The relationship between the Chair of the Audit & Risk Committee & CFO – When things go wrong

In many of my other columns, I have touched on the subject of the above relationship, but what happens when things go wrong and who takes responsibility?

The CFO takes responsibility for the financial statements, financial processes and the relationship with the auditors.  The CFO also manages the Audit Committee and, in many instances the enterprise and operational risk, and serves as the Audit Committee’s connection to the financial part of the organisation.

The Audit Committee Chair, usually an independent member of the Board of Directors, tries to ensure that the CFO and finance team maintain accurate and transparent financial records and adhere to accounting standards.

Building a solid relationship between the CFO and Chair of Audit is thus of paramount importance.

The attributes necessary for this relationship are well documented and include Trust, Responsiveness and Accountability.

But what happens when things go wrong, and who bears the responsibility?

All organisations have their share of issues and thankfully most are resolved easily and effectively. Issues should be discussed with the Chair of Audit long before the formal committee meets. The Chair can decide on the severity of the issue or issues and whether other members should be involved, but many can be resolved with the finance team and auditors, and solutions proposed and implemented and thus brought to the committee for noting only. A lot of work goes on behind the scenes to prepare for a seamless Audit Committee meeting.

There can be issues that are unresolved or for which there is no immediate resolution. These include writing off goodwill, large bad debts, etc., and need full discussions at Audit Committee meetings.

An interesting case study of ‘what can go wrong’ is Phoslock Environmental Technologies Limited, which was listed on the ASX under the code PET.

The extent of the of the company’s fraud was, to quote Joe Ashton from the AFR,  “truly spectacular” .

There appeared to be:

• Instances of widespread fraud
• falsified accounting
• bribery and corruption
• bogus sales
• breaches of Chinese and Australian law
• irregular tax compliance
• extensive conflicts of interest and self-dealing

The majority of sales were not Phoslock product, but product sourced by the Chinese Directors, who sold them to PET at a significant markup and then on-sold these products to companies who had the same Chinese Directors or they effectively controlled.   

To give some background to the above, the trouble started at Phoslock in June 2017 when Chairman Laurence Freedman invited Zhigang Zhang and later Ningping Ma to join the board and heavily incentivised them to build a new revenue stream from China. The company issued 50 million performance options to Zhigang, Ningping and other Chinese managers. Their revenue hurdles were met in 16 months flat and both directors netted at least $20 million. But whilst the new revenue was booked, not very much of it was actually collected.

In an announcement dated 12 Feb 2019, Laurence Freedman stated “the vesting condition required the total group sales exceed $25m for the period 10 April to June 2019 and was achieved 6 months ahead of schedule”.  The Company also raised significant funds during this period.

On 3 Dec 2019, the Company put out a preliminary forecast of sales of $50 -$70 million followed by a very bullish announcement on 31 Feb 2020

Barely 10 months later, on 21 Sept 2020, the company published an announcement detailing the irregularities listed above.

This was a gross failure on so many fronts. Whilst I am not suggesting that the Managing Director and Chairman had anything to do with the above, these two Directors also took vast sums of money off the table before the irregularities were announced. (Laurence Freedman took over $20m from share sales during this period).  The Managing Director resigned on 25 May 2020 and the Chairman resigned on 30 September 2020.

On 29 Jan 2021 the company published its half-year results for 30 June 2020 showing losses of $21m ($7.5m was impairment of assets) on revenue of $2m despite announcing to the market on 25 May 2020 (almost 5 months into the above 6 month period) that the company was forecasting sales of $50 million and receipts from customers of $40 million for FY2020.

Without wanting to get into too much debate, where does the blame lie? Is it with the Chairman and the Managing Director? Where does the CFO, Chair of Audit and Auditors fit into the above?

Whilst hindsight is an exact science, the CFO, in looking at the way the two directors and the others were incentivised, should have raised the issue that the performance options should only vest once the revenue had been collected.   The CFO is responsible for preparing financial statements and providing the necessary information to the Audit & Risk Committee for review.

So why and how did the CFO and the Chair of Audit not raise red flags, or did everyone get carried away with the good times that were expected from the Chinese sales.  The Chinese entities were given terms of between 60 and 150 days enabling the revenue hurdles to be met long before the debts were due. The CFO,  Chair of Audit and Auditors should have known that even if the debts were real, collecting debts in China can be challenging and China’s legal system can be complex and opaque, but the incentives were not related to cash collected.

On 10 August 2022, ASIC after receiving complaints on PET replied:  “their vision is to ensure a fair, strong and efficient financial system for all Australians” with the inference that the above irregularities and share trading did not fall into their remit and that shareholders should “seek professional legal advice about any private actions”.  If the above irregularities and share trading do not fall into ASIC’s remit, then I have to admit I am not sure what ASIC’s remit actually is.

However, I am led to believe that ASIC have subsequently changed their position.  As at today’s date, PET’s shares remain suspended and as at the last announcement on this subject by PET,  there are extensive and ongoing investigations by the AFP and ASIC.

Author:  Jon Brett

Jon Brett is a Non-Executive Director of Corporate Travel (CTM) and Chair of the Audit and Risk Committee. Jon is also a Non-Executive director of Raiz Invest (RZI) and the NASDAQ listed Mobilicom.

Jon is the author of the very successful podcast series “The Taking of Vocus” which chronicles the extraordinary rise of Vocus, what went wrong with the M2 merger and concludes with the privatisation of Vocus. The podcast can be found here via LinkedIn: https://www.linkedin.com/in/jon-brett-95734732/