Improving the effectiveness of the audit committee

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New Delhi | Published: June 16, 2018 2:18:11 AM

To ensure investor confidence, the Companies Act introduced Section 292 A, vide an amendment in the year 2000 providing for formation and functioning of audit committees.

Corporates should strengthen this vital institution of corporate governance

Over the last decade, the business scenario across the world has become increasingly complex and uncertain, and we are truly living in a VUCA world—Volatile, Uncertain, Complex and Ambiguous—which creates difficult conditions and situations for doing business. At the same time, a powerful force is driving the entire business world towards a new commercial reality. The power of rapid technological changes is fast transforming the world into one common marketplace for goods and services. The greatest challenge before managements today is: How to keep strategic control on the business while simultaneously decentralising operational control? The series of global financial scandals (and the collapse of marquee firms like Lehman Brothers and Bear Stearns) and closer home the infamous Satyam scandal shook investor confidence in the corporate world during the last two decades.

To ensure investor confidence, the Companies Act introduced Section 292 A, vide an amendment in the year 2000 providing for formation and functioning of audit committees. Subsequently, SEBI framed regulations for corporate governance, included in clause 49 of the listing requirements, based on the recommendations of the Kumar Mangalam Birla Committee on corporate governance. More recently, the Uday Kotak committee on corporate governance suggested some reforms but stopped short of making comprehensive recommendations with regard to the audit committees’ role.

The cornerstones for the audit committee to be effective in today’s business scenario are:

– Audit committee to be well-constituted with competent business professionals as its members, who are financially savvy and have requisite qualifications;
-Members to be truly independent, unbiased and without any conflict of interest;
– Members should be able to spend adequate time and efforts to diligently discharge their role;
– A well-structured and fair compensation package for the members; and
– A clearly-defined tenure and rotation of the members.

Unfortunately, in a majority of cases, most of these criteria are followed only as an exception rather than the rule. The members are generally appointed randomly by promoters or majority shareholders, without adequate thought, and the large body of shareholders (including minority shareholders) have no say whatsoever with regard to their appointment, since these appointments are not ratified at the annual general meeting (AGM).

Imagine a situation where a senior bureaucrat or an academic scholar is an audit committee member and it is futile to expect him to critically question and review the performance of a statutory/internal auditor, understand the dimensions of related-party transactions or question/evaluate the valuation of business in M&A transactions—as he/she does not possess the requisite know how to do so. The current requirement of “financial literacy” is rather vague—it is like expecting an MBBS doctor to review the performance of a neurosurgeon.

For good corporate governance, there are processes in place—internal audit, independent statutory audit and audit committee of the board. The financial scandals, however, slip through—some of these have been well-reported, like Infosys, ICICI Bank, Nirav Modi, Vijay Mallya, but there are many more that haven’t gotten that kind of public attention.

For improving the effectiveness of the audit committee, we need to lay down a comprehensive code of conduct and rules and regulations. These, then, need to be adopted by the companies, and voluntarily.

The suggested best practices are:

-Minimum financial qualification and functional experience should be prescribed for eligibility to become an audit committee member;
-There should be a minimum of six audit committee meetings in a year—two meetings dedicated to review the complete control environment and risk management related matters comprehensively;
– There should be a limitation on the maximum number of audit committees a person can be a member of;
-The audit committee meetings to be held at least a day before the board meeting, to allow for sufficient time to deliberate and discuss key issues;
-Appointment to the audit committee should be through a well-defined selection process and should not be an appointment by the chairman or board or promoters;
– The appointment and compensation of members should be ratified and approved by shareholders in the AGM;
– The tenure of the audit committee membership should be clearly defined and a transparent succession planning process put in place; and
– The appointment of internal auditors and their reporting should be by and to the audit committee.

As good corporate citizens, the companies that have taken public money should strengthen this vital institution of corporate governance, instead of simply paying lip service and ticking the compliance box.

By- Ram Ramasundar, Client Partner, Alexander Hughes, India.

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