefore proposed: H1: Firms which are audited by a Big 6 auditor are more likely to have audit, remuneration or nomination committees.

Institutional investor hypothesis Large shareholders are likely to benefit from better monitoring arising from improvements in corporate governance practices and would therefore be expected to take a greater interest


7

in the monitoring of the firm. Small shareholders do not have sufficiently large investments to justify additional expenditure on monitoring of management (Shleifer and Vishny, 1986). Small shareholders have incentives to either do nothing or to free-ride on the actions of larger shareholders.8 Institutional investors have been a vocal investor group in the corporate governance debate. Institutional investors are the shareholder group that is most likely to systematically influence corporate governance practices in listed companies. According to Cadbury (1993), it is in the interests of the institutions to raise levels of corporate governance because their shareholdings are so large that if a parcel of shares is sold due to dissatisfaction with corporate governance issues, they can only be purchased by another institution. Additionally, Cadbury feels that the institutions have the necessary resources and expertise to monitor companies’ standards of governance practices. It is noted that any active interest on the part of institutions must be in the context of increasing value for the institutions’ own beneficiaries or shareholders. The presence of an audit committee may give the audit process more credibility to investors. Shareholders are likely to demand remuneration committees as the issue of executive compensation is a classic agency problem. The role of institutional investors in the presence of nomination committees is less clear. It has been suggested by Percy (1995) that institutions ‘‘should take a positive interest in the composition of boards with particular reference to . . . the appointment of a core of non-executive directors of the necessary caliber, experience and independence’’. Fabris and Greinke (1999) highlight that activism by institutions may be contingent on factors such as size of investment, type of proposal or poor performance. Accordingly, the following hypothesis is focused on substantial institutional shareholdings: H2: Firms which have substantial institutional investors are more likely to have audit, remuneration or nomination committees.

Director hypotheses In relation to the influence of the board of directors, two types of hypotheses are proposed. The first relate to board composition, that is, the mix of non-executive and executive directors, on the board and whether the chairman of the board is also a member of management. The second type of hypothesis relates to the formal linkages that the board

Volume 10

Number 1

January 2002


8

has with other organisations through other board positions held by the directors.

Board composition hypotheses Prior studies have examined the role of non-executive directors. Weisbach (1988) demonstrated that boards dominated by non-executives were more likely to remove the CEO on the basis of poor earnings or share price performance than boards dominated by management. Kaplan and Reishus (1990) found that managers of high performing firms were more likely to obtain nonexecutive directorships of other companies than managers of low performing firms. Kren and Kerr (1997) suggest that this is because managers of high performing firms are perceived to be better monitors in their additional role as a non-executive director of another organisation. The share market reacts positively to the appointment of non-executive directors. Rosenstein and Wyatt (1990) document significantly positive share price returns around the announcement of non-executive director appointments to the board of directors but no share price effect for announcements of executive director appointments. Mayers, Shivdasani and Smith (1997) find an association between numbers of non-executive directors and lower levels of perquisite consumption by managers in the form of reduced rent and salary costs, but no effect was noted on non-perquisite related expenditure (for example, taxes, advertising, commission) in mutual insurance companies. This provides early evidence that non-executive directors do act as monitors of management. This variable was tested by Pincus, Rusbarsky and Wong (1989) and Collier (1993) and was found to be significant in relation to audit committee presence. Collier and Gregory (1999), in reviewing prior studies, found that the only consistently significant relation in the audit committee literature was between voluntary formation of audit committees and board structure. In contrast, Arkley-Smith (1997) did not find proportion of non-executive directors to be significantly related to audit committee formation in an Australian sample. However, in light of the strong findings in prior research, the following hypothesis is to be tested: H3: Firms which have higher proportions of non-executives on the board of directors are more likely to have audit, remuneration or nomination committees. The separation of the chairman of the board from management is a fundamental govern-

Volume 10


ance measure suggested by Cadbury (1992), Hilmer (1993) and Bosch (1995a). As the role of the board is to monitor the actions of management, the person leading this board should be independent of management. Specifically, the chairman’s role is to direct the board and be responsible to the shareholders, while the managing director is responsible to the board for implementing decisions and for managing day-to-day operations. Forker (1992) coins the term ‘‘dominant personality’’ to describe the situation where the chairman of the board is also the managing director. The chairman of the board, in a stronger case than for directors generally, is also likely to have reputational capital at risk and will therefore seek to be associated with higher standards of corporate governance. Forker (1992) finds that firms with a non-executive chairman of the board are more likely to disclose information about share options. Consistent with this, Collier and Gregory (1999) found a negative association between the presence of a dominant personality and audit committee activity. Arkley-Smith (1997) provides evidence in the Australian environment of a relationship between a non-executive chairman and audit committee formation. In determining if a non-executive chairman is associated with sub-committee presence in this study, the following hypothesis is proposed: H4: Firms which have a non-executive chairman of the board are more likely to have audit, remuneration or nomination committees.

Intercorporate relationships hypothesis Pennings (1980) characterises the board as a ‘‘boundary spanning unit’’ which manages ‘‘the organization’s interactions with its environment’’ (p.47). This role is likely to be fulfilled by directors who hold multiple directorships. Much of the prescriptive literature on multiple directorships has been both emotive and negative. The group of high profile directors who hold multiple directorships has been described as a ‘‘cabal’’ in Australian companies.9 Accordingly, research into multiple directorships has focused on the facilitation of collusion, reduction of competition and avoidance of trade practices restrictions (See for example, Hall, 1983; Carroll, Stening and Stening, 1990; Alexander and Murray, 1992; Carroll and Thanos, 1994). This literature minimises the benefits accruing from multiple directorships including the ‘‘cross-fertilisation of best practice’’ (Alexander, 1993, p.100). These benefits were demonstrated by Petty and Chua (1999) in their



examination of the transmission of quality certification information between companies. However, multiple directors may play a broader role than just transmitting information. Shivdasani (1993) suggests that the number of directorships of other listed companies held by the directors of a company may be a proxy for board quality. He examines the case of hostile takeovers and finds that firms where directors hold a large number of other directorships have a lower probability of being taken over. However, Beasley (1996) provides some evidence that multiple directors may not necessarily improve monitoring in the organisation. He finds that as the number of outside directorships increases, the likelihood of financial statement fraud increases. He suggests that additional outside directorships may distract directors from their internal monitoring responsibilities and therefore increase the likelihood of fraud. The following hypothesis is proposed: H5: Firms which have higher numbers of intercorporate relationships are more likely to have audit, remuneration or nomination committees.

Sample The sample consists of Australia’s Top 500 listed companies in 1996. Those companies that were not in the Top 500 in the subsequent year were eliminated, leaving 410 companies. 42 trusts (which are subject to differential reporting requirements) and seven companies with incomplete data were eliminated. The final sample consisted of 361 companies.

Dependent variable The dependent variable is a dummy variable coded 1 when a committee is present and 0 when a committee is absent (for each of audit, remuneration and nomination committees).

Independent variables BIG6 – Dummy variable coded 1 if a Big 6 firm signed the audit opinion. This variable is used to test Hypothesis 1. INVMGRS – Percentage of shares owned by investment managers as advised in substantial shareholder notices.10 This variable is used to test Hypothesis 2. PROPNED – Number of non-executive directors on the board as at 30 June 1996 divided by the total number of directors.11 This variable is used to test Hypothesis 3.


9

NECHAIR – Dummy variable coded 1 if the chairman of the board was a non-executive director. This variable is used to test Hypothesis 4. LINKS – Number of directorships of other listed companies that the board of directors in total hold. This data was hand-collected from the directors’ information provided in the annual report and cross-checked against the other companies’ annual reports. This variable is used to test Hypothesis 5.

Control variables LNMKTCAP – Pincus, Rusbarsky and Wong (1989) and Collier (1993) find that large companies tend to be ‘‘early adopters’’ of audit committees. This is consistent with arguments presented in the agency literature. It seems likely that larger firms are also more likely to have remuneration and nomination committees. Additionally, the cost of a committee is likely to be fixed. Therefore, the relative cost of maintaining a committee reduces as firm size increases. BOARDSIZ – Menon and Williams (1994) suggest that one of the advantages from assigning board responsibilities to committees is board efficiency. Utilising dual measures to control for size is consistent with Bradbury (1990) who finds board size to be associated with audit committee presence. He notes that firm size in itself is unlikely to be a determinant of committee formation, citing the example of a large firm with a single director which would clearly have no need for any committees at all. DEBTASST – This variable proxies for the agency costs of debt and has been consistently used in the agency literature. In the audit committee literature, higher levels of gearing have been found to associated with audit committee formation by Collier (1993) and Collier and Gregory (1999) and in the Australian environment by Arkley-Smith (1997).

Model specification Logistic regression models (logit) were required due to the dichotomous nature of the dependent variables. The model used for testing was: logit (r = a + b1(BOARDSIZ) + b2(LNMKTCAP) + b3(DEBTASST) + b4(BIG6) + b5(MID)12 + b6(INVMGRS) + b7(NOMINEE)13 + b8(OTHER)14 + b9(NECHAIR) + b10(PROPNED) + b11(LINKS) + e where r is the probability that the dependent variable (committee presence/absence) equals one.

Volume 10

Number 1

January 2002

10

Volume 10 Number 1 January 2002

Table 1: Correlation matrix for independent variables BOARDSIZ LNMKTCAP DEBTASST

BIG6

BOARDSIZ LNMKTCAP

1.000 0.654**

1.000

DEBTASST BIG6

0.308** 0.278**

0.239** 0.330**

1.000 0.064

1.000

70.148**

70.180**

0.041

70.616**

NECHAIR PROPNED

0.228** 0.175**

0.165** 0.155**

0.093 0.054

LINKS INVMGRS

0.252** 0.017

0.393** 0.005

0.196** 0.055

MID

MID

NECHAIR PROPNED

0.197** 70.166** 0.152** 70.178**

1.000 0.551**

1.000

0.219** 70.057

0.042 0.194**

0.056 0.168**

1.000 70.053 70.158**

70.035 0.078

INVMGRS NOMINEE OTHER

1.000

NOMINEE

70.130*

70.185**

0.007

70.009

70.010

0.064

0.024

OTHER

70.126*

70.168**

70.037

70.045

70.017

70.263**

70.176**

70.069

1.000 0.147** 70.448**

1.000 70.195**

1.000



Key: ** Significant at the 0.01 level (2 tailed) * Significant at the 0.05 level (2 tailed)

LINKS


Descriptive statistics 75 per cent of the sample were audited by Big 6 firms. Substantial shareholders have a significant presence on the share registers of Australian listed companies. On average, investment managers hold 11.49 per cent of a company’s shares. 62 per cent of companies in the sample had investment managers as substantial shareholders. Relative to other countries, Australia has lower levels of institutional shareholdings but higher levels of ‘‘other’’ substantial shareholdings (on average, 30 per cent). This is due to the large number of overseas owned subsidiaries also listed on the Australian Stock Exchange. Approximately 25 per cent of companies in the sample have substantial shareholders totalling more than 50 per cent of the shares on issue. 55 per cent of the sample have substantial shareholders with a greater than 20 per cent total interest in the company. This would confirm Stapledon’s (1996) contention that there is a low threat of takeover in the Australian market. 76 per cent of companies have non-executive chairmen; the average proportion of nonexecutive directors is 69 per cent and the average number of executive directors is 1.97 and non-executives is 4.68. The average board, with 6.65 members, will have just over six linkages to other listed companies. The mode number of intercorporate relationships for a board is zero which suggests that a large number of companies are not ‘‘linked in’’ to the rest of corporate Australia.

Correlation matrix Table 1 shows that a few variables are highly correlated. With three exceptions, none of the correlations are above +/7 0.500. Additional

11

analysis using a linear specification suggests that there is no indication of multicollinearity, with VIF scores 52.2 and condition indices 520.

Results As shown in Table 2, 84 per cent of companies in the sample disclose having an audit committee. Remuneration committees (in 57 per cent of companies) are less prevalent, reflecting the fact that they are a less wellaccepted structure. Only two companies that had nomination committees did not have both remuneration and audit committees. Clearly, there is a much lower incidence of nomination committees than remuneration and audit committees. An explanation may be found in the AICD Boardroom Report (1997). Of the companies surveyed, forming a nomination committee was only on the current agenda for 6 per cent of companies with revenue greater than $25 million. It may be that many companies perceive a nomination committee as being of limited value because they focus on its role in selecting new board members, rather than evaluating and assessing the performance of the board.

Audit committee results The results of the logistic regression for each committee type are shown in Table 3. The model is significant at the p50.01 level. Big 6 is significant, suggesting that there is an association between Big 6 auditors and their clients’ audit committees. As anticipated, two control variables, board size and market capitalisation, were both highly significant. The influence of multiple directorships is also significant, with a positive association between

Table 2: Committee descriptive statistics Committee

Number

Percentage

Audit Committee (Disclosure) No Audit Committee (No Disclosure) Total

302 59 361

84% 16% 100%

Remuneration Committee (Disclosure) No Remuneration Committee (No Disclosure) Total

204 157 361

57% 43% 100%

Nomination Committee (Disclosure) No Nomination Committee (No Disclosure) Total

62 299 361

17% 83% 100%


Volume 10

Number 1

January 2002

12

Volume 10 Number 1 January 2002

Table 3: Logistic regression analysis of sub-committee presence AUDIT COMMITTEES —————————————————————————

Variables Control Variables BOARDSIZ LNMKTCAP DEBTASST Variables of Interest BIG6 (H1) MID INVMGRS (H2) NOMINEE OTHER NECHAIR (H4) PROPNED (H3) LINKS (H5) Constant

NOMINATION COMMITTEES ————————————————————————

Coefficient

Significance

0.7217*** 0.5432*** 70.373

0.0000 0.0074 0.9600

0.2856*** 0.2009* 1.5833***

0.0006 0.0804 0.0072

0.2165** 0.0928 2.1038***

0.0151 0.5195 0.0071

0.7595** 0.9339 70.4792 70.2074 70.1777 70.1536 0.9498 0.1070*** 76.3267***

0.0290 0.1309 0.3769 0.9259 0.8409 0.3713 0.1600 0.0093 0.0000

1.2661*** 0.7518 2.2101** 70.4351 71.0352* 70.1832 70.9331 0.0429** 73.6297***

0.0008 0.1494 0.0220 0.8226 0.0738 0.3048 0.1020 0.0398 0.0000

0.7574 71.4441 0.2837 1.6349 71.0769 70.1824 70.0956 0.0200 74.8930***

0.1233 0.2294 0.4078 0.5195 0.1596 0.3580 0.4637 0.2741 0.0001

w2

Significance

w2

Significance

w2

Significance

0.0000

110.080***

0.0000

62.844***

103.752***

Coefficient

Significance


Key: *** Significant at p50.01 ** Significant at p50.05 * Significant at p50.10 One tailed tests are employed for hypothesised variables (as noted), two tailed tests for all other variables.

Coefficient

Significance

0.0000


Goodness of Fit

REMUNERATION COMMITTEES ——————————————————————————


the number of intercorporate links and the likelihood of having an audit committee. This would suggest that audit committees are accepted in the corporate community as best practice. Their widespread implementation amongst Top 500 firms (84 per cent as per Table 2) is also evidence of this. Accordingly, Hypotheses 1 and 5 were supported, indicating that Big 6 auditors and higher numbers of intercorporate linkages are associated with audit committee presence. Hypotheses 2, 3, and 4 were not supported, suggesting that institutional investors and board composition are not factors associated with audit committee presence. The results of this investigation, to date, suggest that factors of the boardroom environment (such as board size) as well as auditor influence play a role in determining corporate governance policies. These results are consistent with Bradbury’s (1990) results which suggest that as board size increases so does the incidence of audit committees.

Remuneration committee results The model for remuneration committees is significant at the p50.01 level. The results support Hypothesis 1, suggesting that there is a significant association between Big 6 auditors and remuneration committees. As anticipated, the control variables, board size, market capitalisation and leverage, were all significant. Hypothesis 5 was also supported, indicating that the greater the number of intercorporate relationships, the more likely that there is a remuneration committee, after controlling for board size and market capitalisation. This may indicate that these intercorporate linkages are being used to transmit corporate governance information, in particular concerning remuneration committees, which are evolving into current best practice. Hypothesis 2 was also supported. Investment manager presence on the share register as substantial shareholders is therefore significantly associated with remuneration committee presence. This would suggest that investment managers are increasingly interested in, and supportive of, attempts to rein in the remuneration schemes of managers. There was no evidence to support Hypotheses 3 and 4 of an association between board composition and remuneration committee presence.

Nomination committee results The results of the logistic regression for nomination committees are shown in Table 3. There was no evidence to support the hypotheses proposed. The only variables


13

which are significantly associated with nomination committee presence are board size and leverage. This would indicate that nomination committees are being formed for reasons of board efficiency and to mitigate agency costs of debt. Note that market capitalisation is no longer a significant determinant of nomination committee presence. This result supports the classification of nomination committees as in their infancy, and it also provides some support for Bradbury’s (1990) and Menon and Williams’ (1994) suggestions that audit committees (in voluntary settings) were formed for reasons of board efficiency. This study is also conducted in the voluntary setting with adoption rates for nomination committees at comparable levels to audit committees in Bradbury (1990). This may explain the consistency of results across these studies.

Additional analysis Analysis of the factors associated with companies who have formed audit, remuneration and nomination committees (n=59) compared to companies who have formed two or less of these committees (n = 302) was also undertaken. Consistent with the results reported above, board size and agency costs of debt are associated with the presence of all three committees. Companies with at least an audit committee and a remuneration committee (n = 198) were compared with those without both of these committees (n = 163). Board size and leverage were consistently significant supporting the conclusions reported above. Big 6 was highly significant (p50.01) and intercorporate relationships were also significant (p50.05). Marginal significance for investment managers, mid size auditors and other substantial shareholders was also evident. Board size alone provides a good predictive model of committee presence. However, significantly more powerful models specifying additional variables suggest that the environment in which corporate governance mechanisms are chosen is rich and complex.

Summary and discussion of results Audit committees are found to be a highly developed corporate governance mechanism, and are associated with Big 6 auditors, higher numbers of intercorporate relationships and the size control variables employed in the study (board size and market capitalisation). It was suggested that both remuneration and nomination committees were relatively less

Volume 10

Number 1

January 2002


14

accepted forms of corporate governance structures. Differences were found between the influences associated with remuneration committees compared to nomination committees. Remuneration committees (57 per cent of companies had a remuneration committee) had influences more similar to audit committees (84 per cent) than to nomination committees (17 per cent). This would suggest that remuneration committees are a more advanced corporate governance structure than was anticipated. This is consistent with notions that remuneration committees are current best practice. Their presence was found in this study to be associated with Big 6 auditors, higher numbers of intercorporate relationships and with higher levels of institutional investment. The control variables for size were also significant. Nomination committees can be classified as being a ‘‘corporate governance mechanism in development’’ in the prescriptive literature and in practice, consistent with the findings that nomination committee presence is highly associated with the size of the board and leverage. This gives weight to suggestions that committees in their infancy are formed for reasons of board efficiency (Bradbury, 1990 makes this suggestion in relation to the voluntary formation of audit committees in New Zealand in 1981), which suggests that the results from prior research into audit committees should be considered in context of the institutional environment. The following conclusions about the influence of auditors can be drawn from the results. Big 6 auditors are influential in the formation of audit and remuneration committees. As auditors (and particularly Big 6 auditors) derive the most benefit from the formation of an audit committee, in terms of greater access to the non-executive directors, it was expected that this relationship would hold. The fact that Big 6 auditors are associated with remuneration committee presence is the more interesting finding. There are a number of possible conclusions that can be drawn here. The first is that companies who demand a higher quality audit (i.e. a Big 6 audit) are more likely to be aware of quality issues regarding their corporate governance structures. The second is that Big 6 auditors are actively encouraging firms to form these committees as a way of strengthening the position of the non-executive directors and as an additional control over management. The finding that auditor type is not related to nomination committee structures is also of interest. This would suggest that auditors are not influential in the determination of processes associated with selection of new

Volume 10


appointees to the board or annual performance reviews of the board of directors. The influence of large investors is also considered in this study. Whilst the identities of large investors differ, this study focuses on the role of institutional investors as they are the most homogeneous group, in relation to corporate governance expectations, among the large investors. No association was found between institutional investors and audit or nomination committees. However, a strong relationship was found between institutional investor shareholdings and remuneration committees. This would suggest that the presence of a remuneration committee (as indicative of corporate governance best practice and of the directors’ concern in monitoring management remuneration) attracts institutional investment – or vice versa. The first set of hypotheses relating to directors (board composition) were generally not supported. This was an unexpected result. This would suggest that committee presence is independent of the characteristics of the board’s structure – a finding that is surprising given the consistent dominance of recommendations regarding the merits of non-executive directors and non-executive chairmen in the prescriptive literature. A potential explanation may be that the quality of directors (whether executive or non-executive) may be more important to corporate governance standards than sheer numbers of non-executive directors. This finding is of importance to regulators who may seek to mandate board composition. The second set of hypotheses relating to directors (intercorporate relationships) were highly supported for audit and remuneration committees. Another way of viewing the intercorporate relationships measure is as a proxy for board quality (Shivdasani, 1993). This is a reasonable measure of board quality because a director of a company who is asked to join another board is generally asked to do so because of their capabilities and reputation. Linking this to the conclusions drawn previously about Big 6 auditors being providers of higher quality audit services, higher quality boards are also likely to demand better standards of corporate governance. At the time of this study, better standards of corporate governance would be reflected through the use of audit and remuneration committees, but not nomination committees. These findings are consistent with Davis (1996) who concludes that interlocks ‘‘provide a mechanism for practices to be legitimized and spread’’ (p.158). As with any study of this type, there is no ability to determine causality, as the data is drawn from a specific point in time. The



research aim of this study was to examine these structures at a point in time for the purposes of comparing the development of committees which is proposed are at different stages of evolution. This can also have the potential problem that the factors which initially caused the formation of these committees may no longer be in effect as at the time of interest for this study. This is an ongoing issue in the literature – many studies claim to be investigating the formation of audit committees but have in fact been examining factors associated with their presence. Despite the limitations outlined above, this research contributes to our knowledge of the development of committee structures and the influences associated with their presence. In particular, our knowledge is extended in relation to audit committees, testing the intercorporate relationships measure for the first time in relation to Australian corporate governance structures. Our knowledge is also extended in relation to remuneration and nomination committees which have been largely neglected in the literature. One of the key contributions of this study is to adopt an empirical and theoretical approach to corporate governance issues which have been largely the domain of the prescriptive literature. This literature consistently proposes the addition of non-executive directors and non-executive chairmen to the board of directors as a solution to improving standards of corporate governance. In a most unexpected finding, this study has shown that these measures are not related to the presence of these committee types. The conclusion that can be drawn from this is that a better reflection of the quality of corporate governance practices used by an organisation can be gained using measures of board quality and the ‘‘tone at the top’’ of an organisation. This study uses two measures that can be described as quality measures – Big 6 auditor presence (monitoring quality) and intercorporate relationships (board quality). Both these measures were significantly associated with audit committee and remuneration committee presence. The mere presence of non-executive directors is not enough for corporate governance standards to improve. This study is able to inform future debates about the role of non-executive directors in the prescriptive literature, shifting the focus from a sheer weight of numbers argument to a quality argument. Future research could consider changes in corporate governance structures in a crosssectional manner. The issue of boardroom (and committee-room) operation and dynamics is


15

clearly another area for research (see Pettigrew and McNulty, 1995, p. 847). Another line of study is the consideration of committees as part of a mix of monitoring mechanisms that a company may choose. The substitutability of these mechanisms with other corporate governance structures is an area for future research.

Acknowledgements This paper has benefited from presentation at the University of Sydney, Monash University and the 1999 meeting of the Accounting Association of Australia and New Zealand. The comments of Roger Simnett, Michael Bradbury, Allen Craswell, Neil Fargher, Kar Ming Chong and colleagues at the University of New South Wales are also appreciated.

Notes 1. McKesson-Robbins investigation by the Securities Exchange Commission (Birkett, 1986). 2. For a review of the development of audit committees in the United Kingdom refer to Collier (1996). 3. AIMA (1995) guidance would suggest that to be independent a director should not be a substantial shareholder, past employee, current professional advisor, significant customer or supplier or have other conflicts of interest. 4. This may be the case in European countries, for example Tricker (1978, p. 66) noted that audit committees begin ‘‘to resemble a second tier for the board’’ and concluded that where a two tier board structure is present, there may be no need for the additional monitoring potentially offered by an audit committee. However, not all companies may find an additional tier of monitoring desirable (for example, Lorsch, 1997). 5. Newman and Wright (1995) compared increases in executive remuneration for companies with insider remuneration committees and outsider remuneration committees. Their results indicate that CEOs of firms with remuneration committees, which had at least one executive member, were paid 20 per cent more than CEOs of firms with independent remuneration committees. 6. Conyon (1994) characterises the period 1988 to 1993 in the UK as a time of radical change in governance innovation. It seems that a similar period of intense change occurred from 1992 to 1996 in Australia. 7. Price Waterhouse and ASCPA (1990); Ernst & Young (1991); Ernst & Young (1992); KPMG (1995); Coopers and Lybrand (1990); Coopers and Lybrand (1995); Arthur Andersen (1992); Arthur Andersen and Malleson Stephen Jacques (1995).

Volume 10

Number 1

January 2002


16

8. Note that there is no mechanism for the pooling of small shareholder votes in Australia. 9. ‘‘A secret intrigue; political clique’’ (Oxford Dictionary, 1985). The full quotation reads as follows ‘‘Australian boards are inbred, dominated by a cabal of directors who hold a disproportionate level of power’’ (Cornell, 1998). 10. Companies are required to disclose the identity of substantial shareholders to the Australian Stock Exchange under ASX Listing Rule 4.10.4 / Rule 3.1(1)(d). 11. No distinction has been drawn between independent non-executive directors and nonindependent non-executive directors. Support for this position comes from Beasley (1996) and Mayers, Shivdasani and Smith (1997) who have both found that there is no informational benefit to be derived from the analysis of independence of directors over and above a split between executive and non-executive. 12. Three auditors accounted for 45 per cent of the non-Big 6 group – BDO (15 firms); Pannell Kerr Forster (19 firms) and Grant Thornton (8 firms). This indicates that the firms in the non-Big 6 portion of the sample are not evenly distributed. For this reason, audit clients of these three firms will be coded as the large non-Big 6 firms (MID). Support for grouping these firms separately from the other non-Big 6 firms is from ‘‘Who Audits Australia?’’ (Craswell, 1996). These three firms audit 41, 44 and 39 firms respectively (not all of these are included in this sample) and are clearly much larger than the other non-Big 6 firms. The next largest number of audits is 17 (Stanton Partners). Audit fees also appear to be larger than the other non-Big 6 firms. 13. Percentage of shares held by substantial nominee shareholders i.e. where beneficial ownership of shares is not known or disclosed. 14. Percentage of shares held by substantial other shareholders i.e. not institutions and not owned by nominee companies.

References Alexander, M. and Murray, G. (1992) Interlocking Directorships in Top 250 Australian Companies: Comment on Carroll, Stening and Stening, Company and Securities Law Journal, 10 (December), 385–395. Alexander, Lord (1993) Corporate Governance – The Role of the Banks, in D.D. Prentice and P.R.J. Holland (eds) Contemporary Issues in Corporate Governance, Oxford: Clarendon Press. Arkley-Smith, T. (1997) Audit Committee Formation and Disclosure, Masters thesis, Charles Sturt University. Arthur Andersen, (1992) Audit Committees in the 1990’s, Sydney: Arthur Andersen. Arthur Andersen and Malleson Stephen Jacques (1995) Results of the 1994/95 Audit Committee Survey, Sydney: Arthur Andersen. Auditing Practices Board (1992) The Future Development of Auditing: A Paper to Promote Public Debate, London: CCAB.

Volume 10


Australian Institute of Company Directors (1993) Nomination Procedures, Sydney: AICD. Australian Institute of Company Directors (1997) The Boardroom Report: Fifteenth Round, Sydney: AICD. Australian Investment Managers’ Association (1995) Corporate Governance: A Guide for Investment Managers and A Statement of Recommended Corporate Practice, Sydney: AIMA. Australian Society of Certified Practising Accountants and Institute of Chartered Accountants in Australia (1993) A Research Study on Financial Reporting and Auditing – Bridging the Expectations Gap, Australia: ASCPA/ICAA. Australian Stock Exchange (1998) Rules of Business, Listing Rules and Guidance Notes, Sydney: ASX. Beasley, M. (1996) An Empirical Analysis of the Relation Between the Board of Director Composition and Financial Statement Fraud, The Accounting Review, 71, 4, 443–465. Birkett, B.S. (1986) The Recent History of Corporate Audit Committees, The Accounting Historians Journal, 13, 2, 109–124. Bosch, H. (1995a) The Director at Risk: Accountability in the Boardroom, Melbourne: FT Pitman. Bosch, H. (1995b) Corporate Practices and Conduct (3rd edition), Melbourne: FT Pitman. Bradbury, M.E. (1990) The Incentives for Voluntary Audit Committee Formation, Journal of Accounting and Public Policy, 9, 19–36. Cadbury, A. (1993) Highlights of the Proposals of the Committee on Financial Aspects of Corporate Governance, in D.D. Prentice and P.R.J. Holland (eds) Contemporary Issues in Corporate Governance, Oxford: Clarendon Press. Cadbury Committee (1992) Report of the Committee on the Financial Aspects of Corporate Governance Including Code of Best Practice, London: Gee and Co, Ltd. Carroll, R. Stening, B. and Stening, K. (1990) Interlocking Directorships and the Law in Australia, Company and Securities Law Journal, October, 290–302. Carroll, R. and Thanos, M. (1994) Director Interlocks and Part IV of the Trade Practices Act 1974, Australian Business Law Review, 22, 411–425. Collier, P. (1993) Factors Affecting the Formation of Audit Committees in Major UK Companies, Accounting and Business Research, 23, 91A, 421– 430. Collier, P. (1996) The Rise of the Audit Committee in UK Quoted Companies: A Curious Phenomenon? Accounting and Business History, 6(2), 121– 140. Collier, P. and Gregory, A. (1999) Audit Committee Activity and Agency Costs, Journal of Accounting and Public Policy, 18, 311–332. Conyon, M.J. (1994) Corporate Governance Changes in UK Companies Between 1988 and 1993, Corporate Governance: An International Review, 2, 2, 97–109. Coopers and Lybrand (1990) Audit Committees – The Next Steps, Melbourne: Coopers and Lybrand. Coopers and Lybrand (1995) Audit Committees – The Way Ahead, Melbourne: Coopers and Lybrand.



Cornell, A. (1998) The Cabal that Runs Australia’s Companies, Australian Financial Review, June 6. Craswell, A.T. (1996) Who Audits Australia? Sydney: The Accounting Foundation, University of Sydney. Davis, G.F. (1996) The Significance of Board Interlocks for Corporate Governance, Corporate Governance: An International Review, 4, 3, 154–159. DeAngelo, L.E. (1981) Auditor Size and Audit Quality, Journal of Accounting and Economics, 3, 2, 183–199. Eichenseher, J.W. and Shields, D. (1985) Corporate Director Liability and Monitoring Preferences, Journal of Accounting and Public Policy, 4, 1, 13–31. Ernst and Young (1991) A Guide to Audit Committees, Sydney: Ernst and Young. Ernst and Young (1992) A Guide to Audit Committees, Sydney: Ernst and Young. Fabris, P. and Greinke, A. (1999) Institutional Activism: Attitudes of Australian Fund Managers, Corporate Governance: An International Review, 7, 4, 379–384. Forker, J.J. (1992) Corporate Governance and Disclosure Quality, Accounting and Business Research, 22, 86, 111–124. Hall, C. (1983) Interlocking Directorates in Australia: The Significance for Competition Policy, The Australian Quarterly, 42–53. Hilmer, F.H. (1993) Strictly Boardroom: Improving Governance to Enhance Company Performance, Melbourne: Information Australia. Institute of Chartered Accountants in England and Wales (1997) Audit Committees: A Framework for Assessment, UK: ICAEW. Kaplan, S.N. and Reishus, D. (1990) Outside Directorships and Corporate Performance, Journal of Financial Economics, 27, 389–410. KPMG (1995) Disclosure of Corporate Governance Practices in 1995 Annual Reports, Sydney: KPMG. Kren, L. and Kerr, J.L. (1997) The Effects of Outside Directors and Board Shareholdings on the Relation Between Chief Executive Compensation and Firm Performance, Accounting and Business Research, 27, 4, 297–309. Lee, C. Rosenstein, S. Rangan, N. and Davidson, W. (1992) Board Composition and Shareholder Wealth: The Case of Management Buyouts, Financial Management, 21, 58–72. Lorsch, J. (1997) Should Directors Grade Themselves? Across the Board, 34, 5, 40–44. Mayers, D. Shivdasani, A. and Smith, C. (1997) Board Composition and Corporate Control: Evidence from the Insurance Industry, Journal of Business, 70, 1, 33–63. McDonald Commission (1988) Report of the Commission to Study the Public’s Expectations of Audits, Toronto: Canadian Institute of Chartered Accountants. Menon, K. and Williams, D. (1994) The Use of Audit Committees for Monitoring, Journal of Accounting and Public Policy, 13, 121–139. Newman, H.A. and Wright, D.W. (1995) Compensation Committee Composition and its Influence on CEO Compensation Practices, Working Paper, University of Michigan Business School.


17

O’Sullivan, N. and Diacon, S. (1999) Internal and External Governance Mechanisms: Evidence from the UK Insurance Industry, Corporate Governance: An International Review, 7, 4, 363–373. Pennings, J.M. (1980) Interlocking Directorates: Origins and Consequences of Connections among Organizations’ Boards of Directors, San Francisco: Jossey-Bass. Percy, J.P. (1995) The Cadbury Report and Corporate Governance in the UK, The CPA Journal, May, 24–28. Pettigrew, A. and McNulty, T. (1995) Power and Influence in and Around the Boardroom, Human Relations, 48, 8, 845–873. Petty, R.M. and Chua, W-F (1999) Mimicry, Director Interlocks and The Interorganizational Diffusion of a Quality Strategy: A Note, Journal of Management Accounting Research, forthcoming. Pincus, K. Rusbarsky, M. and Wong, J. (1989) Voluntary Formation of Corporate Audit Committees among NASDAQ Firms, Journal of Accounting and Public Policy, 8, 239–265. Price Waterhouse and Australian Society of Certified Practising Accountants (1990) Audit Committees: A Working Guide, Sydney: Price Waterhouse. Rosenstein, S. and Wyatt, J.G. (1990) Outside Directors, Board Independence and Shareholder Wealth, Journal of Financial Economics, 26, 175– 191. Rutteman, P. (1993) Corporate Governance and the Auditor, in D.D. Prentice and P.R.J. Holland (eds) Contemporary Issues in Corporate Governance, Oxford: Clarendon Press. Ryan Commission (1992) Report of the Commission of Inquiry into the Expectations of Users of Published Financial Statements, Dublin: ICAI. Shivdasani, A. (1993) Board Composition, Ownership Structure, and Hostile Takeovers, Journal of Accounting and Economics, 16, 167–198. Shleifer. A. and Vishny, R. (1986) Large Shareholders and Corporate Control, Journal of Political Economy, 95, 461–488. Spira, L. (1998) An Evolutionary Perspective on Audit Committee Effectiveness, Corporate Governance: An International Review, 6, 1, 29–38. Stapledon, G.P. (1996) Institutional Shareholders and Corporate Governance, Oxford: Oxford University Press. Toronto Stock Exchange Committee on Corporate Governance in Canada (1994) Where Were the Directors? Guidelines for Improved Corporate Governance in Canada, Toronto: TSE. Treadway Commission (1987) Report of the National Commission on Fraudulent Financial Reporting, Washington. Tricker, R.I. (1978) The Independent Director, London: Tolley. Vafeas, N. (2000) The Determinants of Compensation Committee Membership, Corporate Governance: An International Review, 8, 4, 356–366. Watts, R.L. and Zimmerman, J.L. (1986) Positive Accounting Theory, Englewood Cliffs: Prentice Hall. Weisbach, M. (1988) Outside Directors and CEO Turnover, Journal of Financial Economics, 20, 431– 460.

Volume 10

Number 1

January 2002


18

Elizabeth Carson is a Lecturer at the University of New South Wales where she teaches postgraduate financial accounting. She joined UNSW in 1997. She is a Chartered Accountant and previously worked in Insolvency and Audit and Business Services at Price Waterhouse. She holds a BCom (Hons) and MCom (Hons) from UNSW and is

completing a PhD examining issues associated with global industry specialisation of audit firms. Her research interests also include corporate governance, auditor independence and assurance services. She has published in Australian accounting and legal journals and presented her work at Australian and international conferences.

‘‘We must distinguish between appearance and reality. A great deal of governance law is characterised by misleading verbiage. The misuse of words from the political lexicon to describe the process of selecting directors suggests the question of whether we are concerned with creating an acceptable face for autocratic corporate power. The practice of shareholder ratification of independent auditors suggests a process of informed consent at odds with reality.’’ Robert A. G. Monks, Deputy Chairman, Hermes LENS Asset Management in Global Investment, June 2001, Volume 7, Number 3, p. 4.

Volume 10

