prpri Effectiveness of Audit Committee Effectiveness of Audit Committee

Savita Joshi

‘Mutual Fund Sahi Hai’

This tagline has been the driving force amongst small investors to start SIP in hope of amassing a fortune. However, internationally and nationally since the 90s,the world has experienced scams such as Enron, Worldcom and our very own infamous big bull Mr. Harshad Mehta. These frauds have resulted in some serious thinking in the direction of protection of small stakeholders by the lawmakers.

Sarbanes Oxley Act, Cadbury committee, Committee constituted under the leadership of Mr Kumarmangalam Birla have all recommended the setting up of an audit committee in order to safeguard interests of small investors and restore their faith.

The board of directors of a company are mainly responsible and accountable for sound financial reporting. The audit committee has been primarily enshrined with the responsibility of overview of adequacy of internal financial controls, financial and risk management policies of the company, efficacy of internal audit function ,appropriateness of the payments to related parties etc.

Corporate Governance was a buzz word amidst the debacle of ‘Satyam‘. The fundamental code for corporate administration was proposed by the Chamber of Indian Industries (CII) in 1998. The definition proposed by CII was

‘Corporate governance means laws, methods, practices and understood principles that decide an organisation’s capacity to take administrative choices—specifically its investors, banks, clients, the State and the representatives.’

In late 2009, a CII task force put forth corporate governance reform recommendations. SEBI report on corporate Governance chaired by Mr Narayan Murthy, Naresh Chandra Committee report were also emphasizing the need to revisit the laws and to rethink disclosure norms and accountability prevalent in India vis a vis international standard of reporting.

Thus the basic legal framework for audit committee was provided by the section 177 of the Companies Act 2013, SEBI guidelines, and accounting standards issued by ICAI and ICSI.

The committee should ensure that management has identified and implemented all significant accounting policies.The committee has to ensure that the company has adequate internal controls and policies to prevent and identify fraud. It also has to ensure that the organization has implemented an appropriate ethics and compliance program. As an audit committee member, one should be aware of three main areas of fraud risk:

  • Financial statement fraud
  • Asset embezzlement
  • Corrupt behaviour at higher management level for personal gains or to increase the market cap of the company.

In terms of Sec 177 of the Companies Act 2013 , an audit committee shall be entrusted with the following functions apart from review and monitoring

of work of auditors

♦ Valuation of assets / undertakings of the company

♦ Scrutiny of intercorporate loans and investments

♦ Evaluation of internal financial controls

Thus the functions are aimed towards benefiting non management shareholders. Another objective is to achieve more efficient allocation of capital .

On this background let us examine what could be the possible means to enhance the effectiveness of audit committee .

The first and foremost aspect is to bridge the gap between the internal / statutory auditors and a layman who is interpreting the contents of financial statements according to his limited understanding and risking his hard earned savings. The audit committee member in his or her professional capacity should be able to interpret the financials and come to a conclusion that the company is following its goals in a desired , legitimate manner. The footnotes to financials should be thoroughly looked into so as to assess any potential dents by way of heavy penalties for non compliances of any laws especially income tax , indirect tax, etc.

Scope of work of an internal auditor may either be defined or reviewed and approved by the committee. The concerns raised by internal auditors should be looked into .The replies given by the management should be evaluated in the light of statutory provisions. It should not be just a cryptic reply or a reply just for the sake of replying, eg. remarks like ‘will be taken care of in future’, N/A , Noted etc . These remarks may be just a tactic of buying some time. As a member of audit committee, one must insist on definitive actions by the management with specific timelines.

There is a thin line between genuine errors and intentional errors. If the audit committee member does not take sufficient care, then he /she may be treated as ’ party to mens rea’ .This may lead to personal consequences from the professional Institute viz ICAI or ICSI of which he or she is a member apart from the penal provisions under various other statutes.

Thus it is imperative for the audit committee member to fully understand the nitty gritty of the business of the company which he or she represents. The knowledge about the industry in general , competitors, market trends , technological advancements in the relevant sector etc should be studied by the member. He may not have the technical expertise but he should broadly understand the business environment .This may be achieved by studying comparables which may be available in ‘Transfer Pricing study report‘. Alternatively there are certain softwares which provide ready reports for most of these aspects. There could be lot of analysis provided by analysts for listed companies etc which the audit committee member should be aware of.

The peculiarities of the business e.g. a cyclical trend or seasonal trends needs to be looked into . This may be helpful in analysing a sudden spurt in sales volumes or say heavy marketing expenses or an urgent capital outlay at that point in time etc.

The member should advisably plan a visit to the actual manufacturing plant and take a bird’s eye view of the enterprise. If the enterprise is engaged in variety of segments then at least the major segments should be looked into. This can be done on a periodic basis . If possible a casual visit to a retail outlet will also be helpful. As a customer he or she can assess what are the perceptions of employees about the company apart from customers. This can be emphasized in the light of ’ Taj terror attack study done by Harvard. All the employees of Taj Hotel were well aware of exit points but not a single employee abandoned the hotel . Instead they helped guests escape from the hotel.’

Thus mindset and culture of the organisation can speak for the rise or fall of the organisation.This information may not always be available or lets say readily available but such psychological factors ultimately contribute to monetary factors. Moreso such visits at point of sales will ensure that the internal controls are really in place and does not merely exist only on policy document.

However when there are companies which are relatively small or medium size no much information is available in public domain. In such case some information could be available on the website of the company. There is no harm in getting the feel of the organisation by asking for a casual visit outside the usual quarterly meetings. The social networking websites may also throw some light on the public profile of the promoters. There may be sector specific organisations such as NASSCOM, Assocham, CREDAI which are the apex bodies for that industry. These organisations often publish industry specific data , achievements , trends etc. This can provide vital information about the company in question. There may be certain awards , special acknowledgements etc by such trade bodies and if the company has achieved any of these then it can be inferred that the promoters are on right track.

As an audit committee member, review of related party transaction is an important facet to examine. It is generally observed that close relatives are appointed at the helm of the affairs or may be as an important team member of marketing or finance functions. In such cases the audit committee member should ensure that the persons are appointed to the position not just because of relation but based on qualification . The person should ideally possess some skill set and experience commensurate with the job profile. Further the remuneration and the qualifications should go hand in hand.

It is advisable to demand the agenda and the briefing about the resolutions to be considered at least a week before the meeting. There should be enough time allotted to read all the material available before the meeting. All fine print points should be studied carefully. If required more information can be demanded from the company . To achieve a constructive discussion at the actual meeting a thorough home work is a must.

The time allotted for discussion of the agenda items should be sufficient according to the significance. A more strategic decision should be discussed at length and not hurriedly at the end of the meeting. Therefore it is necessary to prioritise the agenda items in the order of their importance. In case of agenda items involving a strategic planning, major acquisition, impairment of assets or goodwill then such items should be on taken up at the initial stages of the meeting. Sufficient time should be allotted in the meeting schedule to have a detailed discussion on such points.

There can be a system of having a standard document as ‘ Board Pact ’ . The contents of such document can be standardised . The minimum contents can be designed in such a manner so as to give a 360 degree view of the agenda item . It may vary according to the size of the company say small , medium and large but basic elements of a given agenda item can be enlisted through such board pacts. Certain corporates are already following this.

Effectiveness of audit committee can be achieved only when all its members are having independent mindset. They should not be under obligation of promoters. They should have the courage to constructively challenge the decisions of the promoters if it is detrimental to other stakeholders. There is a need to adapt a more ‘Techno commercial ‘ approach by the audit committee members .The minutes of the meeting are utmost important. It captures the glimpse of the entire discussion. However it may so happen that due to oversight some important aspects discussed in meeting may be missed out in the actual minutes of the meeting. Hence if possible as a prudent practice, a video recording of the meeting can be requested . Alternatively at the end of the meeting, a member may himself take notes and send it to board as his version of minutes. As far as possible, the communication may be through exchange of e mails . This will help in establishing an evidence that the audit committee member had taken all the due precautions before arriving at a decision.

The internal auditors play an important role in ascertaining the effectiveness of internal financial controls and the functioning of the organisation in general. As an audit committee member some extra meetings can be planned with the internal auditors . The entire board may not be present for such meetings. In fact it may be exclusively between independent directors and internal or statutory auditors. This will help in a fair discussion

The audit committee member is often remunerated by way of sitting fees . However sometimes some companies may offer commission or ESOPS too. However this is not an ethical practice . The Institute forbids accepting such percentage sharing remuneration . Further such an inducement may hamper the very purpose of appointing an independent director. A better approach would be to demand robust sitting fees. Further a ‘directors’ liability insurance ‘or a professional indemnity insurance can be obtained .

As a member of audit committee for finance a command on ratio analysis would be of great help. A ratio will easily depict a true picture behind the numbers. Also the other members who have a technical background and are not conversant with the financial jargons can easily grasp this basic arithmetic .

Last but not the least apart from the academic background some soft skills are also required to strengthen the role of audit committee. To name a few

♦ Good command over language . The words should interpret exactly what one wants to say. There cannot be any room for drawing inferences based on a conversation.

♦ Respect the views of others . No matter what one may think of views expressed by others the one should lend an ear to all.

♦ Disagreement should be conveyed politely and firmly. In fact sometimes such divergent views may lead to some ‘out of box’ thinking.

♦ Constructive criticism is welcome but that does not mean that one should always view all management decisions so to find out hidden motives , or loopholes .

♦ To be a part of a cohesive group as a good team member. The other group members may not be able to comprehend the complex taxation problems but then one may endeavour to clarify it to others in a more lucid way.

♦ To be able to devote enough time and energy commensurate with the agenda items

♦ To keep aside personal relationships and adapt an unbiased opinion

♦ To avoid autocratic style of conduct in a meeting

♦ May have to say things the others do not want to hear

♦ Lastly one should be dressed up for the occasion. It goes without saying that people first see and then think .

To meet its obligations to shareholders, the board must ensure that it receives relevant and reliable information. It involves a public responsibility and that is more important considering the fiduciary duty towards the stakeholders at large. Therefore it is imperative to have an audit committee training if needed. A periodic comprehensive review of the audit committee’s responsibilities may also be taken up. Further in case of a resignation of a member a person ensuing that position may take a document on similar lines to ‘No Objection Certificate’ recommended by ICAI. This will give him or her an insight of the existing conflicts , if any.

No governance system, no matter how well designed, will entirely plug the loopholes . However an effective audit committee can prevent people from putting their personal interests ahead of the interests of the companies they manage.

APPENDIX

177. Audit Committee

(1) The Board of Directors of every listed company and such other class or classes of companies, as may be prescribed, shall constitute an Audit Committee.

(2) The Audit Committee shall consist of a minimum of three directors with independent directors forming a majority:

Provided that majority of members of Audit Committee including its Chairperson shall be persons with ability to read and understand, the financial statement.

(3) Every Audit Committee of a company existing immediately before the commencement of this Act shall, within one year of such commencement, be reconstituted in accordance with sub-section (2).

(4) Every Audit Committee shall act in accordance with the terms of reference specifiedin writing by the Board which shall, inter alia, include,—

(i) the recommendation for appointment, remuneration and

terms of appointment

of auditors of the company;

(ii) review and monitor the auditor’s independence and

performance, and

effectiveness of audit process;

(iii) examination of the financial statement and the auditors’ report thereon;

(iv) approval or any subsequent modification of transactions of

the company

with related parties;

(v) scrutiny of inter-corporate loans and investments;

(vi) valuation of undertakings or assets of the company, wherever it is necessary;

(vii) evaluation of internal financial controls and risk management systems;

(viii) monitoring the end use of funds raised through public

offers and related

matters.

(5) The Audit Committee may call for the comments of the auditors about internal control systems, the scope of audit, including the observations of the auditors and review of financial statement before their submission to the Board and may also discuss any related issues with the internal and statutory auditors and the management of the company.

(6) The Audit Committee shall have authority to investigate into any matter in relation to the items specified in sub-section (4) or referred to it by the Board and for this purpose shall have power to obtain professional advice from external sources and have full access to information contained in the records of the company.

(7) The auditors of a company and the key managerial personnel shall have a right to be heard in the meetings of the Audit Committee when it considers the auditor’s report but shall not have the right to vote.

(8) The Board’s report under sub-section (3) of section 134 shall disclose the composition of an Audit Committee and where the Board had not accepted any recommendation of the Audit Committee, the same shall be disclosed in such report along with the reasons therefor.

(9) Every listed company or such class or classes of companies, as may be prescribed, shall establish a vigil mechanism for directors and employees to report genuine concerns in such manner as may be prescribed.

(10) The vigil mechanism under sub-section (9) shall provide for adequate safeguards against victimisation of persons who use such mechanism and make provision for direct access to the chairperson of the Audit Committee in appropriate or exceptional cases:

Provided that the details of establishment of such mechanism shall be disclosed by the company on its website, if any, and in the Board’s report.

Special mention :CA/CS Mahesh Gavaskar | CA Rajneesh Desai | CA/CMA Mahendra Jain

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