The value of audit committees

Here in the developed world, I sometimes hear executives complain about the excessive burden posed on them by corporate governance structures. But it is worthwhile to remind ourselves why we introduced these governance rules in the first place. Because if you don’t have them, things tend to go horribly wrong.

I once was asked to give a presentation about ESG in a frontier country, i.e., a country with a capital market even less developed than emerging markets. I deliberately kept my presentation as basic as I could since I expected the audience to be new to the topic and have little understanding of the issues at hand. At the drinks reception afterward a local investment consultant approached me and told me that in this country, their current problem is to convince people that they should form a board of directors for their business. I clearly missed the mark on that day…

Most emerging markets are somewhere in between the two extremes of tight governance regulation and no governance at all. This allows people like Yakshup Chopra to test the impact changing governance has on firm performance. He looked at listed and unlisted companies in India and the governance reforms introduced in 2013 and 2014. In 2013, a new law was passed that mandated that every listed company must have an audit committee with powers that were expanded compared to the previously existing law. Then on 1 April 2014, the regulator mandated that private, unlisted companies must also have an audit committee with similar powers as for listed companies if the private company exceeded one of three threshold tests:

• Paid-up capital in excess of INR 100m ($1.6m)

• Total debt in excess of INR 500m ($8m), or

• Sales in excess of INR 1bn ($16m)

This allows one to test the impact of audit companies on privately held businesses by comparing the behaviour of private companies just below the threshold with private and listed companies just above the threshold.

The result was that firms that introduced an audit committee got better credit terms from their banks and had to pay less on their debt and loans. Banks rewarded them for having better governance in the form of lowering the cost of debt. Yet, while the cost of debt decreased, firms did not increase debt on their balance sheet. Quite the opposite. Balance sheet leverage on average dropped some 16% after an audit committee was formed. This can be traced to the oversight of the audit committee that reduces excessive risk taking by executives. Whether this happens by intervening in proposed or already enacted investment decisions of executives or whether executives simply refrain from taking excessive risks because of the presence of an audit committee is unclear. What is clear, though is that the mere introduction of audit committees makes improves business performance and makes these companies less risky and more efficient in their use of capital.