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The essential role of an audit

The market doesn’t like uncertainty ... While time is of the essence, and investigations carried out by the regulators may take time, it is also important for the market to hear from the auditors themselves as to their side of the story, especially now that the special notice has been withdrawn. After all, the issue at hand is related to audit matters and only they could put the record straight

THE powers and duties of an auditor are clearly defined under Section 266 of the Companies Act, 2016. Here, the law states that an auditor has a statutory duty to report to members with regards to the financial statements, company’s accounting and other records related to those financial statements. The auditor is also required to state in a report whether the financial statements presented give a true and fair view of the affairs of the company. An auditor is required to provide reasons if he or she is not satisfied with any matters related to the financial statements. The function of an auditor is also clearly defined in the code of corporate governance, which came about mainly due to corporate failures, losses, scandals, economic turmoil as well as demand from stakeholders. The origins of corporate governance itself can be traced back to the United States. The US Securities and Exchange Commission (SEC) led the early establishment of corporate governance among corporates when it required companies to have audit committees among listed companies. In the 1980s, as the US stock market was rapidly developing and more and more US companies saw the emergence of institutional investors, the demand from these investors grew as they wanted to have more say on how these corporates were run with greater accountability and transparency. The institutional demand grew louder in the 1990s but nothing materially changed until the Enron and WorldCom cases emerged in early 2000. These two corporate failures were the cornerstone of change when it came to corporate governance and the role of auditors. Fictitious accounting In Enron’s case, it was revealed that the board failed to perform its duty as fictitious accounting and earnings were reported. The board was more concerned on the value of their shareholding, and to maintain Enron’s stock price, they effectively adopted strategies that were high risk and to ensure reported earnings can be managed to meet market expectations. Enron has since become a well-known example of wilful corporate fraud and corruption. The scandal also brought into question the accounting practices and activities of many corporations in the United States and was a factor in the enactment of the Sarbanes–Oxley Act, 2002. The scandal also caused the dissolution of Arthur Andersen, one of the largest audit firms globally then. In Worldcom’s case, the company was caught using creative accounting in booking “line costs” (interconnection expenses with other telecommunication companies) as capital expenditures on the balance sheet instead of expenses and inflating revenues with bogus accounting entries from “corporate unallocated revenue accounts”. In recent times, we have seen some large financial scandals too involving companies like Wirecard of Germany, Luckin of China, or even Hin Leong from Singapore. Historically, Malaysia too has its fair share of scandals that has brought shame and ridicule. We have seen in the past how scandals like the Pan-El crisis of the 1980s or the case of Transmile’s accounting scandal in early 2007 cause significant losses to investors. In some of these cases, it is the management of the companies themselves who were involved but at the same time, the auditors too failed to detect early warning signs, until it was too late. One does not need to go very far as even in the case of 1MDB we had observed how auditors had performed their fiduciary duty as earlier appointed auditors could not complete their work, resulting in a change of auditors. When new auditors were brought in, despite vouching for the financial statements, they disowned their own opinions later on following the report from the Department of Justice (DoJ). The dynamics of the Serba saga Over the past 10 days or so, the most talked about story in the financial market was that of Serba Dinamik. It all started on May 7,2021, when the company announced to Bursa Malaysia that it was changing its financial year from a December year-end to a June 2021 year-end, or effectively an 18-month financial period from its last audited accounts of Dec 31,2019, or the financial year 2019 (FY19). The reason cited by Serba based on stock exchange filing was “continuing extension of the movement control order (MCO) in Malaysia and lockdowns in countries in which the group have hampered the ability to finalise the group’s financial statements; expansion of groups operations in new countries further add to more time required to finalise financial statements; to facilitate better audit planning and allocation of resources to avoid the peak financial reporting period” The market took little attention to this change in year-end by the company but there were some red flags from here itself. For example, the company announced its full-year unaudited financial results for FY20 on February 26,2021. There was no mention about any change in the year-end then, and judging by the preceding year’s FY2019 timeline, Serba, after announcing the year-end results in that year, had issued its annual report (AR) on May 29,2020. In that AR, the auditors and directors had signed off the financial statements and the audit report on May 6,2020. Based on this, it does seem that the audit work carried out for FY20 by the auditors was well within the timeline set in previous years. It was only revealed to the market via Serba’s response to the exchange and an online corporate and media presentation done last Saturday, May 29,2021, that the audit matters were raised by the auditors on May 3,2021. Interestingly, in the FY19 audit report, the auditors had highlighted three key audit matters then and they include: > Existence, accuracy and completeness of revenue recognition; > Completeness and existence of material on-site amounting to RM908mil; and > Valuation of trade receivables and contract assets valued at RM1,526mil. In FY19, the auditors addressed these key audit matters via various methods and means to ensure the financial statements were accurately reflectively of the balances presented. Hence, on May 25,2021, to the surprise of the market, Serba announced that it was seeking suspension of trading of its shares as it was informed by its auditors “on some matters” on the statutory audit and at the same time the board announced that it is appointing an independent firm to commence a special independent review to assess the veracity and accuracy of the matters. Serba shares remained suspended for the rest of last week, pending the release of further information. On May 28,2021, Serba announced that it has received a special notice from a non-independent, non-executive director with a shareholding of 15.96% for the company to convene an EGM, to remove its current auditors and to appoint BDO PLT as new auditors of the company for the new financial year ending June 30,2021. On the same day, Serba also detailed out its response dated May 6,2021, on the key audit matters that were raised by its auditors three days before that, as explained earlier. Serba claims that while it has responded to the matters that were raised by the auditors, the auditors themselves have not reverted to the company. Last Saturday afternoon, in a rather unusual and rushed dissemination of information, Serba called for analysts/fund managers briefing as well as a separate media briefing on the chronology of events that has occurred. Serba must be applauded for making the effort to come clean and to explain to investors and the media its side of the story for the matters that were raised by the auditors. At the same time, we have also heard from Serba that the present auditors have reached out to independent directors of the company concerning the key audit matters. While it was not mentioned who these independent directors are, a quick check on the latest board of directors list suggests that Serba has nine board members, of which five are independent non-executive directors (INED), including one senior INED. The audit committee (AC) comprises four members, with the senior INED as chairman and two others being the INED. Only one of the AC members is a non-independent non-executive director. Hence, since the present auditor has reached out to the INED, it can be concluded that at least three of them are AC members. Of the three INED AC members, two are members of the Malaysian Institute of Accountants (MIA) and one of them is a former partner of the present audit firm. There is indeed no reason to doubt as to why the auditors have reached out to the INED and in particular, the INED who are AC members, as they do understand and can comprehend the issues that have been raised by the auditor. In a late statement on Thursday, the INEDs too have expressed their concern on matters raised by the auditors and are taking steps to resolve the issues at hand, which include the appointment of an independent firm to assess the veracity and accuracy of the matters raised by the auditors, independently and objectively, without any element of interference from any party. The time to come clean is now The market doesn’t like uncertainty. At the time of writing, Serba’s share price was last seen at 83.5 sen as at Thursday’s close, or 48.1% lower than its pre-suspension price of RM1.61. Some RM2.89bil in market capitalisation has been wiped out due to the uncertainty created by this impasse between the board and the auditor. It has also wide repercussions for the company’s bonds as rating agencies have downgraded the debt papers. Regulators have stepped in to investigate the matter. With the pressure coming from various stakeholders as well as concerns raised by several institutional investors, the special notice issued earlier has since been withdrawn. Serba has taken measures to buy time by extending its accounting period to June 30 and this will allow the present auditors to complete the audit in time. While time is of the essence, and investigations carried out by the regulators may take time, it is also important for the market to hear from the auditors themselves as to their side of the story, especially now that the special notice has been withdrawn. After all, the issue at hand is related to audit matters and only they could put the record straight. Pankaj C. Kumar is a long-time investment analyst. The views expressed here are his own.

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