This article has been written by Golock Chandra Sahoo, pursuing a Course on Personal Branding Program for Corporate Leaders from LawSikho and edited by Shashwat Kaushik.
It has been published by Rachit Garg.
Table of Contents
Introduction
With so many scams in so many companies, public or private, limited or unlimited, national or global, the role of independent directors has been enhanced manifold. This paper discusses some points where the involvement of ID at some signal points is supposed to be noteworthy and their responsibilities to recommend solutions to these issues can never be undermined by the management.
Independent Director (ID), as the name of this position indicates, is never dependent. Id is not an employee working for remuneration; rather, it is a fee and commission based position. It has its own uniqueness. Under Section 178 of the Companies Act 2013, ID is a position for which nomination is made from the Nomination and Remuneration (NRC) Committee. To maintain good governance, the NRC does everything with fairness and transparency. Next, the appropriate candidate is finalised by the board out of the nominated list and the appointment part is approved by calling a meeting of the shareholders.
Roles and responsibilities of an independent director
The role of ID after being appointed is too challenging. For not being an employee, the ID is to see all activities that are in the interest of the entity. The Satyam issue of 2009 is worth discussing here, based on which the concept of retaining IDs was strengthened in the Act. Satyam management showed profit inflated fictitiously, exhibited so many fake debit entries, and showed many employees on paper and the net effect was just to attract more share from the market. In this way, Satyam could lure investors, while no ID was there then. Finally, the truth came to light and the IT company could return to earth from a heavenly position. Now, IDs are duty bound for all irregularities with vast responsibilities, more not spoken but on paper. The sword is about to fall on the non-performing IDs. A sharpened edge of the facing down sword from the top may guide the IDs, who perform and venture to act against management but in the interest of the entity. Certain points of the red sign where IDs need to perform and act meticulously are discussed here.
IDs are to check the computation of all financial ratios and study their impacts. Some ratios where red flags are noticeable may be given as follows.
Expense ratio
This ratio is computed with reference to net sales for a particular financial period. As ID, one should see that unwanted expenditures are controlled and sales revenue is increased. This ratio, if rising, shows that expenditure is getting inflated and so to control this situation, the cause of expenditure is to be investigated. Please keep in mind that there may be opposition, while one attempts to control all expenses not warranted for a purpose. Since ID is not an employee and cannot watch this situation all the time, some action at any time may signal management to watch the situation.
Gross profit ratio
This ratio is normally computed at the end of the financial year. But yet, this can happen at the end of each quarter to have a comparison between various quarters. The formula is the gross profit divided by sales. With an increase in sales revenue, gross profit rises and if ID comes across a situation of decreasing profit, S/he attempts to see the cause, inquire as to the percentage of decrease in sales, check if the purchase of raw materials is in excess of the need with dumping in store and also check the cost of the final product, comparing the same with the cost of local availability. Final alertness may be given to management to act with the prescribed means of controlling the situation.
Stock turnover ratio
This ratio shows efficiency in managing inventory. This ratio is calculated by taking the cost of goods sold (please note the cost of goods that were sold) and dividing the same by the average stock. The standard is fixed as per financial Management in practise, as 5-6 times. Let us suppose that ID notices something unusual in this ratio, as computed as 2.5. It is concluded that the stock is not movable and that results in the blocking of funds. It is informed to management with the conclusion that either the procurement is in excess of the need or the procured materials are not in process. So either of these two actions is to be taken immediately.
Current ratio: Any business entity needs to be alerted to its current ratio, which is computed as the ratio of current assets (CA): to current liabilities (CL). The standard ratio of 2:1 is significant for business. CA takes into account all debtors, stock, loose tools, accrued income, bills receivables and the position of cash and bank balances as of the date of computation of the current ratio. Similarly, CL takes every amount booked in a financial year under sundry creditor, including bills payable, outstanding expenses, unclaimed dividends, all provisions, any proposed Dividend amount, all overdrafts, etc. The computation of current liabilities is for testing short term solvency or knowing the financial strength of an entity. Let us suppose that ID notices that CA is lower than the prescribed standard of 2:1 and it is concluded that a lower ratio indicates inadequacy of working capital and the red sign of inadequacy of working capital may lead to a devastating situation affecting production and other ancillary items linked with production. So accordingly, ID may alert management to initiate the necessary action to maintain the working capital as per the need.
Suppose ID notices some high employee turnover. This is a very bad scenario. ID should call for reasons as to why employees are leaving. The feedback of such employees may be reviewed and the board may be advised accordingly based upon the feedback. The high turnover needs to be controlled with certain measures. The measures may include taking certain welfare measures to retain the old employees on roll, incentivising active employees as a reward, taking regular up-gradation measures, taking seniority and performance into consideration and finally checking strict measures at the time of recruitment in terms of obtaining a bond from the recruited employee or recruiting with the agreement that in case of leaving the job, the employee is to deposit a certain amount towards compensation. ID may opine the best measure to the management.
Role of an Independent Director as member of audit committee
While ID is a member of the audit committee, the board has naturally bestowed all responsibility on ID to manage the audit, manage audit compliance and finally settle all past audit objections pending in the audit. So ID is to be careful in all drafting of compliance and be vigilant in supplying records to audit after checking all pros and cons of the available documents. Hiding any data, though not advisable, is in the interest of the entity, so ID may be tactful in handling all cases. It is better to comply with audit observations on the spot for settlement without any lingering so that observation goes without reporting. ID needs to have had access to the audit reports for at least the past three years. If it is a public company, the findings of government auditors should be reviewed. Normally, chartered firms certify the accounts as per management needs, but in reality, they never audit. So government auditors get the opportunity to comment straightaway, relying on the certified figures. ID, hence, is to see the deficiencies pointed out by the government auditors and how that affected the assurance of management. All compliances with such audits from the past years may be examined. ID may recommend certain actions based on the audit findings that act as an active action to deal with red flags. ID should attend the entry meeting of the audit team to the company and should inquire about the detailed audit criteria based upon which audit shall be performed to conduct the audit. The records they need may be detailed by them in a complete format. This in turn will help to maintain the supply of documents after due verification during the audit. It is advisable that the supply of records be made piecemeal and not at a time in a lump. The audit duration is pre-fixed and it may be difficult for the audit to obtain extra man-days which may help the ID safeguard its interest in the audit of the entity. ID should maintain his/her position and should know how to talk tactfully with audit people. Generally, the audit team tries to talk more with a specific purpose to elicit hidden messages. In the message they get, they usually check the details with reference to records. So ID is to be seen to maintain precaution. To the extent possible, s/he may get the audit team diverted. Any audit memo should be responded to in reply during the course of the audit. It may be yes or no, yes or no, but If no, that should be justified in writing to audit camping on the spot to see that the objection is dropped/ closed then and there without any continuance in the audit report. If yes, ID may comply, stating yes but mentioning the constraints that result in lapse. This may result in, in the long run, making that objection lose its value. With a reply of yes, the audit has little scope to include that objection in their report as they are duty bound to report all the replies in their final report. Similar is no, but ID is denying the audit observation with some mention.
IDs should see that the audit report is ready on the closing day of the audit. Under no circumstances should the audit team be allowed to draft their report after taking off from the audit camp. This will create scope for any additional issues with data collection and usage by them. ID should see this aspect. Since the report of findings in the audit is there, ID should see that every page of the report is signed by the head of the audit team.
In the audit exit meeting, ID should see that the Chairman and Managing Director are there to discuss with the team his express his/ her satisfaction or displeasure for the audit or for others involved in the audit. This will boost the spirit of working for ID by pointing out some important issues as a warning sign and raising some red flags for the MD and Chairman.
So far as reviewing various contracts is concerned, ID is to see that all contracts are well drafted as per norm, safeguarding the interests of the entity. While all past contracts are out of the reach of the ID, current cases should be entered under the full supervision of the ID. Even past contracts can be amended if scope exists. Audit tries their best to find out deficient contracts and they usually stick to all ambiguous clauses where the organisation has incurred monetary losses on the pretext of weak clauses. The audit observes all deficiencies in monetary terms that can’t be complied with to their satisfaction and there, the credibility of the entity is put in danger. So ID is to personally study all contracts in vogue before handing over those documents to audit.
Shareholders are interested in the profit of the entity. ID should see that profits are exhibited after meeting all provisions. Anything left behind records profit on the higher side and that very much affects the payment of dividends. The certified accounts should be reviewed by ID to see that profit has appropriately been apportioned among different funds, such as sinking fund, depreciation fund, provision to meet future liability, the creation of the reserve fund, etc. As already mentioned, chartered firms certify accounts based on management needs, and this makes audits advantageous to observe and comment on.
ID may (let us suppose) notice the liabilities increasing at a high rate. As a result, interest liability is showing a higher trend, which in turn affects profitability. Stakeholders look at this side attentively. The cause of increasing liability may be reviewed to find means to control it. This may be due to excess purchases of raw materials or unprocessed work in progress blocking the fund without any usage.
Suppose ID finds a sudden change in the auditor. The reason may be that one auditor may have raised some objection, which is not suited to management. Another reason may be a significant reduction in audit fees or the client’s intentional non-sharing of information. Poor financial reporting may be another cause. In any case, auditors, while resigning from their assigned task, must have indicated this in their application. ID must inquire about everything, including the audit notes of the auditor who resigned. Choosing a second auditor may be a biassed decision that should be carefully watched.
In the area of environment and social governance, ID may look at the funding provision and how the same has been incurred. Good governance is an indicator of better trusted management. Employees prefer to continue in an organisation that is well governed. There should be specific means of waste disposal, carbon reduction exercises, plastic disposal, and disposal of e-waste to save the environment, save the climate, and care for society, looking at the impact on social issues covering the development of nearby areas, etc., and in a way creating an organisation specific culture. If anything is wanted, ID may point it out, and every time, a written note should be there with management. S/he should not feel the need to point out anything and everything that is surpassed, which affects the credibility and trust of the entity.
Suppose ID finds some unusual rise in profits. That may be by inflating profit through various ways of adopting unusual practises. That should be surveyed and reviewed. If the inflating profit is exhibited only in books of accounts, that should be immediately attempted to be stopped. All IDs on the forum/ or board should voice their commonality. Attracting shares from the market at higher rates based on this exhibition of high profits may act in the short run and may cause devastation afterwards. In the past, so many companies have suffered and closed due to the adoption of this policy.
Conclusion
The role of the ID is to march on the face of a falling sword or to manage to walk on the edge of the sword. S/he is to keep his/her eyes and ears open all along. It is challenging to fairly and accurately evaluate every situation because you are not employed on a regular basis. But in any case, while coming to attend the board meetings, all relevant data or information is to be collected by the ID. She/he must be attentive to all the activities of the entity, even without his or her availability on the premises.
References
- https://www.icsi.edu/media/webmodules/Guidance_Note_on_IDs.pdf
- https://www.icsi.edu/media/webmodules/companiesact2013/INDEPENDENT%20DIRECTOR.pdf
- https://repository.uclawsf.edu/cgi/viewcontent.cgi?referer=&httpsredir=1&article=1152&context=hastings_business_law_journal
- https://cleartax.in/s/independent-directors-applicability-roles-and-duties
- https://economictimes.indiatimes.com/small-biz/legal/independent-directors-the-governance-guardians-of-the-board-need-to-revitalise-their-role/articleshow/76904950.cms
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