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
employer’s 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 year’s Annual
General Meeting of Pifco-Zen Chen Company Limited’s gross income and net profit
before taxation increased by 10%, while its main competitor’s performance was declining
at an alarming rate. Chairman Wan always wanted to find out what is the main reason
driving its company’s 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
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,
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Financial Analysis – Window Dressing
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.
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
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)
US$
(miilion)
125
90
40
60
30
1
346
45
30
55
75
205
141
Total Net Assets
216
Financed by:
Long-term Debts
80
Capital
Accumulated Profit until 1975
90
46
136
216
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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 Manager’s 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 company’s financial performance”.
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 company’s 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?
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Financial Analysis – Window Dressing
ANSWERS TO THE CASE STUDY
Q 1.
Pifco-Zen Chen Co’s managers have involved themselves with window dressing the
company’s 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
company’s 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 company’s 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 company’s 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.
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 company’s Net Worth position has been reduced quite considerable from US$136
million to US$ 72 million.
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Financial Analysis – Window Dressing
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
client’s 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.
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:
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Financial Analysis – Window Dressing
(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.
Q. 9
Chairman Wan’s lesson from this scenario can take different dimension.
Learn from his past mistake – not to trust the figures only
Pay much attention to his/her Internal Auditors comments
Be more pro-active in the management of the business
Request for regular financial statement and deep analyses of the market and the
company’s 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.
(a)
(b)
(c)
(d)
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Financial Analysis – Window Dressing
Corrected
US$
(miilion)
45
30
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
Accurals
Short-Term Debt
Overdraft Balance
Net Current Assets/(Liabilities)
US$
(miilion)
125
90
40
Figure
45
30
100
81
33
60
30
1
346
60
27
1
302
45
30
55
75
205
141
45
30
65
85
225
77
Total Net Assets
216
152
Financed by:
Long-term Debts
80
80
Capital
Accumulated Profit/(loss) until
1975
90
90
46
-18
136
72
216
224
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