A clutch of news reports in financial papers on the international conference held in the capital by the National Financial Reporting Authority (NFRA) on the topic of 'Transparent Financial Reporting and Audit Quality: Pillars of Corporate Governance’ for the past few days made for some useful reflection on the subject. It is quite interesting, and it must be one of its kind, that the regulator is conducting such a conference which is typically done by the business chambers of professional bodies.
The extract on the right side is the view expressed by the NFRA chairperson to questions posed to him by the media. Only a relevant part of the entire interview is placed here for convenience. The reference to the failure of the oversight of the audit committee and of the board of the companies in cases where governance failures struck is certainly well-directed. The emphasis on the audit committee having to better communicate with the auditors on financial reporting issues is quite appropriate to the discussion on the shared responsibility between the auditors and the independent board on proper reporting by corporates.
The reference to audit committee meetings being just a warm-up session before the board meeting is not entirely out of place or an exaggeration!
NFRA, by virtue of having examined various audit firms on their quality of documentation in the context of reported audit failures, is certainly well-equipped to appreciate the reasons for the shared responsibility of the different players in poor financial reporting.
Hence, the reference to the audit committee and the board having to play an involved and constructive role in ensuring better quality reporting is a new strand to the discussion on this subject which, so far, has focused only on the auditors.
Using this as a trigger, the article looks at the subject of the audit committee and its common failings.
The starting point is the way the committee is constituted. Board appointments in the Indian context still suffer from factors of familiarity and favoritism, and lack an independent process in identification and selection.
The law is quite liberal in allowing a person to be a director in seven listed companies. Some favourites make sure they fill all seven slots and, if they also sit on audit committees, one can imagine the extent of time they can commit!
The next important point for consideration by NFRA in the role played by the audit committee is the way auditors are appointed.
It is no secret that most Indian listed entities are dominated by the promoters and their influence in the choice of the auditor is similar to that of the appointment of the independent directors.
The role performed by the audit committee in this regard should be tested with empirical data by taking up cases after 2014 when the law changed on rotation.
The NFRA should peruse the copies of the minutes, and in the period post-Covid, the transcripts of the video calls of these meetings to find out the level of diligence and scrutiny and the extent of the discussion concerning such appointments.
The findings of this exercise for a few select companies may actually equip the NFRA to fully understand the shortcomings in the process and also the level of involvement of the AC (audit committee) in the discussion and the process of shortlisting and selection.
What applies to the choice of the statutory auditor is equally relevant to the choice of the internal audit firm.
The NFRA should recognise the aspect of audit concentration among the few leading firms, as this phenomenon narrows the choice to a limited universe. The other side of the coin is that the small and medium firms lack adequate capacity to service effectively listed entities that require quarterly audits and reviews.
Most large companies have a grand and imposing terms of reference (ToR) for the audit committee and NFRA should assess if, in practice, the audit committees are alive to that and effectively address all areas of the ToR.
For example, the audit committee ToR of Infosys Ltd specifies partner rotation and the relevant portion is extracted below.
It is interesting that in the case of Mahindra and Mahindra, while appointing the auditor in 2018, the notice for appointment specified that a particular partner alone would sign the accounts as he possessed the right credentials.
The said partner, Jamil Khatri, signed till 2022 and thereafter, due to his resignation from the audit firm, another partner took charge!
A cursory look at the historical data shows that seldom is a partner rotated in a five-year block except due to resignation or retirement.
Partner rotation is possible only in the case of the top dozen (a liberal estimate) audit firms in the country. This is out of the question in other firms with limited bandwidth. Many firms may show on paper a long list of partners but most of them would be namesake retired persons with little audit experience!
CA&AG appoints firms based on such criteria but a responsible audit committee should interview at least three partners of a firm that is considered for appointment to ensure that adequate bandwidth exists to service the company.
The audit committee should also check the number of listed companies audited by the concerned partner(s) of the firm to avoid concentration with one partner.
The next aspect is the number of AC meetings held in a year. In most cases, the audit committee meets only in the context of approving the quarterly unaudited financials and for approving the annual report.
One of the US-listed companies has this as part of the audit committee charter-'The Committee holds meetings at least eight times a year. Additional meetings may occur as a majority of the Committee or its chair deems advisable’.
This clearly establishes the seriousness in purpose of the committee to have a very close engagement with the management that prepares the financial statements and the auditor that certifies its accuracy.
The committee should make it possible for the auditors, at least once a year, to provide direct feedback about the quality of personnel and processes involved in the preparation of the accounts and the pressure, if any, applied to them to accommodate a particular accounting treatment or a specific outcome for some transactions. Such a meeting cannot have the presence of any full-time personnel of the company even if otherwise part of the committee.
In the US context, the audit committees obtain a written report from the independent auditor describing: the firm’s internal quality control procedures; any material issues raised by the most recent Public Company Accounting Oversight Board inspection, internal quality control review, or peer review, of the firm or by any inquiry or investigation by governmental or professional authorities within the past five years, concerning an independent audit or audits carried out by the firm, and any steps taken to deal with those issues;
Audit committees tend to skirt such enquiries in the Indian context.
The discussion can go on endlessly. It will be interesting to see what the NFRA sets as an agenda for such meetings with the audit committee members and how the audit committee process improves post its initiative!
(Ranganathan V is a CA and CS. He has over 43 years of experience in the corporate sector and in consultancy. For 17 years, he worked as Director and Partner in Ernst & Young LLP and three years as senior advisor post-retirement handling the task of building the Chennai and Hyderabad practice of E&Y in tax and regulatory space. Currently, he serves as an independent director on the board of four companies.)
