Financial acumen may not be every director’s strength but ignorance is no excuse when it comes to understanding company accounts.

Financial acumen may not be every director’s strength but ignorance is no excuse when it comes to understanding company accounts. The former directors of property group Centro found this out the hard way when the Federal Court brought down its landmark decision against them regarding their lack of due diligence in the lead-up to the company’s near collapse in 2007. The eight former directors and executives were found to have breached the Corporations Act by signing off on financial reports that failed to disclose billions of dollars of short-term debt. The case was watched closely by boards of directors across Australia, although the recently announced penalties were considered lenient. Declarations of contravention were made against all defendants.

 

Regardless of the lightness of the penalties, the case will continue to hold important lessons for Australian company directors. In his ruling, Federal Court judge John Middleton commented that the omission of more than A$2 billion of debt from the accounts could have been identified ‘without difficulty’. What was required of the directors was ‘critical and detailed attention’, rather than relying on the information presented to them by management and Centro’s auditors PricewaterhouseCoopers ‘no matter how competent or trustworthy they may appear to be’. The Centro case will continue to be upheld as a prime example of what can go wrong when directors rely on others for information rather than make it their business to read the financial statements and check them.

‘The judgement is more of a wake-up call to say “don’t skim the accounts and don’t rely on the assurances of others. You need to exercise judgement and use an inquiring mind”. Which is consistent with the legal principals [sic] that directors have to be pro-active when it comes to understanding company affairs including its financial affairs,’ [Anil Hargovan] says. Leigh Warnick, a partner with Lavan Legal in Perth, says there are two key messages company directors and their advisers should take home from the Centro judgement: directors are the last line of defence on financial reporting; and information overload is no excuse— directors must take control. Directors across Australia 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 this is not the case, Warnick says. The requirements outlined by Justice Middleton were to have enough financial literacy to understand basic accounting conventions, and to exercise proper diligence in reading financial statements.

John Colvin, managing director and chief executive of the Australian Institute of Company Directors (AICD), says the judgement against the Centro directors highlights important issues and provides some timely reminders of the significant responsibilities that come with a board seat and just how difficult being a director can be. ‘It is important for all company directors to have an understanding of the business they oversee, as well as a basic understanding of the financial position of the company,’ says Colvin. However, in an environment where the complexity of financial reporting standards and their application continues to increase, the role of company directors continues to become even more onerous.

The Centro judgement reminds directors that they are entitled to rely on specialist knowledge and advice provided by management and external advisers, but cautions directors that there are limits to that reliance, according to Colvin. ‘Board members should apply their individual, considered judgement to matters that are highly significant to the company before approving financial statements, and while we (at the AICD) agree that “directors are an essential component of corporate governance”, we are of the view that it is not the role of non-executive directors to be involved in the day-to-day management of the company,’ says Colvin.

‘You may find that some directors are not confident about their ability to understand the basic accounting concepts in the financial statements,’ says Warnick. ‘The only safe option for directors in this position is to take an appropriate course to improve their skills.’ (BusinessThink 2011)

Required

(a) Discuss the main issues for directors that are evident in the extract above.

(b) Critique the judgement made in the case regarding the level of financial knowledge required of directors.

(c) Suggest the consequence of the Centro decision for the diversity of Australian boardrooms.

(d) A continuing controversial topic relating to management and the board is remuneration. Given the decision in the Centro case, predict the consequences for the remuneration of board members and the effect this would have on other stakeholders.

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