A human skeleton is displayed in an office campus. (Photographer: Mike Kane/Bloomberg)

Board Failures: Why Audit Committees Aren’t For The Faint-Hearted

BloombergQuintOpinion

The audit committee is unquestionably the most powerful of all board committees. The board is responsible for eliminating the conflict of interest and reducing information asymmetry between shareholders and management. The audit committee is its principal arm for fulfilling these responsibilities.

The audit committee’s mandate is to oversee financial reporting and related controls. It encompasses a review of financial earnings releases and filings, risk oversight, oversight of the external auditor, monitoring ethics and compliance policies, and oversight of internal audit. In practice, the audit committee becomes the referee in all matters involving questionable management conduct.

The audit committee’s role became prominent in several companies including Infosys, IL&FS, Jet Airways, Ricoh International, ICICI Bank, the National Stock Exchange, and the Tata Group. The matters included acquisitions, real estate investment, financial reporting, top management decisions, related party transactions, and promoters’ conduct.

At least four critical functions of the audit committee are either ignored or deserve more importance. From boards and committee members.

1. Accounting and Financial Expertise

Audit committee directors should be proficient in accounting. They should understand the accounting standards and practices related to the company’s business. Accounting is getting more tortuous with every passing day. Revenue recognition and leases are just two current examples of Byzantine accounting regulations.

I once asked an audit committee chair of a defence equipment company about the key accounting issues in the business. A celebrated scientist, he replied that he did not have to worry because the company’s chief financial officer would know them.

Fortuitously, he had a smooth tenure. However, later he was ensnared in an accounting scandal in another company that cost him his hard-earned lifetime reputation and a lot of money in legal costs.

Also read: Accounting Weakest Link, Says Uday Kotak In A Chat With Anand Mahindra, M Damodaran On Corporate Governance

2. The Audit Game

The audit committee recommends auditors and reviews their work. Appointing a good auditor is a necessary, but not a sufficient, condition for prevention and detection of wrongdoing. For a start, auditors define their responsibilities so narrowly that they cannot be held responsible for many failures. When something goes awry, they come up with defences such as that the terms of engagement do not cover such matters, management is responsible for controls, they have to rely on information provided by management, auditing is not intended to detect fraud, and suchlike.

When all is said and done, an unlikely coalition of management, board and auditors could blame the audit committee.

However, the audit committee often becomes the management’s hatchet man.

The audit committee mediates between management and auditor. Its job is to ensure that management addresses auditor concerns.

In promoter-controlled companies the audit committee even chastises the auditor for daring to question the promoters. In my experience, auditors are mostly putty in management’s hands, notwithstanding occasional brave words in audit committee meetings. In joint audits, they sometimes compete to please the management. Since the buck stops with the audit committee, it should not hesitate to take independent advice for better assurance.

Also read: Board Failures: A Series Of Columns On Corporate Governance Crises

3. Arbitrating On Conflict Of Interest

Securities and Exchange Board of India regulations require audit committee approval for all related party transactions. There should be a policy for consideration and approval of such transactions. Key considerations for approval would include the business reasons for a transaction, the terms including price, how insiders may benefit from it, and how outsiders may view it. The board has a fiduciary duty to the shareholders. Any suggestion that insiders seek to benefit from a transaction will adversely affect a company’s reputation and stock price.

In September 2018, the market value of Infibeam Avenues was destroyed by 71 percent based on a WhatsApp message that said that the company had given interest-free and unsecured loans to related parties. PC Jeweller and Raymond were also hit by related party questions.

4. Risk Management

The audit committee is responsible for reviewing the company’s risk management and mitigation policies. It should question the relationship between strategy and risk. Cybersecurity risk and foreign exchange risk require constant attention. The audit committee should ask for information about security drills and hedging. Mergers and acquisitions run the risk of overpayment and lack of a strategic and cultural fit. In financial services firms, an asset-liability mismatch is a major risk.

Reports suggest that IL&FS’ risk management committee did not meet even once a year.

Unfortunately, even a major fraud has not been able to reduce the prevalence of incompetent or ill-equipped or spineless audit committees.

Satyam Slack Versus Enron Effect

The role of the board and the audit committee came under scrutiny in the wake of the irregularities in Satyam Computers Ltd.. A corporate collapse that shook India’s markets and regulators, and was widely characterised as ‘‘India’s Enron,’’ should have led to major improvements in the functioning of audit committees of Indian companies.

Research shows that the Satyam failure had a limited effect on Indian audit committees. Here are some numbers for Satyam and Enron:

*Satyam fiscal year: Pre 2007-2008; Post 2009-2010. ** Enron fiscal year: Pre 2000; Post 2002. *** Sample for India has BSE 500 companies excluding government companies and non-March 31 fiscal year companies. Sample for U.S. has S&P 500 companies. Companies with insufficient data have been excluded in both samples.
*Satyam fiscal year: Pre 2007-2008; Post 2009-2010. ** Enron fiscal year: Pre 2000; Post 2002. *** Sample for India has BSE 500 companies excluding government companies and non-March 31 fiscal year companies. Sample for U.S. has S&P 500 companies. Companies with insufficient data have been excluded in both samples.

Also read: Independent Directors Lack Teeth, Says Sanjay Nayar In A Chat With M Damodaran And Arundhati Bhattacharya

The reactions in the two countries to a major corporate scandal could not have been more different.

  • Though the number of audit committee directors increased after Satyam, it is still below the pre-Enron U.S. average.
  • The proportion of independent directors hardly changed after Satyam, as compared to a significant increase after Enron.
  • The number of audit committee meetings increased significantly after Enron, but was much less after Satyam.
  • Counter-intuitively, attendance at audit committee meetings declined after Satyam.
The Satyam fraud should have jolted corporate governance practices but all we got was a mild jerk, at best.

The Companies Act, 2013 lays down a code of conduct for independent directors. SEBI has widened the responsibilities of the audit committee in the Listing Obligations and Disclosure Requirements Regulations, 2015. These include reviewing the functioning of the whistle-blowing mechanism.

There are high expectations from audit committee directors. Deep accounting and financial expertise, the ability to manage tricky relationships with management and auditors, and constant alertness to risks and conflicts are necessary for a successful and trouble-free audit committee. These positions are not for the faint-hearted, for sure. Unfortunately, the audit committee is often regarded as a frill by both management and board. That is a costly a mistake.

R Narayanaswamy is Professor of Finance and Accounting, Indian Institute of Management, Bangalore. Views are personal.

The views expressed here are those of the author’s and do not necessarily represent the views of Bloomberg Quint or its editorial team.

Also read: India Needs To Look Beyond Trophy Directors, Says Arun Nanda In Conversation With S Sandilya And Amit Chandra