The Hindu Business Line : Case for more clarity to ‘third eye’

An Audit Committee is a specialised branch of the board and its constant monitoring will help a company rectify its own weaknesses regarding risk management and internal control. Hence, it is important to ensure the Committee’s independence and transparency.

Vikas Varma

India, with its 20 million shareholders, is one of the largest emerging markets in terms of market capitalisation. Modern businesses, given the sheer size of their operations and sophistication of expertise, tend to be corporatised with an inevitable rift between ownership and management.

Also, both domestic and foreign institutional shareholders are becoming more demanding in their approach towards the companies they have invested in, seeking information and influencing corporate decisions As a result, the need to protect investors’ interest is being felt acutely.

An Audit Committee becomes an important component of the whole project because nothing can be of greater priority than a mechanism to ensure the security of investors’ money and to scrutinise if the money is being used in a proper way or not.

It is necessary to define and develop the constitution, role and function of the Audit Committee in clear, unambiguous terms. Unfortunately, that clarity is lacking in the various corporate laws.

Confusion between Clause 49 and Companies Act

The Audit Committee can be constituted both in terms of the requirements of section 292A of the Companies Act of 1956 and in terms of the requirements of the sub-clause II of the Listing Agreement of SEBI.

But in case the Audit Committee has been constituted according to the Companies Act, it has to meet the additional requirements of Clause 49.

Clause 49, after the amendment of 2004, prescribes that “all members of the Audit Committee shall be non-executive directors, with the majority of members and its chairmen being independent directors, and at least one of them having accounting or related financial management experience”.

But the Companies Act mandates an Audit Committee comprising three or more directors, at least two-thirds of them being non-executive.

The Act does not insist on any of the directors or the chair being independent. Also, the Act makes any matter regarding the financial management, including the audit report, binding on the board whereas Clause 49 is silent on this issue.

A related question is how far the other members of the board can be absolved of any responsibility concerning the financial management of the company, while the spirit of the Act seems to advocate the collective responsibility of the board.

Seen as unsavoury duty

Since the appointment of the committee members first has to undergo the process of nomination by the CEO/Chairman, their absolute independence remains suspect.

The companies take it as an unsavoury duty to form an Audit Committee and, more often than not, either perform this duty with utter non-seriousness or deliberately constitute an ineffectual Audit Committee.

Also, the rapidly changing modern accounting literature puts added demands on the Audit Committees in discharging their role in an effective manner.

There have been attempts on the part of the Securities and Exchange Board of India (SEBI), and the different committees appointed by it, to clear the corporate climate of such confusions while at the same time promoting the efficacy of the Audit Committee.

To make the functioning of the committee more transparent and effective, the SEBI mandate of 2004 has made definitions of ‘independent’ and ‘financially literate’ directors very specific. It has also made the presence of the CEO and the CFO dependent on the invitation of the Audit Committee.

The Naresh Chandra Committee has tried to bring even unlisted companies within the jurisdiction of the regulation, recommending that the Audit Committees of all listed and unlisted public limited companies with a paid-up share capital and free reserves of Rs 10 crore and above or turnover of Rs 50 crore or above, should consist exclusively of independent directors.

As far as the role and power of the Audit Committee is concerned, SEBI has mandated an expansive horizon starting from the oversight of the company’s financial reporting process and the disclosure of its financial information, recommending to the board the appointment, re-appointment and if necessary, replacement of statutory auditors, reviewing the performance of statutory directors and internal auditors, looking into the reasons of default, reviewing the Whistle Blower mechanism, etc.

The Audit Committee has at its disposal powers to effectively intervene in the risk management mechanism of the company. Sub clause V of Clause 49, dealing with CEO/CFO certification, makes it mandatory for the CEO and CFO to indicate to the auditors and Audit Committee significant changes in the internal control during the year.

The Audit Committee ensures and monitors the adequacy of the control framework to manage risks across the organisation. Further, since the presence of the CEOs and the CFOs is strictly on the invitation of the committee, they can neither influence its functioning nor manipulate its report.

As both the executive and statutory auditors have to report directly to the Audit Committee, the probability of the flow of information being hindered by the management becomes less.

Some vital do-s

Companies have to realise that setting up efficient Audit Committees is for their own benefit. An Audit Committee is a specialised branch of the board and its constant monitoring will only help the company rectify its own weaknesses regarding risk management and internal control.

It is necessary to ensure the independence of the Audit Committee, particularly from the influence of direct and indirect relationships. Transparency has to be brought into the nomination process as well.

More coordination has to be effected between Clause 49 and the Companies Act. Also, they have to be made effective across the maximum number of companies, pushing them towards forming independent Audit Committees.

The Audit Committee members should undergo regular training in order to keep themselves up-to-date on recent developments in the fast-changing accounting scenario.

The rest of the board should also be given training about the proper role and functions of the Audit Committee so that a correct coordination can be established between the board and the Audit Committee.

Audit Committees should adopt an effective self-evaluation mechanism based on some broad expectations of the different interest groups, namely the shareholders, regulators, as well as fellow board-members.

Creditable progress

Adam Smith, back in the nineteenth century, had expressed his doubts over how far the directors “being the manager rather of other people’s money than their own” can be expected to watch over it “with the same vigilance with which the partners in a private copartnery frequently watch over their own.”

We have come a long way since then, making the directors supervisors of the investor’s money.

In the Indian context, it is particularly important to protect small investors so that they are not crushed under the fast moving chariot of world capital. Strategic and effective maintenance of able Audit Committees is important in this milieu.

(The author is CEO, Nirvana Corporate Institute Pvt Ltd, and can be reached at vikas@nirvanaconsultants.com)

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