There’s no sting in audit committees

The concept of audit committees of the board has gained prominence in the corporate world in India and globally after the series of financial scandals, including Enron. The Companies Act introduced Section 292A through an amendment in the year 2000 providing for the formation and functioning of the audit committees. Subsequently, SEBI formed regulations on corporate governance in India.

An audit committee (AC) is required to consist of three directors with independent directors forming the majority. Its members are expected to be financially literate with a reasonable ability to read and understand financial statements and familiarity with internal controls and financial management.

Broadly speaking, the AC is expected to perform a threefold role:

(a) Provide strong oversight of financial reporting process and identify “Hot Button” issues; (b) Ensure that a robust internal control mechanism exists in the company by encouraging thinking strategically on Enterprise Risk Management issues and add value; and (c) Share recommendations on auditors’ appointment, their fees, and review the performance and effectiveness of audit processes. The audit committee’s role, therefore, is critical to protect and safeguard the interests of all stakeholders

Reporting under the new Indian Accounting Standards (Ind AS) will result in a significant increase in penetration and disclosure requirements in financial statements (such as revenue recognition policies, impairment testing of businesses/assets, etc). Hence, the audit committee should have the necessary bandwidth to have a meaningful dialogue with auditors to assess the situation and make recommendations to the board of directors.

Regrettably, barring a few enlightened corporations, most view the audit committee more as a compliance requirement and not as a strong second line of defence. A quick dipstick survey of the listed and public companies raises several concerns regarding the actual effectiveness of ACs.

For instance, (a) AC meetings tend to be very short (45 minutes to 1 hour), and are convened just one hour before the board meetings. Thus, there’s insufficient time for meaningful review. (b) The agenda papers are generally sketchy with inadequate details; risk management as well as internal control aspects are hardly ever discussed. (c) Most members of the AC do not even understand financial statements, leave alone the changes in accounting policies and their implications.

Besides, (d) although management is always present at the AC meetings there is hardly any follow-up on management’s implementation of audit recommendations by internal and/or external auditors. (e) Related party transactions are hardly ever subjected to rigorous scrutiny. In fact, (f) the AC is invariably not involved in the appointment of internal auditors of the company. In most cases, the internal audit function reports to the CFO rather than to the CEO/audit committee; the internal auditor’s relatively low status in the organisation’s hierarchy doesn’t empower the function with the authority it demands.

In theory, AC is supposed to be a specialist committee of the board to ensure strong oversight on financial management and reporting, but in practice, it is a rubber stamp of the CEO and management.

The process of constitution and composition of ACs is far from transparent. Some basic questions remain unanswered.

(a) How are the members selected and appointed; what are the criteria? Is there an impartial assessment of their competence to discharge this critical role? In quite a few ACs, there are members from diverse backgrounds such as general management, sales and technical streams who are not capable of delivering.

(b) Do they have enough bandwidth to discharge their responsibilities? If, for instance, a director is a member of say 10 audit committees, can he perform this fiduciary responsibility with the diligence it deserves?

(c) How is the succession planning issue managed regarding AC membership? This is critical If there is a vacancy in the AC, it is invariably filled up from the existing pool of directors, in an ad hoc manner. Unfortunately, shareholders do not have any say in the composition and selection of AC members nor is there any communication to them. Transparency is essential to the process.

How can ACs be made effective governance tools? Here are some suggestions:

Selection and appointment should not be a matter of Kitchen Club appointments by the CEO/MD/board; such critical appointments should be handled through professional search firms who can map the universe, identify the right talent fit, and bring in the relevant competence and capability to the committee. The involvement of professional firms for selecting AC members will bring objectivity to the process and eliminate bias, especially in the context of a huge dearth of talent for such positions. A professional approach by an outside search firm would also assure the shareholders of the integrity of the audit committee composition.

The AC should only consist of independent directors and the chairman of the AC should be a proper qualified accountant/finance professional with the necessary background and experience. There should be a well-defined and standardised charter for ACs of listed companies (to begin with) and the AC should submit a formal report to the board based on this charter.

Additionally, AC meetings should not be held on the same date as the board meeting; there must be a gap of at least one day between them.

Also, a clearly defined remuneration policy for the AC members is urgently needed. The challenge is how to remunerate well while at the same time avoiding conflict of interest issues.

We need to recognise that the AC is a vital institution of corporate governance and investor protection to prevent corporate malfeasance. Money belonging to millions of retail investors is at stake and there is a need to strengthen this institution. As Warren Buffett once said about taking risk: “Never test the depth of the river with both feet.”

The writer is Partner-India, Alexander Hughes

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