As per Ramaiya’s Guide to Companies Act (17th edition, 2011 page 1933), the concept of audit committee got its first recognition in the United States of America in 1940, when the Securities Exchange Commission recommended the establishment of audit committee in the context of Mckesson and Robbins In Inc., investigation. In the testimony before senate committee, the chairman of Securities Exchange Commission voiced pressing need for raising the level of conduct of the business community and advocated for a truly independent character in board of directors of companies through the institution of audit committee consisting of independent directors
Hence, the concept of audit committee is certainly not new – and the same has been around in India for the last two decades for listed entities. However, the role of the audit committee has seen a gradual evolution and enhancement – and is not linked to just the audit, but a broader spectrum of matters relating to the listed entity’s financial statements. The Companies Act, 2013 as well as the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015, set forth requirements in relation to constitution of audit committee, its constitution, terms of reference, powers and other related matters for listed entities. Similarly, over the last two decades, the role of the audit committee has also substantially enhanced (and its composition and powers reflect its proposed role).
A brief overview of the key role/requirements in this regard is below:
(i) At the outset, the composition of the audit committee (comprising solely of, or a majority of independent directors and the chairperson being an independent director, with all members required to be “financially literate” and at least one member to have “accounting or related financial management expertise”) provides a clear overview of the role that the members of the audit committee are expected to perform.
(ii) The audit committee has also been given relevant powers to perform its role. The audit committee, at its discretion, can invite the head of the finance function, head of internal audit and representative of the statutory auditors, and has the power to investigate any activity within its terms of reference, seek information from any employee, obtain outside legal or other professional advice and secure attendance of outsiders with relevant expertise, if it considers necessary. The format of compliance certificate to be provided by the chief executive officer and chief financial officer also requires confirmation on requisite disclosures being made to the audit committee. Additionally, where the board has not accepted any recommendation of the audit committee which is mandatorily required, the same is required to be disclosed along with reasons thereof.
(iii) The above powers are accompanied by substantial responsibilities on the audit committee – while their role is detailed in the succeeding paragraphs, the audit committee is required to mandatorily review certain information such as:
· In relation to internal control weaknesses, internal audit reports and management letters/letters of internal control weaknesses issued by statutory auditors;
· Appointment, removal and terms of remuneration of chief internal auditor;
· Statement of significant related party transactions; and
· Management discussions and analysis of financial condition and results of operations.
Given the expansive role of the audit committee, these are a subset of the information and documents that the audit committee would need to review to discharge its functions effectively. Additionally, the audit committee is required to meet at least four times a year, and its quorum requires at least two independent directors. The chairperson of the audit committee is required to be present at the annual general meeting to answer shareholder queries.
(iv) The role of the audit committee includes the following key areas:
· Oversight of financial reporting process and disclosure of financial information;
· Approval of appointment of the chief financial officer after due assessment;
· Reviewing appointment of statutory auditors and their terms of appointment, including payment for non-audit services, performance and independence of auditors and effective of audit process;
· Reviewing performance of statutory auditors, and adequacy of internal control systems;
· Discussions and follow up on significant findings of internal auditors, and internal investigations by internal auditors in case of suspected fraud, irregularity or failure of internal control systems;
· Reviewing annual and quarterly financial statements before submission to the board (with focus on certain key areas in case of annual financial statements). Pre-audit discussions on scope of audit, and post audit discussions on any areas of concern;
· Reviewing use of funds raised through capital raising;
· Approval of related party transactions;
· Scrutiny of inter-corporate loans and investments;
· Evaluation of internal financial control and risk management systems;
· Reviewing the functioning of the whistle-blower mechanism. Additionally, the vigil mechanism (whistle-blower policy) is required to provide for direct access to the chairperson of the audit committee in appropriate or exceptional cases; and
· Looking into reasons for substantial payment defaults (whether to depositors, debenture holders, creditors or shareholders (in case of non-payment of declared dividends).
(v) In addition to the matters above, the audit committee (in the course of its role) has other areas of focus as well – as an example, the audit committee has the following key matters to consider vis-à-vis subsidiaries:
· Periodic review of financial statements of subsidiaries, audit/limited review reports if any thereon;
· Approval (and noting) of related party transactions (as already covered above);
· Reviewing utilisation of loans and/or advances from/investment by the listed entity in a subsidiary exceeding specified thresholds;
· Focus on other transactions (such as investments by unlisted subsidiaries, and obtaining a confirmation from material subsidiaries in relation to disposal of assets exceeding a specified threshold); and
· Gain visibility on total fees paid by the listed entity’s statutory auditors to statutory auditors of the listed entity and all entities in the network firm/network entity to which the statutory auditor of the listed entity is a part.
The role of the audit committee becomes more complex and nuanced if there are a large number of subsidiaries, material subsidiaries or overseas subsidiaries. In this regard, reference is drawn to SEBI Circular dated March 29, 2019 – which sets out detailed requirements relating to group audit. While these relate to responsibilities of the auditors and the management, the role and functions of the audit committee (given their role outlined above) also become relevant – the extent of relevance and involvement of the audit committee is necessarily a case-specific analysis.
(vi) The above is not an exhaustive enumeration of the role of the audit committee in listed entities. For instance, for schemes of arrangement involving listed entities, audit committee is required to submit a report recommending the same (which is required to be submitted to stock exchanges), after considering inter alia the valuation report received. The audit committee also has a crucial role to play in case of resignation of auditors, in terms of SEBI circular dated October 18, 2019. Additionally, the Companies (Auditors Report) Order, 2020 has also substantially enhanced disclosure requirements (on assets, borrowings, investments and other matters) as well as qualitative judgments (covering business operations/financial statements, compliance with laws and judgment on ability to meet debts/financial obligations) from auditors. These will also involve the audit committee’s role, both in terms of review of the financial statements and of the audit itself.
To conclude, as financial reporting requirements continue being strengthened and enhanced, the role of all the stakeholders in the financial reporting process also undergoes a change – and the role of the audit committee, with its powers, role and responsibilities, is an increasingly important and critical part of this process.
Prerak Ved, Partner
Siddhartha Das, Associate