Are audit committees working?
Enron will be a watershed in more ways than one, and for all our glacial pace of reforms, some of its effects will surely affect the way listed Indian companies and their auditors go about doing business with shareholder funds. To my mind, the most immediate repercussion will be the way our audit committees go about doing their work.
After SEBI accepted the major corporate governance recommendations of the Kumar Mangalam Birla Committee, clause 49 of the listing agreement came into play. According to this, it is mandatory for listed companies to constitute a board level audit committee. The committee has to consist of a minimum of three non-executive directors, of which the majority should be independent, with at least one director having financial and accounting knowledge. The chairman of the audit committee has to be an independent director, and must be present at Annual General Meeting to answer shareholder queries.
The audit committee is supposed be oversee the company’s financial reporting process and the disclosure of its financial information to ensure that the financial statement is correct, sufficient and credible. It has to review with management the annual financial statements before submission to the board. To do so, it has to focus on changes in accounting policies and practices; major accounting entries that involve judgement by management; qualifications in the draft audit report; significant adjustments arising out of audit; related party transactions; adequacy of internal control systems and internal audit functions; any suspected fraud or irregularity; the nature and scope of external audit as well as post-audit discussion to ascertain any area of concern; financial and risk management policies; the reasons for substantial defaults in the payments to the depositors, debenture holders, share holders and creditors; and recommend the appointment and removal of the external auditor.
It is a huge list and a daunting, time-consuming task that requires a great deal of expertise and commitment. I know, because I happen to chair the audit committee of one company, and am a member of another. By the time the financial year comes to an end, I will have spent at least 10 full working days only on audit functions in the company where I chair the committee.
While in general, non-executive directors are significantly less liable to prosecution than their executive counterparts, it is now becoming clear that the audit committee and its chairman carries greater liability than that facing an ordinary non-executive director. This is because the audit committee chairman has to not only submit a declaration of compliance in the annual report, but also attend the AGM to answer shareholder queries.
So, given Enron on the one hand and the greater liabilities and responsibilities of the audit committees on the other, how are Indian companies going about the task? In a pithy phrase, “pretty poorly”. What we are seeing for over 90 per cent of the listed companies is an adherence to the letter, and hardly the spirit, of the law. Throughout 2001-02, I have seen companies hastily set up audit committees to comply with the Listing Agreement and the amendments to the Companies Act. It can be safely said that for most companies, the audit committee meetings are a formality. More often than not, these committees barely make the quorum. My experience as a consultant is that the audit committee meetings are often structured as adjuncts to the formal quarterly board meeting, and rarely last an hour — an amazingly small amount of time given the responsibilities and liabilities of these committees. Rare is the case where internal auditors are quizzed very closely; more often than not, the committee members don’t know where to begin, and most are not particularly interested in learning about the financial innards of the company. More often than not, the CFO or CEO sits in and their writ runs either obviously or subtly. In short, all form and no substance — great for declarations in the “Corporate Governance” chapter of the annual report, but devoid of the fiduciary importance that an audit committee should deserve.
To be sure, there are notable exceptions. I personally know of at least ten leading listed companies where the audit committee works according to best international standards. And, maybe, the list can be extended to twenty, or even twenty-five. But what about the rest?
For them, I have some bad news and some advice. The bad news is that, sooner or later, one or two of the chairmen of these non-functioning audit committees will be hauled over coal by the shareholders, the financial press and SEBI. And that’s going to happen sooner rather than later. Enron shows why audit functions are critical to safeguard shareholder wealth, and there are enough people in India who have understood this well. Some of them will surely question financial disclosures — and do so loudly.
To prevent such public embarrassment and, heaven’s forbid, class action suits against fiduciary negligence, it is well worth the while for most audit committee members to look up the recommendations of the Birla Committee and carefully read Clause 49 of the Listing Agreement. I have another suggestion, and that’s from Warren Buffett, arguably the best long term investor in the world. Here are his three questions for an audit committee:
1. If the auditor were solely responsible for preparation of the company’s financial statements, would they have been done differently, in either material or nonmaterial ways? If differently, the auditor should explain both management’s argument and his own.
2. If the auditor were an investor, would he have received the information essential to understanding the company’s financial performance during the reporting period?
3. Is the company following the same internal audit procedure the auditor would if he were CEO? If not, what are the differences and why?
Which audit committee in India asks these questions? You tell me.
Published: Business World, March 2002