Flat Cargo Berhad: An Auditor’s Conundrum ZAKIAH MUHAMMADDUN MOHAMED“ AND TAKIAH MOHD ISKANDAR® ABSTRACT Flat Cargo Berhad (FCB) was one of the largest air freight companies in Malaysia, servicing several government linked companies including Freight Malaysia Berhad, and had Kencana & Associates served as its auditors. In 2006, during a routine financial audit, the auditors identified several suspicious findings that resulted in a delay in finalising the auditor’s report. The case presented an auditor’s dilemma involving the possibility of fraud in a financial audit engagement. Keywords: fraud, auditors, professional scepticism INTRODUCTION It was 5 February 2006 and Mr Chuah Mun Soong had just finished a meeting with his audit team. He was silently enraged. “Not another Media Com or Blue Vital. Could there be a fraud in Flat Cargo too?” he wondered. His firm, Kencana & Associates, could not deal with another client scandal. He had just been informed by his subordinates that there had been inconsistencies in the accounts of Flat Cargo Berhad (FCB). His team was to report to the audit committee of FCB in two weeks. His boss, Mr Keong Chee Wah, the managing partner of Kencana & Associates, had to be informed immediately of the situation.. Taking time to calm himself down, Mr Chuah decided to work through the company’s information to assess the possibility of fraud. He needed the information to help him explain the situation to Mr Keong. COMPANY BACKGROUND FCB was a listed company operating primarily as an air cargo carrier. It was registered as an investment holding company with several subsidiaries. The principal activities of FCB subsidiaries included air freight services and aircraft * School of Accounting, Faculty of Economics & Business, Universiti Kebangsaan Malaysia » School of Accounting, Faculty of Economics & Business, Universiti Kebangsaan Malaysia * Corresponding author: E-mail:zmm@ukm.my 15Asian Journal of Case Research (AJCR) ground handling services. FCB’s wholly owned subsidiaries included FC Spare Sdn Bhd, Cargo Management Sdn Bhd, FCB (SPV), Cargo Air Services Sdn Bhd and FC Air Ltd. The company’s head office was located in Selangor. FCB started operations in 1997 with two aircrafts: a Boeing 737-200F and a Cessna Grand Caravan. FCB’s maiden flight in November 1997 had been an overnight air express transport service for Freight Malaysia Berhad to Singapore. Flat Cargo Group obtained listing in Bursa Malaysia! on 15 September 2001. FCB’s major shareholder in 1997 had been Bangor Berhad, which was part of a diversified international family owned conglomerate, the Miri Group. The Miri Group had a China based company called Miri Logistics Ltd which owned logistic businesses extensively in the Asian region. In 2004, the Miri Group” bought a controlling interest of 55.2 million shares or 26.5% of FCB from the founders, Lim Loon Sim and Ali Bin Ahmad, via an off market deal. The fast growing intra-Asian air express market fuelled FCB’s expansion plans between 2001 to 2004. With the extensive growth in e-business activities, the demand for express transportation services increased. FCB aimed to maintain their niche position in the Asia Pacific region by delivering best quality customer service and satisfying customer demands. The corporate structure of FCB is seen in Figure 1. ane enor err) ie ASE aC resort) eS Aes st Arnon res) any Teta} Aen Cnr) Figure 1 Flat Cargo Group Berhad’s corporate structure Main Activities FCB was the only dedicated Intra-Asian overnight express cargo operator based in Malaysia. Its core business was to provide air freight transportation, which included aircraft charter and leasing. FCB’s prompt handling of large shipments to meet customer demands was attributed to its expansion in freighter fleet size for its Boeing 737s, 727s, MD1 Is. In addition, it had access to an international cargo complex covering 24-hour custom facilities at the Sultan Abdul Aziz Shah Airport in Subang. If it had not ' Formerly known as the Kuala Lumpur Stock Exchange (KLSE). 2 The Miri family owned China -based Miri Logistics and had strong interests in the transportation and logistics business and presence in most parts of Asia. 16Flat Cargo Berhad: An Auditor’s Conundrum been for the scandal, FCB would have likely remained as the nation’s leading air cargo carrier. With an array of landing rights in the Asia Pacific region, FCB was in the ideal niche position to offer express air services to international integrators, freight forwarders and major airlines within the Asian region. It managed to secure major landing rights in various countries in Asia including China, Japan, Thailand, Singapore, India, Indonesia, Taiwan, Sri Lanka, the Philippines, Korea, Myanmar and Cambodia. FCB Customers a Up to 2005, FCB secured agreements with well-established companies such as Worldwide Express, United Parcel Services (UPS), Nationwide Express, Citylink, Bax Global and Nippon Express. Cargo Malaysia Services and Bangor Berhad, being FCB major shareholders, also used FCB’s air freight forwarding services. FCB offered regular flights to fast growing countries like China, Thailand and India. Other destinations in the region included major cities in the Asia Pacific region. Governance Structure in FCB The Chairman of FCB was Dato’ Ibrahim Samad who was also an independent non-executive director of the company. He was the former Director General for the Ministry of Transportation. He was also Malaysian Chamber of Commerce’s former President. The top management team comprised 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 Lim Loon Sim was the founder for FCB and had been a board member since 1997. As at 31 December 2006, he owned 6.5 million shares in FCB, worth approximately RM97.5 million valued at RM15 per share. Mr Ali Bin Ahmad, who had been a board member since 1999, held 30,000 shares in the company. He was also the chairman of the company’s Audit Committee and a member of its Employee Share Option Scheme Committee. As shown on Appendix D, the Board of Directors comprised of two independent non-executive directors and six non-independent directors, of which three were executive directors and the remaining non-executive directors. The composition of the Board of Directors was in adherence to the Malaysian Code of Corporate Governance (See Appendix E). The Audit Committee of FCB consisted of three members. 17Asian Journal of Case Research (AJCR) The director shareholdings of the company by 31 December 2005 were as follows: Directors Number of ordinary shares of RMI each as at 31/12/2005 Lim Loon Sim 65,500,000 Ali Bin Ahmad 30,550,000 Lee Guan Choi 10,550,000 Miri Kim Chen 120,750,000 Dato’ Ibrahim Samad 6,187,000 FCB Financial Growth In 2005, FCB’s counter was ranked 4th in terms of capital gains and dividends to shareholders. Its share price at 31 December 2001 had been RM1.89, but by end of 2005, the share price surged to RM10.60 per share. It was reported that FCB had been able to pay dividends at a steady 3% per annum for over 4 years. Turnover for 2005 was RM550 million, which is more than 1% times than that for 2004 (see Appendix A). Analysts were expecting FCB’s revenue to increase for the next year by a further 54% to RM809 million because of its major capacity expansion in 2005 despite the rising fuel prices. FCB also acquired several new aircrafts, namely MD-11s and two B727s, and projected to secure additional landings rights in China. Despite the rave reviews made by various investments houses, FCB’s high gearing, nevertheless, posed serious concerns. Rating Agency Malaysia (RAM) tated FCB’s RM150 million Commercial Papers or Medium Term Notes to AA3/ P1 and downgraded the company’s long term rating from stable to negative. The rating was due to the company’s high gearing ratio and weak debt servicing ability. Excerpts from FCB’s Audit Working Papers for 2005 Audit working papers for 2006 revealed the following: + 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 a hangar. * Several debtors’ confirmation letters were returned because the addressees had changed their mailing addresses. + A large sum of sales transactions was found with no supporting documents. Most of these transactions involved small clients. 18Flat Cargo Berhad: An Auditor’s Conundrum + Aloan received from a Hong Kong based company was found to be incorrectly recorded in the debtors’ account. + Several abnormal transactions involving the purchase of aircrafts by FCB and offsetting the debtors’ accounts were found in FCB’s books. THE AIR CARGO INDUSTRY The industry is described as highly competitive with low profit margin. There are about 85 operators servicing all over Malaysia and the Asia Pacific region. The major players in Malaysia include MAS Cargo Sdn Bhd, a subsidiary of Malaysia Airlines Bhd, Malaysia’s national carrier. The growth rate for the air cargo industry had been about 21.3% per year from 1991 to 2003. However, the International Air Transport Association (IATA) reported that there was to be a mere 3% growth for the international freight traffic in the Asia Pacific region for 2005. In 2005, an international crisis occurred with the exceptional increase in oil prices. The hike started in mid-2004 at US$40 per barrel but eventually, the increase continued to stages of US$50, US$60, US$65, US$70 and US$80 per barrel. The price hike in fuel surcharges drastically affected the freight forwarding industry significantly because of its reliance on fuel for operations. CONCLUSION Mr Chuah decided to consult his firm’s legal department for advice as he was not willing to risk his firm’s reputation because of a client. The report prepared by his audit team was going to be presented to FCB’s audit committee in a few days. Meanwhile, he convinced himself that FCB was a reputable company with a good business model and the possibility of irregular activities in FCB was remote. REFERENCES Business News (2005, November 5). Asia's Air Cargo Industry Struggles with Continued Fuel Surcharges, Retrieved October 15, 2010 from http:/www.prweb.com/ releases/2005/11/prweb306197.htm 19Asian Journal of Case Research (AJCR) APPENDIX A FCB?’s Financial Statements from 2001 to 2005 2001 2002 2003 2004 2005 Income Statement. |§ —— ——— ——___ —_____. —_.____ RM’000) =RM’000 )=6RM’000) = RM’000 = RM’000 Revenue 180,692 219,278 +=. 289,169 346,180 = $50,078 Operating expenses (13,336) (13,177) (14,035) (16,829) (429,943) Other income 604 1,012 456 1,187 11,274 Profit from operations 44,571 51,347 72,700 97,642 ‘131,409 Interest expenses (10,924) (7,896) (7,605) (8,543) (21,510) Income from associated 57 (2,706) (2,579) 425 491 companies & other investments LS Profit before tax 30,941 43,508 65,526 86,620 110,390 Taxation (3,657) (3,993) (16,388) (24,227) (35,543) Profit after tax 27,284 39,514 49,464 62,393 74,847 2001 2002 2003 2004 2005 Balance sheet ———— Non-current assets: Land & buildings, 336,733 445,519 475,443 595,072 1,565,807 plant & equipment Goodwill 1,161 1,113 1,064 1,015 966 Investments in associated 532 588 13,528 1,176 13,263 companies Long term investments _18,782__‘18,782 u 18,792 20 357,208 466,002 490,046 + 616,055 1,580,056 Current assets: Work in process 684 7 14,168 5,313 ‘12,568 Debtors 88,509 75,129 72,392-«105,71 111,113 Other receivables 66,498 34,125 39,261 202,959 79,770 Cash in bank 10,877 30,524 31,638 —«165,240 261,235 166,568 139,778 157,459 479,283 464,686 Less current liabilities: Creditors 28,914 24,086 23,147 24,302 58,463 Other payables 41,141 42,062 32,467 61,119 64,613 Loan & overdraft 71,289 50,766 48,043 44,316 27,939 Provision for taxation 5,873 8,422 3,183 1,075 2,561 147,217 125,336 106,840 130,812 153,576 20Flat Cargo Berhad: An Auditor’s Conundrum ‘Net current assets 19,351 14,442 50,619 348,471 311,110 Total 376,556 480,444 540,655 827,754 1,891,166 Financed by: Share capital 93,251 149,918 157,884 201,072 233,537 Reserves 135,859 137,749 164,526 427,995 700,916 229,110 287,667 322,410 629,067 934,453 Reserves attributable to - - - - 15,659 polenta) wiareholde I ———— Total owners’ equity 229,110 287,667 322,410 += 629,067 950,112 Non-current liabilities . Long term loan 143,892 188,400 173,694 131,242 833,474 Deferred tax 3,554 4,377 44,551 67,445 107,580 147,446 192,777 218,245 = 198,687 941,054 Total 376,556 480,444 540,655 827,754 1,891,166 21Fleet Information for FCB Group Asian Journal of Case Research (AJCR) APPENDIX B Aircraft type Configuration Delivered Status Exit date Boeing 737-275C(A) Cargo 01-04-1999 Active Boeing 737-248C Cargo 26-03-1994 PT-MTATAF — 17-09-2000 Linhas Aereas Boeing 737-230C Cargo 24-02-1995 PT-MTATAF 01-08-2002 Linhas Aereas Boeing 737-2X6C(A) Cargo 15-03-1996 N747AS 16-02-2001 Alaska Airlines Boeing 737-200A\(F) Cargo 02-12-1996 Active Boeing 737-209(A) Cargo 15-01-1997 N827AL 19-06-1998 Aloha Airlines Boeing 737-275C(A) Cargo 15-01-1997 Active Boeing 727 Cargo 01-05-2005 Active Boeing 727 Cargo 01-08-2005 Active McDonnell Douglas Cargo 13-02-1998 N831LA —_—10-08-1998 DC-10-30 Virgin Express McDonnell Douglas Cargo 25-02-1998 N833LA 05-1998 DC-10-30 Laker Airways McDonnell Douglas Cargo 26-04-2005 Active evtd MD-11 MD-11F McDonnell Douglas Cargo 12-04-2005 Active evtd MD-11 MD-11F McDonnell Douglas Cargo 10-06-2005 Active evtd MD-11 MD-I1F McDonnell Douglas Cargo 21-07-2005 Active evtd MD-11 MD-I1F Source: www planespotters.net 22Flat Cargo Berhad: An Auditor's Conundrum APPENDIX C 5 year Group Financial Highlights 2001 2002 2003 2004 2005 Net profit 20,531 21,869 38,107 45,463 84,369 Total assets 523,985 605,780 653,934 1,088,909 2,044,742 Total shareholders’ funds 229,110 270,903 322,410 629,067 950,112 Paid-up shares in issue 93,251 149,918 157,884 201,072 233,537 (-000) Net tangible assets per share 2.46 1.81 2.04 3.13 4.07 (RM) Earnings per share 14.90 14.50 24.50 25.10 38.50 (cent) Gross dividend per share 3.00 3.00 3.00 3.00 3.00 Net Profit Total Assets TIED pre ee 3,000,000 +-————- 2,000,000 + 50,000 1,000,000 arte ° "Net Profit 0 "Total Assets rc aNO = wo “A P & R888 SSS Source: Flat Cargo Group Annual Report 2005 23Asian Journal of Case Research (AJCR) APPENDIX D Board of Directors The list of FCB’s Board of Directors: Director Role Dato’ Ibrahim Samad Chairman, Independent Non-Executive Director Lim Loon Sim Chief Executive Officer, Non-Independent Executive Director Ali Bin Ahmad Non-Independent Executive Director Lee Guan Choi Non-Independent Executive Director Miri Kim Chen Non-Independent Non-Executive Director Tan Sri Rahim bin Fahmi Non-Independent Non-Executive Director Datuk Abu Bakar bin Sharif Non-Independent Non-Executive Director Sulaiman bin Ahmad Kamil _Independent Non-Executive Director Chong Kee Kit Independent Non-Executive Director Audit Committee Audit Committee members as reported in FCB’s 2005 Annual Report: Chong Kee Kit (Chairman) Ali Bin Ahmad (Member) Sulaiman Bin Ahmad Kamil (Member) Top Management Team Lim Loon Sim (Chief Executive Officer) Ali Bin Ahmad (Executive Director, Employee Share Option Scheme Committee Member) Low Boon Wah (Chief Financial Officer) Source: FCB Annual Report 2005 24Flat Cargo Berhad: An Auditor’s Conundrum APPENDIX E Relevant Information on Corporate Governance in Malaysia In Malaysia, the practice of corporate governance is governed by the Malaysian Code on Corporate Governance (hereforth known as “Code”) which was first issued in March 2000. It codifies the principles and best practices of good governance and describes optimal corporate governance structures and internal processes. The reporting of compliance with the Code has been made mandatory to all Malaysian public listed companies (PLCs). Thus, shareholders and the public are able to assess and determine the standards of corporate governance of those companies. The Code was revised in 2007. “The key amendments to the Code are aimed at strengthening the Board of Directors and Audit Committee, and ensuring that they are to discharge their roles and responsibilities effectively. The eligibility criteria for the appointment of directors and the role of the nominating committee are clearly spelt out in the amendments. Similarly, the eligibility criteria for the appointment of audit committee members, the composition of audit committee, the frequency of meetings and the need for continuous training are defined. In addition, the amendments require all PLCs to set up internal audit functions. In order to maintain independence, the Code specifies that the board should include a balance of executive directors and non-executive directors (including independent non-executives) as one of the key principles of corporate governance. This principle is important so as no individual or small group of individuals can dominate the board’s decision making. To further strengthen the independence of the board of directors, PLCs must adhere to the principle that there should be formal and transparent procedures for the appointment of new directors to the board. There must also be a formal and transparent procedure for developing the policy on executive remuneration packages of individual directors. The details of the respective remunerations must be contained in the company’s annual report. An audit committee is established by the board of directors to carry out certain duties including the appointment of the external auditor, the co-ordination of the external audit work, the review of financial statements and internal audit functions, and the continuous engagement with the senior management of the company. The Code requires that an audit committee must comprise at least three members, a majority of whom are independent. All members of the committee should be non-executive directors. The committee is required to meet regularly. The details of the activities of the audit committee, the number of audit meetings held in a year, the attendance details of each director with respect to meetings, and the attendance details of the relevant training attended by members should be disclosed in an informative way. The Code clearly specifies that external auditors should independently report to shareholders in accordance with statutory and professional requirements and independently assure the board on the discharge of its responsibilities. 25