Financial Fundamentals for Directors 1 Chapter Extract Copy

FINANCIAL FUNDAMENTALS FOR DIRECTORS

DIANNE AZOOR HUGHES

2Logo colours

To cater for the numerous applications which will carry our branding we have developed a selection of logo colour variants. To help you, a library of master logo artworks has been specially created for your use.

Our logo has been specially drawn. To maintain consistency always use an original artwork from the Artwork Library.

1

Masterbrand colour paletteOur logo can be used in a variety of colours when used for masterbrand applications, all are acceptable and which is used will depend on the application.

2

Secondary colour paletteWhen using our logo on colours from our secondary colour palette it can only appear in blue to maintain legibility and consistency.

3

Mono logo (positive)For black and white applications, such as fax sheets, use the mono version of the logo. The entire logo reproduces in solid black.

4

Mono logo (negative)This version is for use only when the logo must appear in white on third party applications, when acting as a sponsor or partner. The entire logo reverses white out of a solid background.

1

3 4

2

Financial Fundamentals For directors

s. dianne azoor Hughes

Financial Fundamentals For directors

the australian institute of company directors is a member institute for directors dedicated to having a positive influence on the economy and society by promoting professional directorship and good governance. company directors delivers director development programs, information and advocacy to enrich the capabilities of directors, influence the corporate governance environment in australia and promote understanding of, and respect for, the role of directors. With offices in each state of australia and more than 34,000 members, company directors represents a diverse range of organisations, from the top asX 200 publicly listed companies to not-for-profits, public sector entities and private companies.

disclaimer the material in this publication does not constitute legal, accounting or other professional advice. While reasonable care has been taken in its preparation, company directors does not make any express or implied representations or warranties as to the completeness, reliability or accuracy of the material in this publication. this publication should not be used or relied upon as a substitute for professional advice or as a basis for formulating business decisions. to the extent permitted by law, company directors excludes all liability for any loss or damage arising out of the use of the material in the publication.

any links to third party websites are provided for convenience only and do not represent endorsement, sponsorship or approval of those third parties, any products and services offered by third parties, or as to the accuracy or currency of the information included in third party websites. the opinions of those quoted do not necessarily represent the view of the australian institute of company directors.

copyrightcopyright strictly reserved. the text, graphics and layout of this guide are protected by australian copyright law and the comparable law of other countries. the copyright of this material is vested in the australian institute of company directors. no part of this material can be reproduced or transmitted in any form, or by any means electronic or mechanical, including photocopying, recording or by any information storage and retrieval systems without the written permission of the australian institute of company directors.

© australian institute of company directors 2014.Published in april 2014 by:the australian institute of company directorslevel 30, 20 Bond street sydney nsW 2000

t: 61 2 8248 6600F: 61 2 8248 6633 e: [email protected] W: www.companydirectors.com.au/bookstore

text design Kirk Palmer design

national library of australia cataloguing-in-Publication data:azoor Hughes, s. dianneFinancial Fundamentals for directors

isBn: 978-1-876604-26-4

subjects: company directors – australiaGovernance – australia Business – australiaFinancial literacy – australia

iii

AcknowledgementsContributors

The Australian Institute of Company Directors thanks Dianne Azoor Hughes for her dedication to writing Financial Fundamentals for Directors. We also thank Amir Ghandar and Peter Wallace for their contribution in the early stages of the development of this book:

Amir Ghandar MAICD, CA, CPAPolicy adviser at CPA Australia, member of the Company Directors’ Reporting Committee, co-writer of Company Directors’ In-Focus course, ‘Strengthening Financial Governance’, member of In The Black editorial board, member of Australian Auditing and Accounting Public Policy Committee, and Australian School of Business guest lecturer.

Peter Wallace FAICD, CAManaging director of Endeavour Capital, non-executive chair of Ambertech Ltd, member of the Institute of Chartered Accountants, registered business valuer, and facilitator for Company Directors.

Reviewers

All Company Director books are rigorously reviewed, and we gratefully acknowledge the extensive voluntary contribution of our reviewers, particularly Judith Downes who was involved in three layers of the review process, and Jan West, Lynn Wood, and Natasha Whish-Wilson. All peer and lay reviewers gave generously of their time and had an important impact on this final publication. This book also benefitted from the input and review of Nicola Steele, senior policy advisor with Company Directors. More detail about all of our reviewers is as follows:

Jan West AM, GAICD, FCA Member of the Order of Australia, Fellow of the Institute of Chartered Accountants in Australia.

Financial Fundamentals For directorsiv

Judith Downes FAICD, FCA, FCPAChair of bankmecu, non-executive director, Devine Ltd and member of the Company Directors’ Reporting Committee.

Lynn Wood FAICD Trustee of the International Financial Reporting Standards (IFRS) Foundation, chair of the Financial Reporting Council (FRC), member of the External Reporting Board (XRB), and chair of Good Beginnings Australia.

Natasha Whish-Wilson MAICD, CSAChief Risk Officer, MyState Limited.

Nicola Steele MAICD, CA(SA)Senior policy advisor with the Australian Institute of Company Directors and secretariat for the Company Directors’ Reporting Committee.

v

About the author S. Dianne Azoor Hughes MBusLaw, PGradDipAdvAcc, MAICD, FCA

S. Dianne Azoor Hughes is a partner and executive director at Pitcher Partners, Melbourne. She leads the firm’s Technical Standards and Research Team, consulting externally with clients on governance and reporting issues and overseeing quality and risk management within the firm.

Dianne has 30 years of business experience having spent the first half of her career working with large listed entities and the past 12 years working with growing businesses. As a result, she has an astute appreciation of how growing businesses need to adapt their governance and risk processes as they transform from small, closely held entities, into larger businesses with a wider stakeholder group.

Dianne’s executive career has positioned her as a leading spokesperson for growing businesses in Australia. She actively participates in the debate and development of various aspects of reporting regulation, with a keen understanding of the competitive market and the cost/benefits of implementing new requirements.

Dianne was appointed as a board member of the Australian Auditing and Assurance Standards Board in 2004, serving three terms of office, prior to retirement from this statutory committee in December 2012.

Dianne Azoor Hughes is a member of the Institute of Chartered Accountants in England and Wales and member of the Company Directors’ Reporting Committee.

vi Financial Fundamentals For directors

vii

Foreword

We live in an increasingly complex world and many directors in Australia complain that it is becoming more difficult for them to deal with the resultant complexity of financial statements. These complaints are

further fuelled by recent legal decisions, not the least of which is the Centro case that confirmed, among other things, that directors cannot delegate to the audit committee, and others, their responsibility for approving the statutory financial reports. Directors must read the financial statements and consider whether the disclosures they contain are consistent with the director’s own knowledge of the company’s affairs.

A task force of the Financial Reporting Council (FRC) has considered the issue of complexity within financial statements and determined that while complexity was inevitable in modern financial reporting, directors need to consider the expectations of a wide range of stakeholders. The FRC discussion paper suggested that entities should attempt to manage this complexity and consider alternative ways of presenting their financial information. This might include the provision of some information on web sites and considering whether all disclosures made are, indeed, material and necessary to understand the business.

Despite this suggestion that the complexity of financial statements can be managed, the perception within the director community is that disclosures are becoming more complex, especially with changes to accounting standards that require grossing up of certain derivative transactions, and other disclosures resulting from differences between International Financial Reporting Standards and the accounting standards of the United States’ Financial Accounting Standards Board (FASB). There is also considerable uncertainty about the likely impact of proposed changes to the leasing standard.

It is not necessary for all directors to be ‘financial experts’. However, they must be sufficiently financially literate to satisfy themselves that they understand the results and financial position of the business and are able to fulfil their statutory obligations. Importantly, they need to know when to ask for expert advice.

viii Financial Fundamentals For directors

A survey of directors conducted by the Financial Reporting Council in 2012 identified a need for the development of a range of courses and publications targeted specifically at directors to assist them to develop their financial literacy. The publication of this book by the Australian Institute of Company Directors entitled Financial Fundamentals for Directors is a timely contribution. Written by Dianne Azoor Hughes, a member of Company Directors’ Reporting Committee and the Technical Standards partner at Pitcher Partners in Melbourne, this book aims to help directors and inter alia includes a schedule of over 100 questions for directors to consider when reviewing financial statements.

No single publication can provide all the answers to the complex world of financial reporting. However, this book should help all directors, whether seasoned financial professionals wanting a contemporary view on accounting, or non-accountants hoping to better understand the financial reports.

Congratulations to Dianne for authoring Financial Fundamentals for Directors.

Michael J. Coleman FAICD, FCA, FCPAChairReporting CommitteeAustralian Institute of Company DirectorsAdjunct Professor of BusinessAustralian School of BusinessUniversity of New South Wales

ix

Contents

Chapter 1 Financial literacy and governance 1

1.1 Introduction 1

1.2 Financial expert vs. financial literacy 4Commitment to lifelong learning 4

1.3 Financial governance 5Strategy 7Financing 8Reporting 8Monitoring 9Insolvency 9

1.4 Sources of funding for growth 10Equity 10Debt funding 12Banks 13Other sources of debt financing 14Convertible debt 16

1.5 Selecting the right capital structure 16

1.6 Impact on the governance model and stakeholder expectations 18

1.7 Summary 18

Chapter 2 The nature and purpose of financial information 19

2.1 Introduction 19

2.2 Financial information used by management and the board for internal purposes 20Periodic financial statements or management accounts 21Examples of management reports 21Projected cash flows and budgets 22Variance analysis 23

2.3 Financial information produced for external reporting 24Statutory financial reports 25Accounting disclosures 26Comparison of statutory financial statements and management accounts 28

x Financial Fundamentals For directors

Other corporate reporting disclosures 28Directors’ reports 28Directors’ declaration 29Sustainability 30

2.4 Summary 32

Chapter 3 The fundamentals of accounting 33

3.1 Introduction 33

3.2 Financial position, financial performance and cash flows 34Financial position 34Financial performance 36Cash flow 37

3.3 Underlying assumptions 39Accrual accounting 39Going concern 40Indicators of going concern problems and/or the risk of insolvency 42

3.4 Qualitative characteristics 43True and fair presentation 43

3.5 The elements of financial statements 44Assets 44Liabilities 47Equity 48Income 49Expenses 50

3.6 Contingent assets and contingent liabilities 51

3.7 Summary 52

Chapter 4 Accounting frameworks and accounting standards 53

4.1 Introduction 53

4.2 Accounting frameworks 53

4.3 International Financial Reporting Standards 55

4.4 Australian Accounting Standards 55

xiCONTENTS

Reporting entities 56General purpose financial reports 58Special purpose financial statements 60Areas requiring expert advice 61

4.5 Australian Accounting Standards, IFRS and US GAAP 63

4.6 Accounting classifications 64Current and non-current classifications 64Working capital and liquidity 67

4.7 Summary 68

Chapter 5 How does financial information flow through a company? 69

5.1 Introduction 69

5.2 The accounting system 69Book-keeping – debits and credits 69The general ledger 70Sub-ledgers 70Debtor information flow 72Payables information flow 73Inventory information flow 74Payroll information flow 75Plant and equipment register information flow 76

5.3 The system of internal control and risk management 77Internal controls 77Risk management 78Interfacing with management 78

5.4 The role of the board 79The role of the audit committee 79The role of other board sub-committees 80

5.5 The role of the external auditor 81

5.6 The role of the internal auditor 83

5.7 The role of minutes to capture financial decision-making and reports 84

5.8 Summary 84

xii Financial Fundamentals For directors

Chapter 6 How and when do we recognise financial information? 85

6.1 Introduction 85

6.2 Different types of financial information 85

6.3 Initial recognition 86Assets purchased under financing arrangements 88Employee benefits 88Transactions denominated in foreign currencies 89Derivatives used to mitigate risk 89Income tax and deferred tax 90

6.4 Subsequent recognition 90Revenue from contracts with customers 91Services received over a period of time 91Investments in equity securities 92Property 93Leases 93Receivables 94Intangible assets 94

6.5 Summary 95

Chapter 7 How do we measure elements of financial statements? 97

7.1 Introduction 97

7.2 Carrying amount 97

7.3 Historical cost 98

7.4 Amortised cost using the effective interest method 98

7.5 Fair value, including ‘mark-to-market’ 98

7.6 Revaluations 100

7.7 Impairment 101

7.8 Quick sale valuations 102

7.9 Summary 102

xiiiCONTENTS

Chapter 8 Review of financial reports 103

8.1 Introduction 103Approach to reviews of financial reports 104

8.2 110 questions to consider when reviewing financial reports 105Q1-6 Nature and purpose of the review 105Q7-11 Compliance with accounting standards 106Q12-14 Compliance with government regulations 106Q15-21 Listed companies 107Q22-24 Preparation of financial statements for non-statutory reasons 107Q25-39 Overview of financial results and financial position 108Q40-43 Internal auditors 109Q44-47 Compliance with the company’s policies and procedures 110Q48-65 Assets 110Q66-75 Liabilities 112Q76-80 Foreign exchange exposure/derivatives 113Q81-84 Related party transactions 114Q85-89 Going concern 114Q90-92 Dividend policy/capital management 115Q93-98 External auditors 115Q99-107 General 116Q108-110 Concluding review procedures 117

8.3 Summary 117

Appendix 1 Special considerations – listed companies 119

Initial public offering – matters to consider 120Raising capital 120To provide incentive to employees 120Recognition and credibility 121New shareholders and directors 121The additional costs of an IPO 121Eligibility to list on ASX 121Offer information statements 123

xiv Financial Fundamentals For directors

Statutory financial reports for listed companies 124Operating and financial review 124Underlying profits 125Remuneration reports 125Directors’ declaration 126Declarations by the chief executive officer and chief financial officer 126The financial report 126

Continuous disclosures 127

Corporate governance statement 127

ASX Corporate Governance Council’s Principles and Recommendations 129Principle 1: Lay solid foundations for management and oversight 129Principle 2: Structure the board to add value 131Principle 3: Act ethically and responsibly 132Principle 4: Safeguard integrity in corporate reporting 133Principle 5: Make timely and balanced disclosure 134Principle 6: Respect the rights of security holders 134Principle 7: Recognise and manage risk 135Principle 8: Remunerate fairly and responsibly 136Audit Committees 137

Appendix 2 The Centro Case 139

Background to the Centro Case 139Key issues 140Decision 141What was required of the directors? 142

Suggested further reading 143

1

Chapter 1 Financial literacy and governance

1.1 Introduction

A director of a company is expected to exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they held that same position of responsibility. This is the general duty of care and diligence as set out in the Corporations Act 2001 (the Act).1 Financial literacy is just one aspect of a director’s duty with respect to the corporation.

Financial literacy encompasses a combination of skills, background and experience. For company directors, financial literacy is largely about the ability to:

1. acquit formal legal and statutory obligations as they relate to financial matters, such as signing off on the annual financial reports

2. monitor financial results to assess solvency3. balance risk mitigation (financial and otherwise) with the ability to drive

the company’s financial performance by understanding the ‘story’ told by its financial reports

4. know when financial experts are required to assist with the above points.

While these are the four pillars of financial literacy, other factors may shade the depth of financial skills and knowledge needed, such as:

• the company’s business model

1 Refer Corporations Act 2001: http://www.comlaw.gov.au/Details/C2013C00003.

2 Financial Fundamentals For directors

• business plans and strategy• stage of growth• the company’s financial health• risk profile• the skills mix around the boardroom table• the economy.

For instance, a start-up needs very different financial strategies to an established public company and therefore directors need to consider whether they have the appropriate skills and expertise to effectively balance risk and drive performance for that company’s particular circumstances.

A smaller, not-for-profit (NFP) board may require board members with an extensive background in NFP fundraising with knowledge of how to balance the cost of this activity with the return. The financial governance practices of NFP companies are likely to require a depth of understanding of different aspects of financial literacy in comparison to an established public company.

And yet, despite these very different scenarios, all directors should have an appropriate level of financial literacy to meet their legislative responsibilities, understand the company’s financial information needs, and recognise when consultation with a financial expert is needed.

If a company operates across borders and different legal obligations and accounting standards exist in these other territories, directors will need a new level of financial literacy together with an understanding of the economic environment in which business is conducted. Understanding risk management includes financial literacy as it enables a director to steer companies and organisations through boom and bust cycles.

Company directors are required to comply with statutory obligations set out in the Corporations Act 2001 and a lack of compliance could result in financial and other penalties. For instance, no director – no matter the type of organisation, paid or voluntary – can delegate their responsibilities to sign off the company’s statutory financial reports (which are prepared in accordance with Australian Accounting Standards) to other directors, company officers, financial experts, or any party.2

2 Refer Section 2.3 for more information on financial information provided for external reporting.

3FINANCIAL LITERACY AND GOVERNANCE

While director statutory obligations have not changed, there have been several court cases over the past decade or so that have highlighted how vital financial literacy is, and how severe the consequences can be when it is lacking. The global financial crisis of the late 2000s resulted in company failures ranging from small privately held businesses to companies and institutions deemed “too big to fail.” A recent high profile legal matter in Australia, known informally as the Centro case,3 put the spotlight back on director duties and responsibilities as they relate to financial matters when it concluded in 2011 with significant penalties for several directors.

In 2012, the Financial Reporting Council (FRC)4 surveyed company directors and financial professionals to gauge financial literacy around the boardroom table. The resulting report, released in September 2012, revealed that both groups agreed directors need more financial knowledge and skills. Financial professionals had a far lower opinion of director financial skills than directors themselves, who nevertheless, saw room for considerable improvement.

Essentially, the FRC survey highlighted that the financial literacy of directors as a whole may not be what it needs to be to adequately enable directors to acquit their legal and statutory obligations, balance risk and performance, and understand when to seek advice from financial experts.

Some respondents to the FRC survey went even further, calling for compulsory accreditation for directors to demonstrate their achievement of a minimum level of financial literacy and continuous professional development to ensure directors are required to keep up with changes in reporting laws, accounting standards and regulatory expectations. This would codify expectations for director financial literacy, however, there are no current regulatory proposals regarding this.

In response to these concerns Financial Fundamentals for Directors seeks to help directors develop their financial literacy. However, this book is just one element of a lifetime of learning; other opportunities to develop this skill set should be sought whenever possible.

3 The Centro case (ASIC v Healey & Ors [2011] FCA 717) is described in Appendix 2 and provides a good case study of the consequences of failing to meet statutory financial reporting responsibilities.

4 Refer to the FRC summary and survey results on director financial literacy: http://www.frc.gov.au/reports/other/Financial_Literacy_Survey/Financial_Literacy_Survey_2013.asp.


1.2 Financial expert vs. financial literacy

A financial expert can identify and action the most appropriate accounting treatment in a given set of circumstances. A financial reporting expert can choose and apply the correct accounting framework.5

However, the financially literate director is not expected to have an in-depth knowledge of different accounting frameworks, or have the ability to action the required accounting treatment. Instead, a financially literate director should be satisfied that the accounting framework required in the circumstances, has been applied. He or she should also be able to understand when financial expertise is needed, and why a particular course of action has been followed.

Financial reporting is a language used to explain business activities in financial terms. Directors should have an in-depth understanding of business activities and must have confidence ‘the story’ portrayed in financial terms in the company’s financial statements is consistent with their understanding. The ability to read and understand this ‘story’ is at the heart of a director’s financial literacy.

Commitment to lifelong learning

The business environment is dynamic and a company’s business activities are likely to expand and contract in response to changes in that environment. Changes in the economy and the business environment drive changes in financial reporting requirements and often, financial reporting changes are delivered in response to new developments. For each company, business activities will evolve over time. As such, the nature of the company’s financial reporting requirements will also evolve.

For example:A company starts life as a small proprietary company and over years, grows to become a large proprietary company. It then changes status to a public company for an initial public offering (IPO). After establishing itself as a listed company it then diversifies its operations. Each new status is likely to introduce additional financial reporting obligations.

5 Accounting frameworks explain when, why, what and how transactions should be described in accounting terms in a financial report. Several different accounting frameworks exist and the applicable accounting framework will not be the same in all circumstances. Accounting frameworks are explained further in Chapter 4.


Companies may remain at a stable level of operations, or may actively seek new opportunities. However, no strategy is risk-free and inevitably companies will take action to mitigate risk or simply agree to accept and monitor perceived risks with no immediate action taken. Companies are unlikely to operate in isolation; they are likely to have suppliers, customers, employees and perhaps even communities that are impacted by their activities. A company’s strategies, business activities, risk mitigation and relationships are captured and explained in the financial statements, both in the numbers reported and in the disclosure notes. As each of these factors evolve and change, the ‘story’ told in the financial statements will also evolve and change.

1.3 Financial governance

The Australian Government’s business resources website includes a straightforward description of corporate governance as being “good decisions being made by the right person”.6

This principle can also be applied to financial governance,7 which is an essential element of a company’s overall corporate governance systems and processes to ensure it meets its financial obligations to shareholders, financiers, government agencies and other stakeholders.

The primary areas of financial governance are:• strategy• financing• reporting• monitoring• solvency.

Financial governance also includes the company’s responses to key issues and financial risks that arise at each stage of the company’s lifecycle. It will also determine

6 Refer: http://www.business.gov.au/. 7 The Australian Institute of Company Directors has a range of courses, including the Company Directors Course,

which includes finance modules, and other courses specifically designed to improve financial skills for directors, such as the In-Focus course ‘Strengthening Financial Governance’: http://www.companydirectors.com.au/Courses.


how financial decisions are made on a daily basis, ensuring there is an appropriate level of authorisation and oversight – depending on the extent of risk associated with the nature of the transaction.

For example:Routine transactions are likely to be approved by managers with appropriately delegated authority, whereas complex and unusual transactions would often require board approval.

Financial governance includes the response to reporting obligations, both internal and external, and the consideration of the critical financial issues and risks that are implicit in those processes. For directors and boards, ensuring that “good decisions are made by the right person” includes identifying the expertise and capabilities required to carry out different financial roles within the company. Depending on its complexity, the financial skills and expertise needed may range from basic book-keeping to an in-depth knowledge of technical accounting requirements.

Financial governance includes oversight of:• the employment of appropriately skilled persons• consultation with external professionals as needed• the continuing professional education of financial staff employed by the

company• the expertise and reputation of external advisors.

In a small company without complex transactions, financial governance may involve establishing systems and processes to record transactions when they occur and monitor cash flows on a regular basis. Monitoring cash flows might be as simple as ensuring revenue is collected promptly and debts are paid as and when they fall due. In these circumstances, the company may only require that staff have basic book-keeping skills. Budgets and cash flow forecasts, together with periodic accounts, are likely to be prepared with the assistance of an external accountant. For a small company, these procedures may adequately satisfy financial governance obligations.

In contrast, financial governance practices will be significantly more extensive in


a large company with more extensive business activities and/or complex transactions. Customer invoicing systems will generally include more complex terms of trade, such as customer financing arrangements. Credit control activities may be required to ensure monitoring and collection of overdue debt. Goods and services might be supplied under a strategic alliance with a third party; they may be imported or exported and denominated in foreign currencies. The company may work more closely with its bankers to establish processes to mitigate foreign currency risk.

To handle these scenarios and others, the larger company will probably have a finance team led by a financial controller or chief financial officer. The board of directors will need to have a good appreciation of the nature and extent of the company’s transactions to ensure the financial governance practices in place are appropriate.

Strategy

Different corporate strategies will have differing financial impacts, which in turn, drive the company’s financial governance practices. Financial literacy encompasses understanding the financial implications of strategy, including the associated risks. For example, the financial aspects of strategy include:

• sources of funding• funding limits• capital structure• cost of capital• cash flows• return on investment• dividend decisions• impact of the accounting standards on the recognition and measurement

of transactions.

The company’s strategy and financial plans should be closely aligned with each other. Financial governance ensures the strategic plan includes an evaluation of the sources of funding available to the company to support implementation of its plan, assessment of the effectiveness of investment decisions, and the extent to which additional funding may be required at each stage of strategy implementation.


Financing

It is essential for directors to consider how the company will be funded – generally a combination of both equity and debt. The directors will also decide whether profits are retained in the company or returned to the shareholders through issuing a dividend. As business activities become more complex, good financial governance will often require a formal treasury management policy for foreign currency, interest rate hedging and other related matters. Policies for capital management and capital investment decisions may also be appropriate.

Reporting

Most companies have both internal and external reporting obligations. All companies need internal reporting to monitor performance and to provide evidence that the company is not trading while insolvent. External reporting obligations vary with the size and nature of the company and its sources of finance.

Certain types of companies have obligations under the Corporations Act 2001 to present and approve annual financial statements that are prepared in accordance with Australian Accounting Standards and present a ‘true and fair’ view of the company.8 These companies are required to lodge their financial reports with the Australian Securities and Investments Commission (ASIC), and thereby make them available to the public. Directors of listed companies have additional reporting obligations as laid out in the Australian Securities Exchange (ASX) Listing Rules9 and must ensure they are aware of the extent of their responsibilities, including continuous disclosure reporting obligations.

Companies also have reporting obligations to the Australian Taxation Office and other government agencies. Further reporting may be needed to external finance providers, such as banks, to satisfy reporting obligations under the terms and conditions of financing arrangements.

All financial information presented for board approval to meet company reporting obligations should be robust and accurate, without material error. Directors will want to be satisfied the company has established appropriate accounting systems

8 Public companies, large proprietary companies and small proprietary companies that are foreign owned, have statutory reporting obligations under the Corporations Act 2001.

9 For further information in respect of listed company reporting obligations, refer Appendix 1.


and internal controls.10 These processes may include, or require, external auditing of the financial information presented for board approval.

Monitoring

Financial monitoring of the company’s performance is a key responsibility of the director. As such, information presented to the board and management should facilitate this process and will include key performance indicators, cash flow forecasts and budgets. If the company is required to achieve certain performance criteria specified in debt covenants, the board will also monitor these criteria to ensure there is no breach of the terms and conditions of finance.

Insolvency

Insolvency is defined as the inability of a company to pay all of its debts as and when they become due and payable, as set out in Section 95 (2) of the Corporations Act 2001. Section 588G makes it an obligation of the directors of the company to not trade while insolvent. As such, directors must be able to determine if there are reasonable grounds to believe the company can pay its debts as and when they fall due.

In order to determine whether debts can be paid as and when they fall due, reliable, accurate and complete financial records must be maintained by the company. In Australia, a failure to keep appropriate records is a prima facie indicator of insolvent trading and can therefore have serious consequences for directors, who will be deemed, prima facie, to have permitted the company to trade while insolvent. The nature and extent of business activity determines the nature and extent of accounting records that need to be maintained to demonstrate that the company’s accounting records are adequate.11

10 Matters relating to internal controls over financial reporting processes are described in Section 5.3.11 For a more detailed discussion about insolvency and its link to the accounting concept of ‘going concern’ refer

Section 3.3.


1.4 Sources of funding for growth

A key attribute of financial governance is to ensure the company has the funds needed to achieve its business plans on a timely basis. The nature and extent of capital invested in a business will depend on the availability of the various sources of funds and the company’s risk appetite. Capital will be needed when the company is first incorporated in order to commence operations. A company may also seek funding at various stages of its evolution.

For example:A company may seek funding to expand its business operations to new locations or to diversify its business activities.

Sources of finance fall into two main classifications: 1. share capital (equity) and retained earnings2. debt.

There are also more complex sources of finance, such as convertible debt instruments and structured leasing arrangements. Convertible debt instruments may have the characteristics of debt at inception, together with an option to convert the debt to equity at a later stage. These sources of finance are considered further below.

Directors need to consider the optimal mix of equity, debt and possibly convertible instruments, to manage the cost of capital while mitigating perceived risks. Financial capital management decisions, including how a company will be funded, are some of the more important financial decisions a director will make.

Equity

At incorporation a company is generally formed by investors subscribing for shares in return for a cash payment. The allotment of shares in this way establishes the share capital or equity of the company. As the company commences operations, its business activities may generate a profit or a loss. If the company earns a profit, the directors may decide to pay a dividend to shareholders. Any profits retained in the business can be used to fund future growth or future dividend payments. Equity


describes the aggregate amount of share capital, retained earnings and other reserves that accumulate in the company.

Ordinary shareholders have a residual interest in the company only, meaning the shareholders are only entitled to any amounts remaining in the company after all other creditors have been paid in full.12 Further, there is no obligation to pay dividends, although there may be an expectation that dividends will be paid as and when the company makes a profit.

From the company’s perspective, equity funding, through the issue of shares to investors, is relatively low risk as there is no obligation for the company to return the funds invested, or to pay dividends.

For example:Investors in exploration companies should recognise they may not initially receive dividends on their investment; rather, the investment is made in the anticipation of the exploration activity being successful (eventually), and therefore, the value of their shares may increase substantially at that date; or, the value may be lost completely. In the interim period, the investor is willing to accept the risk of no returns now in exchange for the possible reward of returns in the future.

Share capital, issued with no expectation of dividend payments in the near future, has no cash cost to the company during that period. Directors need to consider how much profit should be retained, and how much profit should be delivered to shareholders by way of a dividend. These decisions may be critical to a company’s ability to attract equity investors at a later date.

A company will need to secure funds at its inception, in order to commence activities. In the early stages of a company’s lifecycle, financial governance may be focused on identifying the most appropriate sources of finance. At this preliminary stage, financial governance will include the timing of expected future cash flows of the business, as well as the company’s ability to repay debt or provide returns to investors.

In contrast, the financial governance of a more established, stable company, will

12 A company may also repay capital if it decides to reduce or buy-back its capital. A reduction or buy-back of capital can only be conducted in accordance with the provisions of the Corporations Act 2001, and directors generally seek legal advice before embarking on this course of action.


be closely linked to the business strategy. When it seeks to diversify and identify new investment opportunities, financial governance will include examining the various opportunities for growth and the different funding sources available to achieve this. When the current owners embark on an exit strategy, financial governance will be focused on how the business is sold.

Debt funding

Debt is the borrowing of money from others, generally a finance organisation or by issuing debt securities to the market. It is repaid over time or at maturity, and the borrower usually pays interest on the loan. The advantages of debt financing include:

• when shareholders expect a market rate return on investment, debt funding may be less expensive than equity funding if the lender has security over the assets of the company

• companies may receive a tax deduction for the interest expense, whereas there is no tax deduction for dividends paid

• there is no dilution of shareholder interests as debt providers do not typically share in any growth in the share value or dividends from the company.

The disadvantages of debt financing include:• debt finance incurs an interest expense that must be paid on a regular

basis, regardless of company performance• the borrowings must be repaid within the term of the finance agreement

or renegotiated as a new finance facility prior to the debt maturity date• debt financing is generally secured by the assets of the company and is

given priority in liquidation proceedings over most other liabilities• providers of debt funding may require the company to agree to certain

financial conditions (covenants)• if the company breaches its lending covenants, the debt funder may be

able to take action to recover their debt by appointing a receiver and manager to the company, or negotiate terms and conditions

• the availability and cost of debt funding varies in response to the economic cycle and therefore may be difficult to obtain and/or costly at times when it is most needed.


Banks

Banks are the primary source of debt funding for Australian companies and offer a myriad of loan funding products, ranging from short-term overdraft facilities to longer-term loans. They can also facilitate international currency transactions and currency hedges. Ordinarily, a bank will provide a letter of offer outlining the basis for which the bank initially lends and continues to lend money to the company. Directors need to be aware of these banking covenants as the bank may seek to recall the loans if the company breaches the covenants. Banking covenants will vary depending on the size of an organisation, its industry, stage of development and the amount of the loan. The nature of covenants may also vary over the economic cycle.

For example:Terms and conditions of bank borrowings may include:

• financial covenants

• amount of the facility

• components of the facility, such as overdraft, term loan, bill facility, letters of credit, foreign currency, and payroll

• interest cost, typically described as a margin over the bank’s prime rate or over the bank bill rate

• payment of interest at specified intervals

• repayment of principal either periodically or at maturity

• maturity date of the debt facility

• monthly or quarterly reporting to the bank

• annual reporting to the bank.

Financial covenants are a series of ratios that the bank may require the company to operate within in order to continue to have access to the facility; they protect the bank’s position from a customer with a deteriorating financial position. In the event these financial covenants (or general conditions) are not met, the bank may seek immediate repayment of the loans.


For example:Financial covenants may include:

• Interestcoverratio – EBIT/interest expense:13 measures the amount of earnings available to meet the interest expense. A typical interest cover ratio is 3.0 or more.

• Gearingratio – interest bearing debt/equity: the gearing ratio shows how much of the company’s financing is provided by the bank compared to shareholders. Another form of gearing ratio measures interest bearing debt/EBITDA,14 which gives the bank an approximate amount of time that would be needed to pay off the loans, before the impact of interest, tax, depreciation, and amortisation.

• Currentassetratio – current assets/current liabilities: the current ratio shows how many times the current assets are greater than the current liabilities, with 1.5 times or greater being a rule of thumb.

It is recommended that directors monitor management’s compliance with these financial ratios by receiving regular reports, including any potential breaches arising in forecasts. If an actual, or potential, breach of the financial covenants is identified, the directors will want to take appropriate action, which may include negotiating waivers with the bank, raising additional equity and considering alternative debt sources. A breach of financial covenants often results in the bank having the right to terminate the borrowing facility and therefore removes an unconditional right to defer payment of debt beyond 12 months. This results in debt that may otherwise have been considered as long-term, as being classified as current debt in the financial statements, often with further disclosure in the notes concerning the breach. In extreme situations, the appointment of an administrator may be necessary to mitigate the risk of insolvent trading or to pre-empt the appointment of a receiver and manager.

Other sources of debt financing

Other sources of debt financing from financial institutions include factoring, leases and hire purchase.

13 EBIT is earnings before interest and tax.14 EBITDA is earnings before interest, tax, depreciation and amortisation.


FactoringFactoring involves the company selling its accounts receivables to a finance company at a discount. In return, the company receives an advance of, say, 80% of the face value of the invoices. The discounted rate will vary with the nature of the facility provided, which may also include terms such that a further sum is received when debts are collected in full or that the amount of the “bad debt” reverts back to the company when a debtor fails to pay amounts due. The fee to cover the costs of providing the finance and transactions costs is often included in the up-front discounted amount, or may be deducted from sums received from debtors and passed back to the company.

Leases Operating lease – an operating lease provides access to an asset by the lessee for the period of the lease. They are often used to give companies access to premises, such as offices or retail outlets, as well as equipment, such as photocopiers.. However, unlike a finance lease, the lessee does not have the right to acquire the asset at the end of the lease period. The lessee may make an offer to acquire the asset, but the lessor is not obliged to sell. Assets used by the company under operating lease arrangements have not previously been included in the financial statements as assets of the company, although changes to lease accounting have been proposed for a number of years.15

Finance lease – the lessee (the borrower) may wish to acquire an asset, such as a motor vehicle and the lessor (a finance company) provides the funding for the purchase. The lessee has the use of the asset during the term of the lease, during which time the lessee make a series of payments, say, 36 or 48 months. These payments include a principal repayment and interest to the lessor. At the end of the lease, the lessee may either acquire the asset at the agreed price or return the asset to the finance company. Ownership of the asset remains with the lessor until the lease is paid out. In these circumstances, where the company effectively uses the asset for most of its economic life, accounting standards require the leased asset to be included with assets owned by the company, albeit as a separate classification.

15 Lease accounting is also considered in Section 6.4.


Hire purchaseHire purchase is similar to a finance lease as it enables a company to have use of the asset but pay for it over time. However, the primary difference between the two sources of finance relates to ownership of the asset. Under a hire purchase arrangement, ownership of the asset is transferred to the company when the transaction is initiated. In contrast, a lessee under a finance lease does not have ownership of the asset; ownership remains with the lessor until the lease is paid out.

Convertible debt

Private investors and venture capitalists may choose to provide finance through convertible debt, which is a financial product that initially resembles debt because it involves interest payments. The terms of the instrument may also include provision for the repayment of the principal amount of the debt. Convertible debt includes an option to convert to equity at a later date, and depending on the arrangements in place, conversion may be at the discretion of either the borrower or the lender, and/or the option may arise should certain circumstances play out.

Convertible debt arrangements need careful scrutiny in order to fully understand the risks involved and the accounting implications. Convertible debt can be used to manage risk effectively but there is also the potential to inadvertently transfer control to a third party when performance expectations are not met. Convertible debt may also be referred to as convertible notes and redeemable convertible preference shares.

1.5 Selecting the right capital structure

The capital structure of a company will influence how much of the funding is provided by debt and equity. The ‘best’ capital structure is different for each company and depends on a multitude of factors that vary over time due to both internal and external factors.

Established companies are likely to use a combination of both debt and equity to fund their operations. This ratio of debt and equity is called the gearing ratio (or leverage) and is typically calculated as follows:

Gearing ratio = Interest Bearing Debt Equity


When a company has the same level of equity funding as debt funding, this ratio equals ‘1’. When a company has a gearing ratio greater than 1 this means the company is funded by a higher level of debt than equity. When there are increasingly higher levels of debt in comparison to equity, the company will have a higher gearing ratio. A higher gearing ratio indicates the company has accepted a higher level of financial risk because it must generate a minimum level of surplus cash from its operations in order to service the debt repayments. If debt repayments are not made in accordance with the terms of borrowings, the lender is likely to have recourse against the company and/or its assets, which can adversely impact the company’s ability to continue its business activities.

When a company is performing well, debt finance can contribute to generating a superior return to shareholders because the cost of debt can be a tax-deductible expense. However, when the company is under competitive pressure, or when there are adverse economic conditions, a high level of gearing can be difficult to manage; it may not be possible to fully recover the cost of debt through increased prices, and customers may take longer periods of credit. On balance, this means the amount of cash available to repay debts as and when they fall due needs careful management. At these times, a company’s ‘financial risk management strategy’ is critical to ensuring any debt finance is appropriately structured and closely aligned with the company’s ability to generate cash flow.

When a company accepts a higher level of financial risk, the interest rates on the finance obtained is likely to be at a relatively higher rate as debt providers will want to be compensated for carrying a higher exposure to financial risk. Generally, an acceptable gearing ratio will depend on the size of company, the industry in which it operates and the current economic environment.

High growth industries with higher business risks than the norm, such as information technology and biotechnology, are more likely to be funded by equity as there may be less certainty in projecting growth and the cash flows available to service debt. More established and lower business risk industries can justify having a higher level of debt (or financial risk) as they can forecast cash flows more reliably and therefore have greater confidence that sufficient cash will be likely to be available to service debt.


1.6 Impact on the governance model and stakeholder expectations

Funding decisions impact how company performance is monitored and affect expectations for shareholders returns. Directors need to ensure the company plans its long-term funding arrangements to determine whether loans will be repaid over time, or the extent to which loans will be renegotiated under new terms and conditions. If a company has a debt facility maturing, the company will need to be in discussions with the financier several months before the facility expires to determine whether the facilities can be rolled over or whether a new loan agreement is needed.

Directors need to understand the terms and conditions of borrowings to be satisfied the company can comply, and to determine the internal reporting requirements needed to demonstrate compliance. In the event the company is not performing as expected, directors will want to ensure the bank or financier is kept up to date so there are no surprises. A lack of communication and missed targets can deeply impact the company’s financial credibility, which can have significant short and long-term consequences.

1.7 Summary

Financial literacy is needed to implement appropriate financial governance practices. Financial governance and financial risk management are closely aligned with the funding type used to support business activities.

When a company depends on equity funding, directors will want to ensure shareholder expectations for the return on investment are carefully managed. However, shareholders have a residual interest only in the company’s net assets and have no claim for repayment of their investment except on liquidation of the company, where the repayment is made only from the assets (if any) remaining after all creditors have been paid in full.

Debt funding is provided under contract and therefore directors will want to ensure the company can comply with the terms and conditions of borrowing, including generating sufficient cash from business activities to make principal and interest payments as required.

Documents

Financial Fundamentals for Directors 1 Chapter Extract Copy