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IIFT2009 (A – SERIES)

SECTION – 2 (Part 1)

 

Directions for questions 29 - 33: Read carefully the four passages that follow and answer the questions given at the end of each passage:

 

Number of words in this passage: 1,430

 

Passage I

 

The most important task is revitalizing the institution of independent directors. The independent directors of a company should be faithful fiduciaries protecting, the long-term interests of shareholders while ensuring fairness to employees, investors, customers, regulators, the government of the land and society. Unfortunately, very often, directors are chosen based on friendship and, sadly, pliability. Today, unfortunately, in the majority of cases, independence is only true on paper.

 

The need of the hour is to strengthen the independence of the board. We have to put in place stringent standards for the independence of directors. The board should adopt global standards for director-independence, and should disclose how each independent director meets these standards. It is desirable to have a comprehensive report showing the names of the company employees or fellow board members who are related to each director on the board. This report should accompany the annual report of all listed companies.

 

Another important step is to regularly assess the board members for performance. The assessment should focus on issues like competence, preparation, participation and contribution. Ideally, this evaluation should be performed by a third party. Underperforming directors should be allowed to leave at the end of their term in a gentle manner so that they do not lose face. Rather than being the rubber stamp of a company’s management policies, the board should become a true, active partner of the management. For this, independent directors should be trained in their roles and responsibilities. Independent directors should be trained on the business model and risk model of the company, on the governance practices, and the responsibilities of the various committees of the board of the company. The board members should interact frequently with executives to understand operational issues. As part of the board meeting agenda, the independent directors should have a meeting among themselves without the management being present.

 

The independent board members should periodically review the performance of the company’s CEO, the internal directors and the senior management. This has to be based on clearly defined objective criteria, and these criteria should be known to the CEO and other executive directors well before the start of the evaluation period. Moreover, there should be a clearly laid down procedure for communicating the board’s review to the CEO and his/her team of executive directors. Managerial remuneration should be based on such reviews.

 

Additionally, senior management compensation should be determined by the board in a manner that is fair to all stakeholders. We have to look at three important criteria in deciding managerial remuneration-fairness, accountability and transparency. Fairness of compensation is determined by how employees and investors react to the compensation of the CEO. Accountability is enhanced by splitting the total compensation into a small fixed component and a large variable component. In other words, the CEO, other executive directors and the senior management should rise or fall with the fortunes of the company. The variable component should be linked to achieving the long-term objectives of the firm. Senior management compensation should be reviewed by the compensation committee of the board consisting of only the independent directors. This should be approved by the shareholders. It is important that no member of the internal management has a say in the compensation of the CEO, the internal board members or the senior management.

 

The SEBI regulations and the CII code of conduct have been vary helpful in enhancing the level of accountability of independent directors. The independent directors should decide voluntarily how they want to contribute to the company. Their performance should be appraised through a peer evaluation process. Ideally, the compensation committee should decide on the compensation of each independent director based on such a performance appraisal.

 

Auditing is another major area that needs reforms for effective corporate governance. An audit is the independent examination of financial transactions of any entity to provide assurance to shareholders and other stakeholders that the financial statements are free of material misstatement. Auditors are qualified professionals appointed by the shareholders to report on the reliability of financial statements prepared by the management. Financial markets look to the auditor's report for an independent opinion on the financial and risk situation of a company. We have to separate such auditing from other services. For a truly independent opinion, the auditing firm should not provide services that are perceived to be materially in conflict with the role of the auditor. These include investigations, consulting advice, subcontracting of operational activities normally undertaken by the management, due diligence on potential acquisitions or investments, advise on deal structuring, designing/implementing IT systems, bookkeeping, valuations and executive recruitment. Any departure from this practice should be approved by the audit committee in advance. Further, information on any such exceptions must be disclosed in the company’s quarterly and annual reports.

 

To ensure the integrity of the audit team, it is desirable to rotate auditor partners. The lead audit partner and the audit partner responsible for reviewing a company’s audit must be rotated at least once every three to five years. This eliminates the possibility of the lead auditor and the company management getting into the kind of close, cozy relationship that results in lower objectivity in audit opinions. Further, a registered auditor should not audit a company if, during the year preceding the start of the audit, the company’s CEO, CFO or chief accounting officer was associated with the auditing firm. It is best that members of the audit teams are prohibited from taking up employment in the audited corporations for at least a year after they have stopped being members of the audit team.

 

A competent audit committee is essential to effectively oversee the financial accounting and reporting process. Hence, each member of the audit committee must be ‘financially literate’. Further, at least one member of the audit committee, preferably the chairman, should be a financial expert-a person who has an understanding of financial statements and accounting rules, and has experience in auditing. The audit committee should establish procedures for the treatment of complaints received through anonymous submission by employees and whistleblowers. These complaints may be regarding questionable accounting or auditing issues, any harassment to an employee or any unethical practice in the company. The whistleblowers must be protected.

 

Any related-party transaction should require prior approval by audit committee, the full board and the shareholders if it is material. Related parties are those that are able to control or exercise significant influence. These include: parent-subsidiary relationships; entities under common control; individuals who, through ownership, have significant influence over the enterprise and close members of their families; and key management personnel.

 

Accounting standards provide a framework for preparation and presentation of financial statements and assist auditors in forming an opinion on the financial statements. However, today, accounting standards are issued by bodies comprising primarily of accountants. Therefore, accounting standards do not always keep pace with changes in the business environment. Hence, the accounting standards-setting body should include members drawn from the industry, the profession and regulatory bodies. This body should be independently funded.

 

Currently, an independent oversight of the accounting profession does not exist. Hence, an independent body should be constituted to oversee the functioning of auditors for independence, the quality of audit and professional competence. This body should comprise a majority of non-practicing accountants to ensure independent oversight. To avoid any bias, the chairman of this body should not have practiced as an accountant during the preceding five years. Auditors of all public companies must register with this body. It should enforce compliance with the laws by auditors and should mandate that auditors must maintain audit working papers for at least seven years.

 

To ensure the materiality of information, the CEO and CFO of the company should certify annual and quarterly reports. They should certify that the information in the reports fairly presents the financial condition and results of operations of the company, and that all material facts have been disclosed. Further, CEOs and CFOs should certify that they have established internal controls to ensure that all information relating to the operations of the company is freely available to the auditors and the audit committee. They should also certify that they have evaluated the effectiveness of these controls within ninety days prior to the report. False certifications by the CEO and CFO should be subject to significant criminal penalties (fines and imprisonment, if willful and knowing). If a company is required to restate its reports due to material non-compliance with the laws, the CEO and CFO must face severe punishment including loss of job and forfeiting bonuses or equity-based compensation received during the twelve months following the filing.

 

29.  The problem with the independent directors has been that:

I.     Their selection has been based upon their compatibility with the company management

II.   There has been lack of proper training and development to improve their skill set

III.  Their independent views have often come in conflict with the views of company management. This has hindered the company’s decision-making process

IV.  Stringent standards for independent directors have been lacking

A.   I and II only                B.    I, II, and III only         C.   II. II, and IV only              D.   I, II, and IV only

 

       Explanatory Note:

       The matter of independent directors is discussed, and current shortcomings are pointed out, in the first half of the passage. Statement 1 is spoken of in para 1. Statement 2 is the matter discussed in para 3. Statement 4 is spoken of in para 2. Statement 3 is incorrect. Choice D is, therefore, appropriate.                                                                                                                                                                                                                                                                                                                                     Choice (D)

 

30.  Which of the following, according to author, does not have an impact on effective corporate governance?

A.   Increased role and importance of independent directors

B.   Increased compensation to independent directors

C.   Not hiring audit firms for other services

D.   Stringent monitoring and control of related party transactions

 

       Explanatory Note:

The discussion in the first half of the passage is summed up in Statement A. Para 7 discusses Statement C. Statement D is spoken of in para 10. Statement B is incorrect. While remuneration is discussed in para 6, the indication is it should be based on performance, that is, it should be the effect of good governance and not the cause.                                                                                                                                                                                                                                                                                                                       Choice (B)

 

31.  To improve the quality and reliability of the information reported in the financial statements:

I.     Accounting standards should keep pace with the dynamic business environment

II.   There should be a body of internal auditors to oversee the functioning of external auditors

III.  Reports should be certified by key company officials

IV.  Accounting standards should be set by a body comprising of practicing accountants only and this body should be funded from a corpus built up from the contributions made by the companies

A.   I, and II                       B.    II, and III                           C.   I, and III                            D.   I, III, and IV

 

       Explanatory Note:

       Statement 1 is discussed in para 11. Statement 3 is the content of the last para. Statement 2 is inappropriate – while para 9 discusses an audit committee, it does not speak of the committee as internal auditors. Statement 4 is also inappropriate - the penultimate para indicates that standards should be looked into by non-practising accountants.                                                                                                                                                                                                                                                                                        Choice (C)

 

32.  Which of the following may not help in improving the accountability of management to the shareholders?

A.   A third party assessment of the performance of independent directors

B.   Rotation of audit partner

C.   Increasing the fixed component in the salary structure of the management

D.   Laying down a proper procedure for handling complaints regarding unethical practices

 

       Explanatory Note:

       Statement A is spoken of in para 3. Statement B is spoken of in para 8. Statement D is spoken of in para 9. Statement C is incorrect – it is the opposite of what is explained in para 5.                                                                                                                                                                                                                                                                                  Choice (C)

 

33.  The author of the passage does not advocate:

A.    Increased activism of independent directors

B.   Measures to improve the independence of auditors

C.   Framing the accounting standards in the light of changing business conditions

D.   Active intervention by the regulators in the day-to-day functioning of the company

      

       Explanatory Note:

       Statement A is suggested in para 4, Statement B in paras 7 and 8, and Statement C in para 11. Statement D is incorrect.                                                                                   Choice (D)