Question

Fresh Ltd. (Fresh) manufactures organic fruit drinks and its year end is December 31, 2020. You are an audit manager of Lea & Bettiol CPAs and are currently planning the audit of Fresh. You attended the planning meeting with the audit engagement partner and CFO last week and made the following notes:

Notes of planning meeting for Fresh

Fresh’s sales have been strong and the company is forecasting revenue of $40 million this year, which is a 25% increase over the prior year. During the year, the company invested significantly in its beverage production process at its factory to ensure it can keep up with the product demand. It also spent $4 million updating, repairing and replacing most of the machinery used in its production process. Because of the significant demand, the company also expanded the number of warehouses it uses to store inventory. It now utilises 15 warehouses; some are owned by Fresh and some are rented from third parties. There will be inventory counts taking place at all 15 of these sites at the year end.

A new accounting general ledger was introduced at the beginning of the year, with the old and new systems being run in parallel for a period of two months. In addition, Fresh spent $1.3 million on developing a new brand of protein drinks. The company started this process in July 2020 and is close to launching their new product into the market.

As a result of the increase in revenue, Fresh recently recruited a new credit manager to collect outstanding receivables. The CFO is sure the new manager will be successful and so he does not think Fresh needs to continue to maintain a general allowance for doubtful accounts and so he has not booked one for 2020.

The CFO stated that there was a problem in the mixing of raw materials within the production process which resulted in a large batch of drinks tasting different. A number of these products were sold; but due to complaints by customers, no further sales of these beverages have been made. No adjustment has been made to the valuation of the damaged inventory, which will still be held at a cost of $1 million at the year end.

As in previous years, the management of Fresh is due to be paid a significant annual bonus based on the value of year-end total assets.

Required:

(a) Using the notes provided, identify and explain SEVEN audit risks

(b) If the auditor determines the engagement is high risk- what does this mean for detection risk and materiality?

(b) Assuming the auditor determines the inventory is overvalued, what would be the impact, if any, on the audit report?

(c) What type of audit procedure would provide the auditor the best evidence for the existence of the inventory? (1 Mark)

Answer 1

a) Audit risk is the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially mistated. This risk arises because the financial statements may be materially misstated prior to the audit. This points out to risk at 3 levels - inherent risk, detection risk and control risk. In the current the audit risks can be identified as :

1. Mistatement of inventory - Adjustment has not been made for damaged inventory which accounts for 2.5% of turnover. Information on profitability has been provided to access the percentage of profit that needs to be utilised to write off the above inventory.
2. Overstatment of receivables - A through analysis of trade receivables needs to be carried out, it is possible that disputed customers may not pay up.
3. Inadequate provision - No provision is made for bad and doubtful debts which will result in material misstatement of receivables
4. Business risk - The impact on future sales and profitability needs to be evaluated in the light of customer complaints and loss of reputation due to sale of beverages.
5. Employee remuneration - Payment of bonuses based on value of assets in incorrect since the value need to be recasted in the light of inventory and receivables highlighted above.
6. Credit risk - The client has undertaken huge investment in the beverage section and the ability to fulfill fixed commitments in the form of rent and interest needs to be considered
7. Inherent and Control risk - The significant expansion, unexpected market response, accounting policies, management opinions point to an overall high inherent and control risk.

b) High detection risk and materiality- It is very likely that the auditor will fail to detect a material error. The auditor would get into detail and reduce the materiality thresholds.

c) Overvaluation of inventory results in overstatement of profit and current asset. It also impacts retained earnings, shareholder's funds and the relevant financial ratios. In such a case, the auditor will give a qualified audit report.

d) Substantative procedures - Inspection and recalculation