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Jayanthi Iyengar

By stipulating that directors who sit on a company's audit committee must come from outside the firm, the US SEC is trying to create a parallel and presumably independent structure on the board, headed by the nominee directors who, in turn, would oversee the functioning of the outside auditors.

THE first serious attempt at breaking the nexus between the auditors and management of a company by erecting a Chinese wall between them has finally begun. The initiative is still at a nascent stage, but the US Securities and Exchange Commission (SEC) seems to have set the ball rolling in a small way in this regard.

An April 1 release from the US securities regulator announced that directors who sit on a company's audit committee must come from outside the company. It also stipulated that the audit committee must be responsible for hiring, paying, supervising and firing outside accountants, who must report directly to the committee and not the company's chief executive or other senior managers.

Further, the SEC ruled that audit committees must also set up procedures for handling complaints by company employees, including anonymous ones, on accounting matters. The new norms are set to come into force from January 15, 2004, and would apply to all annual meetings held after that, and have to be adopted by all listed companies not later than October 31, 2004. The sole exception to these norms would be those foreign companies whose board structures are inconsistent with the US standards.

What the SEC is trying to do is to create a parallel and presumably independent structure on the board, headed by the nominee directors who, in turn, would oversee the functioning of the outside auditors. The underlying assumption here is that outside directors are independent and what needs to be broken is only the nexus between the promoter directors and auditors of a company. As Enron has already proved, this assumption is not entirely correct. Yet, the SEC move of at least making the auditors answerable to the part-time directors is a step forward in the right direction, though for true independence, salaries, sitting fees and appointments of outside professionals would have to be ultimately delinked from the management of companies.

As far as India is concerned, many of the steps taken by the SEC thus far have been old hat. Requirements such as the certification of annual report by the Chief Executive Officer (CEO) of a listed company are already enshrined in the Indian corporate law, which is drawn from the English company law. As a matter of fact, soon after the Enron debacle, and the passage of the Sarbanes-Oxley Act of 2002 in the US, the Finance and Company Affairs Minister, Mr Jaswant Singh, wanted to simultaneously tighten the Indian accounting and disclosure norms.

Interestingly, the Department of Company Affairs advising the Minister was unable to suggest anything dramatically new, since most of the provisions contained in the new US legislation already existed in the Indian company law. Finally, the Institute of Chartered Accountants of India came up with norms for members. These norms required practising chartered accountants to separate their accounting and advisory incomes, since many of them, including the Big Five, wear the dual hat of auditors and advisors.

This separation of the dual roles is a desirable move in the right direction, but it still does not address the root cause for most of the accounting scams: the employer-employee relationship between the promoter directors of the company and the auditors and nominee directors. This is possibly the reason that when Prof Jim Heskett of Harvard Business School recently sought reader reactions in HBS Working Knowledge about the probability of another accounting scam, the reader opinion was overwhelming that the chances were now higher than ever before. The responses came after the SEC's clean-up of corporate accounting practices and promulgation of the Sarbanes-Oxley Act in 2002.

If one looks closely at issues, most accounting scams take place because of the nexus between the promoter and the auditor. This nexus exists because the promoter is the employer of the auditor. The law sees the outside directors as the balancing factor in this relationship, but apart from the auditor's remuneration, the sitting fee of nominee directors is also borne by the company. And since companies are legal entities managed by the promoter directors and their representatives on behalf of shareholders, vicious circle becomes complete.

Now expecting persons with such dependence on the management to speak up against its questionable corporate practices amounts to asking too much. Auditors know that management can easily replace them with more "willing" professionals, if they tend to be difficult. Similarly, nominee directors — with the exception of public directors these days, who are the elected representatives of the shareholders — know management can lobby with the powers that be for their ouster if they speak out of turn. The only solution, thus, seems to be to break the link that forges a special bond between the promoters and the outside professionals, which largely stems from remuneration and appointment. Any talk of breaking the link raises the question of how should the appointments and payments to outside directors be handled.

At the moment, the payments come out of a company's kitty. Regulators run scared of breaking this tie, since nobody wants to take on the financial responsibility of paying the outside professionals. Yet, it is possible to earn the outside professionals financial independence from the management of companies, by merely modifying the existing structure. The simplest structure that regulators could put in place is the creation of fund, funded through a cess on companies. The salaries and sitting fee could come out of this fund, automatically severing the direct financial link between the promoters and the outside professionals. To ensure minimal interference by the regulator or the administrator of the fund — nobody wants to replace promoter director's hegemony with the hegemony of bureaucrats — audit and sitting fees could be standardised, linking payments to size and profitability of the company.

Already, this principle is followed in the case of managerial remuneration of whole time directors and there is no reason why it should not be extended to cover outside professionals, whose remuneration would come out of a central kitty, contributed to by companies.

To delink appointments of outside professionals from the management of companies, the regulator could empanel a pool of professionals from which specific appointments could be made.

Empanelling of a kind is presently followed in case of the institutions. For its audit requirements, the RBI empanels auditors who conduct certain audit functions such as the verification of non-performing asset provisioning by the banks and financial institutions (FIs) in their book of accounts. The same principal of empanelling and drawing from the pool could be extended to all audit functions, encompassing financial and manufacturing companies.

It is probable that the strongest opposition to the suggested move would come from auditors themselves. Though some in the professional would welcome the independence that financial delinking from corporate management would endow upon them, the bulk would prefer the continuation of the existing arrangement. This is because the potential for greater leveraging with corporate management comes from discretionary appointments and payments system which is currently in operation. Standardisation of procedures and payments would explode this advantage.

(The author is a freelance writer and can be contacted at

jayanthiiyengar1@yahoo.com)

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