In Registrar of Hong Kong Institute of Certified Public Accountants v Wong the Court of Appeal declined to interfere with a disciplinary committee's finding that the respondent accountants had failed to observe a professional standard when issuing an unqualified opinion regarding the financial statements of a listed company. The Court of Appeal has more recently refused to grant permission to appeal to the Court of Final Appeal. The outcome in the case (to date) confirms a general caution on the part of the courts when asked (on a civil appeal) to review the decision of a professional body's disciplinary committee that a member failed to observe a technical standard or guideline.(1)
The case arose from an audit of financial statements for a listed company, performed by a firm of accountants.
The listed company held approximately 71 million shares in another company, which it treated in its financial statements for 2009 as "available for sale financial assets". The shares had been purchased at an original cost of HK$37.7 million, but their fair value at the quoted market price at the date of the audit was HK$14.922 million – more than 60% less than their original cost.
The listed company recognised the cumulative loss directly in equity, on the basis that it represented a temporary fluctuation, rather than an irreversible and permanent loss in value. In doing so, it avoided having to recognise the loss as an "impairment" under Hong Kong Accounting Standard (HKAS) 39 ("Financial Instruments: Recognition and Measurement"). If the decline in fair value was in fact objective evidence of impairment under HKAS 39.61, the cumulative loss should instead have been recognised in the profit and loss account, where it would have represented approximately 21% of the consolidated profit of the listed company group for the year. The auditors issued an unqualified audit opinion in respect of the financial statements.
Given that the possible auditing irregularity involved a listed company, the Institute of Certified Public Accountants (the governing body over certified public accountants) made an initial referral to Hong Kong's Financial Reporting Council. There followed an audit investigation and a formal report which concluded that the respondents should have expressed a modified opinion on the listed company's accounts. The report was referred by the council to the institute for it to determine what action should be taken. The matter then made its way to a disciplinary committee appointed by the institute.(2)
The disciplinary committee found that the respondents had breached Section 34(1)(a)(vi) of the Professional Accountants Ordinance (Cap 50) by failing or neglecting to observe, maintain or otherwise apply a professional standard – namely, HKAS 39. The committee considered that the respondents should have ensured that the decline in value of the shares was reflected in the profit and loss account of the listed company's financial statement for 2009.
The committee ordered each respondent to pay a penalty of HK$10,000 to the institute and the costs of the disciplinary proceedings. The committee also ordered that its sanction should not be made public without the respondents' consent. However, the respondents appealed to the Court of Appeal in order to have the complaint against them dismissed.(3)
The respondents' appeal raised two principal issues for determination by the Court of Appeal – the first technical, the second more substantive:
- whether the complaint had in fact been wrongly laid against them under Section 34(1)(a) of the ordinance, on the basis that HKAS 39 is not concerned with professional standards (the first issue); and
- that HKAS 39 does not, in any event, require an event causing loss in value to an equitable instrument to be treated as an impairment, unless there is evidence that the loss in value is permanent (the second issue).
A third issue also arose as to whether the respondents' reliance on the published price of the shares was, in any event, not unreasonable or improper.
Interestingly, the institute chose to make its own cross-appeal, seeking an order that there be no restriction on publishing the sanctions imposed by the disciplinary committee.
In relation to the first issue (concerning whether a wrong charge had been made), the respondents argued that HKAS 39 imposed a responsibility upon the audited entity to assess at the balance-sheet date whether there was any objective evidence that a financial asset or group of financial assets was impaired, but did not impose any such responsibility upon the auditor. Therefore, any charge against the auditor (so the argument went) should properly have been brought under Hong Kong Standard on Auditing 700, which deals with the respective roles and responsibility of an auditor and management as regards published financial statements.(4)
As to the second issue (an issue of construction), the respondents argued that the correct construction of HKAS 39.58 and 39.59 is that an impairment adjustment to an asset's value should be made only if there is both a loss event and available objective evidence which suggests that the original investment cost may not be recovered (a so-called 'two-stage test'). They submitted that this was consistent with the nature of investment in shares to be held for the longer term, as temporary fluctuations in fair value are not normally recognised in an income statement.
The Court of Appeal dismissed the respondents' appeal.
As regards the first issue (the nature of the complaint), the court held that, in order to properly discharge their responsibility as auditors, the respondents had to determine whether HKAS 39 had been properly observed by the listed company in respect of the loss in value of the shares. By wrongly agreeing with the management of the listed company, the respondents had failed or neglected to observe, maintain or otherwise apply a professional standard, as set out in HKAS 39.
Interestingly, in its decision refusing to grant permission to appeal, the Court of Appeal elaborated on its reasoning. It noted that the purpose of the professional standard is to provide a full and complete picture of a corporation, and that the respondents had both exercised a professional judgement and assumed responsibility for determining whether there had been any objective evidence that the value of the shares in question had been impaired under HKAS 39. The Court of Appeal appears to have been unwilling to accept anything that might permit an auditor to exclude responsibility for certain parts of the financial reports – in this case, an impairment to the value of assets by classifying them as the responsibility of the management alone. As the Court of Appeal stated: "It is difficult to see the value of professional auditing if this requirement was not within the remit of the respondents."(5)
With regard to the second issue (one of construction), the Court of Appeal rejected the respondents' argument. The court noted that the triggering event identified by HKAS 39.58 is the existence of "objective evidence that a financial asset… is impaired".(6) If such evidence exists, the loss must be reflected in the profit and loss account. According to the court, there is no additional requirement that there be evidence that the investment cost may not be recovered.(7)
In respect of the third issue (the respondents' exercise of a reasonable judgement, albeit one not shared by the regulator), the court declined to question the disciplinary committee's interpretation of an accounting standard in the absence of any obvious error in its approach.
Finally, as a matter of statutory interpretation, the Court of Appeal held that there was no jurisdiction for the institute to appeal a decision of the disciplinary committee and its cross-appeal was an appeal for this purpose.
At the time of writing, the respondents have applied to the Court of Final Appeal for permission to appeal.(8) It appears that the focus of that application may be the interaction between HKAS 39 and a certified public accountant's responsibility to observe a professional standard.(9) The Court of Appeal has already declined to grant permission for a final appeal.
Thus far, the case and the underlying disciplinary proceedings (and the preceding investigation) illustrate the complexity of many disciplinary proceedings involving certified public accountants in Hong Kong.
It should be stressed that there was no finding of any dereliction of duty on the part of the respondents. Rather, the respondents were found to have omitted to observe a standard, in respect of which they appear to have a genuine difference of opinion with their regulator. Given the small amount of the penalty and non-public nature of the sanction, it would have been understandable if the respondents had accepted the disciplinary committee's decision, rather than appealed. However, the respondents appear to consider that there is an important point of principle involved (concerning, among other things, not exposing auditors to unreasonably onerous burdens) – it will be interesting to see whether the Court of Final Appeal agrees later this year.
For now, the Court of Appeal has shown a preference for not reducing an auditor's responsibilities and for not interfering with a regulator's decision as regards technical accounting matters.
For further information on this topic please contact Mike Allan or David Smyth at Smyth & Co in association with RPC by telephone (+852 2216 7000) or email (email@example.com or firstname.lastname@example.org). The RPC website can be accessed at www.rpc.co.uk
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(7) Also see the Basis for Conclusions to HKAS 39. BC 106 provides that the International Accounting Standards Board considered that for marketable investments in equity instruments, any impairment trigger (other that a decline in fair value below cost) is likely to be arbitrary to some extent, but that in a reasonably efficient market, "today's market price" is the best estimate of the discounted value of the future market price. To avoid the risk of arbitrariness, HKAS 39.61 recognises a significant or prolonged decline in the fair value of any equity instrument below its cost as objective evidence of impairment (supra note 1, at paragraph 4.32-33).