PROBLEM-CASE STUDY-Financial Statement Analysis.-Word

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 2004. 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
1
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.
2
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 2005.
US$
(miilion)
Net Fixed Assets 45
Investment in Subsidiaries 30
US$
Current Assets (miilion)
Stocks 125
Debtors 90
Prepaid Expenses 40
Bank Deposits (7 Day Call Account) 60
Cash at Banks 30
Petty Cash 1
346
Less: Current Liabilities
Creditors 45
Accrued Expenses 30
Short-Term Debt 55
Overdraft Balance 75
205
Net Current Assets/(Liabilities) 141
Total Net Assets 216
Financed by:
Long-term Debts 80
Capital 90
Accumulated Profit until 1975 46
136
216
3
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”.
4
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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What issues have been identified with the financial reporting of Pifco-Zen Chen Company Limited?

Who is responsible for the inaccurate financial reporting?

Financial Analysis – Window Dressing

CASE STUDY – FINANCIAL REPORT ANALYSIS

Three Executives of a well-known multi-national company decided to form a new

Total Net Assets 216

In the financial statement there is an amount of US$ 25 million worth of over-valued

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