Internal Audit Report

CBI Holdings
New York, USA

Fieldwork Conducted during May 15 to

June 10, 1993
Issued: June 20, 1993
Distribution List:

Mr. Rey D. Amaya, Audit Committee Chair

Ms. Pamela Dadang, CFO
Mr. Robert Castello, Board Chair

Table of Contents
I. Executive Summary .....................................................2
II. Observations and Recommendations ..........................4
A. Corporate Governance . 5
B. Overstatement of Inventory. 7
C. Unrecorded Liabilities
... 9
D. Excessive Bonuses
...10

I.

Executive Summar y

During the months of May and June 1993, the internal audit team performed a review of the financial
statements for the fiscal periods ending April 1992 and April 1993. The purpose of the review was to provide a
reasonable assurance that the financial statements fairly represent the actual financial condition and
performance of CBI and that the internal control under which such statements were prepared are effective.
Particularly, this is to ascertain CBIs compliance with agreements with TCW and several banking & financial
institutions pertaining to certain financial performance ratios.

Background
CBI is a large wholesale distributor of pharmaceutical products in the US. In a highly competitive business
environment, CBI undertook in the early 1990s a strategy of growth by acquisition. It borrowed capital
extensively from various banks & financial institutions (through loans) and from TCW (through issuance of
capital stock). These agreements required CBI to achieve and maintain specific financial targets-including an
earnings to fixed charge ratio, a net worth ratio and other standard covenants to avoid default on existing bank
loans and in order to prevent control-triggering events to occur (which would eventually allow TCW to take
over CBI). These arrangements coupled with CBIs insufficient control environment present a high risk that
financial statements may not faithfully represent the results of the companys operations and that a controltriggering event has actually occurred.

Scope
The internal audit covers the financial statements for the fiscal periods ending April 1992 and April 1993. The
internal audit primarily focused on:
Accounts Payable
Inventories
The audit also includes the evaluation of internal controls relevant to the aforementioned accounts.

Objectives & Approach

The objective of the internal audit is to evaluate the accuracy and reasonableness of the account
balances, specifically the inventory and accounts payable accounts, presented in the 1992 and 1993
financial statements and the effectiveness of the related internal controls.
To accomplish our objective, the audit addresses the following management assertions:

Existence For the inventory account, we conducted a physical inventory count and vouched
significant additions to inventories to their supporting documents such as vendor invoices and
corresponding receiving reports.
Rights and obligations We sent positive confirmation letters to the top ten largest suppliers of CBI.
We also sent negative confirmation to CBIs minor suppliers. Moreover, we reviewed the minutes of
the meeting and the debt covenants pertaining to the bank loan and the note payable to TCW. We
test the reasonableness of financial ratios and compared it to the required financial ratios in the
debt covenants.
Completeness For the accounts payable account, we reviewed documentation payments made
after the year ended 1992 and year ended 1993. We identified and tested selected controls over
high-dollar payments related to the Advances to Suppliers account.
Valuation We ascertain the correct balances of the accounts payable through confirmation with
CBIs major and minor suppliers. Pertaining to the inventory accounts, we reconcile the totals on the

compiled total inventory counts to the general ledger. We also ascertain the possible impact of any
misstatement of inventory or purchases to the net income figure.
Presentation and Disclosure We examine how the payments to suppliers after year-end described
as Advances to Suppliers presented in the financial statements. We performed a walk-though of
the advance payment transactions occurring after the 1992 and 1993 financial year-end and traced
transactions to postings in the general ledger to determine the accounting treatment of the said
advances.

Results
Overall Report Rating High Priority
The Observations section of this report provides detailed descriptions of each observation and
recommendation. Because of the unique circumstances of CBI with regards to the maintenance of specific
financial ratios, the following issues are assessed as high priority:
Corporate Governance
Overstatement of Inventory
Unrecorded Liabilities
Excessive Bonuses

HIGH PRIORITY
HIGH PRIORITY
HIGH PRIORITY
HIGH PRIORITY

Corporate Governance
CBIS management has been dominated largely by the companys President and Chairman of the Board of
Directors Robert Costello. As such, financial reporting and the surrounding controls have been constantly
overridden by Costello and his confederates in an attempt to misrepresent the companys financial position and
performance such that breach of loan covenants with several banks and take over by TCW will not materialize.

Overstatement of Inventory
Inventories are overstated though the recording of phantom inventories in the books in violation of the
existence and valuation assertion of management to maximize the inventory available for collateral for CBIs
bank loans. This results to an overstatement of the earnings before interest and tax (EBIT), artificial increase in
the times interest earned ratio (TIE) and the possible occurrence of a control triggering event.

Unrecorded Liabilities
There is a material understatement of Accounts Payable due to the non-recognition of liabilities arising from
Purchases and the recording of payments as Advances to Accounts, which is presented as a deduction from
Accounts Payable. The improper accounting of liabilities may lead to the concealment of a control-triggering
event and a violation of loan covenants as well as improper management of liabilities.

Excessive Bonuses
Excessive annual bonuses for fiscal years 1992 and 1993 have been granted to Castello on the basisi of falsely
inflated reported net earnings. Motivated by the desire to receive bonuses under a progr essive system of bonus
plans and for fear of possible job loss resulting from bankruptcy in case of bank loan defaults and takeover by
TCW, net earnings were fraudulently increased by understating Purchases and consequently understating Cost
of Goods Sold

II. Observations and Recommendations

A. CORPORATE GOVERNANCE
Observation

HIGH PRIORITY
Business Impact

Criteria:
The organizations governing body and senior management are
vested with the responsibility of practicing good corporate
governance and ensuring the integrity of the accounting and
financial reporting systems and that appropriate controls are in
place.

The reliability and integrity of the

companys financial and operational
information can be compromised.
The company is very much exposed
to management fraud which leads to
material misstatements in the
financial
statements.
The
Condition:
falsification of these financial
The control environment of CBI is ineffective. The management is reports can lead to multiple lawsuits
dominated by Robert Castello who is also the president and that may be filed by the
chairman of the board. There is a presence of domineering stakeholders.
management behavior towards the auditor in attempt to influence
the scope of the auditors work. Aggressive positions are also taken
by the management personnel regarding key accounting estimates.
Cause:
The corporate governance structure is weak and ineffective. There
are no compensating controls such as effective oversight from the
Board of Directors. There is a lack of members who are independent
of management. There is only little attention paid to financial
reporting matters and to the internal control systems specifically the
lack of segregation of duties.

Recommendations
1

Management Response

The Board must establish a set of good corporate governance

practices. This includes the improvement of the board
composition wherein independent directors must be included
to protect the right of the stakeholders. It is highly
recommended that the CEO and the Chairman of the Board
are two different directors. The Board members should be
active in participating in the administration as well. A formal
resolution must be instituted requiring independent directors
in the board and its definition of independence. Key
committees like Audit Committee, Compensation Committee
and Nominating Committee should be composed mainly of
independent directors. A Code of Conduct must be developed,
publicized and followed within the company. Monitoring
compliance should also be done to make appropriate actions
for those who failed to comply with the Code.

Appropriate systems of internal control must be instituted.

Incompatible duties must be properly segregated in the
department. It must also emphasize the importance of
independent checks, accounting records and the control access
to these documents and records.

A supervisory review must be done when segregation of

duties is not feasible or monitoring budget variances in the
absence of transaction processing controls.

B. OVERSTATEMENT OF INVENTORIES
Observation

HIGH PRIORITY
Business Impact

Criteria: Inventories should be actually existing and owned by the

company as of the balance sheet date. They should be valued and
presented in the financial statements in their appropriate amounts.

Tactical Level:
Overstatement
of
recorded
inventories understates Cost of
Goods Sold and inflates the Profit
Condition: CBI borrowed capital from a bank to finance its growth Margin and eventually, the earning
prospects. Pursuant to debt covenants, CBI is bound to maintain a before interest and tax (EBIT).
specific financial target including earnings to fixed charge ratio, a Overstatement of EBIT artificially
net worth ratio and other standard covenants that CBI to have increases the earnings to fixed
continuous access to credit and to avoid default on its existing loans charge ratio (TIE), a specific
with that bank. This debt covenants also restricted its subsidiarys financial ratio to be maintained in
available credit to a certain percentage of inventory and accounts CBIs loan covenant with the bank.
receivable. Moreover, TCWs securities purchase agreement also
stipulated that upon the occurrence of certain control-triggering Puffed up earnings may also have
events- to wit:
resulted to an overstatement of
(1) a breach of the earnings to fixed charge ratio (TIE bonus that is received by the
ratio)specified in the Securities Agreement; and
President-Board Chairman.
(2) a failure to pay the principal on TCW's corporate notes, whether
such payment was due at maturity or by reason of acceleration.
The Securities Agreement permitted TCW to accelerate CBI's note
payment schedule in the event of certain defaults, including the
making of any unauthorized loan to a CBI officer (e.g., Castello).

Strategic level:
Discovery of these misleading
financial ratios can lead to
immediate cut-off of credit from the
bank and the acceleration of CBIs
outstanding loans to the bank and
In light of the aforementioned conditions and the potential risk TCW. Furthermore, this can give
associated with the inventory account, certain issues have been rise to a control triggering event as
uncovered. Fictitious inventories have been found out to be specified in the purchase agreement
recorded in the books. These inventories are then included in the with TCW that will prompt it to
initiate an immediate takeover of
calculation of total assets.
CBI.
Cause: This must have done most likely to meet up with the
requirements of the loan covenant. Recording phantom inventories
increases the amount of inventory available as collateral for CBI's
bank loans, thus increasing the amount of money that CBI can
borrow from the bank.

Recommendations
1

Management Response

Establish heightened internal controls regarding the receipt of

inventories and the recording of inventories. CBI should:
(a) Segregate the receiving department and the recording
function of inventories.
(b) Reconcile significant increase in account balances of
inventory to authorized supporting documents such as the
purchase requisition, approved purchase order, vendors
invoice and the receiving report.
(c) Interim physical count of inventories to assure that
recorded inventories actually exist and are owned by CBI and
this figure is the amount reflected in the financial statements.

Develop a back-up plan for additional lines of credit from

other financing institutions just in case the banks credit line
is suspended.

Management should restate or revise the 1992 and 1993

financial statements due to the material overstatement of
Inventories.

C. UNRECORDED LIABILITIES

HIGH PRIORITY

Observation

Business Impact

Criteria:
Once ownership of inventories is transferred to CBI, the entry to be
recorded is a debit to Purchases and a credit to Accounts
Payable. Upon payment, the entry is a debit to Accounts Payable
and a credit to Cash. For payments for inventories that have not yet
passed to CBI, the entry is a debit to Advances to Suppliers and a
credit to Cash. Once ownership passes, the entry is a debit to
Purchases and a credit to Advance to Suppliers

Since
Accounts
Payable
is
materially understated, the financial
ratios computed using Account
Payable are also deemed incorrect.
There is a probability that a controltriggering event has occurred and
that CBI has violated its loan
covenants.

Condition:
No entries were made on the credit purchases of a significant amount
of inventories in the fiscal periods 1992 and 1993. Upon payment of
the unrecorded liabilities, the bookkeeper debited Advances to
Suppliers and credited Cash. Moreover, the Advances to
Suppliers account was shown as a deduction to Accounts Payable
in the balance sheet.

Because of improper accounting,

CBI
may
have
significant
difficulties
in
managing
its
liabilities resulting to lost discounts,
late payments and strained supplier
relationships.

Cause:
Management has apparently interfered with the accounting function
in order to conceal the happening of events that would have
prompted TWCs take over and that would have made CBI to violate
its loan covenants.

Recommendations
1

The Accounting Department should refer to supporting

documents, such as purchase order, vendor invoice and
receiving reports, in order to identify the nature of the
transaction and the appropriate accounts to be used.

A schedule reconciling the beginning and ending balances of

Accounts Payable and Advances to Suppliers as well as a
schedule classifying outstanding Accounts Payable based on
maturity should be prepared periodically in order to facilitate
the determination of whether charges to the accounts are correct
and to assist the timing of payments.

Management should restate or revise the 1992 and 1993

financial statements due to the material understatement of
Accounts Payable.

Management Response

D. EXCESSIVE BONUSES
Observation:

HIGH PRIORITY
Business Impact

Criteria:
(1) Bonuses are given to managers and others with similar
accountability and responsibility in recognition of excellent
performance during a specified period measured by appropriate and
relevant key performance indicators.
(2) Net earnings, on which bonuses are based, must represent actual
company performance during a specified period. All revenue and
expense transactions transpiring during the year must be recorded at
proper amounts.

Bonuses represent actual cash

disbursements paid or payable within
a short period of time. Excessive
granting of such bonuses will cause
more assets (cash and other
considerations) to flow out of the
entity than what the entity has
actually benefited from (services and
expertise rendered by managers). The
entity might become less liquid and
Condition:
might fall into cash shortage and if
(1) Castello had an employment agreement with CBI in which he was perpetually done, might face
eligible for an annual bonus in an amount tied to the company's net bankruptcy.
earnings.
(2) Net earnings have been reported higher than what it should have Underrecording of Purchases made
been due to failure of recording of suppliers invoices for goods during a particular period will
ordered and received during the fiscal year. Understated Purchases effectively overstate Net Earnings.
understates Goods Available for Sale, and coupled with an Net earnings is one of the key figures
overstatement in Ending Inventory, understates Cost of Goods Sold stakeholders look into in assessing
for the period. Reported earnings skyrocketed and in turn, caused companys
performance.
Any
Castellos bonus to be inflated.
material misstatement in this report
will cause distrust in investors and
Cause:
other providers of company capital.
(1) Top managements severe avarice for perpetual acceptance of
extravagant and undeserved bonuses.
(2) Top managements (especially Castellos) utter apprehension of
being taken over by TCW in case companys financial condition
and performance measured by key financial ratios reach critically
low and undesirable levels.

Recommendations
1

Management Response

Purchases cut-off procedures must be performed

immediately before and after year-end to ensure recording of
Purchases at proper amounts in the proper accounting period.
As Suppliers Invoices are received, corresponding Receiving
Reports must immediately be collected and attached to the
pertinent Invoice; and kept intact until payment is made.

In addition to Net Earnings as a determinant of bonuses to be

given to Castello and other managers, other performance key
indicators must be established in order to provide for
sufficient assurance that bonuses are given as they are
properly earned.

Management should restate or revise the 1992 and 1993

financial statements due to the material overstatement of Net
Income.

10

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