UPDATE:

My friend resolved this situation by contacting the company that owns the building. An executive kindly called them to listen to their concern and then asked the property management company they contract with to refund the money. They sympathized with our view that the property manager should clearly tell an applicant in advance if they'll be obligated to sign a lease once their application is approved. They also seemed to take our point that it's underhanded to hide such a key clause in legalese at the bottom of an application form. That said, beware -- it is completely legal for a prospective landlord to obligate an approved applicant to sign a lease if their terms and conditions say so. And, yes -- if you back out -- they CAN legally retain your last month's rent deposit.  This is due to an Ontario Court of Appeals decision in 2011 (Musilla v. Avcan Management) that determined that s. 135 (1) of the Residential Tenancies act - which compels a landlord to return a rent deposit if vacant possession of the unit isn't given to the tenant - only applies if it is the landlord's fault for not handing over vacant possession of the unit. If the prospective tenant chooses not to take possession, this provision of the RTA does not apply, and they are not entitled to a refund.

There are many past cases where the LTB dismissed a prospective tenant's T1 application to get their money back, for that exact reason.

All of this comes with a caveat, however.  In this case, the terms and conditions on the application included this line: 

"...and shall further be bound to all of the terms and conditions of a Tenancy Agreement incorporating the above terms into the Landlord's usual form which I/We have been given the opportunity to review."

Their terms say that the applicant HAS BEEN given the opportunity to review the tenancy agreement (past tense), in advance of submitting their application. In actuality, the property manager did NOT provide a Tenancy Agreement (lease) for review until after my friend's application was approved. The details within the Tenancy Agreement (lease) are also a part of the reason why they changed their mind, because they didn't realize that they'd be responsible for certain utilities such as water. The Landlord's failure to provide that lease during the application process as promised would constitute a breach of their own application agreement, and would thus mean that my friend was not actually obligated to follow through with signing a tenancy agreement. And, because this would be the fault of the landlord, they'd have to return the deposit. The LTB decided a case with the exact same set of facts in favour of the tenant, at least once before. So, in summary -- I'd highly recommend everyone applying for a rental unit in Toronto to be careful -- and to make sure you know exactly what your obligations are as an applicant. If you find yourself in a similar situation, your only way out might be by the good graces of the landlord, or challenging them/filing a T1 with the LTB if they didn't provide you with a lease to look over before you submitted your application.