PublicationsThe Role of an Audit Committee in Corporate Governance; Issues and Solutions

October 1, 20200
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Abstract

The audit committee is one of the most important board committees, as it is the backbone of corporate governance that is meant to eliminate the asymmetrical relationship between managers and shareholders. This paper examines the role and functions of the audit committee, how these functions were altered over the years, and the issues with the committee. Further, the paper also analysis one of the biggest corporate scandals that exposed the issues with India’s corporate governance, and the failure of the audit committee. This paper concludes by discussing the learnings and the way forward for the audit committee post the Satyam Scandal.


Introduction

Corporate Governance is a system that embodies pragmatic, moral, and ethical business practices in pursuance of promoting corporate efficiency, accuracy, and transparency. This system is a set of principles that governs the functioning of the company and forms the basis of how a company is controlled and directed. It distributes the responsibilities and rights among the various stakeholders of the company. Corporate Governance can be categorized as having an internal and external governance mechanism.[1] For example, the internal governance mechanism would consist of the composition of the committees, and the external governance mechanism would consist of external auditors, etc.

The Board of Directors is at the core of the corporate governance mechanism as they play a crucial role in overseeing the management and interests of the stakeholders since they are the ones directly involved with the management of the company. The shareholders are not directly involved and so the Board is entrusted to act keeping in mind the best interests of the company. According to that, to make informed decisions, the Board of Directors appoints and constitutes various Board committees to delegate specific areas of work.

These committees function to provide very detailed reviews, specific recommendations, and help in the decision making process in the affairs of the Company. As per the Companies Act, examples of some important committees to be formed are the audit committee[2], the nominations and remunerations committee[3], stakeholder relationship committee[4], and corporate social responsibility committee[5].

This research paper seeks to understand, explore, critically analyze, and comment on the role and functioning of the audit committee. This paper will also examine the merits and demerits of the existing provisions. This topic is of utmost importance as it enables a corporation to effectively understand and improve its corporate governance mechanisms and help in the functioning of the business by promoting transparency, accuracy, and management. Taking a look at one of India’s biggest corporate scandals, the Satyam Scandal, and the effect it had on corporate governance will help us understand the deep-rooted issues and possible solutions to the issues faced by the audit committee in corporate governance.


Role and Function of the Audit Committee

The audit committee plays a very crucial role[6] in ensuring that the audit process is independent. The audit committee[7] is constituted to provide credible, reliable information so that one can assess the performance of the company. Transparency and accuracy of the financial status of a company are one of the main goals of the audit committee. In India, as per the Companies Act, 2013, and the Securities and Exchange Board of India Act, 1992, or SEBI, listed companies must constitute an audit committee.

As per Section 177 of the Companies Act, 2013 and SEBI, every audit committee is to consist of a minimum of three directors of which there must be a 2/3rd majority formed by the independent directors. Members of the audit committee must be financially knowledgeable, however, at least one member must have expertise in financial management. The Chairman of an audit committee must be an independent director and must mandatorily attend each Annual General Meeting. The company secretary must also hold the position of secretary in the audit committee.

The audit committee functions[8] to monitor and manage the company’s internal and external audit, risk management activities, financial reporting, financial disclosure, regulatory compliance, etc. An audit committee is also to review related party transactions. The Companies Act, 2013 in-fact mandates that all related party transactions require the approval of the audit committee. The audit committee must consider whether the transaction is purely for business purposes, how such a transaction would affect the company, the impact that such a transaction would have on the financial statements of the company, and identify the parties that benefit from the transaction. Related party transactions must be subject to scrutiny.


The Committee Reports

The Bajaj Report[9], 1991 headed by Rahul Bajaj was the first to call and recognize the need for the establishment of an audit committee. The Kumar Mangalam Birla Committee[10],1999 was then convened by SEBI in pursuance of improving the corporate governance in India. This committee made various recommendations for the audit committee. Clause 49 of the Listing Agreement arose from the recommendation of the Kumarmangalam Committee which was an important step towards codifying the norms of corporate governance. Clause 49 distinguished between three types of directors; executive directors, non-executive directors, and independent directors. It further also states the requirement of half the board of a listed company must consist of independent directors and requires the inclusion of an annual report on corporate governance.

The need for independent directors is so that the interests of the minority shareholders are not hurt. In India especially there is an issue of concentrated shareholding, therefore, the need for an audit committee to have a 2/3rd majority of independent directors on its board is justified. The Naresh Chandra Committee[11], 2002 then further went on to bridge the statutory relationship between auditors and company and examined many other issues such as rotation of statutory audit firms and partners, auditor fees, the appointment of auditors, and true and fair financial affairs of the company. The Narayan Murthy Committee[12], 2002 focused on the quality of financial disclosure, the responsibilities of the audit committee, and requiring boards to assess and disclose business risks of companies in its annual reports.


Failure of the Audit Committee and Corporate Governance – An Analysis of the Satyam Scandal

The Satyam scandal[13] is one of the biggest scandals of corporate failure and fraudulent auditing. The company, Satyam Computer Services Ltd. founded by B Ramalinga Raju, misrepresented its accounts and deceived  SEBI, its investors, the registrar of companies, and many other stakeholders. Pricewaterhouse Coopers, an acclaimed audit company was auditing Satyam for 10 years and yet it failed at being able to take into cognizance any of the fraudulent behaviour of the company.

This case was truly a massive failure on part of the audit committee as even though every document went through the auditing company, they still couldn’t catch the fraud due to gross negligence. They failed to perform due diligence and failed to take any step to prevent malpractices that would lead to such a fraud occurring. Ironically in September 2008, Satyam had won the “Golden Peacock Award for Excellence in Corporate Governance.” The failure of corporate governance was on multiple fronts – failure of independent directors, unethical behaviour, ineffective audits, ineffective Board, non-disclosure of vital information to stakeholders, and failure of independent directors.

SEBI became extremely vigilant post the Satyam scandal[14] and began enforcing existing norms much more strictly.  Clause 49 of the Listing Agreement was amended to improve corporate governance and include accountability and transparency. A monitoring body was set up by the stock exchange regulator to ensure that Clause 49 was being complied with and quarterly compliance reports had to be monitored by them. Further, the Clause was amended and made a minimum of 50% non-executive directors mandatory and at least one female director must be present on the board. The Companies Act, 2013 then introduced more provisions that imposed sanctions on fraudulent behaviour and enabled investors to sue a company along with its directors and auditors.


Learning from the Satyam Scandal and the way forward

One of the important ways forward posts the Satyam fraud is having an effective whistleblower policy or a vigil mechanism[15]. A whistleblower is a person with authority who essentially informs potential fraudulent activities or misconduct ongoing in their company. It involves employees reporting malpractices or actions which could potentially question the ethics and integrity of a company.  It plays a vital role in preventing fraud and abuse of resources.

The audit committee plays an important role in monitoring suspected violations of the internal and external policies of a company. A good whistleblower policy would ensure the anonymity and safeguard of those communicating their suspicion as this would encourage people to speak up about the suspicious activities that they have observed. The audit committee must acknowledge such concerns and determine whether or not the allegations are too broad or whether it is a cause for concern and must be looked into and conduct an investigation.

The credibility of the allegation must be determined with utmost scrutiny and sufficient evidence must be provided to help decide on the seriousness of the misconduct. The audit committee must weigh the effect such a report of misconduct would have on the company, the larger the potential loss the more important and urgent it is for the audit committee to conduct an investigation.  A procedure must be laid down for the protection of the whistleblower and they must cooperate and help with the investigation. It would be ideal for a quarterly report to be sent to the Board of the company regarding the number of allegations made along with the finding of the audit committee regarding the same. The company must maintain all such records. A good, well-drafted whistleblower policy would be an ideal way to try to prevent and catch misconduct and fraud occurring in a company.

Another possible solution in the fight against preventing fraudulent activities and misconduct would be trying to improve the transparency in the constitution of the audit committee. One must consider how potential members are selected for the audit committee and how are they assessed as to whether or not they can successfully discharge their responsibilities. The promotors, board, or chairman must not be allowed to select members of the auditing committee and instead, it should allow a professional firm to do so to eliminate bias.

Financial and accounting expertise is required to bridge the relationship between auditors and management. The audit committee must be extremely vigilant and cautious in its approach.  The audit committee must employ a feedback mechanism.

Related Party Transactions[16] must also be monitored. One of the main issues of corporate governance in India is the abuse of related party transactions as it is difficult to identify such transactions. A transparent succession plan for the audit committee must be laid down.


Conclusion

Corporate governance is an extremely important aspect of maintaining ethics and moral conduct in business. India, post the Satyam Scandal as had to redefine corporate governance as it witnessed a complete breakdown of the corporate governance mechanism. The audit committee plays a central role in determining and maintaining the transparency and accountability of a company and in maintaining good corporate governance. Therefore it is of utmost importance that we keep evolving and using recommendations to improve the functioning of the audit committee in pursuance of a good corporate governance mechanism[17].

REFERENCES-

[1] [2009] 14 CPT 483 (CAT)

[2] Section 177, Companies Act, 2013

[3] Section 178, Companies Act, 2013

[4] Section 178 (5), Companies Act, 2013

[5] Section 135, Companies Act, 2013

[6] Al-Mudhaki, Jawaher and Joshi, P L. 2004. “The Role and Functions of Audit Committees in the Indian Corporate Governance: Empirical Findings.” International Journal of Auditing. 8. 10.1111/j.1099-1123.2004.00215.x.

[7] D Chatterjee. 2011.  Audit Committee Observation/ Recommendations Versus Practices as a Compliance of Corporate Governance in India. DLSU Business & Economics Review.

[8] [2006] 68 SCL 262 (MAG.)

[9] Confederation of Indian Industries. 1997. Desirable Corporate Governance : A Code.

[10]Securities and Exchange Board of India. 1999. Report of the Kumar Mangalam Birla Committee on Corporate Governance.

[11]Ministry of Finance Department of Company Affairs. 2003. Report of the Committee on Regulation of Private Companies and Partnerships. http://reports.mca.gov.in/Reports/3-Naresh%20Chandra%20committee%20report%20on%20regulation%20of%20private%20companies%20and%20partnerships,%202003.pdf

[12] Securities and Exchange Board of India. 2003. Report of the SEBI Committee on Corporate Governance.  https://www.sebi.gov.in/reports/reports/mar-2003/the-report-of-shri-n-r-narayana-murthy-committee-on-corporate-governance-for-public-comments-_12986.html

[13] Narayanaswamy, Raghunandan, and Rama, Dasaratha. 2014. Satyam Failure and Changes in Indian Audit Committees. IIM Bangalore Research Paper No. 471. Available at SSRN: https://ssrn.com/abstract=2520414 or http://dx.doi.org/10.2139/ssrn.2520414

[14] Singh, Kumar and Uzma, Shigufta. 2010. Satyam Fiasco: Corporate Governance Failure and Lessons Therefrom. The IUP Journal of Corporate Governance. https://www.researchgate.net/publication/228118526_Satyam_Fiasco_Corporate_Governance_Failure_and_Lessons_Therefrom

[15] Section 177 (9), Companies Act, 2013

[16] [2020] 115 taxmann.com 148 (Article)

[17] M L Bhasin. 2016. Strengthening Corporate Governance Through An Audit Committee : An Empirical Study. Wulfenia Journal.

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Legal Maxim (October 26, 2020) The Role of an Audit Committee in Corporate Governance; Issues and Solutions. Retrieved from https://www.legalmaxim.in/the-role-of-an-audit-committee-in-corporate-governance-issues-and-solutions/.
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The Role of an Audit Committee in Corporate Governance; Issues and Solutions.” Legal Maxim [Online]. Available: https://www.legalmaxim.in/the-role-of-an-audit-committee-in-corporate-governance-issues-and-solutions/. [Accessed: October 26, 2020]
AUTHOR DETAILS
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Name: Aileen Aditi Sundardas

Affiliation: Jindal Global Law School, Sonipat

Year: 4th 

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