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ACC605 Auditing

tag 0 Download 15 Pages / 3,559 Words tag 26-10-2020


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



30 June 2017 (audited)

Cash and cash equivalents

$ 243,689


Trade and other receivables



Allowance for doubtful debts






Prepaid expenses



Total current assets






Plant and equipment



At cost or fair value



Less accumulated depreciation



Total plant and equipment



Loan to previous CEO



Intangible assets









Total intangible assets



Total assets






Trade and other payables



Bank loan payable



Accrued liabilities



Income tax payable



Current portion of long-term bank loan



Total current liabilities



Long-term bank loan



Total Liabilities




Net Assets






Shareholders’ equity



Ordinary shares issued



Retained earnings



Total shareholders’ equity




Income Statements and Movements in Retained Earnings



30 June 2018


30 June 2017






Less: Cost of sales



Gross profit



Distribution, administration, sales and marketing expenses



Lease expense



Superannuation expense



Loss on foreign exchange



Interest expense



Total operating expenses



Operating profit before tax



Income tax expense



Operating profit after tax



Add: Opening retained earnings






Dividends paid



Closing retained earnings






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. 


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.


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.



Industry average for 2018

Current Ratio

Current Assets 
Current Liabilities


Liquidity Ratio

CA – Inventory
Current Liabilities


Debt to Total Assets Ratio

Total Liabilities
Total Net Assets


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)


Inventory turnover


Accounts Receivable Turnover

Credit Sales
Accounts Receivable

10.43 times

Average Collection Period (days)


A/R Turnover


Total Assets Turnover


Total Assets

2.83 times

Gross Profit Margin

Gross Profit 


Net Operating Margin

Net Operating Profit



Return on Total Assets

Net Profit before taxes

Total Assets


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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