Question

Nicolas Drinks Inc. (Nicolas) manufactures fizzy drinks such as cola and lemonade as
well as other soft drinks and its year end is 31 December 2017. You are the audit
manager of B&J CPAs LL.P. and are currently planning the audit of Nicolas.
You attended the planning meeting with the engagement partner and finance director
last week and recorded the minutes from the meeting shown below. You are reviewing
these as part of the process of preparing the audit strategy.
Minutes of planning meeting for Nicolas
Nicolas’ sales results have been strong this year and the company is forecasting
revenue of $85 million, which is an increase from the previous year. The company has
invested significantly in the cola and fizzy drinks production process at the factory. This
resulted in expenditure of $5 million on updating, repairing and replacing a significant
amount of the machinery used in the production process.
As the level of production has increased, the company has expanded the number of
warehouses it uses to store inventory. It now utilises 15 warehouses; some are owned
by Nicolas 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 has been introduced at the beginning of the year, with
the old and new systems being run in parallel for a period of two months.
As a result of the increase in revenue, Nicolas has recently recruited a new credit
controller to chase outstanding receivables. The finance director thinks it is not
necessary to continue to maintain an allowance for receivables and so has released the
opening allowance of $1·5 million.
In addition, Nicolas has incurred expenditure of $4·5 million on developing a new brand
of fizzy soft drinks. The company started this process in January 2017 and is close to
launching their new product into the market place. The finance director stated that there
was a problem in November in the mixing of raw materials within the production process
which resulted in a large batch of cola products tasting different. A number of these
products were sold; however, due to complaints by customers about the flavour, no
further sales of these goods have been made. No adjustment has been made to the
valuation of the damaged inventory, which will still be held at cost of $1 million at the
year end.
As in previous years, the management of Nicolas is due to be paid a significant annual
bonus based on the value of year-end total assets.
Required:
1. Using the minutes provided, identify and describe SIX audit risks, and explain the
auditor’s response to each risk, in planning the audit of Nicolas Drinks Inc. (12
marks)
2. Describe substantive procedures the audit team should perform to obtain
sufficient and appropriate audit evidence in relation to the following three matters:
(i) The treatment of the $5 million expenditure incurred on improving the
factory production process;
(ii) The release of the $1·5 million allowance for receivables; and
(iii) The damaged inventory.

Answer 1

1.Identification of risk based on the review of minutes

a)Estimation risk - Nicolas is forecasting a sales of 85 million for the succeeding year based on such forecast it is making huge expenditures. There is a possibility that the estimation made by the management is not correctly reflecting the market situation,

Audit response - The auditor should take the responsibility of evaluating the reasonableness of accounting estimates made by management, when planning and performing procedures to evaluate accounting estimates, the auditor should consider, with an attitude of professional skepticism, both the subjective and objective factors.

b)Warehousing risk - Due to expansion there is an increase in the number of warehouse this might lead to warehouses not being monitored, resulting in financial losses.

Audit response - To mitigate such risk auditor has to ensure whether physical verification of inventory takes place regularly.For warehouses that arises his suspicion he might himself undertake such physical verification.

c)Inaccurate or omitted transaction - Since accounts are being maintained over two systems there is a high probability of transactions not being recorded.

Audit response - The auditor must obtain sufficient and appropriate evidence to make sure that all the transactions pertaining to a year have been recorded. He can even follow analytical procedures to check and investigate upon variances.

d)Misstatement - The release of allowance for receivable as directed by the finance director due to appointment of credit controller might result in huge credit balance in the income statement which might misled the stakeholders.

Audit response - Auditor has to do a detailed study of the terms and conditions of credit controller's engagement to ensure collection of debts.

e)Legal risk - There are instances of customer complaints about the new product that was offered.There might arise costly legal battles due to the sale of a faulty product.

Audit response - Auditor has to ensure whether precautionary measures have been taken by the management to protect themselves from legal obligations.If the management is not sure about what to do auditor has to check whether any appropriate provisioning is required.

d)Wrong accounting - Inventory of a product line that was discontinued is being maintained at cost.

Audit response - Auditor has to ensure there is a market available for the product if not the inventory has to be valued at fair value (if it is lesser than cost).

2.Substantive Procedures

i) 5 million expenditure - Vouching for the expenditure, Matching purchase records to stock in hand,Checking the capitalization norms,Examining accounts payable and its supporting documents,etc

ii) Release of allowance - Accounts receivable confirmation, Communication with management regarding collectibility, Terms of engagement of the credit controller, etc

iii) Damaged inventory - Confirm the calculations on an inventory valuation report, Confirm inventories not on-site, Confirming marketability of such inventory, Finding the fair value of such inventory, etc.