Refer to the case on “Johnson Turnaround” in Appendix A.
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The newly appointed CEO of Johnson Pte Ltd., Encik Azmi, is tasked with the design and implementation of a turnaround strategy for the company. An effective turnaround strategy consists of assisting the company to identify, develop and implement initiatives that increase profits and market share, or position the firm to raise needed capital. The objective of the turnaround initiative is to focus on areas of business risk and generate successful results.
Assume that you are part of the management team which Encik Azmi has assembled to assist him in formulating the turnaround strategy. By focusing on key functional areas of the business, identify the various initiatives that can be undertaken and incorporated by Encik Azmi into his turnaround strategy for Johnson Pte Ltd.
Refer to the case on Smart Entertainment Videos Bhd (SEV) in Appendix B.
(a) What warning signs do you see of possible fraudulent financial reporting at SEV? (b) What factors should SEV’s external audit firm consider during its audit of the financial statements, in light of the above warning signs? (c) What types of earnings manipulation schemes might these warning signs indicate? Provide examples.
Appendix A: Johnson Turnaround
Azmi had just joined Johnson Pte Ltd. (JPL), a public non-listed subsidiary of a fast moving consumer goods (FMCG) Hong Kong-based group of companies, as its chief executive officer in November 2009. He had been handpicked by the Chairman to purposely plan and execute an appropriate turnaround strategy. He’s now reviewing the financial statements and looking at the various options available.
General Company Background
JPL is located in the southern Indian region and was wholly-owned by the Indian government. Twenty years after began operations, the Hong Kong group of companies acquired 80% of its shareholdings. JPL manufactured and distributed a range of products, including frozen chicken, noodles, pastries, bread products, yeast and fats. It also traded in commodities such as oil. It owned a chain of restaurants and retailing outlets.
The objective of the takeover, which was well recognized by the parent company’s board members, was the strategic priority to increase its international presence. It was a way to gain quick international market share as well as to increase its ability to service an expanded and geographically dispersed customers.
Organization and Management Structure
The company was structured into four main functional units, each headed by a director, namely, Sales and Marketing, Finance and Accounting, Production and Services and Human Resource Management. Each of the functional directors together with the chief executive officer formed the executive management team of the company.
Sales and Marketing
The company was one of the key market players, other than Nestle and Unilever that dominated the consumer-based market in the Asia Pacific region. In 2007, the company had 30% of the regional market share and the balance was shared by the other key players. Azmi realized that JPL need to fight the competition based on quality, cost and service.
Finance and Accounting
Despite its huge loses, to the extent that the shareholders’ fund plummeted from $300 million to $180.96 million over a period of 10 years, the Hong Kong group of companies saw prospects in JPL for the accomplishments of their strategic mission.
Johnson operating conundrums were reflected in the unaudited accounts brought to Azmi’s attention (see Figures 2 and 3). Azmi could not help noticing the excessive spending in advertisement and promotional costs which amounted to $5 million in 2008. Poor management of the accounts receivables contributed to the company’s inability to service its debt which was rocketing high. There was a significant $40 million total provision made for bad debts in the accounts over a 10 year period. Azmi thought the monthly provision of bad debts of 2% of sales was not a healthy financial trend for the company. Upon investigation, he discovered that the problem stemmed from wholesale distributors who were defaulting. Azmi also noted that in 2008, as well as the preceding years, the company had been having negative cash flows. This he reckoned was due to the mismanagement of inventory and accounts receivables as well as the poor asset management.
Production and Services
The objective of the production arm of the company was to meet the desired quality and production standard as per the Haphazard, Analytical, Critical, Control Points (HACCP) requirement as well as best industrial practices.
Industry records show that as far as the food and beverages competition was concerned, both Nestle and Unilever would take turns to win. It was thought that these two companies invest heavily in research and development, advertisement and promotion. These are the market leaders and they spend in the range of 2 – 3% of their turnover to improve or at least maintain their market shares.
The noodles brand were marketed based on many product flavors, for instance, chicken noodles in a variety of flavors. Records show that of all the company’s sales mix, noodles line of products had the highest gross profit
margin, although it had to compete with the likes of Maggie noodles under the Nestle group.
Financial data showed that the company owned 45 retail outlets. Of these, there were a few that were persistently incurring losses, perhaps because of non-strategic locations. Such a negative financial situation exacerbated the conventional high operating costs facing JPL. In order to boost turnover, the company had consistently investigated opportunities in new markets.
Human Resource Management
JPL had, on average, 1,000 employees including senior management and general and administrative staff.
Detailed investigation into the credit control management records revealed that there were insufficient bank guarantees given by the dealers and wholesalers for the goods taken on credit up to one month. Azmi noted the practice in the company of accepting the placement of motor vehicles as part of collateral for the goods obtained.
Instructions from Head Office
Azmi had been instructed by the group chairman from the Hong Kong headquarters that he was to plan and execute an appropriate turnaround strategy. Azmi had to take into account the financial statements and relevant management accounting information (see Figures 1, 2, 3, 4 and 5) and he has been advised that all unnecessary spending were to be avoided.
Figure 1: Johnson’s Business Unit Expenses Analysis (all figures in $):
Service Operations expenses
Benefits (EPF, medical, etc)
Travel and entertainment
General and miscellaneous
Sales and Marketing expenses
Benefits (EPF, medical, etc)
Travel and entertainment
General and miscellaneous
Finance and Accounting
Benefits (EPF, medical, etc)
Dues and subscriptions
Provision for bad debts
Advertisement & promotions
Figure 2: Johnson’s Income Statement summary (all figures in $):
Cost of Sales
Sales and marketing
Finance and accounting
Other gains (losses)
Appendix B: Smart Entertainment Videos Bhd
Smart Entertainment Videos Bhd. (SEV) is an international chain of stores specializing in renting copies of movies and video games to retail customers. SEV also sells new and used copies of these products, and offers “memberships” entitling members to unlimited use of DVDs or video games for one year (one DVD or game at a time). With over 700 stores in the ASEAN region (approximately 400 in Malaysia and 300 in the other ASEAN countries), SEV is among the top two or three companies in the industry. Founded twenty years ago, it has been an audit client of your audit firm for the past three years.
For several years, the traditional movie and video game rental industry has been saturated, and recently has been declining by an average of 4% per year as measured by industry gross margins and by 6% per year as measured by industry profits. Lately, companies in the movie rental industry have been facing stiff competition on a number of fronts. First, other competitors in the industry offer internet-based subscription services, taking business away from traditional stores like SEV and forcing them to discontinue charging late fees to customers, a significant source of revenues. Second, retail superstores such as Giant, Tesco and Jusco have been selling new copies of both newly-released and classic DVDs at rock-bottom prices, sometimes even at a loss, also taking business away from traditional stores like SEV. Finally, many customers have turned to video-on-demand cable and satellite providers (often in conjunction with digital video recorders, or DVRs) to satisfy their desire for quality in-home movie experiences. Overall, Malaysian consumer spending on in-home movie viewing has been increasing at a rate of 11% per year, though this rate is expected to slow to about 8% over the next five years.
Many of SEV’s smaller competitors have been forced into bankruptcy. One of SEV’s large competitors has responded to industry market pressures by discontinuing its late fee policy and starting its own online video subscription service. SEV has done the same, necessitating additional borrowing to cover the up-front costs of its online initiative. SEV’s online
video subscription service has been operational for one year, with revenues climbing at a somewhat slower pace than anticipated. SEV’s CEO, Peter Chin, has gone to some lengths to successfully convince stock analysts that its online initiative will soon bolster SEV’s bottom line significantly. In addition, SEV has announced that it is currently in talks with officials of the People’s Republic of China to enter that market by opening 100 stores in that country. Opening these new stores will probably require the incurrence of additional debt or equity financing.
Financially, SEV has recently reported earnings and even earnings growth, though earnings growth has recently dwindled, and cash flows from operations last year were negative for the first time in its history. SEV’s return on equity and return on assets ratios have exceeded industry averages somewhat in recent years. Recent operating cash flow problems have made it a challenge for SEV to meet its debt payments in a timely manner, though it has not yet missed a payment. As with most companies, SEV’s financial statements are the product of an accounting process involving significant estimates. In SEV’s case, significant estimates involve revenue recognition, rental library amortization, write-down of obsolete inventory, and impairment of goodwill, among others. Recently, SEV’s estimates have trended towards being more aggressive in terms of their impact on earnings. One member of the SEV’s executive team who has very little accounting or finance skill has been heavily involved in the selection of accounting methods and the determination of accounting estimates.
SEV has a corporate mission statement and code of ethics. The code specifies that if an employee becomes aware of any improper or unethical acts on the part of others within the company, that employee is expected to report such behavior using a toll-free “alert line.” SEV has a policy prohibiting retaliation against those reporting wrongdoing. Several employees indicated that they don’t believe that this policy is taken seriously. One mentioned that her supervisor said she disagreed with the policy because it encourages workers to “spy on” one another. Another said his supervisor gave an employee who had recently reported an ethical violation a low performance rating because he was not seen as a “team player.”
SEV’s top management team has substantial personal investments in the shares of SEV. In addition, several key officers have contracts which provide for substantial bonuses in the event that some rather aggressive (relative to the industry) earnings targets are met. In most years, these earnings targets have been met, though only barely in recent years. Mr. Peter Chin, SEV’s CEO, is a charismatic and dominant personality at SEV who rarely tolerates opposing views once his mind is made up. Mr. Peter Chin founded SEV and has been known to refer to SEV’s Board of Directors as “The Board of Directed.” There has been a marked increase in turnover among accounting and internal audit personnel lately, though mostly at the staff level and, to a lesser degree, the supervisory level.
In the past, SEV’s relationship with your audit firm has been generally positive, though a few “unresolved audit differences” have recently caused some concern about that relationship by members of the audit team. SEV’s CEO has been pushing fairly aggressively for your audit to be completed quickly, citing the negotiations currently taking place with officials of the People’s Republic of China. Also, Mr. Peter Chin has strongly encouraged your firm to replace one of the audit seniors on the engagement with someone who “places more reasonable time demands” on SEV personnel. The Board of Directors and the Audit Committee do not seem to oppose Mr. Peter Chin’s desire for a quick audit with audit seniors who understand that time is money.