SCC abandons investors, part II: The purpose of financial reporting

TORONTO – The December 20, 2017 decision in the case of Deloitte & Touche v. Livent Inc. (Receiver of) by the Supreme Court of Canada focused upon two main claims: materially misleading audited annual financial statements for fiscal 1997 (Livent won this claim by a 4-3 vote); and a Livent prospectus offering in October 1997 (Livent lost 7-0). 

In this, my second column for Canadian Accountant focusing on the SCC decision, we look at the 1997 annual audit, and I will follow up with the prospectus offering tomorrow.  In my view, the reasoning employed by the SCC in both situations is quite bothersome for various reasons, and has created serious continuing problems for investors. 

Lawmakers should act promptly to pass legislation to correct the SCC’s archaic and ill-focused concept of the purposes of annual audits of public corporations. Otherwise, over time, investors will likely bypass Canadian markets, as the deck is stacked against them. 

5 reasons to question the Court

The most harm to non-shareholders and investors will potentially arise because the 2017 SCC decision has clung to an archaic, artificial construct that was set forth in Canada in the 1997 SCC decision on Hercules Managements Ltd. v. Ernst & Young. 

In Hercules, the hypothesized prime reason for requiring annual audits of financial statements was inappropriately described as allowing shareholders to “… collectively supervise management and to take decisions with respect to matters concerning the proper overall administration of the corporation …” with “… the shareholders, acting as a group ….” (emphasis added.) 

Such a “supervise management” concept is just plain empty of meaning in Canada, for five reasons: 

1.  Shareholders are currently forced to judge management’s competence and ethics based strictly on whatever financial reporting choices management itself chooses to report. Yet bonuses and stock options often place management in conflicts of interest. Times have changed since 1997 but the parties did not update their arguments for current realities.

2.  The required reporting standards in Canada since 2011 typically allow for many (including opposing) alternative dollar and timing presentations, with several reporting standards being loosely written. Such wide choices allow for flattering, unwarranted bonuses based on self-selected, exaggerated profits and bloated cash flows.

3.  I believe and have long been on record as saying that Canadian auditors are involved in inherent conflict-of-interest situations. Yet, to date, the audit profession is permitted by governments to write governing rules and standards, which should not be written by self-governing and advocacy bodies.

4.  Canadian governments repeatedly pass the buck on responsibility for monitoring and policing misleading financial reporting. Appropriate standards must be set and strongly worded by non-conflicted, non-auditor specialists, as occurs in the U.S.

5.  Canada has had a long history of huge corporate failures that have been traced to weak and distorted reporting measurements and standards. Yet, a decade ago, the Canadian government allowed the profession to adopt weak international standards for Canada. My critiques of the grossly fabricated, yet audited, financial statements of our marijuana growers, were reported this week by Maclean’s Magazine, Canadian Business, the Globe and Mail, and Bloomberg Businessweek — and agreed with by many analysts and executives in the marijuana industry.

The real purpose of financial reporting

How shareholders can possibly, “as a group,” evaluate management, when management can doctorfinancial statements, is an obvious fiction. (How could they possibly assemble as a group?) In short, the 1997 and 2017 SCC decisions are loosely anchored to an immensely faulty “supervise management” commencement point.

The audit profession’s own training and professional obligation documents clearly assert purposes of financial reporting well beyond the narrow, impractical shareholders’ “supervise management” role.

Section 1000 (Financial Statement Concepts) of the CICA Handbook, which was published long before the 1997 Supreme Court of Canada decision, sets forth a much greater purpose for financial reporting than the SCC’s “supervise management” role:

“…the objective of financial statements for profit-oriented enterprises focuses primarily on information needs of investors and creditors….” (emphasis added).

“…Investors and creditors of profit-oriented enterprises are interested, for the purpose of making resource allocation decisions, in predicting the ability of the entity to earn income and generate cash flows in the future to meet its obligations and to generate a return on investment.” (emphasis added)

Thus, for the SCC to craft an overly vague, hypothetical purpose for audited financial statements that is especially narrow, and is contrary to what external auditors themselves claimed as services to the public, is especially disturbing.

Where is the detail in today’s audited financial statements so as to calculate non-manipulated cash flows and cash-based profits? To not have updated itself for its 2017 decision has exposed our Supreme Court to warranted criticism.

Tomorrow, the faulty reasoning behind “supervising management.” The views and opinions expressed by contributing writers to Canadian Accountant are their own. Canadian Accountant and its parent company bear no responsibility for the accuracy and opinions of contributing writers. 

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE, provide independent, forensic accounting investment research. They are the co-authors of Easy Prey Investors: Why Broken Safety Nets Threaten Your Wealth. Learn more at Accountability Research Corporation and Rosen & Associates Limited.