ROLE OF THE AUDIT COMMITTEE IN CORPORATE GOVERNANCE

INTRODUCTION
The term ‘corporate governance’ may be defined as ‘the activity of controlling a company’.
However this definition merely distinguishes this term from others and leads to several questions
in respect of the ideal manner in which such an activity must be done, the authority which must
be responsible for doing such an activity and most importantly the objectives behind such an
activity. So, in order to present cogent and coherent views on the role of a particular body in
‘corporate governance’, it is very important to spell out the definition of ‘corporate governance’
which one seeks to base his views on.
Several definitions of this particular term have been given by jurists depending on the objective
which in their opinion must be achieved by the activity of controlling a company. The ultimate
reason for such difference in opinions is that the scope of stakeholders in a company is under
contention- so, while few theorists argue that the working of a company must be so influenced
and directed by legal rules and judicial review so as to take into account the externalities a
company imposes on other stakeholders such as society at large.
Conversely, other set of theorists argues that the aim of any system of controlling the company
must be aimed at increasing the value of the firm’s residual claims which typically rest in a
firm’s common stockholders. Thus the activity of controlling a company must in view of such
theorists be aimed at to use the banal phrase, shareholder-wealth maximization. This argument
may perhaps be best captured in the following phrase:
‘Corporate governance deals with the ways in which the suppliers of finance to corporations
assure themselves of getting a stream of return on their investments’.
For the purposes of succinctness, the researcher has based this paper against the backdrop of the
latter conception of corporate governance. As far as audit committee is concerned, perhaps it is
sufficient to mention at this juncture that it is a committee of board of directors which was
brought into existence through legal provisions and at the risk of over-simplifying it may be said
that it is supposed to play a crucial role in increasing the reliability of financial statements
published by a company.
AUDIT COMMITTEE: THE GENESIS
The members of board of directors of a company i.e. directors exercise the power vested in a
company either directly or through managers appointed by them.
Considering the fact that the scope and quantity of work pertaining to a company is so great that
it may not be done by a bunch of people, it is inevitable that the board will appoint managers
specialized in several areas to share their burden. One among such tasks is the preparation of
financial statements and annual accounts which is a mandatory task. This is an important task
from the perspective of the prospective investors as well because the annual report of the
company is an indicator of the financial health of the company.

Since the annual report represents the financial health of a company, the management of a
company might be tempted to present a rosy picture of the same by modifying the numbers and
thus avoiding incisive questions by the board as to its performance. In view of this possibility
provision for compulsory audit of the annual accounts has been made.
The auditors are, based upon the information which they gather from the company; expected to
ascertain whether the annual accounts of a company present a ‘true and fair view’ of the
company’s financial position or not. However, there have been instances of accounting and audit
failure which led to several brainstorming sessions by the regulators who suggested different
modes of ensuring that such scandals become events of the past. Instances of such failures like
those in the cases of Maxwell, BCCI and Polypeck in the United Kingdom led to the
appointment of Cadbury Committee on Financial Aspects of Corporate Governance. This
committee in a report submitted in 1992 recommended that an audit committee consisting of
three directors be appointed by companies and this committee was to work in accordance with
the terms of reference decided by the board of directors.
The objective of setting an audit committee was as will be illustrated in the later parts of this
paper to provide a ‘channel of communication between auditors and board of directors’ in order
to ensure that any difference in the opinions of the auditors and that of the board of directors
could be addressed in a manner so as to ensure the reliability of financial statements. After this
particular committee’s report there have been several changes suggested by bodies such as Blue
Ribbon Committee sponsored by the New York Stock Exchange (NYSE) and National
Association of Securities Dealers (NASD) which proceeded on the same assumption, that is,
audit committee would improve ‘management’s production of reliable financial statements
through more effective oversight by the board of directors’ and went on to suggest several
changes in the composition of audit committee.
AUDIT COMMITTEE: FUNCTIONS & LIABILITY
This part of the paper deals with the functions of the audit Committee as required by regime in
force in the United States of America and India and the liability of the audit committee. As far as
the United States of America is concerned, the Securities and Exchange Commission (SEC) has
been very serious about introducing rules strengthening the audit committee so as to protect the
interests of the investors in a better manner than before. In December, 1999 the SEC adopted
several new rules based on the recommendations of the report submitted by Blue Ribbon
Committee on Improving the Effectiveness of Corporate Audit Committees. The audit committee
as per these new rules was supposed to
(1) Review and discuss the audited financial statements with the management;
(2) discuss with the independent auditors certain important matters including disagreements with
the management over the application of accounting principles, method used to account for
significant accounting policies for significant unusual transaction etc; and
(3) receive written disclosures from external auditors in respect of the latter’s independence and
submit an audit committee report mentioning whether it had undertaken the functions mentioned above.
The Sarbanes-Oxley Act, 2002 made certain amendments in this regard and included in the list
of the functions of the Audit committee the task of appointment and oversight of the work of an
accounting firm employed by the company for the purposes of preparing an audit report.
However, it is to be noted that these rules are applicable only to companies whose securities are
listed on stock exchanges in USA.
It is pretty apparent on reading the provisions mentioned above that the setting up of an audit
committee entails involvement of the board in the financial reporting process and it is expected
that by doing so the board will be able to exercise some control over management - dissuading
the latter from applying flexible accounting principles to report earnings that meet the
expectations of analysts, shareholders etc. and entering into some sort of implicit understanding
with the auditors in getting the financial statements validated.
Similarly, in the opinion of the researcher the provision in respect of the discussion with the
auditors is aimed at gathering information about the independence of auditors which is very
essential for an objective assessment of the company’s financial statements.
As far as the liability of members of audit committee is concerned, the most important point
which needs to be considered is the duty of care owed by the members of the audit committee. In
this regard it is to be noted that the requirement in respect of the submission of audit committee
obligates the committee to disclose whether it took certain actions like reviewing the company’s
financial statements and discussing with management and outside directors and this duty of care
seems to the researcher to be one demanding very little diligence and the only case wherein the
audit committee may be said to have breached its duty of care is when it makes an incorrect
statement in the report in respect of certain actions which it is expected to take.
As far as the regime in respect of audit committee in India is concerned, the amendment to the
Companies Act, 1956, requires that the audit committee (which must be set up by every
company with a paid-up capital of Rupees 5,00,00,000 or more) (1) should discuss with the
external auditors matters related to the scope of audit, internal control systems; (2) should review
the half- yearly and annual financial statements before submission to the board; and (3) ensure
compliance of internal control systems (a system established by a company which includes
internal audit function to prevent fraud).
Securities and Exchange Board of India, Listing Agreement, cl. 49, by which every company
seeking to list its securities needs to enter into provides that the audit committee in addition to
the above functions is expected to perform some other functions including (1) overseeing the
financial reporting process of the company and disclose its financial information; and (2)
approving the Director’s responsibility statement to be included in the annual report. However
unlike the requirement in the USA; there is no requirement in respect of publication of an audit
committee report.
The duty of care expected of the audit committee members in India appears to be even lower
because in absence of the publication of any report the main functions expected of it viz review
of financial statements may be done in a perfunctory way and since the audit committee isn’t
expected to attest publicly to the soundness of the financial statements. In respect of the duty of
the audit committee to ensure compliance of internal control systems, the committee may seek
information from the management in this regard and in the opinion of the researcher, it is
reasonable to assume that the audit committee owes a duty of care of higher level to the board of
directors.
AUDIT COMMITTEE: COMPOSITION
Based on the recommendations of the Blue Ribbon Committee; the AMEX, NYSE and NASD
adopted regulations requiring that the audit committee is to constitute of at least three members
all of whom should be independent directors and must be financially literate and in addition to
these qualifications; one among the members must have financial management or accounting
expertise. The Sarbanes- Oxley Act,
2002, also provides that all the members of the audit committee must be independent directors
(subject to an exemption granted by the SEC).
On the other hand, the Companies Act, 1956, provides that the audit committee will consist of
not less than three directors and such number of other directors as the Board may determine, of
which two-third of the total number of members will be directors, other than managing or wholetime
directors whereas cl. 49 of the listing agreement provides that two-third of the members of
the audit committee will be independent directors and all members of audit committee will be
financially literate and at least one member shall have accounting or related financial
management expertise.
The emphasis on the independence of the directors who may serve on the audit committee is yet
another reflection of the obsession of the regulators with corporate governance. The stipulations
in respect of the independence of the members of the audit committee seek to ensure that the
monitoring role of the committee is not diluted by any ‘ties between the audit committee and
management’ which may hinder the critical evaluation of the management’s financial reporting
by the committee. In terms of the effectiveness of these provisions which seek to sever ties
between the management and the Audit
Committee, the results of an empirical study indicate that independent directors are more likely
to support the external auditor vis-à-vis the management in case a dispute arises between the two
on issues of inclusion or exclusion of a particular item in the financial statements.
CONCLUSION
In the opinion of the researcher the underlying facets of audit committee which are supposed to
assure the shareholders of the reliability of the financial statements are as follows:
The audit committee is expected to act as a channel of communication between external auditors
and board of directors. This is expected to facilitate the flow of such information to the board of
directors as would enable them to carry out supervision of the management in a better manner.
The provision for setting up of audit committee has in the opinion of the researcher added
another level of scanning of financial statements apart from the external auditors and in the
process given the board of directors an opportunity to wield control over the management and
thereby acting as a sort of assurance to the shareholders that the information they receive in
respect of the finances of the company will not be doctored by shrewd managers who in their
attempt to guise their failures or low levels of successes may inflate earnings. This role of the
audit committee needs to be read with the amendment in the Companies Act, 1956, providing for
the Director's responsibility statement.
However, in view of the fact that the audit committee does not and is not expected to carry out an
‘audit’ of the auditing process undertaken by external auditor (entailing low level of duty of care
owed by them to the company) it will in the opinion of the researcher be more fruitful from the
perspective of ensuring that the financial statements of a company present a true picture of the
financial health of a company to increase the powers and responsibilities of the external auditor
as ultimately it is the auditor who has the competence as well expertise to verify the entries in the
financial statements as also the adherence to other requirements e.g. those in respect of
accounting standards.