The Hindu Business Line : Inbreeding doesn't help internal audit

THERE is no magic wand that can turn a bruised bottom line into black all of a sudden unless one is allowed to jack up prices heftily at short intervals, keep duties high to prevent imports and, as an additional bonus, let interest rates tumble within a short span. You have then a recipe for instant success.

This is what has happened to some of the big names outside the oil and gas sector (particularly the steel sector), making them jubilant about an upward trend for their hitherto lowly priced shares. This overnight development obviously cannot be the result of improved productivity or cost cutting measures or change in product mix for companies that were on the verge of becoming sick and were clueless for years about the direction they have to go.

These unforeseen external factors will not be readily visible to an unpractised eye in reading balance sheets. This turnaround should not lull one into false complacency that all is well with public sector units (PSUs). The basic maladies perhaps still continue to haunt them. Barring a few PSUs many are still in the doldrums or readying themselves to be categorised as sick. The correct picture does not come out fully until it is too late.

Surprisingly, most of the PSUs that are not doing well are not in the priority list for disinvestment as they should rightly be. Strangely, it is only the profit-making ones that engage the Ministry's immediate attention while the loss-making units continue to incur heavier losses at the cost of the public. These units need microscopic attention of all stakeholders to halt the downward slide, lest they gobble up whatever little assets they are left with.

Balance-sheets do not always reflect the true and fair picture of companies' health notwithstanding the certificates of the statutory auditors. There is lot of jugglery that practised hands can do to facelift what would otherwise present a gloomier picture.

The external audit professionals, both statutory and government, rely on the company for all the financial statements and cannot be expected to check fully the correctness of all transactions that affect profit and loss. Only major deviations or changes in the accounting policy or in the system of valuations are likely to come to their notice. Being outsiders they are not conversant fully with the many intricacies of the company's working. Further, their emphasis is towards checking the correctness of financial accounting than on propriety of the transactions. They have to perforce depend on the internal control systems and the internal audit organisation within the company for information about the serious deficiencies noticed, losses incurred or window dressing done to hide unpalatable features.

Based on the available data from this source, they qualify their certificate about the accuracy and correctness based on the signatures of the management on the financial statements. Banks, financial institutions, rating agencies, and all stakeholders necessarily have to go by the printed annual accounts as certified by statutory auditors for their decisions. The correctness of the decisions taken by the different institutions in their respective areas are, in turn, in direct proportion to the reliability of these statements. It is not a very comfortable situation.

It is in this context the extent and effectiveness of internal control in PSUs, and on which much depends, assumes importance. The concern expressed by the CAG in his reports about the deficiency in the internal control systems and the poor functioning of audit committees as envisaged in company law brings to sharp focus the inability of the statutory auditors to highlight this serious lacuna in companies. This deficiency in the internal audit system in PSUs casts a genuine doubt on the reliability of their annual accounts.

Under company law, statutory auditors are required to make a remark about the adequacy or otherwise of internal control consistent with the size and nature of the business of the company. Normally, no adverse comments are made so long as the company produces some evidence of some internal audit system, such as the number of men in audit, its periodicity of inspections and coverage. This is understandable as the statutory auditors are not rotated and cannot be expected to comment on the inadequacy suddenly in one year. They seldom go into their effectiveness, the findings in the reports, and the follow-up action taken. Important findings of internal audit get shielded from the eyes of external auditors.

High-level audit committees, too, cannot do much unless fed with requisite information by the internal and external auditors. This is what the CAG said in the address to Directors of Finance of PSUs in January 2003: "Audit committee need to be alert to the indicators of business risk, and mechanisms should be established to enable the Audit Committee to obtain periodic assurance on the internal control environment. This is possible only if there is a transparent process of identifying, capturing and communicating pertinent information across the various levels of the organisation. There should be independent flow of information between the Audit Committee and internal audit, and the findings of the internal and external auditors should be reviewed by the Audit committee."

The committees, too, are without independent professional auditor as members in some companies. Internal auditors drawn from company executives and working under its administrative control can hardly be expected to reveal serious lapses without fear of reprisal at a later stage. This is the primary reason for the serious ills that afflict companies remaining hidden. Most of the grave errors get suppressed at the unit level or at the finance director's or chairman's level and hardly come to the notice of the committee. The committee is rendered ineffectual with very little flow of useful information

A capable internal audit wing with its intimate knowledge of the company's working can unearth many shady and undesirable operations. There is always an attempt to smother good functioning lest the darker sides surface, and the department is generally filled with people who lack the motivation to work. The choice of people for audit reflect the management's attitude towards internal audit. The management should look upon the internal audit as integral to better functioning than a legal imposition or cruel necessity. Most of the in-depth audit done by CAG personnel tends to be a post mortem on transactions relating to previous years and does very little to remedy the defects immediately on occurrence. They are more historical in nature and unrelated to the current working, akin to bolting the stable after the horse is stolen.

The malady can be set right only if the internal audit wing is outside the control of the company but does concurrent audit throughout the year.

Alternatively, the status of the head of internal audit should be equal to and independent of the finance director and be a member of the board with all internal audit personnel coming under his control. He will be a member of the audit committee. Bright men with professional qualifications should man the audit department. Auditing is a very demanding discipline requiring mastery of the work. The effectiveness of audit and management's commitment have a linear relationship. The most powerful expression of their commitment is their positive attitude to the findings of internal audit. Unfortunately, it is this commitment that is lacking in most of the PSUs.

The internal audit department should, therefore, have a separate cadre with its own line of promotions. Rather than being a verifier of stale and sterile matters, it should appraise all operations — past, present and future. They can then bring a wealth of useful information on the wayward ways in which public money is lost by wrong decisions or by irregular means.

How the internal audit and internal control within the company can be strengthened and rendered independent without bringing it under governmental control defies a ready answer. The ICAI has also a responsibility to devise a suitable mechanism to ensure the credibility of the statutory audit on its observations about the adequacy of internal control.

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