Context
As the financial year 2023-24 draws to a close in a few days, it is the right time to reflect on the functions and responsibilities of the Audit Committee as well as address some “inconvenient” questions concerning their effectiveness vis-a-vis various listed and unlisted companies.
Following the audit of year-end financial statements, the Audit Committee typically convene meetings, examine the statements, and confirm to the Board of Directors that such financial statements (FS) reflect the “true and fair view” of the state-of-affairs of the company as mandated by law. But can one be certain that the Audit Committee arrived at the conclusion after a robust examination and understanding of the financial statements? Interestingly, recent regulatory orders (where Audit Committee members have been held liable for accounting standard violations under Regulation 4(2)(f) of the PFUTP Regulation 2023[1]) has also re-ignited debate on the need to streamline the roles and responsibilities of the Audit Committee. In the above backdrop, the author deals with some practical challenges and the limitations of the Audit Committees to provide such a confirmation to all the stakeholders.
Regulatory architecture
The basic law governing role of the Audit Committee is contained in:
(a) Section 177 of the Act for both listed and unlisted companies.
(b) Reg 18 of the LODR read with Part C of the Schedule II for listed companies.
(c) Section 134 (5) of the Act about the Directors’ Responsibility Statement.
How deep is the Audit Committee’s scrutiny of the FS?
Section 129(1) of the Companies Act, 2013 (“Act”), provides that the financial statements (“FS”) shall give a ‘true and fair view’ of the state-of-affairs of the company, and they comply with all the applicable accounting standards (which are Ind AS accounting standards in most cases.)
For the listed companies, Reg 33 of the LODR needs to be complied with as it provides regulatory architecture.
Further, Section 134(5) of the Act, inter alia, provides that the Directors’ Responsibility Statement, which forms a part of the Boards’ report to the shareholders should, inter alia, state that:
(a) in the preparation of the annual accounts, applicable accounting standards had been followed, along with proper explanation relating to material departures.
(b) the directors had selected such accounting policies and applied them consistently and made judgments and estimates that are reasonable and prudent to give a “true and fair view’ of the state of affairs of the company at the end of the financial year and of the profit and loss of the company for that period.
(c) the directors had taken proper and sufficient care for the maintenance of adequate accounting records in accordance with the provisions of this Act for safeguarding the assets of the company and for preventing and detecting fraud another irregularity.
(d) the directors had prepared the annual accounts on a going concern basis; and
(e) the directors, in the case of a listed company, had laid down internal financial controls to be followed by the company and that such internal financial controls are adequate and were operating effectively.
The Board then relies largely on the Audit Committees to take care of all these aspects. But the moot question is how many Audit Committee members can honestly say that they have scrutinised the FS in detail before declaring such FS reflect a “true and fair view”?
Preparation and approval of FS – The process
In any company, the Chief Financial Officer (“CFO”)-headed management team prepares the FS using applicable accounting standards. The statutory auditor, who audits the FS upon receiving it from the CFO and his team, is mandated by law to report to the members of the company that to the best of his knowledge and information, the FS give a ‘true and fair view’ of the state- of- affairs of the company at the financial year end. Significantly, in almost all situations, the auditors give their certification based on the signatures of both Chief Executive Officer (“CEO”) and the CFO on a detailed representation letter (“Management Representation Letter”) as well as the CEO and CFO compliance certificate provided to the Board in terms of Reg 17(8) read with Part B of the Schedule II of the LODR.
The Audit Committee, which receives the finalised FS for examination, is required to confirm to the Board that the FS are accurate drafted in compliance with applicable accounting standards and reflect “true and fair view”. The Committee then recommends the Board to approve the FS. In most cases, the Board approves the FS by largely relying on the approval of the Audit Committee members, without substantial debate/ deliberations at the Board meeting. However, unlike the NYSE and Nasdaq-listed companies, the Audit Committees in India don’t need to present any formal report to the Board on the integrity of financial statements, etc. India relies on the oral confirmation of the Chairman of the Audit Committee.
Typically, the CEO or the CFO along with the statutory auditors make a brief presentation on the FS, following which the Chairman of the Board seeks its approval and confirmation from the directors, asking them if the same should be recommended for adoption at the annual general meeting.
Certification of ‘true and fair view’ by the Board – A mere leap of faith?
In most cases, the draft FS are supplied to the directors a few hours before the Board meeting, on the purported ground an advance intimation may result in “insider trading” by the directors. Moreover, Board meetings of most listed companies often fall within the same week, given the ‘uniform financial year’ construct and the prescribed time-limit for holding such meetings, which is within 45 days of the end of quarter. This results in a situation where the independent directors (“IDs”) and the non-executive directors (“NEDs”), who serve on multiple Boards and have other pressing commitments, are not able to examine the FS in detail owing to paucity of time and a general lack of knowledge/ awareness of the applicable Ind AS Accounting Standards.
However, the legal architecture casts the responsibility on the entire Board to confirm “true and fair view” of the FS. Despite the clear statutory mandate, in practice, the Board certifies ‘true and fair view’ without much deliberation. The Audit Committee relies on the certification provided by the auditors, who in turn, rely and pass the buck on the CEO and CFO by always insisting on the Management Representation Letter.
It is also interesting to note that on most occasions, the Management Representation Letter and the Directors’ Responsibility Statement are not even placed before the Board, even though they form the edifice of the entire process for certifying the “true and fair view”!
There are also various complex accounting issues involved when a company has global operations, multiple business divisions and subsidiaries as well as associate companies, and extensive training is required to familiarise oneself with all such issues, especially under the Ind AS Accounting Standards, which are vastly different from its predecessor (GAAP). The audit committee is required to make critical accounting estimates and significant judgement in the applying accounting policies. The estimation is required for life of various tangible and intangible assets, and assumptions used in determination of employee- related obligations and fair valuation of financial and equity instruments. Given the time constraints, the audit committee may find it very challenging to make an independent assessment on all these aspects and may rely largely on the management representation in this regard.
Given that the Audit Committee is essentially a sub-committee of the Board consisting of non-executive directors who are not involved in the day-to-day management of the company, it is important that regulators introspect and re-define the job of the committee.
It would be best, if the following fundamental questions are candidly discussed and debated by all stakeholders, including the regulators:
- After the enactment of 2013 Companies Act and SEBI LODR 2015, is there a systematic attempt by the lawmakers and various regulators at passing on “pure managerial responsibilities” on to the Audit Committees? With securing the integrity of financial statements as their primary responsibility, does it not violate the cardinal principle of corporate governance of separation of roles of the Board (which is more of oversight and supervision) and the management team, which is falling more in the domain of day-to-day management of the company by the CEO/CFO?
- Examining and approving quarterly, half-yearly and annual financial statements as well as RPTs, ensuring due compliance of insider trading regulations, valuations in M&A transactions and examining various whistle blower complaints, etc., are onerous responsibilities that have been entrusted on the Audit Committees under the Companies Act, SEBI LODR, ICDR, SAST, & PIT Regulations. Shouldn’t this “regulatory overload” on the Audit Committees be appropriately rationalised?
- Who bears the ultimate responsibility of ensuring the integrity, compliance with applicable accounting standards and depiction of a company’s “true and fair value” in the financial statements? This responsibility is routinely passed amongst the Management team, the Audit Committee, the Statutory Auditor, and the Board of Directors.
- Given the tough stand taken by the National Financial Reporting Authority (“NFRA”) towards the audit community, it is not unfathomable why they try to obtain proper management representations on all important accounting and internal control issues that they are called upon to certify. How much time does the Audit Committee devote to ensure that such representations are adequately scrutinised and backed by appropriate documentation/realistic estimates and assumptions?
- How important it is for the Chairman of the Audit Committee/ few members of the Audit Committee to develop a personal rapport with the Chief Internal Auditor and Statutory Auditor? Should they be spending quality time with them outside of the Audit Committee meetings?
- Is it reasonable to assume that every Audit Committee member has the time and a sound domain knowledge of all applicable Accounting Standards, including that of complex business models connected to the global operations of most listed companies, to recommend the Financial Statements to the Board for approval and adoption? Do the deliberations at the Audit Committee meetings give them adequate satisfaction and comfort to confirm to the shareholders that the company has the necessary internal financial control systems and processes, which are working effectively to prevent any fraud, etc., and that the financial statements reflect “a true and fair view” of the financial health of the company? Is there a need for more training of Audit Committee members?
- The moot question which needs to be addressed is why isn’t the appointment of “lead independent director” not made mandatory in India yet? Such directors, with an office and adequate secretarial support, will have the ability to ask questions and seek clarifications from the senior management. This practice is quite common in more advanced jurisdictions like the UK and the US. Does India Inc. fear that it will create a parallel power centre, which could dilute the authority of the CEO or the Chairman? Will the appointment of a lead independent director provide an effective direction to the body of independent directors and would lead to more substantive governance issues discussed at the Audit Committee and Board meetings?
Unless we have a proper debate all the above issues in the appropriate forums, and satisfactorily address these concerns by suitable legal and regulatory amendments, the financial statement approval can at best be termed as a “leap of faith” taken by key stakeholders tasked with maintaining the integrity of the financial statements.
[1] Regulation 4(2)(f): “Knowingly publishing or causing to publish or reporting or causing to report by a person dealing in securities any information relating to securities, including financial results, financial statements, mergers and acquisitions, regulatory approvals, which is not true or which he does not believe to be true prior to or in the course of dealing in securities.”
