RxBar Ltd is a niche protein bar maker. The company was founded in 2013 in a basement
Question:
RxBar Ltd is a niche protein bar maker. The company was founded in 2013 in a basement by two childhood friends, Peter Ever and Ralph Franklin, who had an idea to create protein bars that were made of simple ingredients without sugar or additives. Their protein bars were unique in that they only contained 3 different ingredients - eggs, dates and nuts.
In 2015 the company relocated to 20,000 square foot unit in Mississauga. At that time the bars were hand-made and extremely labour intensive. The company secured funding from investors to finance the automation of the manufacturing process and to hire employees. The loan had a conversion feature which could be triggered by the investors if the current ratio fell below 1.2. If the conversion feature is triggered every $100 of the loan's principal value is converted to 10 common shares. As a result of the new financing the company wasb able to produce 1.5 million bars and employ 40 people in 2015
A turning point came in early 2016, when the company redesigned its labels. The new labels focused on the short, real-food ingredient list and as the two owners put it had a "no B.S." mantra. The redesign of the label really changed the business and for the year ended September 30, 2017 the company sold 12 million bars, creating $ 100 million in revenue.
RxBar initially sold the bars to exercise gyms in the GTA and it also established an online presence where customers could purchase bars online with Canada Post delivery. In 2017, the company began to sell nationally at the major grocery store chains (Loblaws, Sobeys etc) and also penetrated the U.S. market with sales to major grocery retailers (Whole Foods and Target).
Peter and Ralph were recently approached by the multinational cereal company, Kellogg's, who expressed interest in purchasing RxBar. The most striking element for Kellogg's was RxBar's outstanding revenue growth. Kellogg's has asked for audited financial statements to be provided to them by October 31st to assist them in the valuation of RxBar. Peter and Ralph see this opportunity to cash in on a major wind-fall, they are very excited - the proposed sales price by Kellogg is $600 million. The proposed price was based on RxBar's revenue growth.
You, CPA, are an audit manager at Fox LLP a professional accounting firm that provides audit, tax and advisory services. Fox LLP, has been providing accounting services to RxBar since its inception. Every year, the RxBar controller, Susan (Peter's mom) provides Fox LLP with a trial balance and Fox LLP prepares adjusting entries and the financial statements (including note disclosures) and the tax return. The financial statements have never been audited as this was not required as part of the loan agreement.
It is now October 12, 2017. Tom Prance, an audit partner at Fox LLP has approached you to help out with this new engagement. Shelly Park, an accountant in the advisory services of the firm has worked on RxBar for several years and she annually prepares the financial statements and tax return based on the trial balance she receives from Susan. She has developed a strong relationship with Susan and the accounting clerks at RxBar and has an in-depth understanding of the business. Since she has just completed the financial statements for RxBar, she has been assigned to the audit and was asked to prepare the initial audit plan. Tom asked you to review Shelly's initial work to be sure that she was on track.
Appendix I (attached)
Appendix II - EXCERPTS FROM THE AUDIT PLANNING DOCUMENTATION
All working papers were prepared by Shelly Park and completed on October 12, 2017.
WP 100 Client Acceptance Considerations and Engagement Letter
This is a continuing client. In past engagements, there have not been any indicators which put to question management integrity. The company is financially viable and in a growth stage. The engagement letter was already obtained in prior year. Refer to prior year files. The imposed deadline for audit completion by October 31, 2017 is feasible given the auditor prepares the financial statements and audit staff have experience in the food industry and already work with the client. No further work required.
WP 200 - Materiality Assessment
This is a high risk engagement since the financial statements will be used to value the company. Company valuation would likely be based on assets and as such this will be used as the benchmark for materiality. Professional guidance suggests materiality based on assets to be between ½ to 1%. The higher end of the range 1% was selected due having many users including the lenders and investors. Assets x 1% = 617,380. Say $617,000.
Performance materiality - set at 85%, since the risk of any errors is low as the financial statements are prepared by the auditor. Materiality @ 85% = $524,450.
WP300 - Audit Strategy Memo
Assessment of Entity-Level Controls
Internal Control Environment
Management is competent and committed to a good control environment. Peter and Ralph believe that everyone should have an opportunity to participate in the company's success and all employees have an opportunity to receive a bonus for finding new customers. Since the bonus has been so popular, in 2017 Peter and Ralph announced that the bonus would be increased.
In order to be adaptive to change, Peter and Ralph believe in having a flat organizational structure. This type of structure provides everyone with the ability to pitch in. For instance, in peak production times, the accounting people will help out in the warehouse and process shipping documents.
Control Activities and Monitoring
Credit Policy - Given the importance of revenue growth, Susan maintains tight control over credit policy. For all new customers, Susan performs an extensive credit check. She requires that the new customers provide 3 references including their bank. Each reference is emailed and the prospective new client's credit history is evaluated. For public companies, she also reviews the financial statements and evaluates the company's liquidity. For international clients outside of Canada and U.S., Susan obtains credit risk insurance from Export Development Canada (EDC). The insurance covers up to 90% of the losses related to the sale.
Susan prepares a monthly summary of new customers and an analysis of aging of accounts receivable. Peter and Ralph have complete trust in Susan and do not see the need to review any of the credit reports or the accounts receivable aging. Based upon my review of the new customer reports, I noted that all had the appropriate documentation with the exception of ten of the international customers, who did not have EDC insurance. Susan explained that she had been away for three weeks and since she is the only one with authority to obtain the insurance, it was missed. It was noted that all customers were in good standing and therefore the control was effective.
Monitoring of Financial Reporting - Given that Fox LLP prepares the annual financial statements and that Susan spends so much time on credit related issues, Susan is not involved in period-end closing and the preparation of the monthly financial reports. One of the accounting clerks prepares monthly income and cash flow statements and budget to actual analysis for Peter and Ralph's review. Since Fox LLP posts many adjustments at year end, Susan explains that Peter and Ralph do not use the income statements or the budget analysis to monitor operations and focus on cash flow. Given this compensating control, management has effective monitoring over financial reporting.
Developments in the Business
Whole Foods, which makes up 20% of revenue was purchased by Amazon in June 2017. Following the acquisition, Amazon announced it will be making significant price reductions and will be reviewing all supplier contracts. As a condition of being a continuing supplier, Amazon required all suppliers to make a 25% price reduction immediately.
A recent newspaper article reported that two customers complained to the Canadian Food Inspection Agency about improper labelling of the Fruit Exclusive bars. The customers had tree nut allergies and experienced allergic reactions from eating the bars. They claim that the bars were not appropriately labelled with the warning "may have been in contact with tree nuts".
Preliminary Analytical Review
Inventory has gone up by 113% The main reasons for the increase are: 1) increased sales levels and 2) one of the purchasing agents had ordered dates way in excess of the production needs. The dates have a three-month shelf life and RxBar is unable to return the product.
Accounts receivable have increased 300%. The main reasons for the increases are: 1) increased sales levels and 2) a change in credit terms from 30 days to 45 days for international customers. Susan explained that this increase was necessary to entice international customers to try their product. Since RxBar has EDC insurance for international customers, there was no need to increase the allowance for doubtful accounts.
Compliance with Laws & Regulations
I inquired with regards to compliance with laws and regulations. Susan confirmed that the company is in compliance with Food Safety and Quality Act and with food labelling requirements and that the newspaper article was "fake news". Susan's explanation is reasonable and no further work required.
REQUIRED
a) Critique Shelly's analysis in the client acceptance working paper. In your analysis, consider those factors which she analyzed NOTE: In your discussion, ensure to explain why or why not each factor Shelly analyzed was appropriate and whether Shelly's conclusion was appropriate. (4 marks)
b) Do you agree or disagree with the benchmark selected and the percentage applied to establish overall materiality? Provide a rationale as to why or why not and recalculate a revised materiality if required.(5 marks)
c) Do you agree or disagree with the percentage selected for performance materiality? Provide a rationale as to why or why not (include in your discussion the impact on the audit) and recalculate a revised performance materiality if required. (4 marks)
d) Refer to Shelly's risk assessment of entity level controls in the audit strategy memo. Identify 2 control weaknesses, explain the implication of the weakness for RxBar (what can go wrong), and provide a recommendation to address that control weakness. (6 marks)
Weakness
Implication
Recommendation
e) In Shelly's risk assessment of entity level controls, she concluded that the controls over credit policy were effective, do you agree with this conclusion? Why or why not? Do you think she had sufficient and appropriate evidence to make this conclusion? Why or why not? (4 marks)
f) Refer back to the description of the analytical review performed in the audit strategy memo. For the analytical review procedures identify the relevant assertion(s), and based on the case facts, indicate whether the misstatement would be an overstatement or understatement and explain the impact on the audit and what additional testing should be done. (6 marks)
Inventory has gone up by 113%
Procedure
Assertion
Over/Understatement
Impact on the audit/additional audit testing
Accounts receivable have increased 300%.
Procedure
Assertion
Over/Understatement
Impact on the audit/additional audit testing
g) Assess the risk of material misstatement (RMM) at the overall financial statement level.(OFSL) The assessment should include at least 3 factors and an explanation as to WHY it increases or decreases the RMM. (6 marks)
Factor that increases or decreases the risk at the OFSL
Increases or Decreases
Explanation
Expert Answer:
a Critique Shellys analysis in the client acceptance working paper In your analysis consider those factors which she analyzed NOTE In your discussion ensure to explain why or why not each factor Shell... View the full answer
