The Director's Dilemma

Welcome to the June 2009 edition of The Director’s Dilemma newsletter. I hope you find it interesting, informative and inspiring.

I advise Boards and Directors on complex and challenging issues which can be resolved in a variety of ways. Each way has different pros and cons for the individuals and companies concerned. Every month this newsletter considers several responses to a real issue. Which response would you choose?

Raj is a director and audit committee chairman of a Government-owned company. The company is a highly profitable monopoly business and the Minister takes a great interest in the company because it is a consistent source of pleasant news coverage.

The company has been investing and has a large capital expenditure program. The largest project has had difficulties that were not foreseeable at the time the contract was let. These will result in additional costs and the infrastructure being built will not provide the returns that were expected or start to generate a return on investment until almost a year after the expected commissioning date.

The Minister has been kept appraised of the situation and likely consequences. As the contract terms are commercially sensitive and confidential there has been no formal release of information and little mention of the issues in the press.

In the accounts there are now provisions for the expected additional costs and also a write down of the asset as it will not generate the cashflow that was used to provide valuations before the issues arose. These have almost obliterated the annual profits and, because of the rigid formula used by Treasury, also greatly reduced the dividends.

The Minister’s aide asked to meet Raj and told him that the Minister wants the provisions and write down reduced because the government relies on the dividend stream to support their budget. She does not want the meeting minuted and advises Raj not to write or email the Minister about this issue but to ‘fix it’ before the accounts and annual report are finalised.

How would you advise Raj?

Sandeep’s Answer

Raj is clearly in a difficult situation here and needs to calmly think about the issue and the implications of possible actions he might take.

The most obvious decision Raj needs to make is to act ethically since that is his moral and legal obligation, regardless of the consequences.

Next, Raj should ascertain whether the current accounting treatment applied in the accounts is correct. He should ask for clarification in writing from the CFO and reiterate his legal obligation to ensure that the accounts are in accordance with applicable laws and standards. If he is not satisfied with the CFO’s explanation, he should to get a written opinion on the matter from the company’s auditors.

Provisions are based on the accounting principle of prudence. Provisions are recognised only if the following conditions are met:

a present obligation exists
it is probable that outflow of resources is required
the amount of obligation can be reasonably estimated

Impairment (write-down) of fixed assets is allowed if impairment testing reveals that a company is holding an asset in excess of it’s “recoverable amount”. In this case, it must recognise an impairment loss, which is reported in the income statement for that period.

As Audit Committee Chairman, Raj is entrusted by the board as a specialist advising on the financials, and thus has a greater obligation than other directors in ensuring the financial statements are in order.

If it is established that the current accounting treatment of the provisions and the write-down are correct, Raj should arrange for a meeting with the Minister to explain why he cannot comply with his request. It is possible that the Minister is not aware of the stringent laws and standards that govern the preparation of financial statements.

Sandeep Padey, a Chartered Accountant, is an accomplished finance professional. He is a Senior Manager at Ineum Consulting based in Melbourne Australia, a firm specialising in assisting CFOs with their business performance management and process reengineering.

Mark’s Answer

In this situation, it is important for Raj to take the approach of “educating” the aide and the Minister about the “unintended” consequences of such an action.

The aide is asking Raj (at least in the U.S.) to commit fraud by covering up information as well as disregarding his fiduciary responsibility. By writing an email to an aide in a non-accusatory fashion, Raj can clearly indicate his position, which includes giving the aide the benefit of the doubt. It could be that Raj is dealing with an ambitious and “helpful” aide who is acting on her own initiative and doesn’t understand the implications of her request. By responding to the aide, it allows everyone to save face. If the Minister in fact suggested or initiated the request, they have now been “educated” about the issues surrounding the action. If the Minister was not directly involved, the aide knows where Raj stands and has been given a clear position without any accusations being made.

In responding quickly to keep all stakeholders on track, it is important to give people the benefit of the doubt and to explain to them why their request cannot be fulfilled without accusing them of deliberate wrongdoing. Where appropriate, one can even go a step further and address in a collaborative and inclusive manner the consequences of taking a wrong course of action.

By corresponding in writing with the aide and taking a conciliatry approach, Raj has the following:

a written record of his response
a “retreat” opportunity for the aide (that is, the opportunity to say “I didn't understand what I was asking was inappropriate”)
the face-saving benefit of the doubt for the Minister

If requests like this or pressure continues, Raj will have to take a more direct course of action.

Mark Herbert is a Principal at New Paradigms LLC, Oregon, USA.

Julie’s Answer

Raj has several potential problems, but he is lucky on two counts:

He made no commitment other than to consider the issue
The problems are not his to solve

Regardless of whether the aide is acting with or without the knowledge of the Minister (which is the Minister’s problem) an important point has been raised. The Minister is a key stakeholder and his or her need for information is valid. This is a task for the Chairman, possibly accompanied by Raj, to accomplish in a confidential meeting.

Before involving his Chairman, Raj needs information. Judgement is involved in setting provisions. Claims and costs are uncertain until they are finalised. If he does not already know, Raj must ask the CFO and auditors:

What is the maximum provision possible, what assumptions underpin that provision, and what are the risks of such a conservative stance?
What is the minimum provision possible, what assumptions and risks accompany this?
What considerations were used to arrive at the suggested provision?
Which stakeholders have had input into, or information about, provisioning?

The audit committee should consider this information and provide a range of possibilities with pros and cons. The Chairman can then sensibly discuss with the Minister (and maybe the Treasurer) before a decision on provisions is made. Provisions move losses from the year in which they are paid to the year in which they are assessed as payable. The cash losses will be apparent eventually. The key issue for the board (led by the Chairman) is to decide what amount to book in these annual accounts.

Raj should also check with Treasury department officials as there are often two formulae; one based on accounting profit and one based on cash. The aide may not know this.

Raj can also help the board with strategies for disseminating the information so it does not shock parliament or the public.

There are political sensitivities regarding elections and other events that may lead an incumbent government to wish to shift the effects of corporate activity between accounting periods. Wise Chairmen keep their boards out of this politicisation of a technical accounting judgement. They also appreciate Audit Committee chairmen that provide them with options for satisfying stakeholder needs.

Andy’s Answer

In this case, the Minister, through her aide, is acting improperly. Crown assets are not playthings to be meddled with by the Government of the day in order to make Ministers look good. They are there to benefit the Crown.

Crown assets like this government owned company have independent Boards of Directors, of which Raj is a member. The Minister, through her aide, is asking Raj to materially affect the company’s financial statements, and thus misreport the company’s performance. He is to do so, as Chair of the Audit Committee, without leaving a paper trail.

The lack of a paper trail is problematic, and it gives the Minister "plausible deniability" should the situation become unraveled. No doubt this has been arranged in this fashion on purpose.

Raj would be wise to consider his career options carefully: he can comply with the Minister’s request, and thus compromise his fiduciary duties. If he does, he is hardly in a position to resist the Minister’s future demands: for there shall almost certainly be a “next time”. At some point pursuing this path could easily lead to jail.

He could resign quietly on principle and search for work elsewhere: problem is, work is seldom where and when you need it. And his resignation may not remain quiet: the Minister will probably make that decision.

He could resign noisily and let the chips fall where they may. That may make his future employability problematic, particularly amongst government boards. He could seek intervention from a well-connected colleague, either with the Minister’s aide or with the Minister herself. Or he could quietly tip-off the Auditor General. The problem with any of these options is that, once invoked, what follows will be taken completely out of Raj’s hands, and his fate will be in the hands of others.

To avoid this, Raj should instead advise the Minister's aide that because of the audit and governance issues involved he cannot action these instructions without written direction from the Minister. He should outline the specific risks in his note to the aide. And he should cc: his Chairman and the other members of the Audit Committee, as this represents a significant governance risk.

Andy Cawston is CEO and Chairman, International Alliance of Guardian Angels NZ Charitable Trust.

Disclaimer
The opinions expressed above are general in nature and are designed to help you to develop your judgement as a director. They are not a definitive legal ruling. Names and some circumstances have been changed to ensure anonymity.

What’s New

Book review – Directors do a lot of reading. I keep a note of my thoughts on each book I read. Here is my review of What Got You Here Won’t Get You There by Marshall Goldsmith. It echoes much of my own findings on the difference in skills required for successful company directors and successful corporate executives. It should be mandatory reading for anyone attempting a career change to non-executive roles.

Video Tip – Government boards are different to commercial and not-for-profit boards. Here is a video with some ideas for success in the government owned environment.

Where’s Julie? – A few readers managed to catch up with me on my travels and it was such a pleasure to meet them that I have decided to divulge my non-confidential travel plans each month.

In June I shall (of course) be at the Company Directors Conference in Cairns from the 10th-12th. I will also be in Newcastle on the 4th, in Hobart on the 15th-16th, in Canberra on the 18th-19th; and back in Sydney on the 24th.

July is already booking solid and I shall be in Spain (Madrid, Barcelona and Alicante) from the 9th to the 20th.

Please call or email me if you would like to schedule a meeting.

This newsletter – If you have any ideas for improving the newsletter please let me know. If you are reading a forwarded copy please visit my website and sign up for your own subscription. It is (still) free.

Suggestions for dilemmas – Thank you to all the readers who have suggested dilemmas. I will answer them all eventually.

Be an expert – I will post the next dilemma on LinkedIn. If you would like to feature next month just log on to my Q&A and type in your advice. I will pick the best answers to be published in the next newsletter.

Farewell until next issue (due 1 July 2009). Enjoy governing your corporations; we are privileged to do what we do!

Best wishes
Julie

www.mclellan.com.au | PO Box 97 Killara NSW 2071
email julie@mclellan.com.au | phone +61 2 9499 8700 | mobile +61 411 262 470 | fax +61 2 9499 8711

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