You have joined a public accounting firm as a junior auditor and have been assigned to the audit team for one of your firm’s largest audit engagements, Cold Beverages Corp. (CB), a large public company. CB was incorporated in Canada several decades ago. Your firm has audited CB for many years. Based on your review of previous years’ audit working papers, CB’s 20X3 quarterly reports, and its draft 20X3 Management Discussion and Analysis, you have learned the following.
CB is one of the world’s largest non-alcoholic beverage producers, providing about 65% of the world’s retailer branded soft-drinks, bottled water, juice drinks, and teas. Approximately 90% of its output is sold to retailers for sale under the retailers’ brands, with the remainder sold under CB’s own brand names.
The company operates in North America, Mexico, the U.K., and Europe. In the past four years, CB has expanded its production and distribution capabilities mainly through acquisitions of other businesses. It plans to grow in future mainly by leveraging existing customer relationships, developing new products and distribution channels, and obtaining new customers in new markets. During 20X1 and 20X2, CB rationalized its business by focusing on its highest performing production facilities, resulting in plant and warehouse closures in North America.
CB’s products are sold primarily to a small group of very large customers, including large grocery and retail chains. One customer, Tram-Mart, accounts for about 40% of CB’s total 20X3 revenues, and its nine next-largest customers account for about 30% of 20X3 revenues. Products are delivered by third-party carriers or are picked up by customers at CB’s plants.
The main raw material used in production is water. Other materials required are mainly plastic bottles, aluminum cans, packaging materials, sweeteners, and flavourings. CB typically enters into annual arrangements with its suppliers rather than long-term contracts. At the end of each one-year period CB must renegotiate with the suppliers or find new suppliers. The prices of these materials fluctuate on world markets, but generally there are adequate supplies available and this is expected to continue in future. During 20X2, the price of aluminum cans increased substantially and CB’s management decided to enter a five-year agreement with a supplier at a fixed cost. During 20X3, the price of aluminum fell quite substantially. Because of growing demand for corn-based products, the costs of the main sweeteners used by CB have increased substantially in 20X3. CB does not use derivatives to manage the risks of these price changes.
A key to CB’s success is its intellectual property, consisting of trade secrets, beverage formulas, and trademarks for its beverage brands. These intangibles are protected mainly by registration, contractual agreements, employee confidentiality agreements, and rigorous prosecution of any infringements using all available common and statutory laws.
Competition in the soft-drinks industry is fierce. Three huge multinationals control about 85% of the consumer sales, and spend heavily on promotion. Other competitors are local independent producers who sell at aggressively discounted prices, and some large U.S. retail chains that manufacture their own soft-drinks and actively seek new customers to expand their sales. CB’s management addresses these competitive threats by offering efficient distribution choices, top-quality products, attractive packaging, effective marketing strategies, and superior service.
CB’s business is subject to many federal, state, provincial, and local laws and regulations that govern product manufacturing, distribution, labeling, and safety. It is also subject to a number of environmental laws relating to fuel use and storage, water use and treatment, waste disposal, and employee safety. Failure to comply with these laws and regulations can have very negative consequences including penalties and fines. Currently, CB is not in compliance with the Ontario Environmental Protection Act requirements that set a minimum percentage of its products that must be sold in refillable containers. At this time, the Ontario government is not enforcing this law. CB’s management believes that none of its main competitors is in compliance either, and so it could not remain competitive if it attempted to comply.
During 20X3, CB’s management identified material weaknesses in the company’s internal controls over financial reporting. The main issues related to controls over periodic inventory counts and credit notes. Inventory counting procedures were not properly executed because employees were not properly trained and supervised, resulting in an inability to produce a complete and accurate physical count. Lack of segregation of duties in the issuing of credit notes to customers permitted a fraud to occur. An accounts receivable clerk was discovered to be colluding with a warehouse employee to divert cases of high value beverages from legitimate customer orders, and cover up the shortages by issuing phony credit notes. The stolen beverages were sold by the warehouse employee to small local restaurants and variety stores. Both employees have been fired, and management is in the process of redesigning its inventory control and credit note issuing procedures. Another weakness was found in the global material acquisition function, where supplier contracts were not being properly authorized, resulting in improper agreements being entered into, and increased risk of employees in different countries accepting bribes from suppliers or engaging in other illegal acts.
Early in 20X4, CB reported its fourth quarter of 20X3 performances, a large loss that was worse than financial analysts expected and much worse than the fourth quarter of 20X3. CB management blames the poor performance on price competition and on declining soft-drink consumption in developed countries. Over the 20X3 year, the company has reported very poor quarterly results and its share price has fallen dramatically all year. The analysts have also expressed concern that CB is close to violating its debt covenants and may have difficulty obtaining the financing it will require to succeed unless its profitability improves substantially in the early part of 20X4.
To try to please investors, CB’s new CEO, a respected industry veteran, recently held a press conference to show off the company’s new head office in Arizona and its innovative new products, and to explain how it is changing the company culture to focus on a turnaround strategy.
a. Identify key business factors in the CB case and explain why its auditors must understand each factor to assess the risks of material misstatements. As a guide, consider the following categories:
• Industry, regulatory, other external risk factors
• Nature of CB’s business (operations, investments, financing)
• CB’s objectives and strategy to address business risks
b. Link the business risk factors you identified in part (a) to some specific risks of material misstatement of the CB financial statements. Explain clearly how the risks could lead to the financial statements being materially misstated.
c. What information relevant to understanding internal control is indicated in the case? Consider control environment and accounting controls relevant to financial reporting. How would you assess the effectiveness of CB’s internal control to reduce the risk of material misstatement?