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Strong companies need strong boards

Jul 05 2017 05:00
Mark Graham*

Being a board member or company director is about more than having industry expertise - the will to make executive decisions and the ability to commit time and energy to the proper management of a company are also crucial, says Mark Graham.

ACCORDING to a study by the Centre for Corporate Governance at the Institute of Directors in Southern Africa (IoDSA), board composition is probably the single most important governance factor determining an organisation’s future success.

Appointing members for political reasons, blurred lines of accountability and a lack of industry knowledge and financial skills are cited as key challenges for the composition of boards.

South Africans have in recent years been treated to a sideshow of how things should not be done at board level, but the vast majority of men and women who sit on boards of companies and state-owned-enterprises in the country are there because they want to improve the performance of the entity.

It is not an easy role, even under the best of circumstances, and the demands on board members are significant. So what are the key things they need to know to add maximum value?

Understand the context within which the business operates

The distinguishing objective of business was traditionally regarded as being the maximisation of shareholders wealth. This applied equally to companies, close corporations, partnerships and sole traders.

But some now argue that the objectives of business should also include taking care of employees, protecting the environment and operating responsibly within the wider social context. A business cannot ignore the community in which it operates, as it is often largely dependent on this community for business as well as for its workforce. 

Even if this is not the case, poor treatment of people and planet will likely draw negative attention from authorities and customers and impact on the sustainability of business.

Board members therefore need to start by taking the time to familiarise themselves with this bigger picture. Being told that they have to achieve the business objective of making a profit only, is like telling an aspiring soccer forward that all he has to do is to score lots of goals!

Understanding financial statements is key

It follows that being able to make wise choices about how to direct company resources to ensure sustainability in the wider context is a key function of a board member. This is largely dependent on their ability to understand the language of finance and read financial statements in particular.

The purpose of these documents is to enable individuals to evaluate the decisions and events that have affected a business in the past and to determine whether the business has achieved its ultimate objective, as well as to assess its potential for doing so in the future.

Someone who understands the financial statements of a business understands the business in a way that is not otherwise possible. It’s like looking beneath the hood of a car and understanding how it all fits together. Financial statements are highly complex and have become more so over the last decade due to regulatory changes.

These are all in aid of better and more responsible business practices and therefore it is vital to know what to look out for on the statements, and which sections or areas are most important to understanding the health of the business.

Focus on financial standards

Beyond the numbers, board members also need to be familiar with the regulatory environment within which financial statements are drawn up. There are a variety of accounting standards that govern the financial world. The set of rules and guidelines that prescribe how various events are accounted for is collectively known as generally accepted accounting practice (GAAP).

Before 2005, most developed countries had their own accounting standards, which specified how various events were to be accounted for by local businesses.

During the 1990s, there was a global movement towards standardising these standards.

Today, the standards used by most countries around the world, with the notable exception of the USA, are known as International Financial Reporting Standards (IFRSs).

The full IFRS comprises over 38 standards and more than 20 interpretations of these standards. While being quite complicated and sometimes inconsistent, the IFRS helps to prohibit some of the dubious accounting practices that some accountants used to engage in.

It also requires far greater disclosure of information about, for instance, future cash flows and further information helpful for analysis.

From 2005, all companies listed on the JSE were required to comply with IFRS. In 2012, SA GAAP was withdrawn and now many unlisted local companies and large state owned entities have to comply with IFRS.

Recognise red flags

The advantage of being able to correctly interpret financial statements and understand the financial landscape, is that board members don’t have to rely on other people to explain the numbers to them. They are empowered to make up their own minds and, crucially, to recognise the red flags when they see something is amiss.

This is becoming increasingly important, not just for the sake of the company but for themselves as well.

Following a landmark ruling in Australia some years back, the personal liability of company directors and board members has become an increasingly hot topic. The courts found that one of the country’s largest listed real estate investment trusts, Centro, had (among other disclosure irregularities) classified current liabilities amounting to AUD1.5 billion as non-current liabilities, and that the directors breached their duties in failing to notice the multi-billion dollar errors in the company’s accounts.

While there was no question that the directors were dishonest, the judge emphasised that the case was ‘‘not about a mere technical oversight’’ but that it went to the heart of whether directors must ‘‘apply their minds’’ to their review of financial statements and the directors’ report, in order to determine if the information is consistent with what they know and that it does not omit material matters.

The South African Companies Act requires local directors to exercise a similar level of scrutiny. This means board members cannot hide behind a lack of financial skills or know-how when it comes to the way statements are compiled and presented.

In fact, if they want to help a business be successful and profitable, while also making sure that they don’t fall foul of the law, board members and directors need to make sure that they are more than mere spectators of the game; they must be able to tell the score as well. And being able to read the scorecard – which would be the company financial statements – is a non-negotiable for anyone wanting to add value to a board.

* Associate Professor Mark Graham convenes the annual Understanding Financial Statements for Directors programme at the UCT Graduate School of Business. The course will run at GSB-Johannesburg.

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