3.1 Governance aspects
Governance issues were not an important consideration until the adoption of the economic reforms programme in India in 1991. With gradual integration with global markets and an increasing number of Indian corporations accessing global markets and being listed on overseas exchanges, public concerns have become more focused on the effective protection of investors' interests, the promotion of transparency of operations and the need to move towards international standards in terms of disclosure by the corporate sector.
There are presently three distinct, though mutually reinforcing, avenues through which the active (‘voice’) and passive (‘exit’) options of outside debt holders and equity holders in corporate governance are sought to be ensured. These include the Companies Act 1956, the Securities and Exchange Board of India Act 1992 and a market for corporate control.
The activities of Indian companies are regulated through the Companies Act 1956. Through the consolidation of several successive amendments, the Act has sought to ensure that the interests of shareholders and creditors are protected and that shareholder voice is adequately represented in the management of companies. The Act also lays down provisions for the constitution of boards of directors, their appointment, remuneration, frequency of board meetings as well as powers and restrictions of the board. Several amendments in the Act have occurred in the 1990s, with the most recent one coming through the Companies (Amendment) Act 2001.
Central to these amendments has been the move to revamp the Board of Directors to make them more responsive to the interests of shareholders, since the board is the focal point of the decision-making process. In India, company boards are typically single-tiered, comprising a Chairman and Managing Director (one person can hold both posts) and other board members, in either executive or non-executive capacity. Previously, there was no specification regarding the proportion of executive to non-executive members. The Companies Act simply provided broad guidelines on how the board should function.
A need was increasingly felt that some statutory governance codes be instituted in view of several malpractices (like insider trading) that inflicted losses on small investors and undermined investor interests in capital markets. Accordingly, several committees were appointed by the Securities and Exchange Board of India (SEBI) to examine this aspect in its totality. Following the recommendations of these committees, SEBImade certain mandatory provisions for listed companies through a listing agreement from 2002. Accordingly, it was stipulated that a half of board members should be non-executive directors. The Board of a company should set up a qualified and independent Audit Committee with a minimum of three non-executive Directors, with the majority being independent. It was also stipulated that at least one Director needed to be well-versed in financial and accounting knowledge.1 In addition, companies were directed to constitute different sub-committees like audit and remuneration committees and report the remuneration of the CEO as part of their corporate governance report.
The activities of the stock market are regulated by the Securities and Exchange Board of India (SEBI), whose functions are similar in scope to the Securities Exchange Commission in the US. The SEBI Act 1992 imparted SEBI with statutory powers to protect the interests of investors in securities and to promote the development of, and regulate, the securities market. Before the Act, all issues of capital by Indian companies were controlled by a government agency, the Controller of Capital Issues, which regulated both the terms as well as the pricing of the issue. Under the SEBI Act, companies have been given the freedom, subject to stringent disclosure requirements, to price their issues and raise funds to meet various types of business requirements. In order to ensure that promoters' interests are closely integrated with those of minority shareholders, SEBI guidelines also contain a stipulation as to minimum promoters' contribution and lock-in period.
The market for corporate control has been rather inactive in India. The first attempts at regulating takeovers were made by incorporating a clause (namely, Clause 40) to the listing agreement that provided for making a public offer to the shareholders of a company by any person who sought to acquire 25% or more of the voting rights of the company. Current regulations, by making the disclosure of substantial acquisitions mandatory, have sought to ensure that the equity of a firm does not covertly change hands between the acquirer and the promoters. At present, the acquisition of 15% of shares/voting rights triggers a minimum public offer of 20%. Further, promoter groups holding a stake not less than 10% are allowed to consolidate their position through the provision of ‘creeping’ takeover up to 5% of shares, without attracting the mandatory public offer requirement. However, takeover defence mechanisms as poison pills for incumbent management as prevalent in the US and UK are not permitted under current regulations.
While the alignment of managerial and shareholder interests is possible through higher shareholding by corporate insiders, expropriation of minority shareholders becomes an issue in cases where the control rights of insiders, particularly those of company promoters, are disproportionately more than their cash flow rights. This is an important feature of corporate ownership structure in India, as it is in many other countries, where family-owned business groups are prevalent (Claessens et al., 2000).
3.2 Accounting aspects
The enactment of the Indian Companies Act in 1857 for the first time introduced the concept of preparing company balance sheets on a voluntary basis. Following Independence in 1947, an Expert Committee was constituted to examine the scheme of an autonomous association of accountants in India, which led to the enactment of the Chartered Accountants Act (1949) and the establishment of the Institute of Chartered Accountants of India (ICAI) in the same year. The Chartered Accountants Act governs the accountancy profession in India. A broad revision of the legislative framework relating to the accountancy profession has been underway over the last couple of years, primarily in the wake of the accounting irregularities in the US. Towards this end, the Chartered Accountants (Amendment) Bill 2003 has been prepared which seeks to reconfigure the current regulatory regime and the disciplinary arrangements in relation to the accounting profession.2
The Companies Act 1956 governs the form and contents of balance sheet and profit and loss accounts of limited liability companies. The Act requires the preparation, presentation, publication and disclosure of financial statements; and an audit of all companies by a member-in-practice certified by the ICAI. Schedule VI of the Act prescribes the form, content and minimum disclosure requirements of financial statements. The Act has been amended several times, most recently in 1999. The amendment requires all companies to comply with (Indian) accounting standards, disclose any deviation, provide reasons for such deviation and state the impact of the deviation on the financial statements. Subsequent amendments, mostnotably in 2001 and 2002 included, among others, incorporation of directors' responsibility statements in the board's report to highlight the accountability of directors in good corporate governance, prescribe voting through postal ballot and delimiting the number of companies in which a person can hold directorship to ten from more than 20 previously.
Smaller firms dominate the Indian auditing marketplace, even though the Indian affiliates of large international firm networks audit approximately 47% of the top 100 listed companies.3 The ICAI reports that about 53,000 audit firms operate in India, including members/affiliates of most of the international networks of accounting firms. About 1,000 firms audit at least one economically significant enterprise; and about 15 of the largest firms audit more than 70% of the top 100 listed companies. Government-owned companies and unlisted companies are generally audited by small- and medium-sized firms apparently because of the unremunerative fee scales prescribed for these engagements.
In most cases, the regulator or the Office of the Comptroller and Auditor General of India (CAG) mandates joint auditors for state-owned enterprises. A panel of firms qualified to undertake audits of state-owned enterprises is updated annually. Allocation of audit work among these audit firms is based on a points system that gives credit based on information self-disclosed by the audit firms,4 which includes the number of partners in the firm, number of employees and trainees, experience of the firm and the term of association of the partners with the firm. The Board of Directors of state-owned enterprises determines the professional fee of the auditor on the basis of guidelines issued by CAG and subsequently approved by the shareholders of the company. The CAG conducts a supplementary/test audit of all such companies on a regular basis. The state-owned enterprises that are incorporated under specific acts have associated rules with respect to auditing. Depending upon the audit arrangements, as specified by these rules, the audit may be performed either by a state-appointed auditor (which may include the office of the CAG or its appointee) or a private sector auditor or a combination of both state and private auditors.
The members of the ICAI are required to follow a detailed code of ethics as prescribed under the Chartered Accountants Act. The ICAI council is entrusted with disciplinary powers that are exercised through its disciplinary committee. Some of the salient legal restrictions on auditors include: the name of any firm that intends to register for ICAI membership must have a combination of the names of the partners of a name in being (that is, a name in use before this rule was introduced);5 after 1995, the display of any association with any firm, domestic or international, was banned; the number of partners in an audit firm is limited to a maximum of 20; the Companies Act prohibits indebtedness of audit partner to audit clients in excess of Rs.1000 (≈US$22) which includes any arm's length transactions (for example, a credit card with a banking client); and, advertising and publicity is prohibited.
Mandatory audit firm rotation, after serving as auditor for four to five years, exists for government-owned companies. Audit partner rotation has never been mandatory, and hence is not widely followed across the profession. In considering auditor independence, the Government-appointed Committee (see note 2) recommended adoption of audit partner rotation. The ICAI has recently put forward a resolution that will make mandatory audit firm rotations and joint audits for all listed companies. A final decision on this aspect, which has been referred to a high-level committee for further deliberation, is awaited.
As regards ensuring compliance with auditing standards, the Department of Company Affairs, a wing of the Government under the Ministry of Industry, enforces regulatory norms and acts decisively against any non-compliance. The two primary stock exchanges, the Bombay and National Stock Exchanges, rely on external auditors to monitor compliance with the accounting and disclosure requirements. The corporate relations department of the stock exchanges pursues any qualification by the auditors with the company and requires corrections by the following year-end.
The ICAI has made a beginning as a self-regulator by introducing peer-review of audit firms. As part of the process, an 11-member Peer Review Board was established in March 2002.6 The Board provides guidance to enhance the quality of services provided by ICAI members.
In the light of these developments, the present study seeks to formulate a coherent empirical model to explore the association among external auditing, managerial monitoring and firm valuation. It is argued that external auditing, managerial ownership and firm valuation are jointly determined and, therefore, should be modelled within a three-equation system of equations. The results demonstrate the existence of a substitution monitoring effect between auditors and the managerial group. Additionally, the results indicate that the number of auditor relationships and firm performance are positively related, suggesting that external monitoring enhances firm performance.