As directors sit down to review their companies’ accounts this month, Domini Stuart examines how the Centro case may have changed boardroom behaviour.
Just over a year ago, the Australian Securities and Investments Commission (ASIC) hailed the Federal Court’s verdict against eight directors and former executives of Centro Properties Group as a "landmark" decision. The case was widely reported as having serious implications for company directors – there was even talk of boardrooms emptying overnight.
Today, with boardrooms still well populated, most observers agree the case was less about adding to directors’ responsibilities than reminding them of the ones they already had.
A central fact in the Centro case was the directors’ failure to notice that $2 billion in current liabilities had been wrongly classified as non-current. The court found they knew, or should have known, these liabilities were payable in less than 12 months. All eight directors argued they had employed accounting firm PwC as auditors and should have been able to rely on it to ensure the accounts were correct. However, Justice John Middleton found they had breached the Corporations Act 2001 by not checking the figures.
"All that was required of the directors in this proceeding was the financial literacy to understand basic financial conventions and proper diligence in the reading of financial statements," he said.
While this caused many directors to question their own financial acumen, Leigh Warnick FAICD sees no grounds for panic.
"Directors would be entitled to react to the Centro case with alarm if it obliged them to read financial statements with the eyes of an expert, but it does not," says Warnick, a partner at Perth-based law firm Lavan Legal who specialises in corporate law.
"The Centro directors didn’t miss the errors because they didn’t understand the financial statements, but because they didn’t read them carefully before they were issued."
Nevertheless, "financial literacy" is open to interpretation.
"I know people from accounting or finance backgrounds who don’t consider themselves financially literate because they’re not up to date with the latest accounting standards and interpretations," says John Allpass FAICD, who holds a number of directorships and is chairman of Envestra.
"I don’t agree with that view. I see financial literacy as being able to understand financial concepts, how they’re applied, the consequences of certain applications and what questions to ask if there is something in financial reports that is obscure or exceptional. The risk is that some people will be frightened off the board because they don’t have a financial qualification. If people carry the Centro judgment too far, boards could end up with higher proportions of financial expertise at the expense of diversity."
Volume and complexity
The Centro directors also suggested it might be unreasonable to expect them to have detected the error given the complexity and quantity of the material they had to work through.
"It’s true that one line item – one number in a balance sheet – was wrong," says Meredith Paynter, a partner at King & Wood Mallesons. "But the company’s debt position was front and centre; the directors had been discussing the issue at board meetings."
The Centro Group structure was certainly very complex and the process of preparing annual accounts for the group did impose a heavy workload on the directors, but Justice Middleton did not accept that as an excuse.
"People seem to have forgotten that, if you take on these board responsibilities, you’ve got to be able to manage the amount of work generated by the structures," says Warnick.
"If you’re on the boards of 99 subsidiaries, you’re going to have to read 99 sets of accounts, so get ready to do it."
What are directors doing differently?
After the finding, some audit committees suddenly became very popular.
"There was a rush of directors attending these meetings," says Paynter. "They felt that if they were ever going to get into trouble it would be by getting the numbers wrong, so they should be aware of every detail. Then they paused to reflect that they were making the audit committee superfluous."
However, Allpass cautions boards against swinging back too far the other way.
"On any board, and as chairman of an audit committee, I’ve always been at pains to remind all board members they can’t just flick things off to an audit committee and say: ‘Well, they have given their imprimatur to this, therefore, tick, we can sign off’," he says. "Financial statements and reporting are matter for the whole board. I’ve been even more particular about that since Centro."
The circumstances of the Centro case were quite specific; most directors have come to realise it has had no effect on their duties or responsibilities.
"I think they want to be confident they are operating with executives who are professionals and know what they’re doing," says Paynter.
"They also see now that they can still take advice from someone who is properly qualified and has applied due care and diligence. It’s just that they can’t take it on blind faith."
For some, the case has clarified the role of the auditors – that, while they provide an important check for companies, they are not an alternative to directors doing their duty.
"An external audit should add value to a business by providing a comprehensive review of the entity’s governance practices," says Dianne Azoor Hughes, a partner at Pitcher Partners.
"However, the quality of that review will vary according to the depth and breadth of the experience of the reviewer. Many boards have treated audits as an exercise in compliance, but they may make false savings when they look for the cheapest option."
Lynda Tomkins, assurance partner at Ernst & Young, has noticed boards, and audit committees in particular, taking more time to "turn the pages" of the financial statements and discuss their contents, although she believes this reflects current economic circumstances as much as the outcome of the Centro case.
"There’s more engagement between the audit committee and the auditors, with the auditor asked to attend more meetings," she says. "There are also more discussions between the chairman of the audit committee and the auditors between meetings."
Auditors are being asked to provide more points of view to the board about management conclusions – not just whether they can accept the outcomes.
"This is particularly the case for areas of significant judgement such as impairment and provisions," continues Tomkins. "For example, the board doesn’t just want to hear we concur with the conclusion, but rather wants to hear where management’s conclusion sits within the range of acceptable outcomes. It also wants to understand the alternative views that could have been taken, the effects of those views and why, ultimately, they were not taken."
ASIC has announced that directors and auditors should pay particular attention to a number of areas, including revenue recognition and expense deferral policies; asset values and the disclosure of associated assumptions; off-balance sheet arrangements; and going-concern assessments.
"These are very important for accurate reporting of earnings and could influence reporting in challenging economic circumstances," says ASIC commissioner John Price.
However, experienced director Fiona Harris FAICD does not believe the boards she is involved with will change their processes this year.
"In my role as chairman of the audit and risk-management committee, I would always read the financial statements in detail and try to view them through the lens of my overall knowledge of the company," she says. "Regarding the specific issue at Centro, for those of my boards that have debt, the structure is very simple and the board has a good understanding of maturity dates.
"In terms of other ASIC areas of focus, my expectation is that most of my boards will update their internal models to test for carrying value and impairments – those internal models have been subjected to external validation in previous years. And, in terms of interaction with external auditors, in the committee’s private sessions with them, we always ask the ‘Warren Buffett question’ about how the accounts would differ if they were solely responsible for their preparation."
What should directors be doing differently?
ASIC has also made it clear that directors and auditors need to be thinking carefully about disclosure.
"In particular, directors need to have a keen understanding that the statutory financial report is intended to meet the financial information needs of investors," says Azoor Hughes.
"The nature of information provided in the statutory financial report based on the concept of economic value may be somewhat different from the financial information used for commercial decisions and the internal management of the business. However, commercial decisions will always affect how transactions and proposed transactions are reported in the financial report.
"It follows that directors should ensure significant commercial decisions have been considered and appropriately presented in the financial report. They also need to remain up to date in their professional development to be aware of changes in the business and reporting environment."
What have we learned?
Lavan Legal’s Leigh Warnick suggests five practical lessons can be learned from the Centro case:
- Every board should ensure it has at least one "financial terrier" among its members – a director who has real financial expertise and can be relied on to bring that expertise to bear on a thorough review of the financial statements.
- Directors should not leave it all to the "financial terrier". They must read the financial statements, notes and directors’ report, carefully and critically. If they find anything that raises any questions, they should ask management to explain. Any director not confident in his or her ability to understand the basic accounting concepts in financial statements should undertake a course – or find a different occupation.
- Directors should insist management provides draft financial statements to the audit committee and board with enough time to review them. If the corporate structure is complex and generates multiple sets of accounts, directors will need even more time.
- Directors must ensure the CEO and CFO provide the declaration required by section 295A of the Corporations Act 2001, stating that financial records have been properly maintained and that the financial statements give a true and fair view and comply with accounting standards. This will expose any concerns held by senior management about the financial statements. But even if management gives a clean declaration, it does not give directors an excuse to avoid reading and focusing on the financial statements themselves.
Directors should review the way management presents information to the board throughout the year. Board papers and presentations must give directors a clear picture of what’s going on in the company, without overloading them with information. Ultimately, that’s what the Centro case said: Directors must have their own picture of the company, understand the picture being presented by the financial statements, and ensure there is no difference between the two.
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