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 New Star Company Limited in 1974. These three executives were becoming close to their retirement age. Pifco-Zen Chen Company Limited, the company that they worked for had been in business for the last 80 years. It was their previous employers policy to retire the executives with a golden hand-shake worth approximately US$120,000 each. The three executives occupied the following position with Pifco-Zen Chen Company Limited, (1) Finance Manager Mr. Zu Chang, (2) Sales & Marketing Manager, Mr. Lim Lam, and (3) Risk Management Manager, Mr. Shu Ching. In their previous position with Pifco-Zen Chen Company Limited, they were regarded as the most respected executives because the company made significant progress in terms of organic growth and diversification. The Chairman of the Board of Directors, Dr. Wing Wan used to call them the three wise men. Pifco-Zen Chen Company Limited main business activities were the manufacturing of twisties and acted as wholesale distributor of a special drink called Wysalt. The drink is full of calcium and protein and it is very popular in the South East Asia. Each years Annual General Meeting of Pifco-Zen Chen Company Limiteds gross income and net profit before taxation increased by 10%, while its main competitors performance was declining at an alarming rate. Chairman Wan always wanted to find out what is the main reason driving its companys operational success. In a nutshell, Chairman Wan always believed that the financial result was too good to be true because whenever he has a chance to play golf with one of the Chairman of his competitor company, he was told that life as the head of a corporate is becoming unbearable due to competition and increased in the cost of living. Still, Mr. Wan kept quiet while congratulating his three wise men for a fantastic job each year. Even the external Auditors could not believe the significant progress, which the company used to, when the three wise men were working for Pifco-Zen Chen Company Limited. The auditors knowing too well the performance of the company before the departure of Mr. Chang, Mr. Lam, and Mr. Ching cautioned the Chairman that it would be a great loss for the company to loose three key executives in one go. In view of the continued pressure and perplexities of the situation, one afternoon, Chairman of Pifco-Zen Chen Company Limited, Dr. Wan called a special Board of Directors meeting to address his concern regarding the retirement of Mr. Chang, Mr. Lam, and Mr. Ching. One of the vocal directors. who did not get along very well with these three managers, said it does not matter if all of the three men were to leave the company today because

Financial Analysis Window Dressing they are not indispensable people. He went on to argue further that we can replace them easily because there are other professionals looking for work.

According to the employment contract of the three wise men, they were paid a basic salary plus they also benefited with a 2% commission on the net profit of the company each year after the accounts have been finalized by the external auditors. The Internal Auditor, Miss Wen always queried this employment terms that it favours mostly these three managers at the detriment of the other hard-working employees. One day in a management meeting, Miss Wen expressed her frustration of the favourable treatment of the three managers because she felt that they are working very close and perhaps, manipulating the figures so that they can benefit a hefty remuneration every year. Chairman Wan felt every uneasy during this meeting and closed the meeting earlier than expected. After the meeting, Miss Wen wrote a memo to the Chairman of the Board 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 Pifco-Zen Chen Company Limited runs the risk of facing a corporate collapse, when those three managers had left.

Financial Analysis Window Dressing In the abridged version of the financial statement of Pifco-Zen Chen Company Limited, the following item appears at the end of the financial year 1975.
US$ (miilion) 45 30 US$ (miilion) 125 90 40 60 30 1 346 45 30 55 75 205 141 216

Net Fixed Assets Investment in Subsidiaries

Current Assets Stocks Debtors Prepaid Expenses Bank Deposits (7 Day Call Account) Cash at Banks Petty Cash Less: Current Liabilities Creditors Accrued Expenses Short-Term Debt Overdraft Balance Net Current Assets/(Liabilities) Total Net Assets Financed by: Long-term Debts Capital Accumulated Profit until 1975

80 90 46 136 216

Financial Analysis Window Dressing

In the financial statement there is an amount of US$ 25 million worth of over-valued stocks, which has been in the accounts for the last 5 years. No provision has been made in the Debtors Account for non-performing account worth US$9 million. Current operating expenditure to the value of US$ 7 million has been accounted as prepaid expenditure. The bank reconciliation has not been done properly for the last 3 years, and the external auditors have accepted the Finance Managers figure of US$ 30 million. It appears that there are 10 cheques valued to US$3 million has been deposited in the accounts, and have been returned by the banks because the customers did not have funds. There has need no adjustment made subsequently to correct the balances at banks. The exact figure for the Short-Term Debts should be US$ 65 million and not US$ 55 million as disclosed. There is a mistake in the disclosure of Overdraft Facility; the figure should appear as US$ 85 million and not US$75 million. In addition, the Sales & Marketing Manager has entered into a financial contract for one of the raw material suppliers to supply equipment to the value of US$15 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 been received by the company, then there is no point to account for this transaction. A review of the quarterly report issued by the Risk Manager does not indicate any abnormality in the financial statement from a risk management perspective. Instead, the Risk Manager would normally end his report with the words I foresee that the company is operating in a very sound and successful manner. The Board of Directors should be proud of such achievement. The Sales & Marketing Manager would give the indication that the company is progressing very well and eventually, it should be able to launch a bid to takeover one of its competitive rivals. The Finance Manager would normally end his reports with such phrases such as good performance, we are on the right track the Board of Directors should feel proud of the companys financial performance.

Financial Analysis Window Dressing QUESTION TIME

1. In reading this case study, what is your first impression of the state of affairs with Pifco-Zen Chen Company Limited? 2. Is the company on the right track after you have read the financial statement? 3. Have you identify any problem with this company? 4. If you were to correct the financial statement using the supplementary notes given, what will be the final outcome, in terms, of the companys Net Worth? 5. Who is responsible for the sad state of affairs, which the company finds itself? 6. What are the responsibilities of the External Auditors? 7. What are the responsibilities of the Internal Auditors? 8. What actions can the company take with the three managers? 9. What lessons can the Chairman, Dr Wan take from this scenario?

Financial Analysis Window Dressing ANSWERS TO THE CASE STUDY

Q 1. Pifco-Zen Chen Cos managers have involved themselves with window dressing the companys financial statements for their own gains (e.g. extra payment on the net profit of the company, that is , besides their basic salary).

The managers have behaved in a very dishonest manner to give a false impression on the companys financial performance.

The Chairman did not have proper controls set in the accounting system that would prevent such happenings taking place.

Q.2 Certainly, when all the financial adjustments have been made to correct the sate of affairs, the company ends up in a very poor financial standing.

The companys accumulated profit of US$ 46 million has been turned into a Net Loss of US$ 18 million. It means that the total manipulation of the transactions amount to US$ 64 million.

Q. 3 The major problem of this companys management is that the Chairman had relied too much on the professional judgment and honesty of the three managers.

The company risk of loosing more money and perhaps of a take-over bid, when the news filters in the market.

The New Star Company Limited 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 Pifco-Zen Chen Company Ltd. 6

Financial Analysis Window Dressing Q. 4 Please find attached a copy of the revised financial statement of Pifco-Zen Chen Company Ltd after the necessary adjustments have been made with the exclusion of the US$15 million, which should appear as a capital commitment (off-balance sheet financing).

The companys Net Worth position has been reduced quite considerable from US$136 million to US$ 72 million.

Q. 5 Normally, when such a development takes place, the entire responsibility should be attributable to the Chairman as the Head of the Company and all the other directors.

It is the Board of Directors responsibility to ensure that the company, which they are managing from a strategic level, must perform in the best interest of all the stakeholders (e.g. shareholders,. employees, customers, suppliers, Government, media, Taxation, Competitor, Bankers, Financial Analysts, Community).

Q. 6 The External Auditors have a prime duty to ensure that a thorough job is performed on its clients books 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 responsibility to perform their professional audits in the best interest of all the stakeholders and to report any abnormal findings in its audit report with fear or favour.

They should act as the watch dog in preventing an fraud or manipulation of accounts by any agent of the company that they audit.

Financial Analysis Window Dressing In 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.

Q. 7 The responsibilities of the Internal Auditors defer from that of the External Auditors that they report their audit findings to the Board of Directors for necessary actions.

They should ensure that there is a sound internal control system and that the employees must abide by the internal rules and regulations.

Monitor and verify the authenticity of the transactions that they reflect their stated value in accordance with International Accounting & Auditing Standards.

Be in constant touch with the Board of Directors through regularly reports and highlight the necessary administrative adjustments that will allow a business to function in accordance with its stated objectives and mission.

Q. 8 The Board of Directors of Pifco-Zen Chen Company Ltd reserves the following rights of actions against the three managers:

(1) Request that they return all the extra benefits being paid as a result of the manipulation of the figures. (2) Bring a court case against them for professional negligence and theft. (3) Request for an in-depth report as to when the actions to window dress the financial statement started.

Financial Analysis Window Dressing Q. 9 Chairman Wans lesson from this scenario can take different dimension.

(a) Learn from his past mistake not to trust the figures only (b) Pay much attention to his/her Internal Auditors comments (c) Be more pro-active in the management of the business (d) Request for regular financial statement and deep analyses of the market and the companys cost structure (e) Watch for the physical movement of trade (f) If unable to rectify those actions, then he should resign from his position and allow another person to carry on with the business.

Financial Analysis Window Dressing

Corrected

Net Fixed Assets Investment in Subsidiaries US$ (miilion) 125 90 40 60 30 1 346 45 30 55 75 205 141

US$ (miilion) 45 30

Figure 45 30

Current Assets Stocks Debtors Prepaid Expenses Bank Deposits (7 Day Call Account) Cash at Banks Petty Cash Less: Current Liabilities Creditors Accurals Short-Term Debt Overdraft Balance Net Current Assets/(Liabilities) Total Net Assets Financed by: Long-term Debts Capital Accumulated Profit/(loss) until 1975

100 81 33 60 27 1 302 45 30 65 85 225 77

216

152

80 90 46 136 216

80 90 -18 72 224

10