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Corporate Advisory Alert: Federal Court decision - Directors must ensure financial statements are correct - 27 June 2011

Justice Middleton of the Federal Court has delivered a judgement that will have a far reaching impact on the duties of directors to ensure that they have read the financial statements they sign off on to ensure they are correct and the extent to which directors are entitled to rely on the judgement and advice of management and experts when signing off on financial statements.

Here, Partner Michael Hansel and Associate Lea Fua look at this Federal Court decision and the critical points Justice Middleton has made.

Background

In 2009, ASIC commenced proceedings against current and former directors and officers of the Centro Properties Group alleging that they failed to discharge their duties with due care and diligence in approving financial reports for the year ended 30 June 2007 which failed to disclose more than $2 billion dollars of short-term debt. The directors argued before the court that they took reasonable steps to guard against error by relying on auditors to ensure the accounts were correct.

Ruling

In his judgement given today, Justice Middleton noted that there has been no suggestion that the directors were dishonest, however a number of critical points were made (emphasis added by HopgoodGanim):

  • What is required is that documents such as financial statements before they are adopted by the directors be read, understood and focussed upon by each director with the knowledge they have, or should have, by virtue of their position as a director.
  • The case law indicates that there is a core, irreducible requirement of directors to be involved in the management of the company and to take all reasonable steps to be in a position to guide and monitor. There is a responsibility to read, understand and focus upon the contents of those reports which the law imposes a responsibility upon each director to approve or adopt.
  • All directors must carefully read and understand financial statements before they form the opinions which are to be expressed in the declaration required by the Corporations Act. Such reading and understanding would require the director to consider whether the financial statements are consistent with his or her own knowledge of the company's financial position. This accumulated knowledge arises from a number of responsibilities a director has in carrying out the role and function of a director. These include the following:
    - a director should acquire at least a rudimentary understanding of the business of the corporation and become familiar with the fundamentals of the business in which the corporation is engaged;
    - a director should keep informed about activities of the corporation, whilst not required to have a detailed awareness of day-to-day activities;
    - a director should monitor the corporate affairs and policies;
    - a director should maintain familiarity with the financial status of the corporation by a regular review and understanding of financial statements;
    - a director (whilst not an auditor) should still have a questioning mind.
  • A director is not relieved of the duty to pay attention to the company's affairs which might reasonably be expected to attract enquiry, even though it is outside the area of the director's expertise.
  • Directors are entitled to delegate to others the preparation of books and accounts and the carrying on of the day to day affairs of the company. What each director is expected to do is to take a diligent and intelligent interest in the information available to him or her, to understand that information and apply an enquiring mind to the responsibilities placed upon him or her. Such a responsibility arises in adopting and approving the financial statements of a company. Because of their nature and importance, the directors must understand and focus upon the content of financial statements and if necessary make further enquiries if matters revealed in these financial statements call for such enquiries.
  • A reading of the financial statements by the directors is not merely undertaken for the purpose of correcting typographical or grammatical errors or even immaterial errors of arithmetic. The reading of financial statements by a director is for a higher and more important purpose: to ensure, as far as possible and reasonable, that the information included therein is accurate. Scrutiny by the directors of the financial statement involves understanding their content. The director should then bring information known or available to him or her in the normal discharge of the director's responsibilities to the task of focussing upon the financial statements. These are the minimal steps a person in the position of any director would and should take before participating in the approval or adoption of the financial statements and their own directors' reports.

Impact on directors

The critical decision by Justice Middleton sets out clear guidance on the duties of directors when reviewing financial statements and reports for disclosure to shareholders and the market. It undoubtedly places on directors the obligation to ensure that financial statements are accurate and that whilst they can delegate the preparation of books and accounts, directors must still apply their minds to financial statements to ensure they are accurate.