Financial Analysis Window Dressing

CASE STUDY FINANCIAL REPORT ANALYSIS

Three Executives of a well-known multi-national company decided to form a new
company named !ew "tar #ompany $imited in %&'() These three executives were
*ecoming close to their retirement age) +ifco-,en #hen #ompany $imited the company
that they worked for had *een in *usiness for the last -. years) /t was their previous
employer0s policy to retire the executives with a 1golden hand-shake2 worth
approximately 3"4%5.... each) The three executives occupied the following position
with +ifco-,en #hen #ompany $imited 6%7 Finance 8anager 8r) ,u #hang 657 "ales
9 8arketing 8anager 8r) $im $am and 6:7 ;isk 8anagement 8anager 8r) "hu
#hing) /n their previous position with +ifco-,en #hen #ompany $imited they were
regarded as the most respected executives *ecause the company made significant
progress in terms of organic growth and diversification) The #hairman of the <oard of
Directors Dr) Wing Wan used to call them 1the three wise men2) +ifco-,en #hen
#ompany $imited main *usiness activities were the manufacturing of 1twisties2 and
acted as wholesale distri*utor of a special drink called 1Wysalt2) The drink is full of
calcium and protein and it is very popular in the "outh East Asia) Each year0s Annual
=eneral 8eeting of +ifco-,en #hen #ompany $imited0s gross income and net profit
*efore taxation increased *y %.> while its main competitor0s performance was declining
at an alarming rate) #hairman Wan always wanted to find out what is the main reason
driving its company0s operational success) /n a nutshell #hairman Wan always *elieved
that the financial result was 1too good to *e true2 *ecause whenever he has a chance to
play golf with one of the #hairman of his competitor company he was told that life as the
head of a corporate is *ecoming un*eara*le due to competition and increased in the cost
of living) "till 8r) Wan kept ?uiet while congratulating his three wise men for a fantastic
@o* each year) Even the external Auditors could not *elieve the significant progress
which the company used to when the three wise men were working for +ifco-,en #hen
#ompany $imited) The auditors knowing too well the performance of the company
*efore the departure of 8r) #hang 8r) $am and 8r) #hing cautioned the #hairman that
it would *e a great loss for the company to loose three key executives in one go) /n view
of the continued pressure and perplexities of the situation one afternoon #hairman of
+ifco-,en #hen #ompany $imited Dr) Wan called a special <oard of Directors meeting
to address his concern regarding the retirement of 8r) #hang 8r) $am and 8r) #hing)
Ane of the vocal directors) who did not get along very well with these three managers
said 1it does not matter if all of the three men were to leave the company today *ecause
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Financial Analysis Window Dressing
they are not indispensa*le people2) Be went on to argue further that 1we can replace them
easily *ecause there are other professionals looking for work2)
According to the employment contract of the three wise men they were paid a *asic
salary plus they also *enefited with a 5> commission on the net profit of the company
each year after the accounts have *een finaliCed *y the external auditors) The /nternal
Auditor 8iss Wen always ?ueried this employment terms that it favours mostly these
three managers at the detriment of the other hard-working employees) Ane day in a
management meeting 8iss Wen expressed her frustration of the favoura*le treatment of
the three managers *ecause she felt that they are working very close and perhaps
manipulating the figures so that they can *enefit a hefty remuneration every year)
#hairman Wan felt every uneasy during this meeting and closed the meeting earlier than
expected) After the meeting 8iss Wen wrote a memo to the #hairman of the <oard of
Directors to complain that the external auditors come on the premises of the company for
a very short time to perform the audit) They do not carry out an efficient audit and the
+ifco-,en #hen #ompany $imited runs the risk of facing a corporate collapse when
those three managers had left)
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Financial Analysis Window Dressing
/n the a*ridged version of the financial statement of +ifco-,en #hen #ompany $imited
the following item appears at the end of the financial year %&'D)
US$
(miilion)
Net Fixed Assets 4
In!estment in S"#sidi$%ies &'
C"%%ent Assets
US$
(miilion)
Sto()s *+
De#to%s ,'
P%e-$id Ex-enses 4'
.$n) De-osits (/ D$0 C$ll A((o"nt) 1'
C$s2 $t .$n)s &'
Pett0 C$s2 *
&41
Less3 C"%%ent Li$#ilities
C%edito%s 4
A((%"ed Ex-enses &'
S2o%t4Te%m De#t
O!e%d%$5t .$l$n(e /
+'
Net C"%%ent Assets6(Li$#ilities) *4*
Tot$l Net Assets +*1
Fin$n(ed #03
Lon74te%m De#ts 8'
C$-it$l ,'
A(("m"l$ted P%o5it "ntil *,/ 41
*&1
+*1
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Financial Analysis Window Dressing
/n the financial statement there is an amount of 3"4 5D million worth of over-valued
stocks which has *een in the accounts for the last D years) !o provision has *een made in
the De*tors Account for non-performing account worth 3"4& million) #urrent operating
expenditure to the value of 3"4 ' million has *een accounted as 1prepaid expenditure2)
The *ank reconciliation has not *een done properly for the last : years and the external
auditors have accepted the Finance 8anager0s figure of 3"4 :. million) /t appears that
there are %. che?ues valued to 3"4: million has *een deposited in the accounts and have
*een returned *y the *anks *ecause the customers did not have funds) There has need no
ad@ustment made su*se?uently to correct the *alances at *anks) The exact figure for the
"hort-Term De*ts should *e 3"4 ED million and not 3"4 DD million as disclosed) There
is a mistake in the disclosure of Averdraft FacilityF the figure should appear as 3"4 -D
million and not 3"4'D million) /n addition the "ales 9 8arketing 8anager has entered
into a financial contract for one of the raw material suppliers to supply e?uipment to the
value of 3"4%D million to increase production of twisties and this contract does not
reflect in the statement of accounts) The external auditor stated that since there is only a
commercial contract and the official invoice has not *een received *y the company then
there is no point to account for this transaction) A review of the ?uarterly report issued *y
the ;isk 8anager does not indicate any a*normality in the financial statement from a risk
management perspective) /nstead the ;isk 8anager would normally end his report with
the words 1/ foresee that the company is operating in a very sound and successful
manner) The <oard of Directors should *e proud of such achievement2) The "ales 9
8arketing 8anager would give the indication that the company is progressing very well
and eventually it should *e a*le to launch a 1*id2 to takeover one of its competitive
rivals) The Finance 8anager would normally end his reports with such phrases such as2
good performance2 1we are on the right track2 1the <oard of Directors should feel proud
of the company0s financial performance2)
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Financial Analysis Window Dressing
9UESTION TI:E
%) /n reading this case study what is your first impression of the state of affairs with
+ifco-,en #hen #ompany $imitedG
5) /s the company on the right track after you have read the financial statementG
:) Bave you identify any pro*lem with this companyG
() /f you were to correct the financial statement using the supplementary notes
given what will *e the final outcome in terms of the company0s !et WorthG
D) Who is responsi*le for the sad state of affairs which the company finds itselfG
E) What are the responsi*ilities of the External AuditorsG
') What are the responsi*ilities of the /nternal AuditorsG
-) What actions can the company take with the three managersG
&) What lessons can the #hairman Dr Wan take from this scenarioG
D
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ANS;ERS TO T<E CASE STUDY
9 *=
+ifco-,en #hen #o0s managers have involved themselves with window dressing the
company0s financial statements for their own gains 6e)g) extra payment on the net profit
of the company that is *esides their *asic salary7)
The managers have *ehaved in a very dishonest manner to give a false impression on the
company0s financial performance)
The #hairman did not have proper controls set in the accounting system that would
prevent such happenings taking place)
9=+
#ertainly when all the financial ad@ustments have *een made to correct the sate of affairs
the company ends up in a very poor financial standing)
The company0s accumulated profit of 3"4 (E million has *een turned into a !et $oss of
3"4 %- million) /t means that the total manipulation of the transactions amount to 3"4 E(
million)
9= &
The ma@or pro*lem of this company0s management is that the #hairman had relied too
much on the professional @udgment and honesty of the three managers)
The company risk of loosing more money and perhaps of a take-over *id when the news
filters in the market)
E
Financial Analysis Window Dressing
The !ew "tar #ompany $imited also runs the risk of its own demise that customers
would not trust the three owners when they will get to know the financial manipulation
of +ifco-,en #hen #ompany $td)
9= 4
+lease find attached a copy of the revised financial statement of +ifco-,en #hen
#ompany $td after the necessary ad@ustments have *een made with the exclusion of the
3"4%D million which should appear as a capital commitment 6off-*alance sheet
financing7)
The company0s !et Worth position has *een reduced ?uite considera*le from 3"4%:E
million to 3"4 '5 million)
9=
!ormally when such a development takes place the entire responsi*ility should *e
attri*uta*le to the #hairman as the Bead of the #ompany and all the other directors)
/t is the <oard of Directors responsi*ility to ensure that the company which they are
managing from a strategic level must perform in the *est interest of all the stakeholders
6e)g) shareholders) employees customers suppliers =overnment media Taxation
#ompetitor <ankers Financial Analysts #ommunity7)
9= 1
The External Auditors have a prime duty to ensure that a thorough @o* is performed on its
client0s *ooks of accounts and records so that the financial statement reflect the true
position of the client at a particular point in time)
They also have a responsi*ility to perform their professional audits in the *est interest of
all the stakeholders and to report any a*normal findings in its audit report with fear or
favour)
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Financial Analysis Window Dressing
They should act as the 1watch dog2 in preventing an fraud or manipulation of accounts
*y any agent of the company that they audit)
/n the event that they are prevented or constrained to perform their audits with the full
and uncompromising professional ethics they should resign and make known their
reasons)
9= /
The responsi*ilities of the /nternal Auditors defer from that of the External Auditors that
they report their audit findings to the <oard of Directors for necessary actions)
They should ensure that there is a sound internal control system and that the employees
must a*ide *y the internal rules and regulations)
8onitor and verify the authenticity of the transactions that they reflect their stated value
in accordance with /nternational Accounting 9 Auditing "tandards)
<e in constant touch with the <oard of Directors through regularly reports and highlight
the necessary administrative ad@ustments that will allow a *usiness to function in
accordance with its stated o*@ectives and mission)
9= 8
The <oard of Directors of +ifco-,en #hen #ompany $td reserves the following rights of
actions against the three managersH
6%7 ;e?uest that they return all the extra *enefits *eing paid as a result of the
manipulation of the figures)
657 <ring a court case against them for professional negligence and theft)
6:7 ;e?uest for an in-depth report as to when the actions to window dress the
financial statement started)
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Financial Analysis Window Dressing
9= ,
#hairman Wan0s lesson from this scenario can take different dimension)
6a7 $earn from his past mistake not to trust the figures only
6*7 +ay much attention to hisIher /nternal Auditors comments
6c7 <e more pro-active in the management of the *usiness
6d7 ;e?uest for regular financial statement and deep analyses of the market and the
company0s cost structure
6e7 Watch for the physical movement of trade
6f7 /f una*le to rectify those actions then he should resign from his position and
allow another person to carry on with the *usiness)
&
Financial Analysis Window Dressing
Co%%e(ted
US$
(miilion) Fi7"%e
Net Fixed Assets 4 4
In!estment in S"#sidi$%ies &' &'
C"%%ent Assets
US$
(miilion)
Sto()s *+ *''
De#to%s ,' 8*
P%e-$id Ex-enses 4' &&
.$n) De-osits (/ D$0 C$ll A((o"nt) 1' 1'
C$s2 $t .$n)s &' +/
Pett0 C$s2 * *
&41 &'+
Less3 C"%%ent Li$#ilities
C%edito%s 4 4
A(("%$ls &' &'
S2o%t4Te%m De#t 1
O!e%d%$5t .$l$n(e / 8
+' ++
Net C"%%ent Assets6(Li$#ilities) *4* //
Tot$l Net Assets +*1 *+
Fin$n(ed #03
Lon74te%m De#ts 8' 8'
C$-it$l ,' ,'
A(("m"l$ted P%o5it6(loss) "ntil *,/ 41 4*8
*&1 /+
+*1 ++4
%.