Livent Inc.

Brought to you by IndepenDANCE Auditors

Act I: Setting the Stage

Cast:

Garth Drabinsky

Who Said It?

Myron Gottlieb

Michael Ovitz

Maria Messina

The Facts
Messina refuse to
sign letters of
representation

1993 Livent
Inc. IPO
1989

1994

1995

$7m Kickback
Scheme over 4 yrs
SEC approval
for NASDAQ

Internal
investigation on
Cineplex Odeon

1996

Messina
pleads
guilty to
fraud

1998

Ovitz: $20m
investment
and sues for
$325m

$7.4m Real Estate

revenue, Messina
becomes CFO

$450m civil
lawsuit
against
Deloitte

2013

2009
Drabinsky and
Gottlieb
convicted

Act II: Intent to Deceive

Poll

AU 316 - Consideration of Fraud in Financial Statement Audit

Auditor Responsibility: Provide reasonable assurance
that financial statements are free from material errors,
either caused by error or fraud (Para. 01).

Attitudes/Rationalization

Analytical procedures are used in the planning stage to

broadly identify fraud risk indicators (Para 28, 30).
Fraud Risk Indicators:
1. Previous fraudulent activity (Para. 35)
2. Management ability to override Internal Controls
(Para. 42)
3. Complexity of certain accounts or classes of
transactions (Para. 39)
4. Improper revenue recognition (Para. 41)

Opportunity

Incentives/Pressures

Fraud indicators were present before acceptance

Fraud risk red flags:

Non-fraud related factors to consider:

Drabinsky & Gottlieb:

Major operations were located in Canada, but

stock was publically traded in the United States

1. Associated with previous fraud while at

Cineplex Odeon
2. Tyrannical and abusive leadership
Unique business model:
3. Only publically traded company whose
major operations was to produce
theatrical performances

Booming economy in North America increased

consumer spending, resulting in rise of
popularity of theatrical performances
Auditability concerns:
1. Heightened SEC scrutiny combined with a
client with unique business processes
2. CFO (Messina) was previous engagement
partner at Deloitte

Accept the engagement - heightened awareness to

fraud risk
Posed an opportunity to audit a client in a growing industry
Must be aware of the fraud risks prior to accepting the engagement
1. Ensure engagement team understands and documents fraud risks
2. Assess a much lower Audit Risk (AR) compared to other new audit clients

Planning - Inherent Risk Analysis

Non-transaction specific Inherent Risks and Fraud Risks present in audit of Livent:
Complex accounting structure:
1. Unfamiliar and highly material accounts a. Preproduction Cost (Asset) and related amortization
CFO did not sign Letters of Representation in 1996 and 1997
2. Can we believe what management is orally communicating to us is fact?
Previous disputes over revenue recognition
3. Real estate development transaction
4. Naming rights sale to AT&T

Planning - Control Risk Analysis

Red Flags:
Control Environment: Tone at the Top management dishonesty trickles down to employees
Control Activities: Management was able to override established controls
Information and Communication: Communication between Management and External Auditors;
Accounting department feared communicating illegal activities

In the Livent Case:

These control risks are very difficult to detect for this case, especially if in compliance with GAAP
The controls may appear to be efficient in design, but they are not effective in operation

Addressing Control Risk

What Should Be Done:
Perform walkthroughs of system processes; determine if employees are able to override
the controls
Evaluate how each employee performs their specific duty as well as their inability to
perform anothers duty
Document Livents internal control processes via narratives
Inquire of management regarding independent and effective internal audit function
Audit Assurance Model
The assessment of control risk high, increases the risk of material misstatement
Thus, Detection Risk must be set very low to decrease our overall Audit risk of giving an
unqualified opinion on materially misstated financials

Addressing risks of material misstatement due to fraud

AU 316 - Paragraphs 52 & 53:
Nature: Prepare to collect highly reliable and extensive corroborative evidence
Timing: Less predictable; apply more substantive testing throughout the period
Extent: No reliance on the fairness of financial statements; large sample sizes
What did the auditors do?
1. Did not exercise heightened professional skepticism nor assess possibility of
fraud risks.
2. Trust CFO and management on financial reporting assertions

Intermission

Act III: Accounting Atrocities

Poll

Act III - Scene 1: Aggressive Revenue Recognition

Act III - Scene 2: Examination of Fixed Assets and Expenses
Act III - Scene 3: Pre Production Asset Account Activity
Act III - Scene 4: Collusion

Aggressive Revenue Recognition

Analytical Procedures:
Examine growth over past 3 years, compare to industry
(In Millions)
Gross
Contribution

Production
Revenue

Earnings Per
Share

1996

1995

1994

$81.8

<------

$69.2

<------

$49.0

41.2%

<------

$197

44.2%

$0.98

<------

$0.50

$4,452.5

96.0%
<-----19.2%

$3,734.2

18.2%

$314

<------

$284

10.6%

Disney's revenue

$0.75

<------

-23.5%

Aggressive Revenue Recognition

Reasons for skepticism:
Very high revenue growth in a short period
Public company doubles EPS from 1994 to 1995
Compared to Disneys production revenue growth, Livent grew 2x during this
period

Aggressive Revenue Recognition

Other red flags from transactions relating to revenue:
Complex transactions made for gains are included in production revenue
Several disputes with auditors over revenue recognition
1997 real estate sale was a related party transaction
1997 sale of naming rights was highly material, but a gray area

Aggressive Revenue Recognition

Potential Misstatement:
Naming Rights Sale: tendency to overstate to inflate revenue.
Real Estate Sale: tendency to overstate to inflate revenue.
Assertion:
Naming: Occurrence of an agreement in accordance with GAAP.
Real Estate: Occurrence of a sale that is in compliance with GAAP.

Aggressive Revenue Recognition

The SEC has the following guidance on revenue recognition (SAB Topic 13.A.1)
All of the following criteria must be met for revenue to be recognized:
1. Persuasive evidence of an arrangement exists,
2. Delivery has occurred or services have been rendered,
3. The sellers price to the buyer is fixed or determinable, and
4. Collectibility is reasonably assured

Aggressive Revenue Recognition

Naming rights: Livent arranged sale of naming rights for one of existing theaters
and new theater for $12.5 million.
Procedures:
Vouch the amount of transaction from production revenue journal to the contract
with AT&T. Confirm agreement and terms of contract with other party (AT&T) via
blank confirmation
1. Persuasive evidence of an arrangement exists,
2. Delivery has occurred or services have been rendered,
3. The sellers price to the buyer is fixed or determinable, and
4. Collectibility is reasonably assured

Aggressive Revenue Recognition

Real Estate: 1997, $7.4 million dollar sale of parcel of land to real estate firm.
Procedures:
Vouch the amount of sale and terms of contract from production revenue journal
to contract with counter party.
Inspect terms of contract, to evaluate reasonably assured collectability.
1. Persuasive evidence of an arrangement exists,
2. Delivery has occurred or services have been rendered,
3. The sellers price to the buyer is fixed or determinable, and
4. Collectibility is reasonably assured

Aggressive Revenue Recognition

What the auditors not do?
Didnt exercise higher skepticism due to signs of fraud environment
- Arguments over revenue recognition are a sign of fraud environment

Evidential matter should have been of higher reliability

Naming Rights: Caved to uncertainty of peers, and allowed the transaction to
stand
Real Estate: Correctly caught and deferred the revenue, and correctly followed up
to ensure put option recorded properly

Fixed Assets Capitalization

Analytical Procedures: Over the past two years, Livents PPE balance increased
by 65%

Fixed Assets

1996

$133,200,886
Fixed Balance
.00

Expenses

1995

Growth

1995

65%

$80,821,536.
00

Growt
h

Expenses

1996

Growth

1994

General & admin

$13,045,855.00

10.6%

$11,796,710.00 20.1% $9,823,978.00

Amrt of PPC
Depr and amrt

$45,783,242.00
$4,028,117.00

41.2%
21.2%

$32,432,415.00 24.2% $26,120,826.00

$3,323,701.00 1.8% $3,264,853.00

Fixed Assets Capitalization

Red Flags:
Raised skepticism due to initial trading on NASDAQ
Assets growing exponentially while general expense growth declining

Potential Misstatements:
Tendency to overstate assets by capitalizing items that should be expensed
Assertion: Existence

Fixed Assets Capitalization

Audit Procedures by IndepenDANCE:
Inquire of management regarding capitalization thresholds (asset cost and useful
life)
Physically inspect the fixed assets for improvements and condition.
Inspect PPE ledger to determine source of increases in account balance overtime.
Vouch invoices for items that are improving the asset accounts to the PPE ledger

Preproduction Cost Account

1996

Analytical Procedures:

1995

Preproduction
costs

$ 75,588,136

$ 55,463,566

Total Assets

$306,048,401

$188,996,730

24.7%

29.3%
Growth

Red Flags:

PPC

$75,588,136

36%

$55,463,566

PPC represented approximately 25% of total assets - highly material account

Related amortization approximated 70% of total expenses
Amortization

$45,783,242

41%

$32,432,415

Preproduction Cost Account

Audit Assurance Model Implications:
Inherent Risk: Livents 1996 notes describing the PPC account:
...the Company may revise the estimated revenue and resultant amortization
period for pre production costs based on the sales experience for that production
and its experience with other similar productions.
Unusual account specific to Livents unique business practice.
Assessed Inherent Risk: High

Preproduction Cost Account

Audit Assurance Model Implications:
Control Risk:
- Livent did not close Preproduction Accounts relating to specific shows
- Management was able to shift preproduction costs from one show that was
already running to a show in preproduction
- Result: Perpetually deferred expense recognition

Assessment of Control Risk: HIGH

Preproduction Cost Account

Potential Misstatement:
Management is not appropriately capitalizing expenses to related PPC
account (Understating PPC)
Assertions:
Completeness
Cutoff

Preproduction Cost Account

PPC - Ragtime

Advertising
Expense Invoice Ragtime

PPC - Phantom of
the Opera
Other Asset Account
(PPE)

Preproduction Cost Account - Cutoff

Procedures for testing Cutoff:
1. Establish Preproduction period for specific shows
2. Obtain a sample of preproduction cost item invoices two months before and
two months after the opening weekend of the show
3. Trace invoice date to PPC subsidiary ledger; ensure no cost is capitalized
after the opening night show

Preproduction Cost Account - Completeness

Procedures for testing Completeness:
1. Obtain a sample of preproduction cost item invoices
2. Confirm item, amount, and date with vendors
3. Trace and reconcile confirmation information to appropriate PPC account

Preproduction Cost Account

What did the auditors not do?
Tested for existence as with most asset accounts, not completeness
Failed to understand the motives behind deferring amortization costs

External Collusion
Livent was colluding externally with two major vendors
Vendors accepted reduced profit on Livent purchases
Remitted the excess payment to Drabinsky and Gottlieb
This is very difficult to detect, even if suspected
Auditors responsibility is to provide reasonable assurance against material
misstatements due to error or fraud

External Collusion
What did the auditors not do?
Needed to consult Vendor auditors to detect this
Confidentiality issues
Requires client permission
Practically speaking, requires a significant reason to suspect
Pervasiveness of scheme reflects managements integrity issues

External Collusion
Second collusion scheme was reimbursements to the same 2 vendors for
buying tickets
Livent repaid the vendors and debited fixed assets instead of expenses
Detected via the fixed asset existence procedures described prior

Act IV: The Aftermath

Whistleblowing protection under SOX

1514A (a). WHISTLEBLOWER PROTECTION FOR EMPLOYEES OF PUBLICLY TRADED COMPANIES. - No company
with a class of securities registered under section 12 of the Securities Exchange Act of 1934 (15 U.S.C. 78l), or that is
required to file reports under section 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78o(d)), or any officer,
employee, contractor, subcontractor, or agent of such company, may discharge, demote, suspend, threaten, harass, or in
any other manner discriminate against an employee in the terms and conditions of employment because of any lawful act
done by the employee
1514A(c)(1). An employee prevailing in any action of filing a complaint with the Secretary of Labor or bringing an action at
law or equity for de novo review in an appropriate district court of the United States if the Secretary has not issued a
financial decision within 180 days, shall be entitled to all relief necessary
1514A(c)(2). Relief for any action should include:
Reinstate with the same seniority the employee would have had
Amount of back pay, with interest
Compensation for any special damages sustained as a result of discrimination. I.e., litigation fee
1514A(d). Under Federal and State law, nothing in this section should be diminish employees right, privileges, or remedies.

U.S. Auditor Liability (SOX 2002)

SEC. 105(c)(5) Sanction
Intentional or Other Knowing Conduct. the sanctions and penalties
(A). Intentional or knowing conduct, including reckless conduct, that results in
violation of the applicable statutory; or
(B). Repeated instances of negligent conduct

Epilogue
Remaining Assets of Livent were purchased by SFX Entertainment in July 1999
Accountants were sanctioned
Drabinsky: Started serving the sentence in 2011 for 5 years
Gottlieb: Started serving the sentence in 2011 for 4 years
Maria Messina: fined $7,500 and suspended from chartered accountant for 2 years
Christopher Craib: 6 months suspension in Canada and $1,000 fine, 3 years suspension from practicing before SEC
Deloittes Auditors: Publically reprimanded by ICAO, total fines against Deloitte and its auditors was $1.55 million. Ontario
court had Deloitte pay $85 million.

Questions?
Brought to you by IndepenDANCE Auditors