Introduction of the Korean court's decision that the error in the assessment of inventory assets is a false statement of a material fact
In the first trial of a lawsuit to claim damages filed by the plaintiff who is one of the shareholders of SGC Energy(Samkwang Glass), the 21st civil division of Seoul Central District Court decided that evaluation fallacy of inventories’ net realizable value is tantamount to a false statement of a material fact on a business report and thus the company shall be liable to pay for the damage the plaintiff sustained.
Samkwang Glass received qualified opinion over financial statements due to inventory false statement
Samkwang Glass scrapped inventories which was worth about 17-billion-won based on the ledger balance on the time around November 2017. The company recognized it as a loss and applied it to cost of sales. Afterwards, the company received qualified opinion from an accounting firm who conducted the audit on March 29th 2018 over 2016 and 2017 financial statements, which commented ‘it is hard to confirm that the estimation of inventory loss and inventories’ net realizable value before the end of the current and preceding fiscal year was properly implemented.’
November 6th 2018, the company submitted and publicly announced a declaration of correction for 2017 business report, and revised allowance for overvaluation of inventories and amount of connected account on current financial statement which is included in 2015~2017 business report.
Consequently, inventory assets in 2015 business report were decreased from 121.5 billion won to 112 billion won. In 2016 business report, inventory assets were decreased from 123.2 billion won to 112.1 billion won, sales profit 3.6 billion won to 1.7 billion won; and net profit in the term was decreased from (-)2 billion won to (-)3.6 billion won. Inventory assets in 2017 business report were decreased from 114.7 billion won to 105.3 billion won as well. In short, Inventory assets of Samkwang Glass has been exposed to obsolescence risk prior to year 2017, therefore net realizable value has been degrading.
The plaintiff claimed that Samkwang Glass shall indemnify for stock price drop caused by the false announcement
The plaintiff, one of the shareholder of Samkwang Glass, claimed that the company shall be liable to pay for the damage sustained by stock price fall based on article 162 (1) 1 of Financial Investment Services And Capital Markets Act since the company reported and publicly announced business report which include overstatement of material facts such as inventories, sales profit, net profit, and plaintiff purchased company’s stocks trusting this wrongly-recorded report.
On the other hand, Samkwang Glass stated that even though the company did revise inventory assets of 2015 and 2016 financial statements by a declaration of correction after receiving the qualified opinion from an accounting firm, this was just retroactively changing the way of estimation of inventories which was occurred by the change of accounting policy, hence was not a correction of error in prior fiscal year.
The court ruled, a fallacy in evaluation on inventory assets is tantamount to ‘a false statement of a material fact’
Considering importance of financial statements which listed corporations report and publicly announce as investment indicator and necessity of preparing financial statement according to corporate accounting standards, Supreme Court views recording overestimated assets into the financial statements which is overrated beyond the reasonable and objective limit allowed in corporate accounting standards is tantamount to a false statement like counting fictitious assets.
On the condition of above, the court decided that the error Samkwang Glass made by overstating its inventories in year 2015 and 2016 financial statements could significantly impact on investor’s reasonable investment judgement, and this is ‘an important prior period error’ referred in Korean International Financial Reporting Standards and this is also ‘a false statement of a material fact’ in article 162 of Financial Investment Services and Capital Markets Act. Therefore, Samkwang Glass shall be liable to pay for the damage plaintiff sustained.
In addition, the court rejected Samkwang Glass’s argument and judged, “changing the way of estimation of inventories’ net realizable value is change of accounting estimate, not the change of accounting policy.”
However when judging the causal relation between Samkwang Glass’ false announcement and the loss the plaintiff sustained, since the causal relation is factually presumed when the stock is acquired after the business reports with false statements released, the causal relation of stock-trading for stocks the plaintiff acquired after March 30th 2016 - the day 2015 business report was announced – is acknowledged but the not for stocks acquired before March 30th 2016.
Court reaffirmed that there is no limitation for the way to prove a false statement of a material fact
An overstatement of asset value or sales profit is a typical way of accounting fraud which is ‘a false statement of a material fact’ by Financial Investment Services and Capital Markets Act, and there is no exception even if it is based on a fallacy of evaluation of inventories’ net realizable value. False statement in a financial statement can be proved not only by investigation of the prosecution office or any financial supervisory authorities but also by a qualified opinion or correcting public announcement. In Samkwang Glass case court re-affirmed such common sense.
Dong Wook Kim (dwkim@hnrlaw.co.kr)
Han Gyul Lim (hglim@hnrlaw.co.kr)
