THINK TANK

Financing:

The Transparency And Governance Mantra

In recent times, a key remit of governments the world over is to demand higher levels of governance from industry. In India, that finds reflection in multiple forms as our government and regulators seek to ensure fairness and transparency in corporate functioning and financial reporting. The newly constituted National Financial Reporting Authority is a response to hold both auditor and eventually, their customers, to higher levels of scrutiny. Even more recently, SEBI accepted almost in majority the recommendations of the Kotak Committee to enhance the efficiency of corporate governance norms in India’s listed corporations through higher disclosure requirements with an end goal to minimise the information asymmetry between a company’s managers and its shareholders. Both of these, as hallmarks of a proactive regulatory environment that listens to industry and remains resolute in its aim to create greater transparency and accountability, are bold measures to improve the corporate governance environment in India. On its part, India Inc needs to be well prepared to embrace the changes.

The Case for Change

Policy makers have been conscious of the importance of corporate governance and holding business accountable - for a number of years. Several committees such as Kumar Mangalam Birla Committee in 2000, Narayana Murthy Committee in 2003 and Adi Godrej Committee in 2012 have made valuable suggestions that have been largely adopted. However, governance issues have propped-up time and again in some of the most reputed listed Indian companies. An increasingly complex regulatory environment and numerous corporate governance failures across the world have in any event sharpened the focus on good governance. Yet another committee – the Kotak committee – was recently entrusted with the task of enhancing fairness and transparency in the corporate governance landscape in India. This was guided by some underpinning of perception that many public companies were obsessively focused on short-term performance often at the cost of long-term performance – a fact corroborated by a recent McKinsey survey in which nearly half of the C-suite respondents stated that the reason for their organisations’ over-emphasis on short-term financial results as opposed to long-term value creation was the company’s Board. Data reviewed by the committee also suggested that PE-owned companies outperform publicly listed ones, and that directors in PE-owned companies are believed to spend far more time on strategy and risk management and have deeper functional and industry expertise.

In early May 2018, SEBI, after much deliberation, accepted the majority of recommendations of the Kotak committee that aims to align Indian CG practices with global norms while basing it on local business realities unique to India. Just prior to this, the National Financial Reporting Authority (NFRA) was created as an independent regulator for the accountancy and auditing professions.

Ultimately, good governance cannot be legislated. Having the best accounting and auditing standards and service providers are just one part of the equation. The other crucial elements are the ‘ethos’ of the top management and principal shareholders that emphasises substance over form, and long-term value creation that goes beyond numbers to also focus on environmental and sustainability factors. It is however incumbent upon business and CFOs to respond to the expectations of regulators.

Improving Transparency: The Kotak Committee Recommendations

Of the 78 recommendations of the Kotak panel, 40 were accepted without modification, 15 with modifications, and eight were referred to the government and other departments.18 suggestions were rejected, including those on sharing information with promoters and significant shareholders, an increase in the number of independent directors on board, minimum compensation to independent directors and matrix reporting. Of the rejected ones, two notable recommendations – on information sharing and matrix reporting – could have been path-breaking, if notified. Specifically, the committee recommended that a promoter (including promoter of a promoter) or significant shareholder may access material information by way of signing an agreement with the company. Arguably, this could have extended the scope of confidentiality to others instead of causing information asymmetry as claimed by the regulator. Some experts suggest that this could have legitimised an existing practice, but SEBI did not approve of it. The other recommendation by the committee on the matrix reporting structure was to require a confirmation that the Board of the listed Company is responsible for the business and overall affairs and that the reporting structures, formal and informal are consistent with such an assertion. This would have required Boards, particularly of multinational companies to review their reporting and control mechanisms and ensure that supervision is exercised through the Board of the listed company.

Some of the key amendments made by SEBI relate to the Board of Directors, executive compensation, subsidiaries, related parties, financial reporting and auditors.

Board of directors

Separation of CEO/MD and Chairperson
The amendment suggests that the Chairman should be non-executive and not be related to the CEO/MD. Globally, separation of management and the Board is recognised as a good practice. Culturally, it will be challenging to make this transition in India and therefore, this rule will be initially made applicable to the top 500 listed entities (by market capitalisation) with a deadline of April 1, 2020.

Disclosure of expertise/skills of Directors
The Board of every listed entity is required to list the competencies and expertise – in the annual report – that it believes its directors should possess to guide the company. Typically, Boards are heavy on financial, legal and marketing competence while IT and HR skills are not well represented. Going forward, Boards will be required to prepare a detailed ‘skills matrix’ that provides insights into the areas of strengths and importantly, the skill gaps of their directors, and link them potentially, to the needs of the organisation.

Eligibility criteria for Independent Directors
The Kotak committee recognises the critical role of independent directors in a good governance framework; and that one of the most important elements of such a role is their ‘independence’. An added criteria for IDs is therefore, that they cannot be a member of the promoter group of the listed entity. In that regard, IDs need to annually certify their independence in the context of regulations as well as any situation that may arise to question their independence. Additionally, an ID should not be appointed resulting in a ‘board inter-lock’ – a situation where a non-independent director of Company A is appointed as an independent director in Company B and a non-independent director of Company B is appointed as an independent director in Company A. With the recent incidents of fraud and purported regulatory violations, the expectations from IDs have heightened in terms of having oversight on vast aspects including strategy, financial reporting, governance, risk management, and compliance, among others. Clearly then, the role of IDs is much riskier than ever as evident in the compliance penalties, legal costs, personal liabilities and reputational impact.

Board to recommend shareholders for any resolution placed before them
So far in India, Boards were not required to take any stand on a resolution put before shareholders. However, this practice was tested in the high-profile case of Raymond where the company proposed to sell one of its prime properties to related parties at a price lower than market price and the resolution was put up for approval of shareholders. The resolution was severely criticised by proxy advisory firms and the Board did not indicate clearly its position on the resolution. SEBI has recommended two changes. First, the Board must clearly indicate its recommendation for resolutions placed before shareholders. Second, the new rule prescribes changes to the ‘majority of minority’ rule by allowing related parties to cast a vote against a proposed resolution, as such voting cannot be considered to be in conflict of interest.

Other changes
The committee recommends reducing the maximum number of directorship to seven by 2020. To further improve gender diversity on corporate boards, the committee recommends that every listed entity have at least one independent woman director on its board of directors. Additionally, a disclosure of the Board’s evaluation is recommended to be made including the previous year’s observations and actions taken. Lastly, on the resignation of IDs, the new rules suggest that a copy of resignation along with reasons need to be submitted to the stock exchanges.

Executive Compensation

The committee noted various cases of disproportionate compensation paid to executive promoter directors.) In response, the Kotak committee has recommended that the fees or compensation payable to executive directors, who are promoters or members of the promoter group in excess of Rs 5 crores or 2.5% of net profit, shall be subject to the approval of shareholders by a special resolution in a general meeting. Similarly, if the compensation of any single non-executive director exceeds 50% of the total pool distributed to non-executive directors, shareholder approval is mandatory. The committee recognises the independence of the Nomination and Remuneration Committee (NRC) as a crucial factor for effective governance. Therefore, the committee recommends having at least two-thirds of its members as IDs.

Subsidiaries

Many Indian listed companies operate through a subsidiary structure to optimise business operations. In many instances, these unlisted subsidiaries lack an appropriate level of audit review and oversight mechanism as that of the parent company. The Kotak committee has emphasised improving governance standards of subsidiaries through enhanced monitoring by a dedicated group governance unit; review of utilisation of loans, advances and investment in the subsidiaries exceeding prescribed limits; notifying Board on any significant transaction (that exceeds ten percent of total revenue or total expenses or total assets or total liabilities).

The committee has revised the definition of ‘material subsidiary’ as the one whose income or net worth exceeds ten (twenty earlier) percent of the consolidated income or net worth of the listed entity. At least one ID on the Board of Directors of a listed entity is required to be a director on the Board of an unlisted material subsidiary (once again raising the risk profile of the role of ID). Lastly, the Group auditor has been made responsible for the review of audit opinion of material unlisted subsidiaries. Going forward, this could lead to greater migration of audit work to the principal auditor and alignment with global auditing practices. Globally, jurisdictions that follow International Standards on Auditing (ISA) are governed by the requirements of ISA 600, which makes the group auditor alone responsible for the audit opinion on group financial statements.

Related Parties

The definition of a related party has been revised to include any person or entity belonging to the promoter or promoter group of the listed entity and holding more than 20% or more of shareholding in the listed company. In terms of the disclosure of related party transactions (RPTs), the amendment mandates listed entities to disclose RPTs on a half-yearly consolidated basis. A transaction with a related party shall be considered ‘material’ if it exceeds 10% of the annual turnover of the listed entity. The committee also recommends reviewing the materiality policy every three years, and that payments made by listed entities with respect to brands usage/royalty amounting to more than 5% of the consolidated turnover of the listed entity require prior approval from the shareholders on a ‘majority of minority’ basis. SEBI has accepted this proposal but with a reduced limit of 2% of consolidated turnover.

Financial Reporting

From the first quarter of 2019, it will be mandatory to report consolidated quarterly financial results of Group along with half yearly cash flow. The committee has clarified that standalone results shall continue to be published. Clearly, the burden of compliance will rise further. Companies are now required to highlight the ‘aggregate’ effect of material adjustments made in the results of last quarter pertaining to earlier periods.

Auditors

To improve transparency, the total fee paid to auditors and their network entities must be disclosed by the listed entity in its annual report; and if there is any material change in the fees paid to a new auditor as compared to the current audit fee, the rationale for the same must be provided. To strengthen disclosures, companies are mandatorily required to ‘quantify’ audit qualification. The onus of quantification is on the management (not auditors) by clearly providing an explanation on arriving at the estimates.

To ensure that the shareholders are able to make informed decisions on the appointment of auditors of listed entities, the committee is of the view that the company should disclose the credentials and terms of appointment of the auditors to be appointed. The committee has included auditor resignation as part of the material events to be reported to the stock exchange within 24 hours of the receipt of resignation. Now, companies are mandatorily required to submit a disclosure, highlighting the reasons for the resignation of its audit firm.

Creating an Independent Audit Regulator: The NFRA

Every corporate scandal is followed by a wave of regulatory changes in corporate law and in the creation of independent auditors or regulators. Globally, this is evident in other jurisdictions, including the United States and the UK, which have, in the wake of accounting scams, moved away from self-regulation to create independent audit regulators. In the US, the Public Company Accounting Oversight Board (PCAOB) handles the task, while in the UK, it rests with the Financial Reporting Council (FRC). Today, the International Forum of Independent Audit Regulators (IFIAR) has 52 independent audit regulators. India has been toying with the idea of an independent regulator for several years ever since India’s biggest corporate fraud and governance failure unearthed at Satyam. However, the recent PNB banking scandal forced the government’s hand in approving the creation of the NFRA.

Envisaged as an ‘oversight’ body, the NFRA is responsible for setting auditing standards, monitoring auditing quality and investigating professional and other misconduct that may have been committed by CA members or firms. In this regard, its jurisdiction, under Section 132 of the Act, will extend to listed and large unlisted public companies. All auditors will be required to get themselves registered with the NFRA without which they will not be allowed to audit publicly listed companies. This means NFRA will get to assess, among other things, the quality control systems, documentation processes, and training mechanisms at the auditors’ end. The draft rules recommend that the NFRA be a 13-member committee, with 9 part-time members that should include three ex-officio members of the ICAI, the Chairman of the Accounting Standards Board, and the Chairman of the Auditing Standards Board. The full-time members and Chairperson cannot be associated with any audit firm during their tenure, and for two years after demitting office. However, with the majority of the NFRA members from the bureaucracy, experts from the audit and accountancy community share concerns on the quality of oversight that the body would be able to provide.

The NFRA is meant to complement the role of the ICAI, and its mandate will be wide, extending to both listed and large unlisted public companies. According to the new guidelines, ICAI’s regulatory remit will remain intact and will be limited to small companies, but the NFRA’s presence will have an ‘over-ride effect’. The biggest impact, however, will be seen on ICAI’s QRB (Quality Review Board). While the NFRA could draw on all this expertise, clear guidelines will be required to ensure a healthy collaboration. More seriously, under the new rules, the QRB’s scope has been limited to conducting audit reviews of private limited companies, public unlisted companies, and certain sub-classes of listed companies that the NFRA may delegate to it. The Central government will also refer to the NFRA when an entity needs to be investigated on grounds of ‘public interest’. However, there could be potential disruptions arising from regulatory overlap. This is because other regulators will have concurrent jurisdiction on issues related to listed companies: SEBI on matters of investor protection, and the RoC (Registrar of Companies) and SFIO (Serious Fraud Investigation Office) when it comes to fraud investigations. The law clearly states that once the NFRA begins an investigation, all other ongoing investigations must cease.

Q&A

On the future of audit business:
The recent collapse of Carillion, the biggest construction company in the UK, has initiated a global debate on splitting the Big Four into smaller multi-disciplinary firms or making them spin-off their consulting work to create audit-only businesses. Regulators the world over are increasingly pushing to solve ‘conflict of interest’ and ‘expectation gaps’ embedded in the industry. There is a perception that auditors’ independence is compromised in an effort to cross-sell non-audit services. Auditors believe that breaking their firms may not be the best remedy; instead, conflict of interest can be managed by capping the revenue that an audit firm can earn from non-audit services and also the oversight that audit committees provide in approving non-audit services from auditors Further, the gap between the role of an auditor, as perceived by the auditor, and the expectations of the users of financial statements is constantly increasing. Auditors usually follow a ‘sampling’ approach to review their work which may not be effective in detecting or preventing fraud. Going forward, there may be a new auditing standards that could mandate auditors to adopt an ‘investigative’ approach which responds to the risk of fraud.

On any violation of law by MNC auditing firms:
The Supreme Court has directed the Centre to constitute a Committee to look into the functioning of multi-national auditing firms (MAFs) in India. It is alleged that some MAFs had indulged in infusing foreign money in violation of the FDI norms, engaging in illegal accounting insurance policies and acquiring another auditing firm irregularly. Additionally, it is claimed that MAFs comply with policies and governance frameworks ‘in form and not in substance’, by registering partnership firms with Indian partners, even though the foreign companies remained the real beneficiaries of the business of chartered accountancy. The Indian members of international audit firms, on their part, are being vocal about their position in the global network of firms and the level of independence they have in matters such as selecting their clients and other operational and strategic matters. Audit firms expect new regulations, but want the government to look into making amendments to existing laws to make them relevant to the current scenario.

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The contents of this paper are based on discussions of The India CFO Forum in Delhi and Bangalore with Sudhir Soni, National Director and Partner, Assurance Services, SR Batliboi & Co LLP in June 2018. The views expressed may not be those of IMA India. Please visit www.ima-india.com to view current papers and our full archive of content in the IMA members’ Knowledge Centre. IMA Forum members have personalised website access codes.