You are a senior auditor at Zales and Brook LLP, a CPA firm. Bruno Drinks Inc. i
ID: 389412 • Letter: Y
Question
You are a senior auditor at Zales and Brook LLP, a CPA firm. Bruno Drinks Inc. is a large
publicly traded firm based in California and has been audited by your firm for years. You are
assigned to lead the FY2007 audit of Bruno Drinks (DB). You read previous year working papers,
BD’s quarterly reports and have learned the following facts.
BD is a large multinational
non-
alcoholic drink producer, selling bottled water, juice drinks, and
other soft drinks in Canada, U.S., Mexico, and UK. Mexico, a growing market with a large
population, accounts for 35% of the total sales and Canada accounts for roughly 25%. UK is a
mi
nor market for BD and accounts for only 10% of the firm’s total revenue. It has its own Bruno
brand, but sells most of its products (90%) to retailers under their private labels. Between 2002
and 2005, BD expanded its production and distribution capacities
through several acquisitions. In
2006, after the retirement of the previous CEO, Jack London was picked by the board of directors
to be the new CEO. Jack soon adopted a new strategy of rationalizing its existing capacities: the
firm focuses on its best pe
rforming production facilities and started to close down some plants
and warehouses in North America.
BD sells most of its soft drinks to a group of very large customers, such as large chain grocery
stores or discount retailers. For example, Mel
-mart, acc
ounts for about 35% of BD’s 2007 sales,
and the next four largest customers account for 30% of the revenues.
BD’s main input is water, while other raw materials mainly include plastic bottles, aluminum
cans, sweeteners, and flavoring additives. BD has ann
ual contracts with its suppliers for most raw
materials, so that it can renegotiate with the suppliers for better price. During 2006, the price of
aluminum cans rose substantially. Consequently, the management decided to enter a 5
-year
agreement with one s
upplier at a fixed price established in January 2007. Then in 2007, the price
of aluminum declined substantially. Due to the Subprime Mortgage crisis and the subsequent
turmoil associated with Bear Stearns, the future price of aluminum fell another 20% in
the first
quarter of 2008. You learned from the CFO that BD does not use derivatives to hedge against raw
material price changes.
You also learn from permanent audit files that BD’s business is subject to many federal, state, and
local laws and regulation
s with respect to manufacturing, distribution, labeling and safety.
California also has local environmental protection laws that regulate storage, water use and
treatment, and waste disposal. Currently, BD is not in compliance with the California Recycling
Act requirement that demands a minimum percentage of its products that must be sold in
refillable containers. In 2007, the state government is not actively enforcing this law, but there is
already public pressure from some powerful environmentalist groups
. The newly elected
governor promised in December 2007 to set the enforcement as one of his priorities. You raised
the non-
compliance issue in a business meeting, but the BD management argued that compliance
is too costly for the whole firm, despite the fa
ct that California is BD’s major market given its
large population.
During 2007, the client management identified two internal control weaknesses in the firm. One
is related to inventory and the other is related to purchase function. Lack of segregation of duties
between an account receivable clerk and a warehouse employee allows them to divert expensive
beverages from legitimate customer orders and use faked credit notes (a supporting document
used to write off accounts receivable) to cover up the shortag
e. Then the warehouse employee
13
sold the stolen beverages to local small restaurants and pocketed the proceeds. BD’s controller
told you that BD has fired both employees and has re
-engineered its inventory control and credit
note issuance process and he is
confident that internal control weakness has been eliminated. The
second weakness was found in the purchasing function. It seems that weakness in the
authorization process might result in improper agreements by low
-level purchasing staff. There is
anecdota
l evidence that some buyers in different countries have been compromised by local
suppliers with bribes.
BD has not released its 4
th
quarter report of 2007 yet. But you have noticed from the first three
quarters of 2007 that the 2007 performance is not good. Its stock price fell 20% in 2007, and the
management blamed the subprime
-mortgage
-related turmoil for the decline. Several analysts
agreed with the management and recommended BD’s stock as “HOLD”. But two analysts from
Morgan Turley and Silverman Saches disagree with their peers: they predict that BD is close to
violating its debt covenants. Given the market turmoil and BD’s declining profitability, they
believe that BD might have difficulty in refinancing its current bank loans.
Required:
1. Identify key business risk factors in the BD case. You can group all factors into three
categories.
a. Industry, regulatory, and other external risk factors
b. Nature of BD’s drink business (operation, investments, financing)
c. BD’s business strategy
2. Link the
business risk factors identified above to some specific accounts which might be
subject to material misstatements.
Explain clearly
how the risks could result in material
misstatements in the financial statements
Explanation / Answer
1. Currently BD is facing mltiple rsks within different categories as follows:
a. Industry and regulatory risk: The risks are in lieu of the compliance and the statutory requirements and policies. This requires that the policyrequirements are complied with, and this applies to the entire industry. The regulations are laid down by external agencies and hence it is a completely external risk.
b. Nature of operations: The non hedge funding approach increases the degree of risk, also the improper segregation of duties that has come to limelight has not yet been explored across the other fucntions of the value chain. The same needs to be validated upon.
c. The business strategy posesa risk with strong integration of manufacturing and centralisation of business operations auditing and control in certain geographies. While the other geographies are completely outside the scope and purview of audit, the compliance of the local regulations may /may not be ensured in that region. There is no stringent, regular/ periodic control to make it stronger.
2. The risks highlighted in the last section could potentially lead to misstatement of materials in the financial statements. The materials could be stated as recyclable to be in complaince with the rgaulations , though they might not be in actual. The pricing could be varied to be in compliance. This would lead to the mis reprsenation of notjust the material but also the numbers posing a greater risk for audit and financial reconciliation.
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