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How should Fancy’s board respond to this state of affairs and are there consequences if it chose to allow Fancy to continue trading?

What legal obligation is there on Fancy’s board, to ensure accounting records are kept?

 

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FACTUAL SCENARIO

Fancy and Flamboyant Furniture Limited (‘Fancy’), is a duly incorporated company under the Companies Act 1993(CA 1993). It has 5 shareholders/directors, who each respectively hold a fifth of the shares in Fancy. The shareholder/ directors are Jim Jones, Dion Dunstan, Sam Swindle, Anton Archibald and Collin Crooks. Fancy operates a furniture manufacturing business and supplies items of premium household furniture, to furniture retail outlets in Hamilton city and the wider Waikato. The furniture is produced at Fancy’s workshop based at industrial premises, which it owns in Frankton, Hamilton.

The profitability of Fancy’s operations over the last ten(10) years has exceeded expectations. Despite this, Dunstan and Swindle have expressed serious reservations at numerous company board meetings, about the lack of a clear long-term strategic direction for Fancy, in the premium furniture market. Both Dunstan and Swindle have consistently and persuasively argued at board meetings that Fancy should capitalise on its formidable reputation as a supplier of premium quality furniture. Accordingly, they argue, Fancy should expand its customer base to include the Bay of Plenty, South Auckland and Hawkes Bay. Further, it should begin manufacturing custom-made furniture for supply to commercial customers such as businesses, schools, rest homes and private hospitals. In addition, Dunstan and Swindle argue that Fancy’s healthy balance sheet, would ensure that the proposed expansion could be funded partially from the company’s reserves and the balance funded through debt.

Fancy’s board finally resolves to commission, first, a comprehensive appraisal of the expansion and diversification proposal and secondly, a thorough report of the findings and recommendations to the board. For these purposes, it engages the professional services of Waikato Strategic Business Planning Ltd(WSBPL), a firm of highly reputable business consultants. WSBPL prepares a comprehensive report which is submitted to Fancy for consideration by Fancy’s board of directors. The report concludes, that Fancy’s business is projected to remain profitable in the medium to longer term, provided it can continue to both retain and expand the number of retail outlets, it supplies furniture to, in the wider Waikato. The report also examines the prospects of expanding the business beyond the Waikato and diversifying into supplying furniture to commercial customers. While it concludes that there are significant advantages in the proposed expansion and diversification of Fancy’s business, it also highlights significant risks. Some of the risks include a weaker than expected demand in a number of North Island provinces  excluding  the Waikato, a significantly higher  level of debt needed for the  diversification of the business and the great difficulty in securing a bigger site for Fancy’s expanded furniture manufacturing operation.

The report observes that weakened demand could jeopardize Fancy’s ability to service any debt incurred for the proposed expansion and diversification. However, the report also comments on the strategic advantage of investing in an expansion program under prevailing business conditions. These include the lowest costs for borrowing in a generation, coupled with Fancy’s present ability to service any additional debt. A particularly strong factor for making the investment, is the strong demand for Fancy’s product range in Canterbury. This has arisen due to potential competitors having suffered irreparable earthquake damage to plant, machinery, buildings and other critical infrastructure. The report comments favorably on the strategy of investing in the proposed expansion program. To do so, would ideally position Fancy to take full advantage of the widely anticipated upturn in demand for its products.

The WSBPL report is tabled at the May 2016 company board meeting. There is a full and frank discussion of the report’s contents. However, the discussion has raised a number of important questions that the board would like clarification on.

 

The questions are:

a)What potential legal implications are there for WSBPL, in terms of the following:

The Board decides that it requires WSBPL’s expertise on a consultancy basis to monitor and actively participate in the implementation of the report’s recommendations. WSBPL agrees entirely with the Board’s decision and is actively engaged by the Board for this purpose.

 

i)What are the implications if this consultation took the form of WSBPL’s directors being present at Fancy’s board meetings to advise Fancy’s board on how best to implement the recommendations?

 

ii)Would your answer in (i) be different, if WSBPL’s directors were not present at Fancy’s board meetings but Fancy’s board was reliant on direction from WSBPL’s directors on the implementation of the report’s recommendations?

 

 

b)Due to a deadlock at Fancy’s board, Dunstan, Swindle and 2 employees of WSBPL who wrote the report, are seriously considering resigning from their respective positions. They plan to form a new company in order to supply furniture retailers outside the Waikato as well as industrial and commercial consumers as recommended in the WSBPL report.

 

i)Would the four individuals be held accountable in any way for their proposed course of action? If so on what basis?

 

ii)If there would be a very high likelihood of the individuals being held accountable, advise them on how best they should proceed with implementing their plan in order to avoid being held accountable for their actions?

 

 

c)Fancy has since last year experienced a downturn in its trading operations due to weakening demand for its products. Its accountant has produced a set of accounts for the last six months of 2015, which indicates a trading loss of $400,000. Six months later, debtor and creditor reconciliations reveal payables of $600,000 and receivables of $300,000. Fancy has also since the beginning of this year, been unable to pay both its PAYE and GST debts as they fall due to Inland Revenue and a number of company cheques have been dishonoured this year. Despite this state of Fancy’s financial affairs, the company’s accountant advises the board that Fancy can continue operating and thereby trade its way out of financial difficulty. Fancy’s General Manager has also assured the Board that Fancy has secured other major clients as substitutes for the few smaller ones it had lost.

 

i)How should Fancy’s board respond to this state of affairs and are there consequences if it chose to allow Fancy to continue trading?

 

 

d)Fancy’s board of directors expects the company accountant to provide the board with financial information on Fancy’s trading operations on a regular basis. However, the accountant has been unable on numerous occasions to meet this demand.

 

i)What in law is the purpose served by such records and what if any, specific information should they contain?

 

ii)What legal obligation is there on Fancy’s board, to ensure accounting records are kept?

 

iii)If there is a legal obligation on the board, what consequences may follow for any failure to comply?

 

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