There is an urgent need for managers to be monitored

ACCOUNTANCY

There is a divergence between the ownership and control of most large corporations. While the shareholders of a company are a dispersed group of individuals and other entities such as financial institutions, decisions that determine the earnings of these shareholders are taken by the group of salaried managers.

This gives rise to the need for institutions that ensure that the decisions these managers take are in keeping with the interests of the shareholders and that the managers do not indulge in self-enrichment or put the capital invested by the shareholders to unnecessary risk.

The corporate governance model that has received wide acceptance globally focuses on monitoring the manager. There are two types of monitoring. The board of directors actively monitors the manager. Passive monitoring is done by the market for corporate control. The existence of a market for corporate control, together with efficient capital markets, helps in disciplining managers through the threat of losing control in a takeover. An underperforming company becomes a good target for takeover because its shares become underpriced.

The effectiveness of this passive monitoring depends on the integrity of financial reporting. Hence, the most common corporate governance reforms worldwide has been the mandatory creation of audit committees, which are subcommittees of the Board with the specific task of ensuring the integrity of financial reporting.

One of the requirements of the Indian corporate governance code is that the board must form an audit committee. The audit committee should have a minimum of three directors as members. Two-thirds of the members of audit committee should be independent directors.

All members of audit committee should be financially literate and at least one member shall have accounting or related financial management expertise. The chairman of the audit committee should be an independent director. The chairman of the audit committee is required to be present at the Annual General Meeting to answer shareholder queries.

Clause 49 describes the role of the audit committee. One of the roles of the audit committee is to oversee the company's financial reporting process and the disclosure of financial information to ensure that the financial statement is correct, credible and sufficient. The audit committee reviews any change in the accounting policy and practices and the reasons given for them and ensures that such changes are appropriate. The audit committee also reviews financial statements before they are placed before the Board for approval.

The statutory auditor of a company provides assurance to the users of financial statements that financial statements provide a true and fair view of the financial position, operations and cash flows of the company. Users of financial statements rely on the auditor's assertions because of their knowledge, skills and independence. It is one of the tasks of the audit committee to protect the independence of the auditor.

The audit committee recommends to the Board the appointment, re-appointment and if required, replacement or removal of the statutory auditor and the fixation of audit fees; discusses with the statutory auditors about the nature and scope of audit; on completion of audit, hold discussions with statutory auditors to ascertain any area of concern; and reviews the qualifications in the draft of audit report.

The audit committee reviews the performance of the statutory auditor. It approves payment to the statutory auditor for any other services rendered by them. In a way, the audit committee ensures that the payments are not disproportionately high, because payments significantly higher than the market rate impair the independence of the auditor.

The audit committee is also charged with reviewing the adequacy of the internal control system. The scope of internal control is very wide. Simply speaking, an internal control system aims to protect the assets of the company. 'Protection of assets' has very wide connotations. It includes protection from undue exposure to risks and protection from wrongful use or waste of assets. 'Protection of assets' demand adequate and effective information security. Therefore, review of internal control includes review of risk management strategy and adequacy of the risk management system, and also review of the information security system.

The audit committee reviews the adequacy of the internal audit function and discusses with internal auditors any significant findings and follow-up thereon. The appointment, removal and terms of remuneration of the Chief Internal Auditor is subject to review by the audit committee.

Thus, scope of work of the audit committee is quite wide. Audit committee members are expected to understand the business model well and to spend significant time in performing tasks specified in the corporate governance code. A survey in USA indicates that each member of the audit committee should spend 50 to 100 hours depending on the size of the company.

The corporate governance code requires that the audit committee should meet at least four times in a year. In most cases, audit committee meets only four times. The duration of a meeting is around four to eight hours. Therefore members who attend all the meeting spend around 16 to 32 hours. Therefore, each member is expected devote time beyond the meeting hours. What should they do outside the meeting?

They need to spend time to discuss audit reports and other issues with the internal auditor and the statutory auditor. They should also interact with senior executives, including the finance director, to understand the corporate and functional strategies and also the risks arising from those strategies. A question arises whether interaction with executives outside the meeting impairs objectivity.

This was debated for long at the time when many companies introduced the practice of pre-audit of transactions by the internal auditor. Now, the position is more or less settled. The Institute of Internal Auditors of USA believes the internal auditor should play the role of an advisor.

There is always a tradeoff. When an internal auditor performs the role of advisor, he/she may not be able to review decisions as objectively as would have been possible otherwise.

But the loss is more than offset because when he/she plays the role of an advisor, his/her understanding improves and the subsequent review is more effective. Similarly, if audit committee members meet senior executives regularly, they will be able to do their job more effectively.

The effectiveness of the audit committee depends on the approach of the Board. If the board does not appreciate the role of the audit committee, the audit committee will remain ineffective. The Board should take a professional approach and should provide all support to the audit committee in performing its tasks. Perhaps, audit committee members should be rewarded adequately for their onerous responsibilities and the time they spend to accomplish their tasks.

The purpose of the audit committee is to support the board of directors in its oversight function. Audit committee does not exonerate the Board from their responsibilities.

For example, the Board is responsible for any misrepresentation in the financial statements, even though the financial statements were reviewed by the audit committee before they are placed for approval by the Board. Therefore, the Board should apply due diligence while approving financial statements. An audit committee should also develop a self-evaluation procedure.

Often experts differentiate between corporate governance and enterprise governance. They use the term corporate governance in a narrow sense. According to them corporate governance does not focus on the quality of decisions. It just ensures that the management is not enriching itself or ignoring the shareholders' interest.

Enterprise governance focuses on quality of decisions. It ensures that the manager takes best possible decisions directed towards enhancing the value of the company. Audit committees play an important role in enterprise governance. In general, they have been more effective than other sub-committees of the Board. But there is a long way to go.