Audit committee
The board sub-committee responsible for reviewing a company's financial statements and nominating its auditors, which SEBI requires to be at least two-thirds independent directors.
In plain language
A company's own managers write its accounts. Someone outside that management must then check the numbers, so shareholders can trust them.
That check is the job of the audit committee. It is a small group set up by the board, separate from management. Its job is to review the financial statements and to pick who audits the company.
How it works
The workbook: "The audit committee is responsible for reviewing the financial statements of the company and for nominating the auditors. Ideally, the audit committee should comprise entirely of independent directors. SEBI regulation requires at least 2/3rd of the members to be independent."
The committee also has a role in related party transactions: the workbook notes SEBI does not currently mandate its pre-approval, only that material related party transactions be placed before it, with justification required where a transaction is not on an arm's-length basis.
A worked example
A company's audit committee has 6 members. The SEBI minimum requires at least two-thirds independent:
2/3 × 6 = 4 independent directors required
If the committee actually has only 3 independent directors out of 6, it fails the SEBI test by one member. A 9-member audit committee, by the same rule, needs at least 6 independent directors (2/3 × 9 = 6) to comply.
Why NISM asks about it
Chapter 7.6.2(vi) sets out the audit committee threshold as part of the nine governance checks in the chapter. Expect a direct numeric question on the two-thirds figure, or a scenario giving a committee's composition and asking whether it meets the SEBI minimum.
Common exam traps
- Do not confuse the audit committee's two-thirds independence threshold with the board's own independent-director threshold (50% if the chairman is executive, one-third otherwise) or the remuneration committee's rule (all non-executive, chairman independent) — three separate thresholds sit in the same section of the workbook and are easy to mix up.
Check yourself
1.A company places every related party transaction before its audit committee only AFTER the transaction is executed, and publishes a justification for one transaction that was not at arm’s length. Which is correct?
- a)This breaches SEBI regulation, which mandates pre-approval of all related party transactions
- b)This meets the current SEBI requirement, though pre-approval of material transactions is the ideal
- c)This breaches SEBI regulation because non-arm’s-length transactions are prohibited outright
- d)Related party transactions need not be reported to the audit committee at all
Show the answer
Answer: (b) This meets the current SEBI requirement, though pre-approval of material transactions is the ideal
The workbook draws this distinction deliberately: "Ideally all material related party transactions should be presented to the audit-committee for pre-approval. Currently, the SEBI regulation does not mandate pre-approval but requires placement of all related party transaction in front of the audit committee. If the transaction is not on an arms-length basis, then the regulation also requires that the company should provide justification for the same."
So the company has done both things SEBI requires — placement, plus justification for the non-arm’s-length transaction. Option A imports the ideal into the regulation and is the most-chosen wrong answer. Option C is wrong because non-arm’s-length RPTs are not banned; they require justification. Option D contradicts the requirement of placement entirely.
The reason RPTs matter at all: they can enrich the promoter group or other majority shareholders at the cost of minority shareholders.
2.As per SEBI regulation cited in the workbook, if the chairman of the board is an executive director, independent directors should constitute at least:
- a)One-third of the board
- b)50% of the board
- c)Two-thirds of the board
- d)The entire board
Show the answer
Answer: (b) 50% of the board
The rule has two limbs and the exam tests the join between them. If the chairman is an executive director, independent directors must be at least 50% of the board. In all other cases, 1/3rd of the board.
Option A is the other limb — correct when the chairman is not an executive director, wrong here. Option C, 2/3rd, is the audit committee requirement, deliberately placed to catch candidates mixing the two thresholds. Option D is not required anywhere; the workbook’s stated ideal is that a majority of the board be independent.
3.Why does the separation of ownership and management in a company create agency risk?
- a)Because shareholders are legally barred from meeting the management
- b)Because management may pursue personal interests at the cost of shareholders, or may not be capable enough to run the organisation
- c)Because the board of directors is appointed by the management
- d)Because auditors are appointed by the promoter group
Show the answer
Answer: (b) Because management may pursue personal interests at the cost of shareholders, or may not be capable enough to run the organisation
Shareholders own the company but a separate management team runs it day to day. That reliance creates agency risk — the risk that management pursues personal interests at the cost of shareholders, or is not capable enough to run the organisation effectively.
Option C reverses the reporting line: the management team reports to the Board of Directors, who are appointed by the shareholders. Option D is wrong as stated — the audit committee is responsible for nominating the auditors. Option A is simply invented; nothing bars shareholder engagement.
Where this is taught
Free preparation for NISM Series XVRelated terms
- Agency riskThe risk that a company's management, who control day-to-day decisions, pursue their own interests rather than those of the shareholders who actually own the business.
- Auditor independence testThe corporate-governance check that an auditor's total fees from a company or group stay below 10% of the auditor's overall income, so it is not financially dependent on that one client.
- Auditor rotationThe corporate-governance rule that a company's statutory auditor must be changed at least once every five years, so a long-standing relationship cannot let facts stay hidden.
- Corporate governanceThe rules, processes and procedures followed in running a company, judged by an analyst against a checklist of board, audit and related-party tests rather than by reputation.
- Related party transactionA deal between a company and a party connected to its controllers — promoters, their relatives, group firms. Watched because it can enrich the promoter group at minority shareholders' cost.
- Independent directorA director who is neither part of management nor otherwise connected to the company — at least half the board where the chairman is executive, and one-third otherwise.
- Non-executive directorA board director who is not part of day-to-day management, but who is also not classed as independent — a third category sitting between executive and independent directors.
- Remuneration committeeThe board committee that decides the pay of directors and senior management, which SEBI requires to be made up entirely of non-executive directors with an independent director as chairman.
- Obligations of trusteesThe duties SEBI places on a mutual fund's trustees: hold scheme property in trust, review every AMC-associate transaction quarterly, and certify to SEBI half-yearly that nothing improper happened.
- ESG frameworkA framework in which investors assess a company on environmental, social and corporate governance criteria, used as a screening filter before the usual financial analysis is done.
- Nomination committeeThe board committee that appoints independent directors, which the workbook says should ideally consist exclusively of independent directors so that company executives have no role in the appointment.