Audit Committee - An Overview

(Section 292A of Companies Act, 1956 & Clause 49 of Listing Agreement)

An “Audit Committee” is a key element in the Corporate Governance process of any organization. The emergence of corporate governance, which refers to the establishment of a structural framework or reforming the existing framework to ensure the governing of the company to best serve interests of all stakeholders, is a vital concept which has become indispensable in the present capital market state of affairs so as to safeguard the interest of stakeholders.

In the United States, the New York Stock Exchange has required all listed Companies to have audit committees composed solely of independent directors. In India, the 1992 stock market scams had stunned the investors by shaking their confidence and that paved the way for emergence of Corporate Governance & Audit Committee. Recommendations by various committee’s on the code of corporate governance starting for the Cadbury Committee for Corporate governance constituted in the United Kingdom to the Committee on Corporate governance constituted by the Securities Exchange Board of India under the Chairmanship of Kumar Mangalam Birla have all recommended the setting up of an Audit Committee in companies to safeguard the interest of investors and restore their faith.

The Board of Director’s of a company is responsible and accountable for sound financial reporting. The Audit Committee being a sub-group of the full board is enshrined with the responsibility of monitoring the process supporting responsible financial disclosure to ensure better corporate governance. It is not the role of the audit committee to prepare financial statements or engage in the myriad of decisions relating to the preparation of these statements. The Audit Committee is formed to regularly review processes and procedures to ensure the efficacy of internal control systems so that the accuracy and competence of the reporting of financial results is maintained at high level at all times. It is imperative for the members of Audit Committee to have formal knowledge of accounting and financial management or experience of interpreting financial statements. The Committee’s function is clearly one of supervising and monitoring, and in carrying out this function it relies on the senior financial management of the company and the outside auditors. Thus, the role of the Audit Committee is to perform as a catalyst for effective and transparent financial reporting.

Section 292A of the Companies Act, 1956

Section 292A requires that every public company having paid-up capital of not less than Rs. 5 crore shall constitute an Audit Committee of the Board. The other requirements are given as under:—

1.It will consist of not less than three directors; two thirds of its total strength shall be of director other than managing and whole-time directors.

2.The members of the Audit Committee shall exercise such powers and perform such functions as may be specified by the Board.

3.The members will elect one amongst themselves as chairman.

4.The Auditors of the company, the internal Auditor, if any, and the director in charge of finance will participate in the meetings and shall not have right to vote.

5.The Audit Committee shall have discussions with the Auditor periodically about internal control systems, the scope of audit etc. and review the half-yearly and annual accounts before submission to the Board.

6. The Audit Committee shall have authority to investigate any matter above stated and shall have access to records of the company.

7.The composition of the Audit Committee shall be mentioned in the annual directors' report.

8. The recommendations of the Audit Committee relating to financial management, an audit report shall be binding on the Board.

9.If the Board does not accept the recommendations of the Audit Committee, it shall record the reasons therefor and communicate such reasons to the shareholders.

10.The Chairman of the Committee shall attend the annual general meetings of the company to provide clarification on any matter relating to audit.

Audit Committee under Sub-clause II of Clause 49 of Listing Agreement

II    Audit Committee.

A.  Qualified and Independent Audit Committee

A qualified and independent audit committee shall be set up and shall comply with the following:

(i) The audit committee shall have minimum three directors as members. Two-thirds of the members of audit committee shall be independent directors.

(ii) All members of audit committee shall be financially literate and at least one member shall have accounting or related financial management expertise.

Explanation(i): The term “financially literate” means the ability to read and understand basic financial statements i.e. balance sheet, profit and loss account, and statement of cash flows.

Explanation(ii): A member will be considered to have accounting or related financial management expertise if he or she possesses experience in finance or accounting, or requisite professional certification in accounting, or any other comparable experience or background which results in the individual’s financial sophistication, including being or having been a chief executive officer, chief financial officer, or other senior officer with financial oversight responsibilities.

(iii) The Chairman of the Committee shall be an independent director;

(iv) The Chairman shall be present at Annual General Meeting to answer shareholder queries;

(v)The audit committee should invite such of the executives, as it considers appropriate (and particularly the head of the finance function) to be present at the meetings of the committee, but on occasions it may also meet without the presence of any executives of the company. The finance director, head of internal audit and when required, a representative of the external auditor shall be present as invitees for the meetings of the audit committee;

(vi)The Company Secretary shall act as the secretary to the committee.

(B)Meeting of Audit Committee

The audit committee should meet at least four times in a year and not more than four months shall elapse between two meetings. The quorum shall be either two members or one third of the members of the audit committee whichever is greater, but there should be a minimum of two independent members present.

(C) Powers of Audit Committee

The audit committee shall have powers which should include the following:

1. To investigate any activity within its terms of reference.

2. To seek information from any employee.

3. To obtain outside legal or other professional advice.

4.To secure attendance of outsiders with relevant expertise, if it considers necessary.

(D) Role of Audit Committee

(i)   The role of the audit committee shall include the following:

1.Oversight of the company’s financial reporting process and the disclosure of its financial information to ensure that the financial statement is correct, sufficient and credible.

2.Recommending the appointment and removal of external auditor, fixation of audit fee and also approval for payment for any other services.

3.Reviewing with management the annual financial statements before submission to the board, focusing primarily on;

(a) Any changes in accounting policies and practices.

(b) Major accounting entries based on exercise of judgment by management.

(c) Qualifications in draft audit report.

(d) Significant adjustments arising out of audit.

(e) The going concern assumption.

(f) Compliance with accounting standards.

(g) Compliance with stock exchange and legal requirements concerning financial statements

(h) Any related party transactions

4. Reviewing with the management, external and internal auditors, the adequacy of internal control systems.

5.Reviewing the adequacy of internal audit function, including the structure of the internal audit department, staffing and seniority of the official heading the department, reporting structure coverage and frequency of internal audit.

6. Discussion with internal auditors any significant findings and follow up there on.

7.Reviewing the findings of any internal investigations by the internal auditors into matters where there is suspected fraud or irregularity or a failure of internal control systems of a material nature and reporting the matter to the board.

8. Discussion with external auditors before the audit commences about nature and scope of audit as well as post-audit discussion to ascertain any area of concern.

9. Reviewing the company’s financial and risk management policies.

10.To look into the reasons for substantial defaults in the payment to the depositors, debenture holders, shareholders (in case of non payment of declared dividends) and creditors.

Explanation(i): The term “related party transactions” shall have the same meaning as contained in the Accounting Standard 18, Related Party Transactions, issued by The Institute of Chartered Accountants of India.

Explanation(ii): If the company has set up an audit committee pursuant to provision of the Companies Act, the company agrees that the said audit committee shall have such additional functions / features as is contained in the Listing Agreement.

(E) Review of information by Audit Committee

(i) The Audit Committee shall mandatorily review the following information:

1.Financial statements and draft audit report, including quarterly / half-yearly financial information;

2.Management discussion and analysis of financial condition and results of operations;

3.Reports relating to compliance with laws and to risk management;

4.Management letters / letters of internal control weaknesses issued by statutory / internal auditors; and

5.Records of related party transactions

6.The appointment, removal and terms of remuneration of the Chief internal auditor shall be subject to review by the Audit Committee.

Section 292A of the Companies Act, 1956  Vs. Clause 49 of Listing Agreement A Synopsis

Audit Committee under The Companies Bill, 2011

Clause 177 of The Companies Bill, 2011 will deal with the Audit Committee.

177.

(1) The Board of Directors of every listed company and such other class or classes of companies, as may be prescribed, shall constitute an Audit Committee.

(2) The Audit Committee shall consist of a minimum of three directors with independent directors forming a majority:

Provided that majority of members of Audit Committee including its Chairperson shall be persons with ability to read and understand, the financial statement.

(3) Every Audit Committee of a company existing immediately before the commencement of this Act shall, within one year of such commencement, be reconstituted in accordance with sub-section (2).

(4) Every Audit Committee shall act in accordance with the terms of reference specified in writing by the Board which shall inter alia, include,—

(i)the recommendation for appointment, remuneration and terms of appointment of auditors of the company;

(ii) review and monitor the auditor’s independence and performance, and effectiveness of audit process;

(iii)examination of the financial statement and the auditors’ report thereon;

(iv) approval or any subsequent modification of transactions of the company with related parties;

(v)scrutiny of inter-corporate loans and investments;

(vi) valuation of undertakings or assets of the company, wherever it is necessary;

(vii) evaluation of internal financial controls and risk management systems;

(viii) monitoring the end use of funds raised through public offers and related matters.

(5) The Audit Committee may call for the comments of the auditors about internal control systems, the scope of audit, including the observations of the auditors and review of financial statement before their submission to the Board and may also discuss any related issues with the internal and statutory auditors and the management of the company.

(6) The Audit Committee shall have authority to investigate into any matter in relation to the items specified in sub-section (4) or referred to it by the Board and for this purpose shall have power to obtain professional advice from external sources and have full access to information contained in the records of the company.

(7) The auditors of a company and the key managerial personnel shall have a right to be heard in the meetings of the Audit Committee when it considers the auditor’s report but shall not have the right to vote.

(8)The Board’s report under sub-section (3) of section 134 shall disclose the composition of an Audit Committee and where the Board had not accepted any recommendation of the Audit Committee, the same shall be disclosed in such report along with the reasons therefor.

(9)Every listed company or such class or classes of companies, as may be prescribed, shall establish a vigil mechanism for directors and employees to report genuine concerns in such manner as may be prescribed.

(10) The vigil mechanism under sub-section (9) shall provide for adequate safeguards against victimisation of persons who use such mechanism and make provision for direct access to the chairperson of the Audit Committee in appropriate or exceptional cases: Provided that the details of establishment of such mechanism shall be disclosed by the company on its website, if any, and in the Board’s report.

Important Points:

1) Audit Committee can be constituted both in terms of requirements of section 292A of the Companies Act, 1956 and in terms of requirements of clause 49 of Listing Agreement. Provisions of section 292A, also covers non listed companies and therefore those companies need not comply with requirements of clause 49 of Listing Agreement. When a company falls within the ambit of provisions of both section 292A and clause 49, requirements of both the provisions has to be complied with.

2) Independent Director has not been defined anywhere in the Companies Act, 1956 and as a result section 292A  does not put much stress on the requirement of Independent Directors in the constitution of Audit Committees. It only contains provision regarding presence of Non-Executive Directors, whereas clause 49 of the Listing Agreement compulsorily requires the presence of Independent Directors in the Audit Committee which shall not be less than 2/3 of the members of Audit Committee.

3) Clause 49 of Listing Agreement also provides the definition of Independent Director. The definition of Independent Director has also been given in sub-clause (5) of Clause 149 of The Companies Bill, 2011.

4)The Companies Bill, 2011 contains the provision regarding Audit Committee which is almost (not in entirety) a replica of the provisions of Clause 49 of Listing Agreement.

5)Definition of Independent Director as contained in Clause 49 of the Listing Agreement---

For the purpose of the sub-clause (ii), the expression ‘independent director’ shall mean a non-executive director of the company who:

a. apart from receiving director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its directors, its senior management or its holding company, its subsidiaries and associates which may affect independence of the director;

b. is not related to promoters or persons occupying management positions at the board level or at one level below the board;

c. has not been an executive of the company in the immediately preceding three financial years;

d. is not a partner or an executive or was not partner or an executive during the preceding three years, of any of the following:

i. the statutory audit firm or the internal audit firm that is associated with the company, and

ii. the legal firm(s) and consulting firm(s) that have a material association with the company.

e. is not a material supplier, service provider or customer or a lessor or lessee of the company, which may affect independence of the director;

f. is not a substantial shareholder of the company i.e. owning two percent or more of the block of voting shares.

g. is not less than 21 years of age.

6) As per Sub-clause (5) of Clause 149 of The Companies Bill, 2011 an independent director in relation to a company, means a director other than a managing director or a whole-time director or a nominee director—

(a) who, in the opinion of the Board, is a person of integrity and possesses relevant expertise and experience;

(b)(i) who is or was not a promoter of the company or its holding, subsidiary or associate company;

(ii) who is not related to promoters or directors in the company, its holding, subsidiary or associate company;

(c) who has or had no pecuniary relationship with the company, its holding, subsidiary or associate company, or their promoters, or directors, during the two immediately preceding financial years or during the current financial year;

(d) none of whose relatives has or had pecuniary relationship or transaction with the company, its holding, subsidiary or associate company, or their promoters, or directors, amounting to two per cent. or more of its gross turnover or total income or fifty lakh rupees or such higher amount as may be prescribed, whichever is lower, during the two immediately preceding financial years or during the current financial year;

(e) who, neither himself nor any of his relatives—

(i) holds or has held the position of a key managerial personnel or is or has been employee of the company or its holding, subsidiary or associate company in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed;

(ii) is or has been an employee or proprietor or a partner, in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed, of—

(A) a firm of auditors or company secretaries in practice or cost auditor of the company or its holding, subsidiary or associate company; or

(B) any legal or a consulting firm that has or had any transaction with the company, its holding, subsidiary or associate company amounting to ten per cent. or more of the gross turnover of such firm;

(iii) holds together with his relatives two per cent. or more of the total voting power of the company; or

(iv) is a Chief Executive or director, by whatever name called, of any nonprofit organisation that receives twenty-five per cent. or more of its receipts from the company, any of its promoters, directors or its holding, subsidiary or associate company or that holds two per cent. or more of the total voting power of the company; or

(f) who possesses such other qualifications as may be prescribed.

Regards.

CMA. Sanjay Gupta