If you are struggling to understand the financial reports, find ways to educate yourself, because directors cannot simply rely on the company’s auditors.
Star Entertainment went into a trading halt earlier this year when it announced it would not be able to file its half-year results on time. The casino giant has since done so, but questions remain.
Its directors have been criticised for allowing shares to continue trading when it was running out of cash. Emergency funding it so desperately needs has been proposed. While shares have resumed trading, an independent expert is concluding what is in the best interests of shareholders.
Investors might wonder how any board could have overseen such a spectacular corporate failure.
But how exactly does a director know whether a company is merely suffering a downturn or if it’s entering a period of crisis?
Directors have a range of duties and obligations under the general law and the Corporations Act 2001 (Cth), backed up by potentially severe personal penalties.
These include a general obligation for directors to take reasonable steps to place themselves in a position to guide and monitor the management of a company.
Red flags in financial reporting
A starting point is that financial reports should be accurate, clear and timely. Here are five specific red flags that directors should be alert to:
Frequently running low on cash
Regular changes in accounting policy
Unexplained one-off items
Sudden changes in sales, costs or other numbers
Any pushback on asking questions.
There are also more specific duties around financial reporting, including the requirement that directors sign off on financial statements, confirming compliance with accounting standards, accuracy, fairness and solvency.
The Centro case involved errors in the financial reports of the Centro Group, a retail investment organisation, which significantly understated its short-term liabilities.
The Australian Securities and Investments Commission (ASIC) brought legal action against the Centro Group directors for breaching their duties under the Corporations Act 2001 (Cth).
The judgment made it clear that directors can’t just rely on a company’s auditors to ensure that financial statements are correct, even where they are highly complex.
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," Justice Middleton said at the time of judgment.
Pay attention
Directors must take the time to read the statements themselves and, where necessary, make their own further enquiries.
“Over the past 20 years, it’s become more and more clear that as a director you have to understand what’s going on with a company,” says Michael Coleman FAICDLife, an adjunct professor of business at UNSW and former non-executive director and audit committee chair of Macquarie Group.
“You can’t palm it off and say I’m not competent to do that. You have to make sure you understand what’s happening at the company.”
So how should directors ensure that a company’s financial reporting is of sufficient quality? And how might they spot any red flags contained in their board papers?
What to look for
“The turnaround time of being able to produce reports gives an indication of the quality of the controls and governance in place in the business,” says Felicity Gooding, an executive director and group CFO of Vulcan Energy, and a non-executive director and audit committee chair of Bannerman Energy.
“There should be a good mix between the numbers and commentary, with clear explanations of any deviations from what was expected."
“You want an indication that those numbers have been reviewed and have had the appropriate oversight from management. It’s a red flag if management is unable to explain its own numbers.”
It’s also important to have positive board dynamics “where directors are encouraged to ask questions and delve deeper, with open discussion at the board level and between the board and management”, she says.
A numbers game
In reviewing the figures, Gooding believes even directors without a financial background can tap into personal experience.
“Cash is king. Cash goes in, cash comes out,” she says. “Everyone has cash they’re managing in their personal lives. So, no matter what your experience, you should be able to understand where the cash goes. It’s important not to be overwhelmed by the numbers and bring it back to basics.”
In terms of red flags, Coleman echoes the point about cash. “If you keep running out, that’s a horrible red flag,” he says.
It’s also worth looking closely at the reconciliation between cash flow and profit, notes Gooding.
“This is where accounting judgments take place,” she says. “So you need to know what those judgments are and think about whether they make sense and whether they’re being applied consistently.”
In fact, Gooding would see regular changes in accounting policies as a potential problem in its own right, as she would any unexplained one-off items, such as write-downs.
Sudden changes
Beyond that, Coleman and Gooding are both looking for sudden variances in the numbers.
“If you see huge dips in sales or increases in costs, which aren’t explained or aren’t readily explainable, you probably should be asking people about it,” says Coleman.
“These are the things you’d be querying in a small operating business, like a local hardware store, all the way up to a large corporate entity.”
When to speak up
How to deal with any queries or areas of concern will depend on their nature and the dynamics within an organisation, but it’s important to be proactive.
“It’s one of the challenges of modern directorship,” warns Coleman. “If you have a concern and wait until a board meeting, there’s always a possibility that it might be too late.
“A good start might be to contact the chair, or the chair of the audit committee, and say, ‘I don’t understand this. Can you help me, or can we talk to the CFO?’
“Also bear in mind that the audit committee is a subcommittee of the board. Just because you haven’t been appointed to the subcommittee doesn’t mean you don’t have a right to attend those meetings.”
It would register as suspicious if you received pushback with any of this, Coleman adds.
Ask questions
In some circumstances it may also make sense to speak to a company’s auditors, although it would generally be appropriate to discuss this with the chair or the audit committee chair before you do so.
There should also be an opportunity to ask questions of the auditors when they present their audit report.
“Good governance is that the auditors come and present their report to the board or audit committee,” says Gooding. “The report should be transparent, and they usually give their view of the quality of financial reporting. You should be able to ask questions freely.”
In general terms, if directors find they’re struggling to understand the financial reports, they should find ways to educate themselves further.
AICD Practice resources — supporting good governance:
- What to consider before approving financial statements
- Finance for Directors
- Foundations of Directorship
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