Flat Cargo Accounting Fraudulance

CASE STUDY 1:
FLAT CARGO BERHAD: AN AUDITORS CONUNDRUM
A. INTRODUCTION OF THE CASE
There are many puzzling issues that could occur in the process of
auditing a listed company. These issues could be created either
intentionally or the other way around. Therefore, an objective
analysis is needed to clear the puzzles especially if the auditors
wish to curb fraud cases among their clients.
In the case of Flat Cargo Berhad (FCB), the auditor has found
some inconsistencies in the accounts of FCB. Thus, a case study
is conducted to bring the hidden mystery to the light as possible.
Based on the study, a report was written to summarise the
situation. The aspects that were given highlights in the report
included the issues contributing to those inconsistencies and the
possible reasons that have led to this situation. Based on the
identified problematic issues, several possible solutions have been
suggested to overcome the said problems. Finally, an objective
conclusion is made to make a stand about the given case study.
This is important as it could facilitate the auditor to make an
appropriate decision for the said case.
B. COMPANY BACKGROUND
Flat Cargo Berhad (FCB) was established in 1997 as the mean of
providing air freight services to the Intra-Asia air market. FCBs
services were not only limited to air freight and aircraft ground
handling but also included aircraft charter and leasing.
FCB was chaired by Dato Ibrahim Samad, a former Director
General for the Ministry of Transportation and former President of
Malaysian Chamber of Commerce. He was the companys
Independent Non-Executive Director (INED). The top management
team consisted of Mr Lim Loon Sim as the Chief Executive Officer,
Mr Ali Bin Ahmad as the Executive Director and Mr Kim Boon
Chok as the Chief Financial Officer. Mr Ali Bin Ahmad also held
the position of FCBs Audit Committee Chairman besides being a
member of Employees Share Option Scheme Committee.
In terms of financial growth, FCB showed a tremendous increase
from year 2001 to 2005. It attained 1 times of increase in
revenue amounting RM 550 million in 2005 compared to 2004 and
was projected to increase further by 54% to RM 809 million in the
following year. The increase in share price per unit was also
significant from RM 1.89 in 2001 to RM 10.60 in 2005. The amount
of dividend paid for four consecutive years were at a steady rate of
3% per annum.
However, we can see from the financial statements that FCB had
low debt coverage ability and high gearing ratio over the years.
One way to identify this situation is by performing debt ratio
computation. Here, we found that the debt ratio for year 2004 and
2005 were 0.3 and 0.54 respectively. The number increased by 44%
in 2005 compared to its previous year. This indicated that FCB
depended highly on debts to run operations and would probably
have difficulties in paying back the debts as half of its assets were
used to cover its debts over the years.
C. ISSUES LEADING TO INCONSISTENCIES IN FINANCIAL
RECORDS OF FCB
1. The auditors were unable to verify the aircrafts claimed to have
been purchased by FCB in 2005. The audit team found a non-
functional rundown aircraft barely worth RM231 million in hangar.
The auditors found out that in the FCBs financial statement for
2005, recorded the purchasing of aircrafts worth of RM 231 million
but in contrast with the record, the auditors was only shown by the
FCB with a non-functional rundown aircraft barely worth RM231
million in their hangar. As the logistics service provider, FCB
provided courier transportation services between Peninsular
Malaysia and East Malaysia by using the aircrafts as their main
mode of transportation.
There are two frauds that can be found in this case. Firstly, FCB
bought the old aircraft with current value but record it with a higher
price tag and the secondly, FCB forged the purchasing of the
aircrafts.
1. Old aircrafts, high price tag
By stating the high amount of purchasing in financial statements,
FCB had overstated the current assets. By overstating the assets,
FCB might have broken the law. An incorrect beginning or ending
asset balance can overstate its value. It would affect the balance
sheet as well. On one side, it recorded company assets. On the
other, it listed the company liabilities and the share capital -- the
value of the ownership stake after subtracting debts. If the
company overstated the value of its assets, it would give a raise on
the other side of the equation as an increase in owner's equity but
it would not have any effect on liabilities.
2. Documents forgery
Some people in the FCB might have taken the opportunity of the
loopholes that they know, to forge the purchasing of the aircrafts. It
might happen with the blessing of the FCBs management as the
value of the purchasing is more than a million ringgit.
According to Chad Albrecht, Mary Jo Kranacher & Steve Albrecht
(Asset Misappropriation Research White Paper for the Institute for
Fraud Prevention)[1], this scenario was called as asset
misappropriation. Specific assets of the organisation (in this case,
aircrafts) were taken to directly benefit the individuals committing
the frauds. The distinguishing elements of asset misappropriation,
however, are that an organisations assets are taken through
trickery or deceit, rather than by force.
Asset misappropriation frauds are generally divided into two 2
main categories:
i. the theft of cash; and
ii. the theft of non-cash assets.
Misappropriation of assets may occur under different
circumstances:
i. before they are recorded in the books and records of an
organisation (i.e. skimming),
ii. while assets are currently held by the organisation (e.g. larceny
or misuse of equipment, inventory, supplies, cash, etc.), or
iii. during the process of purchasing goods or services (e.g., billing,
expense reimbursement, payroll schemes) .
In this final scenario, the organisation pays for something it shall
not pay for or pays too much for purchased goods or services.
Thus, for this FCBs case, the third scenario fit the case well.
3. Conclusion
The Management of FCB should be held responsible on the
overpayment of the junk aircrafts. The transaction involved such a
large sum of money and obviously the payment was done with the
approval by the management. A thorough internal audit will
prevent the same case to occur in the future.
2. Several debtors confirmation letter were returned because the
addressees had changed their mailing addresses.
Debtor confirmation is one of the common procedures carried out
by auditors. This confirmation aims to increase the reliability of the
debtor balances posted on financial statements. The amounts
provided by debtors are expected to be the same as per clients
book; otherwise, reconciliation is required to be performed.
Observation from the case, we would assume that the auditors
issued positive confirmation to the clients debtors. This is because
the auditors expected to receive responses from the debtors.
However, Mr. Chuah Mun Soong revealed that his audit team
received the return of debtors confirmation letters due to invalid
addresses.
1. Inappropriate accounting technique used
The failure to receive confirmation from debtors increased the
possibility of FCB in presenting financial statements
inappropriately. As mentioned in the case, FCB was not aware on
the change of debtor addresses, which also indicated that FCB
had several aged debtors and ignored in monitoring the credit
worthiness of the debtors. In other words, FCB accumulated
possibly uncollectible debts in the financial statements.
Furthermore, this problem also shows FCB did not expense off the
uncollectible debts. It was not aligned with standard practices in
preparing income statement. The revenues gained in that
particular year were not charged appropriately with expenses
incurred. Eventually, the expenses were misallocated to the
irrelevant financial periods. In addition, FCB also disregarded to
minimise the net assets and net income as a prudent practice. As
the Financial Accounting Standards Board encourages the
companies shall be placed on the ground of conservatism.
However, FCB failed to apply this practise in the income statement.
2. Invalid addresses lead to the possibility of phantom clients
On the other hand, the return of debtor confirmation letter pointed
to the unfavourable view on FCB. Debtors owned the obligations to
pay FCB on services ordered on credit. And hence, debtors were
the current assets of FCB, as FCB was officially permissible to
collect the payments from debtors. In the perspective of analysis,
the higher of total current assets may contribute to more
favourable reviews on FCB. Acid test ratio can be employed to
measure the ability of the company to cover current liabilities by
highly liquid current assets. In other words, ratio of 1: 1 may be the
least favourable in this measurement. Based on the financial
statement, the acid test ratio reduced from 3.66 to 2.94 for year
2004 and 2005 respectively. The numbers show that FCB had high
ability to cover the current liabilities although little reduction
involved in both of the years. Therefore, the possibility of phantom
clients is not deniable due to maintain at high ability to cover
current liabilities.
3. Conclusions
1. Adoption of allowance for doubtful debts
Relevant expenses shall be recognised accordingly in respective
financial years, to reflect the more reliable and accurate financial
statements. A tool addresses this issue is the implementation of
allowance for doubtful debt. This is commonly employed by the
companies to estimate the uncollectible debts in advance. And, the
bad debts expense is more reasonably matched with the revenues
generated in the same financial period. Furthermore, this practice
is also aligned with conservatism concept. The thoughts of lower-
profits and higher-expenses shall come in place when the
companies require anticipating the unrealised amounts. A reason
to support this, the debtor accounts will be net off against the
allowance provided. As such, FCB will be presenting lower debtor
balance in the financial statements. Thus, this method meets the
objectives of risk reduction and improves security of assets of FCB.
2. Detailed investigation shall be implemented to judge the
possibility of phantom clients
Auditors play major roles in this circumstance. Some procedures
are necessary to be carried out by auditors. Service agreements
shall be presented to auditors to prove the both entities, i.e. FCB
and clients, were bound by the agreed clauses. This practice is
also relevant to the recommendation emphasised above, because
the service agreement stated the credit term after delivery of
service. On the other hand, company registrations of the several
clients are required to prove the existence. To further enhance the
effectiveness of this investigation, auditors are encouraged to
obtain explanations from FCB concerning on this problem and
transactions related to these clients. Therefore, auditors may have
more knowledge and higher confidence in making judgment on
FCB.
3. A large sum of sales transactions was found with no supporting
documents. Most of these transactions involved small clients.
The auditors have found this issue as one of the key point in
accounting fraud happens in FCB. FCB has failed to backing up
sales transactions with proper supporting documents.
3.1 Revenue recognition fraudulence
FCB stated that they had made massive sales transactions in
financial year 2004, RM 346,180,000 and financial year 2005, RM
550,078,000. Whereby, it did not reflect the same in their balance
sheet. It had high possibility that FCB recorded pre-collected
revenue in the same year it was received although services had
not been delivered yet in that particular year. This activity did not
comply with conservatism concept. FCB might be, as former
Securities and Exchange Commission (SEC) chairman Arthur
Levitt stated, manipulated the recognition of revenue.
According to Jon M, Principles of Accounting.com, a transaction
will be evidenced by at least a source document. It can be invoices,
bank deposit slips or cash receipts to support the transaction.
FCBs revenue figures might be inflated by fictitious sales which
there were sales transactions billed but the services had not been
delivered yet. Without proper supporting documents, it would be
difficult to decide on nature of the transactions and accounts
involved.
1. Corrective Measures
FCB should conduct regular reconciliation in order to prevent such
matter happens again. The risk of losing supporting documents for
sales transactions can be detected earlier. SEC has issued Staff
Accounting Bulletin No. 101 (SAB 101) which it proclaims that
revenue can be realized and earned with four (4) conditions:
1. Persuasive evidence
SEC has considered that any form that has customers purchase
authorisation whether it is written or electronic evidence can be
considered as persuasive evidence.
2. Delivery
The delivery of products or services has happened.
3. The sellers price to the buyer is fixed or determinable
The price that was agreed by both, FCB and their customer,
remained until the customer has received and accepted FCBs
service.
4. Assurance of products or services accepted by buyers
Buyers have acknowledged risks and rewards of ownership of the
products or services.
By executing regular reconciliation also can prevent fraudulent
occurs among managements as well as executives in FCB. It has
been indentified that people tend to misconduct in the FCBs
accounts when they are in pressures of meeting top management
expectations, approaching the target earnings in order to secure
bonuses and assuring stock price will continue rise up in stock
exchange board as claimed in various investments houses reviews.
This unethical behaviour needs to be contained by compliant the
principles that have been set by SEC and government.
2. Conclusions
From the analysis from this case, the root cause for these
fraudulences is financial pressure. The company was in pressure
to meet the target earnings for stakeholders such as dividends and
bonuses. This would not be happened if the FCB strictly follow the
rules and regulation set up by SEC, GAAP, FASB and government.
Another root cause is that the internal auditor committee has not
executed their work well enough. As we know, a member is
prohibited from accepting appointment as an internal auditor if he
or she has any interest in shares of the company, directly or
indirectly. Therefore, Mr Ali bin Ahmad should not be the chairman
for the internal Audit Committee.
4. Loan received from a Hong Kong based company was found to
be incorrectly recorded in the debtors account.
It was found that the amount of loan received from a creditor
company based in Hong Kong was incorrectly recorded in the
debtors account. There are two possible root causes for this
situation. One, it could be due of an Accounting Error named Error
of Principle, which is almost impossible as FCB is a listed
company with professionals handling accounting records.
The second possible root cause will be that FCB tried to conceal
the acquired loan from its stakeholder despite the rules and
regulations governed by the Malaysian Code of Corporate
Governance that requires all Malaysian listed companies to be
transparent and highly responsible in their reporting and
management. Below are the two root causes being elaborated:
1. Error of Principle
An error of principle occurs when one or both sides of the double -
entry item wrongly recorded and posted to a wrong account. (Error
of original entry[2])
In this case, the loan received from the Hong Kong based
company is the companys liability. It is an obligation that must be
fulfilled by FCB. However, it was recognised as an asset when the
debtors account was credited. Hence, this result in mistake while
posting the transaction to the current assets account, the account
was debited as well to show an increase in asset.
1. Corrective Measures
1. Control accounts
Error of Principle relating to this problem can be corrected by using
control accounts for these accounts. We call them as the Debtors
Control Account and Creditors Control Account.
Below are the layout of the debtor account and the creditor
account.
|Debtor accounts |
|Balance owing to us at start |Cash/cheques received |
|Credit sales made during period |Returns inwards |
|- |Discounts allowed |
|- |Balance owing to us at end (*1) |
(*1 this is a debit balance but it is initially carried down from the
credit side when the account is balanced off)
|Creditor accounts |
|Cash/Cheques paid |Balance owing by us at start |
|Returns outwards |Credit purchases made during period |
|Discounts received |- |
|Balance owing to them at end (*2) |- |
(*2 this is a credit balance but it is initially carried down from the
debit side when the account is balanced off)
2. The importance of control accounts:
1. Saves time to find error
We could easily detect the incorrect entry into debtor and creditor
ledgers if the control accounts are not balance.
2. Curb fraud incident
Since the debtors and creditors accounts and the control accounts
can be kept by two different personnel say by the account clerk for
the personal accounts and the accountant for the control accounts,
the possibility of deception in entries can be minimised.
2. Misconduct of FCB in concealing loan from stakeholders.
As we have said earlier, there are high chances of FCB of trying to
hide the loan from its investors. Basically, the management should
never meddle in the financial reports and take advantage of any
occurrence to their own favour. In the case of FCB, the loan
received was recognised as a debtor to show increase in cash flow
without claim against its asset.
Let us assume that the loan received is a discounted loan (short-
term) and for the purpose of covering future expenses. The
interest borne had been deducted earlier and FCB is needed to
settle the principle according to the terms agreed with the lender.
As a consequence, FCBs cash flow and operations would be
affected in paying back the loan in the current future. Hence, the
stakeholders must be informed about this situation instead of
misleading them with false financial status by saying FCB had less
debt claim.
Therefore, FCBs case can be classified as misstatement resulting
from fraudulent financial reporting as FCB might has falsify the
accounting records and supporting documents in the preparation
of the financial statements.
1. Correction Measure
To avoid such circumstance, FCB should adopt a more
transparent and ethical manner of accounting adherence to the
regulations stipulated in Malaysian Institute of Accountants (MIA)
Code of Ethics.
As we are concerned, Mr Ali Bin Ahmad holds both positions
ofExecutive Director and Chairman of FCBs Audit Committee.
This is a little fishy especially in his intention of misusing his power
in both management and internal auditing areas, thus approving to
the inconsistencies in accounting reporting and leading to
misstating of financial status of the company. FCB should have
more control over its management system and distinct between
management and internal audit committee to govern issues
relating to operation and finance.
3. Conclusion
After comparing both root causes, we shoulder that the second
one stating misconduct of FCB in concealing loan from
stakeholders will address this issue the best compared to error of
principle. As such, FCBs management should take the full
responsibility of said misconduct if it is proven in the auditing
process later.
5. Several abnormal transactions involving the purchase aircrafts
by FCB and offsetting the debtors accounts were found in FCBs
books.
Several transactions become abnormal included in aircraft
purchasing because FCB did not want to disclose the high cash
outflow to investors. In accounting, the term of transaction is very
compulsory and for each transaction, the debit amount must equal
the credit amount. This is why bookkeeping is called double-entry
bookkeeping, in case the recording of a transaction in which debits
do not equal credits is incorrect.
To explain further, transaction will be representing the cash flow,
generally cash flow is the movement money into or out of a
business, project or financial product. They can be representing as
a record of something that has happened in the past, such as the
sale of a particular product, or forecast into the future, representing
what a business or a person expects to take in and to spend. Cash
inflows usually arise from one of three activities like financing,
operations or investing, although this also occurs as a result of
donations or gifts in the case of personal finance. On the other
side, cost outflows result from expenses or investment. This holds
true for both business and personal finance. An accounting
statement called the statement of cash flow, which shows the
amount o cash generated and used by a company in a given
period.
Thus, a recommendation to solve that issue is by the rules for
recording revenues and expenses are derived from the rules for
owner equity. By definition, a revenue increase owner equity, and
owner equity increase on the credit side. Expenses are the
opposite of revenue that expenses decrease owner equity.
Therefore, the rule for expenses is debits.
Assets = Liabilities + Owner Equity
Debit (+) Credit (-) Debit (-) Credit (+) Debit (-) Credit (+)
Besides that, by offsetting debtor account, investor may not able to
see from the annual report and cash in. Offsetting is the process
where an amount owed to a debtor is used to pay an outstanding
account of the debtor. In addition, prior to offset, departments must
notify the debtor and provide them with an opportunity to present
any valid objection to use of the offset procedure.
D. OUR RECOMMENDATIONS
Through the analysis of the issues revealed from the FCBs audit
working paper 2006 by the Kencana & Associates, it can be
concluded that there are two root causes for all the financial fiasco
of the FCB. The two are improper accounting practice and non-
independency of the auditing committee.
i. Improper accounting practice
The root cause for the fraudulences in FCB is financial pressure.
The company was in pressure to meet the target earnings for
stakeholders such as dividends and bonuses. This would not be
happened if FCB strictly followed the rules and regulation set up by
SEC, GAAP, FASB and Malaysias Government.
Managers and employees are often in pressured or willingly alter
financial statements for the personal benefit of the individuals over
the company. Managerial opportunism plays a large role in these
scandals. For example, managers who will be compensated more
for short-term results may tend to report inaccurate information,
since short-term benefits outweigh the long-term ones such as
pension obligations.
An outline of the measures that could be taken is as below (as per
preventive occurrence measures implemented by Seiko Epson
Corporation during their financial scandals in 2009 in South
America[3]):
increase oversight of accounts;
introduce appropriate accounting processes for management of
accounts receivable, and reorganize both the process for
compiling financial reports and the accounting system; and
implement, operate and evaluate a companywide internal control
system encompassing IT, and companywide financial reporting
processes and work process controls.
ii. Non-independency of the Audit Committee
The audit committee plays a critical role in providing oversight and
serving as a check and balance on a companys financial reporting
system. The committee provides independent review and oversight
of a companys financial reporting processes, internal controls and
independent auditors. It provides a forum separate from
management in which auditors and other interested parties can
candidly discuss concerns.
By effectively carrying out its functions and responsibilities, the
audit committee helps to ensure that management properly
develops and adheres to a sound system of internal controls, that
procedures are in place to objectively assess management
practices and internal controls, and that the external auditors,
through their own review, objectively assess the companys
financial reporting practices.
Audit committee becomes increasingly important in the corporate
world nowadays. It is mandatory for all public companies in order
to be qualified and listed in Bursa Malaysia. This committee holds
several key functions in a company. Its responsibilities include
overseeing financial reporting, evaluating the audit process, and
reviewing conflict of interest and related party transactions. In
addition, audit committee is also expected to have frequent
communication with the internal audit function of the company. The
composition of audit committee shall not be neglected. The audit
committee must consist of at least three non-executive members
with majority of independent directors and at least one of the
members must be possess with financial expertise (Bursa
Malaysia, 2007[4]).
However, an assumption is made on the case due to no specific
timeline given. Mr. Ali Bin Ahmad was the Executive Director of
FCB and also appointed as the chairman for Audit Committee. The
combination of two different roles is restricted because he was the
Executive Director who involved directly and executed in FCBs
operations.
To overcome this problem, it is encouraged for FCB to implement
the segregation of duties in between chairman of Audit Committee
and Executive Director. Appointment of chairman of Audit
Committee shall be made on Independent Non-Executive Director
in FCB. The impact of unfavourable review can be reduced from
Bursa Malaysia after this segregation of duties is at place.
Furthermore, the board of FCB may work effectively as the
Independent Non-Executive Director will oversee the efficiencies
and capabilities of the Executive Director.
Demonstrate critical thinking and analytical skills (problem solving
and decision making)
a. In a case setting, our students will be able to correctly identify
business problems, analyze and solve them using appropriate
techniques to help decision making
| |Traits |Performance levels |Score |Wt. |Marks |
| |Poor (1 2 3 4) |Fair (5 6) |Good (7 8) |Excellent (9 10) | |(%) | | |1
|Identification and summarization of problem at issue |Does not
identify and summarize the problem, is confused or identifies a
different or inappropriate problem |Identifies the problem but does
not summarize it effectively |Identifies and summarizes the
problem effectively |Identifies and summarizes the problem very
effectively. Recognizes the nuances of the problem. | |20 | | |2
|Specification of key assumptions |Does not identify the
assumptions and ethical issues |Identifies some of the key
assumptions and ethical issues |Identifies all the key assumptions
and the ethical issues |Identifies all the key assumptions and the
ethical issues. Questions the validity of the assumptions and the
ethical issues | |10 | | |3 |Identification of relevant information /
sources required to solve the problem |Does not identify the
relevant information / source. Uses irrelevant information to solve
the problem |Identifies some relevant information/sources to solve
the problem. |Identifies the relevant information/source to solve the
problem. |Identifies the relevant information/source to solve the
problem. Specifies the shortcomings of the information/source. |
|20 | | |4 |Synthesis of information / data from various sources
|Does not synthesize the information to identify and solve the
problem or does not know to synthesize the information
|Synthesizes information/data from some sources. Struggles to
solve the problem. |Synthesizes the data/information effectively to
identify and solve the problem |Synthesizes the data/information
very effectively to identify and solve the problem. Understands the
characteristics of the information.
| |20 | | | | |Poor (1 2 3 4) |Fair (5 6) |Good (7 8) |Excellent (9 10) | |
| | |5 |Provision of evidences and quality of evidence |Merely
repeats information provided, taking it as truth or denies evidence
without proper justification. |Provides some evidence and the
source of evidence. Does not question its accuracy, precision,
relevance, and completeness. |Examines the evidence and source
of evidence, questions its accuracy, precision, relevance, and
completeness. |Observes causes and effects and addresses
existing and potential consequences. Clearly distinguishes
between fact, opinion, and acknowledges value judgments | |10 | |
|6 |Application of qualitative/quantitative tools to analyze and solve
problems |Does not use the right tools to solve the problem.
|Identifies the right tools but does not use them effectively to solve
the problem. |Identifies the right tools and uses them effectively to
solve the problem. |Uses combination of right tools (triangulation)
to solve the problem. | |10 | | |7 |Conclusions, implications and
consequences |Fails to identify and discuss conclusions,
implications, and consequences of the issue. |Identifies conclusion,
implications, and consequences but do not discuss them forcefully.
|Identifies and discusses conclusion, implications, and
consequences. |Objectively reflects upon own assertions. | |10 | |
|Overall Marks: 1-3.9 Unacceptable; 4-7.9 Acceptable; 8-10
Merit
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[1]http://www.theifp.org/research-grants/IFP-Whitepaper-5.pdf
[2] http://www.businessdictionary.com/definition/error-of-original-
entry.html
[3]
http://global.epson.com/newsroom/2009/news_20090225_2.html
[4] Bursa Malaysia. (2007). Corporate Governance Guide,
Malaysia