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Effective audit committee can ensure financial reporting quality
June, 21st 2007
With regard to quality of the work done by the auditor and rules relating to his independence, Clause 49 has surprisingly not dealt with this subject matter at all, even though it can have a deeper impact on the quality of financial reporting. MR NAVIN AGRAWAL, DIRECTOR, ERNST & YOUNG INDIA.

The constitution of an audit committee to review and be satisfied with the adequacy of a company's financial reporting process, as mandated by the revised Clause 49, is a significant step in the right direction, according to Mr Navin Agrawal, Director, Ernst & Young India.

However, a few areas of concern remain, he added. These include the quality of the work done by the auditor and rules relating to his independence and the ability of the audit committee to discharge its role in an effective manner, given the "current milieu of rapidly changing accounting literature."

Speaking to Business Line on what the provisions of the revised clause mean to the public and minority shareholders, he said: "The new elements of the revised clause will help bring in a greater sense of accountability on the part of corporate management when it comes to reporting of financial performance."

Earnings management

Stating that it was important to understand the framework of review and governance that exists and controls the quality of financial reporting, he said that companies could succumb to the pressures of earnings management.

"Very often, the quality of the reported numbers will depend on the quality of the auditor and the competence and ability of the audit committee."

Since earnings management, in order to meet investor and market expectations, gets top priority from board members and the CEO/CFO, it results in "potential situations of conflict, since people in a financial reporting or oversight role are under constant pressure to meet targets and expectations."

He added that they stand to benefit directly or otherwise face the flak, based on the reported numbers.

"These factors create an environment where the virtues of true and fair reporting may get eclipsed. But now there are several provisions in the revised Clause 49 that mitigate the risk of fraudulent reporting."

As per the revised clause, which became mandatory for all listed companies with effect from January 1, 2006, board members and senior management (including functional heads) must adopt a code of conduct and confirm compliance every year, in the form of a signed declaration by the CEO in the company's annual report.

The CEO and CFO must certify every year that they have reviewed the financial statements and cash flow statement for the year, and that these statements give a "true and fair view" of the company's affairs and are in compliance with the accounting standards and laws of the land, as applicable.

Mr Agrawal said that they also need to confirm that they have assessed the operating effectiveness of internal controls and processes related to financial reporting and ensured that deficiencies therein have been disclosed to the auditors and the audit committee with proposed remedial steps.

The audit committee must have a majority of independent members and at least one member with expertise in accounting and financial management matters.

"It has to take responsibility for key accounting matters, including application of accounting policies and use of estimates."

Besides, it has to co-ordinate the internal and statutory audit functions and play a key role in recommending the appointment of auditors, their scope of work and remuneration.

"It has to review the financial statements of the company, including quarterly results and auditor's reports, and those of material non-listed subsidiaries," Mr Agrawal said.

The committee must also review all related-party transactions or transactions not in normal course, and any transactions not at arm's length, and report its recommendations to the board.

"Clearly, the audit committee has been entrusted with a lot of responsibility. Further, under the provisions of the Companies Act, its recommendations are binding upon the board of directors. If the board does not accept them, the reasons need to be put on record and communicated to the shareholders."

According to Mr Agrawal, the quality of financial reporting "critically hinges" upon the ability of the audit committee to discharge its role in an effective manner and this is an area of concern.

"In the backdrop of impact of IFRS and global convergence of standards, as well as emergence of new and complex business transactions and quasi-deals, it is a challenge for the members of the audit committee to keep themselves constantly updated."

Mr Agrawal suggested that SEBI, in conjunction with professional bodies such as the ICAI, may consider making it mandatory for the independent director, who is required to possess good knowledge of financial and accounting matters, to comply with accreditation rules so that this role is discharged effectively.

Quality of work

"On the larger concern with regard to quality of the work done by the auditor and rules relating to his independence, Clause 49 has surprisingly not dealt with this subject matter at all, even though it can have a deeper impact on the quality of financial reporting."

He added that the rules relating to independence of auditors in India are less strict compared to US SEC rules.

For instance, although the auditor and fellow partners cannot hold securities in the audited entity, there is no restriction preventing their relatives or other members of the audit team from holding shares in the companies they audit.

"Clause 49 requires disclosures to be made to shareholders in respect of shareholding of non-executive directors, but this rule does not apply in the context of auditors, their relatives and partners."

He also said that the existing law has not considered the possibility of a situation where the auditor's judgment and independence can be considered to have been impaired, since a substantial part of his income is derived from rendering services to a particular client or corporate group.

"We don't have any concept of a `covered person' and there are no restrictions relating to employment of preceding auditors, as are applicable under SEC rules."

Though the ICAI has laid down some rules restricting the fees that an auditor may earn for non-audit work, the guidance on prohibited services under US SEC rules is "far more detailed and stringent," according to him.

"For an emerging economy like India, everything may not be relevant, but SEBI should try to deal with this subject in greater detail."

D. Murali
C. Ramesh

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