Background of Bega Cheese Ltd.
Corporate Governance Structure of Bega Cheese Ltd.
Industry-wide challenges affecting the Australian Dairy industry.
Areas Susceptible to fraud.
Spike in production despite the tough conditions affecting the industry.
Unrealistic inventory values and unfair accounting treatment for inventories.
Risk of fraud in Acquisition accounting done by the company.
Scenario describing financial statement fraud committed by CEO/CFO (Hypothetical)
Recommendations on actions to be taken to monitor and prevent fraud.
Enquiry into figures of production volume.
Suspicious transaction analysis.
Placing emphasis of proactive fraud detection measures.
Bega Cheese Limited is one of the top 200 ASX listed companies in Australia. The company is involved in the manufacturing and processing of dairy products and other food products. The products of the company are distributed all over Australia and are also exported to other countries of the world. The headquarters of the company is located in New South Wales. Some of the main products manufactured and produced by the company include Cheeses of different varieties, spreads of different varieties, grocery products, and other health and nutrition products ( Bloomberg, n.d.). The company has established itself as a popular brand in the Australian dairy industry however; it is currently facing some challenges which have affected the complete Australian dairy industry. The company has made rapid expansion since the time of its establishment and has recently acquired some other firms. Bega cheese Ltd acquired Bega Foods and Peanut Company of Australia in the year 2017 for a purchase price of $ 453 million and $ 12 million respectively (Bega Cheese Limited, n.d.a). The company again made another significant acquisition in the year 2019 when it acquired the Koroit processing facility for a purchase price of $251 million (Bega Cheese Limited, n.d.b).
An environment of weak corporate governance and poor culture may promote the occurrence of fraud at any company while the existence of good corporate governance and a strong focus on corporate ethics prevents the occurrence of fraud at the company. As per the corporate governance statement included in the 2019 annual report of the company, the group aims to achieve and maintain high standards of transparency as well as accountability in the conduct of business activities and decisions taken for the company(Bega Cheese Limited, n.d.b). There is no information available to us which may point out towards lack of appropriate or poor corporate governance structure at Bega Cheese Ltd. However, there were certain recent changes in the governance board of the company, which cause us to be open to explore the possibility of "earnings management techniques" which may have been resorted to by the company.
A lot of studies have been conducted in this direction, which has pointed out that there is a strong tendency of the incoming management personnel to involve in earnings management techniques to be able to report a lower income in the year of change in management, such that they can present higher stream of incomes in the next year(s) to be able to present that the increase in income in next year was caused as a result of their high performance (Wells, 2002). There was a change in the Chairman of the company in the year 2019, where Mr. Barry Irvin AM was replaced by Mr. Max Roberts (Bega Cheese Limited, n.d. b). Interestingly, the net profits of the company for the year 2018 declined from $ 50884 to $18911, and the main reason for this decline were one-off items such as impairment losses, increased finance costs, increased administration expenses (Bega Cheese Limited, n.d. b). These circumstances pointed out the existence of a possibility of earnings management in the year 2019 as a result of a change in the Executive Chairman of the company.
The company has been facing several challenges since the last year, the most significant of it is increasing drought conditions in the country since the last few years. Australia has witnessed low rainfall in the last few summers and this has had a huge adverse impact on the production and supply in the dairy industry (Dairy Global, 2019). The adverse weather conditions characterized by a low level of rainfall posed many operational challenges not just for Bega Cheese Limited but for the entire dairy industry in Australia. All the dairy farms owned by the company are located in the town of the Bega which falls in the state of New South Wales. The New Southern Wales region was the most severely affected region by a deficiency in rainfall (Dairy Global, 2019). The impact of the decline in rainfall on different parts of Australia has been shown in the below picture which shows the parts of Australia that were most severely impacted, highly affected, and the ones that were slightly affected by the prevailing drought conditions.
Figure 1: Lack of Rainfall in Australia between periods 1 March 2018 to 31 August 2019
Source: Dairy Global, 2019
The production in the dairy industry is largely dependent on the maintenance of dairy farms where livestock is kept. The worsening farm conditions and increase in the prices of inputs such as grains and low access to water have made it difficult for dairy farmers to maintain their livestock, specifically in those regions which faced severe lack of rainfall (Dairy Global, 2019). The farms of the company have been running down of their grain inventories which has a direct impact on the size of farm inventories (livestock) maintained by the company. The reduction in the size of farm inventories has caused a big decline in the average farm business profit (Plastow, 2019). The business activities and supply of the company were largely impacted by drought conditions that prevailed in the year 2017 but it experienced some improvement in its supplies owing to favorable weather conditions in the year 2018 (Bega Cheese Limited, n.d. b). However, in the year 2019, the company again experienced a decline in farm profits owing to significantly lower rainfall.
According to a report by the Australian Government of Agriculture, the milk supply in Australia has reduced by nearly 6 percent in the year 2019 as compared to the year 2018 (Department of Agriculture, Water, and Environment, 2019). The adverse weather conditions were accompanied by a steep rise in the prices of animal fodder as well water which caused a sharp fall in the profits of companies operating in the dairy industry. Further, it was also highlighted by the Australian Department of Agriculture that low level of rainfall has led to low soil moisture which has also reduced the quantity and quality of pasture growth especially in big areas of New Southern Wales and Southern Australia. The climatic conditions in the country, existing challenges related to water supply, and the high cost of fodder have placed immense pressure on dairy farmers and the entire dairy industry (Omstedt, 2018). Therefore, all these factors have brought down the profits of even the biggest dairy companies in Australia. The below table shows the trend in real farm cash income of different states of Australia from the year 1999 to 2019:
Figure 2: Trend in real farm cash income from the year 1999 to 2019
Source: (Department of Agriculture, Water, and Environment, 2018)
It is evident from the above line graph that the dairy farms in New Southern Wales experienced a significant decline in their cash income in the year 2018-19 as compared to the year 2017.
Spike in production despite the tough conditions affecting the industry
The company reported an increase of 8 percent in its production in the year 2019 as compared to the year 2018. As per the figures provided in the “Performance Highlights” section in the Annual Report of the company for the year 2019, the production volume was 280,405 tonnes in the year 2019 while it was 259,235 tonnes in the year 2018 (Bega Cheese Limited, n.d. b). The claim made by the company regarding the increase in its production volumes is in sharp contrast to the prevailing conditions in the industry which have caused a high level of decline in productivity of dairy farms across Australia. As almost all of the farms owned by the company are located in the town of Bega in the state of New South Wales, which was the worst drought-hit region of Australia, this raises some obvious doubts on the claim made by the company regarding an increase in its production volume. This indicates a likelihood of fraud or misrepresentation that could have been made in the financial records of the company.
As per the information provided in a report of the Australian Department of Agriculture, the real cash income of dairy farms in NSW went down significantly due to falling in the production volume amidst difficulties faced by the dairy companies in maintaining their livestock (Department of Agriculture, Water and Environment 2018). It is unlikely that farms and livestock inventory owned by Bega Cheese Ltd would have not been impacted by the drought conditions and other challenges that were affecting the entire Dairy Industry of Australia. In our opinion, there is a high chance that the production volumes reported in the year 2019 are overstated to a large extent. Therefore, based on these discussions and findings; this is considered by us a potential area where a possibility of manipulation or misrepresentation of financial information exists. It is also important to note that any manipulation in the production output
Unrealistic inventory values and unfair accounting treatment for inventories
The drastic increase in the value of inventory held by the company immediately after the business acquisitions made by it have pointed towards the existence of the possibility of misrepresentation in the financial statements of the company. it was also noted by us that those inventories which were received by the company as a result of acquiring Mondelez Grocery Store were presented by the company in its financial statements at fair values instead of cost or net realizable value whichever was lower. The company recognized a large portion of its inventory for the year 2018 at fair value and this accounting treatment was justified by the chief executive officer of the company by explaining that the said inventory valuation was a one-off item and it was justified to present inventories at fair value which included the profit margin (Bega Cheese Limited, n.d. a). However, this accounting treatment of inventories was against the Accounting standard 102 and this matter was also reported by the external auditors of the company in their auditor’s report.
Risk of fraud in Acquisition accounting done by the company
The company has made some major business acquisitions in the last two years. It acquired Mondelez Grocery Business (Bega Foods) and Peanut Company of Australia in the year 2017 and Koroit in the year 2018. The company was recorded an abnormal increase in the value of its intangible assets owing to the high amounts of goodwill recognized by it related to the recent acquisitions of these firms made by Bega Cheese Ltd. There exists a high possibility that these intangible assets recorded by Bega Cheese Ltd are not reported at their real values. Their valuation of intangible assets was one of the key audit areas that were pointed out by the external auditors of the company in their auditor's report of the year 2018 as well as the year 2019.
The value of intangible assets owned by Bega Cheese Ltd was a mere $ 22 million in the year 2017 however, there was an increase of $ 389 million, in the valuation of intangible assets of the company in the year 2018 (Bega Cheese Limited, n.d. a). As a result, the value of intangible assets owned by Bega Cheese Limited went up to $411 million, which was extremely high. This increase in the valuation of intangible was caused as a result of the recognition of new goodwill and other intangible assets of the company after acquiring Mondelez Grocery Business. The company further recorded goodwill and intangible assets upon acquisition of Koroit in the year 2018, such that the total value of intangible assets reported by the company was $ 476 million in the year 2019 (Bega Cheese Limited, n.d. b).
The values assigned to the goodwill recognized by the company after acquiring another business entity are dependant on the judgments made by the company concerning the estimated value of future cash flows that were expected to be received by the company as a direct result of the acquisition of the said firm. The estimates and judgments formed by the company's management are regarded as another area that may be susceptible to fraud. It is possible for management and directors of the company to intentionally represent the intangible assets of the company at an unrealistically high value to present a strong picture of the asset base of the company to the investors.
In our opinion, there existed a strong possibility for the existence of fraud in accounting for acquisitions done by the company. Hence, we performed a detailed evaluation to assess the reasonableness of the assumptions, judgments, and estimates formed by the management concerning the valuation of intangible assets that arose as a result of new business combinations and acquisitions made by the company. It was revealed to us by the results of our investigation that the estimates formed by the management were not realistic especially concerning forecasts of future cash flows. The estimates for cash flow forecasts made by the chief financial officer of the company were not in accordance with the industry growth rates and trends in the Australian Dairy and Consumer goods industry. This is indicative of deliberate attempts made by senior management to window dress the balance sheet of the company to overstate the value of its assets to present a strong asset position.
Further, even though the company has recorded high goodwill concerning the acquisition of the new businesses, which shows that the company expects an increase in its profits and earnings as a result of these acquisitions, there has been no considerable improvement in profitability and earnings of the company since last two years. Also, the expectations of the company to achieve improvement in profits after acquiring these firms, in not reflective in its market sentiments, as the price of its shares remains low (Mickleboro, 2019). As the benefit expected to be earned by the company after acquiring these three businesses is not reflected in its earnings pattern, this also points towards a possibility that the consideration paid by the company for these acquisitions was not justified and company paid a much higher amount than the actual worth of these newly acquired firms (Holand, 2017). This is also indicative of a deeper fraud or misappropriation of funds where those officers or employees who made the valuation of net assets and prospects of these acquired firms intentionally presented lifted values to favor the acquisition of these firms by the company, in return for a direct or indirect benefit by these firms.
It is recommended that the board of directors should take the following actions to be able to prevent fraud from occurring and to be able to quickly identify fraud if that occurs within the company
Enquiry into figures of production volume
It is recommended that the records related to the production process and production volume generated by each farm held by the company should be reviewed and checked in detail. The production volumes reported by the company are questionable after taking into consideration the challenges affecting the Australian Dairy industry at present. In the present circumstances of adverse weather conditions and other challenges related to the high cost of fodder and challenges relating to the cost of water supply which also mentioned by the Ex-Chairman of the company Barry Irwin AM in his review on the performance of the company relating to the year 2018, many suspicions are raised on the overwhelming production volume reported in the year 2019 (Bega Cheese Limited, n.d. b). The fact of a decline in Australian milk production due to prevailing drought conditions was further reaffirmed by the Mr. Paul van Heerwarden in his review of the performance of the company relating to the year 2019 (Bega Cheese Limited, n.d. b).
Given that the challenges affecting the dairy industry, it is hard to believe that the company experienced an increase in its production volume even when the entire New Southern Wales area was the worst drought-hit area for the year 2019, where most of the dairy farms owned by Bega Cheese Ltd are situated (Bega Cheese Limited, n.d. b). We consider this as a significant area because if the figures of production volume reported are incorrect or deliberately manipulated, this would indicate a possibility of manipulation in the revenue, cost of goods, and the closing inventory reported in the financial statements of the year 2019. Therefore, it is highly recommended that an internal enquiry be conducted to audit the production volumes reported by the company in the year 2019. This enquiry should specifically be directed at determining how the production output of each month was recorded in the accounting software and financial system of the company and it must also be assessed that whether there exists a possibility of manipulation of records in the accounting system (software) of the company.
Suspicious transaction analysis
It is also recommended that the Board of directors of Bega Cheese Ltd should put in place automated detection programs which makes it possible to identify the indicators of fraud in the financial records of the company within no time. If an organization uses manual testing to identify the possibility of frauds, it usually involves a lot of time and may not lead to the detection of some or all the frauds. An automated detection program makes it possible for the company to identify fraud indicators quickly and effectively as it can search through a high number of records in no time (PWC, 2018).
Placing emphasis on proactive fraud detection measures
The company should put in place a whistleblower protection programme and another detection programme which would enable the company to strengthen its corporate governance and have stronger risk mitigation measures in place (PWC, 2018). The board of directors of the company should take the required actions to create an organizational culture that promotes high integrity, values, and ethics. To promote employees to disclose any instance of fraud or malpractice to the management, the company should take strong steps to protect those employees who act as whistleblowers.
Bega Cheese Limited (n.d.a). 2018 Annual Report. Retrieved from https://www.begacheese.com.au/investors/annual-reports/
Bega Cheese Limited (n.d.b). 2019 Annual Report. Retrieved from https://www.begacheese.com.au/investors/annual-reports/
Bloomberg. (n.d.). Bega Cheese Ltd. Retrieved from https://www.bloomberg.com/profile/company/B6G:GR
Dairy Global. (2019). Australia’s dairy sector still facing immense pressure. Retrieved from https://www.dairyglobal.net/Market-trends/Articles/2019/10/Australias-dairy-sector-still-facing-immense-pressure-492403E/
Department of Agriculture, Water and Environment. (2018). Drought impacts on broad acre and dairy farms in South-Eastern Australia 2018. Retrieved from https://www.agriculture.gov.au/abares/research-topics/surveys/drought-impacts-broadacre-and-dairy-farms
Holand S.(2017). Has Bega Cheese Limited just created an expensive mess? Retrieved from.https://www.fool.com.au/2017/10/27/has-bega-cheese-limited-just-created-an-expensive-mess/
Mickleboro J. (2019). Bega Cheese shares fall to a 52-week low on weak half year results. Retrieved from https://www.fool.com.au/2019/02/27/bega-cheese-shares-fall-to-a-52-week-low-on-weak-half-year-results/
OmstedtS.(2018). High input costs create strain. Retrieved from http://adf.farmonline.com.au/news/magazine/farm-business/general/high-input-costs-create-strain/2757753.aspx
Plastow K. (2019). Dairy industry takes further hit as drought conditions become ‘new norm’. Retrieved from https://thenewdaily.com.au/finance/finance-news/2019/05/23/dairy-farmers-drought-fonterra/
PWC. (2018). Fraud. Retrieved from https://www.pwc.com.au/consulting/assets/risk-controls/fraud-control-jul08.pdf
Wells, P. (2002). Earnings management surrounding CEO changes. Accounting & Finance, 42(2), 169-193.
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