As we approach the June 30 end of financial year, directors must ensure they are across their reporting obligations.
For most Australian entities, 30 June marks the end of the financial year. Boards that may have spent the past few months dealing with the ever-changing effects of COVID-19 on their organisations now have to consider how they will report on it. The virus has created a world of uncertainty and volatility. How then should directors go about making the judgements and forecasts that underlie the financial reports? What about boards that have to make previously unheard-of fine judgements on going concern and solvency?
Reporting on the material effect
COVID-19 will have a material effect on most Australian businesses, and most reporting entities will be required to report on it, or disclose why it does not have a material effect. For listed companies, the effect of COVID-19 will likely be information reasonably required by shareholders, so will be required to be reported on by directors in the operating and financial review (OFR).
Part of that disclosure will be backwards-looking — reporting on the financial year that has been. However, the financial accounts necessarily contain forward-looking statements, including judgements about costs and revenue, valuation of assets and cashflow forecasts. This requires entities to make difficult assumptions and judgements, at a time of global uncertainty, particularly about the next year. Entities may wish to model a range of possibilities, from best case to worst, and note their effects on their business.
When applying these scenarios to the accounts, directors may need to form judgements on matters such as:
- Liquidity and liquidity risk
- Cashflow forecast scenarios and discount rates
- Potential diminished demand for products or services
- Potential operational disruption including supply chain/distribution networks
- Impairment, including of non-current assets and intangibles such as goodwill
- Assessment of fair value, particularly in an inactive market such as real estate
- Financial instruments (provision for doubtful debts, hedging, debt covenants)
- Impact on human capital resources and productivity.
The effect of each measure will vary and boards will need to work closely with management to ensure they are capturing the full extent of the pandemic impact on their business. These predictions and assumptions will need to be subject to audit and may be the subject of robust debate. Boards and managers will need to explain or justify their projections to their auditor. Involving the auditor early may facilitate that process. Boards will need to consider the extent of disclosure in their financial reports and, where relevant, in the OFR. Australian directors face significant disadvantages relative to other jurisdictions given the lack of protections for forward-looking statements and an environment extremely favourable to securities class action claims.
Assessment of going concern
As boards consider the effects of COVID-19, they may have to make a judgement on whether they are a going concern; that is, whether the company can continue in operation for the foreseeable future, at least the next 12 months. The Australian Accounting Standards requires the board to make this assessment before determining whether the company can prepare its accounts on a going-concern basis. The entity’s auditor is then required by Australian Auditing Standards to review the directors’ going-concern assumption and determine if, in the auditor’s judgement, there are events or conditions that cast significant doubt on the company’s ability to continue as a going concern.
The directors’ judgement is not whether an entity is a going concern today, but rather a continuing going concern. That means the application of the modelling and forecasts discussed above.
Where uncertainty exists, directors may be able to deal with the going-concern assessment by making a going-concern statement with a material uncertainty around pandemic-related issues — which will require detailed disclosure of what those uncertainties are. An auditor who agreed with that assessment would then issue an emphasis of matter paragraph in their opinion, detailing the COVID-19 material uncertainties set out by directors. There may be an increase in qualified opinions as auditors disagree with judgements made by entities around future prospects or going concern.
The AICD understands that the Australian Accounting Standards Board and the Auditing and Assurance Standards Board will soon release additional guidance to assist directors and auditors with this disclosure. The AICD believes it is important for the markets and users of financial statements to accept that many financial statements are likely to have material uncertainty around going concern from directors, and an emphasis of matter from auditors. A measured approach from users of that information will facilitate and encourage proper disclosure from boards and entities. This should not necessarily be a black mark against an entity, but rather an acknowledgment of the extraordinary degree of uncertainty created by the pandemic.
Australian directors face significant disadvantages relative to other jurisdictions given the lack of protections for forward-looking statements.
Annual financial reports (and half-yearly reports for listed companies) must contain a director’s declaration that the entity is solvent; whether, in the directors’ opinion, there are reasonable grounds to believe the company will be able to pay its debts when they become due and payable. For audited financial reports, this statement will be subject to independent audit. If an entity does not submit a financial report to the Australian Securities and Investments Commission (ASIC), they must pass a solvency resolution at least once a year and notify ASIC if it is negative.
Normally, a company that passed a negative solvency resolution would immediately call in the administrators. However, this practice has been complicated by the federal government decision to temporarily suspend the duty to prevent insolvent trading and raise some of the thresholds by which a creditor can apply to have a company wound up. Under this temporary safe harbour, a company may potentially continue to trade while insolvent, without directors breaching their duty. Indeed, ASIC has confirmed that a company may be insolvent while remaining a going concern.
ASIC has confirmed that in circumstances where directors are unsure of an entity’s solvency given market uncertainties, they can make qualified declarations as to solvency and disclose their material uncertainty. The ASIC Regulatory Guide 22 Directors’ statement as to solvency provides some assistance. ASIC also has a FAQ on its website.
In practice, directors may be reluctant to qualify their solvency declaration given the practical, commercial and legal implications that could follow. For example, a qualified solvency declaration may lead to a qualified audit opinion, which in turn leads to a breach of debt covenants. It is also possible that the disclosure of the entity’s precarious state of solvency in published financial reports may precipitate its decline. This seems unavoidable.
Liability and litigation risk
Reporting and disclosure around COVID-19 clearly increases litigation risk for companies and potential liability for directors, especially those of listed entities. As reported in Company Director, the AICD has been active in bringing this issue to the attention of governments. It assists no-one, including users of financial reports, if reporting and disclosure is made more complex, convoluted and confusing because of legitimate concerns from those charged with governance about the risks of being sued — using the benefit of hindsight.
As the AICD has long argued, we need significant legal reform in this area — and this argument has been strengthened by COVID-19 uncertainties.
For many boards, meeting reporting deadlines poses significant challenges in this environment. ASIC has the power to make both individual and class exemptions for deadlines for filing and/or publication of financial reports. It has already provided a one-month extension for unlisted entities whose financial years ended 31 December 2019 to 31 March 2020. ASIC’s current position is that a blanket extension, including for listed entities, is unnecessary and that companies should apply for individual relief.
The AICD position is that an extension should be provided for all entities balancing between 31 March and 30 June. This will give them the time and space to deal with some of the uncertainties around COVID-19. An extension will allow firms more time to complete their financial reports and/or audits, which may be impacted by physical distancing or workforce issues. Regulators in the US, UK, EU, Canada and New Zealand have all provided for extensions to reporting deadlines.
Listed companies wishing to apply to ASIC for individual relief also need to ensure they continue to meet the ASX listing rules. These were also recently amended to allow for extension of reporting deadlines in certain circumstances, including obtaining ASIC consent prior to applying to the ASX. The Australian Charities and Not-for-profits Commission has provided blanket extensions to charities whose 2019 annual information statement is due between 12 March and 31 August 2020.
Until such time as further relief is offered, the AICD encourages entities that might struggle to meet their reporting deadlines to engage promptly and openly with their regulators to see what flexibility might be available.
Financial reporting at front of mind
COVID-19 related issues around financial reporting are evolving rapidly. The AICD is heavily engaged in policy discussions with government and regulators on behalf of the director community. We will continue to promote the director voice in policy discussions and will keep members informed of any developments.
Directors must think long and hard about their legal obligations with respect to financial reporting, as well as directors’ duties more broadly. While directors must always pay close attention to their organisation’s financial situation, COVID-19 means the risk of failing in their duties becomes more acute. All diligent directors would be well-advised to receive regular updates on the financial state of their organisation and not rely solely on management assurances or the working of audit or risk committees.
For more resources and tools, go to our dedicated COVID-19 hub here.
EOFY checklist for directors
- Are we up to date with our creditor and tax office obligations?
- What challenges are we experiencing in preparing and auditing our annual accounts?
- Will any COVID-19-related balance sheet adjustments or post-balance sheet disclosures need to be made?
- Do we have reasonable grounds to believe the company is solvent to make the directors’ declaration of solvency?
- Do we need to consider issuing a qualified statement of solvency and is that a suitable route to take given the practical, commercial and legal implications?
- Is there a risk the auditors could have concerns regarding the ability of our company to continue as a going concern, and may qualify the audit? Could this trigger a default under loan agreements or have other negative outcomes?
- Will we be able to meet our reporting deadlines or do we need to apply for an extended filing deadline?
- Are we meeting continuous disclosure obligations, if we have them?
- Have we carefully reviewed our insurance policies to assess whether there is adequate cover for the legal and financial risks that may arise from COVID-19? What exclusions exist in our policies — are we covered for business interruption and event cancellations?
- How will our D&O policy respond to events related to COVID-19? Where could coverage limitations be applied?
- Have we spoken to our insurance brokers about our COVID-19 D&O risk and advised them of any anticipated changes in our business circumstances?
- With the D&O market hardening significantly, what COVID-19 exclusions and other limitations could be imposed on us when we renew our policy?
- Have we taken advantage of all assistance packages available to us, including federal/state packages, financier, landlord and ATO concessions?
- Are we technologically prepared for holding a virtual or hybrid AGM?
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