ACCT90014 Auditing and Assurance Services
EARTH FOODS CASE
Introduction Earth Foods Ltd (Earth) is an innovative food company, whose main products are snack foods and nuts. They own several well-known brands in this space, including traditional “junk” food brands as well as healthier options such as popcorn. The company’s strategy is to build and energise brands as well as identify opportunities to add value by making a relevant connection to the contemporary consumer. They have been very successful in this, taking advantage of the 21st century trend for “clean” eating, with products based on, amongst other ingredients, root vegetables, pomegranates, quinoa, chia, avocados, walnuts, and almonds. Such products are in great demand in overseas markets, based on the “clean and green” reputation of Australian produce.
Earth’s products are distributed globally and it is a listed company. Earth Foods originally started as an agricultural co-operative many decades ago and has a strong heritage. In 2005, it converted to a corporation, and successfully completed an initial public offering (IPO). After this, it began to expand by acquiring established brands of chips and popcorn products. The acquisitions helped Earth achieve impressive sales growth and profitability. Every year since its incorporation in 2005, Earth reported higher revenues, gross profit, and net income than the year before; its reported earnings per share (EPS) has exceeded the consensus analysts’ forecast in most years1 . The superior financial performance of Earth was reflected in its share price, which increased from $17 (IPO) in July 2005 to $76.53 in July 2011, earning investors a compound annual return of 28 percent.
The Leadership Team
The “star” leadership team behind Earth Food’s success was Michael Tan, the Chief Executive Officer (CEO), and the Chief Financial Officer (CFO) Andrew Neil. Tan, in particular, played a pivotal role. He joined Earth in 1991 as the Head of International Sales and Marketing and was promoted to CEO in 1997. Tan was a member of Earth’s Board of Directors beginning in 2005 and its Chairman from January 2011 to February 2012. During his tenure at Earth, Tan worked hard to turn Earth into an entrepreneurial and performance-driven organisation. He developed a deep understanding of Earth’s culture and employees.
Accounting for Grower Payments
Everything seemed to be going perfectly for Earth, until the publication of an analyst’s report in September 2011. The analyst noted that Earth’s earnings for 2011 were likely overstated because the company made payments during that year to pay off growers who were underpaid the prior year. Typically, the company takes delivery 4 of almonds during the autumn harvest season and pays for the purchase in three instalments, per the guidelines issued at the beginning of the season. The price for almonds is not known at the time of delivery. Therefore, Earth records the costs of almonds in its quarterly financial statements using an estimate.
Each quarter, Earth’s finance department would prepare a memorandum justifying the almond price used to value almond inventory and the cost of almonds sold during the quarter. This memorandum was provided to the company’s independent auditors, and the auditors relied on the memorandum as a management representation that the almond price had been determined in accordance with the accounting policy.
While the first two instalments for the Autumn 2009 crop were made in customary fashion, the third and final payment of $20 million in August 2010 was unusual. Earth sent a letter to growers, signed by the CEO Tan, stating that the payment was intended to “represent both the final payment for the Autumn 2009 crop and a ‘relationship payment’ reflecting the value of the multi-year supply arrangement.”
The payment patter for the 2010 crop was similar to that for the 2009 crop, except that the ‘relationship payment’ was $60 million. Earth sent out two cheques to each grower toward the final payment, dated two days apart. Neither of these payments used the words “final payment” as Earth had done in the past.
The market price of almonds had been rising for the past several years. The average almond prices per kilogram were $1.28 for the 2008 crop, $1.90 for the 2009 crop, $2.05 for the 2010 crop and $2.90 for the 2011 crop. The prices received by the almond growers from Earth have been generally competitive, except for the 2009 and 2010 crops. A comment from one of the almond suppliers stated: “Although the 2008 crop price received from Earth was competitive, for the 2009 crop, even with the ‘relationship payment’, Earth was paying less per kilo than the market price paid by other handlers”. The pressure on Earth to pay higher prices was increasing due to rising almond prices in the international markets.
Views differed on whether the ‘relationship payments’ made to the almond growers were for the crop of the previous or current year. Earth argued that since its external auditors had issued a ‘clean’ audit report, the company had no reason to believe that its accounts were not true and fair. However, several growers maintained that the payment was for the crop of the earlier year. Some of the ‘relationship’ payments were puzzling because they were made in 2011 to farmers who had already terminated their relationship with Earth following the 2010 harvest. One grower stated that she “knew of at least two growers who had already cancelled their contracts to sell almonds to Earth in 2011, but still received the ‘relationship’ payment”.
Earth’s independent auditors inquired about the additional payment included in the final payment to growers, and employees in Earth’s finance department told the auditors that the payment was an advance for the next year’s crop. The auditors required the issue to be addressed in the management representation letter prepared by Earth’s finance department and signed by Tan and other senior management, and the letter specifically stated that the relationship payment was for the upcoming crop.
The Investigations and Lawsuit
The analyst’s report on Earth’s questionable accounting and the media attention it generated resulted in an audit investigation, an investigation by the corporate regulator, and a class action lawsuit. The plaintiffs in the class action alleged that Earth and its senior managers were motivated to inflate share price of Earth during a period in which Earth was seeking to use its shares to acquire Dingles. Further, they maintained that CEO Tan and CFO Neil had knowledge of and access to almond pricing and payment information, and that they were aware of the nature and purpose of the ‘relationship’ payments.
One of Earth’s financial accountants was a witness in the lawsuit. He stated that changing the commodity prices was not a new phenomenon at Earth. He also testified:
Initially I ran profitability and we were losing money or not where we wanted to be at. The controller, the assistant controller and the CFO looked through the financials to see any big ticket items they could shuffle into next quarter. Or if we were making too much money they would push more costs in. Whenever we couldn’t hit our numbers or if they needed extra money, it was always commodity costs that got changed. It seemed like every quarter it was the same dance. If it seemed like EPS was going to be a bit higher than expected, then they would tell me ‘this is a cost, this is a cost’ to increase expenses and lower profits to be closer to analysts’ expectations and leave more room for profits in the following quarter.
It was “common” for Earth to change its “commodity costs” without any business justification for doing so. It was common in preparing month-end and quarter-end financials for the controller or assistant controller to ask me what the earnings would look like “if we dropped commodity prices one cent or half a cent” per kilo. I would make the change and run the numbers and then report back. If the results did not yield earnings numbers that either met or exceeded analysts’ expectations, I was directed to drop the commodity costs by another small increment. When the changes to commodity costs achieved the desired earnings numbers, they told me “okay, we’ll do that”. Then I entered a journal entry for the commodity cost change.
At the conclusion of each month, the company prepared an Excel spreadsheet detailing the monthly financial results. The controller, assistant controller and CFO reviewed those results and “scrubbed them”. This process was particularly rigorous at quarter-end, and the CFO was involved in the quarter-end review, also sometimes known as the “pre-audit” review. Neil had meetings at quarter-end, and instructed employees “to be aggressive”. Those meetings were right before Earth met with its auditors. The result of changing the financials was significant to the company’s bottom line. In one quarter during 2010, that took it from not being profitable when I ran the numbers first, and then all of a sudden we’re profitable.
An assistant treasurer who had also worked for Earth corroborated the observations of the financial accountant: I was involved in several meetings with Neil [the CFO] together with the Controller and the Treasurer, where accounting decisions were discussed in the context of the impact the decision would have on the Earth share price. On numerous occasions, they decided to delay recognising an expense or accelerate a payment to make their earnings look better and improve their share price.
He also stated that the information about almond pricing was not disclosed publicly or internally: Information about grower payments and accounting for those payments was maintained within a very small circle of people, including the controller, the CFO, the CEO, and the executive in charge of the growers’ account, who was the CEO Tan’s brother-in-law.'
Other employees also testified about the tight control Tan [the CEO] maintained over Earth: Tan made every decision at Earth, from what drinks to stock in the vending machine to whom to hire. Tan was a master of detail. You could talk to Michael about anything from nut sourcing to the prices being paid by Earth’s international and retailer customers. Tan’s knowledge of what was happening at Earth was the best of anyone in the company. He even knew where I went to lunch every day, and it wouldn’t surprise me if he knew what I ate there…
Andrew Neil, the CFO was allegedly the co-conspirator with CEO Tan in the accounting manipulations: Beginning in at the least the second quarter of 2010, Neil provided false and misleading information, including written memoranda, regarding the quarterly almond cost accruals to the auditors. Neil also withheld information from the auditors regarding his efforts to manage the almond cost to meet EPS targets. Throughout the audit of Earth’s 2010 financial statements, the auditors asked Neil for information to substantiate his decision to account for the ‘relationship’ payment as an advance on the 2010 crop and his assertions that the ‘relationship’ payment was unrelated to 2009 crop deliveries. In response to these inquiries, Neil made material misrepresentations and withheld information from the auditors. Among other things, Neil omitted information known to him about the competitive prices other handlers [other than Earth] had paid for the 2009 crop. Neil also misled Earth’s auditors regarding his conversations with growers, falsely communicating that the growers had asked for an advance payment for the next crop and omitting facts about conversations in which he, or others at Earth, assured growers a competitive price. Neil misled Earth’s independent auditors with respect to Earth’s recorded almond cost and concealed the second extraordinary payment from the audit committee during its review of Earth’s financial statements for 2011.
EARTH FOODS CASE REQUIREMENTS
Your discussion and analysis should be supported with reference to any relevant auditing standards, professional and ethical standards, and any other relevant professional and legal pronouncements or guidelines or legal cases. You are required to apply the ASA auditing standards. Note: You should also include a reference list.
1. Briefly explain the technique(s) used by Earth Foods’ senior management to manipulate the company’s earnings in 2010 and 2011. Was the accounting for the grower payments in compliance with International Financial Reporting Standards (IFRS)? Explain.
2. Earth’s Audit Committee investigation concluded that the ‘relationship’ payments made to growers in August 2010 of $20 million and in August/September 2011 of $60 million were not accounted for in the correct periods. Assume that a junior auditor of Top Tier’s (TT’s) audit team has proposed that given the size of “the total liabilities and shareholders’ equity” of Earth Foods of $1.226 billion, an adjustment of $20 million of grower payables is immaterial (1.63%) for 2010. Would you agree with the junior auditor? Why or why not? [Note: assume that Earth sold all almonds purchased during the year in that year]. How would you determine whether the effect of the $20 million and $60 million ‘relationship’ paymentsin incorrect accounting periods was material on Earth’s financial statements for 2011? Explain with any appropriate supporting calculations necessary.
3. Why is it important for an auditor to understand a client’s business environment? Provide some examples of Earth’s business risks contributing to the audit risk that TT had to consider in performing the audit for 2011. Explain how the presence of the three aspects of the fraud triangle enabled fraud to occur at Earth Foods in 2011.
4. In its audit of Earth Foods, TT relied on management representations. In your opinion, was such reliance appropriate? Which additional audit procedures could have been performed by TT to assess the reliability of management representations, especially in regard to the almond prices? Describe the importance of professional scepticism in auditing and analyse whether TT exercised sufficient professional scepticism in their audit of Earth Foods.
5. Exhibit 1, Panels A and B show Earth’s common-size balance sheets and statements of operations. How can external auditors use these for analytical procedures? Do you observe anything unusual in the payable to the growers account at the end of 2010 and 2011? What about the gross profit percentage and net profit percentage? For the years 2007 to 2011, compute the purchases for each year, and then compute the ratio of “payable to growers at year-end as a percentage of purchases for the year”. Do you see anything unusual? 13
6. Identify at least two material weaknesses in Earth’s internal control system in 2011. Management override of controls presents a significant audit risk. Provide some examples of where management override of controls occurred at Earth Foods. How should auditors deal with the risk of management fraud related to the override of controls?
Evaluating company’s financial statement and presenting an audit report is essential for reducing number of frauds and mistakes. This assignment has evaluated the financial balance sheet statement and income statement of Earth Foods Ltd. In relation to their financial statement the assignment has presented an audit analysis for the year 2011.
It has been understood from the case study of Earth Foods Ltd that this company has reduced their revenue in the income statement in the business. In the month of August in 2010, the organisation has paid $20 million to their growers. However, in the same month of 2011, the payment has increased by $40 million. Hence, the organisation has faced high cash expenses in the business. In the opinion of Louwers et al. (2015, p.14), the senior executives can use the revaluation accounting technique to manipulate their financial data. Hence, it is clear that the senior manager has re-valued their financial data and decreased their earnings amount. Additionally, the management has increased their financial expenses in the business by increasing their unauthentic payments. Applying the revaluation accounting technique has increased number of fraud and decreased the annual earnings in the business. Therefore, the company has increased their liabilities. Therefore, the company cannot meet their market obligation in 2011.
On the other hand, the payment to their growers has been based on the rules of International Financial Accounting Board (IFRS) standards. As the almond price has increased per year the organisation payment amount has also increased. The growers have received a high amount of revenue, however, the payment highly increased in 2011. This transaction has not followed proper rules and regulations of IFRS standard and the number of frauds increased in the management.
The Audit committee of Earth Food Ltd has investigated that the organisation has faced audit risk regarding their payment. In the year 2011, the payment to grower has increased from 20 million dollars to $60 million. However, the payment immaterial has been 1.63% for the current financial year. This has increased their market liabilities in the business and the company faced financial crisis. Additionally, the company increased their shareholders' equity capital by 1.226 billion dollars. It has been understood from the transaction of 2010, the organisation can pay a high amount of $20 million to the growers. As they can sell all almonds they have been able to collect a high sales revenue rate in the business. Hence, the organisation has paid $20 million as the purchased priced increased per year. The junior auditor has evaluated the financial statement and has presented an accurate audit statement for the organisation. As opined by Zamboni and Litschig (2018, p.133), in case the organisation follows the relevant accounting standard in the business they can reduce audit risks in the business. Therefore, the organisation has increased their cash assets in 2010 and paid their relevant payments to the growers.
On the contrary, it has been understood that the company has increased their payment amount by $40 million in the next year. Therefore, the company has increased financial risks in the business. As the senior managers have applied revaluation technique in the business they are able to manipulate the company’s financial data. In case the organisation sold all their almonds in the current year their payments cannot increase by $40 million. This has clearly shown that this company faced an incorrect accounting. The senior managers did not follow the rules and regulation of accounting standard in the business. In the views of Eugene et al. (2018, p.739), the organisation has to understand the potential of their employees to reduce the number of fraud. Hence, the purchase amount has increased in the business. The almond price in 2011 has been $2.90 per kilogram. Therefore, the company cannot recognise a high payment amount in the current year.
The auditor-firm has to evaluate their transaction and understand the purchased unit of 2011. Based on their purchased units the auditors can be able to calculate the relevant payment amount in 2011. Additionally, the company can increase their financial assets in the balance sheet statement. Hence, the short-term and long-term liabilities can reduce in the business. Additionally, according to Yoon et al. (2015, p.431), the auditor can calculate the payment amount of 2011 by understanding their immaterial rate in the current financial year. In case the immaterial rate is 1.63% per year then the payment increment rate of Earth Food Ltd should be $326,000 for 2011. Hence, the purchase amount would be $20,000,000 + $326,000 = $20,326,000 in 2011. In case the immaterial rate increases payment rate of the company can also increase in the business. Therefore, the company can increase their payment amount to approximately $30 million in 2011. However, it is impossible for the company to increase their payment amount from $20 to $60 million.
As the number of frauds and data manipulation increase in Earth Food Ltd, the management has consulted with Top Tier (TT) auditor firm. As studied by Askary et al. (2018, p.18), an auditor has to evaluate the client’s business environment to understand the employee’s potential. Therefore, the auditor can be able to evaluate their transaction and identify their data manipulator in the business. This can help the business organisation to reduce number of frauds and mistakes in the business. Moreover, the company can maintain high financial growth from year to year in the business.
Due to the audit risk in 2011, the auditors firm has to consider the following business risk while presenting the audit report.
i) The organisation can reduce their cash assets in the business. Therefore, management operation can reduce in the current year. Slow management operations can influence to reduce their annual productivity in 2011. Hence, sales revenue can reduce from year to year.
ii) In case the organisation reduces their income amount in the business the company can increase their market liabilities. Therefore, Earth cannot pay back their loan amount and debts in the future. Hence, possibility of bankruptcy can increase for the business.
The three aspects of fraud triangle are pressure on individuals, opportunity to commit fraud and ability to rationalise this crime. The organisation can face high number of audit risks in case of any of these three aspects is recognised in the business by auditor. Furthermore, in relation to their financial statement, it has been clear that the company has increased their number of fraud as the managers received an opportunity to commit fraud. As the internal control system of the organisation is slow managers are able to apply relevant accounting technique to manipulate data. Hence, the organisation has reduced their financial health in the business and assets can reduce. As argued by Sardasht and Rashedi (2018, p.69), the auditor has to evaluate the three aspects of fraud triangle in the business to understand the possible fraud factors in the business. Hence, the auditor can identify manipulator and take legal action against them.
During an audit evaluation Top Tier (TT) audit firm has to depend on the management. The management has to provide the auditor with relevant business information and financial data. However, in the opinion of Lang and Soled (2017, p.423), an auditor cannot fully dependent on the management during audit evaluation. Auditor has to understand the potential of management employees. Therefore, the organisation can reduce their frauds and mistakes in the business. It is important for TT to maintain scepticism during in the evaluation. This can help to present an authentic data evaluation report in the business. Moreover, the auditor can identify the managers that increased audit risk for Earth Food Ltd in 2011.
During an audit evaluation, auditors follow three specific procedures in the business to understand the number of fraud such as inquiry, observation and inspection. However, in case the auditor identifies fraud in the management they can perform additional audit procedure to reduce audit risks. According to Yang (2016, p.6), in case an auditor identifies fraud in the financial statement they can perform a recalculation procedure to identify the audit risk. In this case, the recalculation procedure can be helpful for the organisation to understand the accurate payment amount in 2011. Hence, Earth can avoid unusual cash expenses in the business and gain financial assets. This can help the business organisation to maintain their financial performance from year to year.
In addition to that, after recalculating the financial data auditor can confirm the audit risk in the business. This can help the organisation take legal action against the data manipulator in the business. Moreover, the company can reduce their market obligation as the earnings can increase in the business. High financial assets can help the business organisation to meet their short-term and long-term market obligations in the business.
It is essential for the auditors to maintain scepticism in the management during the evaluation of their financial data. This can help TT to maintain a proper evaluation of the management. Additionally, the company can be able to take legal action against the data manipulator if auditor can maintain scepticism. Hence, the organisation can reduce their unjustified expenses from year to year in the business. Therefore, the company can increase their business in the future years. In accordance with Giner et al. (2016, p.285), scepticism can help the auditor to improve their audit quality in the business and reduce audit risks in a fast manner.
The auditors can perform their analysis based on the income statement and balance sheet statement. As the organisation increased their payment amount in their income statement the organisation has increased financial liabilities. Therefore, the auditor can reduce their audit risks in the business by recalculating the financial transactions in the business. This can help to calculate the actual payment amount in the business and the organisation can increase their financial assets. The opinions of Christensen et al. (2016, p.31) reflect that the organisation cannot identify accurate income amount until auditor evaluates their financial income statement. This can help the business organisation to increase their financial performance in the business.
It has been understood after evaluating the balance sheet statement of Earth Food Ltd the payable for growers has been added with Accounts payable & accrued liabilities in 2011. However, from 2006 to 2010 the organisation has recorded their payable for growers separately from accounts payable. As the managers receive access to the financial statement organisation balance sheet statement has corrupted (Ward and Forker, 2017, p.351). Therefore, the managers have manipulated their data in the business and increase financial expenses. This has influenced to increase their financial expenses in the business and the organisation has faced high data manipulation in the business.
On the other hand, after evaluating the financial income statement of Earth Food Ltd it has been understood that the organisation has increased their cost of sales in the business. However, the sales amount has increased in the business. Based on the high sales amount the management has calculated the gross profit amount. It is clear that the calculation of annual gross profit is accurate. However, as studied by Karadag (2015, p.26), the company requires to evaluate their financial data to understand if the cost of sales amount is authentic or not. On that basis, the organisation can increase their sales in the future. The calculation of net profit is accurate in the business. As the organisation has reduced unusual losses in the income statement, the organisation has increased their net profit amount in the business.
|Purchase amount ||$57,117||$56,942||$29,149||$35,755||$15,186|
Table 1: Purchase from 2007 to 2011
In relation to table 1, it has been understood that the organisation has reduced their purchase amount in business per year. Therefore, the company expenses have reduced in the business. Based on the annual purchase the organisation has paid the relevant amount to the growers. Hence, it has been understood that the company has maintained a ratio of 1:1 between the purchase and payable to growers’ amount. The ratio between purchase and payable to growers is clearly showing that the organisation cannot increase their payment amount from $20 million to $60 million in 2011. Burtonshaw-Gunn (2017, p.5) has stated that the organisation has to evaluate their financial data and understand their relationship with audit risks. Hence, the company can identify the data manipulator in a fast manner.
After evaluating the financial statement of Earth Food Ltd it has been clear that organisation has been unable to take full control over the management. According to Ge et al. (2017, p.358), lack of control can increase opportunities to commit fraud in the business. Therefore, the organisation has increase frauds and data manipulation in the business. Due to lack of control, the organisation has been unable to reduce their financial expenses from year to year. This has increased financial crisis for the company and possibility of bankruptcy has increased. In the year 2011, the company has failed to maintain control over their management. Therefore, the managers have gained access to their financial statement in the business and increased their expenses. Hence, the company can increase financial difficulties in the future year. As argued by Newton et al. (2015, p.603), a business organisation has to improve their internal control system to monitor their employees and reduce number frauds.
In addition to that, the organisation is facing difficulties regarding their information system. Ineffective information system has increased number of frauds in the business. Therefore, the organisation has been unable to evaluate their transactions in the business. Furthermore, the company has reduced their cash assets in the business. In the views of Cheng et al. (2018, p.1111), the company has to improve their business communication system to reduce audit risks from their financial statement. Therefore, the company can maintain high financial performance from year to year.
As the organisation has failed to maintain an effective control system in the business, the managers increased data manipulation in their financial statement. Therefore, the company has increased financial difficulties. The auditor has to identify the manipulator and provide suggestion to the management to improve their internal control system. The auditor has to provide suggestion about the management faults of Earth Food Ltd.
It can be concluded that the Earth Ltd has increased their number of fraud in the business. Therefore, the auditor has to evaluate their financial data to identify the data manipulator. The organisation has faced difficulties regarding their internal control system. This has increased opportunity to commit fraud for the managers in 2011.