The members have to be alert to any window dressing in accounting and, if need be, they should side with the auditors against the directors of the firm to protect the shareholders
The world over, a number of frauds in business have forced regulators to tighten corporate governance mechanisms to avoid any loopholes. India, too, has had its share of corporate frauds. Since the liberalisation of the economy, India has focused on developing its financial markets and improving the governance of companies. This is one of the ways of protecting shareholders and overseas investors, which in turn will boost foreign investments, leading to the deepening of financial markets. Fairly unknown till the 1990s, Indian lawmakers made great efforts to bring corporate governance regulations to the current level through various institutions like the CII, Department of Corporate Affairs, and committees like Naresh Chandra, NR Narayan Murthy, Kumar Mangalam Birla and so on. The latest enactment of the Companies Act, 2013, is a major milestone in the corporate governance scenario in India and aims to better the standards of corporate governance, simplify regulations and strengthen the benefits of minority shareholders. One of the important panels of corporate Boards is the audit committee that is responsible for the oversight of financial management of the company and monitoring bad/fraudulent accounting. That is the reason why this committee receives attention from the investors and regulators alike. The members of audit committees have to be alert to any window dressing in accounting and, if need be, they should side with the auditors against the directors of the firm to protect the interests of the shareholders.
So, who is an ideal candidate for this committee? To be effective, members should have wide experience to comprehend multifaceted aspects of the business and regulatory guidelines. The member should have the ability to exercise independent judgement, which comes from the fact that neither s/he nor any of the family members have an existing or previous “material” relationship with the firm other than the audit committee membership. Material relations include both direct and indirect ties. Direct relations includes employees, officers in the executive role, auditing companies, advisors, mentors or consultants, whereas indirect ties are in the form of associates, shareholders, officers of the firm that have any relations with the company and so on.
The independence of audit committee members is of utmost importance and to protect it, the regulations of the Companies Act, 2013, mandate that the panel should have at least three members, with the majority being independent in their role. The Board of directors must understand the rules laid down for protecting the autonomy of the audit committee and resolve any conflicts that could compromise it.
In addition, the majority of audit committee members, including the chair, should be financially literate. The President’s Advisory Council on Financial Literacy (PACFL, 2008) defines it as the ability to use knowledge and skills to manage economic resources effectively for a lifetime of pecuniary well-being. Section 134(3) also requires the Board of directors to declare any omission to the recommendations of the audit committee in their corporate governance report. Although financially literate members are an asset to the committee because of their expertise, they should avoid getting into technical details of the day-to-day running of a firm and have an umbrella approach.
The effective functioning of the audit committee is directly dependent on the chair of the panel. This position should be held by a person who is acquainted with the duties of the committee and is highly proficient and adept at conducting and presiding over meetings. The chair should have the capability to take people across the board together and the determination to handle and resolve complex business matters. Over the years, the role of audit committees has expanded to include review of quarterly financial statements, Management’s Discussion and Analysis, and earnings management. The panels are also responsible for developing comprehensive policies and procedures to record information and protect employees by promoting anonymity, confidentiality and job protection.
Having such all-inclusive policies can help encourage “whistle-blowing” by staff which in turn can serve the purpose of forewarning about fraudulent activities. The committee can also be involved in other monitoring activities like compliance with regulations and the required code of ethics, appointment of CFOs and other main finance executives, review of the expenses of the CEO and other executives, and so on.
To help the committees to operate effectively, a written charter elucidating their responsibilities should be established. They are not responsible for approving things but have a monitoring role to perform and are involved in the review of various reports generated by the management, and external as well as internal auditors. Such reviews should provide assurance to the shareholders that the management and auditors are working in their interests; and regulatory compliances are being adhered to. Since financial statements are used by retail as well as institutional investors and analysts, the audit committee is responsible for close monitoring of the financial statements and notes, to provide dependable and consistent description of the firm’s financial situation and quality of earnings.
The information from these observations of the financial statements is presented to all stakeholders. As we are aware, accounting methods, like valuation of assets and liabilities, the method of revenue recognition and the use of off-balance sheet transactions, affect the earnings and valuation of a firm. Therefore, an audit committee should be able to monitor the system of providing the required numbers to the finance team to avoid any errors, omissions and fraud; and also be aware of the accounting principles and whether they are being applied to the financial statements. The Board of directors should understand the charter of responsibilities of the audit committee before approving it, and determine a thorough process of nominating members to form the panel. The Board should set aside time to discuss and review the reports and recommendations of the audit committee. It must participate in discussions regarding the same by posing pertinent queries to the management, auditors and advisors.
The importance of corporate governance is growing by the day due to a litany of financial crises worldwide, making strong corporate governance a basic requirement by regulators and investors, in markets everywhere. The audit committee plays a major role by contributing to the strategy and direction of a firm and its overall control and accountability. In performing its role, the audit committee is responsible for the quarterly and annual audit of the financial statements, compliances of regulatory authorities and ethics requirements, and largely the risk management of the company. To create a transparent and accountable organisation, the Board of directors should support an independent and strong audit committee even though its recommendations may be bitter sometimes. After all, the truth is sometimes a hard pill to swallow.
The writer is Associate Professor, Amity University, Noida. The views expressed are personal.