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Integrated case studies (Acc 4291)

Case report 1
flat cargo berhad: an auditors conundrum

Prepared by:

Checked by: Prof. Dr Shamsul Nahar Abdullah

Case Synopsis The case is related to one company known as Flat Cargo Berhad (FCB). FCB was one of the largest air freight companies in Malaysia which servicing several government linked companies including Freight Malaysia Berhad. FCB is a listed company and was registered as an investment holding company with several subsidiaries. Among its subsidiaries are FC Spare Sdn Bhd, Cargo Management Sdn Bhd, FCB (SPV) Ltd, Cargo Air Services Sdn Bhd and FC Air Ltd. FCB started its operations in 1997 with two aircrafts: a Boeing 737-200F and a Cessna Grand Caravan. FCBs major shareholder in 1997 had been Bangor Berhad, which was part of a diversified international family owned conglomerate, the Miri Group. Up to 2005, FCB secured agreements with well-established companies such as Worldwide Express, United Parcel Services (UPS), Nationwide Express, Citylink, Bax Global and Nippon Express. The Chairman of FCB was Dato Ibrahim Samad who was also an independent non executive director of the company. The top management team comprised of Mr Lim Loon Sim as Chief Executive Officer, Mr Ali bin Ahmad as the Executive Director and Mr Kim Boon Chok as the Chief Financial Officer. In 2005, FCBs counter was ranked 4th in terms of capital gains and di vidends to shareholders. Its share price at 31 December 2001 had been RM 1.89, but by end of 2005, the share price surged to RM10.60 per share. Turnover for 2005 was RM550 million, which is more than 1 times than that for 2004. Analysts were expecting FCBs revenue to increase for the next year by a further 54% to RM809 million because of its major capacity expansion in 2005 despite the rising fuel prices. FCB also acquired several new aircrafts and projected to secure additional landing rights in China. FCBs high gearing posed serious concerned. Rating Agency Malaysia (RAM) downgraded the companys long term rating from stable to negative. The rating was due to the companys high gearing ratio and weak debt servicing ability. This case is also involved Kencana & Associates which served as its auditor. In 2006, during a routine financial audit, the auditors identified several suspicious findings that resulted in a delay in finalising the auditors report. The case presented an auditors dilemma involving the possibility of fraud in a financial audit engagement which will risk his firms reputation. The

auditors were convinced that FCB was a reputable company with a good business model and the possibility of irregular activities in FCB was remote. The protagonist in this case is Mr. Chuah Mun Soong who took the responsibility as the audit team leader for auditing the financial report of FCB in year 2006. Identification of the Problems and Main Issue Problems in this case can be identified by assessing the difficulties faced by the protagonist and also his audit team. By analyzing the case, the problems identified can be categorized into three main categories which are problems during audit process, problems with corporate governance issue and lastly problem with doubted financial performance. For the first category which is problem during audit process, among the problems is the audit team were unable to verify the assets of FCB in term of its existence and true monetary values. This is because the auditors were unable to verify the aircrafts claimed to have been purchased by FCB in 2005. Besides, a non-functional rundown aircraft barely worth RM231 million in was found in hangar during physical siting. In addition, the verification on debtors values cant be made too due to several debtors confirmation letters were returned back to auditors. The auditors were not only unable to verify on the assets but they were also detected suspicious transactions during the audit process. One of them is a large sum of sales transactions was found with no supporting documents. The others are a loan received from Hong Kong based company was found to be incorrectly recorded in the debtors account and several abnormal transactions involving the purchase of aircrafts by FCB then offsetting the debtors account were found in FCBs books. Second category of problem is related to corporate governance issue where the auditors found that there is incompliance towards Malaysian Code of Corporate Governance regarding the composition of Audit Committee. This is because one of the Audit Committee members is Mr Ali bin Ahmad who is Non-Independent Executive Director. According to Malaysian Code of Corporate Governance, all Audit Committee members must be non-executive directors.

Last but not least, auditors also have problems with the financial performance of FCB. From the analysis on the financial data of FCB, the profit margin achieved by this company was around 20% which can be considered as abnormal. According to the norms, the industry or air cargo is described as highly competitive with low profit margin. This is because there are about 85 operators servicing all over Malaysia and Asia Pacific region. Besides, the financial performance showed by FCB portrayed that this company is not affected by market condition where actually in 2005, an international crisis occurred with exceptional increase in oil prices. So, all this situation if compared to what was achieved by FCB has created doubt and problems to auditors in justifying the true and fair of FCBs financial performance. All these problems actually can actually can dilemma for auditors that possibility of fraud may exist in FCB. Of course, internal control is one of the aspect that directly related to fraud. An internal control is one of the elements that fall under responsibility of Audit Committee to be governed and monitored. So, it is believed that the main issue that lead to all the problems as described above is actually rooted from an ineffective role played by Audit Committee which is the main bodies that responsible on the internal control of the FCB. Should auditors be held responsible for not detecting the misstatement that result in fraud? Company that uncovers fraud is often surprised that the incident occurred in the first place. Fraud can happen due to many reasons whether due to lack of internal controls, an ineffective managerial style, or incompliance to code of ethics that employees should adhere to. One thing that cant be denied is when evidence of fraud is found of course the entire organization is severely impacted and affected. It is common that the external auditors are the one that always being blamed every time fraud happened. Why does the finger always point to external auditors? Should they really be blamed if fraudulent activity is not uncovered on their watch? Can responsibility solely be placed on an external and independent body where in this case is Kencana and Associates that hired by FCB as external auditors or should responsibility be shared with all the stakeholders, primarily those who, by intentional or unintentional negligence, have facilitated the fraudulent transactions in FCB? There are many factors must be considered before the auditors can be easily blamed or should be held responsible for not detecting the misstatement earlier.

First of all, it must be clear in the first place who is actually responsible to do preventive actions to ensure that fraud will not happen. Fraud is so hard to be detected and the best defense against its occurrence is in the strength of a companys internal controls. It is managements responsibility to implement internal controls to prevent, detect and deter fraudulent financial reporting, to ensure an adequate tone at the top culture and a zero-tolerance policy vis-a-vis fraud. Yet even if all of the above procedures are adequately implemented, fraud can still occur as no system is foolproof and peoples behavior cannot be controlled. The other factor that should be considered to decide whether external auditors really responsible due to fraud is whether the detecting fraud is one of the task compulsory to be addressed by auditors. The auditing profession has entitled the discrepancy between what investors expect and what auditors actually do an expectation gap. Many investors expect a foolproof audit, with somewhat of a guarantee as to the non-existence or of fraud or misstatements, irrespective of how immaterial they are, whereas audit firms have taken it upon themselves to educate the public as to their actual role in the financial statement audit, which does not in clude guaranteed fraud detection. The audit report is the single most important deliverable the auditor offers also highlights auditors limitations in finding fraud. However, at the same times, the auditors themselves should conduct their audit professionally while keeping an eye out for fraudulent activity. This entails investigating further any warning signs and red flags that may appear during the course of the audit and reporting them in a timely manner. Part of the audit scope entails assessing the control environment in place, and its effectiveness, for the purpose of designing the audit approach. From the above stated criteria, Kencana as the external auditors of FCB can be considered responsible for not detecting the misstatement only but not responsible for causing the fraud. The main reason for this justification is because during the audit process, the auditors have found some suspicious transactions related to sales where one of them is a large sum of sales transactions were found with no supporting documents. So, this group of sales transactions can be the main contributor for inflating the FCBs annual earnings. Besides, this finding somehow can be a good evidence to show that misstatement has been detected then justify the possibility of fraud to be happened in FCB. So, auditors should report this misstatement in their auditors report after finishing their audit process. However, still Kencana and Asscociates cant be the one that solely blamed for this issue because the main parties responsible for leading the

misstatements and fraud are the Board of Directors and Management of FCB who in the first place should ensure good internal control is implemented in the FCB which at least can reduce the risk of fraud. Analysis on situation of FCB based on Fraud Triangle Model The first element in the Fraud Triangle Model is pressure where this element becomes the motivation for individuals and companies to commit fraud. The pressure that can be identified in FCBs situation is related to the financial aspect of the company. The analysts expectation on increment of revenue and the steady payment of dividend despite of the low profit margin business in highly competitive market as well as the increase in oil prices that significantly affect the business can be the main motivation for FCB to inflate its earnings even though it might be through illegal means. The second element in the model is opportunity which is commonly associated with internal control which not strong enough to reduce the risk of fraud. Internal control of a company is closely related to the companys corporate governance because good corporate governance can reduce the possibility of misconduct to happen and high risk detection is there so it will results in strong internal control. The corporate governance in FCB that might be lacking was related to Audit Committee composition. One of the Audit Committee members is Ali Bin Ahmad who is a non independent executive director. This is considered as violation towards the Code of Corporate Governance applied during that time where all the members supposedly consists only non-executive directors. This violation hence might be affecting the independence of the Audit Committee whose function is to oversee the internal control of the company. In addition, whilst there was a good composition between executive and non-executive directors in FCBs board, the composition between independent and non -independent directors seems to be not in balance as specified by the Code thus the objective to maintain independence might have not been achieved.

The third element of the model is rationalization which can be defined as the mindset of fraudsters in justifying themselves. The individuals that involved in intentionally misstated the transactions and financial figures in FCB might had justified themselves so as to maintain the companys reputation and meeting the analysts as well as other stakeholders expectation.

In summary, the three elements of the Fraud Triangle Model might had been existed but not been realized thus led to the late detection on the possibility of fraud in FCB. committed