Reference no: EM132624277

Question - A newspaper article reported that company has been found to have opportunistically window dressed its financial statements.

The executive chairman of a listed company said he was stunned when senior finance managers approached him after the departure of the firm's most senior executive officer. It was reported that there were irregularities in the company's financial accounts which had left its 35 stores across the country on the brink of collapse.

The executive chairman immediately called in its external auditors to conduct an investigation. It was later confirmed the worst: the company's assets had been overstated and its liabilities understated for up to six years, leaving it in the dire position where it was unable to pay its debts.

The executive chairman and its board of directors then reported to the Security Exchange and one week later, the senior executive officer's resignation was then reported to the Exchange. One day later, the chief operating officer informed the board that he was on medical leave. In view of the situation, the executive chairman and the other directors resolved to call in accountants from another international company who told the board to take steps to ensure no further liabilities were incurred. They also advised the board not to pay any debts until the situation could be stabilised.

The international accounting firm told the executive chairman that he had to immediately notify the company's biggest secured creditor, the EMI Bank. A meeting with the bank's credit evaluation centre was scheduled for the following day, where the executive chairman said that if urgent funds were not made available within 36 hours, the listed company would have to stop trading and appoint administrators.

Many meetings were held between the company and the bank with a view to salvage the financial position of the company, and to avoid receivership. After one week, the bank lost it patient aa it found out that it is exposed to potential losses of RM50 million. As such, the bank appointed an insolvency specialist as receiver, who announced the company would be sold to recover its debts.

The sale came as no surprise to the listed company's 1,000 unsecured trade creditors, many of whom had been experiencing difficulties for several years with getting payments. Some had been forced to use debt collectors to ensure bills were paid. One of the creditors, said the company was experiencing a difficult trading year because of the tax, interest rates, increasing petrol prices and the post-COVID spending slump. In the market, there are rumours that creditors exercised caution when supplying stock to its stores in different locations.

According to figures provided by the company, its assets of RM200 million were 'predominantly funded through debts' of RM120 million. Observing this situation 'indicates a cause for concern' as the company was in 'a poor short position, meaning short-term debt is not covered by short-term asset position'.

This situation was confirmed during a creditors' and the company's cash flow projections 'revealed that the liabilities of the company had been understated and the assets overstated'. This 'systematic overstatement of profit has been funded by increased debt both to the bank and to creditors'.

Further investigations were continuing into how these irregularities had occurred. Company records had been seized and copies sent to the Securities Commission. The employees of Commission worked closely with the finance personal of the Company in a bid to unravel what happened inside the Company and how misleading financial accounts were allegedly maintained for up to six years.

The executive chairman who was an internal audit committee with another two board members charged with ensuring the accuracy of the company's financial records, has said senior management did not inform directors of the problems. This situation will be closely examined as it is the legal responsibility of directors to ensure they fully inform themselves about the financial positions of companies they represent.

The Commission also will investigate statements by the directors that they relied on the accuracy of reports prepared by Company's auditors over the past seven years. Both the current and outgoing audit firms lodged formal declarations that the accounts had been subjected to full audits 'conducted in accordance with country Auditing Standards'. This included statements to the Commission which said 'our procedures included examination, on a test basis, of evidence supporting the amounts and other disclosures in the financial report, and the evaluation of accounting policies and significant accounting estimates'.

Required - Read the above newspaper article:

(a) Identify the "dire" condition of the company.

(b) Explain how debt hypotheses under the Positive Accounting Theory can be employed, under the efficiency and opportunistic perspective, to explain and predict the action of the senior executive officer which created the "dire" condition of the company.

(c) The Company typically have a contractual arrangement with the bank with many covenants written to incorporate accounting numbers.

Explain why the Company agrees to enter into such agreement with the bank and do the bank gain from the existence of such agreements?