Reported Decision : 52 ACSR 646 New South Wales Supreme Court CITATION : Stanilite Pacific Limited (In Liquidation) & Anor v William Henry Brown Seaton & Ors Trading as Price Waterhouse [2004] NSWSC 376 revised - 14/05/2004 HEARING DATE(S) : 13,14,15,16,20,21,22,23 October 2003 and 2,3,4,8,10,11,15,16,17 & 18 December 2003. JUDGMENT DATE : 12 May 2004 JURISDICTION: Equity Division Commercial List JUDGMENT OF : Bergin J DECISION : Amended Summons Dismissed CATCHWORDS : [Negligence] - Claims that defendants, auditors, were negligent in (a) consenting to the inclusion of unqualified audit opinion on 31 December 1994 accounts of the plaintiffs in Prospectus on 3 May 1995 - and (b) signing unqualified audit opinion in respect of 30 June 1995 accounts of the plaintiffs - Allegations that the use of earned value method of bringing profit on telecommunications contracts to account was inconisitent with relevant accounting standards - Whether such contracts construction contracts - Whether material loss forseeable. [Contract] - Claims that same conduct amounted to breaches of contract. [Statute] - Claims that same conduct amounted to breach of provisions of Corporations Law in force in 1995. LEGISLATION CITED : Corporations Law AWA Ltd v Daniels t/as Deloitte Haskins & Sells (1992) 7 ACSR 759 Daniels & Ors (formerly practising as Deloitte Haskins & Sells & Ors) v Anderson & Ors (1995) 37 NSWLR 438 CASES CITED : Mahony v J Kruschich (Demolitions) Pty Ltd & Anor (1985) 156 CLR 522 Onassis & Calogeropoulos v Vergottis [1968] 2 Lloyd's Rep 403 Swiss Bank Corporation v Lloyds Bank Ltd and Ors [1982] AC 584 Stanilite Pacific Limited (In Liquidation) (First Plaintiff) PARTIES : SL Electronics (NSW) Pty Ltd (In Liquidation) (Second Plaintiff) William Henry Brown Seaton & Ors Trading as Price Waterhouse (Defendants) FILE NUMBER(S) : SC 50055/01 COUNSEL : FM Douglas QC, and CE Adamson SC (Plaintiffs) JH Karkar QC, IM Jackman SC and MR Elliott (Defendants) SOLICITORS : Deacons (Plaintiffs) Minter Ellison (Defendants) IN THE SUPREME COURT OF NEW SOUTH WALES EQUITY DIVISION COMMERCIAL LIST BERGIN J 13 MAY 2004 50055/01 STANILITE PACIFIC LIMITED (IN LIQUIDATION) & ANOR v WILLIAM HENRY BROWN SEATON AND ORS TRADING AS PRICE WATERHOUSE JUDGMENT Introduction 1 The plaintiffs, Stanilite Pacific Limited (Pacific) (in liquidation) and SL Electronics (NSW) Pty Limited (Electronics) (in liquidation), sue the defendants, William Henry Brown Seaton and others trading as Price Waterhouse (PW) for damages for breach of contract and negligence in acting as auditors of the plaintiffs. The liquidators of the plaintiffs are Kenneth Rennie and Geoffrey James who were partners of Ernst & Young at the time of their appointments and were consultants to that firm at the time of trial. 2 The plaintiffs claim that Mr Seaton, to whom I shall refer as the defendant, and PW, acted negligently and in breach of PW's contract with the plaintiffs in: (a) issuing an unqualified audit opinion on 16 March 1995 in respect of the accounts of Pacific and its controlled entities, including Electronics, for the half year ended 31 December 1994 (the Accounts), or at least failing to insist on the inclusion of a note to the Accounts in relation to recent correspondence with the bankers (the going concern issue); (b) consenting to the inclusion of the unqualified audit opinion on the Accounts in a Prospectus lodged on 3 May 1995 (the Prospectus); and (c) issuing an unqualified audit opinion on the accounts for the year ended 30 June 1995 (the 1995 accounts). 3 The plaintiffs claim damages on the following bases: (a) in the case of Pacific, the difference between the value of its assets had a receiver been appointed in May/ June 1995, and the value of its assets upon liquidation, together with the dividend paid on December 1995 to its shareholders; and (b) in the case of Electronics, the further trading losses incurred by it as a result of the loan made to it by Pacific from the monies raised by the issue and the placement, which permitted it to incur further expenditure on international telecommunications contracts, and to enter into a contract known as the CTI contract, which rendered it unable to repay the loan to Pacific, and greatly increased its indebtedness to its other unsecured creditors. 4 The matter was heard on 13 to 16 and 20 to 23 October 2003 and 2 to 4, 8 to 11 and 15 to 18 December 2003 when Mr FM Douglas QC and Ms CE Adamson SC appeared for the plaintiffs and Mr JH Karkar QC, Mr IM Jackman SC and Mr MR Elliott appeared for the defendants. The Facts 5 PW were retained as the plaintiffs' auditors from 1990 until the plaintiffs were placed into liquidation on 26 August 1996. The Group 6 The Stanilite Group was founded in 1977 by two brothers, Robert and John Harris, who were managing directors at all relevant times. Shares were listed on the Australian Stock Exchange (ASX) in 1989. Pacific carried on the business as a holding company and raised capital from time to time for the purpose of making loans to its subsidiaries, including Electronics. Prior to 1992 the principal businesses carried on by Electronics were the Emergency Lighting Division and the supply of communications systems for ten frigates built for the Australian and New Zealand navies (the ANZAC contract). In 1992 Electronics expanded its operations into manufacturing and installing telecommunications systems in overseas countries that did not have developed telecommunications infrastructure. 7 The telecommunications systems manufactured, supplied and installed by the plaintiffs included the Cellswitch and Trunkswitch systems. The Cellswitch communication system, the focus of this litigation, was described in evidence as "quite complex" comprising mobile phones or radios at one end with mobile phones, radios or land lines at the other end. The system includes the hand held devices, the antenna, and the cellswitch (described as "not unlike a mini telephone exchange"). Software drives the switch and links the switch to the main network and provides billing information to the operator of the network on a user-generated system. The linkage into the main network may be a cable or wireless connection or it may be a satellite link or microwave. The cellswitch is a component within the system (tr. 583). The telecommunications towers that were constructed were an essential feature to the successful operation of the telecommunications system (tr.319). The Group's banker 8 At the end of December 1993 the Group investigated the availability of further funds from its then banker, the ANZ, the National Australia Bank (the bank) and the Hong Kong Bank. The bank was prepared to offer a facility in the order of $35.2 million, some $5.2 million more than the ANZ was prepared to offer. The Group made a decision to transfer its business to the bank. 8 February 1994 facility 9 On 8 February 1994 a Facility Agreement was executed between Pacific, Electronics and other companies in the Group and the bank to refinance the ANZ facilities and to provide further working capital for the increased expenditure on international telecommunications. It was secured by mortgages over real property and fixed and floating charges from all the companies in the Group together with an interlocking guarantee. The Group provided financial undertakings to the bank that, in the main, depended upon a ratio determined by reference to the audited accounts for the year ended 30 June, and the reviewed accounts for the six months to 31 December. The February 1994 review 10 On 7 February 1994 the defendant wrote to the audit committee of Pacific advising that PW had reviewed the half yearly consolidated accounts of Pacific for the six months ended 31 December 1993 that had been presented to the Board at a meeting on 1 February 1994 (the February 1994 review). In that letter the defendant set out what was described as "matters that came to our attention during the review which we believe are relevant to the directors' assessment of the accounts". The letter also stated that the review was not an audit of the accounts and, in the circumstances, no opinion could be expressed on the truth and fairness of the results or the financial position of the Group as disclosed in the accounts. 11 The defendant referred to a number of "errors in accounting" requiring adjustment. One such error was the "carrying value" of a property at 424 Lane Cove Road, North Ryde (the Ryde property) being "significantly above" the independent market valuation as at 20 October 1993. This property was "carried" in the books at $9,947,743 whereas Jones Lang Wootten (JLW) had valued the property on a vacant possession basis at $8,500,000. The defendant advised that directors were obliged to consider the write-down of a non-current asset to its recoverable amount and that based on the valuation, the book value of the property "could be between $700,000 and $1.4 million above its recoverable amount". 12 The defendant also advised that the costs of $565,000 in relation to a rights issue should be written off because it had been completed and the costs no longer represented a recoverable asset or any future benefit to Pacific. The defendant also referred to the fact that Pacific had received Australian government assistance for marketing activities in Eastern Europe, China and Taiwan in the form of international trade (ITES) grants. After noting that Pacific's stated accounting policy was to offset government assistance received against the related deferred expenditure, the defendant advised that $145,000 included in the accounts as sundry income from an ITES Eastern Europe grant should not be brought to account in the profit and loss but should be applied to reducing the deferred cost. 13 The defendant also provided advice in respect of what was described as "inconsistent application of accounting standards". One matter upon which such advice was given was the following: 10 Revenue Recognition on Argentina Project (a) Argentina The profit on the "Argentina project" has been fully taken up in the accounts. Revenue recognition for projects in Stanilite is normally based on an earned value basis with cost of sales being actual cost incurred at the point of revenue recognition. The profit taken up on the "Argentina project" is clearly inconsistent with Stanilite's policy for revenue recognition. The profit taken up is $928,000 higher than that under earned value basis. Moreover, it is arguable that the earned value basis of revenue recognition is not appropriate for telecommunication contracts, such as the "Argentina project". We understand that these contracts are usually for the supply of discreet items, cell switches, which are manufactured to specifications. Each item is separately priced and capable of being separately costed. The items are also usually homogenous within each contract. In such a scenario we believe that it could be strongly argued that these contracts do not fall into the definition of construction contracts under Australian Accounting Standards as they are contracts for supply rather than contracts for construction. Timing of recognition of profits on supply contracts should be based on delivery. On this basis, the profit taken up on the "Argentina project" would be significantly less. (Ex F: 239-240) Argentina order 14 The reference to the "Argentina project" in the 1994 review letter was apparently a reference to a contract between Electronics and GTE/CTI (Compafria de Telefones del Interior) in Argentina prior to February 1994. That project led to a verbal order by CTI on Electronics on 30 March 1994. On 31 March 1994, Electronics wrote to CTI to confirm that verbal order for Cellswitch Base Station Equipment in the following terms: Stanilite Electronics is pleased to confirm your verbal order of the above-mentioned equipment. We understand that the commitment shown by Stanilite in realising your requirements has placed us in a preferential position for your future requirements. The equipment offered is exactly as previously purchased by GTE/CTI. Due to the short lead times that are involved with this purchase, we require your written confirmation by close of business today, 31 March 1994. The delivery schedule, final pricing and order conditions are attached. We thank you for your business and assure you of every possible co-operation and professionalism in completing our supply. (Ex F: 368) 15 The conditions attached to the letter included the prices for "1 + 5 stand alone base station 'Cellswitch'" with a note that 7 complete systems had previously been supplied. Those conditions included the following: Installation It is understood from the discussions that the main goal is to install some key sites in the shortest possible time frame. Assuming these sites were available and complete with power and antenna installed and Cellswitch equipment available at site, a typical installation time of 6 hours is offered for basic operational status only. The manpower for installation will be offered in accordance with the "Technical Services Agreement" which is being negotiated between CTI and Stanilite at this present moment. This agreement would allow a per day usage of the available man power to complete the task. As an indication of cost the per man day rate is offered at $500. This would include the cost of accommodation and living expenses while in the field. Travel expenses are not included. The travel would be supplied either by the CTI group or charged to the group on a cost plus ten percent (10%) basis. Stanilite have made inquiries with local companies who have labour available to fulfil the installation task. They would work under the control of Stanilite and as best suits the requirements of CTI. (Ex F: 371) Capital raising April 1994 16 In April 1994 Pacific raised $15.34 million through the placement of 2,692,000 shares at $5.70 and $411,000 from the placement of 76,570 shares. It raised a further $1.324 million through a dividend reinvestment plan on 29 April 1994 amounting to a total capital raising of approximately $17 million. Request for increased facilities 17 In September 1994, as required by the Facility Agreement with the bank, Pacific confirmed that the Group had complied with the ratios referred to in the financial undertakings. Pacific also supplied the draft statutory financial statements for the year ended 30 June 1994, to be signed at the board meeting on 15 September 1994, together with an operating budget 1994/1995, a cash forecast for the year to 30 June 1995 and a budgeted balance sheet as at 30 June 1995. The letter from Pacific to the bank dated 13 September 1994 included the following: However I now propose that there be an increase in the total facilities of $10 million from the existing A$35.2 million (excluding the US$1.0 million) to A$45.2 million. I submit that this requested increase be mainly allocated between Standby Bills and Overdraft/Bills. … As you can see we propose that we revert to the original structure with the exception being an allocation of an extra $500,000 to the encashment facility. I also advance that on completion of a successful share placement during the financial year the standby facility would again revert to the original $5,000,000 and be subject to further review at that time. (Ex F: 415-416) 18 In response the bank sought clarification of the accounting treatment of certain items. Pacific responded, attaching a revised cash flow forecast which assumed receipt of a new facility from the bank of $10 million in October 1994 and receipt of cash of $20 million in April 1995 from the share placement. September 1994 audit report 19 By letter dated 28 September 1994 the defendants advised the directors of Pacific that they had completed the audit of Pacific and its controlled entities for the year ended 30 June 1994. That letter attached a report to the directors containing matters "of significance" highlighted during the defendants' audit (the September 1994 audit report). Pacific responded to the report by letter dated 30 September 1994. The following are the relevant parts of the September 1994 audit report with Pacific's response in italics: 1. BUSINESS ISSUES 1.2 AUTHORISATION OF RESEARCH AND DEVELOPMENT PROJECTS Research and development has been critical activity in which Stanilite has invested significant amounts in recent years. The research and development costs incurred for the year amounted to $11,892,000. Consideration should be given to implementing formal procedures for the approval of research and development projects before their commencement. The approval process should involve a formal analysis of the viability of the project and should include the following: · justification for the project. The project should be consistent with and support the business strategies of the group; · a detailed budget for the cost of the project. This budget should be used as a means of controlling the costs incurred on the project as it progresses; · an assessment of the return on the project such as a comparison of the present value of future benefits to proposed costs or the payback period of the project; and · an assessment of the risks of the project. … Levels of approval and authorisation for research and development projects should be at least as stringent as for capital expenditure and should involve the board where appropriate. The approval process should be fully and formally documented. Research and development projects should not proceed without prior approval. Research and development projects should be reviewed in accordance with our observations at paragraph 1.5.1. 1.2 As part of the budget process an itemised R&D budget has been reviewed by the Chief Engineer, Product Manager and the Joint Managing Director. It is intended to finalise this schedule when the Joint MD returns from overseas. This will detail the budgeted cost of each R&D project including the assessment and cost benefit and risk analysis. An update of R&D projects will be prepared quarterly and submitted to the full Board as indicated in your paragraph 1.5. 1.3 CONTRACT TENDERS 1.3.1 Approval of contract tenders Contract tender costs are ongoing business costs incurred by Stanilite. However, similar to research and development projects, consideration should be given to implementing formal procedures for the approval of large contract tenders which may involve significant costs prior to commencement of the tender. The approval process should include an assessment of the risks and benefits of the contract and a preliminary assessment of the return on the project. Levels of approval should be formalised and should involve the board for significantly large contracts with high anticipated tender costs. Tenders should not proceed prior to the completion of the approval process. 1.3.2 Continuous review of contract tenders The accounting policy adopted by Stanilite for contract tender costs is to capitalise and defer such costs where in the opinion of the directors it is probable that the company will succeed as a primary or secondary contractor. Whilst deferring contract tender cost is acceptable accounting practice it is usual for listed companies to adopt the more prudent policy of writing off tender costs as incurred. The directors should continuously assess the likely success of tenders with significant associated deferred costs. Costs relating to tenders which are unlikely to succeed should be fully written off immediately. … 1.3.3 Reclassification to research and development Where contracts are not won, tender costs are often reclassified as research and development costs. This is acceptable to the extent that the tender costs include expenses directly related to product development/improvement. Care should be taken to fully analyse such costs before determining the amount to be transferred to research and development to avoid capitalisation of costs which have no on going benefit to the group. We feel that the reclassification of tender costs to research and development should undergo the same formal approval processes which should be implemented for new research and development projects. 1.3 Similarly Contract Tender costs are required to be approved by Executive Directors before each tender cost is incurred. Board papers on these costs will also be co-ordinated quarterly and Directors assessments make each quarter and half-year. Any reclassification of tender costs to R&D will also be referred to Board for due diligence as required. 1.4 REVENUE RECOGNITION 1.4.1 Revenue recognition for telecommunication sales Telecommunications have become an important part of Stanilite's business. In the year ended 30 June 1994 telecommunications sales contributed 36% of the group's revenue. Telecommunications sales are expected to grow significantly in 1994/95. Broadly, Stanilite's telecommunication sales take the form of either supply of products or construction contracts. Consideration should be given to formalising the revenue recognition policy for telecommunications sales. Specific criteria for identifying each type of sales should be formalised and the appropriate revenue recognition policy applied. The process of identifying each type of contract should be implemented at the point of winning the contract, properly documented and signed off by project and finance managers. We believe that the following criteria for defining telecommunication sales types and the related accounting treatment should be adopted. Supply of products: Supply of discreet items which are manufactured to specifications. Each item is separately priced and capable of being separately costed. The items are also usually homogenous within each contract. Accounting convention requires that revenue for such contracts be recognised as each item is delivered and acknowledged as received by the customer. Construction contracts: Design, build and/or installation of unique telecommunications systems. The system may comprise several homogenous components but which are essential to the working of the system as a whole. These contracts can usually be divided into periods of accomplishment or "milestones". These contracts may be brought to account under the "earned value" basis. However, there should be a formal non-cancellable contract to support revenue recognition under this basis. 1.4.2 Review of profit takeup on projects Profit takeup on projects is currently determined by the project department. There is no independent detailed review of projects profit takeup. We believe that several significant errors in projects profit takeup, (including ANZAC) which were identified at the half-year review and during the year end audit, were a consequence of the lack of independent detailed review at each month end. We feel that it would be appropriate for profit takeup on projects to be determined, at the first instance, by the finance department. This is because profit takeup on projects involves the application of accounting concepts and standards. The profit takeup on projects at each month end should then be reviewed in detail by the projects department to ensure that revenue recognition is consistent with their understanding of the progress of the projects. Independent detailed review on a monthly basis of projects profit takeup would ensure that monthly management accounts are a more reliable indicator of the performance of the group and its financial position. … 1.4.3 Consistent application of earned-value calculation The method for calculating the earned-value on several projects for the year ended 30 June 1994 had been altered resulting in the earlier recognition of revenue on these projects. The change in the method involved breaking the project down to its constituent components and treating each of the components as a separate project. This treatment is inconsistent with prior year application of the earned-value calculation. The change was also not applied to all projects but selectively to certain projects. We believe that unless a project is very large and spans several years (such as the ANZAC frigates project) there is little justification to treat each of its components as a separate project for earned-value calculation. We recommend that a formal policy be implemented for the identification of projects to be broken down into its constituents for determination of earned-value. This policy should outline the criteria which would qualify a project for this method of earned-value calculation and include formal approval by both projects and finance management. 1.4 Revenue recognition for telecom sales comments are noted. Subject to any unique specifications the supply of product will be treated in accordance with accounting convention . Where telecoms sales are of the type described as construction contract it is intended to account for these under the earned-value basis. A simple procedure for determination of such contracts is to be finalised and circulated to the marketing executives to ensure proper understanding of accounting procedures. With respect to revenue recognition in the area of projects, your comments are very relevant and have been discussed between the finance and projects departments. The amount of time and effort of all parties in reviewing, adjusting and correcting project revenue calculations at year-end was unacceptable. The finance department must determine profit takeup initially and these calculations reviewed and signed off by the projects department. The endorsement of this approach has been affected by the Executive Directors. 1.5 INTANGIBLE ASSETS 1.5.1 Review of carrying value Intangible assets, including deferred research and development costs, are significant component of Stanilite's balance sheet, accounting for 28% of total assets as at 30 June 1994. To assist the board in assessing the value of intangible assets at 30 June 1994, management presented papers supporting the carrying value of each material intangible item. We encourage the presentation of such papers to the Board. Whilst the papers presented by management provided useful information on the nature of the projects involved they did not always include a comprehensive case supporting the carrying value of the intangible item. We feel that the inclusion of the following additional matters in the papers would assist the board in assessing the carrying value of intangible assets: · the stage of completion of the project and the estimated date of completion; · the estimated cost to complete the project; · expected future revenue to be generated from the items; · the likelihood of the future revenue being achieved; · the period over which the revenue will be achieved. This should determine the period over which the intangible asset is amortised. We would recommend that major intangibles continue to be subject to board scrutiny at least half yearly and that senior management should also formally review every item in intangibles at least quarterly, using a similar standard of documentation as presented to the Board. 1.5 Comments contained under intangible assets are again noted and as previously mention, agreed. Senior management will be instructed to support the collation and justification of amounts capitalised. 1.7 PROVISION FOR BAD AND DOUBTFUL DEBTS There is no provision for bad and doubtful debts. Our audit indicated that there is a minor exposure to potentially doubtful and disputed debts. Although all known bad debts have been written off, some minor disputed balances have not been provided for. Consideration should be given to creating a general doubtful debt provision to cover potential bad and disputed debts which are not covered by the bad debt insurance. 1.7 Subject to a comprehensive review of the status of debtors accounts at December 1994 and June 1995 an assessment as to the level of provision will be determined. Where appropriate and available credit insurance on international orders will be put in place. There is no bad debt insurance cover on general trade debtors. (Ex. F: 430-435) (Ex. F: 449-451) Increase in facilities 20 Pacific wrote to the bank on 30 September 1994 and referred to the acceleration of payment of creditors compared to the previous year. It advised that it currently monitored "very closely the extent to which creditors can be paid without damaging reputation" and advised that it was "judged commercially and in the overall scheme of things" to be more appropriate that "our bank and not the creditors facilitate working capital requirements". The suggestion was made that there might be a restructuring of the new facility excluding the chattels lease. 21 An internal bank document of 13 October 1994 noted that the Group did not generate sufficient cash flow from operations to cover its operating and tax costs and a shortfall of $7.163 million was noted. The document also recorded the view that there was no cash available to cover any financing costs, interest and dividends, any debt amortisation, or any capital expenditure and that borrowing or equity was required to cover those needs. It referred to the fact that the business had to borrow money to pay dividends of $3.7 million in 1994. 22 Another internal bank document of 13 October 1994 included the following: In view of the fact that Stanilite does intend to go to the market late this financial year and our increased assistance is to be short-term, we believe that the Board should pass a resolution of intention to raise equity prior to release of further bank funds. The timing therefore is at their discretion but must be before expiry of the short term facility. We believe that Stanilite should be informed that the equity raising is imperative and that this will be the maximum of our assistance until such time as equity has been raised. (Ex. F: 523-524) 23 On 20 October 1994 Pacific sent to the bank a Certificate of Compliance with Financial Undertakings, the covering letter of which highlighted that one of the undertakings (1(d)) exceeded the 5% of total assets of the Group. The explanation given was that the increase in assets in New Zealand was represented by work in progress in relation to the ANZAC contract and that it fluctuated significantly "depending on the earned value recognition" and the subsequent invoicing and payment by the prime contractor. The letter requested a "formal written exception to the technical breach of undertaking 1(d)". 24 By letter dated 3 November 1994 the bank advised Pacific that it wished to continue its support provided an underwriting agreement for the proposed share placement was in place before the funds were released. It expressed the belief that "proposed growth in 1994 and 1995 may become a problem unless some issues are addressed now". The bank called for a report from the "External Accountants" on certain matters including how much work in progress was written off prior to translation, whether there was obsolete technology still capitalised and a commentary on the country risk strategy. It suggested that the overseas subsidiaries be included in the interlocking guarantee because of the increasing volume of business being done "off-shore" and suggested that an undertaking in this regard would be "sufficient" because the bank did not wish to "hold up release of funds on the technicality of this point". The bank also advised that the irregular position of the trading account had been adjusted pending a formal approval of an underwriting agreement and requested that such limits be respected. 25 Pacific responded to the bank by letter dated 8 November 1994 enclosing a letter from BBY Corporate Services (BBY) agreeing to underwrite the future capital issue "as and when determined by the Board of Stanilite". It advised the bank that it "broached with" PW its requests for a report and that it would be meeting with them on 8 November 1994 to discuss the matters in more detail. The letter concluded: "As you can appreciate the requirement for some of the requested increased facilities is now pressing and we would appreciate the formal release of funds at your earliest convenience" (Ex G: 9161-9162). 26 On 16 November 1994 a meeting was held with representatives of Pacific, the defendant and representatives of the bank including Mr Treadwell and Mr Ray Pridmore from the credit bureau of the bank. A note made by the defendant of that meeting included the following: Pridmore did all NAB talking … seemed to be challenging Teadwell's relaxed attitude towards the extension of credit. Pridmore made it clear that NAB were eager to lend to coy's like SPL – his concern was to be sure that (i) NAB was not being asked to lend money in excess of SPL's available security and (ii) that SPL had a definite capability to manage its business/growth. Pridmore asked whether in my view SPL was managed by reputable and sensible people who were not "scientific boffins" with no commercial sense. I indicated that this was my view. Pridmore asked about inventories-why had they expanded-I said the ANZAC earned value running ahead of building schedule and their build up of telecoms stock and explained nature of ANZAC contract and coy's philosophy of building electronics/telecoms stock to meet anticipated contracts which could only be won if stocks held and also need to have buffer stock … Need for capital raising noted by Pridmore – asked if I thought a large (30-50 m) rights issue could be made – I said could be possible if "good news" could "excite" buyers. … I noted that much of the telecoms revenue is likely to be lumpy. (Ex. G: 9165-9166) 27 The defendant's note also referred to the requirement for the defendant to produce a draft letter setting out items to be addressed. That letter was provided on 17 November 1994 in which the defendant set out the issues upon which PW was required to report and advising that the report would be available by 22 November 1994. The letter noted that Pacific was revising the 1995 cash flow forecasts that would be provided to the bank after the December Board meeting. The Russian Contract 28 On 11 November 1994 Electronics and Techin Trade Limited entered into the Techinfo Network Supply Agreement (the Russian contract) (Ex. F: 533). The details of the terms of this contract are dealt with later in this judgment when I am considering the plaintiffs' detailed allegations against the defendants in respect of their treatment of the revenues from this contract utilising the "earned value" basis. In general terms, this contract was for the supply of products (equipment) and services. The equipment was cellswitch systems, microwave links, billing system hardware and user terminals. The services included the provision of modifications to the existing switching system, the provision of modifications to the existing equipment, the provision of in-country support, the provision of site preparation works, including foundations and fixings, the provision of building works, supporting structures and power supply points, the provision of transport and the provision of site labour for installation and set to work (Ex F: 533). The bank visits the Group 29 On 19 November 1994 Messrs Pridmore and Treadwell visited the Group's premises. Mr Pridmore's rather colourful file note of the visit included the following: It is of some concern that Messrs John and Robert Harris, joint managing directors and driving force behind the company, seem to have studiously avoided or, at best, been indifferent to meeting with their bankers. The only person who has any acquaintance with the two is John Treadwell, who was their personal banker and who was the person who obtained the business for the bank. … Given the rapid expansion of the company and its continuing and increasing need for bank support, it is disappointing that the Managing Directors appear to accord such little weight to the bank relationship and, worse, that nobody else on the Board or in senior management, has either the perspicacity or influence to persuade them otherwise. Notwithstanding that no assessment of the brothers could be made, the tenor of activity at the premises and personalities of the senior management and director who were met did not create an impression of close supervision or attention to costs. Indeed, overall efficiency did not impress. Office staff were standing around, obviously indulging in casual conversation. Despatch staff were similarly talking in small groups and seemed generally inactive. Employees were slowly ambling from point to point, frequently with their hands in their pockets. Whilst R&D staff productivity is harder to judge, with only a few exceptions they seemed so relaxed as to be almost idling. The factory staff were working satisfactorily but the factory itself was poorly laid out with substantial wasted space. (Ex F: 646) 30 Mr Pridmore went on to note that one danger for the company was its ambition, "taking them into a league with major players who have, thus far, ignored them as of no significance". He also noted that the R&D requirement was likely to become greater and greater in future years and continued: This is going to require very careful management and a specific focus for R&D which is not currently apparent. Again, the absence of a strong, pragmatic personality to restrain enthusiasm could be a cause for concern. (Ex F: 648) 31 Mr Pridmore referred to the Cost Schedule Control System, known as CS2, that had been installed and noted that it was the only company that had installed it, "not for a single contract, but now apply it to every contract undertaken by them" and continued: The result is that the company has had imposed upon it a magnificent system that has almost certainly been the making of them since it has ensured that they did not suffer the lack of controls that attends almost every other rapidly expanding company. (Ex F: 649) 32 He noted that under this system, profit to date on a contract could not be taken as indicating overall profit expectation and that there may be recognition of substantial profit on an element of the contract with no prospect of payment for some time. He also noted that where costs change, allowing the company to improve its margin on the contract, the whole of those additional profits are brought to account immediately, notwithstanding that most of the contract may not yet have been completed. He referred to this aspect as very "misleading" and one of which the bank should be aware. 33 In dealing with inventories Mr Pridmore noted that $10 million were actually "Cellswitches for which there is no current customer" and that $5 million were in the form which were "generic", able to be used anywhere once an additional 10% of work was completed to "customise" them for specific areas. He then noted: All of the above points should be of concern to the bank since the great majority of stock and raw materials carried would have an extremely low sale value if, in fact, they could be sold at all. Similarly, WIP has almost no intrinsic worth since it is merely part of contracted work which almost certainly would not be purchased if a third party had to complete the contract. (Ex F: 650) 34 Mr Pridmore observed that "intrinsic value in the absence of the continuing operation is very small". He suggested that the bank needed to "seek comfort concerning the continuing operation of this company since asset values will be sustained only by the on-going business" (Ex F: 651). He noted that one thing that had become clear in conversation was that: "any equity raising of $20 million can be no more than a short term palliative and is most unlikely to fund the company through to June 1996" (Ex F: 652). He then referred to his meeting with the defendant and recorded that he impressed him as being pragmatic, understanding of the bank's concerns and knowledgeable of both the operational and financial position and systems of the company. He expressed a belief that the defendant could be relied upon to provide accurate, independent assessment of the accuracy and reliability of the data contained in the CS2 and to provide the bank with the necessary comfort to support extension of the facilities. He noted that the defendant would comment upon and verify the new cash flow to be tendered on 6 December 1994. 35 Mr Pridmore recommended that subject to a satisfactory report from the defendant the bank should provide further facilities sufficient to support the "new cash flow" on certain conditions. Those conditions included the overseas subsidiaries becoming guarantors; the obtaining of trade indemnity insurance satisfactory to the bank; appropriate covenants to be decided in the light of the cash flow; and future reporting to the bank on a quarterly basis to include detailed management reports and copies of the project performance report for each contract with various details as required. He suggested a standby facility of $5 million on a short-term basis, the drawings for which would have to be preceded by an "acceptable" report from PW attesting to and analysing the information contained in CS2. He considered the option of transferring the account to "Corporate Banking" but allowed it to remain where it was on the basis of the adoption of the monitoring mechanisms referred to in the file note "together with the involvement of Price Waterhouse". The defendant's report for the bank – 22 November 1994 36 The defendant produced the requested report dated 22 November 1994 for use by Pacific and NAB for the purposes of reviewing the banking facilities. That report included the following: The project WIP balance is made up of the cost of work in progress plus attributable profit to date less progress claims. Attributable profit is determined on percentage of completion estimated using the earned value basis under the Cost/Schedule Control Systems (C/SCSC) methodology (refer Paragraph 5.1). A schedule of progress claims or billings is however usually outlined in the contract for projects which would include specific points at which invoices may be rendered. The project WIP balance in effect represents the degree to which progress on the project is recognised in advance of billings. (Ex F: 662) 37 Paragraph 5.1 of the report was in the following terms: 5. PROFIT RECOGNITION ON PROJECTS 5.1 METHODOLOGY In simplistic terms the company adopts the "percentage of completion" method of profit recognition. This method results in profits accruing over the life of the project and being reflected in revenues and gross work in progress valuations in the accounting records. On all contracts cost schedules control system (C/SCSC) procedures are adopted. These have the effect of breaking the contract down into "definable work packages" which are each assigned costs and selling values at the start of the contract. The number of work packages varies by project but may be numbered in thousands such as in the ANZAC contract. At period ends (normally monthly) the stage completion of each package is determined and earned value of each package is established. The aggregate of all packages produces the overall project result. The selling values ascribed to each work package does not necessarily result in the same margin % by package-inherently, more valuable processes or processes with greater risk/return profiles may attract greater margins than simple build packages. Therefore the margin earned on a project will vary over its life depending on the nature of the tasks being undertaken. The establishment of completion levels of each package ideally is by reference to physical completion or achievement of identifiable "milestones". However, on the smaller and simpler projects the work packages completion is established through traditional measurements, such as percentage of costs incurred versus final estimated costs or, if more appropriate, hours spent as percentage of final estimated hours. (Ex F: 665-666) 38 The report also referred to margins since 1 July 1994. The lower monthly gross profit margin compared to the margin for the year to 30 June 1994 was attributed in part to the greater proportion of profit take-up on "high margin telecommunication projects and the ANZAC contract in the year to 30 June 1994" and that, "to date no major telecommunications contract has been reflected in the results whereas 1994 included the very profitable Argentina contract". The ASX announcement of the Russian contract 39 An ASX announcement of 23 November 1994 referred to the Russian contract of $37.5 million for the supply of "22 site cellular telephone systems, the first elements of which were shipped upon finalisation of the agreement". The announcement also stated that: "microwave links, switches, terminals and integration of the system into the Russian telephone network are also being provided" that would ultimately support 10,000 subscribers in the Black Sea region of the Russian Federation. It also suggested that the second consignment of systems was to be shipped later that week with Electronics' engineers departing for Russia within hours of the contract's signing. The defendant's December 1994 letters 40 On 5 December 1994 the defendant wrote to Pacific advising that he had made a number of "principal assumptions". He asked the Board to review and confirm that those assumptions were both appropriate and correct and advised that his report for the bank would state that he had reviewed those assumptions and had no reason to consider them to be inappropriate. However he advised that he would clearly state to the bank that the responsibility for setting the assumptions was with the Board and management. Those assumptions included the following: 11. Cash receipts from debtors (i) Telecommunications It is assumed that, excluding the Techin Russia contract, total domestic and international communications receipts will grow from approximately $1m/month in the last quarter of 1994 to approximately $5m/month in the first quarter of 1995 and to approximately $6m/month in the second quarter of 1995 based on existing prospects, rated by likelihood of success. It has been assumed that the majority of the sales will be on contracts with individual values under $5m and that no individual contract will generate more than $4m in cash receipts in the period to 30 June 1995. (ii) Telecommunications - Russia It is assumed that Techin will be able to repay its commitments in accordance with indicative revenue generation schedules contained within the contract. In particular, it is assumed that Techin will be successful in generating US$22.6m from sales of terminals in the period December 1994 to mid February 1995. (Ex F: 681) 41 On 7 December 1994 the defendant wrote to the directors of Pacific in respect of the "forecast receipts and payments" in terms that included the following: Qualification The forecast receipts include in aggregate $33,919,000 under the caption "Telecommunications International-Russia" in respect of the Techin Trade Ltd contract for the supply of goods and services under the Techinfo network supply agreement. As indicated in forecast assumption 11(ii) on Schedule 2, the receipt of these monies is dependent on ability of the network operator, Techinfo, in which Techin Trade Ltd has majority interest, to generate revenues principally from the sale of terminals to be supplied by Stanilite. We have been unable to independently assess Techinfo's ability to generate the revenues within the timeframes assumed and accordingly we are unable to determine whether the assumptions in respect of these receipts provide a reasonable basis for the forecast. (Ex F: 740-741) 42 On 13 December 1994 the bank wrote to Pacific referring to the defendant's report and advised that the bank's credit bureau would require a cash flow based on the assumption that no funds are received from Russia and "you cease supply and replacement stock" because the revenue from Russia was dependent upon the ability of Techinfo to generate sales of terminals within Russia. 43 On 20 December 1994 Pacific advised the bank that insurance cover had been obtained for the Russia contract; that payment would be made by Techin Trade, a US company; that a charge had been taken over the available assets in the US; that title to the goods did not pass until they were paid for; that shipments of goods from Australia were being made according to plan; that the value of the equipment currently held in Istanbul was US$2.547 million; and that 2 Cellswitches had already been installed in Russia. Pacific also advised that an equity raising was likely to follow the release of the half-yearly results, which was usually at the end of February. Pacific also advised that it saw no difficulty in meeting that timetable because due diligence was already underway. The cashflow 44 A cashflow prepared by PW, apparently in December 1994 (Ex F: 760), showed receipt of $18.8 million from the Russian contract in January 1995. It appears the bank reviewed this document and an internal file note of 30 December 1994 included the following: Our concern stems from the cash flows provided by the company on 23 December … They confirm the parlous state of the company's forward cash position and is well beyond the extra $10m that the company had earlier sought to cover its needs. Based on the company's own figures the very best position that the company faces, which involves the receipt of payments under the Russian contract of $18.8m in January 95, a situation with the contract we feel is remote in the extreme, requires further excesses of approx. $8.0m to a total of $15.5m peak in January 95. Other scenarios presented reveal a much worse position so far as excesses are required! In the scenario that the Russian contract is immediately stopped now with no further expenditure by the company and no receipts under the contract in the period of the cash flows (June 95), the peak debt reaches $21.6m – a further $14.2m on the position as it stands at present. The worst position so far as the excesses are concerned is if the Russian buyer opts to avail of the delayed payment option under the contract and delays payment until August 95. Expenses continue during that time in meeting delivery obligations to the contract. Peak excess is projected then to reach $31.0m in February 95. It is clear from the above that the Bank is now placed in a most invidious position. Our only exit would seem to be through a share placement/rights issue of a minimum of say $35m. This is something to which the company has not yet committed and in fact in its cash flows have projected a raising of only $20m. (Ex F: 764) 45 The note went on to refer to the rampant inflation in Russia and the extreme likelihood that the buyer would avail itself of the delayed payment regime under the contract. Reference was also made to the bank's "grave misgivings" as to whether the Russian company would receive sufficient income to meet its payment obligations to Electronics. The bank concluded that it was of "critical importance" that the receipts under the Russian contract be fully insured. It was noted that the account warranted the most careful monitoring and attention until the bank had a much clearer picture of a number of matters including: details of the level of expenditure on the Russian contract; confirmation that the cash flow projections remained sound; clarity in respect of the proposed equity raising; full details of the insurance cover held for the Russian contract; details of the Russian buyer and how it intended to cover its exchange risk and all other obligations under the contract; and information as to whether the buyer had exercised its option to avail itself of the extended repayment terms. The 4 January 1995 meeting with the bank 46 On 4 January 1995 representatives of the bank met with the managing directors of the plaintiffs and the chief financial officer. The bank suggested that the equity raising should be at least $40 million to give the company enough capital to survive the current cash flow problems. The bank expressed concerns about the Russian contract and the possible exposure of the plaintiffs. It was noted that the insurance cover was only 60% of $7.4 million of a total contract value of $33 million, however after discussion about the capacity of the plaintiffs to "stop supply" the matter was not taken further. There was also discussion about the delays that had been experienced in the deliveries for the Russian contract by reason of storms in the Black Sea region. The bank indicated that it should not fund large deliveries under the Russian contract until a legally binding underwriting agreement in respect of the equity raising had been sighted. The January 1995 facilities 47 On 12 January 1995 the bank advised Pacific of its willingness to provide facilities including a $10 million temporary overdraft to be available until 31 March 1995 on the condition that steps be taken to raise additional equity of at least $35 million, such funds to be used to clear the temporary facility. The bank also advised that a further $5 million would be made available on request but only after entry into an underwriting agreement acceptable to the bank covering an equity raising of at least $35 million. The bank required special undertakings and reporting requirements including the following: 1. That with regard to the Russian contract, the company will, from this day forward, restrict expenditure in relation to that contract to not exceed total actual receipts of revenue from that same contract. This condition is to continue until the equity monies are received when we would consider a review of the arrangement in the light of circumstances then existing. (Ex F: 800) 48 Pacific responded to the bank by letter dated 13 January 1995 pointing out a number of areas of disagreement with some of the comments made by the bank in its letter. Pacific advised that expenditure on international telecommunication projects was "aligned with identifiable opportunities" and although it presented "timing problems" the Board was conscious of and satisfied with, the "level of prudential risk". The letter also included the following: (d) In relation to the Russian contract which we presume has given rise to some unease within the bank, we make the following comments:- (i) a condition precedent was EFIC cover on the first phase of the contract which was agreed by EFIC at 60% of invoicable value up to US$7.4 million. This cover exceeds Stanilite's costs and EFIC have stated that they are prepared to extend the cover as the contract proceeds. (ii) There is no Russian currency risk to Stanilite as our contract is with Techin Trade Limited (Delaware USA) and is expressed in US dollars. (iii) Title to the equipment does not pass until payment in full. (iv) Extensive due diligence on the Russian parties was carried out by appropriate government agencies to the satisfaction of Stanilite's management. (v) The technical nature of the installations are dependent for successful operation on ongoing Stanilite involvement and equipment. (vi) The company has forwarded to the bank evidence that the security over various US assets detailed in the contract have now been filed with the various government departments. (vii) We have also negotiated an additional security for US $1.5 million in the form of an undertaking from the NSTP (Russia) to provide an irrevocable letter of credit drawn on an acceptable UK or European bank. (viii) The company has already had experience in Russia and CIS through Millicom International Cellular (Luxembourg) which, although not nearly of the dollar value of the TTL Russia contract, have been technically and financially successful. (ix) As previously advised to the bank, should revenue not flow as expected and required under the Russian contract, no further commitments will be made and equipment is recoverable with EFIC cover underwriting any losses. (Ex F: 809-810) 49 On 16 January 1995, at the request of the chairman of Pacific, a further meeting was held with the bank. The purpose of the meeting was to advise the bank that the equity raising could not be concluded by 31 March 1995. Pacific requested an amendment to the timetable imposed as a condition of the provision of the facilities. The bank wrote to Pacific on 16 January 1995 amending its requirements to provide for "a clear and unequivocal resolution" by the Board to immediately put in place arrangements to enable the company to raise additional equity of at least $35 million and for the company to "use its best endeavours" and good faith to achieve an acceptable underwriting agreement by 15 March 1995 for an amount of at least $35 million. On 18 January 1995 BBY advised Pacific in writing of its willingness to underwrite an equity issue of $35 million subject to the pricing of the issue and the pricing not being detrimental to the best interests of Pacific. 50 On 19 January 1995 Pacific sent to the bank a copy of the Board resolution accepting the bank's offer for the $15 million overdraft facility on the terms and conditions imposed by the bank. That resolution also included the agreement that the first $15 million of the capital raising would be applied to the repayment of the $15 million overdraft facility and that in the absence of a capital raising, a plan would be produced to enable repayment of the $15 million by 31 December 1995. 51 On 30 January 1995 at a meeting of the Due Diligence Committee, at which the defendant was present, consideration was given to the option of completing full audited accounts for the half year ended 31 December 1994, instead of the planned review of the Accounts. The defendant advised the Committee that the time needed for a full audit would impede compliance with the key dates provided to the bank. Notwithstanding that advice, it was agreed to recommend to the Board that a full audit of the Accounts be carried out and that the timetable should be discussed with the bank. 52 The capital raising was to occur in an environment where Pacific's share price had been "at recent historical lows" and BBY assessed that the group was "in a corner" with the bank in relation to the requirement to pursue the capital raising. In presenting the possible "scenarios" for the capital raising BBY concluded that there would be "uncertainty" in the outcome with a need for a heavy sweetener to the possible detriment of the company and the shareholders. BBY concluded that the bank was exerting "excessive influence" on the funding strategy and recommended a review of the bank terms and a relaxation of them as soon as possible with alternatives for additional debt funding being pursued immediately (Ex. F: 829). 53 By letter dated 25 January 1995 Pacific provided the bank with a revised cash forecast for the period January to December 1995. The explanatory notes advised that the project revenue from the Russian contract had been "rephased" to allow for time delays experienced through Christmas and the Russian New Year period. The notes also included the following: (g) Russian project expenditure rescheduled and payment in January of $450k covers actual commitments. No further commitments will be made until revenue forecast in February is progressively received. … 3. The revised cash forecast shows that, based on anticipated revenues from operations and the successful completion of the $37 million Russian project now by August/September (a delay of 1 month from the original plan) the increased facility of $15 million will be repaid to the bank by end of October 1996. This is in the absence of any capital issue. However it is realistic to anticipate that there will be continual changes to the cash forecast (as required to be updated to bank monthly) and the company will continue to liaise with the bank on all issues influencing changes to the cash forecast. (Ex. F: 839) 54 Pacific also advised the bank that there had been a decision to proceed with an underwritten equity issue for an amount of $35 million and to have the net proceeds available in full before the end of April. It also advised the bank: (b) If no revenue is received from Russia as expected in February ($1.8 million) the project may be suspended by Stanilite. In the event that this happens for the period to June 1996, the net revenues and expenditures as rephased are neutral over this period. However in Q1 of Calendar 1996 revenue is forecast to exceed expenditure by $1.145 million offset by the reverse in Q2. The determination of this scenario to suspend the project will be made in February. (c) In the event that the Russia project is cancelled there will be a negative of $8.5 million (mostly in Q3) effect on the full year cash flow of $24 million. However, EFIC insurance of 60% of the invoiced value to date of approximately $4.0 million would be claimed and receivable in September. This would bring the net reduction in the closing balance to around $6 million from $13.9 million to $7.9 million in funds. (d) Planning is in progress to "project finance" the Russian contract. On the expectation that revenue is received from the sale of terminals etc in accordance with the contract, the objective is to accelerate the project financing of the initial phase one. This would include the immediate reimbursement of invoices issued (to date equivalent A$4.0 million) and advance payment for a discounted profit to Stanilite on a non-recourse basis. If achieved by April, this would accelerate the revenue (forecast $8 million) at a net cost of $1.4 million for eliminating risk. The ongoing success of the project would enable the funding to the next stages of the network and as such provide Stanilite with commercial payment for goods and services provided. (Ex F: 840) 55 Pacific also advised the bank that depending upon revenue inflows, executive management would have to consider the process of reducing inventory purchases during February and beyond. It also advised that there would be a controlled reduction in salaries/wages and operating costs across the board to accommodate timing delays in receipt of orders from March onwards. A plan for the sale of rights of future revenue streams from various R&D projects with the retention of proprietorship of the intellectual property in those projects was also discussed. 56 On 6 February 1995 Mr Pridmore reviewed the revised cash flows and recommended that certain elements should be disregarded by the bank. One of those elements was: The Russian contract yields a surplus cash flow of $8.5M. Even the company is not entirely certain that payment will be received and arrangements have been made to stop all further payments other than those covered by receipts. As such, both payments (other than those already made) and receipts should be removed from the cash flow. (Ex F: 871) 57 Mr Pridmore referred to the prospect of the overdraft exceeding $10 million if certain adverse events occurred and after referring to the prospect of insurance claims, reduction in inventory and the sale of all or part of three R&D projects, he noted: No detailed knowledge is held concerning the above assets, their selling value, potential buyers, etc. In this connection, given the short time before the additional funding is required, it seems likely that we will have to take on trust the company's statements concerning their value. This is, however, only a fall back position. Repayment will actually be looked for from (in order of priority): 1. The proposed share placement of $35M 2. The dividend re-investments. 3. The Russian contract. 4. The sale of the above assets. Only if all of the above fail will the bank be looking to some form of down-sizing in order to achieve repayment of the final $10M. (Ex F: 872) 58 On 7 February 1994 the Due Diligence Committee was advised that the Board had agreed that a full audit of the Accounts was to be carried out. Mr Chan, from PW, advised the Committee that PW planned to provide full audit clearance by 10 March, "but should be able to give an audit clearance to enable the half year's results to be released to the ASX by 1 March 1995, provided that there were no material issues outstanding". It was noted by the Committee that "as the comparative figures for 1993 were not audited" PW would be providing their "normal engagement letter to the company in respect of this audit" (Ex F: 874). 8 February 1995 retainer for audit 59 On 8 February 1995 the defendant wrote to the directors of Pacific in respect of the audit of the Accounts. That letter included the following: Our audit Our function as auditors is to examine the accounts presented to us by the directors. As auditors of the company we are not responsible for the preparation of the accounts nor for the maintenance of proper and adequate accounting records and proper systems of internal control. These responsibilities, together with the requirement to present accounts which give a true and fair view of the state of the company's affairs and of its results, are imposed on the directors by the Corporations Law. Any accountancy or other services which we may provide from time to time at your request are distinct from a function as auditors. Our audit will be planned primarily to enable us to form our professional opinion upon the state of the company's affairs and its results and to report thereon to the members of the company in the terms required by the Corporations Law and AASB 1029. (Ex F: 877) 60 On 13 February 1995 the bank notified Pacific that all pre-conditions of approval detailed in its letter of 12 January 1995 had been met and that the extension of the overdraft facility to a maximum of $15 million was available. In approving the full use of the facilities the bank noted that "cash flow is very vulnerable", but that it had "some fall-back strategies that can be adopted if expected revenues do not materialise as planned" (Ex F: 893). 61 On 20 February 1995 the defendant advised the Due Diligence Committee that PW were "on target to provide adequate comfort to the Board by 28 February" (Ex F: 903). 62 On 21 February 1995 the bank noted that Pacific had not complied with some of the conditions imposed as "special undertakings and reporting requirements" in the letter of offer of 12 January 1995. In an internal memorandum the following was noted: We do not accept the company's reasons for extending its expenditure budget for January and we can only reiterate our desire for strict expenditure control. One of the reasons for requiring the rolling cash flow forecasts is to ensure that any excess of expenditure in any particular month(s) is/are offset by savings generated in future months so as to ensure that the full year result is kept within the original budget. Conversely with revenue; any shortfall in revenue in any particular month(s) is/are caught up during the remainder of the year. To have invested so much time and effort in endeavouring to get to a position where we were comfortable to go forward and having signed off with the company as to the terms and conditions for our continued support, to be in the first month of the new accepted program and for these problems to have occurred at such an early stage, is disappointing to say the least. We must stand firm and make sure that we call the shots with this customer, particularly at this time when we are most at risk (ie, before the equity raising has come to fruition). If we back off at this early stage, we have lost the benefits that we have strived so hard for over the past few months. You probably have seen the attached report from the AFR today which talks about the potential for a $1b radio system for India. Would you please endeavour to find out how this deal will be structured, financed etc as we do not wish to be faced with another situation as we were with the Russian contract. We consider the company to be a little naïve when dealing with these types of commercial transactions and the earlier we can obtain information about them, the more we may be able to guide them as to proper prudential controls/mechanisms etc. (Ex F: 905) 63 The legal firm Corrs Chambers Westgarth (Corrs) provided advice to the Due Diligence Committee in relation to the Group's various contracts and whether they should be included in the Prospectus. In respect of the Russian contract, Corrs noted that they had been instructed that the Due Diligence Committee was to receive a management briefing on the transaction and advised: It is our preliminary view that this is a material contract for inclusion in the Prospectus, given the contract price for Phase 1 (i.e.$US18,648,638.00) the importance of the agreement for prospects of Stanilite and the need to update potential investors on information provided to the ASX and the media. (Ex F: 948) 64 On 1 March 1995 an "update" on the Russian contract was provided at a meeting of directors of Pacific at which the defendant was in attendance. The Minutes note that the project was "currently six weeks behind schedule, but most of the initial problems with the client were now overcome and the project was proceeding with completion expected by December 1995". It was also noted that the original cash flow and business plan were being reviewed and a number of contract variations were required. The PW engagement letter was tabled as were the results for the half-year. The defendant is noted as having "indicated that there was still a lot of work required to complete the audit and resolve the issues raised during the course of the audit ". The Minutes also contained the following: The net profit after tax was $4,238,000 and this compared favourably with previous forecasts. Mr Fayle reported on the adjustments made to the accounts as a result of the audit and discussed revenue and profit from the Russian project brought to account and also outlined the rationale behind the deferral of marketing costs. Full justification papers were being prepared which would form part of the working papers for the accounts. After discussion and on the understanding that the outstanding issues would be resolved without any major amendment to the profits, the board agreed that an unaudited profit after tax of $4,328,000 was appropriate and should be advised to the ASX by Friday 3 March 1995, together with an appropriate covering letter to be prepared by management and reviewed by the Board. (Ex F: 964) Announcement of half-year profit to the ASX 65 On 3 March 1995 Pacific made a "Half Yearly Announcement" to the ASX advising that the Chairman, Mr John Valder, "today announced a profit after tax for the half year to 31 December 1994 of $4.238 million" representing a marginal increase on the previous comparative period's net profit of $4.213 million. The announcement advised that telecommunications experienced a 36% increase in sales revenue and an even greater increase in contribution during the six months to 31 December 1994 compared to the first six months of the previous financial year. It also included the following: The winning of a contract with Techin Trade Limited of the USA to supply a A$37.5 million turn-key cellular telephone network initially in the Black Sea port area of Russia. Significant progress was achieved in this project in the current reporting period. Completion of the project for an initial 10,000 lines will be by the end of 1995, after which an extension of a further 20,000 lines will be made. (Ex F: 967) 66 Also on 3 March 1995 BBY published the interim result for Pacific that included the following: The interim result has highlighted the company's need for capital to meet the growth of its telecommunications business. While its cash flow requirements may hold back performance in the short-term, we believe that the company can still deliver above-average EPS growth over the long term. … Net profit after tax increased marginally to $4.238m from $4.214m for the pcp. This was earned on sales revenue of $48.2m up 17.7%. The result was assisted by a lower tax charge for the period due to R&D reductions. The result was impacted by accelerated amortisation charges and increased interest costs. A flat dividend of 3c unfranked was declared for the half. … Revenue from the telecommunications division increased significantly; it is expected to rise strongly in the second half with deliveries for contracts including China, Russia and South America. This is the fastest growing, but most capital hungry side of the business. The working capital required for projects the size of Russia, combined with the continual demands for R&D funds has led to a significant drain on cash flow. … Operating cash flows were down dramatically reflecting the build up for the aforementioned projects, and the fact that some of the longer-term projects are accounted for on an earned value basis which does not always reflect the cash flow position of the contracts. It is becoming increasingly difficult to predict the cash flow requirements of the group under this method of accounting. While the earned value recognition of earnings is an accepted accounting standard, the company will need to shorten its payment milestones to better reflect the requirement for cash. (Ex F: 984-986) 67 After referring to the options of capital raisings of $20 million and noting that the size of any capital raising would depend on the level of debt the Board felt comfortable with, BBY concluded that the outlook for Pacific remained exciting because many countries in the developing world were considering essential investment in basic telecommunications services and Pacific had positioned itself well to take advantage of such opportunities when they arose. 68 On 6 March 1995 at the Due Diligence Committee meeting, the defendant advised that PW had a commitment to finish the audit by 10 March and "a number of issues were still outstanding which required supporting papers from the company". At the same meeting it was noted that although a verbal report had been provided, a written report was required in respect of the Russian contract. A representative of the bank, Mr J Ferreira, was present at this meeting and prepared a note of the discussion that occurred in respect of the Russian contract. That note include the following: $38,530,000-Margin $12.50M Contract completed to 33% $3.64M Invoiced Goods in Perth not shipped (10 cellswitches) Cellswitch installation approved for connection to subscribers by PTT Post & Telecommunications (Telecom Equiv) last week. Selling price US $4,000 per terminal. Must have 3,000 connected by 1995 end, expect this to happen by June, 1995. Clients problem is cash flow, owes money in the US. Delay in timetable has been due to PTT delays. 1,500 Subs expected by end of March. This is saturation at this stage. Currently can connect 6,000 users at US$4,000 per terminal however, are currently limited to 1,500 at this stage until 40 Cards (Integrated Switches) of US $2,000 each art installed at the PTTS. The second option is the fixed wireless terminal (CDMA). Local PTT's have a level of autonomy therefore, they are not standard in their technology. Equipment is in Nevaesek for distribution. (Ex F: 995) 69 On 7 March 1995 the defendant wrote to the Pacific Due Diligence Committee confirming "the materiality as it should be applied in relation to the due diligence process" and that items which had a greater than A$500,000 value should be regarded as material for the purpose of the Prospectus. He warned that it should not be regarded as "an absolute guide" because items of a lesser amount may require disclosure in relation to "prospects of the corporation" when consideration was given to s 1022 of the Corporations Law (Ex F: 1004). 70 On 9 March 1995 Pacific received an outline of what BBY understood was the proposed brief to it which included the following terms of reference: (1) to review and comment upon Pacific's existing financial and strategic plans; (2) to consider and provide recommendations on alternative future funding strategy; (3) to review the cash management systems and provide recommendations for improvement; and (4) to consider, comment upon and provide recommendations in respect of the accounting policies particularly with regard to intangible assets (Ex F: 1008-1009). 71 On 10 March 1995 Pacific advised the bank of the key balance sheet ratios for the Group and that "unfortunately" two of the ratios "marginally exceed the bank's requirements". The bank was advised that an audit committee and Board meeting had been convened for Monday 13 March 1995 to discuss and approve the Accounts and sought "if possible, confirmation" that the bank considered "the breaches to be minor and technical in nature and that no action will be taken" (Ex F: 1013). Draft letters of 10/13 March 1995 72 The defendant prepared a letter, containing the audit report, to the directors of Pacific in "Draft-for discussion only" dated 10 March 1995 (Ex F: 1014-1029). There is a further draft dated 13 March 1995 (Ex F: 1034). This letter was considered at the Due Diligence Committee meeting on 3 March 1995. The plaintiffs claim that this letter is fundamental to their cases because it evidences what PW knew and is relied upon as a basis for suggesting what PW should have done in the light of that knowledge. 73 The draft letter of 13 March 1995 included the following: We set out below matters which we feel should be clearly understood by the directors in signing the accounts. These matters require serious consideration by the directors in discharging their duty in approving the accounts. 1. GOING CONCERN BASIS OF THE ACCOUNTS The accounts for the half-year ended 31 December 1994 have been prepared on a going concern basis. We believe that the accounts should include a note which outlines the cash flow situation in Stanilite and states that temporary credit facilities have been extended to the group by its bankers. This note should clearly state the creditors attached to the extended facilities. At 31 December 1994 the group was in breach of borrowing covenants set out in the banking facility. In signing the accounts the directors acknowledge that there are reasonable grounds to believe that the company will be able to pay its debts as and when they fall due and that the group accounts are properly prepared on a going concern basis. We suggest the directors seek legal advice on the implications of signing the accounts on a going concern basis in the light of the current cashflow position of Stanilite and the breach of the borrowing covenants. 2. "RUSSIA CONTRACT" The total revenue recognised on the half-year ended 31 December 1994 on the contract was $12.8 million. The profit contribution for the period was $6.4 million. The directors should fully appreciate and understand the aggressive revenue recognition, the credit risks and foreign exchange risks associated with the "Russia Contract". 2.1 Revenue recognition The earned value basis has been applied on the "Russia Contract". As at 31 December 1994, 33.5% of the sales value of stage one of the "Russia Contract" has been taken to revenue. However, due to the aggressive approach in revenue takeup 75% of the profit margin on this stage of the contract has been brought to account. Only two 1+ 17 Cellswitch Systems representing $1 million of the revenue (related profit $362,000) had been delivered to Novorossiijsk and invoiced as a 31 December 1994. In addition, microwave equipment with sale value $225,000 (related profit $38,000) had been delivered to Novorossiijsk but not as yet invoiced. Revenue recognition has been particularly aggressive on the following components of the contract: (a) Revenue on "management effort" The contract includes the provision of items supplied by third party suppliers. Stanilite receives 20% markup on the cost of these items for "management effort" in determining the requirement and arranging the supply of these items. The full 20% markup has been taken up on the following systems no portion of which has been ordered from suppliers as at 9 March 1995: (revenue taken up noted at $1,176,000 in relation to Main Bearer 1400 mB/s ($1,107,000); Spares (Phase 2) ($21,000); and Backup supply systems ($48,000)) The argument for recognising this revenue is that the work in relation to design and logistics administration had been incurred as at year end and that the placing of the order and supply of the equipment require negligible relative effort. In addition the 20% markup has been recognised on the supply of terminal units even though only 1,000 of the 10,000 units have been delivered as at 31 December 1994. The total revenue take up on these terminals is $1.5 million (related profit $252,000). (b) Revenue on partially manufactured items Full revenue of $3,744,000 (related profit $2,040,000) has been recognised on twelve 1+ 17 Cellswitch Systems which were estimated in the following stages of completion in Perth: (3 at 100% completed; 3 at 90% completed; 3 at 60% completed and 3 at 20% completed) It is likely that the components for these items may have been in stock at the half-year end. In any event it is inconsistent with earned value methodology to recognise full revenue on partially completed projects. In addition full revenue of $1.6 million (related profit $847,000) has been recognised on five 1+ 17 Cellswitch Systems and three 1+ 11 Cellswitch Systems which had been delivered to Istanbul, en route to Novorossiijsk. These systems had not as yet been installed ready for use at the half year end. … 2.3 Foreign exchange risk The revenue for the "Russia Contract" is designated in United States dollars. Stanilite has forward exchange contracts for the sale of United States dollars amounting to US$27.8 million to cover the value of the "Russia Contract". The exposure on these forward exchange contracts should the United States dollars not be available at the maturity of the contracts based on the exchange rates at 9 March 1995 is estimated at $850,000. … 3. ACCRUED TELECOM SALES The majority of the telecommunications revenue of $21 million brought to account in the half-year related to telecom sales accrued using the earned value basis of revenue recognition. Excluding the "Russia Contract" total telecom sales accrued at 31 December 1994 amounted to $4 million (related profit $2.1 million) and represented sales takeup on revenue for which the products had not as yet been delivered at 31 December 1994. Of this, no firm orders had been received for sales taken up with related profit amounting to $762,000. It is questionable as to whether it is appropriate to apply earned value revenue recognition where firm orders had not been received at 31 December. The orders on which telecom sales have been accrued were in various stages of completion as at 31 December 1994. The more material accrued telecom sales for which full revenue had been taken up at the half-year end but which were only partially completed were as follows: [the letter then sets out an analysis of seven contracts; four of which were completed and delivered subsequent to 31 December 1994; one of which was approximately 80% complete by 9 March 1995 with delivery expected by the end of March 1995; and two of which were still being negotiated at 9 March 1995 and in relation to which the letter stated: "It is questionable as to whether the revenue on those items had been earned as at 31 December 1994".] In addition to the above, additional revenue with related profit of $550,000 was recognised in the period on the OTE Belgium order. Revenue with related profit of $291,000 had already been recognised in the year ended 30 June 1994. The order, however, was not delivered and invoiced until February 1995. Revenue had been recognised on the earned value basis because it was estimated that all items on the order had been complete, ready for delivery as at 31 December 1994. Revenue with related profit of $309,000 had also been recognised on the Telcel Venezuela order in the year ended 30 June 1994. However, as at 9 March 1995 the specifications of the order were still under negotiation. We understand that there is some uncertainty as to whether a firm order will eventuate. 4. DEFERRED MARKETING COSTS Stanilite has deferred marketing costs incurred in the 6 months to 31 December 1994 totalling $3 million. This represents all costs incurred on international marketing. Stanilite's policy is to defer marketing costs to the extent that it relates to the development of new business and which are incurred prior to achieving a maintainable earnings base. These costs are amortised when revenue is received. (The marketing costs deferred comprise costs deferred in the following areas: Eastern Europe $641,000; China $700,000; South America $201,000; Africa $301,000; North America $338,000; South East Asia $140,000; Corporate Marketing $746,000; (totalling) $3,067,000.) Continuing to defer marketing costs in Eastern Europe, China and South America does not appear to be consistent with Stanilite's policy given that telecommunication sales from these regions with related profit amounting to over $8 million has been recognised in the half-year to 31 December 1994. The corporate marketing costs deferred represents all corporate marketing costs incurred in the half-year. The implication of this is that no marketing costs incurred at corporate level in the half-year can be attributable to Stanilite's established businesses such as emergency lighting and defence projects. 74 The letter also included reference to the fact that no royalty had been accrued as at 31 December 1994 for payment to Telecom pursuant to an agreement on the sale of cellswitches. It noted that the accrual of $374,000 at 30 June 1994 had been reversed and that PW understood that negotiations were ongoing with Telecom over the royalties. There was also reference to the omission of a write-down of $355,000 in inventory transferred from New Zealand and the letter continued: 9. DOUBTFUL DEBTS PROVISION Stanilite has no provision for doubtful debts. It would be improbable that there are no doubtful debts in the total trade receivables balance of $9.9 million as at 31 December 1994. We are aware of a dispute with a debtor in the Philippines, Matrix Telecommunications, with a receivable balance of $228,000 where probable outcome is the return of the products sold. The profit margin on the receivable is $130,000. 10. AMORTISATION FOR DEFERRED RESEARCH AND DEVELOPMENT COSTS The amortisation for deferred research and development costs included in the result for the half-year ended 31 December 1994 has been "skewed" to match revenues. That is the amortisation in the half-year of $675,000 represents approximately 27% of the total amortisation planned for the year. It would be more appropriate for the deferred research and development costs to be amortised on a straight line basis over the year. On a straight line basis the amortisation would be $1.3 million. 11. RUSSIA INSTALLATION REVENUE Included in revenue is $250,000 for "installation" on the Russia Contract. This revenue is in addition to the contract value of the project and no related costs have been accrued. There is no order or contractual agreement to support this revenue. 12. MANAGEMENT ISSUES We believe that all the business issues identified in our Report to the Directors for the year ended 30 June 1994 are still relevant and have not been addressed as at 31 December 1994. (Ex F: 1034 – 1040) 75 On 13 March 1995 the Audit Committee considered the defendant's letter. The defendant's notes of the meeting recorded that the defendant advised that the letter highlighted issues which should be addressed and of which the directors should be aware. They also recorded that the defendant said that without support from the bankers and without a "glowing" short term future "the cumulative effect of the letter is not acceptable". The meeting was advised that Mr Fayle had visited the bank and it had agreed to waive "technical" breach and that it would write to the company in that regard. The note records that the defendant said: "The accounts have to include a note even if we get letter of support from bank". It was also noted that the bank had been asked to extend the facilities by an additional $1 million to the end of March 1995 to meet creditors and that cheques for $3 million for December, January and February creditors had been "held". (Ex F: 1042-1045). 76 The defendant is recorded as noting that the bank had not guaranteed the facilities to 31 December 1995 and that at the review in March it "presumably" could terminate the temporary facility. The solicitor from Corrs, Mr Koeck, who was present at this meeting, advised that if there were to be changes in the results as announced there was a need for "immediate" disclosure and that a failure to make that disclosure "generates criminal liablity". It was noted that the cash flows were "very lumpy" and that BBY should be asked to advise on future management of cash to "give Board comfort". It was also noted that the bank had "relied on the figures announced" and the defendant is recorded as having raised the following matters in discussion: No a/cs since Dec 1994. Delays in getting money from Russia. ANZAC cash receipts slipped. Very aggressive forecast in second half of year. Telecom orders only $1/2 million to date. Russia contract, although $22m in revenue, profit is minimal. Understand there are good prospects but some may not come to fruition. Very little faith in the forecast. Q3 is almost up but results are lagging Russia contract – no change in view but surprised at level of profits available. No suggestion that profit is wrong given going concern. (Ex F: 1045) 77 The note also recorded that the defendant said: "The Board must satisfy itself that it can continue in the longer term. Concern that a company of this size has no accounts for Jan and Feb" (Ex F: 1045A). 78 Pacific had been negotiating with the ANZ for funding and on 14 March 1995 ANZ advised that it was "considering" the provision of facilities that would be sufficient to refinance all existing facilities. 79 On 15 March 1995 the defendant had a meeting with the directors of Pacific at which he was informed that the bank had agreed to issue a letter waiving the covenants and extending the review date from the end of March to the end of April. It appears from the note of this meeting that the defendant advised the directors: "At the time of the ASX release no one was aware that we were in breach of the covenants; we had expectations of Russian receipts; ANZAC cash flow delayed; the situation has deteriorated; we have no idea how we have gone in the last two months; no tangible orders of significance to date". The note records that all the directors are signing the accounts and that the Board has to feel comfortable in signing the accounts and it has to know all the issues in the letter and be sure they are aware and happy before signing the accounts. It also records: "Russia Contract is still a worry because of uncertainty of quantum of profit takeup; no concerns in relation to the long-term prospects of the company; concerns focus on the next few weeks" (Ex F: 1063). 80 By letter dated 15 March 1995 the bank advised Pacific that it had agreed to extend the facilities until 28 April 1995 on the same terms and conditions previously agreed and including compliance with the Agreed Timetable, notification to the bank of failure to comply with the Timetable and the filing of Compliance Certificates. This letter including the following: The Bank acknowledges the breach of Financial Undertakings as at 31st December 1994 and confirms that no action will be taken in relation to the breach of Financial Undertakings as at 31st December 1994. (Ex F: 1058) 81 On 16 March 1995 Pacific wrote to PW in relation to "Accounts at 31 December 1994" advising that "management have taken reasonable steps to identify all costs to complete on contracts where profit has been recognised using the cost basis percentage completion method" (Ex F: 1066). Audit Report and Opinion 16 March 1995 82 At a meeting of the Board of Pacific on 16 March 1995, at which the defendant was present, the letter from the bank dated 15 March 1995 extending the facilities and advising that no action would be taken in respect of the breach of covenants as at 31 December 1994 was tabled. The defendant is recorded in the Minutes of the meeting as having said: "that in view of the bank letters" he was of "the opinion that the accounts could be signed on a going concern basis" (Ex G: 9417). The defendant's notes of the meeting record that he said: "Relationship with NAB improved. The Board should now feel more confident to sign the accounts. Should take into account all the relevant factors". It was noted that creditors "brought in line as a matter of priority". There was also discussion about the draft letter of 13 March 1995 from PW to Pacific and the defendant's note records: The draft letter was used as a basis of discussion. The letter will be a note of correspondence between PW and management. Identifies areas which should be kept under review and scrutiny coming to June 1995. Paragraph 1 has been "resolved" by the NAB letter of comfort. The letter will not be formally issued. (Ex F: 1069) 83 The Minutes of the meeting record that "after the accounts were signed" the defendant "tabled the appropriate Audit Report to Shareholders of Stanilite Pacific Limited signed by himself as partner of Price Waterhouse" (Ex G: 9417). That Report stated: AUDITORS REPORT TO THE MEMBERS OF STANILITE PACIFIC LIMITED Scope We have audited the financial statements of the Company for the half-year ended 31 December 1994 as set out on schedule 1 to 5. The financial statements are the consolidated accounts of the economic entity comprising the Company and the entities it controlled at the end of, or during the half-year. The Company's directors are responsible for the preparation and presentation of the financial statements. We have conducted an independent audit of these financial statements to express our opinion on them in order for the Company to lodge them with the Australian Securities Commission. Our audit has been conducted in accordance with Australian Auditing Standards to provide reasonable assurance as to whether the financial statements are free of material misstatement. Our procedures included examination, on a test basis, of evidence supporting the amounts and other disclosures in the financial statements, and the evaluation of accounting policies and significant accounting estimates. These procedures have been undertaken to form an opinion as to whether, in all material respects, the financial statements are presented fairly in accordance with applicable accounting standard AASB 1029: Half-year Accounts and Consolidated Accounts and the Corporations Law so as to present a view which is consistent with our understanding of the economic entity's state of affairs, the result of its operations and its cash flows. We have not acted as auditors of Stanilite Electronics (NZ) Limited and Stanilite (Hong Kong) Limited. We have, however, received sufficient information and explanations concerning these controlled entities to enable us to form an opinion on the consolidated accounts. The audit opinion expressed in this report has been formed on the above basis. Audit opinion In our opinion, the financial statements of the Company are properly drawn up: (a) so as to give a true and fair view of: (i) the state of affairs of the economic entity as at 31 December 1994 and its results and cash flow s for the half-year ended on that date; and (ii) the other matters required by Divisions 4, 4A and 4B of Part 3.6 of the Corporations Law to be dealt with in the financial statements; (b) in accordance with the provisions of the Corporations Law; and (c) in accordance with applicable accounting standards AASB 1029: Half-year Accounts and Consolidated Accounts. (Ex F: 1071) 84 On 21 March 1995 a further meeting of the Due Diligence Committee occurred at which the defendant was present. The Minutes record the following: Mr Seaton, was requested to review the notes of accounting policies which are included in the accounts for the half year ended 31 December 1994, covering profit recognition on long term contracts and in particular, the application to telecommunications projects. Subject to that review and advice form the auditors, the committee would consider the legal requirements of any suggested change for inclusion in the prospectus. (Ex F: 1099) 24 March 1995 retainer as "independent accountants" 85 On 24 March 1995 PW wrote to Pacific confirming that they had been requested to "act as independent accountants" to Pacific in connection with the preparation of the Prospectus and noted that PW had been separately retained to perform "a full scope audit" on the Accounts to be included in the Prospectus. The letter stated that as independent accountants PW would: (a) participate in the due diligence program through representation on the Due Diligence Committee; (b) report on certain accounting and financial aspects of the due diligence enquiries; (c) report on the accurate extraction of any material financial information disclosed in the Prospectus including significant events subsequent to the issue of the last set of accounts; and (d) attend meetings of the Due Diligence Committee. 86 On 29 March 1995 the Due Diligence Committee received a report from an attorney in the United States of America in relation to some difficulties with Techin's assets over which Pacific had sought to register a charge. That report noted the "highly unusual" circumstance that the valuation of the assets was much lower than the figure provided in the Russian Contract, US$1,920,000 and referred to the very unsatisfactory situation with the lawyers for Techin having resigned over a fee dispute and no other lawyers being retained. It was noted that in view of the missing collateral and information, Pacific had sought and obtained a letter of credit from one of Techin's partners in Russia (Ex F: 1131). 87 On 5 April 1995 at the Due Diligence Committee it was noted that the Chairman's letter to shareholders in the Prospectus was to include a statement in the following terms: "Whilst the nature of much of Stanilite's business is such that it is difficult to accurately forecast short term financial performance, contacts won and currently under negotiation should produce a profit for this financial year which will be higher than last year". The Minutes also record the following: Mr Seaton confirmed that the notes on Accounting Policies included in the half year accounts were appropriate, but there is no reason why they cannot be expanded upon if it is considered appropriate in the body of the Prospectus. (Ex F: 1224) 88 On 24 April 1995 Bain & Co issued a report suggesting a downgrade in Pacific's position and advising that investors should sell shares in the long-term and claimed that Pacific had been forced to foot the bill for the first phase of the Russian contract. Pacific advised Bain & Co that its report was both ambiguous and inaccurate, advising that its analysis of the Russian contract was not correct and that it did not understand the associated risk. Further meetings with the bank 89 On 28 April 1995 and 1 May 1995 the bank met with Mr John Harris and Mr Fayle to discuss the "strategies which are to be taken to improve the company's negative cash position". The bank was advised that Pacific had announced an underwritten placement of 6.5m shares at a price of $1.80 per share, raising $11.70m with proceeds to be received by 5 May 1995. It was also advised that the directors had announced an intention to undertake an underwritten 1:5 renounceable rights issue to all shareholders at $1.60 per share to raise $23m. The Rights Issue was to be partly paid to $0.80 on allotment, July 1995, and $0.80 payable in November 1995. 90 The bank expressed its concerns as to the achievability of the prospective income budgeted to February 1996 "particularly given the experience with the Techinfo Russian contract". In that regard it was noted that the company had invoiced $6 million and received $250,000 with costs to date of over US$10 million. The bank was advised that the company had negotiated a US$4.4 million revolving facility with the Dresdner Bank for the Russian contract conditional upon the EFIC policy being extended to 31 December 1995. It was anticipated that once that facility was in place the company would receive 60% of the invoiced amount direct from Dresdner. The development of the markets for the telecommunications contracts were noted to be at significant cost to Pacific compounded by the R&D expense which was a significant drain on its resources. The payment risk in developing nations was also highlighted with reference to the need to deal through joint venture partners and intermediaries to accommodate the transfers and conversions to US dollars. 91 It was at these meetings that it became apparent to the bank that the company "needs to pay $750,000 in critical creditors immediately to maintain operations". Having regard to the Placement and the fact that funds would be received by 5 May 1995, the bank decided that it was not in its interests "to jeopardise the company's operations" and the increase of $750,000 in the facility was approved. 18 April 1995 subsequent events review 92 The defendant's involvement in the due diligence process included conducting a 'subsequent events review' in order to express an opinion as to whether any matters had arisen since 31 December 1994 that had a material impact on the audited Accounts. A senior audit manager from PW, Alan Chan, assisted the defendant with this review, in that he reviewed the events and then had a meeting with the defendant on 18 April 1995 in which the matters he identified were discussed. 93 The Consolidated Trading Result for March 1995 recorded an actual negative amount of $921,200 against a budgeted positive amount of $6,346,900 with a note made by Mr Chan that: "Due to timing of revenue especially from Telecomm turnaround expected in the last quarter with expected realisation of several prospects" (Ex G: 7727E). The defendant agreed that the $921,200 figure was reached after taking into account the earned value on the Russian contract that had been recognised up to 31 December 1994 that included approximately $12 million of revenue and $6 million of profit (tr. 749 & 751). 94 The subsequent events review notes record that as at 1 March 1995 the "Russia project" was "6 weeks behind schedule" and: Total cash received to date US$204,000 (A$269k). Another tranche of A$800k is expected at end of April 1995. Per David Wheatley no more terminals have been shipped because the system has failed certification. However he still expects completion of the project by Dec 1995. (Ex G: 7727N) 95 The notes also included a review of the Minutes of the Directors' meetings since 31 December 1994 and the bank's letters to Pacific in relation to the available facilitates. They also included reference to BBY's activities and the fact that the bank had confirmed "no action" would be taken in respect of the breach of financial undertakings as at 31 December 1994. The "conclusion" of the review was: No matters have arisen since year end which impact the half year accounts or require specific disclosure in the Prospectus not already disclosed. (Ex G: 7727) The Prospectus 96 On 3 May 1995 PW wrote to the directors of Pacific in the following terms: CORPORATIONS LAW-SUBSECTION 1032 CONSENT This consent is given by WHB Seaton, a partner of Price Waterhouse, pursuant to Section 1032 of the Corporations Law, for the purposes of the Prospectus to be issued by Stanilite Pacific Limited (the "Company") dated 3 May 1995 for a renounceable rights offer of one ordinary share for every five ordinary shares registered to eligible shareholders. I consent to the issue of the Prospectus with my Auditors' Report dated 16 March 1995 on the consolidated accounts of the Company for the half-year ended 31 December 1994 in the form and context in which it is included in the Prospectus and the name of Price Waterhouse appearing in the Prospectus as Auditors of the Company. I do not make or purport to make any statement in the Prospectus other than in the Auditors' Report and expressly disclaim responsibility for other statements. (Ex F: 1351) 97 In another letter of 3 May 1995 to the directors of Pacific, PW reported on their role as independent accountants in connection with the preparation of the Prospectus and advised: 2.2 Nothing has come to our attention that causes us to believe and we do not believe that the issue of shares pursuant to the Prospectus may involve conduct that is misleading or deceptive or that may be likely to mislead or deceive or may involve a contravention of the Corporations Law. (Ex F: 1354) 98 The Board and the Due Diligence Committee met on 3 May 1995 and made the necessary resolutions to lodge the Prospectus. 99 In the Investment Highlights section of the Prospectus, Pacific was described as a "Growth Company", that the directors expected to continue a record of strong profit growth, particularly in the international telecommunications market. It was also noted that "this potential growth is not without risks" and the reader was referred to the discussion of those risks in Section 6 of the Prospectus (Ex F: 1302). 100 The Prospectus stated that the funds would primarily be used to repay bank facilities and to provide working capital to fund growth. In this regard the Prospectus included the following statement: Since 31st December 1994 Stanilite has drawn down a further $7.85 million making a total of $16.35 million of additional short term facilities provided by the National Australia Bank Limited. The terms of those short term facilities require repayment by Stanilite from new equity funds raised. Funds from this issue and the Placement will be used to retire debt under these short term facilities. (Ex F: 1304) 101 The primary purpose of the Issue was stated to be to "replenish cash resources expended in product development and international marketing and make funds available to complete existing contracts and seek new contracts". That type of expenditure was said to be the "hallmark of a rapidly growing company creating and capitalising on opportunities in the telecommunications industry". 102 In respect of the Russian Contract the following was recorded: Stanilite is also pursuing opportunities in telecommunications on a build and transfer basis. This can entail not only the design and manufacture of equipment for a specific telecommunications project, but also the arrangement of project finance to fund the purchase of that equipment in advance of revenue being generated by the project. The Techin Trade contract to supply a $37.5 million cellular telephone network in the Black Sea port area of Russia is the first of this nature by Stanilite and project financing is currently being negotiated. More details of this contract are provided in Section 11.1 of this Prospectus. (Ex F: 1308) 103 Section 11.1, "Material Contracts" stated that in the view of the directors, certain contracts were significant in terms of the offer, to the continuing operations of the company or were otherwise relevant to a potential subscriber to the offer. The section included the following: Techinfo (Russia) Network Supply Agreement This contract is dated 11th November 1994 and is between Staniite Electronics Pty Limited ("Electronics") and Technin Trade Limited ("TTL"). TTL is a company incorporated in Delaware, USA. The controlling shareholder of TTL controls the holder of a licence from The Ministry of Communications of the Russian Federation to provide a cellular radio-telephone service in the Krasnodar and other regions of Russia. Electronics has agreed to supply certain equipment and services necessary to establish and maintain a high capacity local, inter-regional and international wireless telephone system for digital/analogue mobile telephone systems in the Krasnodar region of Russia and in Omsk City. The new telephone system is to be connected to the public subscriber telephone network. The contract includes the supply of software and Electronics has granted TTL a royalty-free licence for use of the software. Electronics is also to provide training for the network operators and maintenance workers. Electronics has agreed to provide software support for a period of one year from the date of commissioning and certifying the system. The contract envisages several stages, of which only Stage 1 is quantified and confirmed. The contracted value to Electronics of Stage 1, Phase 1 is $US18,656,712 which is for supply of equipment and services. Stage 1, Phase 2 has a contracted value of $US9,857,722 giving a total contracted value of $US28,514,434. Stages 2 and 3 are subject to further purchase orders from TTL, which is likely to depend upon the development of adequate income from Stage 1 and project financing arrangements. Electronics expects that payment for stage 1 will occur over the next 12 to 18 months. Invoices issued by Electronics are payable progressively according to a formula in the contract based on projected revenue from users of the network once it is functional. Subject to the risks mentioned in Section 6 of this Prospectus and assuming that TTL and Electronics perform their respective obligations under the contract, payment to Electronics will amongst other things, depend upon: · roll out of the system by TTL; · remittance of money from the sale of terminals by regional operating companies to TTL or directly to Stanilite at the direction of TTL; and · availability of US dollars from the Russian Central Bank. To date, TTL has paid $US204,000 to Electronics. Electronics anticipates that most of the monies owing under this contract will be paid within 12 months. If the expected rate of sales of terminals is not achieved, Electronics may delay the supply of further equipment until such supply is justified by sales of terminals. Electronics has the right to suspend deliveries and remove equipment if payments are not received at the rate specified in the contract. Ownership of the equipment does not pass until Electronics has received payment in full for the equipment. Electronics has taken security over certain assets of TTL and certain personal assets of TTL's principal shareholder and controller, but these securities currently have a low value (approximately $US300,000). Electronics has also received a limited ($US1.5 million) guarantee from the Novorossiijsk Sea Trading Port (a major financial backer of TTL) supported by equivalent funds in a Swiss bank account. The legal status of the guarantee is being examined by Stanilite and is presently unclear. Electronics has taken out EFIC export insurance for 60% of invoice amounts initially up to $7.4 million. This insurance is subject to a number of conditions including that: · all guarantees and securities nominated in the contract be in place by a date to be determined by EFIC; · licences and approvals remain in full force and effect before delivery of equipment on to the Russian sites; and · user terminals have been made available and the goods have been delivered on site in Russia with a Certificate of Acceptance issued. The company has satisfied the second and third conditions and is in the process of satisfying EFIC in respect of first. Due to factors set out in Section 6 of this Prospectus, including the under-developed legal system in Russia and difficulties in negotiating and implementing legal (including contractual) protection, enforcement of rights in relation to this contract, if necessary, could be difficult. (Ex F: 1338-1339) 104 Section 6, Business and Investment Risks, referred to the dynamic market environments in which Pacific operated providing in some cases "high levels of risk". It was noted that in addition to risk faced by all commercial enterprises, the major business risks were technology, contract, country and payment. Continued investment in the R&D of new and existing products was noted to be "essential". The Section also included the following: Whilst sales revenue on telecommunications projects is brought to account based on percentage of work completed, the combination of the above issues can make profit projections, cash flows and the timing and quantum of dividends uncertain. (Ex F: 1313) 105 It was noted that whilst the nature of the business was such that it was "difficult to accurately forecast short term financial performance" contracts that had already been won and currently under negotiation "should produce a profit for this financial year higher than last year" (Ex F: 1312). It was also noted that the directors believed that a commitment to R&D was a major aspect of the company's successes to date and: Stanilite's R&D costs are capitalised where Directors consider beyond reasonable doubt that future benefits exceeding these costs will be derived. Given the nature of the Telecommunications business, recent R&D expenditure has been substantially capitalised and this is likely to remain the case in the medium term. R&D expenditure which is capitalised is amortised over the anticipated life of expected benefits, with a maximum of 20 years. (Ex F: 1310) 106 The Prospectus also advised that business development costs had often been incurred prior to achieving a maintainable earnings base and were deferred where the Directors believed that the future benefits would, beyond reasonable doubt, exceed those costs. In those circumstances the value of that asset was reviewed each half-year and amortised over the period in which revenue was received or written off, if the capital value of the asset would not be supported by future earnings (Ex F: 1311). There was also reference to the fact that Stanilite sometimes deferred contract tender costs where it was expected that they would be recouped when the relevant tender was awarded to the company and also that capitalised tender costs were reviewed half-yearly and written off if it was expected that the contract would not be won (Ex F: 1311). Argentinean contract 107 On 8 May 1995 the bank met with the Board "to discuss the current liquidity difficulties of the company and the steps being taken to address their liquidity position" (Ex F: 1415). The Chairman, Mr Valder, announced that the Group had secured the Argentinean (CTI) contract worth A$33 million due for completion by December 1995 with budgets indicating receipt of full proceeds by February 1996. The directors advised that they anticipated receipt of $5 milllion in respect of this contract prior to 30 June 1995. The bank observed that this contract was "positive" for the company particularly as it had completed a US$20 million contract for the same company in 1994. There was discussion about the appointment of Arthur Andersen to review Pacific's operations to assist in considering "the long term strategy". It was noted that the capital raising would not be sufficient to solve the negative cash position and the company's position was described as "precarious". Extension of facilites/Arthur Andersen retained 108 On 18 May 1995 the bank notified Pacific that it agreed to an extension of the facilities until 31 July 1995 on the conditions that: (1) Arthur Andersen were appointed as "Investigative Accountants"; and (2) Pacific complete quarterly compliance certificates. The bank advised that the extension was without prejudice to its rights in relation to subsisting Events of Default under the facilities. 109 Arthur Andersen were retained and the terms of their letter of appointment were settled between the bank, Pacific and Arthur Andersen. Their brief included: (a) a review of the profit and loss projections for the financial year 1996; (b) a detailed review of the projected cash flow for financial year 1996; (c) examination of proposals for cost reductions and identification of any other opportunities for cost reductions; (d) recommendations on how cashflow management could be improved; (e) examination of policies in respect of the budget and funding projections for financial year 1996; (f) the provision of a framework for regular reporting to the bank; and (g) provision of advice to the management of Pacific on the appropriate level of debt and equity funding and if necessary, sources of both debt and equity financing. 110 Cash flow continued to be troublesome and in late June 1995 the bank supported the temporary increase in the facilities "in view of the circumstances and lack of acceptable alternatives". Revenue from the Argentinean CTI contract signed on 27 June 1995, of $18.8 million and profits of $8.3 million were brought to account as at 30 June 1995. Arthur Andersen's report 111 On 3 August 1995 Arthur Andersen reported to the bank. In the covering letter the bank was advised that the Board of Directors acknowledged that the report had addressed all of the issues in a "fair and reasonable manner" with the exception of the adjustments to the company's 1996 profit and loss budget. The adjusted budget was said to attempt to measure the impact on the company's profitability if certain target areas did not eventuate. Those areas were where adequate support for the budgeted results did not exist, or where Arthur Andersen believed revenue was optimistic based on historical performance and current knowledge of future events. 112 Arthur Andersen advised that: "the company's management and Board of Directors are very confident that the company's 1996 budget is realistic and achievable" and that they have asked that: "it be brought to the attention of the Bank that, historically, significant unbudgeted contracts have been won (for example, the Argentinean and Russian contracts), and that there is reasonable expectation that such contracts will continue to be won". Arthur Andersen advised that they had not amended their report to include the specific additional revenue that the Board of Directors believed should not have been excluded from the adjusted budget. However they did acknowledge the board comments that the adjustments had not incorporated the "significant potential 'up-sides' for the company in the coming year". In conclusion the letter stated that the Board of Directors had requested Arthur Andersen to advise the bank that several of the recommendations outlined in the report had already been initiated and that the company was willing to adopt the remaining recommendations "particularly in relation to the company's accounting policies". 113 Arthur Andersen's report included the following: Stanilite has achieved rapid growth over the last 4 years. Much of this growth has been driven by the company's focus on the supply of equipment for telecommunications infrastructure. This is an area which offers significant opportunities for future growth. Stanilite's recent growth, however, has progressed more quickly than the implementation of appropriate management structures, cash control, funding and executive resources. Stanilite must address all these issues to ensure future growth does not jeopardise the company's viability. In addition, Stanilite has always attempted to present the market with a picture of increasing profitability. In order to achieve this profitability, Stanilite has adopted aggressive accounting policies in relation to revenue and profit recognition and capitalisation of certain costs. The acquisition of Uni-Labs in November 1992 involved Stanilite in merger and integration costs and considerable research and development expenditure to finalise development of Uni-Lab's products. Rather than create an acceptance in the market of the need to "bed down" the acquisition and, therefore, have a period of reduced profitability, Stanilite aggressively reported record profits. The result of this approach can be seen in Stanilite's balance sheet which shows capitalised research and development and other intangibles increasing from $10 million as at June 1992 to $54 million as at June 1995. Over the same period, Stanilite's policy of early revenue and profit recognition has seen unbilled work-in-progress increase from $7 million to $89 million. Our view is that, whilst the company is utilising an accounting methodology which has been sanctioned by its auditor, a more conservative accounting approach should be used in determining arrangements with the Bank. This treatment will help ensure Stanilite's ongoing operations are managed in line with its resources. (Ex F: 1622) 114 The report also included the following: Overview of Stanilite's Revenue Recognition Methodology Stanilite uses an accounting method known as 'earned value' in respect of Projects and the larger international Telecommunications contracts. The earned value concept involves recognising revenue (on the basis of the project's budget) after activity or risk milestones are surpassed in a contract. The revenue is accumulated in a work-in-progress account until the contract reaches a stage of completion which enables an invoice to be issued. The consequences of using the earned value methodology are: there is a timing difference between the recognition of sales and invoicing of a customer; the method usually places a high degree of value on the engineering phase of the contract with the result that revenue recognition in the early phases of a project does not appear commensurate with the level of physical equipment acquired or manufactured; and a large work-in-progress balance may accumulate, but this may not necessarily represent physical work-in-progress as it includes a profit margin and is partially offset by a large earned value trade creditor accrual balance. Although the use of the earned value method has been sanctioned by Stanilite's auditor, we do not believe that the use of this method aids understanding of Stanilite's true operating performance and recommend that, for Bank reporting purposes only, an alternative accounting technique be utilised, which is more indicative of Stanilite's cashflows. We have described this method as the 'covenant reporting method' and its calculation and underlying assumptions are discussed below. It should be noted that the earned value technique was first adopted by Stanilite as a result of a Commonwealth Government requirement for the ANZAC project, which stipulated that the successful tenderer operate a Cost Schedule Control System of project management. It should also be noted that the use of the earned value accounting technique is conveyed to the company's shareholders in the notes to the annual report. Review of Historical Financial Performance … Although the return on sales has remained constant during this period, the cashflow from the operations has been substantially negative. The total cash deficiency for the period was $102 million. … The difference between Stanilite's profitability and the cashflow can be partly attributed to its growth in revenue which has led to an increased demand for working capital. In addition, the accounting policies of Stanilite have resulted in the early recognition of profit which cannot be immediately converted into cash. These combined impacts have resulted in significant differences between the cashflow and the profit and loss. (Ex F: 1623-1626) 115 In dealing in more detail with the earned value method, Arthur Andersen noted that the method was "allowable under AASB 1009" which envisaged construction contract accounting methods as appropriate for long-term projects "where the project's ultimate profitability and stage of completion can be reliably estimated". They concluded that whilst the use of the method was "permissible in certain circumstances" they believed that the company had adopted the technique "excessively" during the year ended 30 June 1995 and expressed the following view: In many instances, contracts which are due to be completed within one year (but which span the 30 June year end) have been treated as earned value contracts. Examples of such contracts include the Argentinean and Russian telecommunications contracts. It is questionable whether contracts which are commenced and completed within one year are long-term contracts and, therefore, should be recognised using the percentage of completion method. (Ex F: 1642) 116 On 8 August 1995 in a meeting between the bank and the board of Pacific, the Chairman advised the bank that Pacific had taken the decision to "move away" from the earned value methodology over 1996 and 1997 financial years except for Government contracts where the method would still be required. One of the conditions later imposed by the bank for the continuation of the availability of the facilities was a requirement on the company to notify the bank whenever the earned value method was to be applied to any contract. The 30 June 1995 Accounts 117 The Board met on 30 August 1995 at which the finalised unaudited accounts for the year ended 30 June 1995 were tabled. It was noted in the minutes of that meeting that: "Approval of a final dividend for the year was deferred until audit of the accounts was completed, but the Board suggested that an amount of 4 cents per share be provided for in the accounts for this purpose" (Ex G: 9629). 118 On 11 September 1995 the defendant informed the Audit Committee that subject to completion of a number of matters in respect of the audit, he had verified the company's results for the year ended 30 June 1995. He advised that he would require the Executive Directors to sign representation letters in respect of the accounts because the company had applied the "earned value" accounting concept across defence and several telecommunications projects to arrive at a profit for the year. He also suggested that because of the difficulties being experienced with the Russian Contract, a suitable note should be included in the Statutory Accounts to report on progress to date and the future risks associated with the project. The defendant agreed that he would draft the appropriate note for inclusion in the accounts with the assistance of Mr Fayle. 119 The letter requested by the defendant was produced and was dated 26 September 1995. It included the following: 7. TELECOMMUNCATIONS PROJECTS The directors are satisfied that proper procedures have been adopted in the recognition of profit on telecommunications projects for which the "earned valued" method of revenue recognition has been adopted. In particular, the directors have taken reasonable steps to ensure that the percentages of completion used in the calculations properly reflects the level of effort incurred on these projects. We make the following specific representation in relation to the following projects: (a) Australian Defence Air Traffic System Projects ("ADATS ") The directors, to the best of their knowledge, confirm that the contract for the project has been awarded to the economic entity with an estimated value of $26,442,000. The estimated related cost of completion for the project is $18,849,000. (b) Technin Trade Limited Network Supply Project (Russia Contract) The directors have taken reasonable steps to ascertain that the amounts of $23,052,000 representing contract work in progress and $5,738,000 representing trade debtors receivable in relation to the Russia Contract will be realised in full, having regard to the uncertainties described in Note 7 to the financial statements. (Ex G: 9652) 120 On 26 September 1995 PW gave an unqualified audit opinion for the accounts for the year ended 30 June 1995. Note 7 to those accounts included the following: Work in progress after deducting progress claims includes $8,702,000 (current) and $14,350,000 (non-current) including attributable profits to date, which relate to a contract dated 11th November 1994 (and as subsequently amended) for the installation of a telecommunications system in Russia with Techin Trade Limited (TTL). In addition, an amount of $5,738,000 is included in current trade debtors in relation to progress claims on the contract. The Group's ability to receive payment for work on this contract and the timing of those receipts is dependent on: (i) the approval of the system by Russian telecommunications authorities and its subsequent roll out by TTL; (ii) remittance of a contracted proportion of the proceeds from the sale of terminals, collection fee and call revenue by regional operating companies to TTL or directly to the economic entity at the discretion of TTL; and (iii) availability of US dollars from the Russian Central Bank. The directors have evaluated the technical and commercial risks associated with this contract. The testing of the system by the authorities is under way and the directors believe that approval of the system is imminent, based on company prepared forecasts in relation to the market in which the systems will operate. The directors consider that the allocation of the assets between current and non-current and recognition of the attributable profit is appropriate, notwithstanding the uncertainties inherent in the matters mentioned in the above paragraph. To date the economic entity has received $269,000 from TTL in relation to the contract. Ownership of the equipment does not pass until payment has been received in full. Export insurance for 60% of the invoiced amounts has been taken out with Export Finance and Insurance Corporation. In addition, the economic entity holds guarantees and other security estimated by the directors to have to a maximum value of $10 million. (Ex F: 1982) 121 On 26 October 1995, at the Annual General Meeting, the shareholders were informed by the Chairman that: With the rapid expansion of the Company into telecommunications, Board and management have given a great deal of thought as to whether the "Earned Value" concept that has been applied to defence contracts is appropriate for its growing volume of shorter-term telecommunications contracts. It has now been decided to move away from the "Earned Value" method for the smaller telecommunications business but to retain it for defence and major contracts which are usually of much longer nature, like the major contract for the supply of communications systems to the Anzac frigates. (Ex F: 2017) 122 On the topic of R&D the Chairman advised the shareholders that in recognition of the fast changing nature of modern technology, there was an intention to amortise more rapidly the sums capitalised each year, even though they formed the basis of much of the company's business. Shortfalls notified 123 On 13 November 1995 Pacific announced to the market that it was experiencing some revenue shortfalls and delays on the Russian contract. It announced that in recent weeks it had emerged that a write back of revenue from that contract "may be required" and "together with the effect of the accounting changes referred to at last month's annual meeting, this would adversely affect the company's results for the current half year". The announcement emphasised the company's other operations including the Argentinean contract, the lighting division and the finalising of major new defence contracts with the Australian Government. 124 On 1 December 1995 Pacific announced to the market that 90% of the second tranche payment of the rights issue had been received. The consolidated trading results for December 1995 showed losses of $41.6 million and for the year to date of $55.48 million. BBY advised in a letter of 5 December 1995: "accepting the fact that despite the earned value accounting concept is in accordance with accounting standards and has been well explained to the capital markets over the years, its application has by itself exacerbated the cash flow problems". On 6 December 1995 Arthur Andersen carried out a security review of Pacific for the bank. 8 December 1995 letter 125 On 8 December 1995 the defendant wrote to the directors of Pacific advising that PW had completed the audit of the 30 June 1995 accounts and setting out the "matters of significance" that were highlighted during the audit (Ex J). I shall deal with the contents of this letter in more detail in considering the plaintiffs case against the defendants in respect of the accounts for the period ending 30 June 1995. Half-year loss 126 On 15 December 1995 Pacific announced a forecast half yearly loss because of the shortfall in revenue expectations. The accounts for the half-year ended 31 December 1995, signed in March 1996, reported a loss of $23.6 million. Pacific was unable to perform the Argentinean contract in a timely way and became liable to penalties. Efforts were made to find a strategic investor to take over Pacific without success. On 21 February 1996 the bank noted: (3) Removal of Earned Value Methodology for all but defence contracts. Earned value gave an incorrect impression of revenue and profit for contracts which had a high degree of uncertainty such as the Techin-Trade Russia contract. Company's P & L is now reflective of operations. (Ex F: 2376) Liquidation 127 Pacific's position worsened and the bank investigated its exposure. In a file note dated 9 April 1996 the bank recorded that a Mr Gatfield, who was considering the restructure of the company, advised that he was not in favour of selling the Lighting Division as he understood it was the only recurring cash flow for the company. On 22 May 1996 Pacific announced that it had received notice of default under the Argentinean contract. Trading of shares was suspended and the bank appointed a receiver and manager, Arthur Andersen. On 26 August 1996 the liquidators were appointed. The role of the auditor 128 Management has an obligation to prepare the accounts of a company and the auditor has a separate duty to give an independent opinion whether the accounts have been drawn up in accordance with applicable accounting standards, and whether they represent a true and fair view of the company's financial position: AWA Ltd v. Daniels t/as Deloitte Haskins & Sells (1992) 7 ACSR 759; Daniels & Ors (formerly practising s Deloitte Haskins & Sells) v Anderson (1995) 37 NSWLR 438. There is no issue in this case that the defendants owed both a duty of care and a contractual duty to the plaintiffs to give such an independent opinion. 129 The plaintiffs submitted that their cases are essentially founded on what the auditor actually knew, and on the reasonable inferences that should have been drawn from those matters. It was submitted that all substantially material facts were within the actual or constructive knowledge of the auditor, and the auditor's concerns appear from the correspondence and minutes of meetings that the defendant and his staff attended. 130 The defendants made a number of submissions, which I accept, in relation to the role of the auditor based, in the main, on the evidence of the plaintiffs' expert Mr Shanahan. It is the directors, not the auditor, who are responsible for selecting and applying accounting policies (tr. 234-235). Where two accounting policies are available for application, it is for the directors to select between these two policies. Selection is outside the responsibility of an auditor, and it is not open for an auditor to qualify the accounts of the company because he prefers an alternative policy that the directors do not prefer (tr. 234-235). It is not for the auditor to contradict directors about a matter of accounting policy unless the auditor has evidence to the effect that the directors are clearly wrong (tr. 338). An auditor has to be careful and sure of his or her grounds before qualifying accounts particularly when the auditor puts a proposition to the directors with which the directors vehemently disagree (tr. 339). The plaintiffs' claims 131 At the commencement of the trial I sought clarification of the plaintiffs' claims against the defendant. Notwithstanding the various claims as pleaded, the claims the plaintiffs make against the defendants are encapsulated in a document entitled, "Plaintiff's Outline of What Price Waterhouse Ought To Have Done" (the Outline). The Outline addressed two matters: "Consent to the inclusion of their audit opinion on the accounts for the half-year ended 31 December 1994" (the Prospectus Consent) and "Unqualified audit opinion on the accounts for the year ended 30 June 1995" (the 1995 Accounts Opinion). 132 Under the Prospectus Consent claims, the Outline sets out 28 matters between 31 December 1993 and 5 April 1995 of which it is alleged PW were aware as at 3 May 1995 when they consented to the inclusion of their unqualified opinion in the Prospectus. It is not alleged that all of these items should have led to the redrawing of, or the addition of a note to, the Accounts. Seven of the claims are alleged to have required the redrawing of the Accounts or the inclusion of a note. Those claims, together with the description under which I intend to consider the claims, are as follows: 12. As at 31 December 1994 the group was in breach of borrowing covenants set out in the banking facility, and the credit facilities extended to the group by the National Australia Bank were temporary and conditional. These matters were such as to affect the group's capacity to continue as a going concern, and to require a note to the accounts, even if a favourable letter from the bank was obtained. (Going Concern) 13. The total revenue recognised in the financial statements for the Russian Contract was $12.8m, with profit of $6.4m, although the accounting standards for earned value revenue/profit recognition had not been met, in that, amongst other matters the Russian Contract was not a construction contract. In particular, there could be no assurance that the revenue would actually be received as its right to receive cash depended on Techin Trade selling the terminals to third parties. Further, and in any event, full revenue and profit had been recognised on partially completed projects, which is in itself inconsistent with earned value methodology. (The Russian contract) 19. Revenue in the order of $4m (on which the profit was $2.1m) for telecommunications sales (excluding the Russian Contract) had been brought to account although the products had not yet been delivered to the customers: (a) $762,000 of the profit taken up related to products in respect of which no firm order had been received as at 31 December 1994. (b) Full revenue had been taken up on sales which were only partially completed. (c) Profit of $448,000 had been taken up on items which were, as at 9 March 1995, still under negotiation. (d) Profit of $309,000 had been recognised from Venezuela although it was not certain whether a firm order would be placed. (Other telecommunications contracts) 20. International marketing costs of $3.067m had all been deferred, although over $8m worth of profit had been recognised from the regions in which the marketing costs had been incurred. As revenue had been recognised, costs incurred in generating that revenue ought to have been brought to account as expenses in the profit and loss statement. (Marketing Costs) 22. A write-down of $355,000 in inventory transferred from New Zealand had been omitted. (Inventory) 23. No provision had been made for doubtful debts; and (Bad debts) 24. Amortisation of capitalised research and development had been delayed. (R&D costs) 133 The vast majority of the Items in the Outline (24 of the 28 items) are derived from the reports given by PW to the directors of Pacific on 7 February 1994 (Ex F: 233), 28 September 1994 (Ex F: 426) and 13 March 1995 (Ex F:1034) following the 31 December 1993 review, the 30 June 1994 audit and the 31 December 1994 audit respectively. Item 11 (the fact that the receipt of monies under the Russian contract was dependent on the sale of terminals by the Russian company (such ability not being able to be independently assessed) was based on the letter from PW to the directors of Pacific dated 7 December 1994 in which PW gave a qualified opinion on the timing of cash flow receipts set out in the cash flow forecast (Ex F: 740); and item 16, (the fact that Techin Trade was in breach of the contract by reason of its failure to supply the required security) was based on a letter from Corrs to Pacific dated 31 March 1995 which dealt with the security on the Russian contract (Ex F: 1158). Items 27 and 28 (the loss of $921,000 against a budgeted profit of $6,346,900 as at 31 March 1995; and the Chairman's proposed statement in the Prospectus) were based on the Minutes of the Due Diligence Committee of 5 April 1995 (Ex F: 1213 & 1223). 134 The Outline in respect of the Prospectus Consent claim includes the following: As at 3 May 1995 a reasonably competent auditor in the position of Price Waterhouse: (1) would not have agreed to the inclusion of the unqualified audit opinion the prospectus; and either: (2) would have insisted that the financial statements for the half year ended 31 December 1994 be redrawn so as to reflect the matters raised in their letter to the Board dated 13 March 1995; or (3) in the alternative to (2), would have given a qualification to their audit opinion to the effect of the matters raised in their letter to the Board dated 13 March 1995. 135 Under the 1995 Accounts Opinion section, the Outline sets out three matters, in addition to the 28 matters referred to in the Prospectus Consent section, of which PW was allegedly aware as at 26 September 1995, namely: 29. Contract tender costs were being capitalised, rather than written off in circumstances where costs associated with unsuccessful tenders should be written off immediately rather than capitalised. 30. Tender costs associated with unsuccessful tenders (and therefore should have been written off) were being reclassified as research and development. 31. Revenue on contracts for the supply of equipment was being improperly recognised on an "earned value" basis, which was not applicable. Furthermore, the methodology for recognising revenue on that basis was not being followed, and was not being applied consistently. 136 The 1995 Accounts Opinion section of the Outline concludes: As at 26 September 1995 a reasonably competent auditor in the position of Price Waterhouse: (1) would not have given an unqualified audit opinion in the financial statements; and either: (2) would have insisted that the financial statements be redrawn so as to reflect the matters raised in their letter to the Board dated 8 December 1995; or (3) in the alternative to (2) would have given a qualification to their audit opinion to the effect of the matters raised in their letter to the Board dated 8 December 1995. 137 Although the Outline did not make reference to it, there is a claim made by the plaintiffs under s 995 of the Corporations Law as it was at the time of the alleged contraventions in 1995 (the s 995 Claim). The plaintiffs claim that Pacific was able to raise moneys through the rights issue by reason of the unqualified audit opinion on the accounts in the Prospectus. It was submitted that it can be inferred that the existing shareholders and members who participated in the rights issue relied on the unqualified audit opinion, which it is claimed was misleading. It was submitted that by reason of the misleading conduct Pacific raised money that was not in its interest to raise having regard to the purpose for which it was to be used and which caused it to suffer loss. The s 995 Claim is dependent upon findings that the defendants ought not to have consented to their unqualified opinion being included in the Prospectus for the reasons outlined in the Prospectus Consent claims. The success of the s 995 Claim is dependent upon the plaintiff establishing that such opinion ought not to have been included in the Prospectus. Statute barred claims 138 In opening the plaintiffs' cases Mr Douglas QC advised that the claim in negligence against the defendants is based on the consent on 3 May 1995 to the inclusion of the unqualified opinion in the Prospectus. Mr Douglas QC opened on this aspect of the matter in the following way: That they should not have given their consent to the inclusion of the unqualified opinion in the prospectus as at 3 May. I was only putting that from the point of view of crystallising the actual negligence because there are limitation issues which have been pleaded in the statement of claim. We say the negligence is the consent to the inclusion of the accounts, because the accounts were drawn up in a prior period. HH: So it is the consent to the inclusion of the unqualified opinion in the prospectus. Yes, your honour, and secondly, it is then in relation to the 30 June 1995 accounts. It is the formation of the opinion which they did form that the accounts did in fact present a true and fair view of the position of the company at that time, without qualifying the account, and that, amongst other things, led to a determination that the company had been trading profitably when it had not been and if the accounts had been drawn up so as to reflect the position of the company, then that profit could not have been available and a dividend could not have been declared. (tr. 51) 139 The defendants submitted that the plaintiffs' opening was a clear concession that any claims against the defendants in respect of the audit of the 31 December 1994 Accounts was statute barred. The plaintiffs' reliance upon the Outline that contains only the claims in respect of the Prospectus Consent and the claims in respect of the 1995 Accounts Opinion is consistent with such a concession. There is no claim in the Outline in respect of the audit of the Accounts, that is, the 31 December 1994 accounts. 140 In opening the defendants' case Mr Karkar QC said: This letter contains the terms of the first retainer, that is to say the retainer by Stanilite Pacific of Price Waterhouse as auditors. This is the audit retainer: "A retainer to perform an audit on and express an audit opinion on the consolidated financial statements of the Stanilite Group for the six months ending 31 December 1994". This retainer, as your Honour has seen in the evidence was performed and was completed when Price Waterhouse signed the audit opinion on 16 March … this retainer was exhausted on 16 March. Price Waterhouse are not and cannot be sued on this retainer because, as our learned friend conceded in his opening, any cause of action based upon or arising out of this audit retainer is statute barred . (tr. 468-469) 141 It was only in final submissions that controversy arose in respect of the plaintiffs' claims against the defendants in respect of the audit of the 31 December 1994 Accounts. The plaintiffs' written submissions include the following: Breach 2.1 The plaintiffs' case is, in summary, that had Price Waterhouse acted as reasonably competent auditors, they would not have: (a) issued an unqualified audit opinion on 16 March 1995 for the accounts for the half-year ended 31 December 1994 or at least failed to insist on the inclusion of a note to the accounts in relation to the going concern issue; (b) consented to the inclusion of their unqualified audit opinion on the accounts for the half year ended 31 December 1994 in the prospectus lodged on 3 May 1995; or (c) issued an unqualified audit opinion on the accounts for the year ended 30 June 1995. 2.3 Only the contractual claim based on (a) above is statute barred: the cause of action for breach of contract accrued on breach, and the breach occurred on 16 March 1995, more than six years before the summons was filed. Paragraph (a) above nonetheless gives rise to a claim in tort, which does not accrue before damage is suffered. The damage was suffered at the earliest when the placement monies were paid over to Stanilite on 5 May 1995, or when the accounts were lodged with the prospectus, on 3 May 1995. Each of these dates occurred less than six years before the summons was filed (26 April 2001) and are therefore not statute barred. 142 In final submissions Mr Karkar QC submitted: Indeed, the opening on behalf of the plaintiffs appeared to narrow the ambit of the claims in two respects; first, my learned friend accepted, it seems to us, any action for breach of contract or tort or otherwise based upon the defendants' audit opinion of 16 March 1995 was statute barred, the action having been commenced on 26 April 2001, notwithstanding that in recent days my learned friend sought to resile from that position. We will submit in due course to demonstrate to your Honour that concession of my learned friend was properly made. That is one way in which the opening narrowed the ambit. The second, all claims in respect of the 31 December 1995 accounts and review have been abandoned. (tr. 1031) 143 Mr Karkar QC articulated the defendants' position in this regard in the following submission: These proceedings were commenced on 26 April 2001. To the extent that the plaintiffs plead that there was a breach of contract of the first retainer, that cause of action, it is well-established, arose at the date of the alleged breach. That is 16 March 1995. Therefore the contractual claim is statute barred. Insofar as the plaintiffs plead that we were negligent either because of a breach of common law duty or a statutory duty – might I pause here to say that we do not concede that there is a statutory duty, notwithstanding that Rogers J held that there was in Daniels. We reserve our rights in respect of that. The Court of Appeal did not deal with that issue. But insofar as it is pleaded against us we were negligent either because of a breach of a common law duty or a statutory duty, the cause of action arose on the date upon which it is said the plaintiffs suffered damage. We emphasise the word "damage". It is damage that one looks for, not damages. Damages is the money award that your Honour hopefully will not award. But damage is of course the injuria. In negligence it has been established by the High Court in Mahony v Kruschich that damage here would be, on the allegations of the plaintiffs, the continuation to trade. Here the only damage pleaded as resulting from the negligent conduct of the retainer is the continuation to trade. Your Honour yesterday asked my learned friend twice, if not three times, to tell your Honour when would the receiver have been appointed. Very artfully my learned friend dodged the question because the answer to your Honour's question would have fixed the time effectively on which the damage would have been suffered. So on the assumption that the 16 March opinion was qualified, or that the accounts were adjusted in a manner that the plaintiffs contend, on their case a receiver would have been appointed shortly after that. However, a receiver was not appointed. The company continued to trade. Therefore the loss was suffered almost immediately after 16 March. There is evidence, on the other hand-if one wants to seize on evidence-at Vol 24 of the tender bundle. On the fourth page of that bundle which is 7727E your Honour will see at the foot of that page the loss of $921,000 which was said to have been suffered by the end of March 1995. So that by the end of March 1995, as a result of the continued trading, a loss of $921,000 had occurred. So at the very latest, on this evidence, the damage was first suffered then and the action is statute barred. So we submit your Honour need certainly not be troubled by the audit report as published on 16 March 1995. (tr. 1047-1048) 144 The case was fought on the premise that there was no cause of action propounded against the defendants in respect of their audit of the 31 December 1994 accounts. The evidence in relation to those Accounts was understood, at least by the defendants, to be relied upon for the purposes of propounding a case against the defendants for giving consent to the inclusion of the unqualified audit opinion of 16 March 1995 in the Prospectus. The assessment of that opinion as at 3 May 1995 in the form and context in the Prospectus was the case opened and the case fought. I am of the opinion that it is inappropriate to change the position in final submissions in the manner outlined above having regard to the plaintiffs opening and the content of the Outline. 145 Even if the change of position were to be allowed the submissions made by Mr Karkar QC are persuasive. Although this case is distinguishable from the facts in Mahony v J Kruschich (Demolitions) Pty Ltd & Anor (1985) 156 CLR 522, the principle that the damage suffered is the injury rather than damages or compensation for the damage (at 527) is applicable for the purpose of assessing the date of the accrual of the cause of action. I am satisfied that it is more probable than not that any alleged damage suffered from the alleged tortious conduct on 16 March 1995 would have occurred prior to 26 April 1995 and the claim is thus statute barred. The evidence 146 The plaintiffs' cases rely in the main on the documentary material generated in the period 1994 to 1996. There are thousands of pages in evidence. Exhibit F consists of 10 folders of evidence referred to at times as the Critical Bundle. Exhibit G consists of 32 folders of evidence referred to at times as the Tender Bundle. Notwithstanding this vast volume of material the Court has been greatly assisted by detailed submissions with cross-referencing to documents that have been relied upon in an exemplary fashion. 147 The plaintiffs' main witness on liability was John Bernard Shanahan who expressed expert audit and accounting opinions in four reports, two dated 6 March 2002, one dated 1 May 2002 and one dated 23 September 2003. The plaintiffs' witnesses in relation to the quantification of damages were; Laurence Brian Hunter, a Chartered Accountant, who provided a report dated 2 December 2002 as to what an experienced receiver and manager would have done if appointed to the companies in or about June 1995; Wilhelm Martin Jansen, a Partner of the firm Ernst & Young in the Corporate Finance – Litigation Consulting Services Division, who provided two reports annexed to affidavits of 11 December 2002 and a supplementary report annexed to an affidavit of 10 October 2003 dealing with the quantification of damages based on what he referred to as the "auditors breach", being the consent given to the inclusion of their audit opinion of the 31 December 1994 Accounts in the Prospectus; David Singleton Lindsay, the Managing Director of Channel Investor Relations Pty Limited, a specialist shareholder relations and communications firm, who provided a report dated 3 December 2002 expressing an opinion as to whether Pacific would have been able to raise additional equity capital in May 1995 on an assumed set of facts, in particular if the defendants had refused to consent to their audit opinion to be included in the Prospectus; and Colin Stanley Wight, another Partner of the firm Ernst & Young, Melbourne, and the National Director of the Litigation Consulting Services Division, who provided two reports one dated 1 November 2002 and the other dated 29 August 2003, in the first of which he expressed an opinion on what an Investigative Accountant would have done and in the second of which he responded to one of the defendants' experts', Mr Gower's, report. 148 The defendants relied on the evidence of the defendant, William Henry Brown Seaton and two experts: Peter Douglas Robertson, an Audit Partner of the firm KPMG practising in the firm's Assurance and Advisory division, who provided two reports, one dated 10 April 2003 and another dated 28 November 2003 responding to Mr Shanahan's evidence; and Goodwin Cullimore Allen Gower, Chartered Accountant, who provided two reports, one dated 25 June 2003 and another dated 30 September 2003 responding to the opinions expressed by Messrs Jansen and Wight. 149 There was a challenge to the independence of two of the plaintiffs' witnesses, Messrs Lindsay and Wight, by reason of the fact that the liquidators of the plaintiffs, the moving parties in this litigation, were partners of the firm, Ernst & Young, at the time of the appointments and consultants to the firm at the time of trial. Mr Lindsay gave evidence that he would not give an opinion on liability if a partner of the firm was the litigant but did not see any difficulty in providing an opinion on quantum notwithstanding that the consultant/former partner of the firm was suggesting a particular amount of damages be recovered. However he appreciated that there may be an appearance of partiality (tr. 418-419). Mr Wight accepted that the liquidator's appointment was part of the professional activities conducted by Ernst & Young and also accepted that he did not make any disclosure of those matters in his reports (tr. 99). He did not accept that his independence as an expert had been compromised (tr. 99). 150 These very interesting matters of ethical and professional conduct are in this case only academic because of the conclusions that I have reached that the plaintiffs' cases against the defendants have failed. I shall now consider the claims made in the Outline, the first category of which relates to the Consent on 3 May 1995 to the inclusion of the 16 March 1995 unqualified audit opinion on the Accounts in the Prospectus. THE PROSPECTUS CONSENT Going Concern 151 The relevant item in relation to this claim in the Outline is Item 12 and, for ease of reference, it is repeated: As at 31 December 1994 the group was in breach of borrowing covenants set out in the banking facility, and the credit facilities extended to the group by the National Australia Bank were temporary and conditional. These matters were such as to affect the group's capacity to continue as a going concern, and to require a note to the accounts, even if a favourable letter from the bank was obtained. 152 In his first report dated 6 March 2002, Mr Shanahan referred to the Audit Committee meeting on 13 March 1995 and to notes that indicated that the defendant stated that the financial statements would have to include a note as to the reasons for adopting the going concern basis, even if the company received a letter of support from the bank. In paragraph 25 of his last report dated 23 September 2003, Mr Shanahan stated: Mr Seaton has stated that supportability of the going concern proposition was his "primary audit concern" in the December 1994 audit. It was the first point raised in his "draft" December 1994 Report to Directors wherein he stated that he believed the accounts should include a note addressing the issue. The Price Waterhouse minutes of the Audit Committee Meeting of 13 March 1995 record Mr Seaton as saying that "The accounts have to include a note even if we get a letter of support from bank". There was no disclosure in the financial report of matters such as the principal conditions which initially caused the auditor to question the going concern basis and management's plans and other mitigating factors. 153 The plaintiffs case is not that Pacific was not a going concern, but that a note should have been included in the form of a qualification to the audit opinion to be included in the Prospectus along the following lines, as suggested by Mr Shanahan: The accounts for the half-year ended 31 December 1994 have been prepared on a going concern basis. At 31 December 1994 the group was in breach of borrowing covenants set out in the banking facility and was operating under temporary credit facilities that had been extended to the group by its bankers. Without the continuing support of its bankers, there is a possibility that the Company may not be able to continue as a going concern. A letter of support from the Company's bankers was received on 16 March 1994 (sic). The Company's accounts do not disclose the principal conditions which initially caused us to question the going concern basis, including management's evaluation of their significance and possible effects and management's plans and other mitigating factors. In accordance with AUP 7: Going Concern , our audit opinion is qualified on the basis of lack of disclosure of these matters. (Exs B & C) 154 The defendants discovered that there was a breach of the financial covenants at 8 or 9 March 1995. The reference to this matter in the draft letters of 10 and 13 March 1995 included the following: We believe that the accounts should include a note which outlines the cash flow situation in Stanilite and states that temporary credit facilities have been extended to the group by its bankers. This note should clearly state the creditors attached to the extended facilities. At 31 December 1994 the group was in breach of borrowing covenants set out in the banking facility. In signing the accounts the directors acknowledge that there are reasonable grounds to believe that the company will be able to pay its debts as and when they fall due and that the group accounts are properly prepared on a going concern basis. We suggest that the directors seek legal advice on the implications of signing the accounts on a going concern basis in the light of the current cashflow position of Stanilite and the breach of the borrowing covenants. (Ex F: 1034) 155 The defendant gave evidence that this part of the draft letter was included purely because of the issue that had arisen concerning breach of the facility covenants (tr. 493). After this letter was written and used as a basis for discussion, the bank confirmed in writing that it would take no action in respect of the breach of financial covenants as at 31 December 1994. The defendant gave evidence that he did not expect the bank to give such an unconditional letter. His evidence in cross-examination included the following: Q. I want to put to you that it was your view at the meeting of 13 March 1995 that the accounts had to include a note to the effect of that set out in your letter of 13 March, even if you got a letter of support from the bank and that you are not prepared to concede that today because you realise that if you make such a concession you would then have to explain why there wasn't in fact such a note? A. At that time it was never in our, my wildest dreams that they would get from the bank the sort of waiver that they got, an unconditional waiver, and therefore my reservations about having notes on the accounts and my comments about having notes in the accounts was only in relation to the situation as I foresaw would happen and that is that the bank would reserve its title or reserve its rights. Q. What I want to suggest to you is that that explanation which you have just given is not a truthful explanation? A. Your Honour, that is the truth. (tr. 711) 156 The defendant also gave evidence that in his view the bank's letter "didn't mitigate the issue. That removed the issue entirely. It was an entire removal of the issue. In my mind at the time we signed the accounts, there was no issue" (tr. 495). Indeed at the board meeting on 16 March 1995 the defendant noted that paragraph 1 of his draft letter of 13 March 1995 dealing with the going concern issue had been "resolved" by the bank's unconditional waiver. 157 The plaintiffs submitted that the defendant should not be believed in his evidence, extracted above, in which he gave the explanation as to why he ultimately did not require a note. The suggestions made by the defendant in his letter of 13 March 1995 seem to me to be appropriate and proper suggestions for an auditor to make. The plaintiffs submitted that I should reject the defendant's evidence that he did not require a note because the bank had given an unconditional waiver, based in part on a theory that he knew that if he had required a note of the kind suggested by Mr Shanahan, it would be too damaging to the company because the unaudited profit had already been announced to the market on 3 March 1995 and he buckled under the pressure of the announcement. 158 If that theory runs, it would seem a little silly for the defendant to have written the letter of 13 March 1995 in the first place. It is to be remembered that the drafts were all dated approximately a week after the announcement to the market. If that announcement were to render the defendant supine to the wishes of others in not including a note, one would not have expected him to write a letter to be used as a basis for discussion. There is no evidence establishing that any person pressured the defendant into reaching the view that he did in respect of the note. The plaintiffs' case in relation to the so-called "pressure" seemed to rely on disparate events in 1994 and 1995. Reference was made to a statement made by the defendant to bank representatives in November 1994 that a rights issue could be made if there was "good news" to "excite buyers". Reference was also made to the defendant not expecting an announcement to the market until after all audit issues had been addressed. The defendant was cross-examined on this topic and gave the following evidence: Q. Now, in making that announcement of the profit and the declaration of the dividend, that, could I suggest to you, confounded your previous expectation that the results would not be released to the market until you had had an opportunity to form a view as to the accounts which the company intended to publish? A. It was contrary to my earlier expectations, yes. Q. And it put you, could I suggest to you, under significant pressure to ensure that the accounts which you had audited corresponded with what the directors had in fact released to the market? A. I don't think so. My obligation is to make sure the accounts are true and fair, not that they are the same as the figures released to the market. Q. As at 3 March and at all times subsequent to the date until 16 March you were aware that the company's directors had announced a profit to the market. That is the first thing, isn't it? A. Yes. Q. You were aware that they were proposing to go to market for an issue and a placement? A. Yes. Q. And you were aware from what you had been told by representatives of BBY and the directors, that was important that the half yearly result be a good result in order that the placement be a success? A. That was the view expressed by those gentlemen, yes. Q. And that the issue be a success as well? A. That was their view, yes. (tr. 656-657) 159 BBY published a research piece on 3 March 1995 reducing the four year forecast to a level thought to be more realistic having regard to the company's need for capital to meet the growth in the telecommunications business (tr. 202). Mr Shanahan agreed in cross-examination that at this time the market knew that: (a) the earned value methodology was being used; (b) the effect of the earned value methodology was to bring in revenue and profit as early as possible: (c) the Russian Contract and the Argentinean Contract were accounted for on that basis; (d) the R&D costs had been capitalised and become an asset; (e) a substantial asset of the company was the work in progress; and (f) the work in progress was substantially attributable to the Russian Contract (tr.210-211). 160 The defendant agreed that a qualification to the accounts would have an impact upon the success of the placement and expressed the view that any accounts that went with a qualification would have an adverse reaction in the marketplace (tr. 658). 161 I am not satisfied that I should reject the defendant's explanation of the basis upon which he decided that the note in relation to the going concern issue was "resolved". That was the view that he expressed on 16 March 1995 and it was the view repeated in evidence nearly nine years later. The defendant was cross examined for five days and only part of the testing nature of that cross-examination can be gleaned from the transcript. The relevant events occurred between eight and ten years prior to the cross-examination. 162 The plaintiffs' theory upon which the submission that the defendant buckled under pressure is based is flawed. If the pressure was the announcement, then there would have to be something more, after the announcement, that applied the pressure to the defendant to render him supine, particularly having regard to the fact that he drafted the letters after the announcement, and particularly when he maintained his position at the meeting of 13 March 1995 that a note would be necessary. The direct causal connection to the defendant deciding the issue was "resolved" was the bank's unconditional waiver. The defendant clearly did not expect such an unconditional waiver. The hope was that the bank would still "support" the Company but the expectation was that, if it did, it was probable that it would reserve its rights in relation to the breach of the covenants. I accept the defendant's evidence as truthful and I reject the plaintiffs' submission to the contrary. 163 The defendants submitted that any reasonable reader of the Accounts would see quite clearly that the Company was reliant upon the bank for its continued operations. In this regard emphasis was placed upon: the negative net cash flows from operating activities of $6.9 million; negative net cash flows from investing activities of $14 million; the net decrease in the cash held of $10.5 million; the proceeds from borrowings of $10.790; the bank overdraft of $11.03 million; and the bank loan of $24.45 million (Ex F: 1323: 1331-1332). Emphasis was also placed upon the portions of the Prospectus in which the reader was informed that one of the primary uses of the funds raised would be "to repay bank facilities". 164 The defendants also submitted that the fallacy of the plaintiffs' case in respect of the going concern issue was exposed in part through the following cross-examination of Mr Shanahan: Q. Even on your adjustments, accepting them, each of them, the net assets were $63 million? A. Yes. Q. Substantial net assets? A. Yes. Q. It was a company that, on all accounts, was expanding rapidly? A. Yes. Q. It was a company that, on all accounts, had large contracts on foot to be performed? A. Yes. Q. Its order book was pretty healthy? A. Yes. Q. And its prospects of contracts were pretty healthy? A. Yes. Q. It was a company that was about to raise $35 million in the capital markets, underwritten by well-known stockbrokers? A. Yes. Q. It was a company that had successfully raised many millions of dollars in the past in the capital markets? A. Yes. Q. And was it a company whose bank had expressed support in extending its facilities and waiving the breaches of covenant? A. Yes. Q. It was right that the auditor, in these circumstances, should conclude that the company was a going concern? A. Yes. (tr. 353-354) 165 If it were otherwise extant, which I am satisfied it is not, this evidence would put an end to the plaintiffs' case on this aspect of the matter. I am not satisfied that the conduct of the defendants in not requiring a note to the accounts or a qualification to their opinion to be included in the Prospectus in respect of the going concern issue was negligent or in breach of their retainer. This aspect of the plaintiffs' case fails. The Russian Contract 166 This aspect of the plaintiff's claim against the defendants is contained in Item 13, which for ease of reference is repeated hereunder: The total revenue recognised in the financial statements for the Russian Contract was $12.8m, with profit of $6.4m, although the accounting standards for earned value revenue/profit recognition had not been met, in that, amongst other matters the Russian Contract was not a construction contract. In particular, there could be no assurance that the revenue would actually be received as its right to receive cash depended on Techin Trade selling the terminals to third parties. Further, and in any event, full revenue and profit had been recognised on partially completed projects, which is in itself inconsistent with earned value methodology. 167 Mr Shanahan's suggested qualifications to the opinion included in the Prospectus on the Russian contract were firstly outlined in Exhibit B and then amended in Exhibit C. Exhibit B contained the following suggested qualification: 1. Overstatement of revenue and profit The Company has recognised revenue for the half-year ended 31 December 1994 of $12.8 million on an agreement for sale of cellswitches, network systems and terminals known as the "Russia Contract". Profit of $6.4 million has been recognised in the half-year ended 31 December 1994. The "Russia Contract" was signed on 11 November 1994. The Summary of Significant Accounting Policies attached as Note 1 to the Accounts states that: "Sales revenue on long-term contracts has been brought to account based on the percentage of completion". This implies that the "Russia Contract" is a long-term construction contract being brought to account under AASB 1009: Accounting for Construction Contracts . In our opinion, the "Russia Contract" is not a construction contract and neither revenue nor profit under that contract can be recognised on a percentage of completion basis. Nor is it a long-term contract. The contract was entered into in November 1994 and the confirmed supply timetable under the contract extended only to 31 March 1995. In our opinion, the "Russia Contract" is similar to other contracts of this type entered into by the Company and is properly described as a contract for the supply of discrete items, cell switches and terminals, which are manufactured to specifications. In our opinion, the timing of recognition of profits on supply contracts should be based on delivery. On this basis, revenue recognised under the "Russia Contract" for the half-year ended 31 December 1994 should have been $1.2 million with a profit contribution of $0.4 million. In our opinion, the Company has overstated revenue by $11.6 million and profit by $6.0 million for the half-year ended 31 December 1994. 168 Exhibit C amended that suggested qualification which then became: 1. Overstatement of revenue and profit The Company has recognised revenue for the half-year and 31 December 1994 of $12.8 million on an agreement for sale of cellswitches, network systems and terminals known as the "Russia Contract". Profit of $6.4 million has been recognised in the half-year ended 31 December 1994. The "Russia Contract" was signed on 11 November 1994. The Summary of Significant Accounting Policies attached as Note 1 to the Accounts states that: "Sales revenue on long-term contracts has been brought to account based on the percentage of completion". This implies that the "Russia Contract" is a long-term construction contract being brought to account under AASB 1009: Accounting for Construction Contracts . Under AASB 1009, the "Russia Contract" is classified as a fixed price contract. Under AASB 1009, a condition for profit recognition on a fixed price contract is that total contract revenues to be received can be reliably estimated. Forecast receipts under the "Russia Contract" are $33.9 million. The receipts of these monies is dependent upon the ability of the network operator, in whom the counterparty in the "Russia Contract" has a majority interest, to generate revenues principally from the sale of terminals supplied by the Company. We have been unable to independently assess the network operator's ability to generate revenues within the timeframes assumed. As at 16 March 1995 no monies had been received under the "Russia Contract" and the Company is experiencing delays in receiving monies from Russia. In our opinion, the Company is unable to reliably estimate the total contract revenues to be received. On this basis, no revenue should have been recognised under the "Russia Contract" for the half-year ended 31 December 1994. In our opinion, the Company has overstated revenue by $12.8 million and profit by $6.4 million for the half-year ended 31 December 1994. 169 Mr Shanahan made a further suggested qualification in respect of the Russian Contract as follows: 2. Failure to adequately disclose accounting policy AASB 1001: Accounting Policies-Disclosure requires that the summary of accounting policies shall describe all material accounting policies which have been applied in the preparation and presentation of the accounts or group accounts. The Company has assessed revenue and profit under the "Russia Contract" using an earned value methodology which does not reflect any of the methods of determining percentage of completion under AASB 1009. The effect of the Company's policy is that a large proportion of a contract's revenue and profit may be recognised prior to the actual manufacture, assembly or installation of equipment, with the effect that revenue recognition does not appear commensurate with the level of physical work performed or the ability to claim from a customer. In our opinion, the Company's summary of accounting policies does not describe adequately this material accounting policy. 170 The plaintiffs' contention is that the Russian Contract was not a "construction contract" for the purposes of AASB 1009 (referred to in the relevant year as ASRB 1009) and revenues and profits flowing from it could not, and should not, have been brought to account under the "percentage of completion method" referred to in that Standard. It is contended that no reasonably competent auditor could have concluded that the Russian Contract was a construction contract and thus no reasonably competent auditor could, or should, have consented to the inclusion of an unqualified audit opinion in the Prospectus where profit on the Russian Contract had been brought to account using the percentage of completion method. AASB 1009 171 AASB 1009, as at 1995, provided relevantly (Ex F: 2695): Application .02 This approved accounting standard applies to - (a) the accounting by a contractor for all construction contracts. … Statement of purpose .03 The purpose of this accounting standard is to require in respect of construction contracts in progress - (a) profits to be progressively brought to account; (b) losses to be brought to account as soon as they are foreseeable; and (c) the disclosure of material information; so that users entitled to rely on the accounts or group accounts are able to assess the financial effects of those contracts on the company or group of companies. Definitions .06 In this approved accounting standard unless the contrary intention appears - … construction contract means a contract relating to construction work and includes - (a) contracts to design, build, construct or produce; (b) construction management contracts; and (c) contracts for architectural, engineering and other services relating to the construction work. construction management contract means a contract relating to the supervision and coordination of the construction activity on a project, including the negotiation of contracts with others for the construction work; contractor means, in relation to a construction contract, a company that enters into a contract to build structures, construct facilities, produce goods, or render services to the specifications of a buyer either as a general or prime contractor, as a subcontractor to a general contractor, or as a construction manager; fixed Price Contract means a construction contract where the contractor agrees to a fixed total contract price or to a fixed charge per unit of work, whether or not such contract includes a rise and fall clause; … percentage of completion method means the method of profit recognition whereby profit is brought to account in proportion to work performed on a construction contract for each financial year in which construction occurs. Fixed price contracts .10 The amount of profit on fixed price contracts shall be brought to account in accordance with the percentage of completion method when all of the following conditions are satisfied - (a) total contract revenues to be received can be reliably estimated; (b) the costs to complete the contract can be reliably estimated; (c) the stage of contract completion can be reliably determined; and (d) the costs attributable to the contract to date can be clearly identified and can be compared with prior estimates. Conditions not satisfied .12 If the conditions specified in clause .10 or clause .11, whichever is appropriate to the form of contract used, are not satisfied, either at the inception of a construction contract or during the course of contract, no profit shall be brought to account until they are so satisfied. Provision for foreseeable losses .20 A material loss on a construction contract, whether in relation to work completed or yet to be completed, shall be brought to account as soon as it is foreseeable. 172 The Commentary included in the Standard as "Endorsed explanatory material" was in italics and did "not form part of the approved standard" and was published with the Standard as "an aid to its interpretation" (clause .01). The Commentary included the following: Approach of ASRB 1009 (i) The percentage of completion method provides a measure of periodic accomplishment. Application of the percentage of completion method involves estimates, particularly in respect of revenue and costs. This accounting standard requires that periodic profit on a construction contract is to be determined on the percentage of completion basis and brought to account when progress on the construction contract permits the outcome of a contract to be reliably estimated. This may occur in some circumstances only on completion of the contract. Measurement of the percentage of completion (ii) The percentage of completion method can be measured in three ways - (a) physical estimates or surveys of the work performed to date; (b) the cost basis - this method involves calculating the proportion that costs incurred to date bear to the estimated total costs of the contract; and (c) the billings basis – this method involves calculating the proportion that billings to date bear to the total estimated billings for the contract and should only be applied when it provides a reliable measure of work performed. (iii) When the percentage of contract completion is measured using the cost basis, adjustments are to be made to include only those costs that reflect work performed. Examples of items which may need adjustment are - (a) materials purchased that have not been installed or used in the contract performance; (b) payments to subcontractors to the extent that they do not reflect the amount of work performed under subcontracts; and (c) penalties incurred by the contractor. Provision for foreseeable losses (vi) When current estimates of total contract costs and revenues for any contract indicate that a material loss is probable, the loss is to be brought to account regardless of the amount of work performed on the contract. Disclosure of accounting policies (xviii) As is required under ASRB 1001 "Accounting Policies-Disclosure" the summary of accounting policies included in the accounts or group accounts will provide details of all policies which have been significant in the preparation and presentation of the accounts and group accounts. The summary will therefore include all material details of the basis used to bring to account profit on construction contracts. This could include, for example details of the minimum percentage of completion at which profits are initially brought to account in respect of contracts for various kinds of construction work. Examples of construction contracts (xix) Examples of construction contracts include, but are not limited to, contracts for general building, heavy earth moving, dredging, demolition, dams, pipelines, tunnels, ships and transport vessels. Was the Russian Contract a "construction contract "? 173 The primary question is whether the Russian Contract was a "construction contract" within the meaning of that term in AASB 1009. The Recitals to the Contract provided as follows: A. The Purchaser intends to operate a high capacity international, inter-regional, and local wireless telephone network for Digital/Analogue Mobile Phone Systems in certain territories of the Russian Federation. B. The Purchaser wishes to purchase certain equipment and services from Stanilite on an ongoing basis for the purposes of establishing and maintaining the Network. C. Stanilite has agreed to provide a rapid roll out of Products and Services to allow the Purchaser to satisfy the initial requirements for the establishment of the Network (Stage 1) and future stages will be the subject of subsequent Purchase Orders placed with Stanilite by the Purchaser and accepted by Stanilite. D. The Purchaser and Stanilite have agreed that Stanilite will supply those Products and Services to the Purchaser on the terms and conditions of this Agreement. E. The Purchaser has agreed to purchase the quantity and type of Products set out in Attachment 2 with subsequent (Stages 2 and 3) quantities and types to be provided under separate purchase orders. F. The Purchaser has agreed to purchase further Equipments and Services from Stanilite to provide further growth for the Network. G It is acknowledged that the timetable for Stage 1 of the project is subject to the availability and sale of User Terminals of such types and quantities as are necessary to allow for the progressive and prompt payment of the monies payable to Stanilite by the Purchaser. (Ex F: 534) 174 By clause 2.1, the Purchaser appointed Electronics (referred to in the contract as Stanilite) as the purchaser's preferred supplier of products required for the project. "Products" were defined in clause 1.1 as the "Equipment, Software and spare parts for Equipment". "Equipment" was defined as the equipment listed in Attachment 1 and as further identified in Attachment 2. Attachment 1 identified the equipment as cellswitch systems, microwave links, billing system hardware and user terminals. 175 The "services" that Electronics agreed to supply were defined in clause 1.1 as "all services provided by Stanilite under this agreement including but not limited to installation and training". Clause 3.1 provided that Electronics was to install the products in accordance with Attachment 7. Attachment 7 referred back to Attachment 1. Paragraph 3(a) of Attachment 1 provided that the services to be carried out by the purchaser's nominated sub-contractor included the provision of modifications to the existing switching system, the provision of modifications to the existing equipment, the provision of in-country support, the provision of site preparation works, including foundations and fixings, the provision of building works, supporting structures and power supply points, the provision of transport and the provision of site labour for installation and set to work. 176 "Set to work" was defined in clause 1.1 as "the act of integrating the equipment with the Network, testing and energising the equipment supplied under this Contract and demonstrating its capability against agreed functionality as described in Attachment 6". Attachment 6 provided that Electronics was to, amongst other things, "cause the installation and Set to Work (Commissioning) of the Products in accordance with good workmanlike procedures". 177 The terms of the services sub-contract contemplated by paragraph 3(a) of Attachment 1 were set out in Attachment 12. The purchaser had nominated one of its subsidiaries, Techin Trade Investments LDC (Techin LDC) as the sub-contractor. Under that sub-contract, Techin LDC, as Electronics' sub-contractor, was to provide support and supplies for inclusion in the Network. "Network" was defined in clause 1.1 as "the network described in Recital A". The support, services and goods to be provided by Techin LDC, included the provision, installation and commissioning of certain products, and "building renovations and additional towers all as necessary for the effective operation of the network" (clause 4(i)(a) of Attachment 12). It also included the transport of goods and "the preparation of four sites in accordance with instructions and drawings provided by" Electronics, "including but not limited to preparation of foundations, provision of fixings and a local power supply point"(clause (4)(i)(c) of Attachment 12). It also included the provision of "all buildings, towers, renovations and the like as necessary for the effective operation of the Network" (clause 4(ii)(a) of Attachment 12) and the "provision of labour for installation and set to work, where such work will be undertaken under the instructions of" Electronics' "specialists" (clause 4(iii)(a) of Attachment 12). 178 The Contract contemplated the installation of Stage 1 equipment, the ancillary equipment and the microwave equipment between weeks 3 and 16. It was envisaged that personnel from Electronics would go to the site for the installation of the network and prepare the site, carry out the installation and undertake system testing to ensure completion by week 16. The defendant explained in evidence that the installation process included, amongst other things: (a) getting the network to work using the local power supply which involved dealing with issues such as the strength of the local power supply, and the reliability of that supply and variations in voltage (tr. 584); (b) arranging for the software that drives the cellswitch system to relate to and talk to the local telecommunications computer (tr. 584); and (c) the construction of antennae to receive signals from the mobile phones used by network subscribers, and possibly the construction of other antennae so that the network could relate to the local telecommunications system (tr. 586). 179 The subcontract referred to in Attachment 12 was between Electronics and the Purchaser's nominee. The building and construction work contemplated by the subcontract (the provision of Building Works, supporting structures etc) was work for which Electronics was responsible. The contest between the parties in respect of the nature of this contract was based on a false premise. Mr Shanahan thought that the sub contract was between the Purchaser and the Purchaser's nominee. He recognised this error in cross-examination and accepted that the sub-contract was obviously a construction contract (tr. 308). 180 Having established that the sub-contract is a construction contract the next question is whether the whole of the contract, including the provision of the products, should be appropriately characterised as a construction contract. To assist in deciding this issue it is helpful to ask whether the usefulness or effectiveness of the products supplied depended upon the completion of the building works. This was a contract for the establishment or construction of a communications network. The efficacy and capacity of that network depended upon the building works to be carried out to the design of the drawings provided by Electronics. Without the construction of the towers and antennae it appears the network was doomed to fail. 181 Mr Robertson, in reliance upon the view expressed in "Accounting for Long-Term Construction Contracts": KT Trotman (Ex 1), referred to contracts with a duration of less than a year but crossing financial reporting periods as having the capacity to be categorised as "construction contracts". Indeed Mr Shanahan's following evidence in cross-examination supported this view: Q. So when one speaks of long term contracts in connection with construction contracts one is speaking about contracts that span more than one accounting period? A. Generally, Mr Karkar, the further contracts extend beyond twelve months, if I started a contract on 28 June and finished on 2 July it would span two accounting periods but it would not be long term. Q. But if it were a construction contract strictly speaking you need to account for it separately in each accounting period, wouldn't you? A. Yes. Q. And I am grateful for your answer because your answer shows that the relevant factor in relation to construction contract and the application of the standard is that the contract spans more than one accounting period? A. Yes. (tr. 293) 182 Mr Robertson also mentioned, with detailed references, the international support for the proposition that contracts of duration shorter than 12 months qualify as "construction contracts". The Russian Contract had three Stages due for completion respectively in March 1994, September 1995 and March 1996. Although each stage was less than 12 months the evidence establishes that this does not preclude its qualification as a construction contract within the meaning of that term in the Standard. 183 I am satisfied that the nature of the contract was one in which Electronics was responsible for the building works and was also responsible for the design of the cellswitches and the design of the system whereby the network could be established or constructed. In addition the contract required Electronics to supervise and coordinate the construction activity on the project in the nature of a "construction management contract" within the meaning of that term in the Standard. It is also to be noted that the definition in the Standard includes contracts for "other services relating to construction work". Mr Robertson expressed an opinion, with which I agree, that the design and supply services provided by Electronics under the contract could fall into the category of a contract for "other services". 184 I am satisfied that the Russian Contract could reasonably be described as a "construction contract" within the meaning of that term in AASB 1009. Was the Earned Value basis appropriate? 185 The next issue to be determined is whether it was appropriate to utilise the earned value methodology or basis to recognise revenue and profit under the Russian Contract. The plaintiffs claimed that the bringing to account of revenue and profit was not in accordance with Accounting Standards and accordingly the defendant should have qualified his audit opinion, if the directors were not willing to redraw the accounts so as to remove these items. 186 The plaintiffs submitted that the importance of the recognition of revenue and profit under the Russian Contract appears from the profit and loss statement for the half-year ended 31 December 1994. The net operating profit before tax was $5.399 million. Without the profit of $6.4m brought to account from the Russian Contract, a loss of $1.001 million would have been recorded. 187 The defendants submitted that the evidence establishes that "earned value" basis or methodology is one of the ways in which company management may measure the percentage of completion of a construction contract (tr. 222, 323-325; 457). It was submitted that the three ways of measuring the percentage of completion referred to in the Commentary are not exclusive. Under the "earned value" basis of measuring the percentage of completion, revenue on the contract can be recognised before invoices are raised (tr. 457); and a substantial amount of revenue may legitimately be recognised as early as the date of the order being received and accepted for the supply of products and services, on the basis that the risks associated with the contract were taken in the design stage (tr. 457-458). It was submitted that in line with the evidence (tr. 925) the earned value basis fell within the physical estimate method referred to in paragraph (ii) (a) of the Commentary to the Standard. 188 The plaintiffs submitted that AASB 1009 should not be interpreted in isolation because, although it sets out the percentage of completion method, and the circumstances in which it can be used, it does not define "revenue". It was submitted that in order to obtain guidance as to the meaning of "revenue" within AASB 1009, one must have recourse to Statement of Accounting Concepts 4, "Definition and Recognition of the Elements of Financial Statements" (SAC 4) (Ex 1). The Introductory Note to SAC 4 included a "Summary of Concepts" that in turn included the definition of "Revenues" taken from paragraph 111 which provided: "Revenues" are inflows or other enhancements, or savings in outflows, or future economic benefits in the form of increases in assets or reductions in liabilities of the entity, other than those relating to contributions by owners, that result in an increase in equity during the reporting period. 189 A footnote to the definition provided: The definition has been structured so as to be applicable to a range of measurement models. Accordingly, in interpreting the definition in a given set of circumstances, it is important to have in mind the particular measurement model which would apply. Paragraphs 129 and 148 contain discussion of the impact of different measurement models on the definition and recognition of revenues. 190 Paragraph 129 dealt with the historical cost model and the exit price model. Paragraph 148 dealt with the concepts of capital and capital maintenance. The Introductory Note also included a paragraph entitled "Criteria for Recognition of Revenue" taken from paragraph 125 which provided: A revenue should be recognised in the operating statement, in the determination of the result for the reporting period, when and only when: (a) it is probable that the inflow or other enhancement or saving in outflows of future economic benefits has occurred; and (b) the inflow or other enhancement or saving in outflows of future economic benefits can be measured reliably. 191 Paragraphs 126 and 127 dealt with the "probable inflow or other enhancement or saving in outflows of future economic benefits" as follows: 126 For a revenue to qualify for recognition, it must be probable that the inflow or other enhancement or saving in outflows of future economic benefits has occurred. The term "probable" means that the chance of the inflow or other enhancement or saving in outflows of future economic benefits having occurred is more likely rather than less likely. 127 The probability of such inflows or other enhancements or savings in outflows of future economic benefits will vary. Assessments of the degree of certainty attaching to the inflows or other enhancements or savings in outflows of future economic benefits in any particular situation should be made on the basis of available evidence. For many entities, the majority of revenues will result from the provision of goods and services during the reporting period and the large majority of underlying transactions and other events will involve little or no uncertainty that an inflow or other enhancement or saving in outflows of future economic benefits has occurred, since the entity will have either have received cash or have an explicit claim against an external party. However, an absence of an exchange transaction will often raise doubts about whether the requisite degree of certainty has been attained. In situations where there is uncertainty about the inflow or other enhancement or saving in outflows of future economic benefits and the other criterion for the recognition of revenues is satisfied, revenues would qualify for recognition when the inflow or other enhancement or saving in outflows is probable. 192 Paragraph 130, "Transaction-based models for revenue recognition", provided that in such models it would not be possible to specify detailed tests to identify the appropriate point at which revenues from the provision of goods and services should be recognised. It continued: However, consideration of the following tests will be useful in many situations in identifying whether, for a transaction involving the provision of goods or services, it would be probable that an inflow of future economic benefits will have occurred and will be capable of being measured reliably: (a) an agreement for the provision of the goods or services exists between the entity and one or more parties external to the entity; (b) cash has been received, or the entity has a claim against an external party or parties that: (i) is for a specified consideration, in the form of cash, other assets, or a reduction in a liability of the entity; and (ii) cannot be avoided by the external party or parties without the incurrence of a penalty set sufficiently large as, in normal circumstances, to deter avoidance; (c) all acts of performance necessary to establish a valid claim against the external party or parties have been completed; and (d) it is possible to estimate reliably the collectability of debts or the return of the goods sold. 193 Paragraph 131 provided: Where all of these tests are met, the definition and recognition criteria for revenues will be satisfied, because it will be probable that an inflow of future economic benefits has occurred in respect of the entity's acts of performance and because the future economic benefits that have been, or will be, received can be measured reliably. However, there will be situations where the criteria for recognition of revenues will be considered to have been met even though one or more of the tests identified in paragraph 130 have not been satisfied. 194 As can be seen from these statements in SAC 4, there is no hard and fast rule, but merely guidance that is flexible to accommodate the circumstances of different situations. The last sentence of paragraph 131 makes it abundantly clear that the so-called "tests" need not be satisfied in some "situations" for there to be a recognition of revenue. However by reason of the definition of "revenues", it is necessary for there to have been an occurrence of an inflow and one that can be measured reliably. 195 The plaintiffs submitted that it was inappropriate to apply the earned value method because total contract revenues could not be reliably estimated as required in clause .10 (a) of AASB 1009. The defendants submitted that the Russian Contract was a fixed price contract that, from its terms, had a value of approximately US $28.5 million. The defendants submitted that the plaintiffs' approach is misconceived because it does not recognise the fundamental distinction between the calculation of total revenues to be received, on the one hand, and the timing and likelihood of cash receipts on the other. It was submitted by the defendants that the former is relevant to the application of the percentage of completion method and that the latter was not relevant to such application. It was submitted that the latter relates to the forecasting of cash flows and provisioning against work in progress. 196 Prior to the cross-examination of the defendant, none of the plaintiffs' witnesses had expressed an opinion that SAC 4 was relevant to the applicability or interpretation of AASB 1009. The defendants submitted that SAC 4 has no application to AASB 1009 and in support relied upon paragraph 4 of SAC 4 entitled "Nature and Purpose of Statements of Accounting Concepts" which provided: Consistent with the role of Statements of Accounting Concepts enunciated in Policy Statement 5, the primary purpose of this statement is as a guide to the AASB and PSASB in developing and reviewing Accounting Standards and other authoritative documents. In addition, this Statement may also provide guidance in analysing new or emerging issues in the absence of applicable Accounting Standards. 197 Reliance was also placed on paragraph 5 under the heading "Status of Statements of Accounting Concepts" which provided: The concepts in this Statement are not set out as requirements for the purpose of preparing general purpose financial reports. This is consistent with the purpose of Statements of Accounting Concepts set out in Policy Statement 5, and the non-mandatory status of Statements of Accounting Concepts under Professional Statement APS 1 "Conformity with Accounting Standards" and the Corporations Law. Policy Statement 5 also notes that some Statements of Accounting Concepts have been given legislative backing in respect of some reporting entities in the public and private sectors through requirements specified in legislation, ministerial directives or other government authority. The level of authority given to Statements of Accounting Concepts by governments and other authorities is a matter for those authorities to determine. 198 Paragraph 8 under the heading "Purpose of this Statement" was also relied upon. It provided: This Statement does not address in detail the measurement or display of the elements of financial statements or concepts of capital and profit. These issues will be the subject of separate Statements of Accounting Concepts. 199 Finally reference was also made to Policy Statement 5 (Ex 8), referred to in clauses 4 and 5 of SAC 4. It included the following: Purpose of Statements of Accounting Concepts 5. The primary purpose of Statements of Accounting Concepts is as a guide to the Boards when developing and reviewing Accounting Standards and other authoritative documents. For the AASB, this is consistent with its statutory obligation to develop a conceptual framework, not having the force of an Accounting Standard, for the purpose of evaluating proposed Accounting Standards. 6. Knowledge of the concepts the Boards use in developing Accounting Standards should assist preparers, auditors and other parties with an interest in Accounting Standards to understand better the general nature and purpose of information reported in general purpose financial reports. The concepts also may provide guidance in analysing new or emerging issues in the absence of applicable Accounting Standards. … 8. Statements of Accounting Concepts do not override or amend Accounting Standards. 9. Statements of Accounting Concepts do not have legal force for entities reporting under the Corporations Law. … 11. The status of Statements of Accounting Concepts with respect to members of the Institute of Chartered Accountants in Australia and the Australian Society of Certified Practising Accountants is identified in Miscellaneous Professional Statement APS 1 "Conformity with Accounting Standards". Paragraph 21 of APS 1 (December 1993) includes a statement that "By themselves, Statements of Accounting Concepts are not mandatory in the preparation, presentation or audit of a general purpose financial report. 200 The defendant gave the following evidence as to the approach to be adopted when bringing revenue to account for construction contracts: The prime document to which we have regard is the 1009 and that standard specifically deals with the recognition of revenues and assets in construction contracts. SAC 4 is an underlying general standard but the specific standard relating to this is 1009 and the extent to which you would make a reference to SAC would be very minimal. You would read the standard, which is 1009. SAC 4 is there to give guidance, I believe, in areas where the accounting standards are not specific. (tr. 516) 201 Mr Robertson referred to an hierarchy of accounting literature at the top of which there are UIG, urgent issues group abstracts that represent considered opinions on particular sensitive topics. Below that are the Accounting Standards and further down are the Statements of Accounting Concepts that are used to help establish the framework in which Accounting Standards have been framed (tr. 926). Mr Robertson analysed the percentage of completion method and the manner in which the stage of completion is determined in his report dated 10 April 2003. His analysis included the following: 6.1.14 However, it is noted that "most business entities engaged in contracting can deal adequately with the normal, recurring business risks in estimating the outcomes of contracts." (AICPA, "Statement of position", quoted in "Construction Accounting and Financial Management", Fourth Edition, WE Coombs & WJ Palmer, p. 271). Furthermore, "it would seem to be a rare situation in which a company's overall estimating ability cannot be reasonably depended upon or in which all contracts face inherent hazards to such a degree that the percentage of completion method would not be preferable as an overall policy". (Coombs and Palmer, ibid, p.272) … 6.1.20 … certain activities or costs may be unrelated to the risk and returns on the contract and estimating the degree of completion should take this into account. Consistent with this, Stanilite would appear to be a contractor of the type described by Coombs and Palmer when they note that many contactors "believe that their profits are earned from the efforts expended rather than from the intrinsic value of materials, subcontractors, and other costs incurred on the project". (Coombs and Palmer, ibid. at p. 271) 202 The evidence establishes that one type of cellswitch has an individual price of US$237,000 and another type of US$153,595. The information available in March and May 1995 was that two units had been installed in Russia and invoiced, five units were in Istanbul and 10 units were in Perth. Three of the units in Perth were 20% complete, three were 60% complete, one was 90% complete and three were 100% complete. It can be seen from this evidence that there were "milestones" that could be recognised and that much of the expenditure under the contract in the design, manufacture, transportation and siting the units had been incurred. 203 The defendant acknowledged that a particular instance where SAC 4 might have a role in accounting for construction contracts is where, in the case of recognising revenue, there is doubt as to whether the inflow or benefit had occurred (tr. 517), or there is doubt as to whether the revenues could be reliably estimated (tr. 517). The defendant also agreed that in order to recognise revenue under the terms of AASB 1009, one must first be satisfied that the revenue exists – and guidance in that respect may be obtained from SAC 4, which guidance included the statement that revenue only existed where it is probable that the benefit or inflow has occurred (tr. 510). However, it was submitted that when the defendant was given the opportunity to consider the matter further he indicated that this answer was not accurate, and in fact it was not necessary to have regard to SAC 4 when considering whether to recognise revenue under AASB 1009 (tr. 692; 694). 204 The defendants also submitted that what emerges from the evidence of the defendant and Mr Robertson is that: (a) it is dangerous to seek to apply the guidelines in SAC 4 when considering whether to bring revenue to account under AASB 1009 (tr. 671); and (b) in order to recognise revenues under the earned value method of accounting, one does not have any real regard to SAC 4, and in particular one does not need to be satisfied on the balance of probabilities that the revenues in question will actually be received (tr. 691). Such a test is not relevant, and one must be guided by AASB 1009 (tr. 691; 694). 205 In those circumstances, it was submitted that SAC 4 can confidently be put to one side in considering the question which arises under AASB 1009 as to whether total revenues to be received under a construction contract can be reliably estimated. 206 The plaintiffs submitted that not only was the relationship between SAC 4 and AASB 1009 crucial but also the defendant accepted that SAC 4 was a "persuasive, useful and informative document for the definition and recognition of the elements of financial statements" (tr. 506). The plaintiffs also submitted that although the defendant pointed out that the accounting standards had the ability to override the areas of general principles, it could not be reasonably suggested that there was any inconsistency between SAC 4 and AASB 1009 so as to give primacy to the Standard over SAC 4. 207 The plaintiffs submitted that if revenue which had not been received and which may only be received "on a wing and a prayer" is brought to account as revenue in the profit and loss statement, such could hardly be described as giving a true and fair view of the company's financial position. I am not satisfied that such a description is apt to the circumstances of this case in which 10 cellswitches had been completed, 2 of which had been delivered and invoiced, and of the balance, 1 was 90% complete, 3 were 60% complete and 3 were 20% complete, with EFIC insurance in place and at least some security available. 208 It was submitted that SAC 4 imposes a qualitative standard on the recognition of revenue designed to prevent the "counting of chickens before they are hatched" and certainly before "the hens have even started to nest". Nesting hens and chickens are not analogous unless there is a standard for counting chickens, as there is with profits under AASB 1009, when the time of their hatching can be reliably estimated. These barnyard descriptions adopted by the plaintiffs are not very helpful in interpreting with precision the Accounting Standard and the Statement of Accounting Principles as they apply to the particular circumstances of this case. 209 As the defendant submitted, the accounting concepts within AASB 1009 are expressed as "profit" and "loss". These terms are used in clause .03 referring to the purpose of bringing "profits" to account progressively and bringing to account "losses" as soon as they are foreseeable. In clause .06 the definition of "percentage of completion method" refers to the method of "profit" recognition whereby "profit" is brought to account. In clause .10 referring to fixed price contracts, "profit" is brought to account when certain conditions are satisfied. Those conditions include when "total contract revenues to be received can be reliably estimated" and "the costs to complete the contract can be reliably estimated". Clause .12 once again refers to "profit" not being able to be brought to account unless the conditions of clause .10 are satisfied. Finally clause .20 refers to a "material loss" being brought to account as soon as foreseeable. 210 The defendant submitted that AASB 1009 is concerned with bringing "profit" and "loss" on a construction contract to account and that they are the accounting concepts that are the subject of the Standard. It was further submitted that the reference to "contract revenues" is not a reference to "revenue" as an accounting concept under SAC 4 but to the amounts of money to be earned under the specific fixed price contract. The defendant emphasised that clause .10 of the Standard does not require total contract revenues to be received to be "reliably collected" or "recovered" or "paid". Rather it requires revenues to be received to be capable of reliable estimation and thus, an approximate calculation. In this regard the defendant relied upon the following evidence of Mr Robertson, in paragraph 5.1.25 of his report dated 28 November 2003: However, the Standard does go on to provide that, where the Standard applies, foreseeable losses on contracts should be recognised immediately. If there arose issues regarding the collectability of revenues previously recognised which gave rise to sufficient doubt as to the ultimate recovery of that revenue (as distinct from doubts as to the timing of the expected receipt of that revenue), then this may result in default to the recovery of costs only, or the recognition of a probable loss. However this is a completely separate issue to whether revenues can be reliably estimated, for the purpose of considering whether the Standard applies at all. In the above case, the Standard would still apply to the contract so that when/if the probability of ultimate recovery was restored, the contractor would revert to progressive profit recognition. 211 The plaintiffs relied heavily upon the terms of paragraph 130 of SAC 4 and in particular the conditions set out in the publication "Accounting for Long-Term Construction Contracts": KT Trotman (Ex 1) as follows: (a) There is a written contract executed by the parties which clearly specifies the goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement. (b) The buyer has the ability to satisfy his obligations under the contract. (c) The seller has the ability to perform his contractual obligations. (d) The seller has an adequate estimating process and the ability to estimate reliably both the cost to complete and the percentage of contract performance completed. (e) The seller has a cost accounting system which adequately accumulates and allocates costs to final cost objectives in a manner consistent with the estimates produced by the estimating process. 212 The defendant gave evidence that he was of the view that all of those conditions were satisfied in respect of the Russian Contract. The plaintiff submitted that the defendant's evidence in this regard was not credible when one reviews the contents of his letters of 7 December 1994 and 13 March 1995 referred to earlier in this judgment. The letter of 7 December 1994 included a statement that PW had been unable to independently assess Techinfo's ability to generate revenues within the timeframes assumed. PW then expressed the view of inability to determine whether the assumptions in respect of the receipts provided a reasonable basis for the cash flow forecast that was under discussion with the bank. 213 In his first report dated 6 March 2002, Mr Shanahan referred to the defendant's letter of 7 December 1994 and concluded that its terms cast doubt upon whether the total contract revenues to be received could be reliably estimated. The defendant submitted that the purpose of the 7 December 1994 letter was to review the Group's forecast of timing of cash receipts and payments over a particular period and had no part to play in estimating "total contract revenues" within the meaning of that term in AASB 1009. Emphasis was placed upon the words in the letter "within the timeframes assumed" and "receipts" and it was submitted that those words made it abundantly clear that the qualification in the letter related only to the timing of the receipts and not to estimated revenues under the Russian Contract. The defendant's evidence in paragraph 158 of his statement of 6 March 2003 included the following: I did not consider that the facts giving rise to the qualification in any way cast doubt upon whether the total contract revenues on the Russia Contract could be reliably estimated for the purpose of our subsequent audit assessment of Stanilite's December 1994 accounts. 214 The defendant was cross-examined in relation to his letter of 7 December 1994 and gave the following evidence: Q. May I put to you that what you were recognising in that paragraph was that unless moneys were to be received by the network operator from the sale of terminals to be supplied by Stanilite then no moneys would be available to be paid to Stanilite? A. No. I believe you have to read the qualification as a whole and include the second paragraph. Q. Over the page? A. Where we are concerned and the reservation, qualification if you so like, relates to the ability to generate the revenues within the timeframes which would enable them to pay the money to Stanilite in accordance with the forecast periods. Q. Is it your suggestion that the entirety of this information is only related to timing of revenues and not to the possibility that revenues would be received? A. There is a report on cash, this is a report on cash receipts and most information relates solely to the timing of those receipts. Q. May we then take it from that answer which you have just given us that you had satisfied yourself that ultimately moneys would be received under the contract sufficient to pay Stanilite the amount of $28.9 million but that you were unable to form a view as to the timing of those receipts? A. I was certainly unable to form a view on the timing of the receipts as they had been contained in the forecast, yes. Q. But you had satisfied yourself, may we take it, that Tech Info, the network operator, would be able to generate revenues over time from the sale of terminals to be supplied by Stanilite which would be sufficient to ultimately at some stage pay out the amount of $28.9 million? A. I had no reason to believe that the 28.9 wouldn't come from Techin ultimately. (tr. 569-570) Q. So, you are saying your understanding in December of 1994 was that even if revenues were not received by Techinfo, the network operator, the purchaser had an obligation to make payments? A. That was my understanding of the contract, that there was still an obligation on Techin to pay the 28 million. Q. Could I suggest to you if you go back to page 740 in volume 3 the first paragraph of your qualification, the second sentence, if I could read it to you again: "As indicated in forecast assumption 11(ii) on schedule 2, the receipt of these moneys is dependent on the ability of the network operator, Techinfo, in which Techin Trade Ltd has a majority interest, to generate revenues principally from the sale of terminals to be supplied by Stanilite". I want to suggest to you the answer which you have just given is inconsistent with what you have set out in that qualification on that page? A. I disagree. I am talking about the forecast receipts and the receipt of the money within the forecast is dependant upon the assumption being met and that assumption was at that time that the company Techin would make the payments in accordance with the attachment to the contract. But it doesn't say and nor was, or if you are inferring it says, it was certainly never meant to infer, that the contract collection of the cash was dependant ultimately on only receiving money from Techinfo, from the network, operating the network. (tr. 572) Q. In the event that revenues or, sorry, the payments were not made under the contract what was your understanding in December 1994 through until March 1995 as to how the guarantees referred to in clause 7.7 could be enforced? A. I think, your Honour, through to March 1995 I had no contemplation that the revenues would never be received, so I cannot say in what order I placed emphasis on the ability of the company to receive the money or the ability of Techin to pay the money. Q. Could I suggest to you that that answer is inconsistent with the qualification which appears in your report of 7 December at page 740? A. The qualification, your Honour, in that report relates to the timing of the receipts of the cash in accordance with the schedule which was produced by Stanilite which gave a month by month breakdown of cash receipts. My qualification was in relation to the timing of those receipts and not being able to say whether they were, for example, in the right month or the right quantum at that time. That's what the qualification addressed. It didn't address, in my view, any likelihood the receipts would not be received at all or there may be difficulty in receiving those receipts. It was related to the timing and only the timing of those receipts. (tr. 575-576) 215 Mr Shanahan dealt with this matter further in his statement dated 23 September 2003. After expressing the opinion that the Russian Contract was a fixed price contract with a value of $US28,514,638 and referring to paragraph .10 of the Standard, he went on to state: 131 However, the first condition is that total contract revenues to be received can be reliably estimated. While it is clear that the quantum of maximum total revenue under the contract is clearly established, in my opinion, whether the amount of those revenues that will be received can be reliably estimated is a much more difficult question. 216 The defendants submitted once again that AASB 1009 is concerned only with the total contract revenues to be received under the contract not with specific cash receipts under the contract. In this regard it was submitted that once Mr Shanahan gave evidence that it was clear that the quantum of the maximum total revenue under the contract was clearly established, paragraph (a) of clause .10 was satisfied. However Mr Shanahan advanced the following argument during cross-examination: Q. Let me ask you this. If her honour were to hold that the word "estimated" in subparagraph (a) meant calculated approximately, then you would agree that the total contract revenues to be received could be reliably calculated approximately? A. No, Mr Karkar. Q. Why is that? A. The contract has a fixed price. The contract value is set. The receipt of revenue under the contract, it is dependent upon performance, production, delivery, installation, set to work performance, and then it is further dependent upon sales or terminals, collection of the money by Techin Trade subtracting this cost and then the amount being paid under the contract to Stanilite and it seemed to me there ought to be some hurdles in there before receipt could be estimated. (tr. 321) 217 With these "hurdles" put in the defendant's way, Mr Karkar QC then took the defendants' case over them in the following manner: Q. You would agree that every contract entered into between two corporations would depend, first of all, upon performance by the contracting parties? A. Indeed. Q. And contracting parties may or may not perform? A. Indeed. Q. You say that the issue of whether a party may or may not perform a contract impinges upon the meaning or the application of the condition "total contract revenues to be received can be reliably estimated"? A. Yes, and particularly so in the context of this contract. Q. So that you do not assume, when a contract is entered into, that the parties are going to perform the contract? A. Mr Karkar, no, I don't think you assume you are going to perform. You proceed on the assumption they will. Q. In approaching this contract you would proceed upon the assumption that each party would perform its part of the contract? A. Yes. Q. And that is to say that Stanilite will produce the goods, install them and test them and set them to work? A. Yes. Q. And that Techin would pay in accordance with the contract terms? A. Yes. Q. Her honour should understand from what you said that that is a reasonable assumption for a reasonably competent auditor to adopt when looking at a construction contract, namely, that the parties should be assumed to perform their contract? A. You would assume that the counter party would not have entered into the contract unless they had thought there would be performance on both sides. Q. You would agree that in any commercial contract entered into between parties there is always a credit risk? A. Indeed. Q. You are not suggesting that because in each contract there is a credit risk, the amount of revenues to be received under the contract could not be reliably estimated? A. No. (tr. 321-322) 218 A further attack was made on the defendant in respect of his evidence that he regarded clause .10(a) as having been satisfied. That attack was based upon the terms of Attachment 9 to the Russian Contract in support of the submission that Techin was only obliged to pay if it was able to generate revenue from subscribers to the network. The defendant's evidence was that he understood that Techin's obligation to pay was absolute and that paragraph 2 of Attachment 9 did not relieve it of its obligation to pay (tr.569). Attachment 9 to the Contract provided as follows: PAYMENT PROCEDURES 1. Stanilite will prepare and deliver invoices which shall be due for payment 28 days after the date of their delivery to the Purchaser for: (a) Equipment delivered, at the time of delivery to Novorossiinsjk. (b) Software delivered, at the time of delivery to Novorossiinsjk (c) Services delivered, at the time of Acceptance for each site. 2. The Purchaser shall use its best endeavours to satisfy the invoices by progressive payments to be made to Stanilite generally in accordance with the "Revenue in" predictions shown in the Financial Model included in Attachment 11 and on the basis of: (i) 70% of the audited receipts of monies from the Users by the Operating Company(ies) for the sales of the User Terminals supplied under this Agreement, plus; (ii) 70% of all audited receipts from Users for connection fees, rental fees, and call and/or usage charges made by itself and the Operating Company(ies) or other associated Companies, plus; (iii) A percentage of all call and/or usage charges including transit charges associated with the operation and use of the Earth Stations associated with the Techinfo Network. Such percentage shall be adjusted from time to time in the event that other payments fail to achieve a rate of payment to achieve payment in full by the due date. (iv) 10% of nett profit of the Purchaser accumulated over the period of the Financial Model (expected to be US $600,000) payable at the 31 August 1995. The purchaser shall provide a certified financial statement prepared by its US Auditors to support the amount paid. Stanilite will not share in any losses whatsoever made by the Purchaser. 3. Progressive payments shall be by telegraphic transfer, in US Dollars, on the basis of weekly receipts in the case of item (i), monthly receipts in the cases of items (ii) and (iii) and at 31 August 1995 for item (iv) above. All payments shall be made not exceeding 2 days in arrears. The purchaser shall report Sales of User Terminals and Connections to the Network on a weekly basis and allow full access to Sales and Billing records along with the billing and registration data on the Cellswitch Network to allow monitoring of performance. 4. Should payments not be received by Stanilite at an acceptable rate (as set out in the Financial Model as at Attachment 11) or by the Due Date, then Stanilite may suspend or cancel subsequent deliveries in accordance with Clause 7, and reserves the right to decommission (remove from service) any and all equipment supplied under this Agreement for which payment has not been received. (Ex F: 586) 219 The defendants submitted that paragraph 2 of Attachment 9 did not limit Techin's obligation to pay to circumstances where revenues were generated from subscribers. It was submitted that an agreement to that effect would have been quite uncommercial and not what the parties would have intended. It was submitted that the contract operated to provide an additional means of securing performance of Techin's payment obligations under the contract by providing that a proportion (70%) of the identified fund (collected subscriber revenue) must be used to satisfy those invoices. 220 Paragraphs 3 and 4 of Attachment 9 are also relevant and seem to me to be in support of the submission that the purchaser's obligation was not limited to the condition of receipt of payments. Paragraph 4 makes clear the obligation to pay by the "Due Date" otherwise suspension or cancellation of deliveries may occur. In this regard the defendants relied upon what Lord Wilberforce said in Swiss Bank Corporation v Lloyds Bank Ltd and Ors [1982] AC 584 at 613: Condition (vii) is perhaps capable of two meanings. It might create an obligation to apply the loan portfolio to repayment of the loan and for no other purpose. Or it might create an obligation to repay the loan only out of the loan portfolio and not from any other fund unless authorised. Which of these it is to bear must depend upon the nature of the document in which the condition appears. In a commercial contract, between lender and borrower, the first meaning would be appropriate, possibly the more appropriate of the two. 221 As I have said, paragraphs 3 and 4 support the construction that Techin was obliged to pay the $28 million, in any event. It was submitted by the defendants that whatever may be the construction of the contract as to the payment, the issue does not go to the reliable estimation of total contract revenues under the Russian Contract, but to the receipt of payment under the contract. 222 The plaintiffs also relied upon the special undertaking provided to the bank in January 1995 as a basis for claiming that total contract revenues could not be reliably estimated. As recorded earlier in this judgment, the special undertaking in question was in the following terms: That with regard to the Russian contract, the company will, from this day forward, restrict expenditure in relation to that contract to not exceed total actual receipts of revenue from that same contract. This condition is to continue until the equity moneys are received when we would consider a review of the arrangement in the light of circumstances then existing. 223 The plaintiffs put to the defendant in cross-examination that the position as from 12 January 1995 was that little had been received under the Russian Contract and that unless and until moneys were received, the company could not continue to expend money on the Russian Contract and therefore could not anticipate making further money on the contract. The defendant gave evidence that his understanding of the special undertaking was that it only prohibited the incurring of further expenditure and that it did not prevent the company from paying expenses that it had incurred prior to 12 January 1995. It was also the defendant's understanding that the company had already incurred the majority of its expenditure on the Russian Contract by this time. The defendants submitted that this evidence was consistent with Pacific's response to the bank of 13 January 1995 in which it advised that "should revenue not flow as expected and required under the Russian contract, no further commitments will be made and equipment is recoverable with EFIC cover underwriting any losses" (Ex F: 810). 224 It was submitted that to construe the term "expenditure" in the bank's letter of 12 January 1995 as preventing the company from making payments under existing contractual obligations would have amounted to an unlawful interference with contractual relations, a result unlikely to have been intended by the bank. The defendant's evidence was that the bank was prepared for the plaintiff to continue to do extra work on the contract and that extra work was done. In this regard reliance was placed upon the Minutes of the meeting of the Due Diligence Committee on 6 March 1995 at which Mr Ferreira, from the bank, was present. The note made by Mr Ferreira in respect of the status of the contract and what was happening in respect of it is extracted earlier in this judgment. The defendant gave the following evidence in cross-examination: Q. But as a result of what you knew from the meeting of 6 March 1995 and prior thereto you must also have been concerned that the special undertaking was also being breached? A. I had a lower level of concern about that because the bank were well aware of that. Q. You keep on saying that, what is the basis of you saying that? A. Well, for example, the bank representative was at the Audit Committee meeting on 6 March and was told what was happening. There was ongoing, and there was ongoing conversations with the bank daily, I think, between Stanilite and the NAB. (tr. 673-674) Q. Before I finish dealing with that particular topic you did tell me one of the bank officers was at one of the meetings at which there was discussion about the Russian contract occurrences? A. At least one of the Due Diligence meetings, yes. Q. I have understood your evidence to be referring to that presence as an effective waiver, is that right? A. That was one of the indications I got, yes, but I also had been told by the company that the bank knew they were continuing to push on with the contract because of, that was the best way of actually assisting Techin to realise cash to enable them to pay the balance that was due. (tr. 763-764) 225 The defendant accepted that the special undertaking was never formally waived or relaxed but "in effect everyone was turning a blind eye" and "the bank were living with it" (tr. 764). The defendants also relied upon a number of documents that were claimed to indicate that the bank was aware that after 12 January 1995 the plaintiffs were proceeding to complete the Russian Contract. This included the announcement to the ASX on 3 March 1995, the relevant extract being referred to earlier in this judgement (Ex F:967). Other documents relied upon included the Minutes of the Due Diligence Committee meeting on 6 March 1995 and Mr Ferreira's note of that meeting and an internal bank report on business contact dated 21 March 1995 in which it was noted that project finance would be pursued with the Dresdner Bank and that certain stock was held in relation to the Russian Contract in the amount of $5-$7 million as a sales value, with project finance being about 60% of US $6 million (Ex G:1721). A further document relied upon was the bank's internal note in respect of the meeting with the directors of the plaintiff on 28 April 1995 and 1 May 1995, the details of which are also referred to earlier in this judgment. 226 Mr Robertson gave evidence in respect of the special undertaking that included the opinion that in deciding whether the undertaking was a concern from an audit perspective, at 3 May 1995 or at 16 March 1995, a reasonably competent auditor would be entitled to have regard to the way in which the relationship between the bank and the plaintiffs was being conducted (tr. 949). His evidence included the following: Q. Could I just understand what you are saying about what the auditors' position is though. If there is such a condition in place, and it had to be complied with, assuming that for the moment, is your evidence that the competent auditor would recommend a note to go into the accounts, or with the accounts before he would consent to it being placed in the prospectus or not? A. No, I don't think I'm saying that your Honour. I think the question was first asked in relation to 3 May, and I answered that I thought that conditions at 3 May might offer the auditor some confidence that the condition would be washed away by the capital raising. I was then asked about the same situation at 16 March, and I think I answered that the auditor would consider the weight of that condition at 16 March in light of other information that might be available to him at that time, including the conduct of the relationship between the company and its bank. I think that by the time the prospectus came along, the auditor would not, or may have thought it was not necessary to try and re-open the accounts which had been drawn as at 31 December, in view of whatever he knew about that condition at the time of the prospectus. (tr. 952) 227 Mr Robertson was also cross-examined as to whether a reasonably competent auditor as at 3 May 1995, aware of the condition, would seek to confirm with the bank whether the bank regarded the condition as continuing in force. Mr Robertson expressed doubt about such a need, having regard to all the circumstances that then pertained between the bank and the plaintiffs (tr. 961). 228 The plaintiffs analysed all of the deficiencies that had occurred in respect of the contractual relationship between the plaintiffs and Techin. Those factors included the failure to provide the security as requested, referred to earlier in this judgment; the suspension of deliveries because of the failure to provide the appropriate security; the fact that cash receipts had slipped behind the forecast; the technical difficulties experienced in installation of the network, understood by the defendant to be minor; the fact that Techin was experiencing some cash flow problems; and an apparent disputation between Techin and their United States lawyers. The defendants accepted that these were all matters to be taken into account by an auditor in determining whether the entity had a claim against an external party that was likely to be satisfied. It was submitted by the defendants, a submission with which I agree, that such a process is an entirely separate one from the process of determining whether total contract revenues can be reliably estimated as required by clause .10 (a) of AASB 1009. If such matters weigh the balance to the point where a material loss is foreseeable then that will be brought to account. But this process is different. 229 The cross-examination of the defendant in respect of the difference between contract performance and questions of revenue recognition was, in my view, of assistance on this aspect of the matter. That evidence was as follows: Q. If the buyer doesn't have the ability to satisfy the act under the contract, you would not in 1994 and 1995 use the percentage of completion method? A. I think you could use that method to determine the profit and revenue of the contract but I think however you would then have a separate question, quite separate question which is now going back and perhaps looking at SAC 4 and saying are the assets which result from applying the accounting standards recoverable and that to me is a different question altogether as to whether you can account for the contract under the percentage of profit (sic) method. … Q. Is this the situation. If you had a situation which the buyer didn't have the ability to satisfy his obligations under the contract, you could use a percentage profit method but not recognise an asset or revenues to be received under the long term contract which is under consideration until such time as you have satisfied yourself that the buyer has obtained that ability? A. I am, I don't think this would be at all probable that anyone would enter into a contract if they did not believe the buyer in the first instance had the ability to complete the contract so I think in the first instance – I am going to try and answer your question – so in the first instance I think that the assumption would be that the buyer has the ability to complete the contract and in which case the revenue and profits would be recognised in accordance with the method. If at some time during that contract it transpired that the buyer no longer had the ability to pay then at that stage an assessment of entire value of the recoverable amount of those assets would have to be made in accordance with general accounting practice and care of assets. I think it is very unlikely at day one of a contract you would come to the conclusion that the buyer doesn't have the ability to satisfy the obligations because I think commercial companies don't turn to that sort of contract. (tr. 525) 230 The defendant gave evidence that provision may need to be made in a case where there is sufficient doubt with respect to performance under the contract. The evidence establishes that as at March 1995 both the plaintiffs and the defendant were optimistic that the Russian Contract was going to be successful and that money would be received under it. The defendant gave evidence that there were a number of "hiccups" at that stage, but he expressed the view there was nothing that he believed was going to put the contract "off the rails" (tr.832). 231 The defendants submitted that a natural reading of clause .10 of AASB 1009 leads to the conclusion that the word "estimate" in paragraph (a) means "calculate approximately". It was submitted that if one is able to examine a contract and calculate approximately the total revenues to be received under it by way of mathematical process, then total contract revenues to be received can be reliably estimated. Mr Robertson referred to a contract including incentive clauses, such as a bonus for early completion, as an example of a contract in which total revenues to be received may not be able to be reliably estimated. 232 AASB 1009 does not envisage that when a loss is foreseen the percentage of completion method is abandoned. Rather it requires such loss to be brought to account when it is foreseeable. 233 The plaintiffs were critical of the defendants' contention that the application of clause .10 was "purely quantitative and mathematical" and involved no qualitative assessment of the probability that the moneys under a contract would actually be received by the supplier of goods. 234 Mr Shanahan accepted that there is an assumption that the contract will be performed and that it is upon that assumption that the assessment in relation to total contract revenue is to be made. Clause .10 requires an analysis of the contractual terms to decide whether total revenues to be received can be reliably estimated. Although in some cases it may be difficult to do so that does not mean that it cannot be done reliably. In this particular instance the defendants submitted that the plaintiffs' own expert, Mr Shanahan, made it very clear that the revenues under the Russian Contract could be not only reliably estimated but also could be calculated with some precision. In that regard Mr Shanahan's report dated 23 September 2003 included the following: 37. The analysis shows that installation costs US $2,105,170 represent 7.38 per cent of the total Stage One contract cost of US $28,514,638. On the other hand, equipment being supplied by Stanilite under Stage One of the contract accounts for 20.32 percent of the total Stage One contract value. The equipment to be supplied by Stanilite under the contract included: (Mr Shanahan then detailed various items of equipment totalling $5,793,643). 40. An examination of Stage One Costing Schedule shows Stanilite were selling items described specifically as "installation" with a contract value of USD 75,237 or 0.26 percent of the total Stage One contract value. It was also selling items described as "Installation (Commission)" with a contract value of USD 466,123 or 1.63 percent of total Stage One contract value, training services with a contract value of USD 47,240 or 0.17 percent of total Stage One contract value and software support with a contract value of USD 22,270 or 0.08 percent of total Stage One contract value. Stanilite was contracted to acquire installation services with a contract value of USD 864,300 from third party suppliers and would be reimbursed by Techin Trade amounts of USD 630,000 for Sub-Contractor Costs, USD 642,521 for freight costs and USD 7,264,881 for customs duties. 41. The reasons for dissecting the contract costs in this manner is to illustrate how relatively minor were the contract amounts specifically described as "installation". In my opinion, they do not represent a sufficiently material amount that they colour the entire "Russia Contract" as a construction contract. Rather, they indicate, in my opinion, that the "Russia Contract" was more likely to be of the type described by Mr Seaton in his December 1993 Report to the Stanilite Audit Committee as one for "the supply of discrete items, cell switches, which are manufactured to specifications". 235 There was some debate about what the term "reliably estimated" in AASB 1009 meant. The verb "estimate" is defined as "roughly calculate or judge the value, number, quantity, or extent of" the relevant matter: The New Oxford Dictionary of English, Clarendon Press. Oxford 1998. When the word "reliably", is combined with the word "estimated" in AASB 1009, I am satisfied that the plain meaning is that the judgments made in respect of the revenues and costs could be relied upon. In other words they were not mere guesstimates but have some reasonable basis. 236 Although Mr Shanahan made the above dissection and analysis for other purposes, it is clear that this exercise demonstrates that: (a) total contract revenues to be received could be reliably estimated and (b) the costs to complete the contract could be reliably estimated. Having regard to the fact that the contract was to be performed in Stages and the evidence of Mr Shanahan above it is also clear that (c) the stage of contract completion could be reliably determined. This evidence and the evidence referred to below in relation to the costs of the individual cellswitches also establishes that (d) the costs attributable to the contract to a particular date could be clearly identified and compared with prior estimates. Once those conditions were satisfied there was a requirement to apply the percentage of completion method for the purpose of bringing profits on the Russian Contract to account. On this analysis and evidence the utilisation of the earned value method seems to me to have been appropriate, however the plaintiffs submitted that there were other matters, including a claim that the defendant's evidence was not credible, that should persuade me that it was not appropriate to utilise the earned value method. I will now deal with those other matters. Other matters 237 The plaintiffs made an attack on the defendant's credibility, suggesting that his oral evidence should be rejected in the light of the content of his correspondence in the relevant years 1994 and 1995. This attack was mounted in support of the submission that the defendant knew that the earned value method of accounting was not an appropriate method to be utilised in respect of bringing profit to account under the Russian Contract and that his evidence in this trial that he believed that it was appropriate should be rejected. 238 The plaintiffs submitted that the defendant was at his least credible when he gave evidence in relation to the receipts under the Russian Contract. In this regard reliance was placed on the defendant's evidence that he had no reason to believe that the $28.9 million would not ultimately come from Techin (tr.570); that there was no reason in his mind to doubt at all that they would establish the network and be a very profitable company (tr. 570); that he had no concerns at all about the revenues to be received under the contract (tr.579); and at 13 and 16 March 1995, he had every reason to believe that the contract proceeds would be received and that he had no doubts about that (tr.687). The plaintiffs also submitted that a "chink" appeared in the defendant's "armour" when he gave an answer that PW "went along with the company's view" that in mid 1995 the Russian Contract was still a contract that would be performed and there was no need to make any provision either for the "work in progress or the receipt" (tr. 783). 239 The plaintiffs submitted that these statements in evidence are to be contrasted with paragraph 2.2 of the defendant's letter of 13 March 1995. The statement in that particular letter was in the context of "credit risk" and the aspects of the possible recovery under EFIC Insurance and other revenue. However the plaintiffs claimed that the defendant's statements in evidence should also be contrasted with the knowledge that he gained about the improbability of receipts under the contract from his attendance at the various Due Diligence Committee meetings from January 1995 to March 1995 and the subsequent events review on 18 April 1995. 240 It was submitted that the defendant's evidence was extravagant and at times inconsistent. The plaintiffs also submitted that the Court is entitled to ask rhetorically: what would it have taken to shake the defendant's confidence in the belief that the full revenue would be received under the Russian Contract if the matters referred to already in the evidence were not sufficient to do so? It was submitted that the defendant displayed a "consciousness of guilt" in his extravagantly optimistic statements. It was also submitted that he appreciated that if he expressed doubt as to whether the revenue from the Russian Contract would be received, SAC 4 prevented him from giving an unqualified audit opinion on accounts which brought $12.8 million worth of revenue and $6.4 million worth of profit into account under the contract. It was submitted he had no real choice; he must recant on his unqualified audit opinion or hold the indefensible position that the revenue was likely to be received, despite all indications to the contrary. The plaintiffs went further. It was submitted that the defendant appreciated that if he had any doubt as to the ability of Techin to generate the revenue, he would have had to consider the security under the contract, which he knew to be defective. 241 When the defendants' expert, Mr Robertson, was cross-examined, all of the alleged deficiencies were put to him and reliance was placed upon the following answer: You have wrung concessions from me that on each of these matters individually I agree that they are factors that deserve to be taken into consideration, but I am unaware of the full extent of their context and so damming as the list is when it is compiled together, I don't know what other factors the auditor was in possession of and what weight he would have placed on each of the facts available to him. (tr. 964-965) 242 The plaintiffs' claims in many respects rely upon statements made by the defendant in the correspondence with the directors of the plaintiffs. The defendants submitted that those letters or reports were not lists of issues in respect of which the defendants considered the accounting treatment unsupportable or for which an adjustment to the accounts was required. The defendant gave the following evidence in his statement dated 6 March 2003 in respect of those reports: 40. … Further, the fact that an item was included in a Report to Directors did not necessarily mean we disagreed with the accounting adopted in relation to it. In many cases, it did not even mean that we had any query in relation to the issue, but rather just thought it was something that all the directors may not be, but should be, aware of. 41 The fact that I included an issue in a Report, without a requirement for any amendment to the accounts in respect of that issue, indicates that I had specifically considered that issue in the course of the audit and had reached the view that, although there was scope to adopt a more conservative approach, the treatment proposed by the company nevertheless fell within the range of permissible treatments. 42. In a practical sense, such reports therefore often served as: (a) an agenda of issues for discussion with the directors; and/or (b) a record of the outcome of those discussions depending upon the circumstances of the particular audit. 243 The defendant also gave evidence in that statement that the purpose for which the reports were prepared included: (a) to ensure all the directors were aware of any internal business controls or business risks that had to be identified; (b) to highlight significant accounting decisions taken by management so that all directors were aware of the decision and could, if they wished, discuss and debate the matter internally; (c) to request further information; and (d) to confirm facts upon which the defendants relied. A further important purpose was to convey to the directors PW's requirement for an adjustment or note to the accounts on a particular issue before PW could sign a clear audit opinion. In that instance it was the defendant's practice to state that matter expressly as a requirement so that the directors would not misunderstand it as merely a suggestion. An example of such an express statement appears in paragraph 2 of a Draft Report to Directors dated 7 February 1994 in which the errors in accounting "requiring adjustment to the accounts" were noted (Ex J). 244 It was submitted that Mr Shanahan had seized upon items identified in the Reports to Directors and construed them as adjustments to the Accounts required by PW notwithstanding that those items were not expressed to be required adjustments. For example, it was submitted that Mr Shanahan seized upon Item 1 in the Outline relating to the financial statements for the half-year ended 31 December 1993. That item claimed that PW knew that: Revenue and profit were overstated as revenue and profit on the Argentinean project (and earlier contract with CTI) had been fully taken up in the financial statements, although to do so was not appropriate having regard to the fact that it was a contract for supply rather than a construction contract, and in any event, the recognition of such revenue and profit was inconsistent with the earned value method on cost of sales, even were the earned value method of revenue recognition otherwise appropriate. 245 Mr Shanahan acknowledged that those statements "are not themselves relevant to this action" but claimed that they provided evidence of issues identified by PW during their review. The relevant extract from the defendant's letter of 7 December 1994 dealing with revenue recognition on the Argentina Project is extracted earlier in this judgment, in which the defendants stated that in the particular "scenario" referred to, it could be strongly argued that the contracts did not fall into the definition of construction contracts under AASB 1009 because they were contracts for supply rather than construction. 246 The defendants submitted that Mr Shanahan had expressed his opinion on an unstated assumption that the Russian Contract was a contract of the same kind as the Argentinean project. It was submitted that although Mr Shanahan relied upon the terms of the 7 December 1994 letter, he did not even read the relevant Argentinean Contract nor did he call for the plaintiffs' response to the letter, even though he accepted in his cross-examination that management's response was an important factor to consider (tr.260). The following evidence was given in cross-examination: Q. Wasn't that a matter in respect of which you thought the company's response was important? A Indeed. Q. You thought it was important yet you did not call for the company's response did you? A. On December '93, no Mr Karkar. Q. You see, whether earned value methodology is appropriate is, as you said to her Honour earlier this morning, a matter of judgment? A Indeed. Q. And it is a matter of judgment that primarily is exercised by managers and directors? A. Yes. Q. Accordingly it was of fundamental importance for you to understand what management's response was to the auditor's criticism. A. Indeed. Q. Basic professionalism and independence, I suggest to you Mr Shanahan, called upon you to ask for management's response to this criticism by the auditor didn't it? A. I don't accept that Mr Karkar because management's response was evident given the letters written by Price Waterhouse following the June '94 and December '94 audits. Q. Your answer to my question you thought it was unnecessary for you to call for management's response on the Argentina project because you saw management's response in respect to other later projects, is that your answer? A. Mr Karkar, no, that is not quite my answer, the Argentina project is described as a telecommunications project and they describe the nature of that contract. As Price Waterhouse made similar comments in their letters on similar telecommunications contracts in both, after both the June '94 and December '94 audits, I did not see it necessary to go and ask for management's response to the February '94 letter. Q. Mr Shanahan, you had no conception whatever from reading the letter of the auditor of 7 February 1994 about the nature and extent of the Argentina project, did you? A. I accepted the auditor's description of the type of contract. Q. The auditors hardly described it in paragraph 10? A. I disagree with that Mr Karkar. Q. You did not read the Argentina contract? A. No. Q. You did not know the period of it? A. No. Q. You did not know the nature of the project itself? A. I had only the auditor's description in his letter to the Board, Mr Karkar, yes. Q. You didn't speak to management about it? A. No. Q. Yet you criticised the auditor for issuing an unqualified review opinion without yourself calling for management's response? A. As I say Mr Karkar, I believe that management's response to this concern raised by the auditor was evident as exemplified in the letters the auditor wrote after the June '94 and December '94 audits. Q. Have a look at the letter please which is at 9084 of volume 28 at paragraph 2.2.1? A. Yes. Q. There is management's response: We have subsequently prepared a paper on the Argentina project on revenue recognition on the earned value basis of accounting. This has been reviewed by the project officer and is attached for reference. Do you see that? A. Yes. Q. You did not see that report did you? A. No. (tr.260-262) 247 Although Mr Karkar QC called for the report referred to in that letter, it was not produced. The defendants submitted that had Mr Shanahan made appropriate and professional enquiries he would have discovered a number of matters relevant to the matter included as Item 1 in the Outline. Those matters were that on 7 February 1994 the Audit Committee met and considered the 7 February 1994 letter in draft. At that meeting it was acknowledged that the various matters raised in the draft letter needed to be addressed in some depth by management before the Audit Committee could properly consider its response. On 16 February 1994 the plaintiffs wrote to the defendants noting that they had subsequently prepared the paper referred to in the evidence above. The Audit Committee met again on 22 February 1994 and considered the letter further. The Minutes record that the defendant confirmed that all the issues previously raised had been addressed and corrective actions had been taken (Ex G:9091). 248 On 4 April 1994 the defendants presented the Audit Committee with the finalised report on the consolidated accounts of the Group for the 6 months ended 31 December 1993. That report includes the follows: We have not reiterated issues which were identified by either ourselves or management during the review process and which were resolved prior to the finalisation of the accounts. … There are no substantial areas of disputation between ourselves and management regarding the final presentation of the accounts (Ex G: 9093-9094) 249 No mention was made of the Argentinean project or the application of the earned value methodology for telecommunications contracts in that document. In the light of these matters, the defendants submitted that it was wrong for Mr Shanahan to have placed any reliance on the terms of the draft letter as referred to in Item 1 of the Outline when dealing with the appropriate treatment of the Russian Contract or, indeed, any other contract in the December 1994 audit. 250 The defendants also submitted that the evidence of the defendant is important in relation to this aspect of the matter. He gave evidence that it was his view at the time he wrote the draft letter on 7 February 1994, that what was being supplied was "more or less off the shelf product" (tr.586), however his opinion in relation to that matter changed to a quite firm opinion that each cellswitch was unique and designed individually to meet the separate needs in the location in which it was to work (tr.586-587). 251 Another example is Item 7 of the Outline taken from the letter from PW to the plaintiffs dated 28 September 1994. That item provided: Stanilite did not have formal procedures for distinguishing between construction contracts and contract for the supply of goods, or for ascertaining when it was appropriate to recognise revenue on an earned value basis. The financial statements brought revenue to account inconsistently, and incorrectly in circumstances where it was only appropriate to bring so-called "earned value" to account as revenue in circumstances where: (a) the contract was a construction contract; (b) the project is very large and spans several years; (c) there is a formal, non-cancellable contract with well-defined milestones; and (d) AASB applies and each of the conditions stated therein has been fulfilled. 252 The defendants submitted there was nothing in the report of 28 September 1994 to indicate that PW's subsequent treatment of the Russian Contract was inappropriate. Notwithstanding the way in which Mr Shanahan approached the matter in Item 7, the defendants submitted that what PW did was to set out the difference between contracts for the supply of products and construction contracts for the benefit of management of the Group, identify that treatment of revenue earned on certain contracts was inconsistent and recommended that a formal policy be implemented for the identification of projects to be broken down into its constituents for determination for earned-value. The letter referred to the fact that the policy should outline the criteria that would qualify a project for the method of earned value calculation and included formal approval by projects and finance management. 253 It was submitted that this advice from the defendants was sound advice to the Group with respect to the formalisation of a policy for the application of the earned value method. It was submitted that it could not be used as supporting a conclusion that revenues from the Russian Contract ought not to have been brought to account using the percentage of completion method. In this regard reliance was placed on the defendant's following evidence in cross-examination in relation to the draft letters in March 1995: Q. There were several drafts of this letter? A. Yes. What we wanted to do in that letter, your Honour, was simply say there were a whole range of business issues which had been raised, not matters which impacted on the validity of the figures in the accounts, but matters of good business practice and business control which I thought the directors should be aware of. Notwithstanding that we had a response from management back in the late part of 1994, I still think it warranted further attention. Q. Would you agree that revenue recognition was one of the issues raised on 30 June 1994 with the directors? A. I felt that there should be some form of criteria by the company in recognising which contract … Q. Would you agree with that? A. It was a business issue, yes. Q. And it doesn't fall, may I put it to you, in the answer which you addressed to her Honour about two questions ago? A. This was a question about having a policy in place to aid the company in determining which sales, or products, should be recognised as construction contracts. It was a suggestion we made to the company that there should be a policy identified and the words I said; consideration should be given to formalising the recognition policy. So, we wanted a policy within the form to be adopted and documented to give guidance to the people who applied, both at the accounting level and the project management level, who had control, and to make life a little bit simpler for all involved in the company. It was entered to try to remove some of the subjectivity, or least limit to those who could apply subjective decisions, so people at low levels were not able to make subjective decisions on accounting issues. But, it did not impact on the accounts. (tr.499-500) Q. You say, "we have included, as Section 1 of the report, business issues which we consider warrant close and immediate attention of the directors"? A. I see that, yes. Q. That is very peremptory language for an auditor to write? A. Sorry? Q. That is peremptory for an auditor to write, would you agree with that proposition? A. No, I think it is quite forthright language. Q. Very forceful? A. I'm not sure. Q. Making it absolutely clear to the directors that these were matters that you wanted attended to? A. Not that I wanted to attend to. These were items that I felt warranted the directors' close and immediate attention. Q. If they didn't give their attention to them, it may become something which you would give attention to? A. I may have, but I don't know whether many of these issues fell into this category. We were trying to give the directors a covenant. We were trying to direct attention to business issues and which we felt that the directors should focus on. It was not an issue that the auditors were concerned on how the accounts were ended up being prepared. They were really business issues. (tr.501) 254 The defendants submitted that Mr Shanahan appeared to be influenced by the fact that in their draft report of 13 March 1995 the defendants described the recognition of revenue flowing from the Russian Contract in the accounts as "aggressive". The draft report does not require an adjustment to be made to the accounts with respect to the revenue from the Russian Contract. However during cross-examination Mr Shanahan conceded that he had proceeded to express his opinions on the assumption that the matters in the draft report constituted "serious deficiencies in the accounts" and that they warranted adjustment (tr.289-290). He proceeded on the basis that absent the making of such adjustments the auditor's opinion should have been qualified (tr.290). The defendants challenged Mr Shanahan's approach in this regard and he gave the following evidence in cross-examination: Q. So you proceeded to give your report on the footing that what appeared in the Price Waterhouse letter of 13 March and the previous draft of 10 March had set out a number of serious deficiencies in Stanilite's financial statement for the half year 31 December 1994. That's correct isn't it? A. Yes. Q. If you could go to paragraph 10 in the fourth line you say, If the adjustments recommended by Price Waterhouse in their Report to Directors for the half- year ended 31 December 1994 had been incorporated in the statements, then it will have recorded an operating loss of 6.2 million. A. That's right Q. So you proceed upon the footing in your report to her Honour that Price Waterhouse, in their letter of 13 March 1995, recommended that adjustments be made to the account. Is that right? A. I would hesitate to say that Price Waterhouse recommended adjustments. They raised a number of issues and quantified them. Q. That's what you say, "If the adjustments recommended by Price Waterhouse". Do you see that? A. That is wrong. I am saying Price Waterhouse quantified the adjustment amounts and I took the amounts into the reformulated financial statements. Q. Mr Shanahan, you say if the adjustments recommended by Price Waterhouse in their report to Directors had been incorporated … A. Yes. Q. … in the financial statements. Now are you telling her Honour that you have proceeded upon the footing that Price Waterhouse had recommended adjustments to the 31 December accounts? A. No. I accept Mr Seaton's statement that Price Waterhouse had not recommended those adjustments. Q. So your statement, "If the adjustments recommended by Price Waterhouse" is wrong? A. In a sense of the word "recommended" yes I accept that. (tr. 289) 255 The plaintiffs claimed that the accounts should have contained a statement that the earned value basis was being applied and that the earned value basis was not one of the bases described in AASB 1009. This claim made is based upon the following evidence of Mr Shanahan in his report dated 6 March 2002: 50. Under AASB 1009, profit may only be recognised where, inter alia, the stage of completion can be reliably determined. AASB 1009 requires "details" of the basis used to recognise profit to be disclosed. The financial statements omit any mention of how the stage of completion was measured. In my opinion, this is a material omission. This information was required in order to be able to assess the reliability of the revenue numbers. 256 Mr Robertson expressed a contrary view to that expressed by Mr Shanahan. He was of the view that disclosure was not expressly required by the relevant passage of AASB 1009. 257 Mr Shanahan dealt further with this matter in his report dated 23 September 2003. Although it is sometimes burdensome for the parties reading the judgment in respect of their case to have evidence detailed at length, in this case I regard it as necessary to expose the reasoning of the expert relied upon by the plaintiffs and to deal with the submissions of the parties. Accordingly the evidence of Mr Shanahan in his report dated 23 September 2003 in relation to this issue was as follows: 52. At paragraph 6.3.5 of his report, Mr Robertson states that such disclosure was not expressly required by the relevant passage of AASB 1009. He noted that the reference to such disclosure is contained within the commentary to AASB 1009 and as such is not a part of the Standard. He concluded that, in his opinion, "the reasonably competent auditor could not have compelled Stanilite to disclose details on how profit was progressively recognised". 53. I agree with Mr Robertson that the reference to such disclosure is contained within the commentary to AASB 1009 but disagree with his conclusion. AASB 1009 states as commentary: (xviii) As is required under AASB 1001: Accounting Policies – Disclosure the summary of accounting policies included in the accounts or group accounts will provide details of all policies which have been significant in the preparation and presentation of the accounts and group accounts. The summary will therefore include all material details of the basis used to bring to account profit on construction contracts. This could include, for example, details of the minimum percentage of completion at which profits are initially brought to account in respect of contracts for various kinds of construction work. The commentary to AASB 1009 contains a cross-reference to AASB 1001. 54. Accounting Standard AASB 1001: Accounting Policies – Disclosure states: .30 The summary of accounting policies shall describe all material accounting policies which have been applied in the preparation and presentation of the accounts or group accounts. This requirement is subject to the exception that where the accrual basis or going concern basis has been used, those bases need not be described. Paragraph .30 of AASB 1001 is not commentary, it is effectively "black letter". Under sec 298(1) of the then Corporations Law , a company's directors were required to ensure that the company's financial statements were made out in accordance with applicable accounting standards. The directors of Stanilite Pacific were required by sec 298 (1) of the Corporations Law to comply with paragraph .30 of AASB 1001 i.e. to disclose all material accounting policies used in the preparation and presentation of the financial statements. 55. The "Summary of Significant Accounting Policies" included as Note 1 of the Notes to and Forming Part of the Accounts of Stanilite Pacific as at 31 December 1994 refers to the financial statements as "general purpose half-year consolidated accounts". Under Statement of Accounting Concepts SAC 1: Definition of the Reporting Entity , general purpose reports shall be prepared in accordance with Statements of Accounting Concepts and Accounting Standards: SAC 1, paragraph 41. 56. Under the heading "Operating revenue", the "Summary of Significant Accounting Policies" included as Note 1 of the Notes to and Forming Part of the Accounts of Stanilite Pacific as at 31 December 1994 states: Sales revenue on long term contracts has been brought to account based upon the percentage of completion. 57. AASB 1009 defines the "percentage of completion method" as meaning: The method of profit recognition whereby profit is brought to account in proportion to work performed on a construction contract for each financial year in which construction occurs. 58. Commentary to AASB 1009 states: (ii) The percentage of completion method can be measued in three ways - (a) physical estimates or surveys of the work performed to date; (b) the cost basis – this method involves calculating the proportion that costs incurred to date bear to the estimated total costs of the contract; (c) the billings basis – this method involves calculating the proportion that billings to date bear to the total estimated billings for the contract and should only be applied when it provides a reliable measure of work performed. (iii) When the percentage of contract completion is measured using the cost basis, adjustments are to be made to include only those costs that reflect work performed. Examples of items that may need adjustment are - (a) materials purchased that have not been installed or used in the contract performance; (b) payments to sub-contractors to the extent that they do not reflect the amount of work performed under sub-contracts; and (c) penalties incurred by the contractor. 59. At paragraph 6.3.4 of his report Mr Robertson states that, in his opinion, the earned value method of profit recognition used by Stanilite Pacific was an appropriate method in principle to reflect the operations of an entity and was, therefore, an approach acceptable under AASB 1009. [emphasis added]. In my opinion, the Statement of Accounting Policies as "sales revenue on long term contracts has been brought to account based on the percentage of completion" did not convey to a reader of the financial statements that an earned value method was being used under which percentage of completion was determined by achievement of risk milestones, nor that the measurement of those milestones bore no relationship to the bases described in AASB 1009 for determining percentage of completion. 60. Paragraph B6 of Appendix B to my original report summarised the effects of the earned value approach on Stanilite's profit recognition. It stated that a large proportion of the contract's revenue and profit may be recognised prior to the actual manufacture, assembly or installation of equipment, with the effect that revenue recognition does not appear commensurate with the level of physical work performed or the ability to claim from a customer. In effect, this means that earned value method was not using "physical estimates or surveys of the work performed to date" to determine percentage of completion. 61. It also seems apparent that the "cost basis" was not being used to determine percentage of completion. That method involved calculating the proportion that costs incurred to date bear to the estimated total costs of the contract. Mr Seaton's "draft" December 1994 Report to Directors refers to the full 20 percent mark up having been taken as at 31 December 1994 on back-up supply systems "no portion of which had been ordered from suppliers as at 9 March 1995". It had also been recognised on all 10,000 terminal units even though only 1,000 of the units had been delivered as at 31 December 1994. Indeed, as will be seen later, Price Waterhouse calculated certain costs as "nil" in determining the margin available under the "Russia Contract" as at 31 December 1994. A Price Waterhouse audit work paper [PW awp BE 218; PW 0009, 0259] notes that "the cost involved [is] Nil" because the relevant cost was all management effort. No items had yet been delivered and the management cost was reflected in salaries. In my opinion, this indicates that the earned value method could not properly be described as the "cost basis" of determining percentage of completion and that Price Waterhouse were aware of this fact. 62. Mr Seaton's "draft" December 1994 Report to Directors noted that at 31 December 1994 total revenue recognised on the "Russia Contract" was $12.8 million and the profit contribution was $6.4 million. He also noted that as at 9 March 1995, no money had yet been received and that the $12.8 million revenue recognised on the contract was represented on the balance sheet at 31 December 1994 by $1 million in trade receivables – this indicates that this amount had been invoiced – and $11.8 million in contract work in progress. As total billings to date of $1 million represented only 2.63% of total projected Stage One contract billings of USD 28,515,638 (AUD 38,019,517), it is clear that the "billings basis" was not being used to determine the percentage of completion. 63. In my opinion, to describe the method of accounting as being based on the "percentage of completion" without giving any further description of the earned value method of measuring achievement of (unspecified) risk milestones did not give a true and fair description of the method of accounting being employed. In my opinion, this represented a failure to disclose all material accounting policies used in the preparation and presentation of the financial statements and thus a breach of both paragraph .30 of AASB 1001 and Sec 298(1) of the Corporations Law . If I am correct in this view, Mr Seaton was obliged to qualify his audit report on those grounds. 64. The alternative argument is that use of the earned value method was not a material accounting policy used in the preparation of the financial statements – in my opinion, its use was essential on the "Russia Contract" in order to enable Stanilite to report the level of profit which it did for the December 1994 half-year – and that describing it simply as "percentage of completion" was an adequate description. My analysis above suggests that such a view is untenable. 258 The defendants submitted that Mr Shanahan was in error in stating that disclosure of significant accounting policies in the accounts of the company is "required" by AASB 1009. AASB 1001 requires that a summary of accounting policies is to be included in the accounts where those policies have been significant in the preparation of the accounts. The commentary forms no part of the Standard and as such the relevant Standard for disclosure of accounting policies is AASB 1001 and not AASB 1009. Mr Robertson identified this error in Mr Shanahan's approach and Mr Shanahan acknowledged this error in paragraph 52 and following his report. 259 Mr Shanahan acknowledged in cross-examination that it is the accounting "policies" that need to be disclosed. The "policy" that was applied to the Russian Contract was a "percentage of completion method". In this regard Mr Shanahan gave the following evidence: Q. Accounting policies is defined in the first standard as being the method? A. The accounting principle, basis or method, yes. Q. And 1009 speaks about the method being the percentage of completion method. It says so in terms? A. Yes Q. Look at clause 10? A. Yes and describes … Q. Look at clause 10. The amount of profit on fixed price contracts shall be brought to account in accordance with the percentage of completion method? A. Yes Q. That is the policy isn't it? A. Yes. Q. And that method or policy was disclosed in the accounts fully in compliance with 1001? A. I think, Mr Karkar, clause 05 of the standard is the one. Q. Which standard? A. This is 1001. "If the omission, non-disclosure or misstatement of the inspection about the policy". Q. You are being asked about the concept. The concept is accounting policy or method and you have said that the method is the percentage of completion? A. Yes Q. You can't resist the suggestion that the accounts did disclose that that method had been used can you? A. No, your Honour. (tr.326) 260 The defendants submitted that the policy was not the "earned value basis" which was simply one of the recognised ways by which the percentage of completion of a contract was calculated. As the percentage of completion method is the relevant accounting policy in order to comply with AASB 1001, the accounts would need to disclose that this policy had been applied. 261 The accounts contained the following disclosure: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The principal accounting policies adopted by Stanilite Pacific Limited and controlled entities are stated to assist in a general understanding of these accounts. … ( e) Operating Revenue Sales revenue represents revenue earned from the sale of the economic entity's products and services net of returns. Sales revenue on long term contracts has been brought to account based upon the percentage of completion. Other revenue includes proceeds from sale of property, plant and equipment, government grants and interest income on short-term investments. (Ex F:1324) 262 The defendants submitted that having conceded that the relevant accounting policy was the percentage of completion method and that AASB 1001 required disclosure of the relevant accounting "policy" it was incumbent upon Mr Shanahan to accept that the note in the accounts complied with the relevant accounting standard. This matter was put to Mr Shanahan in cross-examination and it was submitted that his response was most inappropriate. That evidence was as follows: Q. Just let me ask you the question. The policy or method within the meaning of the term "Accounting Policy" in 1001 is the percentage of completion method. That's correct, isn't it? That is the policy, that is the principle, that is the method, that's the basis, isn't it? A. I have to say, Mr Karkar, I accept that answer is true but not fair. (tr.324) 263 In conclusion the defendants submitted that Mr Robertson's opinion on the issue was that the disclosure that appears in the notes to the accounts is "normal and unexceptional for companies involved in the construction business" (tr.931). It was submitted that such an opinion should be accepted and applied in this case. Some may feel that the truth sometimes is not fair, but in this case and in this instance it is only fair, because it is true, to conclude that the disclosure of the Accounting Policy was a proper disclosure in compliance with the applicable Standards. Mr Shanahan's evidence in cross-examination extracted above supports such a finding. Conclusion 264 The question for decision is whether a reasonably competent auditor would not have consented to the inclusion of an unqualified audit opinion in the Prospectus in light of the way in which profit on the Russian Contract had been brought to account in the half year to 31 December 1994 Accounts. 265 AASB 1009 required the percentage of completion method to be applied to fixed price construction contracts when certain conditions were satisfied. I am satisfied that it was appropriate, as the defendants did, to categorise the Russian Contract as a "construction contract" within the meaning of that term in the Standard for the reasons given earlier. 266 Mr Shanahan's evidence ultimately supported the defendants' case. The evidence, including that of Mr Shanahan, established that the pre-requisites of: contract revenues to be received being able to be reliably estimated; costs to complete the contract being able to be reliably estimated; the stage of contract completion being able to be reliably determined; and costs attributable to the contract being clearly identified and capable of comparison with prior estimates, were all able to be satisfied. Once those pre-requisites were established the Standard provided that profit "shall" be brought to account in accordance with the percentage of completion method. I am satisfied that the use of this method was available for use in respect of the Russian Contract by the Group. 267 The plaintiffs have not established that the defendants' failure to refuse to give their consent on this ground was either a breach of duty or a breach of contract. Other telecommunications contracts 268 The plaintiffs' claim in respect of other telecommunications contracts is contained in item 19 of the Outline: Revenue in the order of $4m (on which the profit was $2.1m) for telecommunications sales (excluding the Russian Contract) had been brought to account although the products had not yet been delivered to the customers: (a) $762,000 of the profit taken up related to products in respect of which no firm order had been received as at 31 December 1994. (b) Full revenue had been taken up on sales which were only partially completed. (c) Profit of $448,000 had been taken up on items which were, as at 9 March 1995, still under negotiation. (d) Profit of $309,000 had been recognised from Venezuela although it was not certain whether a firm order would be placed. 269 Mr Shanahan suggested a qualification should have been included in the audit opinion in the Prospectus in respect of this aspect of the matter as follows: 4. Accrued Telecom Revenue The Company has recorded accrued telecommunications sales as at 31 December 1994 – excluding the "Russia Contract" of $4 million, with related profit of $2.1 million. None of the products subject to these sales contracts had been delivered at 31 December 1994. As this revenue relates to contracts for the sale of equipment, in our opinion, it is improper to recognise revenue and profit before delivery of the equipment. In our opinion, revenue and profit for the half-year ended 31 December 1994 for these items has been overstated by $4.0 million and $2.1 million respectively. 270 The plaintiffs' case in this regard is reliant upon Mr Shanahan's opinion that revenue and profit from these contracts should not have been brought to account under the percentage of completion method because the relevant contracts were not construction contracts. It was on this aspect of the plaintiffs' case that the evidence became quite bizarre. The following cross-examination of Mr Shanahan evidences the reasonableness of the use of that epithet: Q. Adjustment 4 is the next largest adjustment in the restated account is it not? A. Yes Q. Of $4 millon? A. That's right. Q. This adjustment you have said is other accrued Telco, it is really with respect to revenue accrued on other telecommunications contracts? A. That's right Q. The principal reason for excluding this amount in your restated profit and loss account is that the revenue should not have been brought in on the earned value principle? A. That's right. Q. That is so because no reasonable accountant in your view, or auditor, would conclude that these contracts were construction contracts? A. That's right. Q. Mr Shanahan, you did not call for or examine any of the contracts that are the subject of that adjustment to determine whether a reasonably competent auditor could reasonably conclude that they were construction contracts, that's right, isn't it? A. That's right, Mr Karkar. Q. You just assumed, did you, for the purposes of your restated profit and loss account that these contracts were for the supply of goods? A. I didn't assume it, Mr Karkar. I, my comment in adjustment 4 represented what Price Waterhouse had put in their draft letter of 13 March. Q. Well, I put it to you that the draft letter of 13 March did not for a moment suggest that these other telecommunications contracts were contracts for the supply of goods? A. If I go back and look at page 5, I discussed Adjustment 4 Mr Karkar. I believe I took the words there mainly direct from the Price Waterhouse letter. The key phrase is "it represented sales take up on revenue for which the products, the products had not as yet been delivered at 31 December 1994 and the reference to products was indicative to me that … Q. Did you assume from that, did you, that the contracts were contracts for the supply of goods? A. Yes, I did. Q. That is the principal basis upon which you have made the adjustment of 4 million A. In the light of the comments made by Price Waterhouse in both the letter of 13 March and the two previous reports to the Board after the December 93 review and the June 94 audit where they discussed revenue recognition on telecommunications contracts and there was nothing in the Price Waterhouse material which indicated to me that this one was a construction contract. Q. Which one? A. This is the other accrued Telco revenue, your Honour. Q. When you said there was nothing in there that suggested to me that this one is a construction contract? A. That's right. Q. Which one are you talking about? A. Effectively, your Honour, not the Russia contract. Q. All other contracts. A. The other telecommunications revenue, well, I said the Price Waterhouse letter states that the total telecom … Q. In your answer to me a moment ago, I am trying to understand your evidence, you said there was nothing in the Price Waterhouse material etcetera that led you to believe that "this one is a construction contract". All I am trying to understand is, what do you mean by "this one"? A. I'm sorry your Honour, I said "this one", I was referring to the matters discussed in adjustment 4, the description Price Waterhouse used was total Telecom sales accrued. Now, that is what I have said, that one, I was referring to those total Telecom sales. Q. Mr Shanahan, you realise, don't you, from reading the letter of 13 March that there were a multitude of contracts with multitude of parties in respect of the item of $4 million? A. Yes. Q. And the adjustment of $4 million to the accounts is a large adjustment, you would agree with that? A. Yes Q. You did not bother to call for any of the contracts to assess their nature prior to making this adjustment, did you? A. No, Mr Karkar. (tr.328-330) 271 I find it rather incredible that a claim should be made by the plaintiffs that these contracts were not construction contracts, based solely on the opinion of Mr Shanahan when he did not even look at any of the contracts prior to proffering such an opinion. 272 The defendants submitted that in the circumstances where Mr Shanahan has not read the relevant contracts, nor sought to place himself in the defendant's shoes with respect to the assessment of the nature of the contracts with the benefit of management's guidance, his criticism of the defendant should be rejected. It was submitted that the appropriate finding is that the defendant was not negligent in his treatment of this item in the audit of the accounts and was not negligent in consenting to the inclusion of his unqualified audit opinion in the Prospectus by reason of this item. 273 Having regard to the extraordinary approach adopted by the expert for the plaintiffs on this aspect of the matter, the plaintiffs have failed to discharge their onus and the plaintiffs' case in this regard fails. R&D Costs 274 This is another aspect of the plaintiffs' case against the defendants that I found rather extraordinary. The claim in respect of this matter appeared in item 24 of the Outline as follows: "Amortisation of capitalised research and development had been delayed". There was nothing in the suggested qualifications to the opinion for the Prospectus in respect of this item (Exs B & C). However Mr Shanahan calculated a proposed adjustment to the accounts on the basis of the statement made in the defendant's letter of 13 March 1995 that: The amortisation for deferred research and development costs included in the results for the half-year ended 31 December 1994 has been "skewed" to match revenues. That is the amortisation in the half-year of $675,000 represents approximately 27% of the total amortisation planned for the year. It would be more appropriate for deferred research and development costs to be amortised on a straight line basis over the year. On a straight line basis the amortisation would be $1.3 million. (Ex F: 1039) 275 The defendant's evidence was that he did not regard the proposed treatment of the amortisation of R&D costs as a breach of or inconsistent with relevant accounting standards. Such standards required the costs to be matched against related benefits. During the course of the audit process, Mr Fayle provided an explanation for the "skewing", the relevant file note of which records: Per discussion with David Fayle, (Finance Controller) he explained that the reason for a lower level of amortisation than in accordance with the 8 yr policy is, that the major portion of sales revenue and GP% will be made in the 2nd half of 1995 yr, therefore budgeted R&D amortisation for 2nd half of 1995 is $2.0m, giving a total yr amortisation of $2.7m, compared to required under 8 yr amortisation policy of $2.5m. Accept basis as reasonable. 276 Mr Shanahan gave the following evidence on this aspect of the matter in cross-examination: Q. The auditor, in his letter of 13 March, raised the issue with the directors of amortisation of research, and development costs had been skewed to match revenue? A. Yes. Q. Right? A. Yes Q. He suggested that rather than skew them to match revenue, a simpler way would be to adopt a straight line basis? A. Indeed. Q. The directors disagreed. They explained the basis for skewing the amortisation of research and development costs to match revenues, and explained to the auditor that in the second half there would be a larger amortisation? A. Yes. Q. Because the revenue is expected to be larger in the second half, that's your understanding, isn't it? A. Yes, Mr Karkar. Q. It was open to a reasonably competent auditor to accept that explanation? A. Indeed. (tr.339-340) 277 Notwithstanding the plaintiffs' own witness' evidence, this claim was propounded even in final submissions. The plaintiffs have failed to establish any negligence or breach of contract on the defendants' behalf in respect of this item. The plaintiffs' case in this respect fails. Marketing Costs 278 The Accounts included deferred marketing costs in the amount of $3.067 million. The plaintiffs' claim appears in Item 20 of the Outline as follows: International marketing costs of $3.067m had all been deferred, although over $8m worth of profit had been recognised from the regions in which the marketing costs had been incurred. As revenue had been recognised, costs incurred in generating that revenue ought to have been brought to account as expenses in the profit and loss statement 279 The plaintiffs contend that $1.542 million of those costs ought to have been expensed in the accounts instead of being deferred. Mr Shanahan suggested that the audit opinion in the Prospectus should have included the following qualification in respect of this Item: 7. Deferred Marketing Costs The Company has deferred all costs incurred on international marketing incurred in the 6 months to 31 December 1994. These costs total $3.0 million. The company's policy is to defer marketing costs to the extent that they relate to the development of new business and which are incurred prior to achieving a maintainable earnings base. These costs will be amortised when revenue is received. Marketing costs of $641,000 for Eastern Europe, $700,000 for China and $201,000 for South America were deferred in the 6 month period ended 31 December 1994, notwithstanding that telecommunication sales from these regions with related profit amounting to over $8 million have been recognised in the half-year to 31 December 1994. In our opinion, the company has understated expenses for the period by accounting for the marketing costs relating to Eastern Europe, China and South America for the period by capitalising them as a deferred cost. In our opinion, the Company has understated expenses by $1,542,000 – and thus overstated profit by a similar amount – for the half-year ended 31 December 1994 in relation to these deferred marketing costs. The non-current asset "Business development costs" is overstated by the same amount. (Exs B&C) 280 The contention that $1.542 million of the costs should have been expensed is reliant upon the opinion of Mr Shanahan, found in his second report, also dated 6 March 2002 in which he referred to the defendant's draft letter of 13 March 1995 in which the following appeared: Continuing to defer marketing costs in Eastern Europe, China and South America does not appear to be consistent with Stanilite's policy given that telecommunication sales from these regions with related profit amounting to over $8 million has been recognised in the half-year to 31 December 1994. The corporate marketing costs deferred represents all corporate marketing costs incurred in the half-year. The implication of this is that no marketing costs incurred at corporate level in the half-year can be attributable to Stanilite's established business such as emergency lighting and defence projects. (Ex F: 1038) 281 Mr Shanahan's opinion was as follows: 22. Marketing costs of $641,000 for Eastern Europe, $700,000 for China and $201,000 for South America were deferred in the six month period. The Price Waterhouse letter states that continuing to defer marketing costs in Eastern Europe, China and South America did not appear to be consistent with Stanilite's policy given that telecommunication sales from these regions with related profit amounting over $8 million had been recognised in the half-year to 31 December 1994. 23. Adjustment 7 increases expenses for the period by accounting for the marketing costs relating to Eastern Europe, China and South America as expenses for the period rather than capitalising them as a deferred cost (i.e. effectively as an intangible asset). This adjustment increases expenses for the period by $1,542,000. The non-current asset "Business development costs" was overstated by the same amount. 282 The accounting policy of the Group in relation to Business development costs was recorded in note 1(n) to the accounts as follows: Costs, net of related government assistance received, which are invested in the development of new business and which are incurred prior to achieving a maintainable earnings base and are not associated with obtaining existing business are deferred where the directors are of the opinion that future benefits derived from this expenditure are expected beyond any reasonable doubt to exceed these costs. These costs are amortised when revenue is received. The directors review the carrying value of business development costs each half year. (Ex T: 32) 283 At a meeting on 1 March 1995 the defendant expressed the view that the Group was "aggressive in the extreme in capitalising" those costs. In cross-examination the defendant gave the following evidence: Q. And would you agree with me that the aggressive approach which the directors were taking to marketing costs, that is the capitalisation of those costs at that time, was something which caused you a great deal of concern? A. At that stage going in to that meeting with the directors I was concerned with the approach to the capitalisation of particular elements of that marketing costs, your Honour, and the element I think which we were addressing with the directors in particular was that element related to the corporate marketing and the meeting was being, was held to get explanations of comments from the directors as to why they had capitalised all of that amount. Q. Did you receive explanations at that meeting? A. Yes. Q. As a result of receiving explanations at that meeting were you satisfied with the explanations which you received? A. I was satisfied that the directors had a basis for applying the accounting that they did. Q. In relation to marketing costs? A. In relation to marketing costs. Q. And their capitalisation? A. Yes. Q. Thereafter it was not of concern to you? A. It was a matter which we raised. Q. Which concerned … A. It was no longer a matter concerning terms of the correctness of the accounts. Q. What was it, what other respect was it a matter of concern to you, if at all, after that point of time? A. It was a matter which I believed the directors, in particular the other directors, should be aware that was the approach that was being taken and it was included in the report to the board or to the audit committee discussed on 13 March, but in relation to the principle and just explaining to the board what has been done, it was not an item which I required an adjustment to the accounts. (tr. 650-651) 284 It is apparent from the notes made at that meeting (Ex G: 7516) that the defendant pursued further discussion with the representatives of the plaintiffs in respect of the approach of capitalising these costs. He was advised that the group took the view that it was not in a "sustaining mode" in any of the markets identified. The defendant gave evidence that he did not require the adjustment because there was evidence to support the assertion that the level of Pacific's presence in the relevant regions was still short of being "established" in those markets, notwithstanding that profits had been generated from Pacific's business presence in those regions. In addition, Pacific had been applying amortisation over a two year period to the international marketing costs (approximately $794,000) and because the whole issue was relatively subjective, the defendant did not see that his line of thinking was necessarily the only acceptable position. 285 Mr Shanahan was cross-examined on this topic. He gave the following relevant evidence: Q. You saw from his statement that management's position was quite different, it was that Stanilite's presence in these relevant regions during the relevant accounting period was still short of being established in those markets? A. Yes, Mr Karkar. Q. That was the position of management? A. Yes. Q. And the directors, you understood that from reading the statement? A. Yes. Q. And you understand from reading the statement that the position of management was that future benefits from those markets are expected beyond any reasonable doubt to exceed these costs? A. Yes. Q. And you understood from his statement that the directors took the view that these costs were an investment in those markets which were laying the foundations for several major deals in the future? A. Yes. Q. Now in those circumstances you would agree with me it was open to the reasonably competent auditor to accept management and the directors' statement in that regard? A. I'm sorry Mr Karkar I can't accept that. Q. Why not? A. Because the company's stated policy is that they would defer those costs, whether being incurred prior to achieving a maintainable earnings basis and as Mr Seaton in his letter of 13 March pointed out, telecommunications sales from these regions with profit amounting to over $8 million had been recognised in the year to 31 December 1994 and to have an $8 million profit contribution in a total profit for the half-year of, as reported, $5.4 million would seem to me to indicate a maintainable earnings basis had been established. Now, if …. Q. You would agree that these markets in China, South America and Eastern Europe are large markets? A. Indeed. Q. And you agree that these markets in these regions are developing markets? A. Indeed. Q. Where new technology is being sought? A. Yes. Q. To be introduced? A. Yes Q. Now you agreed earlier that the note 1(n) spoke about these costs being incurred prior to achieving a maintainable earnings basis? A. That's right. (tr. 333-334) Q. For clarification, Mr Shanahan, if an auditor has given advice, as was given in this case, and management does respond in the way they did in this case, do I understand your evidence to be that the auditor should still, notwithstanding management's explanation, not accept it? A. Your Honour, I believe at a very pragmatic commercial level you would say change the stated policy then the problem would go away. Q. But if the company, its management and directors have formed a view for, whatever reason, that the earnings or maintainable earnings basis is not maintainable, hasn't reached that stage, is it for the auditor to decide whether it is maintainable? A. Your Honour, I did not see, no, your Honour, the management will tell the auditor what they think is going to happen. I don't believe, suggested by Mr Seaton, that management maintain the $8 million in the first half-year was a fluke and that it wouldn't be maintainable. Q. But coming back to what I need to understand about your evidence, if an auditor is given advice or told by the directors that they have formed a view about this particular series of contracts and what stage it has reached, is your evidence that the auditor must then suggest to management that they are wrong? A. No your Honour, but as I understand it in accordance with the stated policy on which the accounts had been prepared you were only deferring these costs until a maintainable earnings base has been established. Q. Yes and if they say it hasn't been? A. If they say it hasn't been, you say, right, happy for you to keep, as long as you can show us the benefits are likely to eventuate, we are happy for you to keep deferring those costs. (tr.336-337) 286 Mr Robertson expressed the following opinion in his report of 10 April 2003: 12.10.5 Whether Stanilite had consolidated their market position is a subjective issue. In my opinion it was reasonable for a reasonably competent auditor to consider management best placed to make this decision. Where the auditor is placing reliance on the views of management, it is preferable management's oral representations also be confirmed in writing by inclusion in a signed Management Representation letter. However, while this is preferable, in my opinion, failure to do so would not result in the auditor failing to meet the standard of the reasonably competent auditor. 12.10.6 Given the above, and notwithstanding the absence of a formal Management Representation letter, in my opinion the reasonably competent auditor could have concluded, as Mr Seaton says he did, that he could rely on management's assertions and conclude that an adjustment was not required. 287 The Prospectus not only included note 1(n) to the accounts, but in addition the following paragraph: 4.2 Business Development Costs Stanilite has made significant investments in business development in international markets. These costs have often been incurred prior to achieving a maintainable earnings base and are deferred where the directors believe that the future benefits will, beyond any reasonable doubt, exceed these costs. The value of this asset is reviewed each half-year and amortised over the period in which revenue is received or written off if the capital value of this asset will not be supported by future earnings. 288 The defendants submitted that the deferral of marketing costs was one that had been sufficiently flagged in the Prospectus and flagged in such a way as to make it clear that a judgment had been made by the directors based on their own view as to whether the maintainable earnings base had been achieved. I accept this submission. 289 Having regard to the evidence of Mr Shanahan and the opinion expressed by Mr Robertson, I accept that the defendant acted reasonably in accepting management's advice that it had not reached the relevant stage of establishment in these regions. The plaintiffs' case in this regard fails. Inventory 290 The plaintiffs' claim in this regard is contained in Item 22 of the Outline that states: "A write-down of $355,000 in inventory transferred from New Zealand had been omitted". Mr Shanahan suggested that a qualification to the audit opinion for inclusion in the Prospectus should have included the following: 8. Inventory Write Off The Company transferred excess inventory from New Zealand to Australia in the year ended 30 June 1994. The total value given to these items in New Zealand was NZ$853,000 (A$701,000). In December 1994 the value of the inventory was determined to be A$346,000. The difference of A$355,000 was not accounted for as at 31 December 1994. In our opinion, the Company has understated expenses by $355,000 – and thus overstated profits by a similar amount – for the half-year ended 31 December 1994 by failing to record the loss in value of inventory. The current asset "Inventories" is overstated by the same amount. 291 Mr Seaton's evidence was that the stock value of $700,000 included stock that was not related to the ANZAC contract. The non-ANZAC inventory was reallocated to another account and the balance of the ANZAC stock was valued at approximately $505,000. As Mr Robertson noted the comparison to the value of the stock on arrival in Sydney to the value when unpacked should be a difference of approximately $160,000. Mr Robertson's opinion was as follows: 12.11.3 Mr Seaton notes that due to poor inventory control, Stanilite could not be sure that they were comparing like with like in the two stock valuation. Furthermore, there was a suggestion that the figure of $346,000 reflected some usage after the stock had been unpacked. 12.11.4 Mr Seaton states he raised this issue to highlight his dissatisfaction with the standard of inventory management. Accordingly, in their draft report to directors, PW noted "the apparent discrepancy in the valuations of the inventory was the full $355,000" intending to convey that this amount had neither been booked nor adequately explained. However in retrospect, Mr Seaton "would have regarded the 'full' amount as being only $160,000". 12.11.5 Given these poor controls, Mr Seaton states that it could have been prudent for Stanilite to make a provision against the value of this stock. However, he acknowledged that it was not clear whether an adjustment was definitely required and on this basis he did not insist upon an adjustment being made. 12.11.6 Based upon the uncertainty over the value of this stock, in my opinion, the reasonably competent auditor would have sought further particulars of major items causing the difference such as usage and costing variations. Based upon Mr Seaton's evidence, the issues remain unresolved despite PW bringing the issue to Stanilite's attention early in the audit. Therefore, assuming that further particulars have not been received, a reasonably competent auditor would have to form an opinion based on the current level of information provided. 12.11.7 In my opinion, a reasonably competent auditor would have preliminarily advised the directors that it was prudent to make a provision against the value of the stock, in the sense that it would constitute a more conservative approach but would not be absolutely necessary to make the accounts true and fair. However, in my opinion, the reasonably competent auditor could have then concluded that there was insufficient evidence as to whether a provision was definitely required or what the provision should have been and I note that this is consistent with Mr Season's view noted above. In these circumstances, the reasonably competent auditor could not have required a provision to be made in respect of this item. 12.11.8 However, in my opinion, the reasonably competent auditor would note the potential difference of $160,000 as a grey item for the auditor's consideration in the light of the financial statements as a whole, as I note Mr Seaton did. 292 Mr Shanahan was cross-examined in respect of this matter. He gave the following evidence: Q. Adjustments Eight and Nine, you have read what Mr Seaton had to say about these small items in his statement? A. Indeed. Q. You are not in a position to disagree with the factual matters set out by Mr Seaton? A. No, Mr Karkar at all. Q. Nor are you in a position to disagree with Mr Seaton's decisions based on those facts? A. That's right (tr.340) 293 In light of this evidence the plaintiffs' case in this regard fails. Bad debts 294 This claim by the plaintiff is contained in Item 23 that states: "No provision had been made for doubtful debts". Mr Shanahan suggested that a qualification to the audit opinion in the following terms should have been included in the Prospectus: 9. Doubtful Debt The company is in dispute with a debtor in the Philippines with a receivable balance of $228,000. The probable outcome of the dispute is the return of product sold. The profit margin on the receivable was $130,000. In our opinion, the company has understated expenses by $130,000 – and thus overstated profit by a similar amount – for the half-year ended 31 December 1994 by the non-recognition of the loss of profit margin on this receivable. The current asset "Receivables" is overstated by the same amount. 295 The adjustment made by Mr Shanahan to the accounts was Adjustment 9. Mr Shanahan's evidence in cross-examination in which he agreed that he could not disagree with Mr Seaton's approach put an end to the plaintiffs' claim in this regard. Conclusion on the Consent Opinion 296 The plaintiffs have failed to establish the claims they make in respect of this part of their cases against the defendants. There is no basis upon which this Court can find any breach of contact or breach of duty by the defendants in respect of their consent to their unqualified audit opinion of the December 1994 Accounts being included in the Prospectus. There is therefore no utility to be served in dealing with the detailed submissions of both parties in respect of damages on this part of the plaintiffs' claims. THE s 995 CLAIM 297 As I have said earlier this aspect of the plaintiffs' claim against the defendants was dependent upon the plaintiffs establishing the matters under the Consent Claim. The plaintiffs failed in respect of each of those matters. There has been no case run or submissions made that are independent of those claims and accordingly the plaintiffs' s 995 Claim also fails. THE 1995 ACCOUNTS OPINION 298 The plaintiffs' case advanced at trial in respect of these accounts was that the audit opinion should have been qualified particularly in respect of the recognition of profit on the earned value basis in respect of the Russian Contract and the Argentinean Contract. The plaintiffs utilised the events subsequent to the audit opinion being signed on 26 September 1995 to submit that what happened in respect of the December 1995 accounts should have applied to the 30 June 1995 Accounts. Those subsequent events included the Group "moving away" from the earned value basis of accounting in respect of contracts other than defence contracts. This was not the way that the case was put at the commencement of the trial. 299 The plaintiffs' case is that Note 7 to the 30 June 1995 accounts was an inadequate response to what the defendant knew. The claim in respect of the 1995 Account opinion as formulated in the Outline was: As at 26 September 1995 a reasonably competent auditor in the position of Price Waterhouse: (1) would not have given an unqualified audit opinion in the financial statements; and either: (2) would have insisted that the financial statements be redrawn so as to reflect the matters raised in their letter to the Board dated 8 December 1995; or (3) in the alternative to (2) would have given a qualification to their audit opinion to the effect of the matters raised in their letter to the Board dated 8 December 1995. 300 The letter of 8 December 1995 from the defendants to Pacific mentioned earlier in this judgment, referred to matters of significance that were highlighted during the defendants' audit of the 30 June 1995 accounts. The defendant advised that the matters in Section 1 entitled "Business Issues" warranted close and immediate attention of the directors and management. The letter continued: In particular we emphasise the following issues: · Implementation of formal procedures for the approval of research and development projects before their commencement should be considered. Levels of authorisation should be at least as stringent as for capital expenditure (refer Section 1.1). · Implementation of formal procedures for the approval of contract tenders before any significant costs are incurred should be considered (refer Section 1.2.1). · Formal procedures should be established to determine the method of revenue recognition which should be adopted for telecommunications as soon as it is awarded. Authorisation of the method adopted should also be formalised (refer Section 1.3.1). · Independent review of profit take up on contracts should be instituted (refer Section 1.3.2). · Monthly management accounts are not accurate principally because there are no formal procedures for determining the monthly profit take up on contracts (refer Sections 1.3.2 and 1.3.3). · Formal procedures for the detailed review of obsolete and slow-moving inventory each quarter should be considered (refer Section 1.6). · Systems for accurately identifying and monitoring warranty costs should be considered (referred Section 1.5). · Procedures for the regular review and authorisation of commercial management reserves included in projects should be considered (refer Section 1.7). · Procedures to ensure that the margins determined for contracts have a sound basis with adequate supporting documentation should be considered. The contract budgets should be formally and explicitly approved prior to commencement of the project (refer Section 1.8). · Development of a comprehensive formal procedures manual for the finance department should be considered (refer Section 1.9). · Consideration should be given to making a general provision for doubtful debts, of say, 2% of the gross value of trade debtors (for Section 1.10). (Ex J) 301 The three matters in the Outline upon which the plaintiffs relied in respect of the 1995 Accounts Opinion were: 29. Contract tender costs were being capitalised, rather than written off in circumstances where costs associated with unsuccessful tenders should be written off immediately rather than capitalised. 30. Tender costs associated with unsuccessful tenders (and therefore should have been written off) were being reclassified as research and development. 31. Revenue on contracts for the supply of equipment was being improperly recognised on an "earned value" basis, which was not applicable. Furthermore, the methodology for recognising revenue on that basis was not being followed, and was not being applied consistently. 302 The plaintiffs' final submissions really concentrated upon the last of these items in respect of the Russian Contract and the Argentinean Contract. However I should deal with the first two matters in any event. In respect of the first, the capitalising of tender costs, the defendants' 8 December 1995 letter included the following statement: Whilst deferring contract tender cost is acceptable accounting practice it is usual for companies with substantial ongoing tendering to adopt a more prudent policy of writing off tender costs as incurred. The directors should continuously assess the likely success of tenders with significant associated deferred costs. Costs relating to tenders which are unlikely to succeed should be fully written off immediately and only costs which are more likely to be recovered than not should be carried forward. (Ex J) 303 The defendant gave evidence that for the audit of the 1995 accounts the plaintiffs did have in place a procedure whereby a formal assessment of deferred tender costs was made by management to ensure that such costs were only being deferred where it was expected beyond "any reasonable doubt" that the amounts would be recoverable. The defendant also gave evidence that the portion of his letter of 8 December 1995 extracted above was not intended to convey an opinion that the amounts booked in this regard were contrary to accounting standards or otherwise rendered the accounts not true or fair. This evidence was not really challenged and I am not satisfied that this Item was a basis upon which the defendants should have refused to issue an unqualified audit opinion. 304 The second item, reclassifying capitalised tender costs as research and development, relies upon the June 1994 Report and the 8 December 1995 letter for its genesis. The defendant gave the following evidence: 313. The June 1994 Report and June 1995 Report were both year-end reports and, as noted above, primarily contained suggestions and recommendations by us for the improvement of Stanilite's business processes, and particularly, the formalisation of its procedures. In respect of this issue, our comment in each year was as follows: 'Where contracts are not won, tender costs are often reclassified as research and development costs. This is acceptable to the extent that the tender costs include expenses directly related to product development/improvement. Care should be taken to fully analyse such costs before determining the amount to be transferred to research and development to avoid capitalisation of costs which have no on going benefit to the group. We feel that the reclassification of tender costs to research and development should undergo the same formal approval processes which should be implemented for new research and development projects (which was the subject of a separate business improvement recommendation, earlier in each Report )' (PW.0019/0152). Again, I did not intend this to convey a concern by me that Stanilite's relevant accounts were not true and fair in respect of any such reclassified costs. 314. Mr Shanahan expresses the opinion (in paragraph 79 of his Primary Report) that 'the policy of reclassifying deferred tender costs when the tender was not won as research and development was flawed… '. It should be noted that Stanilite's policy in this regard was not to reclassify all deferred tender costs on unsuccessful tenders, but only those where the directors formed the view that the costs were likely to be nevertheless recoverable. 315. In my experience, where Stanilite did adopt the position that the costs of an unsuccessful tender were still likely to be recoverable, this was generally on the basis that the expenses related to the development and improvement of products which had a wider application than the particular contract tendered for. As noted in a letter dated 24 May 1995 from Stanilite to the ASC (PW.0031.0029-36): 'The nature of the contracts tendered for require significant up front input into the design of solutions to meet customers (sic) specifications. These costs often result in the development of a product which is separately marketable or in enhancement to existing product group'. 316. In relation to our comment that care should be taken in analysing such costs before re-classification, Stanilite had confirmed to us (in its formal response to our June 1994 Report (PW.0031.0079-81) that 'any re-classification of tender costs to R&D will also be referred to Board for due diligence as required'. Further, as noted above (in paragraph 309), the capitalisation of research and development costs generally was the subject of formal reviews by Stanilite's management and the Audit committee, for the purpose of ensuring that such costs were only being deferred where it is expected beyond any reasonable doubt that the amounts would be recoverable. 317. Mr Shanahan's opinion that re-classifying such costs at all was "flawed" appears to be based on his stated view that 'the failure to win the tender is more indicative … that the prospects for commercial success had diminished rather than improved'. I did not consider it necessary that the prospects for commercial success should be improved in order to support such reclassification. Even if the prospects for commercial success had in fact diminished somewhat from the prospects that existed when the particular tender was still on foot, this did not preclude a finding that the costs were nevertheless still likely to be recoverable, from some other source. 318. In any event, based on my review of our relevant work papers, I believe that this entire issue was academic in respect of Stanilite's June 1995 Accounts-. The schedule at PW.0038.0004-5 sets out an itemised breakdown of Stanilite's deferred tender costs as at 30 June 1995, including the movements on each item since 30 June 1994. That schedule indicates that, of the total deferred tender costs as at 30 June 1995 calculated by Stanilite: (a) approximately $700,000 were written off at June 1995 (with the reason given in respect of the majority of such items being that the tender was 'lost'); and (b) no amount was transferred to research and development or to any other Balance Sheet account. 319. Accordingly, contrary to Mr Shanahan's assumption (in paragraph 76 of his Primary Report) that this issue would have had a 'material effect on the reported results', it in fact had no effect at all on those results. 305 In the light of this evidence and there being no evidence called from the management of the company I am satisfied that this Item is not a basis upon which to conclude that the audit opinion should have been withheld. 306 It was the third item in relation to the recognition of revenue that was the subject of detailed submissions by the plaintiffs. Section 1.3, "Revenue Recognition", of the Business Issues section of the Report attached to the 8 December 1995 letter is relevant to the plaintiffs' claim in respect of the 1995 Accounts Opinion. It contained an almost identical report that had been issued under cover of the letter dated 28 September 1994 with additional information bringing those "issues" in line with subsequent events. For instance, in the section entitled "Consistent application of earned-value calculation" there was the addition of the words: "This method of calculating earned-value continued to be used selectively on certain projects in the year ended 30 June 1995". The section also included the following: Management comment The Board has resolved to treat telecommunications revenue on a billings/invoice basis from 1 July 1995 onwards. Following the restructuring of each of the now three business units, the CEO's of each division will review profit recognition on contracts. Supporting this review will be accountants, reporting directly to Corporate Finance. Each profit calculation will also be the subject of review by the Audit Committee and from this review recommendations will be made to the full Board. 307 In this instance Mr Shanahan did not provide a suggested qualified opinion as he did in respect of the 31 December 1994 Accounts (Ex. B & C). Although the Outline set out the claim that the plaintiffs made against the defendants on this aspect of the matter, the final submissions were put this way: On 26 September 1995, Price Waterhouse gave an unqualified audit opinion on the accounts for the year ended 30 June 1995 (see the annual report at CB, vol 7, tab 213, page 1969, at 1972 ) although they contained the deficiencies of earlier years, and half years, and although they recognized revenue from the Argentinean contract in the same flawed and inappropriate manner as the revenue from the Russian Contract had been recognized in the previous half year accounts. The disparity between revenue brought to account and revenue received under the Russian Contract appears from the notes to the annual report at page 1982 . The note is wholly insufficient: the accounts should have been redrawn as was done at the calendar year end or the audit opinion qualified. Furthermore, not only should the revenue and profit from the Russian and CTI contracts not have been brought to account in the accounts for the year ended 30 June 1995, but the revenues already brought to account in the half year, should have been reversed under AASB 1009 on the grounds that a loss was foreseeable. Mr Seaton's evidence at tr. 832.40-.41 that "at that stage (28 September 1995) neither the company nor I foresaw a loss on this contract" is not credible. If he is telling the truth, then he is a most unreliable auditor, and witness. The fact that he asked for a note to be included in the accounts is palpable evidence that he did in fact foresee a loss. On the facts as known to him it is impossible to draw any other conclusion. No reliance in the circumstances known to him could reasonably be placed on the directors representations. The plaintiffs submit that the accounts for the half year ended 31 December 1995 reflected what ought to have been appreciated by 16 March 1995, 3 May 1995 and 26 September 1995: that it was inappropriate to bring revenue to account under the Russian contract and that, if revenue had been brought to account for a previous period (as it had been for the half year ended 31 December 1994, it should have been reversed and a loss brought to account. (See Mr Seaton's cross-examination by reference to the provisions that were made in the half year accounts to 31 December 1995 at tr. 847.5-851). The dangers to which a company is exposed when an auditor relies on representations of management are well illustrated by the instant case. The representation letter duly came, dated 26 September 1995 (being the day on which the audit opinion was signed) ( TB, 29, 9651 ) and the auditors were duly informed by management as follows: "The directors have taken reasonable steps to ascertain that the amounts of $23,052,000 representing contract work in progress and $5,738,000 representing trade debtors receivable in relation to the Russian contract will be realized in full, having regard to the uncertainties described in Note 7 to the financial statements." Three days later, on 29 September 1995, there was an internal Stanilite memorandum ( CB, 7, 1997 ) attaching details of Stanilite's problem debtors. Techin Trade is first on the list with a debt of $5.7m said to be outstanding for 7-10 months. Although Mr Seaton may not have been aware of the document, he was certainly aware of the underlying facts, and ought not to have permitted the revenue and profit to be brought to account, and should have made provision for a loss. He was certainly well aware that only $269,000 was ever received by Stanilite under the contract (tr. 837.30-.34). The probability that Stanilite would be unable to perform the CTI contract without incurring substantial penalties (having regard to its own liquidity problems) ought to have prevented the revenue being recognized in the 30 June 1995 accounts. There was a further respect in which the audited accounts differed from Stanilite's true financial position. The cash flow statement for the year ended 30 June 1995 showed that at the end of the year Stanilite had a cash deficiency of $162,000 ( TB, 31, 10353 ), whereas the cash flow statement for the half year ended 31 December 1995 showed cash at the beginning of the year as being a deficiency of $8.508m. The discrepancy of $8.346m is accounted for by the circumstance that the bank overdraft was not taken into account (see tr. 805-806). Mr Seaton agreed that as at 30 June 1995, Stanilite was in a negative cash position to the extent of $8.508m at about the time it entered into the CTI contract (tr. 807.1-.7). The observation had been made by Mr Jansen in his report on Electronics at paragraph 2.2 (tr. 809ff) but had apparently not been drawn to Mr Seaton's attention. It ought to have been of considerable concern that Stanilite's cash position was so bad, given that the figure was arrived at after the proceeds of the placement and the first tranche of the rights issue had been received and taken into account in the cash flow statement (tr. 813.16-.20). The deficiency is consistent with the banks understanding of creditors unpaid as at 30 June 1995, and is broadly consistent with Mr Wights evidence (see in particular NAB file note CB 1604 quoted in 3.255 above). (pars. 3.270-3.277) 308 As can be seen from these submissions the main thrust of the plaintiffs' claim in respect of the 1995 Accounts Opinion seems to be that the defendant should not have permitted the profit from the Russian contract and the Argentinean contract to have been brought to account and that there should have been a loss recorded in respect of the Russian contract (and perhaps the Argentinean contract) in those accounts. This is not something that can be gleaned from the letter of 8 December 1995, notwithstanding that the Outline claims that the accounts should have been redrawn "so as to reflect the matters raised" in that letter. That claim changed to a claim that the 30 June 1995 accounts should have been redrawn to reflect what was contained in the 31 December 1995 accounts. 309 Mr Shanahan referred to the defendant's letter of 8 December 1995 and his evidence on this aspect of the plaintiffs' claim was confined to the following paragraphs of his first report dated 6 March 2002: 75. This was the fourth time that Price Waterhouse had raised their concerns over these accounting treatments with the Directors of Stanilite Pacific. The fact that Price Waterhouse had to continue to raise these matters is a clear indication, in my opinion, that the Directors of Stanilite Pacific were not responding in an adequate manner to the concerns which Price Waterhouse raised. Price Waterhouse did not qualify any of the four sets of financial statements on which their concerns were expressed. 76. In my opinion, the issues raised were significant matters. As indicated by my recalculation of the correct consolidated operating loss before income tax for the half-year ended 31 December 1994, they had a material effect on the reported results of Stanilite Pacific. Price Waterhouse identified issues and brought them to the attention of the directors of Stanilite Pacific. An auditor's duty is to report to the members of a company. By issuing unqualified reports where they were aware of and had raised such concerns, in my opinion, Price Waterhouse failed in their duty as auditors. 310 There were general statements made in paragraphs 3 and 10 of Mr Shanahan's first report dated 6 March 2002 that the accounting treatments in the 30 June 1995 accounts were "in contravention of applicable accounting standards" and that the accounts should have been qualified, but these was never really developed. Mr Shanahan's evidence does not deal with this aspect of the plaintiffs' claim separately from the claim in respect of the earlier claim in respect of the Prospectus Consent. There is no accommodation of the prospect of the findings that I have made that there was no breach of contract or breach of duty in respect of the Prospectus Consent Claim. It is evidence of a most general kind that does not delve into any expert opinion on the facts as they presented as at September 1995 that should have caused the auditor to act in a specific manner. 311 Mr Shanahan's claim in paragraph 75 of his report extracted above that the directors were not responding in an adequate manner must be viewed in the light of the evidence that he did not even call for management's response to the September 1994 letter as referred to earlier in this judgment. It is apparent that Mr Shanahan has drawn that conclusion because the defendant kept referring to these matters in the Business Issues section of his letters and reports. But that conclusion ignores the responses that are in evidence and the contents of the 8 December 1995 letter wherein the defendant referred to management's comments and the events subsequent to the earlier letters. 312 The broad brush claim in paragraph 76 in relation to the letter of 8 December 1995 that "the issues raised were significant matters" as a premise to claim that the defendants "failed in their duty as auditors" is a rather unsatisfactory approach to such a serious allegation. 313 The plaintiffs claimed that the operating profits of the Group disclosed in the 1995 accounts was $15.088 million which was significantly less than the sum of the profit for the Russian and Argentinean Contracts. It was submitted that without an unqualified audit opinion on the profit recognition on those contracts, the directors would not and could not have declared a dividend. When adjustments were made to the accounts for 31 December 1995 the Russian Contract contributed to $14.623 million of those adjustments. It was submitted that such amount was sufficient to eliminate most of the operating profit for the whole of the Group had such loss been brought to account on 30 June 1995. 314 It was submitted that as a result of the unqualified audit opinion on the accounts the directors released the results to the market recording a final ordinary dividend of 4 cents per share payable on 4 December 1995. The plaintiffs submitted that the timing was significant because the shareholders of Pacific were to be called upon to make the payment of the second tranche in respect of the rights issue by the end of November 1995 and the dividend was a sweetener. 315 The defendants submitted that the plaintiffs' attempts to establish their case on these accounts through the cross-examination of the defendant failed. Attacks were made on the defendants on two fronts; first, that the revenues from the contracts ought not to have been recognised in the accounts and, second, that Note 7 in the 1995 accounts should have been reflected in the half-year accounts of December 1994. That evidence included the following: Q. What I want to suggest to you is what this Note evidences is that your state of mind was such as at 11 September 1995 that you were of the view that no revenues ought to be recognised in the 30th June 1995 accounts under the Russian Contract? A. I wasn't of the view that no revenue should be recognised, your Honour. Q. Nor should any assets associated with the performance of that contract? A. I was still happy with the assets, your Honour. Q. And what I want to suggest to you is that having regard to the provisions of 1009, the appropriate accounting treatment of the revenues and assets generated by the Russian contract in the 30 June 1995 accounts was not to recognise those assets or those revenues because of your concerns about their ultimate recoverability? A. I don't think that's correct, your Honour. Q. What I want to further suggest to you is that in respect of those amounts which had already been recognised in the 31 December 1994 accounts, that in the event you decided to recognise those revenues in the 30 June 1995 accounts, you should have then brought them to account as a loss under the provisions of paragraph 20 of 1009 on the basis that it was probable that those revenues and the assets derived from those revenues would not be received? A. Had there been a foreseeable loss, your Honour, yes they would have to have made a provision but at that stage neither the company nor I foresaw a loss on this contract. (tr.832) Q. Was the fact that the company had, on 12 January 1995, been placed under a restriction in respect of expenditures it could make under the contract something which you had in mind? A. No. For the reasons I think expressed before, that those I think the bank were essentially taking a blind eye to. The Company had already incurred the majority of the expenditures on the contract. They had equipment in site in Russia, in place to enable the network to be put up in at least one of the cities and from which revenue would have been earned by the Tech Info Company to enable the contract to proceed. Q. Are you able to indicate anything else which you had in mind as a difficulty being experienced with the Russian Contract at the meeting of 11 September 1995? A. I think my only concern was the fact that this had gone on for twelve months almost, or twelve months – eight months at that stage, and very little cash had been received and I wanted that emphasised in the accounts. Q. What I want to suggest to you is that as at the time of this meeting, that is at 11 September 1995, the difficulties being experienced with the Russian Contract were the same difficulties which had experienced since at least March of 1995 when you were considering whether or not to include earned value for that contract in the half-yearly accounts to 31 December 1994? A. I think two points. At 31st, or at March, I think we had already decided that the earned value would be included, your Honour. I don't think we were taking this into account in considering whether the earned value method should be adopted. And going back to the first point I would like to make, I think that this is now eight months or nine months into a contract which is a lot different to being at the very initial stages of the contract which we were at in March. I think things had deteriorated somewhat compared to March. I think in March there was still a great sense of optimism and come September that optimism I think had to be tempered because it is now six months later. Q. I don't want to go back to March of 1995, but I want to suggest to you that in so far as you seek to suggest in that last answer that there was a sense of optimism in March of 1995, that is not a correct or appropriate summary of the situation as it existed at that time as you understood it? A. Yes, I think in March 1995 everyone was quite optimistic that this was going to be a very successful contract and that money would be received. There were a number of hiccups at that stage but nothing which was going to put the contract off the rails, so to speak. (tr.831-832) 316 The plaintiffs' attempts to suggest to the defendant that the provision made in the 31 December 1995 accounts should have been in the 30 June 1995 accounts were met with a firm response by the defendant. He said: "It never, never did we see a need to make the provision of those amounts at 30 June, I want to emphasise that" (tr.849). The defendant went on to explain that the provisions were raised in December 1995: "because of substantial changes in circumstances" between when the 30 June 1995 accounts were signed in September 1995 and when the December 1995 accounts were signed in February or March of 1996 (tr.849). 317 It was suggested to the defendant in cross-examination that the financial position of the Group at 30 June 1995 was such that it would have been unlikely to be capable of performing the Argentinean Contract. The following evidence was given: Q. What I want to suggest to you that critical to the determination of whether or not Stanilite should enter into an agreement of this nature as at the end of June 1995 was the liquidity of Stanilite at that time because if it was illiquid that was a circumstance which was likely to cause it to subsequently become incapable of performing its obligations under the agreement. A. No, I believed it was going to be able to fund this contract out of the $5 million up-front receipt and the other liquidity issues were not seen as being an issue. (tr.805) 318 The defendant also gave evidence that he believed that the Argentinean Contract was going to be funded out of the proceeds from the contract (tr.833). On the topic of whether the Argentinean Contract was a construction contract the defendant gave the following evidence in cross-examination: Q. You recall that you commented upon the original Argentinean Contract in your letter of 7 February 1995? A. Yes, the original Argentinean Contract, yes. Q. Would you agree that the nature of the equipment which was being supplied under the second Argentinean Contract was the same as that which was supplied under the original Argentinean Contract, although somewhat updated as you have said in one of your earlier answers? A. In nature it would have been the same purpose. Q. But the original Argentinean Contract called for the installation of cellswitches and other associated equipment in various parts of Argentina? A. As I recall, yes. Q. And that would you describe the second Argentinean Contract as being essentially similar to the first Argentinean Contract in terms of the equipment to be supplied and the nature of the installations which were to be carried out? A. In essence, your Honour, yes. Q. What I want to suggest to you is in your letter of 7 February 1994 you expressed the view that it was arguable, that is in relation to the first Argentinean Contract, that the earned value basis of revenue recognition is not appropriate for telecommunications contracts such as the Argentinean Contract. A. Your Honour, that was a draft letter on 7 February, I think I have already mentioned, and that wasn't the final letter issued and that wasn't my final view on the Argentinean Contract in 1994. Q. What I want to suggest to you is that the view which you expressed there was a view which you held at 7 February 1994 and one which you continued to hold in relation to the first Argentinean Contract? A. No. Q. The second Argentinean Contract? A. No. Q. And in relation to the Russian Contract? A. No. (tr. 817-818) 319 The defendant's evidence emphasised that by the time the 30 June 1995 Accounts were to be signed in September 1995 the main change was that the Russian Contract had been on foot for six months longer. The optimism that was present at March and May 1995 was tempered by the fact that in the extra time that the contract had been on foot there had not been any further payment received. The evidence does not establish that there were really any other changes. Indeed paragraph 3.268 of the plaintiffs' submissions seems to recognise this aspect of the matter: Although Mr Seaton's knowledge about the Russian contract increased somewhat in the period from 16 March 1995 to September 1995, the increase was not substantial. The only real difference, for example between 16 March 1995 and 3 May 1995 was that he knew for a fact that the securities had not been provided, the EFIC insurance was still conditional and that there were personality and political difficulties between Dr Bolotov and PTT, in addition to the technical difficulties. Although Mr Seaton says that he believed that the EFIC insurance was in force, he had taken no steps to ascertain that that was the case (tr. 838.22-29 and 839). He had no reason to believe that the special undertaking would be enforced. By September 1995, he knew that the NAB had formally and explicitly reiterated the special undertaking (see the letter of 2 August 1995) and that there had been no waiver. Mr Seaton also knew that the only payment ever made was made in March 1995 and amounted to US$204,000 (A$269,000) – tr 837.30-33. The note to the 30 June 1995 accounts articulated what Mr Seaton had long known. 320 I have found that the defendant did not fail in his duty and did not breach his contract by allowing his audit opinion to be included in the Prospectus when the Accounts included profit recognition on the Russian Contract pursuant to AASB 1009 applying the earned value basis. The real questions for decision on this aspect of the plaintiffs' claim are (1) whether a loss should have been brought to account on the Russian Contract in the 30 June 1995 accounts; and (2) whether the Argentinean Contract profit should have been included in the 1995 accounts. If a loss on the Russian contract should have been brought to account and/or the profit from the Argentinean contract excluded from the accounts, then the defendants owed Pacific a duty not to sign the accounts in the form that they were signed with Note 7. 321 In my view the plaintiffs' case has insurmountable evidentiary difficulties. There is no expert opinion expressed as to why a competent and diligent auditor should have formed the view that there should have been a foreseeable material loss as at 26 September 1995 when the audit opinion was signed. Certainly there are facts that demonstrate that Techin Trade was a debtor to the tune of $5.7 million but it is not for the Court to conclude on that fact that there was a foreseeable loss. There is also the subsequent decision of the Board to change the accounting policy in respect of the telecommunications contracts but that is not a proper basis for the Court to conclude that the auditors should have concluded that a foreseeable loss should have been brought to account as at 30 June 1995. 322 The plaintiffs made a forensic decision to call no expert opinion on this aspect of the matter, other than that to which I have referred above, and chose to rely upon the cross-examination of the defendant. Having obtained the evidence that not only the defendant but also the company did not foresee a loss at the relevant time, the plaintiffs submitted that the evidence was "not credible". 323 In support of the claim that the evidence was not credible the plaintiffs relied upon the following passage of what Lord Pearce said in Onassis & Calogeropoulos v Vergottis [1968] 2 Lloyd's Law Rep 403 at 431: "Credibility" involves wider problems than mere "demeanour" which is mostly concerned with whether the witness appears to be telling the truth as he now believes it to be. Credibility covers the following problems. First, is the witness a truthful or untruthful person? Secondly, is he, though a truthful person, telling something less than the truth on this issue, or, though an untruthful person, telling the truth on this issue? Thirdly, though he is a truthful person telling the truth as he sees it, did he register the intentions of the conversation correctly and, if so, has his memory correctly retained them? Also, has his recollection been subsequently altered by unconscious bias or wishful thinking or by over much discussion of it with others? Witnesses, especially those who are emotional, who think that they are morally in the right, tend very easily and unconsciously to conjure up a legal right that did not exist. It is a truism, often used in accident cases, that with every day that passes the memory becomes fainter and the imagination becomes more active. For that reason a witness, however honest, rarely persuades a Judge that his present recollection is preferable to that which was taken down in writing immediately after the accident occurred. Therefore, contemporary documents are always of the utmost importance. And lastly, although the honest witness believes he heard or saw this or that, is it so improbable that it is on balance more likely that he was mistaken? On this point it is essential that the balance of probability is put correctly into the scales in weighing the credibility of a witness. And motive is one aspect of probability. All these problems compendiously are entailed when a Judge assesses the credibility of a witness; they are all part of one judicial process. And in the process contemporary documents and admitted or incontrovertible facts and probabilities must play their proper part. 324 With respect to Lord Pearce it is perhaps dangerous to make generalisations about witnesses because they are so different in so many respects. I am not quite sure what Lord Pearce meant when he referred to "emotional" witnesses, but it seems they fell into a category of people who conjure up legal rights when they do not exist. One can well understand the existence of some "emotion" when one's professional conduct is under attack, however I find it unhelpful to utilise Lord Pearce's generalisation. 325 The plaintiffs submitted that the defendant allowed his position to compromise his evidence. It was claimed that as a professional under attack he had given self-serving answers in preference to truthful ones. It was submitted this may have occurred because he was in the position of having to defend the indefensible. The matter that was indefensible in this aspect of the plaintiffs' claim is apparently that no loss was foreseen on the Russian Contract by him or the Company at the relevant time. What the plaintiffs really emphasised from Lord Pearce's approach was that contemporaneous documents should feature significantly in the assessment of the defendant's credibility. 326 The defendant referred specifically to the fact that the majority of the expenditure had already been incurred on the Russian Contract and the fact there was equipment on site in Russia to facilitate the construction of the network. One contemporaneous document, Note 7, referred to the directors' understanding that the approval from the relevant authorities in Russia, a matter that had delayed the performance of the contract, was imminent. Another contemporaneous document was the letter from the directors referring to the uncertainties listed in Note 7 and stating that they had taken reasonable steps to ascertain that the WIP and the trade debts receivable in relation to the Russian Contract would be "realised in full". The defendant was working with a company that was described in oral evidence and in the contemporaneous documents, as one that was pursuing a strategy of rapid growth. There was evidence of success in this regard in relation to the first Argentinean contract worth $20 million. The defendant gave evidence that the results of the company fluctuated from month to month depending on when contracts came in and contract work was done (tr. 751). These matters together with the optimism of the winning of the Russian Contract running parallel with the approach of a banker that, although it imposed tight reins, was "supportive" were all matters that need to be taken into account in assessing the plaintiffs' claim that the defendant's evidence was not credible. 327 The plaintiffs also submitted that the fact that the defendant required Note 7 to be included in the accounts and required the letter from the directors, is evidence supportive of the submission that he really did foresee a loss on the Russian Contract at that time, in contrast to his oral evidence. 328 The defendant's letters to Pacific do not support the picture that the plaintiffs paint of the defendants' conduct in this case. The letters present rather the opposite picture of an auditor and then independent accountant monitoring the suggestions made to the company and bringing those suggestions back with the response of management for further consideration of the Board. There is nothing in the 8 December 1995 letter that demonstrates that the defendant really foresaw a loss on the Russian contract at the time he signed the opinion in September 1995. 329 The fact that Note 7 was included in the accounts does not demonstrate to me that the defendant foresaw a loss. It is appropriate to refer once again to the contents of that Note: Work in progress after deducting progress claims includes $8,702,000 (current) and $14,350,000 (non-current), including attributable profits to date, which relate to a contract dated 11th November 1994 (and as subsequently amended) for the installation of a telecommunications system in Russia with Techin Trade Limited (TTL). In addition, an amount of $5,738,000 is included in current trade debtors in relation to progress claims on the contract. The Group's ability to receive payment for work on this contract and the timing of those receipts is dependent on: (i) the approval of the system by Russian telecommunications authorities and its subsequent roll out by TTL; (ii) remittance of a contracted proportion of the proceeds from the sale of terminals, collection fee and call revenue by regional operating companies to TTL or directly to the economic entity at the discretion of TTL; and (iii) availability of US dollars from the Russian Central Bank. The directors have evaluated the technical and commercial risks associated with this contract. The testing of the system by the authorities is under way and the directors believe that approval of the system is imminent, based on company prepared forecasts in relation to the market in which the systems will operate. The directors consider that the allocation of the assets between current and non-current and recognition of the attributable profit is appropriate, notwithstanding the uncertainties inherent in the matters mentioned in the above paragraph. To date the economic entity has received $269,000 from TTL in relation to the contract. Ownership of the equipment does not pass until payment has been received in full. Export insurance for 60% of the invoiced amounts has been taken out with Export Finance and Insurance Corporation. In addition, the economic entity holds guarantees and other security estimated by the directors to have to a maximum value of $10 million. (Ex F: 1982) 330 The rendition of the facts in this Note is not equivalent to the test in AASB 1009 that a "material loss" was foreseeable (cl .20). It may be that one might suspect that a person reading this material might have their doubts as to whether some loss might be foreseeable on the contract but what was required to be brought to account as soon as it was foreseeable was a "material" loss. Similarly the fact that the directors wrote the letter at the defendant's request does not establish that the defendant foresaw a "material loss" at the time. It may be concluded that the defendant wanted the directors to ensure that the technical and other difficulties that had been experienced would not further impede the performance of the contract having regard to the fact that time had passed with no further payment, but in my view the evidence is not such as to render the defendant's statement in his oral evidence that neither he nor the Company foresaw the relevant loss, as lacking in credibility. 331 I accept the defendant's evidence that he and the Company did not foresee a loss at that time. The next question would have been – was that view one that was available to the reasonable and diligent auditor on all the facts as they presented at that time? The plaintiffs' evidence does not address this question. Mr Shanahan's evidence, being the only evidence to address this aspect of the matter in only a general way, does not assist. The evidentiary difficulties of the plaintiffs are, as I have said, insurmountable. 332 The same difficulties apply to the claim that the profit on the Argentinean Contract should not have been brought to account. No witness for the plaintiff addressed the details of the contract, the nature of the contract, or the expectation in respect of what a competent and diligent auditor should have done in relation to the profit on this contract in the 30 June 1995 accounts. The only evidence was that of Mr Shanahan referred to earlier in the two paragraphs as extracted. There is certainly nothing in the letter of 8 December 1995 that supports the plaintiffs' claims that the defendants were negligent or in breach of their contract. 333 The Statement of Works in Attachment I to the Argentinean Contract required Pacific to "design and interface its cellular basestation and switching equipment to the CTI supplied satellite network and will optimise the total system within the characteristics imposed by the use of satellite connections between basestations and switching equipment" (Ex F: 1522). The Contract also included the following: Stanilite will be responsible for all the wiring and cabling of the cellular equipment. It will be responsible for connecting the interfaces between the satellite and the cellular equipment. Ancillary equipment such as electrical crimps/lugs, fuses, cable ties, and other consumables needed to support installation of Stanilite equipment will be provided and installed by Stanilite. If any event or circumstance beyond the control of Stanilite that results in delay or otherwise impacts on the work then Stanilite will provide notification to CTI within 1 day of Stanilite becoming aware of the issue. CTI will commence activity to resolve the issue as soon as practicable. An example of such a situation may be temporarily removing a section of the fence to provide additional space. If a work around cannot be accomplished an exception will be generated by CTI. (Ex F: 1533) 334 CTI was obliged to provide services to facilitate the Project Completion including making "sites ready and suitable for installations including towers, antenna, cable, empty buildings/shelters on-site" to accommodate the standard equipment, fencing and certain utilities (Ex F: 1508). This of course was the type of work for which the plaintiffs were responsible under the Russian Contract relevant to the question of whether that contract was appropriately categorised as a construction contract within AASB 1009. What was actually required under the Argentinean contract for the plaintiff to "optimise the total system within the characteristics imposed" as required by the Statement of Works was not explained in the evidence by any of the plaintiffs' witnesses. The design work and the "interface" and "optimising" of the system to the construction work, (the building work including the antennae and towers etc. completed by CTI) seem to me to establish that the contract could reasonably be described, as Mr Robertson did in respect of the Russian Contract, as a contract for "other services relating to the construction work". The plaintiffs called no evidence to establish that the pre-requisites to the application of the percentage of completion, or earned value method, had not been satisfied in respect of the Argentinean Contract. 335 It was suggested to the defendant in cross-examination that there was a danger of the imposition of heavy penalties under the Argentinean contract if there was default. The defendant agreed there were penalty provisions but resisted any suggestion that the defendants or the Company were concerned in mid-1995 or in September 1995 that such would eventuate (tr. 805). It was also suggested to the defendant that the company's liquidity problems should have given him cause for concern that the company could perform the Argentinean contract. The Contract was entered into on 27 June 1995, although Pacific anticipated profits being brought to account on the earned value basis in its Schedule of Revenue Accruals prepared in about April/May 1995 (Ex F: 225). The Contract spanned reporting periods and the defendant pointed out that $5 million was received from CTI in July 1995 that was to fund the performance of the contract (tr. 805). 336 The claim as finally propounded was that the provisions in the 31 December 1995 accounts should have been made in the 30 June 1995 accounts. The defendant's evidence that there were changed circumstances between September 1995 when the 30 June 1995 Accounts were signed and February/March 1996 when the 31 December 1995 accounts were signed is a pertinent observation and one that I accept as reasonable. The change in the accounting policy introduced as a result of the Arthur Andersen report and later review and the bank's requirements had a very great impact on those latter accounts. The fact that such a step was adopted by the plaintiffs in response to the report and the bank's requirements is not evidence that the defendants were negligent or in breach of contract. 337 Mr Shanahan relied upon Appendix 1 to his first report of 6 March 2002 as a basis for the general opinions that he expressed in relation to the 30 June 1995 accounts. Appendix 1 is a partial extract of the letter from the defendants to the directors of Pacific dated 8 December 1995. There is nothing in that extract that supports the allegations made in relation to the Argentinean contract. This aspect of the plaintiffs' claim also has insurmountable difficulties. 338 The plaintiffs' claims in respect of the 30 June 1995 Accounts Opinion fails. Order 339 The Amended Summons is dismissed. If the parties are unable to agree on a costs order I will hear argument on a date to be fixed by arrangement with my Associate, but no later than 23 May 2004. ****************************** Last Modified: 01/20/2005 DISCLAIMER - Every effort has been made to comply with suppression orders or statutory provisions prohibiting publication that may apply to this judgment or decision. The onus remains on any person using material in the judgment or decision to ensure that the intended use of that material does not breach any such order or provision. Further enquiries may be directed to the Registry of the Court or Tribunal in which it was generated.