Financial Statements for Good Governance

A Model for Audit Committee Excellence and Financial Transparency

Introduction

Audit Committees of the corporate board are expected to review financial statements, question auditors and finance staff on oversight governance issues, and advise the board. Most charters of the Audit Committee require independent directors to have expertise in financial oversight, but often, some directors lack this specific expertise, leading to insufficient scrutiny of significant financial issues. Oftentimes, committees may become overwhelmed by the enormity of accounting and financial information or focus on minor details, potentially missing the wood for the trees. This paper aims to explore the Committee's role towards those charged with corporate governance and to propose a structured model to evaluate multi-dimensional aspects of financial statements. It also offers an indicative criterion to assess the committee's effectiveness.

While Independent Directors are generally well-intentioned in their roles, they may sometimes face significant challenges in detecting financial statement fraud.

Model structure

Let us consider a Model as a broad framework to evaluate the financial statements in a structured manner in the audit committee. The Model is presented as Figure 1.

As depicted in Figure 1, this Model categorizes various aspects of financial statements into four distinct quadrants, each representing different levels of importance and impact on organizational operations and governance. Some issues will be cross-cutting in nature and may not be mutually exclusive.

Model: A structured approach to evaluating financial statements

Quadrant 1: Compliance

Quadrant 1 focuses on compliance issues deemed relatively low in importance and impact. These are process-based elements such as accounting policies, procedures, and regulations, which are regularly reviewed by finance departments, internal auditors, and external auditors with their respective accountabilities. Due to their shared responsibilities, in-depth review by the Audit Committee could be minimal. While disproportionate time should be avoided in these areas, the committee must keep an eye on the unusual aberrations, as a culture of non-compliance has huge costs.

It is not uncommon to find trial balances not tallying, use of different currencies in different schedules, internal inconsistencies, and 'adjusting journal entries' of significance at the year-end. Fundamental accounting concepts surrounding the equation {Assets = Liabilities + Owners' funds} are often manipulated to window dress financial performance. The history of financial statement frauds is replete with compromises on accounting concepts. For example, large-scale acquisitions of lands by the Satyam owner were never intended to provide 'future economic benefits' to the company, a noncompliance with the basic accounting concept. Yet, the independent directors failed to question the accounting treatment of these large, unproductive assets.

Quadrant 2: Audit issues

Quadrant 2 highlights audit-related documents, including external audit opinions, long-form reports, cash flow statements, and notes to the accounts. These documents are crucial for the Audit Committee, as they identify potential audit and risk management issues. Despite their importance, there is a risk that committee members might, unwittingly, focus excessively on these documents, neglecting other significant matters of importance.

Audit usually sparks conversation, but of a different kind in the Board! Their primary focus tends to be on whether the audit opinion is unqualified, qualified, adverse, or disclaimer, with some attention to internal controls and risk management. However, this routine is shifting due to new legal liabilities for independent directors. It is understandable that the Audit Committee members must be extra cautious about the nature of the audit opinion and the basis for such an opinion. They need to scrutinize 'matters of emphasis', questioning external auditors about their inclusion or exclusion in reports.

Governance, risk management, internal controls, and accountability issues also evoke different conversations for NGOs and for-profit organizations. For-profit organizations may window dress their financial statements by creatively manipulating estimates, usually for depreciation, inventory, and provisions; the NGOs generally do not. It is incumbent upon the Audit Committee to question the external auditors on significant estimates and to identify material balances that fall outside acceptable limits and obtain assurances.

A major issue for the audit committee is to check the cash flow statement that indicates financial liquidity. Preparing key questions to focus on broad, macro-level concerns rather than dwell in details may lead to a better understanding of core messages from the auditors. Potential red flags include:

(1.) Subsidiary companies maintain separate accounting systems without consolidation, as seen in Enron and WorldCom.
(2.) Internal audit report highlighting liquidity issues and the inability to meet creditor payments within the benchmark period.
(3.) Audit recommendation without closure criteria and high rates of non-implementation over the past three years.

Quadrant 3: Analytical aspects

Quadrant 3 is dedicated to the analytical evaluation of financial statements and associated data. Although organizations typically furnish detailed data analysis, the Audit Committee should undertake its own analysis to gain deeper insights. This quadrant encourages members to ask probing questions and shift focus from less material issues to those with greater impact. The analysis of budget versus actual figures or capital allocation, for example, can reveal issues of higher significance.

Data analytics reveal deep tracks and trends that enable the Audit Committee to be proactive, analytical and invasive by assessing key areas such as ratios, trends, comparisons, impacts and consequences. Even a minor change may trigger a full debate in case of a major financial impact. Ratios and trends point towards financial health and operational agility of the organization.

Expenditure and balance sheet ratios are often more important than revenue ratios in public sector enterprises and NGOs. Audit Committee is expected to identify and analyze the most relevant ratios such as working capital and liquidity ratios. For example, large amount of Standby Letters of Credit (SBLCs) may indicate liquidity traps.

Budgets are especially important as they reflect the financial expressions of approved projects, programmes and activities of public sector enterprises and NGOs. IPSAS requires comparison of budget figures with actual expenditure. Obviously, the Audit Committee role would extend beyond financial comparison to enquiring into the extent of physical delivery of programs and activities relative to the actual expenditure. This multidimensional analysis-both quantitative (financial expenditure) and qualitative (program delivery)-can reveal areas needing improvement and ensure that financial and operational goals are effectively met.

Often, the financial statements serve as the focal point for detecting fraud; hence, an informed, effective, and structured approach by the audit committee is crucial to protect and enhance shareholder value.

Quadrant 4: Stakeholders

Quadrant 4 offers a broad perspective of the organization from the viewpoint of various stakeholders, including governing body members, creditors, auditors, the media, the public, shareholders, beneficiaries, and regulatory bodies. Key documents such as minutes from previous meetings and agendas for future Annual General Meeting, and capital allocation committees provide insights into stakeholder concerns. The Audit Committee's engagement in these strategic discussions can influence the governance body's decisions, especially regarding high-risk or ethically questionable proposals. This quadrant plays a pivotal role in determining the effectiveness of any Audit Committee.

Corporate bodies report to the shareholders, creditors, regulatory bodies on how their financial and operational affairs are steered, monitored and controlled. Audit Committee plays special governance role in this process. Given the dynamics and fluidity of circumstances, members of the Audit Committee are expected to visualize them and identify the elephants in the room.

Some critical issues include Insider trading, related party transactions, and interests of minority shareholders. Examples of ignoring their implications by Audit Committee could be seen in Spicejet (insider trading), Nykaa (declaration of bonus shares after IPO closure date), Olympus Corp Japan (concealing losses for 10 years), Adidas-Reebok, India (ghost distributors), and HSBC, USA (arms and drugs conduit). Issues of significance for the investors could also be extraneous or social but must be evaluated for its risks and impact. For example, Hindenburg report seriously eroded the shareholders' wealth in Adani group of companies during January 2023 triggering stock market volatility.

Mergers & Acquisition (M&A) pose further challenges especially in valuations as seen in AOL-Time Warner, and Microsoft-Nokia deals. The Audit Committee is also tasked to review whistleblower reports and perquisites of the executives which may raise important governance issues.

Suggested lines of inquiry

After outlining the four quadrants of the model, it is perhaps appropriate to suggest a few indicative lines of inquiry for the audit committee.

Whether it's a listed company, multinational corporation, public sector enterprise, UN organization, or large private limited company, the Audit Committee is expected to exercise due professional care and application of mind to inquire into different components of the financial statements. The lines of inquiry narrated in Figure 2 below (relative to our model) are indicative but would prompt the Audit Committee to probe further.

In the end, the Audit Committee must integrate feedback from all quadrants to generate a comprehensive feedforward report to the governance body. This graded, yet holistic, approach ensures that the Committee's evaluations are thorough and impactful, making Quadrant 4 the critical fulcrum for the Committee to leverage its position.

In summary, while Independent Directors and other board members are generally well-intentioned in their roles, they may sometimes face significant challenges in detecting financial statement fraud. The complexity and lack of transparency in such situations can make identifying fraudulent activities particularly difficult, despite their best efforts. A structured approach to assessing financial statements would lend acceptability, context, and credibility to the audit committees.

Maturity model for the audit committee

The Model explained above is a framework of approach to examining financial statements of the corporate body or NGO on a graded scale. Although the audit committees are usually entrusted with many oversight functions such as internal audit, evaluation, investigation and risk management; it is always desirable to assess at what maturity level it operates in relation to each of these functions.

We may use ballpark gauge of the maturity of the Audit Committee by referring to the quadrants used in the examination of the financial statements. Level 1 of maturity may be associated with Audit Committee using only Quadrant 1 compliance-oriented issues. Level 2 level would indicate that the committee is additionally examining the reports /documents prepared on the financial statements. This level is considered 'reactive' as the Members are expected to manage the information provided by others in the documents under Quadrant 2. The Level 3 of the maturity is a 'Defined' expertise that attributes analysis of financial and nonfinancial information and interaction that is controlled on professional parameters under Quadrant 3 of the Model. Level 4 is considered 'Optimized' as the Audit Committee at this level will be focused on governance issues as contained in Quadrant 4.

The use of four quadrants of the Model to evaluate financial statements would provide the roadmap that may allow an Audit Committee to gradually reach Level 4 maturity.

Conclusion

The audit committee is responsible for planning, monitoring, reviewing, and reporting, particularly concerning the governance oversight of the company. The Indian Companies Act of 2013 imposes civil and/or criminal liability for negligence, failure to exercise due professional care, fraud, or insider trading while serving on the Board of Directors. Fines can range from a minimum of Rs. 25,000 to a maximum of Rs. 100,000, and imprisonment can range from six months to ten years. Directors and Officers' (D&O) liability insurance, while not mandatory in India, is recommended due to the legal risks faced by directors. Often, the financial statements serve as the focal point for detecting fraud; hence, an informed, effective, and structured approach by the audit committee is crucial to protect and enhance shareholder value.

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