Auditing Case Study: Livent Inc.

Summary of the Auditors’ Main Shortcomings in the Livent Inc. Case and Explanations of their Occurrence

The auditors’ shortcoming has occurred, because the employees neglected the idea that they are responsible for providing true figures and should oblige company representatives by giving accurate data (Knapp, 2014). This idea can neither be neglected nor influenced by any factors, in particular personal relationship, which has occurred between Maria Messina and the top management of the company, psychological pressure from top managers on auditors or the extreme needs of the company. In the provided case the last factor was provided by “the constant and growing need for additional capital” (Knapp, 2014, p. 206). However, the auditor “realized that concealing the Livent fraud … was among her primary responsibilities” (Knapp, 2014, p. 206). Instead of reporting the truth to the authorities, auditors, and other concerned parties, the Chief Financial Officer supported the illegal fraudulent revenue – generating scheme through engagement in double – entry bookkeeping and suppression of information.

The major shortcoming of auditors was reflected in the changing of the financial information as per request of top management. These changes were made under the psychological pressure, tyranny and verbal abuse from the top management. The auditors were terrified of providing truthful figures, because “Drabinsky berated them when they failed to live up to his perfectionist standards or when they questioned his decisions” (Knapp, 2014, p. 201). They were told to hide the information and to “do as they are told…they were not paid to think” (Knapp, 2014, p. 201). This shortcoming has several explanations. On the one hand, auditors were pressured by the strong character of Garth Drabinsky who has already had experience in the fraudulent revenue – generating schemes. On the other hand, they decided to eat out of hand of their top management and violate the law, instead of revealing the truth.

This problem presented one more shortcoming. In course of time, the financial schemes of Livent Inc. became rather complicated. The operating officers of the company held regular meetings with the top management and chief accountants for discussing of the details of the fraud. They reviewed the preliminarily financial reports prepared by the employees of the financial department and instructed these employees to make certain adjustments to hide their fraud schemes. This shortcoming occurred because of the coercion and intimidation of accountants for the acceptance of this schema. Moreover, the complicity and the great extent of the financial fraud required joint actions of the top staff and a thorough check of all the reports. It should be additionally noted, that the company even developed a special program for these reasons, “because of the sheer magnitude and dollar amount of the manipulations, it became necessary for senior management to be able to track both the real and the phony numbers” (Knapp, 2014, p. 205).

The auditors’ shortcomings are connected with the expenses and liabilities of Livent Inc. They are represented by “erasing from the accounting records previously recorder expenses and liabilities” at the end of each accounting period (Knapp, 2014, p. 204). These manipulations were performed for the financial data concerning the show production. For example, the preproduction costs of an already created and running show were transferred to the show that was under the production during the accounting period. These manipulations occurred because of the necessity to defer (both definitely and indefinitely) the amortization of major costs. It was caused by the already noted constant budget stringency. The worsening of the financial position of the company obliged the auditors to perform further reduction of the amortization charges. It was made through “charging such costs to various fixed asset accounts” which were usually depreciated for over 40 years (Knapp, 2014, p. 204). The increasing pressure from the top management and the obligation to perform further reduction of costs created a situation when even salary expenses were debited to long-term fixed asset accounts.

All these shortcomings were caused by the necessity to decrease expenses and find money for the further projects notwithstanding the budget constraints. The financial shortages of Livent Inc. had several causes. The first one was the desire of Garth Drabinsky to be “motion-picture perfect” (Knapp, 2014, p. 201). The realization of this desire required considerable funds. The second reason was the fraud through the establishment and operation of a kickback scheme. Two vendors prepared and submitted their invoices to the company for services which had never been provided. After the payment, these funds were sent to the private accounts of Garth Drabinsky and Myron Gotlieb. Thus, the company lost millions of dollars. These kickbacks resulted in financial stringency, inability to develop new projects, and necessity to falsify the financial information.

What the Auditors Could Have Done to Address the Shortcomings

The above mentioned shortcomings could be effectively addressed by active steps of auditors which could be performed in accordance with the established practice of auditing. As per Statement on Auditing Standards (SAS), the auditor is responsible for planning and performing the audit and ensuring that the financial statements are free from any misstatements caused by fraud and errors (“Consideration of fraud,” 2002).

The first shortcoming that would be addressed in the current section is changing of financial information because of top management, like erasing accounting records, previously recorded expenses, and liabilities. Additional attention should be paid to the fact that in this situation internal auditors had clear understanding that they provided incorrect information and they clearly understood the reason. Moreover, the chief financial officer performed the periodic reviews of preliminary reports to hide the frauds. After these reviews, internal auditors were obliged to incorporate the required changes. Hence, there are no doubts that they were concerned by the fact of the misrepresentation of the financial information of Livent Inc.

They also knew that the top management was informed about the fraud. Auditors could perform the following actions: change the audit and eliminate misrepresentation in the future, collect more information concerning the misrepresentation of financial statements, and make appropriate steps to address the risks of management override of controls. Then, the shortcoming should be discussed with the appropriate level of management. In the analyzed case, the auditors could refer to Michael Ovitz, who obtained the control over the company’s board of directors in 1998 (Knapp, 2014). This person was interested in providing accurate financial information as he was not involved in the fraud schemes and had necessary power inside the company to influence Garth Drabinsky, Myron Gotlieb, and auditors and force them to cease the shortcoming. Similar actions should be performed concerning the shortcomings which involved the financial data of show production, employees’ salary, and use of the special program for tracking the real and phony financial information.

The second shortcoming that would be discussed in the current section is connected with the kickbacks. The internal auditors did not have any information concerning these fraud schemes. However, it could be identified if the auditors exercised professional skepticism when working with financial figures. This can be realized when the auditors “have a thorough knowledge of the company’s business, including its industry,” the ability to deposit inquiry with some sense of doubt, and self-confidence for resisting persuasion and challenging the assumptions (“Deterring and detecting,” 2010). As per personal understanding, the auditors of Livent Inc. have enough knowledge for the identification of fraudulent schemes. Any possibility of material misstatement should be discussed among the engaged audit team who gather the information necessary for the identification of the fraud. This phase contains following steps: inquiring the staff outside the auditing department about the risk of fraud, consideration of results, fraud risk factors, and other information (“Consideration of fraud,” 2002). Then auditors should identify and assess risks which can be created due to fraud (“Consideration of fraud,” 2002). Additional attention should be paid to the sphere of work of the company and the existing methods of financial control. The risks of material misstatements and identified fraud should be responded to appropriately. This could be performed in the following ways: changing the manner of the audit conduct; providing a response “that involves the nature, timing, and extent of the auditing procedures to be performed” (“Consideration of fraud,” 2002); and performance of procedures directed on the elimination of material misstatements in the future by increasing the extent of control. After providing of necessary procedures, auditors should assess the risks of fraud by performing additional audits and evaluations of whether the accumulated results have any effect on the assessment. Moreover, they should identify whether the detected misstatement can be considered a fraud. The collected information and auditors’ assumptions should be discussed with the top management and the audit committee.

Assignation of the Blame of Fraud

Taking into consideration all factors, the blame of the fraud was not totally covered. This statement is based on the fact that the representatives of Livent Inc. who were involved in the fraud-generating schemes, which took place on the territory of Canada and the USA, stood convicted only under the Canadian laws, which are much milder than the anti-fraud regulations in the USA. For example, Garth Drabinsky and Myron Gotlieb received a prison sentence of five and four years respectively and were paroled prior to the completion of this sentence (Knapp, 2014). At the same time, the corporation’s Chief Financial Officer “was fined $7,500 and suspended from practicing as a chartered accountant for two years” (Knapp, 2014, p. 211). However, as per American regulation, people who are placed in such positions and who are directly involved in the misrepresentation of financial data, could be fined millions of dollars and receive up to 10 years of imprisonment. This regulation and its provisions will be discussed below.

The assignation of blame of the fraud should be analyzed in the background of the discussion of the roles of all involved in this matter. As it is mentioned in “The Internal Audit Function” (2004), internal auditors should “provide an independent assurance service to the board, audit committee, and management” making an emphasis on “reviewing effectiveness of the governance, risk management and control processes that management has put into place” (p. 2). Auditors may advice ways of addressing the risks and controls (“Guidance for audit,” 2004). These statements provide the understanding that the primary responsibility of auditors is not fraud detection. Moreover, as was mentioned above, after identifying fraud auditors are required to report to the top management first, instead of direct reporting to governmental officials. Moreover, in some situations fraud cannot be detected by auditors. For example, in Livent Inc. auditors could not identify the fraud-generating schemes through kickbacks. The auditors relied on management that provides the invoices for payment.

At the same time, these people were directly involved in establishing the accountability of the company and outside reporting of the Livent Inc. and accessibility of truthful financial data to the board executives (“Guidance for audit,” 2004). Hence, the blame for fraud should be also assigned on the internal auditors of the company. At the same time, it is obvious that in this particular case the top management was directly involved in the procedure of inaccurate data presentation and forced the auditors to conceal the fraud. That is why top management should also be blamed for such misconduct.

These statements are supported by the provisions of Sarbanes-Oxley Act, also known as the Public Company Accounting and Investor Protection Act. This document was enacted in 2002 (Public Law 107, 2002) in response to a handful large-scale frauds (Dewey, 2012). It set new requirements to companies’ accounting and responsibilities for providing accurate financial data. The primary goal of this document was the improvement of corporate governance (Hanna, 2014) and protection of the interests of investors (Verschoor, 2012). This act “led to greater internal control of financial reporting, and increased expertise and independence among more-focused boards, committees and directors” (Maleske, 2012.)

The individual responsibility of the senior executives and corporate officers for the accuracy of the financial reports is stated in the section III of the Sarbanes-Oxley Act (Public Law 107, 2002). Additional attention should be paid to the fact that according to the Section 302, the company’s corporate officers represented by the Chief Financial Officer (in the case of Livent Inc. it is Maria Messina) and the Chief Executive Officer are obliged to certify and approve the accuracy of the data in financial reports. Thus, they are responsible for providing of incorrect figures. Moreover, according to the next section, the actions of directors (or individuals who act under their direction and want  to influence the independence of accountants who are engaged in the audit of a company) are considered to be unlawful. Moreover, the head managers of a company should bear responsibility for internal control procedures (Slaughter, 2016). In the chosen case study, the auditors were influenced by the board of directors. Thus, this section of Sarbanes-Oxley act supports the statement that the management of the company should be responsible for the fraud.

It should be additionally noted that this act implies penalties for providing of inaccurate financial data in the form of fines of not more than $ 1,000,000 for misreporting and not more than $ 5,000,000 for willful breaking of the law and / or imprisonment for the term of not more than 10 years in the first case and for the term of no more than 20 years in the second.

Addressing of the Shortcomings through the Increasing of Regulation

The shortcomings described above could be only partly addressed by increasing the regulation of financial information reporting. On the one hand, this initiative would have the considerable effect on the caution of employees who are motivated to commit fraud. They would recognize the penalties and punishments for breaking the law, recognize past failures, and become frightened of being penalized or imprisoned. This feeling would force them to cultivate techniques, adapt to changes, and perform accurate presentation of financial data (Previts & Robinson 2004). Additional attention should be paid to increasing penalties for misrepresentation of figures or forcing internal auditors to perform such actions. This step is necessary to increase personal unwillingness of the involved parties to become penalized. Moreover, senior staff would pay more attention to rechecking information and be less willing to change their reports under pressure from top management and chief financial officers, as the fear of penalties would be greater than the fear of chief executives.

The detected shortcomings could be effectively addressed if they would concern all levels of employees, especially top management, because all of them can be involved in fraud – generating schemes or have an opportunity to recognize or disclose these schemes. At the same time, managers of corporation should clearly understand that their actions should not be limited to non-reporting of financial misrepresentation. They “must be held accountable for making sure that fraud control works at ground level” (Pickett, 2012, p. 8). This statement is based on the understanding that representatives of the top management level can influence corporate governance, shape behaviors of the other workers of the company, and have greater overall control and responsibility for the actions of their staff.

However, the statements and figures from official reports prove that strengthening regulations would not be enough to eliminate misrepresentation of financial data. At the same time, the official statistics provided in the article “Increased Regulation Failing to Improve Levels of Corporate Ethical Behaviour, Reveals EY survey” (2015) prove that adoption of stricter regulations does not lead to sufficient improvement of corporate ethics (only 15 %). That means that the rest 85 % of companies would continue misrepresenting financial data as they did before the introduction of changes. At the same time, as per real life experience of financial reporting after the passing of Sarbanes-Oxley act, “there’s still plenty of fraud…but if we didn’t have Sarbanes-Oxley, the misstatements would be significantly worse” (Sweeney, 2012). The ineffectiveness of increasing regulations to address detected shortcomings can be explained by the statement taken from Fraud & Regulatory enforcement (2012): “financial markets are so complex that regulations are almost always one or more steps behind, and regulators generally lack resources and expertise to pursue complex cases” (“Fraud and regulatory,” 2012). Currently, prosecution has been accomplished only in relatively straightforward cases. That is why, insider trading is investigated more recently that kickbacks. Employees of corporations clearly recognize this matter. Hence, they are less frightened of involving themselves in complex fraud-generated schemes.

Hence, adoption of sharper regulations to audit reporting should be combined with some other initiatives, like strategies directed at improving employee culture. That has a greater effect on elimination of fraud, because it is directed on changing of inherent perceptions and behaviors, instead of simply preventing unlawful actions. These initiatives are usually represented by conducting special trainings and whistle blowing of corporate codes of conduct. Thus, the combination of initiatives directed on strengthening regulations against fraud and improvement of corporate ethics would be effective in addressing the shortcomings described in the current work.

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