Audit Of Kereru Brewing Company Limited (KBCL) For The Year Ending 30 June 2018

Background

Auditor of the company plays the fiduciary relation in its working and reporting. Fiduciary position has been mentioned because of the fact that the auditor has to consider the interest of the stakeholders as well as the interest of the company. The auditor is required to present the report with all the material facts and figures which is necessary to the stakeholders and the shareholders of the company. As the title suggests, the whole report revolves around the auditing of the company – Kereru Brewing Company Limited.  The report has been bifurcated into two parts. First is Part A and second is Part B. The part A of the report has started with the assessment of the audit risk at different levels. It has included the meaning of the acceptable audit risk and performing the analysis through the accounting ratios, horizontal and vertical analysis of the financial statements of the company. Then the materiality levels for the year under audit has been finalized and identified as to how the same will have the impact on the audit of the company. Then in this the importance of the adjusting event has been mentioned as to how the same has been considered in the planning of the audit. The next section is Part B which has dealt with the analysis of the internal control and how the same is very useful for the auditor with the detailed analysis as to how the same will impact on the planning of the audit. The report has then ended up with the conclusion and the recommendation. The data has been obtained from the reasonable sources and the report has been presented for the benefit of the auditors of the company for having an effective and efficient planning of audit.           

1. Acceptable audit risk and Influencing Factors

The risk which the auditor can undertake or considers while issuing the audit report to the client with the opinion which is not qualified in any manner is known as the acceptable audit risk. Also the auditor takes this level of risk knowing of the fact that the financial statements so stated have the material misstatements (AASB, 2016).  The acceptable audit risk has the direct relationship with the detection risk and the inverse relationship with the findings of the audit evidence. If the level of the acceptable audit risk increases then the auditor will be less interested in collecting and obtaining the audit evidence. Thus, the acceptable audit risk has inverse relationship with the audit evidence. And if the level of the acceptable audit risk increases then the detection risk also increases as the auditor will be least interested in detecting the material misstatement if present in the financial statements. Thus, the acceptable audit risk will have such an effect of issuing the unqualified audit report. The acceptable audit risk is influenced by mainly three factors. These three factors have been described below:

• Reliance by External Users – This factors states that the level of acceptable audit risk shall be kept as low where the external users are highly interested in the financial statements of the company. These external users are found more in case of the three factors:
• If the company has the larger clients. In the given case the company has entered into the area of international expansion and starts sending the goods to Japan in the beginning of the December 2017 and has the largest shareholder.
• If the company is publicly held corporation- The KBC limited is not the publicly held company (Mock, 2015).
• If the company has the extensive use of liabilities – The Company has obtained the borrowing on the hypothecation of the plant and equipment amounting to 960000 New Zealand Dollar and hence there is the extensive use of the liabilities.  Also the company is planning to have the additional loan in the year of 2019 so as to expand the business.

Company Operations

Thus, in this manner, the reliance level will be low or medium and the acceptable audit risk will be medium to high.       

• Chances of the failure of Finance – The company has the current ratio and liquidity ratio with the increased figure in the year of 2018 as compared to the year of 2017. The current ratio has been increased from 1.18 to 1.84 and the liquidity ratio has been increased from the 0.42 to 0.83. These figures details that with the addition of the loan of 150000 New Zealand dollar, the current and the liquidity ratio has been improved through which the risk level will be medium to high.   
• Management Integrity –    In the given case of the company, there has been many noticed integrity issues which entails that higher the issues noticed and confirmed on the management of the company more will be the chances of having the acceptable audit risk as low. Following are the reasons for the above statement:
• At first the Chief Executive Officer of the company has been known by the name of high flyer and had undergone through the stage of the bankruptcy.
• Secondly he operates the company where he rules all the employees and takes the tough decisions.
• Thirdly he has been in the process of having the delegation of the responsibility done but not the authority.
• Lastly, during his tenure, auditors have identified the material misstatement which can affect the presentation of the financial statements. 

Thus, the level of the risk will high.

b. Significant Risk of Material Misstatement

The material misstatement is the figure or the fact which is presented in the financial statements of the company and has the power to have the decision changed of the users of the financial statements of the company. It includes the shareholders as well as the stakeholders of the company. Following are the significant risk of the material misstatement which requires the attention of the management and have been divided into two parts. One is the inherent risk and other one is the Control risk:

Inherent Risk –

• The chief executive officer of the company has been the high flyer in the earlier years due to which has faced the bankruptcy also.
• The chief executive officer of the company has been ruling over the company matters in the dictatorship and autocratic manner.
• He only thinks that his job is only to take the important and meaningful decision and big ones. 
• The material misstatement has occurred in the earlier periods during his tenure (Gary, 2017).
• He only remains in the manner where he delegates the appropriate responsibility but does not delegate the authority. The delegated responsibility will not work until the appropriate authority will not be given.
• The company is making all the sales on the credit basis. No time has been defined and no component of cash sales is there due to which the liquidity of the company may gets affected.
• The rising amount of the New Zealand dollar will lead to the loss in the foreign exchange difference and the company has not complied with any of the hedging instruments for the cash flows that will be required to be made in the near future. 
• The new virus has arisen which is known as the Hop Mosaic virus and will lead to the lesser supplies in the future as the raw material is used for the manufacture of the beer.

Control Risk –

• The company has not charged any depreciation on the plant and equipment and that too including the leasehold property improvements.
• The company is required to maintain two ratios as per the banks so as to keep the loan active as obtained from the banks. These two ratios are the net tangible assets to the total liabilities and current ratio and as per the requirement the both the ratios shall be positive.
• The employees are under pressure to finalize the financial statement at the earliest so as to provide to the auditors for issuing the audit opinion thereon.  The deadline as mentioned is 15-09-2018.
• The company is facing the legal case regarding the health and the safety of the employees working under the organization and accordingly there may be the risk of the liability creation in the near future (AASB, 2013).

Thus, the above are the significant risk of material misstatements.

c. Preliminary Assessment of Risk

After the identification of the significant risk of material misstatement, it is very necessary to assess the level of the risk in order to plan the audit accordingly.

Under the head of the inherent risk, the level of risk that has been assessed is Medium to High. It is because the major impact has been due to the chief executive officer of the company which has all the bad images and due to which the functioning of the company will be affected badly and there might be the high chances of having the material misstatement in the financial statements of the company (Anastasia, 2015).   

Under the head of the Control risk, the level of risk that has been assessed is high.  It is because all the risks that have been identified will affect the financial statements in any manner. On one hand the depreciation will be charged on the assets of the company and on other hand the ratios are required to be maintained as per the stipulation made by the bank.

Thus, the overall risk that has been assessed from the above identified risks and their impact is high.   

d. Overall Analytical Review

i. Horizontal and Vertical Analysis 

HORIZONTAL AND VERTICAL ANALYSIS OF THE BALANCE SHEET
	Horizontal 2018		Vertical 2018	Vertical 2017
	(On 2017 Figures)
Cash and Cash Equivalents	182%		1%	1%
Trade and other Receivables	159%		20%	18%
Allowance for doubtful debts	56%		-1%	-2%
Inventories	116%		25%	31%
Prepaid Expenses	119%		0.16%	0.20%
Total Current Assets	136%		46%	48%
Plant and Equipment  at cost	131%		70%	77%
Less Accumulated depreciation	116%		-24%	-30%
Total plant and equipment	141%		46%	46%
Loan to previous CEO	100%		2%	3%
Intangible Assets	348%		7%	3%
Total Non Current Assets	150%		54%	52%
Total Assets	143%		100%	100%
Trade and Other payables	85%		12%	20%
Bank Loan Payable	0%		1%	0%
Accrued Liabilities	121%		4%	5%
income Tax Payable	68%		7%	14%
Current portion of long term bank loan	100%		1%	2%
Total Current Liabilities	87%		25%	41%
Long Term bank Loan	80%		5%	10%
Total Non Current Liabilities	80%		5%	10%
Net Assets	202%		70%	50%
Shareholder’s Equity	202%		70%	50%
Total Liabilities			100%	100%

HORIZONTAL AND VERTICAL ANALYSIS OF THE INCOME STATEMENT
	Horizontal 2018		Vertical 2018	Vertical 2017
	(On 2017 Figures)
Sales	146%		100%	100%
Less Cost of Sales	-135%		55%	59%
Gross Profit	160%		45%	41%
Distribution, Administration, Sales and Marketing	119%		21%	26%
Lease Expense	119%		1%	1%
Superannuation Expense	122%		2%	2%
Loss on Foreign Exchange	154%		1%	1%
Interest Expense	80%		0%	0%
Total Operating Expense	119%		25%	31%
Operating profit	280%		20%	10%
Income Tax	158%		4%	4%
Operating Profit After Tax	343%		16%	6.87%

 
ii. Relevant Financial Ratios

RELEVANT FINANCIAL RATIOS
S. No.	Ratio	Formula	Company Ratio 2018	Company Ratio 2017	Industry Average 2018
1	Current Ratio	Current Assets / Current Liabilities	1.84	1.84:1	1.18	1.18:1	1.91:1
2	Liquidity Ratio	CA- Inventory / Current Liabilities	0.83	0.83:1	0.42	0.42:1	0.92:1
3	Debt To Total Assets Ratio	Total Liabilities / Total Net Assets	0.43	0.43:1	1.02	1.02:1	1.11:1
4	Time Interest Earned	Net Operating profit / Interest Charges	91.04	91 times	21.25	21.25 times	3.00 times
5	Inventory Turnover	Cost of Goods Sold / An Inventory held	6.13	6.13 times	4.89	4.89 times	5.85 times
6	Day Sales in Inventory	365 / Inventory Turnover	59.53	59.53	74.57	74.57	62.39
7	Account Receivable Turnover	Credit Sales / Accounts Receivable	13.25	13.25 times	14.50	14.50 times	10.43 times
8	Average Collection period (days)	365 / Accounts Receivable Turnover	27.54	27.54	25.18	25.18	35
9	Total Assets Turnover	Sales / Total Assets	2.61	2.61 times	2.57	2.57 times	2.83 times
10	Gross Profit Margin	Gross Profit / Sales	45.11	45.11%	41.00	41.00%	50.37%
11	Net Operating Margin	Net Operating Profit / Sales	16.16	16.16%	6.87	6.87%	8.34%
12	Return On Total Assets	Net Profit Before Taxes / Total Assets	0.52	0.52%	0.27	0.27%	6.44%

• The current ratio and the liquidity ratio has been increased from the year of 2017 to 2018 which shows that there is no liquidity crunch in the company  and is very near to the industry average but requires the attention of the auditor (Abidin, 2015).
• The ratio of the time interest earned has been increased 400 times from 21.25 times in the year of 2017 to 91 times in the year of 2018. It shows that the company has been paying the amount regularly and now it can pay more and on the other hand is the doubtful situation for the auditor and shall be check by the auditors (ACCA, 2016).
• Debt to total assets ratio for the last two years has been below the industry average of 1.11:1 which is the alarming situation for the company as it should at least meet the industry criteria.
• Net Operating margin has been increased two and a half times and is double of the industry average although the gross profit margin is below the industry average. The auditor is required to check the accounts in detail.

iii. Accounts requiring Special Attention

Following are the accounts which require the special attention:

• Cash and Cash equivalents have been increased by 182% which shows that the company is cash rich company. On one hand it’s the cash rich company and on the other hand it is applying for obtaining the loan.
• The loss on foreign exchange has been increased by 154% as compared to the last year.  It depicts that the company is not focusing on the ways as to how to hedge the loss that is being incurred from the foreign currency fluctuations.
• The intangible assets have been increased by 348% as with the figure of the last year. The major change has been due to the inclusion of the brands of NZ855000 dollars. The auditor is required to check the detail of the acquisition of the brands (Kharisova, 2014).
• Sales have been increased by 146% whereas the corresponding expenditure has been increased by 119%. The attention is required regarding the correctness of the amount mentioned in the income statement and the corroborative evidences.
• The amount of distribution, selling and administration expenses has been reduced by 5% from 26% in the year of 2017 to 21% in the year of 2016. It requires the special attention as to ascertain with the increase in the sales of the company, the corresponding expenses have not been increased rather reduced.   
• Loan to previous CEO has been decreased by 2% in 2017 to 1% in 2018 which requires attention as to first ascertain why the loan has been given and whether the same is being paid as per the terms of the contract.
• Depreciation has not been charged on the plant and equipment and it has to be considered while finalizing the statement of the profit and loss account and consolidated financial statements.
• The physical verification of inventory as mentioned will be taken on 29^th June 2018 and accordingly the same will be considered in the final financial statements.

Thus, these are the accounts which require the attention of the auditor.

e. Materiality

Materiality is defined as the level of significance which can influence the decision of the users of the financial statements (Chen, 2017).

Management and Internal Controls

i. Different Levels

Planning materiality is purely formed on the premise of the requirements and the expectations of the users of the financial information of the company.

Performance Materiality is related with the errors and the omission if any committed by the personnel employed.  It does not affect the objectivity of the financial information contained in the financial statements of the company (Leung, 2015).

Specific Materiality deals with the areas which are of the utmost importance. It basically links with the various areas like with the notes to accounts of the financial statements or meeting the stipulation as made by the bank agreement.  For instance, like the bank has required that the net assets to the total liabilities ratio and current ratio shall be positive. It comes under specific materiality to check whether it is complying or not (Mao, 2014).

ii. Calculating Materiality levels

Planning Materiality range is NZ 105919 to NZ 1359029.

	(In NZ Dollar)
Planning Materiality	2018
Single Rule	Materiality
5% of pre-tax income	$2,348,167
0.5% of total assets	$89,902
1% of equity	$125,652
0.5% of total revenue	$234,817
Variable Size Rule
0.5% to	$ 105919 to
1% Gross Profit	$211,838
Average Method
Average of Single Rule	$699,634
KPMG Formula
1.84   x (total revenue)2/3	$1,359,029
Total Assets	$17,980,365
Total Revenue	$46,963,338
Pre-tax Income	$9,390,397
Equity	$12,565,213
Gross Profit	$21,183,839

In case of the high overall risk, the performance materiality level will be 60% of the planning materiality level and therefore, the performance materiality comes out as 60% of 0.5% of 17980365 = NZ 53941 dollar.

iii. Calculating Materiality levels for Brands

Specific Materiality level for the brand will be Development cost / (Total Assets + Total Liabilities)* 53941

= NZ855000 / (17980365+ 5415152) *53941 = 3.66% *   53941 = $32365

If the expenditure of $100000 based on the supplier invoice is not adjusted towards the marketing and promotion then the auditor shall issue the qualified report stating the wrong capitalization of the marketing and promotion expense of the brand which otherwise should be charged to the income statement.

a. Relevance of Internal Controls

The internal controls plays a very important role in the planning of the audit as it specifies the policies which are being undertaken by the company for the purpose of running of the smooth functions of the company.

i. Underlying Objective

The main objective of the auditor to adopt the test of controls while verifying the sales is to ensure that whether the internal control system as employed by the company for the purpose of the issuing of the sales and booking the revenue in the accounting books have been correct and in accordance with the law. The second objective is to ascertain whether the company is following the procedure for issuing the sales as mentioned in the written policies and whether any discrepancy has been found or not (Ullah, 2014). 

Financial Situation

ii. Test of Controls and Substantive Controls

Test of controls are conducted in order to check that whether the internal controls so adopted and applied by the company is effective or not.

Substantive controls are the tests conducted to check the reasonableness of the heads or the items that are mentioned in the financial statements.

In the given case both the tests shall be performed.

iii. Stage during the audit

As test of controls are performed to check the effectiveness of the internal control system and it shall be applied mainly at the stage when the discounts are being given to the customer and reconciles them with the basis of discount as mentioned in the policies. Second stage is when the cash is collected from the customer or when the credit is extended.

b. Situation affecting Audit Plan

The above situation will affect the audit plan in the following manner:

1. Due to the high targets as set by Andrew Bigham, there may be the high chances of having the manipulation in the amount of the revenue earned and the discount received by the company.
2. The plan will first include the test of controls and the substantive testing will be done.
3. There might be the possibilities of having the risk of overstatement of the accounts receivable of the company as the company sells the good on credit basis only and with the manipulation the balances of accounts receivable go on increasing.
4. The substantive testing shall include three accounts – Sales, Accounts receivable and debtors. These all three accounts shall be checked with the invoices and the bank statement.

Every company is required to get his accounts audited at the end of the every year and it is very necessary to get the accounting books audited to ensure about the correctness of the results and to provide the true picture of the workings of the company. To conclude the report, it has covered all the aspects and matters as relevant for the audit of the company.

It is recommended to follow the accounting policies and procedures in the letter and spirit so as to avoid the situation of having the qualified opinion. 

AASB, (2016), “ASA 300 – Planning and Audit of a Financial Report” available athttps://www.auasb.gov.au/admin/file/content102/c3/ASA_300_28-04-16.pdf accessed on 02-06-2018.

AASB, (2013), “ASA 315 – Identifying and Assessing the Material Misstatements through understanding the entity and its Environment” available at https://www.auasb.gov.au/admin/file/content102/c3/Nov13_Compiled_Auditing_Standar d_ASA_315.pdfaccessed on 02-06-2018.

Abidin, S., (2015), “The use of analytical procedures by yemeniauditors”,Corporate Ownership & Control, 12(2), 17-25.

ACCA, (2016), “Analytical Procedures”, available on https://www.accaglobal.com/vn/en/student/exam-support-resources/professional-exams -study-resources/p7/technical-articles/analytical-procedures.html  accessed on 02-06 -2018..

Anastasia, (2015), “Financial Statement Analysis : An Introduction” available on https://www.cleverism.com/financial-statement-analysis-introduction/   accessed on 02 -06-2018..

Chen, S., (2017), “Refer to Materiality as a Legal Concept”. Journal of Corporate Accounting & Finance, 28(2), 55-61.

Gary S., (2017), “The Importance of Inherent Risk Factors: Auditor’s Perceptions”, Australian Accounting Review, 3, Pp 38-44.

Glover, (2014),“Between a Rock and a Hard Place: A PathForward for Using Substantive Analytical Procedures in Auditing Large P&L Accounts:Commentary and Analysis”. Auditing: A Journal of Practice & Theory, 34(3), 161-179.

Kharisova, F. I., (2014),“Applying the category of Assertions (orpreconditions)» in audit of financial statement”. Mediterranean Journal of Social Sciences, 5(24), 180

Leung P, (2015), “Modern Auditing and Assurance Services”, Wiley John and Sons, Ed. 6, Pp 425-463, 582-684.

Mao, M., (2014), “Experimental Methods of Materiality Judgment on Auditor’s Experience and Performance” In 3rd International Conference on Science and Social Research (ICSSR 2014) Atlantis Press.

Mock, T. J, (2015). “Auditors’ Risk Assessments: The Effects of Elicitation Approach and Assertion Framing” Behavioral Research in Accounting, 28(2), 75-84.

Ullah A, (2014), “Planning and Audit of Financial Statements” available onhttps://leaccountant.com/2014/12/08/asa-300-summary-planning-an-audit-of-financial -statements/  accessed on 02-06-2018.