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Auditors as Professional Sceptics
Published in the March 2010 issue of Litigation Notes - View Article
Ontario’s Divisional Court has quashed certain findings of professional misconduct made against the auditors of Livent Inc. by the Discipline Committee of the Institute of Chartered Accountants of Ontario. There was a lack of procedural fairness because the auditors were not made sufficiently aware of the case they had to meet. Other charges were upheld because the auditors failed to exercise sufficient professional skepticism and accepted management’s representations despite having been deceived by management in the past. The Discipline Committee did not have jurisdiction to order that costs of the investigation and hearing be paid by the auditors.
Livent Inc. (“Livent”) was a major promoter of live musical theatre in both Canada and the United States. It was co-founded by Garth Drabinsky and Myron Gottlieb who, as of December 1, 1997, were its largest shareholders and most senior officers. Livent was sold in 1998 and the new owners quickly discovered serious irregularities in its books. The company’s financial statements for 1996 and 1997 were re-stated and criminal charges were laid against Drabinsky and Gottlieb, in respect of which they were eventually convicted.
Deloitte and Touche (“Deloitte”) served as auditor for Livent for the fiscal years 1989 through 1997. In April of 1998 Deloitte released an unqualified audit opinion approving the 1997 Canadian financial statements of Livent. These financial statements were not signed by the Chief Financial Officer but rather by Gottlieb and Drabinsky. In 2004, the Professional Conduct Committee (“PCC”) of the Institute of Chartered Accountants of Ontario (“ICAO”) laid charges against 4 Deloitte partners involved in the audit. The charges alleged breaches of Generally Accepted Accounting Principles (“GAAP”) because of the release of the unqualified audit opinion and breaches of Generally Accepted Auditing Standards (“GAAS”) in the conduct of the 1997 audit. The Discipline Committee of ICAO held a hearing and acquitted one of the Defendants, but found other three guilty of some of the charges and ordered a fine of $100,000 and costs of $417,000 payable by each of them. An appeal to the Appeal Committee of ICAO was unsuccessful and an application for judicial review was brought to Ontario’s Divisional Court, requesting that the decisions of the Discipline Committee be quashed. The Divisional Court released its decision on March 22.
The charges fell into two groups. Charge 1 related to four transactions in respect of which it was alleged that certain revenues should not have been recognized in the financial statements. The Discipline Committee found that three of the four charges had been proven. Two of the three related to transactions involving the development of the Pantages Theatre in Toronto.
Charge 2 related to failure to follow generally accepted accounting standards in that there was not sufficient or appropriate audit evidence relating to the reliability of management-prepared budgets, a write-down of pre-production costs, testing of accounts payable, fixed asset testing and a transfer of receivables.
The key issue in connection with the first charge related to a “Put” agreement between Livent and Dundee Realty Corporation, the developer of a proposed hotel and condominium on the site of the Pantages Theatre. The Put arrangement enabled Dundee to exit from its investment in the project. Livent wanted to recognize the revenue it would receive under its agreement with Dundee in the second quarter of 1997. The 1996 audit team at Deloitte advised Livent that this would not be appropriate because so long as the Put was in existence the revenue recognition would not be in accordance with GAAP. Also the revenue should only be recognized in the third quarter, when the agreement had closed. Livent nevertheless went ahead and announced its second quarter financial results on August 13, 1997 and included the revenue from the Dundee transaction. Deloitte took the position that the second quarter financial statements were materially misstated. Livent told Deloitte that the Put had been rescinded and agreed to adjust its second quarter results so that the revenue from the Dundee agreement would be recognized in the third quarter.
In April of 1998 a Deloitte partner was working on the audit of Dundee and discovered a document dated August 15, 1997, which appeared to revive the Put in favour of Dundee. The existence of this agreement had not been disclosed during the Livent audit. An emergency meeting was held at Deloitte in the course of which one of the members of the 1996 audit team urged that Deloitte resign from the audit immediately, as he said that he had been lied to repeatedly by the management of Livent. Deloitte took steps to satisfy itself that the Put had in fact been cancelled, including verifying with senior executives of Dundee.
However, the issue relating to the Put agreement only came to light during testimony at the hearing before the Discipline Committee. In its disclosure and in the evidence that it led, the PCC had taken the position that it was contrary to GAAP to recognize the revenue with respect to the Dundee transaction because significant acts remained to be done in connection with that transaction. The PCC did not make any submission with respect to the Put. Deloittes defended the allegations by leading expert evidence to the effect that it was acceptable under GAAP to obtain reasonable assurance that the transaction would be completed. The Discipline Committee found that there was not reasonable assurance that significant acts associated with the transaction would be completed because “the suspicions about the likely existence of the Put had not been dispelled”.
The Divisional Court ruled that “…it is a fundamental principle of natural justice that when an individual is alleged to have committed professional misconduct, he or she must be given the opportunity to respond to the allegations made. In order to do so, individuals must have sufficient notice of the case to be met so that they can fairly answer the allegations and defend themselves”. In this case, the charges laid and the evidence led by the PCC had nothing to do with the Put. While it was open to the Discipline Committee to consider all the evidence, it could “… fairly rely on evidence only if it was relevant to the charges as laid and particularized”. The Applicants were prejudiced by the Discipline Committee’s focus on the Put issue because they had formulated a defence, obtained expert evidence and presented their case in response to the PCC’s framing of the case. It was open to the PCC to seek an amendment of the charges and to allow the Applicants to respond to the amended charges. This was not done. Consequently the decision of the Discipline Committee in connection with these charges was quashed.
With respect to the various elements of Charge 2, the Divisional Court pointed out that the test for professional misconduct used by ICAO is:
“1. Whether a member has failed to perform his or her professional services in accordance with the standards of the profession; and
2. Whether the failure is ‘significant’ or ‘more than minor’”.
The Applicants argued that the proper legal test should be:
“1. The member’s conduct departed from the generally accepted standards of the profession (in this case GAAP and/or GAAS); and
2. No reasonable professional would have acted as the member did; and
3. The departure from the standards of the profession must be so blatant as to constitute professional misconduct”.
The Court said that there was no legal error in the way that the test was articulated by the Discipline Committee but that the more significant question was whether the Discipline Committee understood the inquiry that it was required to make, namely to determine what the standard of practice was and then to determine whether there was a breach of the standard. In coming to its conclusions the Discipline Committee “… had to determine what reasonable and competent members of the profession would understand to be the standard and conduct departing from the standard, since rule 206 of the Handbook of the Canadian Inatitute of Chartered Accountants (“CICA”) requires it to determine whether a member has departed from the “generally accepted standards of practice”. While the CICA Handbook provides guidelines, some of them are open to interpretation and if a “responsible body of professional opinion” would support the member’s conduct then the member cannot be found to have departed from generally accepted standards of the profession.
Furthermore, caselaw has recognized that an error of judgement does not necessarily equate with professional misconduct. The Applicants argued that their treatment of the various accounting issues in Charge 2 related to matters of professional judgement. However a number of the accounting issues considered by the Discipline Committee in connection with Charge 2 required the auditors to have accepted management’s representations. The Handbook requires that an auditor perform the audit “with an attitude of professional scepticism”. While the auditor can normally assume management’s good faith, he or she must also be alert to evidence which contradicts that assumption.
In this case, Deloitte’s audit plan had identified the client risk associated with Livent as being extremely high because the company was a public company in both Canada and the United States, had a high level of indebtedness and leverage, had substantial production costs and had management who adopted aggressive revenue recognition policies. The fact that management had misled the auditors with respect to the Put should have raised the auditors’ degree of scepticism to the highest level and the fact that they accepted management representations in a number of areas constituted professional misconduct.
The Court went on to consider whether or not the Discipline Committee had jurisdiction to order costs against the Applicants. The ability of a tribunal to order costs is found in section 17.1 of the Statutory Powers Procedure Act (“SPPA”), which provides that a tribunal may not make an order in respect of costs unless “the conduct or course of conduct of a party has been unreasonable, frivolous or vexatious or a party has acted in bad faith…. and the tribunal has made Rules… with respect to the ordering of costs”. When the SPPA was introduced, it contained a grandfathering provision in respect of cost regimes which had been enacted prior to February 14, 2000. However, while the Chartered Accountants Act was amended as of December 6, 2000 to permit by-laws to be passed relating to costs of investigation and hearing in respect of disciplinary matters, the by-law which actually conferred authority to award costs on the Discipline Committee was not effective until February 15, 2001, so that the grandfathering provision did not apply. In the event of conflict between the SPPA and any other statutory provision, the SPPA prevails. Consequently in this case the Discipline Committee did not have jurisdiction to order costs and that aspect of the award was also quashed.
Barrington v. ICAO, 2010 ONSC 338 (CanLII)