NEWSLETTER | February 2018

The Importance of Keeping Proper Financial Records

The importance of keeping proper financial records of a company by a director was highlighted in the case of In the matter of Swan Services Pty Limited (in liquidation) [2016] NSWSC 1724 in which it was determined that the presumption of insolvency in s588E(4) of the Corporations Act applied.

Not keeping proper financial records can have a number of consequences for directors including being held liable for insolvent trading.

Directors may be held liable for insolvent trading by a company if:

(a) a person is a director of a company at the time when the company incurs a debt; and

(b) the company is insolvent at that time, or becomes insolvent by incurring that debt, or by incurring at that time debts including that debt; and

(c) at that time, there are reasonable grounds for suspecting that the company is insolvent, or would so become insolvent, as the case may be.

In order for a liquidator to be successful in an insolvent trading case the liquidator must prove to the Court that the company was insolvent at the time the debts were incurred or the company became insolvent as a consequence of the debts being incurred. Proving insolvency by a liquidator is a costly exercise which involves complex financial analysis and often the reconstruction of the company’s financial records. Due to the high costs associated with proving insolvency often a liquidator is faced with the dilemma of having inadequate funds to proceed with an insolvent trading claim.

A much more cost effective way for a liquidator to establish insolvency is to rely on the presumption of insolvency in s588E(4) of the Corporations Act which provides that if the company:

(a) has failed to keep financial records in relation to a period as required by subsection 286(1); or

(b) has failed to retain financial records in relation to a period for the 7 years required by subsection 286(2);

the company is to be presumed to have been insolvent throughout the period.

ASIC on its website provides a schedule of suggested books and records to be kept by a company. Merely keeping the records provided in ASIC’s schedule may not necessarily shield a director from a liquidator successfully relying on the presumption of insolvency contained in s588E(4) of the Corporations Act as highlighted in the case of In the matter of Swan Services Pty Limited (in liquidation) (“Swan Services”).

In Swan Services, which involved our Anthony Elkerton as liquidator of Swan Services, the Court considered what constitutes proper financial records as provided for in s286 of the Corporations Act. This section states:

(1) A company, registered scheme or disclosing entity must keep written financial records that:

(a) correctly record and explain its transactions and financial position and performance; and

(b) would enable true and fair financial statements to be prepared and audited.

Section 9 of the Corporations Act defines financial records to include:

(a) invoices, receipts, orders for the payment of money, bills of exchange, cheques, promissory notes and vouchers; and

(b)   documents of prime entry; and

(c)    working papers and other documents needed to explain:

(d)    the methods by which financial statements are made up; and

(e)     adjustments to be made in preparing financial statements.

His honour in Swan Services provides circumstances in which the presumption of insolvency will prevail, being:

  • that no documents within the description of “financial records” are kept in the period; or
  • the documents which are kept are “deficient as to content”, because they do not correctly record and explain the company’s transactions and financial position and performance or would not enable true and fair financial reports to be prepared and audited.

Relevant to the Court’s decision in determining that the financial records of Swan Services were deficient was that:

  • the financial records did not properly record taxation obligations, with business activity statements being incomplete and PAYG withholding liabilities being incorrectly recorded.
  • financial statements had not been finalised for several years.
  • management accounts that were available were not up to date.

This case serves as a reminder to directors and their advisors that not only is the failure to keep proper financial records a strict liability offence under the Corporations Act but may also result in a director being held liable for insolvent trading through the application of the presumption of insolvency in s588E(4) of the Corporations Act. The presumption of insolvency will be applied by the Courts even if financial records exist if they don’t correctly record and explain its transactions and financial position and performance.