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ACC605 Auditing

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  • Course Code: ACC605
  • University: Nelson Marlborough Institute Of Technology
  • Country: New Zealand

Questions:

Case Study

You are the audit manager responsible for the audit of Kereru Brewing Company Limited (KBCL) for the year ending 30 June 2018. KBCL is listed on the New Zealand Stock Exchange, and manufactures and distributes a range of premium craft beers and ciders. Its head office and its largest brewery are both located in Blenheim. It has warehouses in Auckland and Christchurch and it also has a sales office and a brewery in Sydney, which is run by its subsidiary company, Kea (Australia) Limited (KAL).

KBCL has been a client of yours for four years, and your audit firm has always had a good relationship with the group. Management and the accounting staff have always been cooperative, honest and positive about the audit and financial reporting. Your firm has monitored the relationship carefully, because when the audit was obtained Andrew Bigham, the CEO, had the reputation for being a 'high-flyer' and had been through bankruptcy at an earlier time in his career. The only material misstatements that were found in the prior year's audit were in respect of cut-off errors at year end.

Bigham runs the group in an autocratic way, primarily because of a somewhat controlling personality. He believes that it is his job to make all the tough decisions. He delegates responsibility to others but is not always willing to delegate a commensurate amount of authority.

The company has grown in size very rapidly as the industry in which KBCL participates has been in a favourable cycle the past few years. Industry profits are reasonably favourable, and there are no competitive or other apparent threats on the horizon, except for the rising New Zealand dollar and the recent discovery of the hop mosaic virus (HpMV) in a hop farm in Motueka that may affect future supplies of hops to be used in the manufacture of beer.

KBCL sells its craft beers and ciders to upmarket bars and restaurants in New Zealand, and Australia, and it started selling its products to supermarkets in New Zealand during the year. It also started exporting its beers and ciders to Japan at the beginning of December 2017 as part of an international expansion plan. It is likely to require additional funding to finance this expansion and is contemplating a share issue some time in 2019. All sales are on credit.

Internal controls for KBCL are evaluated as reasonably effective for all cycles but not unusually strong. Although Bigham supports the idea of internal control, you have been disappointed that management has continually rejected your recommendations to establish an internal audit function and an audit committee.

KBCL has a contract with its employees that if the group’s operating profit before tax, interest expense and superannuation costs exceed $9 million for the year an additional contribution must be made to the superannuation fund equal to 5% of the excess.

KBCL increased its efficiency during the year by installing a new computer system and as a result it laid-off two accounting staff in September 2017. You are also aware from the newspapers that the group is facing a legal case arising from employee health and safety issues at its Sydney brewery.

The group maintains a perpetual inventory system and carries out stocktakes at its breweries and warehouses at the end of each quarter. It is planning to carry out stocktakes at all of its locations on 29 June 2018.

Plant and equipment include leasehold property improvements, which includes $256,000 incurred in 2017 for a waste water disposal pipeline. Depreciation has not been charged in relation to this pipeline.

The bank loan is secured against plant and equipment.  The secured loan is also subject to a covenant agreement which specifies that the company maintain the following ratios:

  • net tangible asset to total liabilities ratio which is positive
  • a positive current ratio

The staff employed by KAL in Sydney are always under pressure to finalise their accounts in time to enable the consolidated group’s accounts to be prepared as soon as possible after the year end so that they are ready for the auditors. The audit reporting deadline for the coming audit is 15 September 2018.

The client has provided you with preliminary (draft) financial information in respect of the year ending 30 June 2018 for the consolidated group (i.e. KBCL and its subsidiary KAL), which is on the following page.KBCL group summary financial statements

Balance Sheets

 

 

 

30 June 2018

(preliminary)

 

30 June 2017 (audited)

Cash and cash equivalents

$ 243,689

133,981

Trade and other receivables

3,544,009

2,224,921

Allowance for doubtful debts

(120,000)

(215,000)

Inventories

4,520,902

3,888,400

Prepaid expenses

      29,500

     24,700

Total current assets

8,218,100

6,057,002

 

 

 

Plant and equipment

 

 

At cost or fair value

12,625,255

9,602,534

Less accumulated depreciation

(4,382,990)

(3,775,911)

Total plant and equipment

8,242,265

5,826,623

Loan to previous CEO

320,000

320,000

Intangible assets

 

 

Brands

855,000

0

Goodwill

345,000

345,000

Total intangible assets

1,200,000

345,000

Total assets

$17,980,365

$12,548,625

 

 

 

Trade and other payables

2,141,552

2,526,789

Bank loan payable

150,000

0

Accrued liabilities

723,600

598,020

Income tax payable

1,200,000

1,759,000

Current portion of long-term bank loan

  240,000

  240,000

Total current liabilities

4,455,152

5,123,809

Long-term bank loan

960,000

1,200,000

Total Liabilities

5,415,152

 

6,323,809

Net Assets

$12,565,213

$6,224,816

 

 

 

Shareholders’ equity

 

 

Ordinary shares issued

3,000,000

3,000,000

Retained earnings

   9,565,213

  3,224,816

Total shareholders’ equity

$12,565,213

$6,224,816

 

Income Statements and Movements in Retained Earnings

 

 

30 June 2018

(preliminary)

30 June 2017

(audited)

 

Sales

$46,963,338

$32,258,015

Less: Cost of sales

25,779,499

19,032,229

Gross profit

21,183,839

13,225,786

Distribution, administration, sales and marketing expenses

10,020,661

8,420,162

Lease expense

571,560

480,270

Superannuation expense

823,643

673,590

Loss on foreign exchange

294,202

191,440

Interest expense

      83,376

   104,220

Total operating expenses

11,793,442

9,869,682

Operating profit before tax

9,390,397

3,356,104

Income tax expense

1,800,000

1,141,000

Operating profit after tax

7,590,397

2,215,104

Add: Opening retained earnings

3,224,816

2,009,712

 

10,815,213

4,224,816

Dividends paid

(1,250,000)

(1,000,000)

Closing retained earnings

$9,565,213

$3,224,816

 

PART A 

REQUIRED:

In respect of the audit plan for the audit of the financial statements of the KBCL Group for the year ending 30 June 2018:

a. Explain what is meant by the acceptable overall audit risk, and describe the factors that influence this risk. Provide an assessment of the acceptable audit risk for the coming audit as high, medium or low. You need to support your answer with reasons.                            

b. Based on the information provided on pages 2 and 3 of the case study, identify the significant risks of material misstatement in the coming audit, and classify them as inherent or control risks.

c. Based on your risk assessments in question (b) above, carry out a preliminary assessment of the risk of material misstatement, and decide whether it is high, medium or low. You need to justify your assessment.

d. Perform an overall analytical review of the financial statements of KBCL. Your review should include:

i. A horizontal and a vertical analysis of the 2018 and 2017 financial statements. Prepare this analysis using an Excel spreadsheet.

ii. Calculation and analysis of relevant financial ratios for 2018 and 2017, including a comparison with industry averages. You may find the financial ratio formulae on page 8 of this case study useful.

iii. From the above overall analytical review, identify the financial statement accounts that will require special attention during the coming audit. You need to support your answer with reasons why these accounts will require special attention.

e. Materiality

i. Explain and differentiate between planning, performance and specific materiality levels.

ii. Calculate a planning materiality level and performance materiality level for the coming year audit. Round your answer up to the nearest $1,000.

iii. Calculate a specific materiality level and a specific performance materiality level for the brands (an intangible asset on the balance sheet). Round your answers up to the nearest $1,000. 

iv. Assume that you find suppliers’ invoices for $100,000 in relation to marketing and promotion of internally generated brands and you discover that this expenditure has been incorrectly capitalised as an intangible asset at 30 June 2018 instead of being expensed. If management of KBCL refuse to adjust the financial statements and given your materiality calculations above, explain the impact of this misstatement on the audit report (assuming that you do not find any other unadjusted errors during the audit). Justify your answer. 

PART B

Your audit plan for the sales cycle places reliance on internal controls. Your testing of the internal controls for sales has found a significant number of instances where customer credit ratings have not been checked and abnormally large discounts have been given to new customers by sales staff without senior management approval. The sales manager states that these changes have been the result of difficulties reaching the very high sales targets set by Andrew Bigham.

REQUIRED:

a. Explain the relevance of a company’s internal controls to the company’s auditor. Include in your answer:

i. The auditor’s underlying objective in undertaking tests of controls.

ii. A distinction between tests of controls and substantive tests of details.
iii. The stage during the audit when tests of controls are usually performed by the auditor.

b. Describe how the above situation will affect your audit plan. Include reference to any potential risks in the sales cycle, and the nature and extent of substantive testing to be carried out in relation to sales and accounts receivable.

Ratio

Formula

Industry average for 2018

Current Ratio

Current Assets 
Current Liabilities

1.91:1

Liquidity Ratio

CA – Inventory
Current Liabilities

0.92:1

Debt to Total Assets Ratio

Total Liabilities
Total Net Assets

1.11:1

Times Interest Earned

Net Operating Profit

Interest Charges

3.00 times

Inventory Turnover

Cost of Goods Sold
Av Inventory Held

5.85 times

Days Sales in Inventory (days)

365

Inventory turnover

62.39

Accounts Receivable Turnover

Credit Sales
Accounts Receivable

10.43 times

Average Collection Period (days)

365

A/R Turnover

35

Total Assets Turnover

Sales

Total Assets

2.83 times

Gross Profit Margin

Gross Profit 
Sales              

50.37%

Net Operating Margin

Net Operating Profit

Sales

8.34%

Return on Total Assets

Net Profit before taxes

Total Assets

6.44%

Relevant financial ratios

Note1: Net Operating Profit is earnings before interest and tax (EBIT).

Note 2: Use the closing inventory figure when calculating the 2017 inventory turnover ratio.

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