Factors to Consider when Reviewing Financial Competence

For too long, the financial skills sought in prospective directors and on boards have often been dominated by those concerned with the scrutiny of past performance. In comparison, less attention has been focused on forward-looking aspects of accounting and finance roles.

The financial literacy expected of board members relates to their duties and responsibilities as company directors. It could be regarded as a core competence of an effective corporate director. The Cadbury Committee which produced the first corporate governance code was set up specifically to examine the financial aspects of corporate governance. Board decisions often have financial implications and consequences. Directors may contribute more to discussions of financial scrutiny, monitoring and reporting if they appreciate the fundamentals of accounting and finance, the basis of pricing, asset valuation and how value, productivity, performance, efficiency, profitability and liquidity are measured.

Methods used should be appropriate, fairly reflect what has been achieved and be difficult to game. While some or most directors may have some financial understanding, an audit committee should ideally contain at least one member with recent financial experience. Literacy should include areas of financial risk and awareness of vulnerability to manipulation, exaggeration and malpractice. Directors should be equipped to question proposals for new initiatives. For example, criteria used to justify a divestment or management buy-out may favour a related party buyer or a buy-out team. Both assets and liabilities may be intentionally over or under valued to serve a particular interest.

Financial literacy and human nature

Financial candour, probity, honesty, prudence, and reliability cannot be assumed when and where human beings are involved. Efforts may be made to conceal, overstate, or otherwise deceive. What is difficult to foresee, predict or estimate may be overlooked or ignored. Initial or start-up costs are frequently underestimated to 'get things moving' and crawl-out costs ignored. Ideally, financial literacy should be accompanied by a balanced and realistic understanding of human nature. Wise directors are not naive. They watch, listen, and learn. They are alert to interference, vulnerability, dependency, and vested interests. Is extra scrutiny required? Are people under pressure, or are things not turning out as expected or promised?

Directors need to be on their guard as investments, acquisitions, and various initiatives can reduce rather than enhance value. Boards should monitor trends and key ratios and increase scrutiny when certain levels or tipping points are reached. Practices such as the overvaluation of assets and the undervaluation of liabilities may indicate possible fraud. For a true picture of a financial situation, a director should look at multiple indicators. For example, what might appear to be a healthy level of profits might not be reflected in a cash flow statement. While production and sales may have increased, unsold stocks of finished goods may be filling up warehouses, and customers might be slow to pay their debts.

On their own, financial literacy and acumen are rarely sufficient. Judgement is invariably also required when responding to what the numbers may reveal and/or the ratios might suggest.

Broad drives towards sustainability and/or the phasing out of fossil fuels may disproportionately affect certain activities and locations. Within top-level corporate data, there may be hidden areas where significant financial liabilities and/or stranded assets that need to be written down may arise. When sudden changes occur and transition and transformation are required, a company's cash flow should be closely monitored. While a balance sheet may show a past snapshot at one moment in time and involve various estimates, regular access to a current cash flow statement may enable directors to see whether and where cash is being generated or consumed, with possible implications for solvency.

Understanding what is happening and where

Various financial ratios and an understanding of what they represent can enable directors to monitor important aspects of business performance and compare it with that of other entities and a board's aspirations. High levels of borrowing can increase vulnerability and insolvency risk in downturns and economic recessions. Liquidity ratios can indicate a company's ability to pay its bills. Whereas one month's figures may be distorted by a particular event or large transaction, a trend over time can be very revealing. However, ratios should be used with care. Growth per se may not lead to higher profit and cash generation. Overall profitability may be less useful than margins on sales, measures of efficiency such as sales per unit of assets, returns on assets, equity, invested capital, certain capabilities, or a limiting factor.

Financial literacy may enable directors to indicate the financial information and reports they would like to receive. For example, trend lines may be more helpful than a page of numbers, some of which for a particular meeting might be atypical. Having comparative figures for different areas may enable high- and low-performing business units or territories to be identified and suggest some teams that might usefully contact and learn from others. Those reporting could be asked to undertake a root cause analysis and suggest actions to address any issues that the information they present reveals. Reports should be considered value-added catalysts of learning and thought for those who prepare them as well as their recipients.

Financial considerations and practices sometimes favour a continuation of existing activities as their costs are known, while those of possible alternatives may appear uncertain and hence seem riskier in comparison. It sometimes helps to know the situation, circumstances, and contexts in which an approval is sought, and probe the motivation of proposers and those who are likely to be the beneficiaries. Costs and benefits are sometimes selected and valued to bias decision makers in favour of courses of action favoured by their proposers. Integrity, honesty, and transparency can instill confidence and build trust. While others may prepare financial statements, directors are required to approve them. They should ensure they provide a fair, balanced, and true picture of a situation and information that stakeholders require.

Insolvency and personal liability

Courts and official inspectors may have views on what might be reasonably expected from a company director, and these may vary by jurisdiction and by being influenced by applicable laws and regulations. In many jurisdictions, directors are at risk of becoming personally liable when a company is unable to pass solvency tests such as positive net assets and the ability to pay debts as and when they fall due. They need to know warning signs to look out for, when their priority concern should be to protect the interests of creditors, and the circumstances in which an insolvency practitioner should be called in. When they do not understand, some directors are reluctant to speak up and acknowledge their own need for development. They might not feel able to contribute to board discussion of accounting and financial issues.

Accounts of solvent companies are usually prepared on a going concern basis. In the event of insolvency or a 'fire sale' in difficult circumstances, assets may not realise their book value, and provisions and contingencies may prove inadequate. Directors should be on the lookout for potential danger signals such as a slower write down of depreciating assets and exaggerated valuations of unsold stock and work in progress. There are games that some executives might play to conceal problem areas and deflect probing questions. An important aspect of financial literacy is knowing what questions to ask and having the confidence to speak up on matters related to the duties and responsibilities of a company director.

When confronted with financial information and financial and management accounts, some directors may feel unable to critique, probe, and question. They may lack the confidence to interrogate executives who have specialist knowledge and pursue the interrelationship of different financial aspects and what a changing market situation might mean for corporate aspirations, plans, prospects, and future value creation. How realistic are proposals? Are projections achievable? Financial pressures and the most appropriate source of funding can change according to a company's stage of development. The timeliness, frequency, and distribution of financial information might be influenced by the situation and circumstances.

Horses for courses

Much depends upon a board's perspective and what it considers the purpose of a company to be. One board might prioritize shareholder returns, while another could focus upon building the value of a company or its capabilities. Those concerned with the interests of a wider group of stakeholders may recognise responsibilities to the environment and/or future generations. Addressing challenges and existential threats and/or transitioning to more sustainable operations could be a corporate purpose. Financial awareness could include the financial consequences of external trends and developments. Directors should be able to ask relevant questions when scrutinising financing options and investment proposals.

The nature of a business and its arena and sector of operations could also influence the financial awareness and understanding that would benefit company directors. Certain areas might be greatly impacted by economic developments and the economic and fiscal policies of governments. A change of government might have significant financial consequences. It helps if directors are aware of the sensitivity of a business to macroeconomic and fiscal changes, such as rates of inflation and various categories and levels of taxation. Aspects to question can reflect aspirations, expectations, and strategies for survival, growth, or transition.

Awareness of professional practices

Directors should not assume that professional practices they encounter are appropriate or current. Past accounting practices and the accounting profession bear a heavy responsibility for the damage that has been done to the environment and eco-systems and for exacerbating certain existential threats, particularly global warming and climate change. For far too long, they have failed to fully address and account for negative externalities of corporate operations, the costs of which have been born by the environment and society generally. To better address them, the use of natural capital accounting could be explored to measure the quantity and quality or condition of particular ecosystems that corporate operations affect.

Management accounting practices have too often focused on recovering or allocating costs rather than supporting the search for less resource-intensive alternatives. Attempts to recover sunk development costs through higher pricing have limited the market for certain offerings and slowed the adoption of some innovations. Faster take-up might well have occurred had past expenditures been regarded as sunk costs and pricing reflected incremental costs and revenues. Critical thinking in the corporate boardroom and a readiness to question and challenge are essential in relation to financial and accounting matters and financial products pushed by finance professionals, such as derivatives, which most people may not understand.

Most board members knew little about collateralised debt obligations (CDOs) before mortgage defaults during economic slowdowns and banking failures appeared in some countries and frantic measures were sought to prevent the international financial system from collapsing. They represented a threat to their adopters and wider society. Most professionals involved in the marketing, sale, and adoption of CDOs, accounting for them and auditing their treatment, and the boards of companies that developed, promoted, and used them, went with the flow. Few 'what if' questions were asked, and cases of individuals incurring any form of liability seem to be very rare or nonexistent in many jurisdictions. If uncertain, speak up.

Forward looking financial literacy

For too long, the financial skills sought in prospective directors and on boards have often been dominated by those concerned with the scrutiny of past performance and the treatment and reporting of past income and expenditure. In comparison, less attention has been focused on forward-looking aspects of accounting and finance roles. Foresight is critical for corporate and collective survival. Many and perhaps most people seem incapable of thinking through the wider implications of investment, acquisition, and expenditure decisions and proposed activities, especially when busy and distracted. This is the case with many negative externalities. Inconvenient costs that might 'complicate' and hold up decisions to buy are ignored.

Artificial intelligence (AI), which commentators, much of the media, and many professionals, instant experts, vendor sales teams, and directors seem to be in a lemming like rush to embrace, is a good example of an arena in which foresight, caution, and informed and balanced critique are required. As more AI applications and tools are adopted, whether for useful or trivial purposes, the energy demands of data centers are increasing at a prodigious rate. They also use up rare minerals required by future generations. With the decommissioning of coal power stations having to be postponed, they continue to contribute to global warming. Balanced assessments should address ethical and regulatory issues and the existential threat AGI poses.

In an era of globalisation many large companies applied a standard operating model to subsidiaries and operations in overseas territories. More recently, fragmentation and the emergence of a multipolar world have resulted in a need for a greater variety of local business and governance arrangements. Contending geopolitical positions have emerged, and sanctions regimes impact jurisdictions differently. Deglobalisation, reshoring, protectionism, and supply chain disruptions have occurred as countries have sought to become more self-sufficient. Some accounting and finance teams have had to cope with a greater diversity of processes, policies, practices, and priorities. This can complicate recording, accounting, and reporting.

Situational and contextual awareness

Understanding changing threats to the integrity and security of accounting and financial systems and responding to them is a continuing challenge. When changes occur, organisations can find themselves more exposed to cybersecurity and other challenges from malicious individuals and bad actors. The process of moving to cloud storage may expose data and provide a window of opportunity to those with malevolent intent. Heightened vigilance is needed at moments of greater vulnerability. While development activities can increase awareness, provide useful tools, and indicate where judgments are required, at the directorial level it often remains for a director and board colleagues to make those judgements.

Providing complete protection may be unaffordable. Greater technical competence and a higher level of advice may come at a cost. Do the advantages of improvements in discretionary information provided exceed the cost of making them? Some judgement calls are more difficult to make than others, whether because of their complexity or consequences. Colleagues may favour a less cautious or prudent but more affordable and less disruptive course of action. Agreement with what an accounting or financial practitioner considers is the right course of action should not be assumed. A board may ask for options with their advantages and disadvantages and question the likelihood of certain eventualities occurring.

The environment in which accounting and financial judgements may be required is uncertain. Unexpected events, unforeseen situations, and actions against a company from authorities and certain interests can arise. Cases and situations that were dormant may erupt. A regulator or public body may decide to act. Existing provisions may seem inadequate, and new ones may be needed. Making or increasing them may set alarm bells ringing and suggest recognition of greater risk or acknowledgement of liability. While at a junior level technical skills may be a more significant financial literacy expectation, at the board level the ability to explain, justify, and communicate financial options, decisions, prospects, and consequences might be sought.

Necessary but not sufficient financial competence

On their own, financial literacy and acumen are rarely sufficient. Judgement is invariably also required when responding to what the numbers may reveal and/or the ratios might suggest. What proves terminal for one board might have been manageable by another. Purely financial responses are often not enough. Smart directors monitor evidence of vulnerability and resilience as well as solvency. What stories do other indicators, projections and trends tell us? Sometimes it is possible to sense that a business is past its peak and/or a market, priorities and tastes have moved on. Being surprised by financials could be evidence that a board is out of touch, remote from customers, detached from reality and lacks a feel for a business.

Sudden shocks do occur. Situations can suddenly deteriorate. Events can move quickly. In slow-downs and recessions, when the tide goes out and the clothes come off, it may be readily apparent that all is not well. There may also be evident warning signs that were missed and questions that directors could have put but did not ask. Awareness of vulnerabilities, risk mitigation and early diagnosis of potential problems can increase the chance of coping and improve the prospects of survival. Experienced and competent directors should value foresight. They pay attention to long-lead indicators and may use adversity to reposition and reinvent. While financially literate they are hopefully also business savvy.

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