Managing complexities in corporate governance

Tata Sons is a private limited company that controls Tata Group companies. This is a 148 years old $100 billion conglomerate with large number of private limited companies and 29 listed companies. In some large listed Group companies the promoter (Tata Sons and others) holds less than 50 per cent voting rights (e.g. Tata Motors 32.45% and Tata Steel 31.55%). Sir Dorabji Tata Trust and Sir Ratan Tata Trust along with some other Tata Trusts hold 66% stake in Tata Sons. Mistry's family, the Shapoorji and Pallonji Group, owns 18.5% stake in the company. Sir Dorabji Tata Trust and Sir Ratan Tata Trust have powers to appoint or remove a chairman of Tata Sons with their own three-member quorum of the selection panel. Ratan Tata chairs those two trusts.

Abrupt removal of Cyrus Mistry from the position of the chairman of Tata Sons, on October 24, 2016, was an unusual event. In India or elsewhere the board of directors (hereafter board) seldom sacks the CEO so abruptly. Ratan Tata, who is the patriarch of the family that founded the Tata group, has come back as interim chairman. Earlier he served as chairman for two decades. Tata Sons saga is not about clash for power. It is not about ego clash between two individuals. It is about managing complexities in corporate governance.

Tata group has 4.1 million shareholders. Shareholders and other stakeholders have a right to know why Mr. Mistry is removed. Unfortunately, Tata Sons has not communicated clearly the reasons for his removal. Good corporate governance requires high level of transparency. Shareholders and stakeholders have a right to get adequate information on important decisions and group’s operating policy. Maintaining right level of transparency is a challenge in corporate governance. It is often difficult to assess how much to disclose publicly so that the group/company is not hurt while shareholders and stakeholders receive adequate information.

From the narratives in media it appears that Mr. Mistry was handling things differently from the way things were handled by Mr. Tata. This difference in approach frustrated Mr. Tata and it has lead to the removal of Mr. Mistry. A CEO who cannot get along with the controlling shareholder cannot survive. Therefore, true professionalization of a family business is difficult unless the family takes a hands-off approach and gives ‘free hand’ to the CEO. It is not easy. Succession planning, in general, is a challenge in a family business. For smooth transition, the family governance should be good and a successor from within the family should be identified early and he should be groomed over years. The problem magnifies if none within the family is available to take up the baton. It is difficult to get an outsider who will be in tune with values, ethos and business approach of the family. Mr. Mistry is not exactly an outsider. He is related to the Tata family through marriage and his family has significant shareholding in Tata Sons. He is a director in Tata Sons since 2006 and was groomed for a year, yet Mr. Tata developed the conviction that Mr. Mistry was not in tune with the values, ethos and business approach of the Tata group.  

With hindsight some strategic choices made by the Tata group appears to be wrong. It might be that some of those choices were driven by Mr. Tata’s aspirations and passion, rather than by sound economic rationale. It is not uncommon that in a company where there is concentration of shareholding, corporate strategy and business strategies are driven by the personal aspiration of the controlling shareholder. Quite often, after long deliberations, the board rationalises the strategic choices of the controlling shareholder. This hurts the interest of non-controlling shareholders, particularly if the controlling shareholder focuses on empire building rather than on value creation.

On November 4, 2016 all the seven independent directors of India Hotels Company Limited (IHCL), in which the promoter holds 38.65 per cent shares, reposed full confidence in the leadership of Mr. Mistry. They praised the steps taken by him in providing strategic direction and leadership to the company. They communicated their views to the Bombay Stock Exchange (BSE). If, boards of other companies, in which the Tata Sons holds less than 50 per cent voting rights, act similarly, the relationship between those operating companies and Tata Sons shall be redefined. It is difficult to assess whether this will benefit or hurt the non-controlling shareholders of operating companies.

As the events will unfold in coming days, we shall develop better understanding of how the group will operate in future.

Rotation of auditors - its side effects

The Companies Act 2013 has introduced important audit reforms. One of the important reforms is rotation of the auditor. All listed companies, unlisted public limited companies having paid up share capital of Rs ten crore or more, all private limited companies having paid up share capital of Rs twenty crore or more, and all companies having public borrowings from financial institutions, banks or public deposit of Rs fifty crore or more are required to rotate their auditor. An individual cannot continue as an auditor for more than one term of consecutive five years and an audit firm cannot continue as an auditor for more than two terms of consecutive five years, that is a consecutive period of ten years. The cooling off period is five years. The Companies Act allows three-year time for complying with the provision. Therefore, the provision must be complied by April 1, 2017. The objective is to enhance the audit independence. This is expected to improve audit quality resulting in improved financial reporting.

Traditionally companies do not change their auditors except in exceptional circumstances. In Large number of companies that are required to rotate the auditor, auditors have already completed more than ten years/five years of providing auditing service. Those companies will change their auditor effective from 2017-18.

Local firms dominate Indian audit market. However, the presence of Big 4 audit firms (Deloitte, PWC, E&Y and KPMG) cannot be ignored. Big 4 are the largest professional service network in the world. They provide audit, assurance, tax, consulting, advisory, actuarial, corporate finance and advisory services. In India, they cannot provide audit services directly. Therefore, they provide services through network of local firms. It is alleged that they flout the rules in order to provide audit and assurance services. Many foreign investors put a condition that the auditor of their choice should be appointed. This helps the Big 4 audit firms to grow in India.

Local firms audit 62 per cent of the BSE five hundred companies. There is an apprehension that many companies that get their accounts audited by local firms will appoint one of the Big 4 or other large international professional service network (e.g. BDO, RSM, Grant Thornton and Baker Tilly) as their auditors. If that happens, the local firms will lose out. It is reported that large 20 local firms have written to the government to intervene to protect their interest. On September 30, 2016, the Ministry of Corporate Affairs has notified constitution of a three member expert group to look into the complaint that Big 4 are circumventing rules and to find ways to help local firms.

Most local firms are small and they do not face any threat from Big 4 and other international firms. They are mostly located in tier II and III cities and small towns. They provide variety of services to small companies. They lack aspiration to become big.  Big 4 and other international firms engage members of the Institute of Chartered Accountants of India (ICAI) to deliver audit and assurance services. In this context, presence of Big 4 firms does not hurt the auditing profession. Therefore, it is debatable whether there is a case for government’s intervention to protect local audit firms.

A proposal is taking round that the government should mandate joint audit with at least one local auditor to create professional opportunities for local firms. This is unwarranted. This will increase the auditing expenses. The audit committee of a company should assess the need for the joint audit and the company should decide whether it should have joint audit. No rule should be framed to create jobs for a profession, particularly for one that is matured.

Chartered Accountants are prohibited from soliciting professional work through advertisement or otherwise. But they can respond to tenders. The practice of issuing tender for the appointment of internal auditors is quite common among public enterprises. Such a practice is not common among private-sector companies. Companies usually do not issue tender for the appointment of statutory auditors. Tendering is the right method to search for the right audit firm. This increases the choice and reduces auditing cost through competition. Companies should not limit their choice to Big 4 and other international firms or a few large local audit firms. There are local firms that have capabilities to audit large and complex transactions. Search through tendering process would help to identify such firms.

It will be interesting to see how the new rules regarding rotation of auditors will actually impact the auditing profession.

Boards must adopt integrated reporting framework

BOARDS MUST ADOPT INTEGRATED REPORTING FRAMEWORK

International Integrated Reporting Council (IIRC) had issued the Integrated Reporting Framework in December 2013. Integrated report communicates the complete story of value creation concisely to enable investors and other stakeholders to assess the ability of the company to create value over long term. It tells how an organization's strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term. Enlightened-companies use the term ‘value’ in much broader sense than what is understood by the term ‘shareholder value’. Shareholder value is created when the company is able to generate return on financial capital that is higher than the cost of capital over a long period of time. Enlightened-companies realise that the ability to create shareholder value hinges on the ability to create societal value. This perception is captured in the Companies Act 2013, which states: “A director of a company shall act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment.”

Integrated Reporting Framework identifies six types of capital (resources) that companies use to create value. Those capitals are, financial capital, manufactured capital, intellectual capital, human capital, social and relationship capital and natural capital. Those include capitals that are not owned or controlled by the company. For example, manufactured capital includes roads and other infrastructures not owned or controlled by the company. None owns some items of natural capital (e.g., clean air). Companies through its activities and outputs create, reduce and transform capitals. A business model is sustainable only if it results in accretion to the net value, taking all the capitals together. Therefore, the management and the board of directors (here after, Board) need to understand the interdependencies and tradeoffs between various capitals and how their availability in future would affect the long-term sustainability of the business model.

One of the guiding principles in the Integrated Reporting Framework is ‘connectivity of information’. Connectivity of information is logical. It is about connectivity between: external environment; governance, opportunities and risk, strategy and resource allocation, business model, performance, and, future outlook; past, present and future; the capitals; financial and other information; qualitative and quantitative information; management information, Board information and information reported externally; and information in the integrated report, information in company’s other communications and information from other sources.

Connectivity of information can be achieved only through ‘integrated thinking’. Integrated thinking refers to holistic approach in decision-making. The Integrated Reporting Framework describes integrated thinking as, “The active consideration by an organization of the relationships between its various operating and functional units and the capitals that the organization uses or affects. Integrated thinking leads to integrated decision- making and actions that consider the creation of value over the short, medium and long term.”

In addition to establishing right processes, changes in behaviours, culture and leadership styles are required for implementing ‘integrated thinking’. Sharing of information across the organisation and consideration of fresh perspectives presented by employees in decision-making are essential for integrated thinking. These require building greater trust between leaders and employees. Close collaboration between different units and functions are required to draw right knowledge and experience and develop holistic view in decision-making. Strengthening the engagement with external stakeholders is necessary to understand stakeholders’ perspective and value in order to ensure that the strategy is sustainable for the long term in changing external contexts. Transparency in decision-making is necessary to develop a shared understanding the business model and broader strategy to enable employees to work for a common goal.

The concept of ‘integrated thinking’ is logical and simple, but it is challenging to apply the concept in practice. The traditional mind set of focusing on shareholder value, financial information and quantitative data and hierarchical leadership style make adoption of integrated thinking difficult. It takes years to fully embed integrated thinking in decision-making. The Board has to take the responsibility of overseeing that the company is moving towards developing necessary processes and culture to support integrated thinking. The Board should deliberate on all material factors that significantly affect the ability of the company to create value in the short-term, medium-term and long-term. It might be a good idea for Boards of companies to start the journey by adopting Integrated Reporting Framework for internal reporting to the Board. Companies should aim issuing integrated report to investors as early as possible in order to build trust with wider stakeholders.

Boards should Focus on Disclosures and Auditors’ Independence

When, in the recent quarter, performance of Infosys failed to meet the market expectations, the media reported it as the first failure of Vishal Sikka, who is the CEO of the company. The media gives total credit for the consistently excellent performance of ITC to Yogi Deveswar, who is the Chairman and CEO of the company for quite a long time. Cyrus P Mistry had revised the strategy of the Tata Group, when he took over as the chairman of the Group. It is obvious that the media and the market believe, and rightly so, that the Board does not contribute significantly in the performance of the company. The leadership qualities and managerial capabilities of the CEO (and his team) determine the performance. In case of companies, where the controlling shareholder runs the company directly or through its nominee, the performance of the company reflects the quality of decision-making by the controlling shareholder. The board of directors (Board) gives free hand to the CEO to manage the company not only because it is right to do so, also because independent directors’ understanding of the business is not adequate to give directions to the CEO. Therefore, in ‘good times’, the Board plays the game to give a semblance of some serious boardroom deliberations on strategy and other critical issues. Of course, competent directors provide some valuable inputs. When, product/service-market performance of the company shows continuous decline, the Board asks certain persuasive questions, to the best of its capabilities. Even in those situations, solutions come from an external consultancy firm appointed by the management or from the management itself. The Board adds some value while deliberating alternative solutions, only if the Board is diversified and capable. Although, the Board remains passive, without intensive engagement with the CEO, when the going is good, it is worth building a diversified and capable Board, which can provide support to the CEO when needed. And in a crisis situation, advantage of collective wisdom can be obtained.

As the he Board gives freehand to the CEO, it is expected to play an important role in the selection of the CEO and his/her team. In this regards, the role of the Nomination and Remuneration Committee (N&RC) of the Board cannot be overemphasised. The Companies Act requires that every listed company, every public company with paid up capital of ten crore rupees or more or turnover of one hundred crore rupees or more and every public company having, in aggregate, outstanding loans, or borrowings, or debentures, or deposits exceeding fifty crore rupees shall constitute a N&RC. The committee consists of at least three non-executive directors, out of which not less than one-half should be independent directors. N&RC has the responsibility of identifying persons who are qualified to become directors and who may be appointed in Senior Management. It is also responsible for developing remuneration policy for directors, key managerial personnel (KPM) and other employees. SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 further requires, among others, that the Committee should devise a policy to diversify the Board. Unfortunately, companies, except some large and good companies, have adopted the tick-box approach in complying with provisions related to N&RC.  Therefore, in practice, engagement of N&RC, and consequently the Board, in the selection and appointment of directors, CEO, KMPs and employees in the Senior Management is minimal.

In practice, the Board does not have substantive involvement either in people management or in the formulation and implementation of strategy. Therefore, it should allocate its time to corporate governance issues, rather than spending more time to review strategy and performance in appearance only.

Investors and other stakeholders are not so much concerned about what is happening within the Board. In any case, that is unobservable. They evaluate the quality of corporate governance by catching signals and symptoms. For example, they evaluate the level of transparency accountability and equity adopted by the management; quality of family governance (e.g., dispute resolution and succession planning); leadership quality of the CEO and the leadership pool within the company; legal proceedings against the company; qualifications in the audit report; relationships between the CEO, promoter and the Board; relationships of the management with stakeholders; reported management fraud; and company’s resilience to quickly respond to the changes in the business environment. Boards should focus on those issues.

Unfortunately, Boards do not pay the desired attention to the quality and level of disclosures in various internal and external documents; and independence of statutory auditor and internal auditor. Boards are required to shift the focus.

AUDIT COMMITTEE’S RESPONSIBILITIES IN CO-SOURCING INTERNAL AUDIT

The Companies Act 2013 mandates appointment of internal auditor by every listed company; every unlisted company having paid up share capital of fifty crore rupees or more, or turnover of two hundred crore rupees or more, or outstanding loans or borrowings from banks or public financial institutions exceeding one hundred crore rupees, or outstanding deposits of twenty five crore rupees or more; and every private company having turnover of two hundred crore rupees or more, or outstanding loans or borrowings from banks or public financial institutions exceeding one hundred crore rupees. Earlier, statutory auditor was required to report the adequacy and effectiveness of internal audit.

The statutory recognition that internal audit is an important monitoring and assurance service for improving corporate governance is a milestone in the evolution of internal audit. The profession is in the process of transition from ‘service to the management’ to ‘service to the Board’. In order to serve the Board of companies, which are operating in VUCA (Volatility, Uncertainty, Complexity, Ambiguity) environment and/or exploring digital business model and automation, the internal audit function must acquire variety of specialised skills. New skills are also required to conduct higher level of audit (management audit) as a service the Board. In order to address this challenge, co-sourcing has emerged as the most preferred model. The Companies Act 2013 permits outsourcing of internal audit. It stipulates that the internal auditor may or may not be an employee of the company. It further stipulates that the Board shall decide to appoint a chartered accountant or a cost accountant or any other professional as internal auditor.

Co-sourcing is a low-cost model for acquiring the required capabilities. For example, traditionally, companies outsource IT audit because it is costly to keep the knowledge updated on the face of rapid technological changes, consistently evolving IT applications and emerging cyber-risks and also because of difficulties in providing opportunities of learning by doing. Another reason for co-sourcing is that companies find it cheaper to appoint local professionals to audit activities/functions in dispersed locations.

Outsourcing poses various challenges. Setting up a good contracting arrangement is important. Expected standard of service should be well articulated to enable the in-house team to monitor the same. There should be clarity about contract termination and the in-house team should ensure that it has access to working papers and documents even after the termination of the contract. It is also important to manage differences in the working practices used by outsourcing service providers and the policies and norms followed by the in-house team. Therefore, co-sourcing is effective only if the in-house internal audit team is strong and efficient.

Outsourcing complete internal audit with skeleton in-house team is not a good idea. One disadvantage is that if the in-house team is not constituted of senior-level executives, contract management might fail. Moreover, in-house team is best bet for financial and operation/process audit, as those audits requires in-depth knowledge of the internal environment and business processes. Similarly, strategy audit and audit of change initiatives cannot be left to an external agency due to confidentiality concerns.  Complete outsourcing makes it difficult to integrate all assurance services, as the outsourced service providers lack incentives for coordinating with other assurance services. It also deprives the company of ‘add on’ services, like consultancy and training, which are provided by the in-house internal audit team.

Internal audit serves the Board effectively only if it is independent of management. It is the ‘third line of defence’ because other assurance services are not independent of the management. In order to protect the independence of internal audit, outsourcing decisions should be taken by the audit committee.

Co-sourcing of internal audit is like any other strategic decision. It requires answering question such as which capabilities to be outsourced and why; and whether all capabilities should be outsourced from a single source. It is the audit committee’s responsibility to choose correctly the capabilities to be outsourced and those to be kept in-house. The audit committee should select the outsourcing service providers and get engaged with them throughout the audit process. For example, the audit committee should discuss with the service provider the audit methodology and the draft report. The chairman of the audit committee should receive the final report directly.

The management has an inherent temptation to filter audit reports before submitting those to the audit committee. This is a possibility of which the audit committee should always be alert regardless of the level of trust it share with the management.

AUDIT COMMITTEE HAS TO EXERCISE ITS POWER EFFECTIVELY

On the backdrop of Satyam scam, the Companies Act 2013 has introduced new rules to improve audit quality and to punish auditors who will be found guilty of negligence or connivance with management in acts of omission and commission by the company. Will those be effective?

We often hear statements like the one that unethical management, with the support from unethical auditors, distorts financial information to mislead investors and other stakeholders. Those statements imply that auditors are corrupt and audit quality will improve only if auditors are penalised heavily, for example with jail terms, for audit errors. I am sure that those who deal with the auditing profession do not believe that the profession is full of corrupt individuals. There are black sheep in every profession and auditing profession is not an exception. But most auditing errors are ‘genuine errors’ and not fraud. Those are errors of judgement.

Errors of judgement arise often due to common cognitive bias similar to ‘self-serving bias’. Research and experiments in psychology have established that one unconsciously reaches conclusions that he/she desires or that serve him/her better. Therefore, when more than one interpretations of a law or situation or information is possible, one takes the interpretation that is favourable to him/her believing that he/she interprets correctly and objectively. Accounting presents number of situations when accounting principles and methods, applicable laws and regulations and information and evidence can be interpreted differently. Accounting ambiguity is evident by the fact that auditors negotiate with clients on accounting policy, methods of arriving at accounting estimates and accounting estimates. In this ambiguity, the bias comes into play. If the auditor believes that conclusions that favour the client favour him/her, he/she will unconsciously interpret laws and information in a manner that favours the client.

For business reasons, auditors have strong motivation to approve client’s financial statements, as an unfavourable report might lead to losing the client. The Companies Act stipulates that the auditor has to be appointed for a term of five years and he/she can be removed only by passing a special resolution in shareholders’ meeting and with the approval of the government. This has reduced the risk of losing the client and thus, has reduced the motivation to approve client’s financial statements.

Audit partners act as an agent of the firm in securing non-audit business from the client and therefore, there is motivation to appease the client. Companies Act 2013 by prohibiting the auditor from rendering specified non-audit services has eliminated one of the reasons for the auditor to remain in client’s good grace.

Companies Act 2013 requires listed companies and some other classes of companies to rotate the auditor effective from the financial year 2017-18. An individual cannot be appointed as an auditor for longer than a consecutive period of five years and an audit firm cannot be appointed for a period longer than a consecutive period of ten years. The cooling off period is five years, after which the individual or the firm can be reappointed as auditor. This has reduced the risk of familiarity bias, which arises from the inherent tendency of not hurting those who are known and impairs objectivity.

Above rules could not eliminate all the reasons that make the auditor believe that what favours client favours him/her.  For example, maintaining good relationship with the management might help in securing higher than reasonable fees, swapping audit with a friendly firm, as management will lend credence to the suggestion of the outgoing auditor, who could maintain good relationship, and reappointment after the cooling off period. In order to protect auditor’s independence from the management, the law has transferred the power to recommend appointment and remuneration of the auditor from the management to the audit committee and requires the audit committee to discuss audit with the auditor before the commencement of the audit, during the audit and at the end of the audit.

In practice, the audit committee does not exercise the power effectively. It approves management’s proposals for the appointment and remuneration of auditors as a routine and does not spend sufficient time in discussing audit with the auditor. There could be many reasons for the audit committee’s passive approach. For example, it is because the audit committee is not independent, as independent directors hold the position at the pleasure of the management; or the audit committee members are not conscious about the impact of their passive approach on audit independence.

Whatever might be the reasons, audit committee’s passive approach would significantly dilute the effectiveness of other audit reforms introduced by the Companies Act 2013.