The Companies Act, 2006 & Audit Committee
By Bharat Raj Upreti & Narayan Chaulagain
The principle of corporate governance has called for the formation of an audit committee in each company in Nepal - especially in large public companies. Recent experiences reveal that audit committees have emerged as an effective tool to enhance the level of corporate governance in corporations. The audit committee's role in reviewing financial statements to ensure veracity, completeness and fairness are considered instrumental in building and upgrading the investor's confidence in the capital market. That is why many jurisdictions have enshrined rules about audit committees in their respective national legislations; though these rules are not uniform.
Countries differ in the basic approach to audit committees in many ways. The UK has adopted the 'comply or explain approach' on corporate governance. It has introduced soft rules on audit committee requirements, which are contained in the Combined Code. Companies are encouraged but not compelled to form an audit committee. But in practice, the companies generally comply with this requirement, as it will be difficult for them to furnish any satisfactory ground for non-compliance.
In contrast to this is the US system, which has a mandatory provision on the formation of audit committees. The Sarbanes Oxley Act, 2002 under Section 301 requires the mandatory formation of audit committees in listed public companies. It is also common and getting popular in South Asia. For example, formation of an audit committee is mandatory in all the public companies having a paid-up capital of Rs. 50 million or more in India. This provision has been inserted in the Companies Act through an amendment in 2000.
In line with international developments, the Companies Ordinance, 2006 of Nepal required certain companies to have an audit committee on a compulsory basis. This Ordinance has been replaced by the Companies Act, 2006 (henceforth "the Act") which became effective from October 6, 2006. Only listed companies having a paid-up capital of Rs. 30 million or more and the companies partly or fully owned by the government are subject to this statutory obligation. But prior to the promulgation of the Act, the Directive relating to Corporate Governance issued by the Nepal Rastra Bank (Directive no. 6/061/62 B.S/ "the Directive" henceforth) required banks and financial institutions to have an audit committee. The Act generally embraces all the listed companies with the said paid- up capital under its regime to meet the requirement.
In this context, this short paper intends to present an understanding of an audit committee, to explain its role and significance in fostering the corporate governance culture and to discuss the prerequisites for the effectiveness of such committees with regards to the relevant provisions of the Companies Act.
1. Nature and Role of Audit Committee
An audit committee is a committee within the board of directors, generally comprising the non-executive directors of the board. The committee is designed to review the company's annual financial statements before submission to the board of directors. It acts as a liaison between the board of directors and the auditor and between the board of directors and shareholders. An audit committee is often referred to as "proxy of shareholders" because it works as a watchdog of the company's financial position and acts as a facilitator appointing auditors on behalf of the shareholders.
The audit committee "is not and cannot be auditor". It is only a supervising and monitoring body. The ultimate responsibility of the quality and truthfulness of financial statements lies with the Board and the committee is not supposed to be the substitution of the role that needs to be played by the Board. It cannot supersede the board's responsibility in respect to financial and accounting matters. But being a specialised body and rigorously concerned with the review and supervision of the accounting and financial position of the company, the suggestions rendered by the committee are generally binding on the board.
The audit committee has specific responsibilities to fulfil. In the present situation, the role and responsibilities that the committee is expected to perform are ever increasing. Section 165 of the Act lists the functions, powers and duties of the committee, which are more or less similar to the developments and rules adopted in many jurisdictions. Following are the principal roles and responsibilities of the committee:
1.1. Reviewing financial information
The primary responsibility of the audit committee is to review the annual financial statements such as balance sheets, profit and loss accounts and cash flow statements prepared by the management before submitting them to the board. The review includes whether these statements reflect the true and accurate financial position of the company.
1.2. Reviewing the auditor's nomination
The committee is required to prepare lists of people eligible for appointment as auditors. It recommends the appointment, renewal or non-renewal of the auditors along with the terms and conditions of appointment (including his remuneration) to the shareholders in the annual general meeting.
1.3. Organising internal audit departments
Organising the internal audit department is also one of the functions of the committee. The internal audit department is required to work in close contact with the committee and report to it directly. The committee should also be involved in selecting persons responsible for internal audit functions.
1.4. Reviewing the overall scope and results of audit
The audit committee is responsible for reviewing the audit work, its scope and results. The committee is supposed to play an important role in monitoring the external auditor, in particular assessing whether the external auditors cover all key risks. It can seek clarifications from the external auditors. It is up to the committee to see whether the auditor has complied with the set audit standard and the code of conduct.
1.5. Assessing the risk management and internal control system
The committee has to review whether the risk management and control system in the company are in proper place. This involves ensuring that significant risks areas have been identified and appropriate risk management system and internal control system are framed, implemented and enforced. For this, it is expected to maintain liaison with the controllers of various departments.
1.6. Selecting and establishing accounting policies
The committee also has the responsibility of selecting and establishing appropriate accounting policies in the company. Besides this, it is also supposed to develop appropriate auditing polices in line with the prescribed auditing standards for the selection, renewal, and termination of the auditor's service.
In addition to those responsibilities, the Act requires the committee to comply with the directives issued by the concerned regulatory body in preparing the long form audit if the company is required to prepare it. The responsibilities stated in the Act are of minimum standards. The company can broaden the committee's scope of the work by entrusting more responsibilities to it and empowering it with more authority. That is why, the Act states that the committee is to discharge any other duties relating to accounting, financial and auditor matters as prescribed by the board.
2. Significance of Audit Committee
The committee can play an important role in enhancing the veracity and creditability of financial statements. The purpose of constituting the committee is to undertake an objective review of the financial statements by a body independent of management, and improve the quality of financial reporting practices. The committee can significantly contribute to the board in exercising better control over accounts, finance and audit functions.
As discussed above, one of the primary roles of the committee is to recommend to shareholders the appointment, renewal or non-renewal of the auditors. This will certainly facilitate the shareholders in making meaningful choices on the auditor's appointment. Indeed, the committee's role can be overwhelmingly important to transform the shareholder's control over the appointment and remuneration of auditors. In reality, the shareholders' role in the process of appointing auditors is episodic as they meet at annual general meetings and make decisions on the basis of limited information. Furthermore, the majority of shareholders may not even possess general knowledge on accounting and financial matters. The committee is able to give more continuous attention to the audit than the shareholders. It can act as a specialised facilitating body on the shareholders' behalf by giving more rigorous and continuous attention to the accounting and financial matters. The audit committee is responsible for assessing the auditor's performance on the basis of independence, objectivity and competence and such judgement help shareholders make meaningful and informed decisions. This body can also prevent the possibility of an unholy alliance between the management and the auditors.
Likewise, it can act as a watchdog on the performance of executive directors. Principally and practically, the management is responsible for the integrity, objectivity, and any material misstatements in financial statements. The audit committee is not the substitute of this ultimate responsibility of the board. But since the audit committee involves non-executive directors (who are not involved in day-to-day company operations), the performance of the executive directors responsible for daily operations are brought under critical scrutiny. Though the committee is a part of the whole board, it can also be a check against the performances of the executive directors.
The committee's role in reviewing the internal risk management and control systems has a great importance too. It can contribute in developing appropriate systems of internal control and risk management. The periodic and rigorous review and monitoring of the implementation of such systems also helps to prevent accidents.
The committee is also helpful in enhancing the public confidence in the credibility of financial statements. An investor likes to invest in the market only if he is assured of transparency and fairness in the corporations. Financial statements supply the information required to make investment decisions. The monitoring and supervision role of the committee over the accounting and financial matters make the financial statements more credible which in turn, helps to enhance the investors' confidence in the market.
To sum up, the importance of audit committee are too many to mention. To conclude in the words of the Report of the Cadbury Committee, the improvement of the quality of financial reporting, reduction of the opportunities for frauds, creation of a culture of independence for the independent director, support for the finance director, strengthening the independence of the external auditor and ultimately maximising the shareholder's value and improving the market confidence in the investors are all the benefits of having the committee in corporations.
3. Who can be appointed in an audit committee?
The forming of an audit committee should not mean fulfilling a mere statutory formality. An audit committee has a contributory role in improving the culture of corporate governance and achieving high-level performance in the company. To achieve these objectives, the committee should be truly and substantially effective.
The quality and independence of independent directors are the most important factors in the committee's effectiveness. That is why all the international jurisdictions require the presence of a non-executive director in the audit committee. The Act and the Directive issued by the Nepal Rastra Bank also state that the audit committee should be composed of non-executive directors. The Act bars any close relative of the chief executive to be appointed as a committee member. Our law in this respect is one step ahead of its Indian counterpart. The Companies Act of India requires the presence of two thirds of non-executive directors. The rest can be executive or whole time directors.
But, the development in the international arena does not end at this point. The recent development is that the audit committee should be composed entirely of independent directors or at least the majority of directors should be independent. The presence of independent directors is important in avoiding conflicts of interest, which the board may have on audit matters. Since, the committee is also a watchdog against the board's performance, the presence of an independent director is much more emphasised in the present days. The Act Law and the Directives do not, however, make the presence of an independent director mandatory. This is a serious defect of the law.
An audit committee is designed as a specialised committee on the accounts, audit and financial matters of the company. So, it is natural that all the members of the audit committee should possess some financial expertise either through accounting or financial management or experience. In India, no qualification and experience has been prescribed for the committee members. The US law requires that all the committee members should be at least financially literate. But under the Act a person should have a professional certificate of accounts and have working experience or should possess at least a Bachelor's degree in Accounting, Commerce, Management, Finance or Economics.
The Companies Ordinance was stricter in this respect. The Ordinance required all the committee members to possess at least a Bachelor's degree in any of the subjects mentioned above along with some work experience. Practically, a company may not afford to have all committee members (who should also be non-executive directors) who are qualified and well experienced. For example, all the directors of a company in the hospital business may not have the required qualifications and experiences. Realising this practical difficulty, the Act has made modifications to allow for some flexibility. The company as per its needs is free to appoint two other committee members outside of the board. This is in line with the present international trend that all the committee members should be financially literate and they should be allowed to have external professional advice if required.
4. Scope of the Function of the Audit Committee
The committee is not a super board but it should be empowered to make binding recommendations on the matters falling within the scope of its authority. The Act has made a good provision in this respect. According to it, the committee's recommendation is binding to the board and the board should implement them. If the board cannot implement any of its recommendations, it should provide reasons and justifications for such non-implementation and such matters are required to be disclosed in the annual report of directors.
Shareholders should have information on the committee's performance. Under the Act, the annual report of directors should disclose the composition of the audit committee, their remuneration and allowances, the number of audit committee meetings and how it has discharged its responsibilities. The report should also disclose the suggestions made by the committee, steps taken by the board to implement such suggestions and reasons or justifications for non-implementation of the suggestions, if there are any. Such disclosure is vital for shareholders because it helps them assess the audit committee's performance and provide feedback. The law requires the chairperson of the audit committee to be present in the annual general meeting for the purpose of addressing the questions and concerns of the shareholders.
To sum up, for effectiveness, an audit committee must be composed of non-executive directors (independent directors) only; all committee members should be at least financially literate and the committee's suggestions should be binding to the board and the committee should be adequately resourced.
5. Prospect for Further Reforms
The Act requires only certain companies to form audit committees. All other public companies which are not listed (and even listed companies having a paid up capital below Rs. 50 million) and private companies have been exempted from this obligation. To start with, this is good. The benefits of forming the committee should outweigh the cost. The provisions on the audit committee enshrined in the Act are in line with the principle of corporate governance and in some respects such provisions are even superior to the law of other developed jurisdictions. The Act has clearly stipulated the power, functions and duties of the committee and has made provisions to make the committee more independent and effective. The Act has also provided flexibility to the companies. All the three members of the Company need not be from the board and all the members of the committees should not be specialised in accounts or related subjects. This has facilitated companies to appoint experts as committee members.
But there are some defects in the Act worthy of mention. The Act and Nepal Rastra Bank's Directive do not require the presence of independent directors in the audit committee. The presence of non-executive directors and the presence of independent directors is not the same thing. The presence of an independent director in the committee is desirable as they do not have any conflict of interest and are also supposed to represent the minority shareholder's voices. Hence, presence of at least one independent director should be made mandatory under the Act and Directive. The requirement to have at least one independent director will not create any burdens to companies, as all public companies are required to appoint at least one independent director. Companies requiring compliance with this obligation can appoint any person having knowledge of accounting and financial matters with sound experience as independent directors. In the cases of other large public companies, which do not require the formation audit committees, the 'comply or explain' approach developed in the UK can be adopted.
If these improvements are made, audit committees are sure to enhance the level of corporate governance in the country.
(Upreti is involved in the corporate law awareness building program launched by FNCCI-CFG Project supported by Asian Development Bank. The authors can be contacted at pioneer@wlink.com.np)
