Archive for August, 2012

10 questions you should ask when approving the annual financial report

Yep, it’s just about that time again.  The board has to approve the annual financial report in a post-Centro world.  Like the judge said:

“All directors must carefully read and understand financial statements before they form the opinions which are to be expressed in the declaration required by s 295(4).”

The approval of the annual financial report, which includes making the directors’ report, is arguably the single most important action the board will take on an annual basis.  So how can you best cover your ass?

After Centro (this is a great summary), here is the most important thing a reasonable and diligent director should do:

  • Actually read the documents – including the financial statements.  While non-accountants may not be able to follow all of the technical matters, every director should be reasonably familiar enough with the company’s financial position to make some contribution to the process – even if it is picking up typos, adds or formatting errors.

One of the Centro directors admitted that they didn’t actually read the annual financial report, but just looked at a summary.  You’ll never found a defence on actions like that.

Here are 10 questions which I reckon address matters that should always be considered before any resolution is passed to accept the financial report.  And please note, I am not an accountant, just a director who wants to hang on to his assets.

Questions for management

1.         Who prepared the accounts and who checked them?

It is reasonable to want to know that the work in preparing the accounts has been carried out by someone whom the board can expect to have the necessary skills and experience, and trust to be doing things the best way possible.  This may be particularly important when the accounts are prepared by an external party.

2.         What process has been followed to ensure compliance with the accounting standards and corporations regulations?

The board is required to pass a resolution about compliance, so directors should be explicitly asking about the steps taken to give them the grounds to do so.

3.         How have the valuations of assets been conducted, and/or the carrying values been ascertained?

The value of the company’s assets is ultimately a question for the board, so the board will want to know how that value has been ascertained, and that it has been ascertained in a reasonable way on some reliable evidence or information.  Feel free to test the basis of the valuation until you are happy that it is appropriate in the circumstances.

4.         What are the areas where judgement has been exercised in coming to the result recorded in the accounts, and if there are any, how was the judgement call arrived at?

Part of the process of preparing the financial statements is to make assessments of particular aspects of the company’s financial performance and position.  One of the commonest, and potentially scariest areas where judgements are made  is the making of provisions.  The board must fully understand the reasons for provisions being made, and how the amount of the provision has been arrived at.

Other areas where judgement may be exercised in coming to the position recorded in the financial report are:

  • Valuation of assets, discussed in question 4.
  • Depreciation rates and life expectancy of assets.

5.         On what basis can we be sure that there are reasonable grounds to believe that the company will be able to pay its debts as and when they fall due?

In view of the gravity of the solvency declaration which has to be made when approving the annual financial report, directors need to be sure that there are proper grounds for making it.  Remember, directors are personally liable for debs incurred if the company is trading while insolvent.

Directors are generally not responsible for the actual preparation of the annual accounts, and they are allowed to rely on information they receive from “competent and reliable” people who advise them about the company’s state of solvency.  They need, however, to take sufficient steps to test what they are being told, for instance:

  • are they happy that the people advising the board about solvency are “competent and reliable”?
  • is there anything about the company’s current trading position which might suggest the need for further specific enquiries?

A company can still be able to pay its debts when they fall due, even if it is in a loss-making position at the time.  It may have the support of its lenders, and sufficient income to service all of its creditors.  In such a situation, though, directors would need to understand very clearly how they can safely make the solvency declaration.  Particularly in this area, there is no such thing as a dumb question.  After all, it’s the roof over your family’s head that may be on the line.

6.         Has anything significant happened in relation to the company or its activities and operations since the end of the financial year which might be important when looking at its overall position?

While the annual accounts report on the performance and position of the company for the last financial year, there may have been events that have occurred since that time which may put that performance and position in a different light going forward.  This can include things like:

  • The sale of important assets or business operations
  • The acquisition of new businesses
  • The instigation of major litigation against the company.

This is another area of judgement call by the board, as to whether anything that has occurred is significant enough to require disclosure in the directors’ report.  If there is some uncertainty about the level of significance, try running it past the auditor and see what they might think.

A question for yourselves as directors

7.         Do the accounts reflect what we as directors, individually and collectively, would have expected given what we have seen of the company’s activities and operations over the financial year?

The annual financial report must comply with specific regulatory requirements, which are not always intuitive in either their form or substance.  But if the financial report shows the company making a loss, and you think it has made a profit, or perhaps more importantly, it is the other way round, you need to have a decent understanding of why that is.

There may be clear reasons why the recorded result may be different to what you understand to be the real world result, like:

  • The creation, or writing back, of a provision
  • The sale of important assets.

The board can apply an important sanity check to the financial report, and while there may be technical requirements which mean things must be reported in certain ways, there should still be a reasonable correlation about how the company has actually performed, and what is being reported.  Make sure you understand what that correlation is.

Questions for the auditor

8.         How did you find the state of the company’s records?

The board is making some important statements about the company.  An external view of the state of the company’s records can be an important indication of whether it is safe and reasonable to be making those statements.  The auditor will have accessed many of those records during the course of the audit.

9.         What level of co-operation did you receive from management while conducting the audit?

If management or staff have been unco-operative, unhelpful, or even evasive, it may be an indication that they have something they either don’t want looked at too closely, or may actually want to hide.  Again, an external view on a factor like this can be re-assuring, or a warning bell suggesting some further enquiry before the board commits itself.

10.       Are there any other matters you consider you should bring to the board’s attention which have not already been discussed?

Despite having asked questions 1 to 9, there may still be some important issue which the questioning has not uncovered.  This is your final opportunity to maximize the benefit of the external overview which the auditor has applied.  Don’t feel backward about taking that opportunity.

And finally …

The thrust of all these questions is the same.  Don’t take anything on face value, or gloss over something you don’t understand because people are telling you it is technical accounting stuff.

You may not be an accountant, but you can still make reasonable enquiries and do your best to ensure that proper processes have been undertaken to truthfully show what the company’s financial performance has been, and what its financial position is.

After all, you don’t want to be bitten by the Centro bug.

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