New challenges for audit committee

Dominant shareholder manages most Indian companies. In those companies, independent directors are de-facto appointed by the management. Similarly, it decides the remuneration of the top management personnel. As a result, the nomination and remuneration committees are non-starters. But the audit committee has established itself as an important institution within the board even in those companies. Is it a contradiction that the management, which does not want interference with the appointment of independent directors and in deciding the top management compensation, wants a watchdog to check earnings management and to protect independence of auditors? There is a contradiction if we assume that the board's primary responsibility is to monitor the executive management and to protect minority shareholders' interest. But there is no contradiction if we appreciate that the board in those companies plays more of an advisory role than the monitoring one. The audit committee's approach is also consistent with the overall approach of the board.

The management values the audit committee's role in strengthening internal audit, internal control and risk management, which aim at protecting assets from fraud, theft and wastes at the operating level. It values the committee's advice on accounting policy and audit report because the committee has the competence to assess how an adverse audit comment or an inappropriate accounting policy would hurt the market sentiment. However, the audit committee seldom goes into details to detect earnings management, if any. It seldom takes up strategy audit to ensure that shareholders' money is not wasted in pursuing empire-building strategies or due to inappropriate strategies. An example is the downfall of Subhiksha.

The audit committee hardly protects the independence of auditors. Both the internal auditor and the statutory auditor hold office at the pleasure of the management. The audit committee hardly gets involved in the process of selecting the auditors. It approves proposals placed before it by the management. The statutory auditor's independence is protected only through regulations. This is the reason why the Companies Bill 2012 has introduced few new regulations to protect the audit independence.

In spite of the above shortcomings, we must accept that the audit committee is doing a good job. It holds independent views on various issues to which it pays attention, although it avoids traversing the terrain that might be murky. The good job done by the audit committee has raised stakeholders' expectations, including those of regulators. Increased expectations have widened the gap between what the audit committee can do and what stakeholders' expect it to do.

The Companies Bill 2012 mandates that the audit committee shall approve and modify, if required, related party transactions (RPT) except those that are entered in the ordinary course of business on arm's length basis. It shall obtain professional advice from external sources, if required.

RPT is a two-way sword - some benefit the company, others hurt minority shareholders' interest. There is a general belief that companies that are managed by the dominant shareholder abuse RPTs to tunnel minority shareholders' wealth. Therefore, there is concern over abusive RPTs across the globe. Presumably, this concern has prompted the government to include the modified provision in the Bill.

In order to determine whether a RPT requires its approval, the audit committee, has to either examine every RPT or establish criteria to test whether a transaction is on arm's length basis. Unfortunately, it is difficult to establish straightforward criteria. Moreover, the committee has to form a judgement on whether a particular RPT is abusive. This situation challenges the independence of the audit committee. If, at a later date, a RPT approved by the committee is found to be abusive or the Income Tax Department considers that the transfer price was not on arm's length basis, quite likely, the committee will join the management to defend the decision. This has the potential to impair the independence of the committee. The Bill also provides that the board report shall disclose where the board had not accepted any recommendation of the audit committee and the reasons therefore. Both the board and the committee will avoid such a situation. Therefore, in certain situations the audit committee might have to compromise with its independent views.

A well-intended provision might have dysfunctional effects. The new provisions might strengthen the motivation of the management to appoint independent directors who are not independent.

Those who can hold independence in an adverse situation might not join the audit committee because they will be required to spend more time than before to diligently carry out new responsibilities. They may also expect, and rightly so, higher compensation than that of other independent directors in the board. Higher compensation to members might impair the independence of the audit committee.

The time will tell whether we have killed a golden goose due to over expectation from it.

Affiliation: Head, School of Corporate Governance and Public Policy, Indian Institute of Corporate Affairs; Advisor (Advanced Studies), Indian Institute of Cost Accountants; Chairman, Riverside Management Academy Private Limited

Email: asish.bhattacharyya@gmail.com