THE REGISTRAR OF THE HONG KONG INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS v. CHAN BING CHUNG

CACV 47/2016

[2018] HKCA 158

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF APPEAL

CIVIL APPEAL NO. 47 OF 2016

(ON APPEAL FROM the Disciplinary Committee of the Hong Kong Institute of
Certified Public Accountants Proceedings No. D- 14-0974F)

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REASONS FOR JUDGMENT

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Hon Yuen JA:

1.  This is an appeal by Mr Chan Bing Chung, an accountant, from an Order made on 3 February 2016 (“the Order”) by the Disciplinary Committee (“the Committee”) of the Hong Kong Institute of Certified Public Accountants (“the Institute”), whereby it was ordered that:

(a)   Mr Chan pay a penalty of HK$50,000¹;

(b)   he pay the costs of and expenses incidental to the proceedings of the Institute and of the Financial Reporting Council in the total sum of HK$125,966.70²;

(c)   the practising certificate issued to him in 2016 be cancelled on the 40^th day from the date of the Order³; and

(d)   a practising certificate shall not be issued to him for a period of 9 months on the 40^th day from the date of the Order⁴.

2.  The complaint lodged by the Institute against Mr Chan was that he had “failed or neglected to observe, maintain or otherwise apply a professional standard”: s.34(1)(a)(vi) of the PAO. 

3.  The Committee found that Mr Chan had failed to maintain professional knowledge or skill and/or failed to act diligently as the engagement quality control reviewer (“EQCR”) for the audit performed by KM Choi & Auyeung Ltd (“the Practice”)⁵ of the Financial Statements of Sing Lee Software Group Ltd (“the Company”) and its subsidiaries (“the Group”) for the year ending 31 December 2009. 

4.  Mr Chan appealed against both the finding and the sanctions.  On 29 June 2017 this court⁶ allowed his application for an adjournment of the hearing of his appeal in order to await the judgment of the Court of Final Appeal in Registrar of the Hong Kong Institute of Certified Public Accountants v Wong Tak Man Stephen FACV10 of 2017, unrep.  As a result of the Judgment of the CFA which was given on 22 December 2017, Miss Elaine Liu counsel for Mr Chan informed this court that she would not pursue two of her original grounds of appeal.   

5.  At the conclusion of the hearing of this appeal, we dismissed the appeal and ordered that Mr Chan pay the costs of the appeal.  My reasons appear below.

Background

6.  The Company was incorporated in Bermuda and was listed on the Growth Enterprise Market of the Hong Kong Stock Exchange.

7.  On 9 October 2007 (“Grant Date”), the Company granted 47.55 million share options at an exercisable price of $0.368 per share to employees of the Group.  The vesting was in 4 tranches over a period of 3 years after Grant Date (8 April 2008 to 8 October 2010).  The exercise period was over a period of 10 years after Grant Date (9 April 2008 to 8 October 2017).

8.  The Group’s Financial Statements were stated to have been prepared in accordance with the International Financial Reporting Standards (“IFRS”).  The following provisions of IFRS 2 are relevant.

-  IFRS 2

9.1   Para. 1 provides that the objective of IFRS 2:

“is to specify the financial reporting by an entity⁷ when it undertakes a share-based payment transaction. In particular, it requires an entity to reflect in its profit or loss and financial position the effects of share-based payment transactions, including expenses associated with transactions in which share options are granted to employees”. (Emphasis added).

9.2.  Para. 12 further states that typically, share options are granted to employees as part of their remuneration package, and usually it is not possible to measure directly the fair value of the services from the employees for this part of their remuneration package.  Accordingly the entity should measure the fair value of the services by reference to the fair value of the share options at grant date⁸.

9.3.  Para. 16 states that an entity should measure the fair value of the share options based on market prices if available.

9.4.  Para. 17 then states that if market prices are not available, then the entity should measure their value using a valuation technique to estimate what the price would have been on grant date in an arm’s length transaction between knowledgeable, willing parties, incorporating all factors and assumptions that those market participants would consider in setting the price.

9.5.  Appendix B of the IFRS is entitled “Application Guidance”.  It is expressly made an integral part of the IFRS.

9.6.  Para. B4 states that if the share options are subject to terms and conditions that do not apply to options traded on the market, then the fair value should be estimated by applying an option pricing model.

9.7.  Para. B6 states in this connection that:

“all option pricing models take into account, as a minimum, the following factors:

(a) the exercise price of the option;

(b) the life of the option;

(c) the current price of the underlying shares;

(d) the expected volatility of the share price;

(e) the dividends expected on the shares (if appropriate); and

(f) the risk-free interest rate for the life of the option”.

(Emphasis added).

9.8.Under the heading “Inputs to option pricing models”, expected volatility, dividends and exercise behaviour are discussed at paras. B11 to B15.  The last paragraph states:

“In summary, an entity should not simply base estimates of volatility, exercise behaviour and dividends on historical information without considering the extent to which the past experience is expected to be reasonably predictive of future experience”.

10.  The message imparted by the above provisions is clear - when an entity estimates the fair value of share options, that valuation can only be reached after the entity goes through an exercise in which a number of factors have to be taken into account.  It is only after that exercise has been undertaken that the fair value can be estimated, and it is this valuation that should be reflected as part of the entity’s expenses during the vesting period.

11.  The consequence of a failure to include such expenses is set out in para. BC309:

“In summary, if expenses arising from grants of share options to employees are omitted from the financial statements, or recognised using the intrinsic value method (which typically results in zero expense) or the minimum value method, there will be a permanent error embedded in the financial statements. …”.

-  The Group’s Financial Statements for years ended 31.12.2007 and 2008

12.1. Coming back to the facts of this case, even though share options had been granted on 9 October 2007, the Group omitted to recognize the share-based payment expenses in the Financial Statements for the years ending 31 December 2007 and 2008.

12.2. This was not picked up by the Practice which audited the Financial Statements.  It signed off the Financial Statements as giving a true and fair view of the Company and Group’s financial position.  The engagement director was Mr KM Choi.  There was no evidence that an EQCR had been appointed for the audits for these years.

-  Practice Review

13.1.  In 2009 the Institute sent a practice review team to the Practice.  Two engagements were selected for review.  It is important to note that the Reviewer’s Report dated 16 October 2009 explicitly stated that “the reviews did not cover every aspect of every engagement”.

13.2. The conclusion was that the Practice had not fully complied with all requirements of professional standards but its treatment of the Share Options for the years ended 31 December 2007 to 2008 was not singled out for mention.

-  The Group’s Financial Statements for year ended 31.12.2009

14.  At the beginning of 2010, the Practice undertook audit work for the Group’s Financial Statements for the year ending 31 December 2009.  Although this was within the vesting period of the share options, again there was an omission to recognize the share-based payment expenses in the Financial Statements, and this omission was again not picked up by the Practice.

-  Professional standards required of EQCR

15.  Mr Chan was the EQCR for this audit.  It is appropriate here to set out the professional standards required of an EQCR in the International Standards on Auditing (“ISA”):

“38. An engagement quality control review should include an objective evaluation of:

(a) the significant judgments made by the engagement team; and

(b) the conclusions reached in formulating the auditor’s report.

39. An engagement quality control review ordinarily involves discussion with the engagement partner, a review of the financial information and the auditor’s report, and, in particular, consideration of whether the auditor’s report is appropriate.  It also involves a review of selected audit documentation relating to the significant judgments the engagement team made and the conclusions they reached. ...”

-  Contemporaneous documentary evidence of EQCR work

16.1.   The material contemporaneous documentary evidence regarding Mr Chan’s work as EQCR in respect of the treatment of the Share Options is set out below.

16.2. First there is a Note of Planning Meeting (at which Mr Choi and Mr Chan were present) dated 12 January 2010.  This Note contains a box entitled “Susceptibility of the entity’s financial statements to material misstatement”.  Some items were written in this box, but what was not written was the engagement team’s omission to pick up the entity’s failure to account for the Share Options in its profit and loss account.  Put another way, Mr Chan had failed to identify the risk of misstatement.

16.3. Notwithstanding the omission, on 22 March 2010 Mr Chan signed the Appendix K Engagement Quality Control Review Worksheet to affirm that he was satisfied that the financial statements complied with IFRS requirements in all material areas.

16.4. On the same day Mr Chan also signed the Appendix L Engagement Quality Control Review Risk Tolerance Worksheet.  In the printed worksheet, Risk Factor No.6 is entitled “Existence of very complex, specialized transactions”.  Under the label “High Risk”, there is a box referring to “Very complex specialized transactions and accounting policies (... stock-based compensation ...)” (emphasis added).  Mr Chan did not tick this box.  Instead, under the label “Low Risk”, he ticked the box that said “No such transactions, estimates or judgments exist”.  In other words, Mr Chan failed to identify the risk associated with the accounting treatment of the Share Options.

16.5. On 24 March 2010, JP Union & Co (Mr Chan’s company) issued a memorandum to the Practice.  Under “Share option”, the following was written:

“The group has not issued additional share options in the current year.

Certain share options are expired and forfeited⁹. Echo with your audit team’s opinion, there is no any financial effect because no share option reserve was recognized in the prior years and hence no subsequent elimination of share option reserves.

(Note: the fair value of the share options on the grant date is NIL because the exercise price is higher than the market price on the grant date).

There are no contentious matters regarding this aspect. The audit works are satisfactory”. (Emphasis added).

16.6. The passage italicized above indicates that in estimating the fair value of the share options as “Nil”, the sole consideration was that the exercise price was higher than the market price on the grant date.  None of the other factors referred to in Appendix B of IFRS 2 (see §§9.6-9.8 above) was mentioned as having been the subject of consideration.

- The Group’s Financial Statements for year ended 31.12.2010

17.1.   The Practice resigned as auditors on 12 January 2011 and another practice (“Deloitte”) took over for the year ending 31 December 2010.

17.2. In the Financial Statements for that year, the Notes contained a “Correction for Accounting Error of Prior Years”.  It stated that in previous years, the Group had not followed IFRS, and the prior period errors were corrected by retrospective restatement.  For the year ended 31 December 2009 (for which Mr Chan was EQCR), the recognition of share-based payment expenses¹⁰ resulted in the profit for that year being restated as a loss.

-  Investigations in respect of the Practice

18.1.   In 2011, the Financial Reporting Council received a complaint of possible auditing irregularities regarding the Group’s Financial Statements for the years ended 31 December 2007 to 2009.

18.2.Mr Choi and the Practice were duly investigated by the Audit Investigation Board (“AIB”).  As a result of the AIB’s findings which were completed in June 2012, a disciplinary committee was established.  Neither Mr Choi nor a representative of the Practice appeared at the hearing on 6 September 2013.

18.3. That committee delivered Reasons for Decision dated 10 October 2013.  It found (among other things) that Mr Choi had failed to apply professional standards in failing to follow para.17¹¹ and para. B4¹² of IFRS 2 in determining the fair value of the Share Options.

18.4. At §8 of that committee’s Reasons for Decision, it referred to correspondence from Mr Choi dated 4 August 2011 and 27 October 2011 to the AIB in which he “admitted his lack of awareness of the existence and application” of IFRS 2 to the Financial Statements for the years ended 31 December 2007 to 2009.

18.5. The committee ordered that Mr Choi’s name be removed from the Register¹³ for 18 months with effect from 18 November 2013, that he be reprimanded¹⁴ and that he pay costs and expenses in the sum of more than $160,000.

-  Investigations in respect of the EQCR

19.  Meanwhile in November 2012, the AIB undertook investigations into the performance of the EQCR.  Mr Chan gave various responses.  As a result of the AIB’s findings contained in its report dated 12 August 2014, the Committee conducted a hearing on 18 November 2015.  Mr Chan attended the hearing at which he defended himself against the complaint.

-  Disciplinary Committee’s Decision

20.  The Committee handed down its Order and Reasons for Decision on 3 February 2016.

Appeal

21.  Mr Chan appealed.  As mentioned earlier, by the time the appeal was heard, the CFA had delivered judgment in Wong Tak Man Stephen andconsequently Miss Liu abandoned two grounds of appeal which were based on similar points of law.

Discussion

22.1.   In the “Overview” of Mr Chan’s case, Miss Liu submitted that exercise behaviour was an important factor in determining the fair value of the Share Options.  She said that according to the past history of the Company, all share options had lapsed with no one having exercised the right.  It was therefore reasonably expected, Miss Liu argued, that the exercise rate for the Share Options would be zero. In such a case, a zero value for the share-based payment was appropriate.

22.2. However it is important to point out that the factor of exercise behaviour was in fact not referred to in the contemporaneous documentary evidence.  Nor was there any evidence that anyone had examined or discussed any such historical information, or considered the extent to which such past experience could be expected to be reasonably predictive of future exercise behaviour¹⁵.

23.  I now come to what were said to be the major grounds of appeal summarized in para. 7 of Miss Liu’s Skeleton Submission.

24.  Miss Liu’s primary argument was that the “conviction”¹⁶ was predicated upon the assertion that a “zero share-based payment in the 2009 Financial Statements did not follow IFRS 2”¹⁷, and there was no cogent evidence to support this assertion.  Her argument that there was no cogent evidence was said to be based on the following matters, which she summarized as (a) to (f)¹⁸, which I will discuss in turn.

25.1.   (a)   The Committee only said in §19 of its Reasons that “apparently, the Group did not follow IFRS 2 in accounting for the Share Options ...”, when in §16 of a letter dated 27 May 2015 to the Council, the Registrar of the Institute used the words “it is clear that the Group did not follow IFRS 2 in accounting for the Share Options ... ”.

25.2.   Miss Liu submitted that the difference in wording (in italics above) showed that the Committee “had deliberately declined to find that it was a clear case of non-compliance”.

25.3.  With respect to Miss Liu, first this is not an exercise in statutory interpretation.  It is well-established that words used in a decision even of the highest court of law should not be construed as if they were contained in a statute.  The same approach must apply to words used in a decision of a professional body’s disciplinary committee.

25.4.  Second, and in any event, Miss Liu was mistaken in treating §19 as a finding of the Committee.  It is clear from the structure of the Reasons for Decision that §§19-28 were “Facts and Circumstances in Support of the Complaint”¹⁹, whereas the Committee’s findings started from §29 onwards.

26.1.   It is appropriate here to analyse the Committee’s findings.

-At §29, the Committee stated that IFRS 2 stipulated that Share Options should be measured at market price.  If the market price was not available, then a valuation technique should be used to estimate the price in an arm’s length transaction between knowledgeable, willing parties²⁰.

-At §30, the Committee considered the availability of the market price as the entity was a listed company in Hong Kong.  It held it was apparent that the market price was available²¹.

-At §31, the Committee carried on to consider the situation where a market price was not available.  Significantly, the Committee held:

“The Respondent [Mr Chan] should have identified that the engagement team’s acceptance of the exercise price of the Share Options as the only consideration in determining fair value did not follow the provisions as set out in IFRS 2”. (Emphasis added).

In other words, the Committee held that Mr Chan’s fault lay in his failure to note the engagement team’s omission to consider other factors set out in IFRS 2²².

26.2.  Thus, the Committee said in §§32-33 that when Mr Chan tried at the hearing to argue ex post facto that it was fair for the entity to treat the valuation of the Share Options as zero, he showed his lack of understanding of IFRS 2.  At the time when Mr Chan performed the EQCR, he accepted an approach which only took into account the exercise price at Grant Date.  Subsequently at the time of the hearing, he sought to argue the relevance of exercise behaviour.  But the issue is not whether Mr Chan could argue, 5 years after the event, that the valuation could be supported by one other factor.  The point is that the IFRS 2 required an EQCR to check whether the engagement team had undertaken an exercise in considering the many factors referred to in IFRS 2 Appendix B.  It was clear from the contemporaneous documentary evidence discussed above that Mr Chan had not done so.

27.  I shall now return to the list of matters argued on behalf of Mr Chan.

28.1.   (b)   The “apparent finding” was wrongly based on the Committee’s “unquestioned acceptance” of

(i)   Deloitte’s “unproved conclusion” in Note 3 of the Group’s Financial Statements for the year ended 31 December 2010²³;

(ii)   the “unproved alleged admission” by Choi of his ignorance of IFRS 2;

(iii)   the absence of Choi and the Practice at the disciplinary proceedings against them, which absence is said to be an “irrelevant consideration”;

(iv)   the decision against Choi and the Practice, which was made at undefended proceedings.

28.2.  As for (i), Miss Liu submitted that expert evidence should have been called to support the accuracy of Deloitte’s conclusion.   With respect, this shows a misunderstanding of the complaint and the Committee’s findings.  The complaint was that Mr Chan had not addressed his mind to the many factors required in the valuation exercise prescribed in Appendix B of IFRS 2.  The issue was not whether, if he had addressed his mind to the factors, the valuation should or should not be the RMB2.8 million figure.

28.3.  Further it is clear from the Reasons for Decision that the Committee did not arrive at its decision on the basis of the Financial Statements audited by Deloitte.  This is clear from §39 of the Reasons for Decision in which the Committee wrote:

“39. The Committee observed that the Respondent [Mr Chan] had repeatedly claimed that the subsequent 2010 Financial Statements were ‘Deloittes’ valuation’ and that such valuation was ‘wrong’ and should be evaluated by the Committee. It clearly shows the Respondent’s lack of understanding of (i) the role of auditors to the Company; and (ii) the irrelevance of subsequent financial statements of the Company to the necessary duties and work done needed by an EQCR in the base year”. (Emphasis added).

28.4.  This reinforces the point at §26 above, ie that Mr Chan cannot be exonerated for his omission to perform his duties many years in the past, by arguing that now that he has done some further work, that valuation might turn out to be correct.

28.5.  As for (ii) to (iv), contrary to Miss Liu’s submissions, it is clear from the Reasons for Decision that the Committee did not find Mr Chan had failed to perform his duties as EQCR because of what Mr Choi did or did not do in relation to the disciplinary proceedings against him (Mr Choi).  The point was that the Committee recorded in its Reasons for Decision²⁴ that Mr Chan “admitted in the hearing that he did not discuss with the audit team in relation to the 2009 audit”.

29.1.   (c)   The Committee misdirected itself that Deloitte’s valuation, on which the Deloitte Conclusion was reached, was irrelevant.

(d)   Notwithstanding the Committee’s finding that Deloitte’s valuation was irrelevant and therefore not necessary to be proved, the Committee “convicted” Mr Chan as if the Deloitte Conclusion was correct and proved.

29.2.  Again, both these submissions indicate a misunderstanding of the Committee’s decision.  The Committee was concerned with Mr Chan’s failure to note that the engagement team had not done the pricing model exercises which encompassed consideration of many factors.  It was not concerned with the end result which Deloitte reached for the following accounting year.

30.1.   (e)   Under the influence of the unquestioned acceptance of the above unproved allegations or otherwise, the Committee (i) had not paid sufficient regard to the Practice Review Report in which the practice review team appointed by the Institute did not find that IFRS 2 was not followed; and (ii) failed to realise that under the IFRS 2 principles, the share-based payment can be nil as reflected in the 2009 Financial Statements.

30.2.  As far as (i) is concerned, the Practice Reviewer’s Report dated 16 October 2009 explicitly stated that “the reviews did not cover every aspect of every engagement”.  Clearly a professional person who is required to perform objective evaluations cannot rely on a report containing that caveat as an excuse for his failure to perform his duties.  As for (ii), this is simply a repetition of matters (a) and (b) which have been discussed above.

31.1.   (f)   The unreliability of the above unquestioned acceptances was amplified by the fact that (i) there was no expert evidence on the correctness of the Deloitte Conclusion or on the compliance with IFRS 2; and that (ii) only a minority of the members of the Committee (2 out of 5) are certified public accountants, and it is unclear whether the 2 members who are certified public accountants have the expertise in the operation and application of IFRS 2.

31.2.  Again, these matters show a lack of understanding of the Decision.  The clear wording of IFRS 2 shows that the valuation exercise required consideration of a number of factors.  And no expertise is needed to see from the contemporaneous documentary evidence that the engagement team had not undertaken that exercise, and Mr Chan as EQCR had failed to spot that omission.

32.1.   Apart from those matters, it was also argued on behalf of Mr Chan that there was an incorrect assumption that Mr Choi was not aware of IFRS 2, and that this contradicted the Institute’s own evidence²⁵.

32.2.  There was no indication what was the Institute’s own evidence that was contradicted.  This ground was not expanded in oral submissions before the court.

33.1.   It was also argued on Mr Chan’s behalf that the finding that he did not identify in the EQCR Memo the engagement team’s acceptance of the exercise price as the only consideration in determining the fair value should not amount to a breach of s.34(1)(a)(vi) PAO²⁶, in particular when (1) the record of nil share-based payment began in the 2007 Financial Statements, (2) the Practice Review did not draw attention to it, (3) the EQCR Memo was not prepared by him; and (4) the valuation in the 2009 Financial Statements can be justified under IFRS 2²⁷.

33.2.  I shall not repeat the matters discussed above emphasizing that the complaint relates to Mr Chan’s omission to perform his duties as EQCR at the relevant time and thus had failed to apply a professional standard.  The contemporaneous documentary evidence bears out that conclusion.  As discussed above, an ex post facto attempt to show that the valuation was possibly correct by taking into account one other factor (exercise behaviour) does not exonerate him.  The Committee was entitled to be unimpressed by his attempt to try to excuse himself by relying on the views of other persons (the Practice Review Team and his staff who prepared the EQCR Memo) when his professional duty was to apply an independent mind.

34.1.   Finally it was argued on Mr Chan’s behalf²⁸ that the Committee did not explain or support by evidence its doubt in §35 of the Reasons for Decision:

“Even if the Respondent [Mr Chan] genuinely believes, whether rightly or wrongly, that the Share Options should be treated as zero under IFRS 2, the Committee have serious doubt whether the respondent had such belief during the material time when the 2009 audit was reviewed by him”.

34.2.  It is clear from the evidence that the Committee was entitled to take such a view.  Mr Chan’s immediate response to the AIB was not that the exercise behaviour justified a valuation of zero under the IFRS 2.   His response has evolved through time. Mr Lau Ka Kin, counsel for the Institute, has summarized the evolution of Mr Chan’s responses²⁹. The following are notable.

-In 2013, Mr Chan’s argument was that because no share option reserve was recognized in previous years, no subsequent adjustment could be made.

-In 2014, Mr Chan seemed to accept that the accounting treatment was wrong, but that it was the fault of the auditing team in previous years and it was none of his business.

-In 2015, Mr Chan advanced the argument that because of volatility, the valuation could be reduced to less than $1 million.

-Later in 2015, Mr Chan advanced the argument that because no options had been exercised in the past, this exercise behaviour justified a valuation of zero.

35.1.   Finally it was argued on Mr Chan’s behalf that in the absence of proof of loss, the sanctions that a practising certificate not be issued for a period of 9 months and an order for the payment of costs and expenses of $125,966.70 were excessive, as he has also been ordered to pay a penalty of $50,000.  It was argued that in Wong Tak Man Stephen, where the complaint was also one of failure or neglect to observe, maintain, or otherwise apply a professional standard, the sanction was less serious.

35.2.  In Lau Koon Leung v Medical Council of Hong Kong³⁰, this court has explained³¹ the reason for caution in considering appeals against sanctions imposed by disciplinary tribunals of professional bodies.  This principle was further discussed and demonstrated in Registrar of the Hong Kong Institute of Certified Public Accountants v Leung Kam Man, Victor CACV37/2016, unrep.  Irrespective of the fact that complaints may be similar, the facts of each case are different.  It should be noted that in Wong Tak Man Stephen³², the Committee dealing with the case held that there were “strong mitigating factors” causing it to take a “very lenient approach”.  The auditors in that case had shown through their working papers that they had considered but had misinterpreted HKAS 39.  That is not the case here.  In the present case, the contemporaneous documentary evidence showed that Mr Chan had accepted that the engagement team could consider only one factor when professional standards required that many factors should be taken into account in the valuation exercise.  The Committee was also unimpressed by his responses which evolved over time, which displays a degree of lack of candour in responding to his professional governing body.

35.3.  I see nothing which would cause this court to interfere with the Committee’s determination of sanctions.

Order

36.  For the reasons set out above, I dismissed the appeal with costs.

Hon Kwan JA:

37.  I agree with the Reasons for Judgment of Yuen JA.

Hon L Chan J:

38.  I agree with the Reasons for Judgment of Yuen JA.