The Centro case is about errors in the financial statements of the Centro Group, for the year ended 30 June 2007. The directors did not detect the errors, because they did not check the financial statements - they relied on management and the auditors to get them right.
The errors that the directors failed to pick up were:
- Current liabilities were wrongly classified as non-current: $1.5 billion for Centro Properties, and $0.5 billion for Centro Retail. The Court found that the directors knew that the relevant liabilities were payable in less than 12 months.
- Centro Properties had given guarantees for short-term liabilities of associated companies (totalling over $2 billion) between balance date and reporting date. These guarantees were not disclosed as post-balance date events.
These errors in the financial statements took on greater significance in late 2007 and early 2008, as the global financial crisis deepened and Centro experienced difficulty in refinancing short term debt. By the end of February 2008 Centro had been forced to issue a series of announcements to ASX disclosing its financial difficulties, correcting the errors in the 2007 accounts - and by doing so, exposing the errors in high relief.
ASIC brought a civil penalty action against the directors, for breach of:
- their duties of care and diligence: Corporations Act sections 180 and 601FD; and
- their duties to take all reasonable steps to comply or secure compliance with the financial reporting provisions of the Corporations Act: section 344.
On 27 June 2011, the Federal Court (Justice Middleton) delivered judgment on liability. Justice Middleton held that the directors had breached both duties. Penalties have yet to be determined.
There are two key messages in the case, for company directors and their advisers.
- Directors are the last line of defence on financial reporting – really
The financial reporting provisions of the Corporations Act provide a regime of checks and balances. In this regime, directors' specific obligations form the last line of defence. Directors do have a real obligation to focus on the accounts, and take reasonable steps to satisfy themselves that the accounts are correct. This function cannot be delegated to others.
This regime of checks and balances makes good economic sense. The financial statements are a portrait of the company, painted as at the balance date for the benefit of shareholders and investors. It's important that the portrait should be accurate. Directors are responsible for the governance of the company and they are supposed to keep informed about the company's business. It's logical that before the company presents its annual financial portrait to shareholders and the market, directors should be obliged to check it and make sure it aligns with reality as they know it.
In this sense, directors are the last line of defence against errors in the financial statements. This analogy is useful, because it makes it plain that the role of directors in checking financial statements can't be delegated to the in-house accountants, senior management and auditors who form the earlier lines of defence. It has never been acceptable for the last line of defence to go off duty, because they left it to the earlier lines of defence to stop anything dangerous getting through.
- Information overload is no excuse - directors must take control
The Centro Group structure was very complex: two "stapled security" structures, each with a listed public company and a listed property trust, and various associated entities. This meant that the process of preparing annual accounts for the Group was very complex and imposed a heavy workload and tight time pressures on all involved - including the directors.
The directors submitted to the Federal Court that they could not reasonably be expected to scrutinise and cross-check all of the detailed information that came to them in Board papers, to pick up on discrepancies between the real financial position of the Group and the position presented in the accounts.
In dismissing this argument, Justice Middleton said it was up to the directors to control the volume and quality of information that came to them. If more time was needed, they should have asked for more time. The volume and complexity of information could not be an excuse for failing to properly read and understand the financial statements.
After Centro, how should directors approach financial statements?
The Centro case says directors do have a duty to focus on financial statements, read them and check them. The evidence showed that the Centro directors did not even try to do this - they relied entirely on the integrity of the draft statements provided to them by management. Therefore, the case does not deal in any detail with the standard that directors have to achieve, if they do make a genuine effort to do their duty.
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. It does not. The requirement outlined by Justice Middleton was "the financial literacy to understand basic accounting conventions, and proper diligence in reading the financial statements”.
Practical recommendations for directors
First, make sure you have at least one "financial terrier" on the Board - 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. He or she will normally be able to do this review as part of the Audit Committee process, before the draft financial statements come to the full Board.
Second, don't leave it all to the financial terrier. Read the financial statements, notes and directors' report yourself. Take the time to read them carefully. Check to see if there is anything there that doesn't align with what you know about the company. If you find anything that causes you any doubt at all, ask management for an explanation. If you’re not confident about your ability to understand the basic accounting concepts in the financial statements, take a course.
Third, issue a clear direction to management to provide draft financial statements to the Audit Committee and Board with enough time to review them. If your corporate structure is complex (generating multiple sets of accounts), you will need even more time. If draft financial statements are presented at the last minute and you are pushed up against a reporting deadline, it's better to break the deadline than risk issuing inaccurate financial statements.
Fourth, insist that the CEO and CFO provide the declaration required by section 295A of the Corporations Act, saying 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 you get a clean declaration from management, don’t look on it as an excuse to avoid reading and focusing on the financial statements yourself.
Fifth, review the way management presents information to the Board. Board papers and presentations should be giving the directors a clear picture of what's going on in the company, without overloading directors with information. The Centro case is really saying that directors must have their own picture of the company, understand the picture being presented by the financial statements, and make sure there's no difference between the two pictures.
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