Audit Committee, Underpricing of IPOs, and Accuracy of Management Earnings Forecasts

• Author: Daniel Coulombe,Jean Bédard,Lucie Courteau
• Published date: 01 November 2008
• Date: 01 November 2008
• DOI: http://doi.org/10.1111/j.1467-8683.2008.00708.x

Audit Committee, Underpricing of IPOs, and

Accuracy of Management Earnings Forecasts

Jean Bédard, Daniel Coulombe* and Lucie Courteau

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paperexamines the role of audit committees (AC) in the initial public offering (IPO) process

in a governance environment whereAC best practices are well established but their adoption is voluntary. We consider the

creation and characteristics of the committee as signalsthat issuing f‌irms can use to reduce the underpricing often associated

with IPOs. We also examine the effect of the committee on the quality of management earnings forecasts included in the

prospectus.

Research Findings/Results: Our empirical analysis is performed on a sample of 246IPOs issued in the Canadian province

of Québec. We f‌ind that the creation of an AC at the time of the IPO has no effect on underpricing unless its members are

independent and have expertise in f‌inancial matters, in which case it decreases signif‌icantly the level of underpricing of the

IPO. However, we f‌ind no signif‌icant association between these two governance attributes and the accuracy of forecasts

included in prospectuses.

Theoretical Implications: Our results suggest that the AC is a credible signal that could be used in the f‌irm’s signaling

strategy and the results provide support for the monitoring role of the board of directors, as proposed by the agency theory.

Practical/Policy Implications: Our results support the worldwide movement in legislations requiring AC independence

and expertise. They stress the importance of the presence of qualif‌ied members on the AC with suff‌icient knowledge of

accounting and f‌inance.

Keywords: Board Composition, Board of Directors Issues, Audit Committee, Board Committees, Canada, Agency

Theory, Corporate Governance

INTRODUCTION

Accounting scandals such as those of Enron and World-

Com have triggered f‌irst an awareness of the effects of

weak corporate governance and then an increase in the

regulation of governance mechanisms in the U.S. and

around the world. Some questions remain about the effec-

tiveness of these regulations (Romano, 2005). We contrib-

ute to the debate by examining a setting where governance

best practices are known and available, but not mandatory.1

In particular, we examine the decisions relative to the cre-

ation and the characteristics of an audit committee (AC)

made by companies in preparation for an initial public

offering (IPO), and their impact on the pricing of the issue.

The IPO setting is ideal for this type of study because, in

preparation for the issue, the f‌irm’s existing shareholders

and managers have to establish disclosure and signaling

strategies that will convince investors to purchase the

newly issued shares.

The IPOs are characterized by a large information asym-

metry between the existing shareholders, who have private

knowledge about their f‌irm’s expected future cash f‌lows,

and investors, with whom they want to share the f‌irm’s

ownership and risk. This information asymmetry drives the

existing shareholders to “underprice” the issue, asking for

an offering price which they know to be lower than the

intrinsic value of the shares being issued in order to attract

investors. Underpricing represents a wealth transfer from

the f‌irm’s founders and existing shareholders to the new

investors (Filatotchev and Bishop, 2002).

The existing shareholders can use signals to communicate

their private information to investors and hence reduce

underpricing. Prior studies have shown, both analytically

and empirically, that signals such as the retention of a sig-

nif‌icant percentage of f‌irm ownership (Leland and Pyle,

1977; Datar, Feltham, and Hughes, 1991; Courteau, 1995) or

*Corresponding author: Université Laval, Département des sciences comptables,Cité

Universitaire, Québec, Canada, G1K 7P4

AUDIT COMMITTEE, UNDERPRICING OF IPOs, AND ACCURACY OF MANAGEMENT EARNINGS FORECASTS 519

Volume 16 Number 6 November 2008

© 2008 TheAuthors

Journal compilation © 2008 BlackwellPublishing Ltd

doi:10.1111/j.1467-8683.2008.00708.x

the hiring of underwriters and/or auditors of prestige

(Beatty and Ritter, 1986; Feltham, Hughes, and Simunic,

1991; Clarkson and Simunic, 1994; Bédard, Coulombe, and

Courteau, 2000) can convince potential shareholders of the

quality of the issue, thus reducing the need for underpricing.

Recent studies suggest that the structure of the board of

directors may also be used as a signal of quality of the

issuing f‌irm (Certo, Daily,and Dalton, 2001a; Filatotchev and

Bishop, 2002).

The objective of this study is to extend the IPO literature

by examining the effectiveness of the existence and charac-

teristics of the AC as a signal and as a monitor of the quality

of information provided in the prospectus. Like the board of

directors, the AC has the potential to play an important

monitoring role, especially regarding the quality of the infor-

mation (f‌inancial and non-f‌inancial)that is communicated to

the markets, through the prospectus in the specif‌ic case of

IPOs. Since the AC is the component of the governance

structure that is the most closely related to the production

and disclosure of information, its creation and characteris-

tics are the most likely to be used by existing shareholders as

credible signals of the quality of their f‌irm and of the quality

of the information it is providing.

Because of the limited knowledge investors have about

IPO companies, they must place substantial reliance on the

prospectus prepared by the new issuer. The presence of an

AC with adequate characteristicshelps ensure that the infor-

mation communicated before the issue is credible and that

the f‌irm’s managers will continue to provide quality infor-

mation even after the IPO. If the signal is effective, investors

will be conf‌ident that the AC in place provides this assur-

ance and that they are likely to require a lower level of

underpricing of the issue. In addition, the presence and

characteristics of an AC mayhave an effect on the credibility

of the information disclosed in the prospectus.

We provide empirical evidence on the role of ACs in IPOs

using a sample of 246 IPOs in a context where both the

creation of the AC and the disclosure provided are volun-

tary. Our results show thatwhile the mere existence of an AC

does not seem to have any effect on the level of underpric-

ing, the independence and the f‌inancial expertise of the com-

mittee members seem to signif‌icantly decrease the level of

underpricing of the IPO. It is not clear that the presence or

the characteristics of the AC have an effect on the credibility

of the prospectus content, however. Indeed we f‌ind no sig-

nif‌icant association between the existence, independence, or

f‌inancial expertise of ACs and prediction errors in the

earnings forecast included in prospectuses.

Our study contributes to the signaling literature by exam-

ining the role of the AC as a signal in the IPO context, which

to our knowledge has never been studied in the past. Our

results suggest that the AC is a credible signal that could be

used in the f‌irm’s signaling strategy. The mere existence of

an AC is not suff‌icient, however, the committee must be

composed of a majority of independent members and

include at least one f‌inancial expert for the signal to be

credible.

The study also contributes to the corporate governance

literature by examining the effect of AC characteristics on

the credibility of disclosure in a context where both the

creation of the AC and the disclosure provided are

voluntary. Contrary to previous studies (Wild, 1994; Bédard,

Marakchi-Chtourou, and Courteau, 2004; Klein, 2002; Kara-

manou, and Vafeas, 2005), we f‌ind no signif‌icant effect on

the credibility of disclosure as approximated by forecast

precision.

The remainder of the paper is organized as follows. The

next section introduces some characteristics of corporate

governance in the Canadiancontext. The third section devel-

ops our research hypotheses from existing theories and pre-

vious studies. The fourth section presents the research

design used to test these hypotheses, the sample selection

procedures and the measurement of variables. Our empiri-

cal results are presented in the f‌ifth section and a conclusion

follows.

CORPORATE GOVERNANCE IN CANADA

Weimerand Pape (1999) classify Canada as havingan Anglo-

Saxon corporate governancesystem, along with the U.S., the

U.K., and Australia. Indeed, like the U.S., Canada is charac-

terized by shareholder orientation, one-tier boards of direc-

tors, shareholder rights, a capital market orientation, and the

existence of a market for corporate control. Compared with

the U.S., however, the ownership concentration is higher

(Gadhoum, 2006) and the legal enforcement system weaker

(de Carteret Cory and Pilkington 2006; Clarkson and

Simunic, 1994).

The corporate governance of Canadian companies is regu-

lated by the act under which they are incorporated, the stock

exchanges, and the Provincial Securities Commissions.

Private companies are not required to have an AC even if

they are preparing an IPO. Once they become public,

however, companies incorporated under the Canadian Busi-

ness Corporation Act (CBCA section 171[1]) have to createan

AC with a majority of non-executive members. Companies

incorporated under the Québec Incorporation Act, however,

are not required to have such a committee. Between 1995

and 2004 the corporate governance guidelines of the various

Canadian stock exchanges recommended that listed compa-

nies have an AC composed only of outside directors (TSX,

2003, Sec. 473 and 474). Compliance with these guidelines

was not mandatory, as long as the non-compliance was dis-

closed. In 2004, the Canadian Securities Commissions

adopted Multilateral Instrument 52-110 (MI 52-110), making

independent AC mandatory for all public companies for

f‌iscal years ending on or after June 30, 2005 (after our sample

period). For IPO f‌irms, this requirement does not apply for a

period of up to one year after the issue if the majority of the

committee members are independent (MI 52-110, par. 2.1).

For the other governance guidelines, the application is still

voluntary and companies must indicate each year whether

or not they comply with the guidelines and explain why

they have chosen not to comply.

In summary, before 2004 Québec public companies were

required to have an AC with a majority of non-executive

members only if they were incorporatedunder the Canadian

Business Corporation Act (CBCA section 171[1]). Between

1995 and 2004 the (non-mandatory) guideline #13 applied to

the various stock exchanges of the country and recom-

mended that ACs be composed of only outside directors

(TSX, 2003, Sec. 473 and 474).

520 CORPORATE GOVERNANCE

Volume 16 Number 6 November 2008 © 2008 TheAuthors

Journal compilation © 2008 BlackwellPublishing Ltd