CASE 6

Water Works Bhd

Contributor: Grace Mui

Background
Water Works Bhd is a well-established Malaysian company that produces
water filters. The company has been in operation for 15 years and its
products are exported to various Asian countries such as Singapore,
Thailand, Indonesia and the Philippines. Water Works is led by an
experienced chief executive officer (CEO), and his main objective is to
maximise shareholders’ wealth.
The most recent inventory audit at the company’s warehouse
highlighted a discrepancy in the inventory of commercial water filters.
There is evidence that points to foul play by the warehouse manager. James,
the CAE, is considering various options available to the company to resolve
this issue.

Facts of the Case

James, the CAE of Water Works Bhd, was reviewing a report on the recent
inventory audit at the company’s warehouse. He noticed the discrepancy
between the physical count and the inventory records for the main
inventory item, commercial water filters. James reaches across the table for
the surat layang1, he received in the mail that morning. The surat layang1
accused John, the warehouse manager, of being the mastermind in the sale
of 500 commercial water filters to a fictitious customer that was eventually
written off as a bad debt. The letter detailed how the commercial water
filters were sold at a 20% discount on the black market.
James remembered that two months ago there was a fire in the same
warehouse. The night watchman at the warehouse noticed the smoke and
called the fire brigade. The fire was promptly put out, and the fire brigade
reported that the possible cause of the fire was a cigarette butt thrown into
a waste bin at the warehouse office. The damage was minimal and repairs
were started at the warehouse office within the same week to ensure
that there was minimal disruption to operations. The warehouse manager
reported that some inventory records were destroyed and some of the water
filters were damaged.
A week after the fire at the warehouse, an employee from the warehouse
was hospitalised for a fortnight after a motorcycle accident on his way
home from work. Soon after, the employee resigned from his clerical

1
An anonymous letter
position at the warehouse and returned to his hometown in the next state.
Not long after his resignation, rumours were circulated that instigated this
employee as the one who started the warehouse fire. However, repairs to
the warehouse office were completed a fortnight after the fire, so there was
no opportunity to gather further evidence from the scene of the fire.
James walks over to the finance manager’s office to discuss this case
with her. Liza has been the finance manager at Water Works for three
years. She has a reputation of being efficient, reliable and thorough in her
work. Over the years, James and Liza had been able to seek each other’s
professional opinion and feedback on various work-related matters.
After Liza listened to James concern about the situation at the
warehouse, she retrieves the inventory records and performs data analytics
on the inventory levels. She prints out the report and hands it to James.
James observes that at the end of each of the past three financial years,
there is a marked reduction in inventory value. He asks Liza about it. Liza
explains to James that at the previous financial year end, a physical stock
take conducted by her team at the warehouse discovered that obsolete
inventory worth RM10,000 had been included in the closing inventory.
She included the write-down of the inventory in the financial statements.
The external auditors had agreed with her that the write-down was the
appropriate course of action in that situation.
Liza informs James of a conversation she had with Zain, the human
resource manager at the beginning of the new financial year about John, the
warehouse manager. John had been with Water Works for 11 years — first,
as a warehouse clerk and four years ago, he was promoted to warehouse
manager after the previous warehouse manager retired. Currently, John
has three warehouse clerks reporting to him. According to Zain, John
was a model employee who worked long hours and hardly applied for
annual leave. At the recent company annual dinner, John was presented
with a service award for his faithful service to the company. In his speech
that evening, the CEO commented that John was probably the healthiest
employee because he had not applied for sick leave in the past three years.
However, Zain did observe that in the last four years John has been
upgrading to new imported luxury cars every year. Further, John had
commented to Zain the year before that he (John) had to work hard
because he had spent RM1,000,000 to acquire a new house. Liza said that
this news was puzzling considering that John’s salary did not seem to
commensurate with his preferences for luxury cars and his new million-
ringgit house.
James asks Liza about the warehouse clerk who was hospitalised and
later resigned. Liza explains that the clerk was with the finance department
for three years before he was transferred to the warehouse six months
before the fire. Liza was of the opinion that he was a reliable employee
who was very thorough in his work. He was well-versed with accounting
for inventory and aware of the various internal controls over inventory at
Water Works. The transfer from the finance department to the warehouse
was made because senior management was of the opinion that the
warehouse manager required assistance to prepare usable and informative
management reports. When the clerk decided to resign from Water Works,
Liza spoke to him personally to persuade him to reconsider his resignation.
However, the clerk was adamant about leaving and commented that he was
tired of being bullied by other warehouse staff.
James tells Liza that he suspects that John is connected to the theft
of the water filters. Liza asks James what he intends to do next. James
explains that as CAE, he is responsible for raising the discovery of the
theft to human resources. It is then the responsibility of human resources
to initiate a domestic inquiry into the matter. The domestic inquiry panel
will then have to decide on the following options: (1) report the theft of
commercial water filters to the police; (2) initiate a domestic inquiry or
(3) not to do anything.
In initiating a domestic inquiry, the domestic inquiry panel has to
decide whether internal audit should gather the evidence or fraud
investigators should be engaged to gather the evidence. After the
completion of the domestic inquiry, senior management has the option of
initiating civil action.
Each of the options available to Water Works has its own benefits and
costs. These options are:

Option 1: Report the theft of the commercial water filters to the police
This option will initiate criminal action as the police will take charge of
the investigation and potential prosecution. However, criminal action tends
to be public in nature and this option can potentially result in the public
perception that Water Works’ internal controls are inadequate.
James was unsure about whether he should name John as a suspect in the
police report or allow the police to identify their suspects. Should James name
John as a suspect and if the police investigation fails, John could possibly sue
Water Works for defamation.
Another concern is if the police investigation finds that there is
insufficient evidence to prosecute the thieves, then lodging the police report
would have been in vain. Further, employees who were under suspicion
could file a lawsuit against Water Works for causing them distress during
the police investigation.

Option 2: Initiating a domestic inquiry and internal audit gathers the

evidence
James can report the discovery of the theft of water filters to the human
resource manager. The human resource manager will then conduct a
domestic inquiry while the internal audit gathers evidence.
James’s primary concern about this option is that he and his internal
audit team do not have sufficient knowledge and experience to gather and
preserve the evidence. Comparatively, the benefit of the internal audit team
conducting the investigation is that they are knowledgeable with Water
Works’ operations, policies and procedures and staff. Therefore, they may
be able to gather evidence in a friendly, non-threatening manner.

Option 3: Initiating a domestic inquiry and engaging the services of fraud

investigators
An alternative to internal audit gathering the evidence is to engage the
services of fraud investigators. This alternative incurs a high cost, but fraud
 investigators have the required knowledge and experience to gather and
preserve evidence that can be admissible in court. This evidence can be
used in the event that Water Works decides to initiate civil action.
Option 4: Don’t do anything
After the completion of the domestic inquiry, senior management can
choose not to do anything in response to the discovery of the theft. Whilst
no further costs are incurred with this option, employees may have the
perception that it is acceptable to perpetrate fraud because there are no
negative consequences for their actions.

Questions:
1. Comment on James’ assessments of the benefits and costs of these options.
Are there other options available to Water Works? Discuss the benefits and
costs of these additional options.
2. What is the audit trail of transactions, records and documents that James
should work through to verify the inventory values and numbers? Identify
the relevant transactions, records and documents in your analysis of the
audit trail.
3. What internal control mechanisms can Water Works apply to address the
misappropriation of inventory by employees?
4. What human resource issues are raised in this case? What possible courses
of action are available to John should he be named as a suspect in this
case? For this question, refer to the relevant IPPF standards, regulations
and laws, where possible.