Board Independence and a Related-Party Lease
Ruhuna Plantations PLC is a family-controlled company listed on the CSE. The chairman is also chief executive. The board has seven directors: the chairman/CEO, two family members, one nominee of a 15% shareholder, and three directors classified as independent. One 'independent' director has served for eleven years and his consultancy firm receives LKR 6 million a year for strategic advice. The audit committee has three members: that director, the shareholder nominee and one other independent director. In February the committee approved a five-year lease of a warehouse from a company owned by the chairman's brother-in-law at LKR 4.2 million a month. Internal audit found that the only comparable quotes were obtained verbally and were about 25% lower. The chairman has asked the CFO to capitalise LKR 180 million of repairs to protect the net debt/EBITDA covenant. The internal auditor reports to the CFO, and a whistleblower has alleged that lease payments fund the chairman's campaign for a trade body post.
1. Assess the independence of the board and audit committee, identifying which relationships and appointments are problematic.
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Board level. Combining the chairman and CEO roles concentrates power in one person and removes the check that a separate chair provides. Two family members plus the chairman give the family bloc three of seven votes, and the 15% shareholder nominee is likely to vote with management. That leaves at most three independent voices, which is not a majority.
The 'independent' director. Eleven years' service creates a familiarity threat; most governance codes treat around nine years as a trigger for reclassifying independence. The LKR 6m consultancy fee creates a direct self-interest threat: the director is financially dependent on the company he is meant to challenge. He should not be classified as independent, and he should not sit on the audit committee while receiving the fee.
Audit committee. It has three members, but only one is genuinely independent. The long-serving paid consultant and the shareholder nominee do not provide the independence the committee needs. Best practice requires a majority of independent directors and an independent chair. The committee also lacks financial expertise if the remaining member is the only independent voice.
Internal audit. Reporting to the CFO compromises the third line of defence; internal audit should report functionally to the audit committee.
Conclusion: the independence disclosures in the annual report are likely to be misleading, and the board composition does not meet the spirit of the Code of Best Practice.
2. Evaluate whether the warehouse lease should have been approved as a related-party transaction. What process and disclosures apply?
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Classification. The lessor is owned by the chairman's brother-in-law. That is a related party, and the lease is a related-party transaction. It should have been identified as such at the outset, not after internal audit raised it.
Process failures.
- No independent valuation or market benchmarking; the only comparable quotes were verbal and about 25% lower, implying an annual premium of roughly LKR 12.6m (25% of LKR 50.4m).
- The chairman should have declared his interest, and he and any connected director should have abstained from the board and committee discussion and vote.
- The audit committee should have obtained written quotes, a valuation and a terms-of-reference comparison before approving a five-year commitment.
- The lease may require shareholder approval under the CSE listing rules if it is material, and it certainly requires disclosure in the annual report as a related-party transaction.
Disclosure. The annual report should disclose the identity of the counterparty, the relationship, the amount, the terms, the approval process and the fact that the chairman abstained. The Companies Act also requires directors to disclose interests and to avoid voting on matters in which they are interested; the company should confirm that the register of directors' interests was updated.
Conclusion: the approval was procedurally defective. The committee should re-open the decision, obtain an independent valuation, and consider whether to terminate or reprice the lease.
3. As the audit engagement partner, explain the ethical threats and the actions you would take, including your response to the CFO's request.
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Threats. The request to capitalise LKR 180m of repairs is an attempt to flatter EBITDA and protect a covenant. Capitalising repairs that do not extend the asset's life or capacity would misstate the financial statements and breach the accountant's integrity obligation. The engagement team faces intimidation from a dominant chairman/CEO, self-interest in retaining a listed audit fee, and familiarity from a long relationship.
Actions.
- Do not accept the accounting treatment. Obtain the repair invoices, the maintenance schedule and an engineering assessment, and confirm whether the expenditure meets the recognition criteria for property, plant and equipment.
- Discuss the matter with the audit committee, not only with the CFO, and document the disagreement.
- Ask the committee to investigate the whistleblower allegation independently. If the allegation is credible and the committee does not act, consider whether the matter affects the financial statements and whether a report to the regulator is required.
- Reassess the internal audit reporting line and the control environment, and consider a modified opinion or a key audit matter if the financial statements remain uncorrected.
- If management and those charged with governance continue to pressure the team, escalate within the firm and consider withdrawing from the engagement, after taking legal advice.
Professional stance: the partner's duty is to the integrity of the financial statements, not to the covenant.