Natalia Annikova
Vyacheslav Belikov
For the past few years, investors have regarded a strong audit committee of the board of directors (board) as clear evidence of a company’s adherence to proper corporate governance. It is no wonder that issues related to setting up such committees have been widely discussed in drafting the Russian Code of Corporate Governance.
Views on the role and functions of an audit committee have recently changed significantly in Russia, due to a new perception of major duties of the board. In the past, the board was regarded as, primarily, a supervisory body and an audit committee as a board structure that maintains relationships with an outside auditor. Now the board not only oversees the management but also enhances efficiency of company operations. In addition to traditional duties, the functions of audit committees include the review of internal controls and their adequacy to deal with corporate risks, which enables members of audit committees (and, accordingly, those of the board to exert influence on future operating results. These changes also raise the question of the future status and usefulness of the inspection panel appointed by the general shareholders’ meeting, and we also discuss this question in our article.
At the board and senior management level of an enterprise, the system of internal control is primarily designed to help the executive body oversee business units of the enterprise, identify resources and the most efficient development scenarios, monitor the level of risk and react promptly to changes. According to the new vision of the corporate governance framework actively promoted by investors from different countries, the board of directors represented by an audit committee, management, including an internal audit department, and outside auditors provide a «tripod» which makes sure the company is efficient and acts in the best interest of the shareholders.
The analysis of operations of boards of directors in foreign companies identifies the following factors that enable audit committees to perform their functions better than the entire board of directors.
Firstly, an audit committee can focus more specifically on the review and detailed discussion of the company’s reporting process, existing internal controls and independence of external auditors. These activities are time-consuming and the entire board is unlikely to perform them .
Secondly, management representatives sit on the board of directors of most companies. Since the financial reporting, system of internal control and risk management are elements of management stewardship, conflicts of interest may arise when managers participate in oversight and evaluation of these matters. Under recommended practices management representatives should not sit on the audit committee, and this prevents these conflicts.
Enhanced independence of external auditors is achieved by the fact that an independent audit committee makes recommendations as to the selection, fees and dismissal of external auditors. This encourages external auditors to raise issues at a relatively early stage and encourage their discussion (at least, in private), as well as provides assurance that the auditors will be more likely to express their views when they are in conflict with those of management.
An independent audit committee enhances status and objectivity of the internal audit department, which is generally part of the internal management system and reports to the Chief Executive. Cases may arise when recommendations of the internal auditor face resistance of the CEO, but this can be overcome if the internal auditor has regular relationships with the audit committee. An independent audit committee is a prerequisite for getting listed on the vast majority of foreign exchanges. Countries all over the world have been increasingly requiring enterprises to set up audit committees in their legal framework. Moreover, in many countries, having an audit committee in a public company is regarded as an important factor in the struggle against corruption.
Things are very different in the Russian corporate sector. As far as we know, not a single Russian company has an audit committee as part of its board. The Russian Federal Company Law neither requires nor prohibits setting up structures within the board and is not an obstacle to setting up a board audit committee (though it might be reasonable to amend the law so that companies have an explicit option to set up committees within their boards). However, this Law contains a special section requiring incorporated enterprises to set up an ‘inspection panel’ as a body that oversees financial and economic activities of the company. In accordance with Section 85 of this Law, this inspection panel must review financial and operating results at least annually. Extraordinary inspections can be called for by an inspection panel, general shareholders’ meeting, board, or shareholder(s) that own at least 10% of the voting shares.
Although members of the inspection panel cannot sit on the board or hold other positions in the company’s governing bodies, they have some functions similar to auditors and an audit committee:
- Express an opinion as to whether reports and other financial documents of the company provide a true view and whether there are breaches of laws and regulations;
- Monitor compliance with regulations governing financial and economic activities of the company;
- Ascertain whether business and financial transactions are recorded completely, promptly and accurately and supervise the optimization and computerization of accounting functions;
- Improve accounting in order to achieve the efficient use of materials, labor and financial resources, review existing controls and preventing misuse of company’s assets.
However, the mission and scope of inspection panels are narrower than the functions and authority of audit committees. The scope of inspection panels is limited to monitoring compliance of the company’s financial and economic activities with current Russian legislation. Another important element is the fact that the Company Law does not set out the responsibility of inspection panel members for their functions (whereas the board of directors is subject to such responsibility). The question arises as to which of the two structures (audit committee or inspection panel) is best able to oversee the preparation of fair financial information and assessing the systems of internal control, risk identification and management?
In our view, audit committees are the best structure because they can perform most of the oversight functions imposed on the board. They also share responsibility for the decisions made with other board members. In addition, audit committees are common in the vast majority of other countries and foreign investors are accustomed to them.
Several amendments to the current law are required in order to implement audit committees in the Russian corporate governance framework. However, the amendments are intended to make board responsibilities more specific rather than change their substance dramatically. Different courses of action are possible with respect to the inspection panel. The first one is leaving its status intact and using it as an additional supervisory body. Another might be to use the experience of inspection panels in developing internal controls (including internal audit), still in embryo in most Russian public companies, helping to detect weaknesses and identify operating improvements.
However, the inspection panel in its traditional sense cannot cost-effectively replace an internal audit department, an important role of which is to be continuously involved in reviewing management functions and organizational activities of enterprises, assessing the quality of management activities and developing proposals for their improvement. Also, the inspection panel reports directly to the general shareholders’ meeting whereas an internal audit department is part of the management structure.
The internal audit department does not disturb the «tripod» of the corporate control system, i.e. management, board of directors and external auditor. An inspection panel, being independent of both management and the board of directors, becomes sort of an additional «fourth leg», and this may give rise to complicated relationships between major components of the corporate governance system. Therefore, under this option after a sound internal audit department is in place, an inspection panel should be eliminated.
Finally, a third option is possible – the inspection panel is terminated as soon as an audit committee is in place as part of the board of directors.
The immediate termination of inspection panels would lead to substantive changes in the current Company Law and might face resistance from the State Duma. This resistance might result from a traditional view of the control system in companies, poor expertise of most State Duma members in modern corporate governance framework, as well as from the unwillingness of some managers and large shareholders to have enhanced supervision of executive bodies. The power of these vested interests indicates that the implementation of the latter option requires a great deal of reasoning provided to the lawmakers.
It is necessary to decide whether an inspection panel should continue its operations during some transition period or it should be terminated as an element of the corporate governance system. Therefore, the overall benefits derived from its operations should now be analyzed carefully, compared to its costs, and a decision taken as to what the new governance structure should be.
Natalia Annikova and Vyacheslav Belikov are with the Institute of Capital Market and Management. They can be contacted by phone (095) 220 4545.