Background of Fresh Essence Ltd Celia Miller is the Managing Director of Fresh Essence (FE) Ltd, a wholesale distributor and retailer of handmade toiletries and cosmetics based in Auckland. Although Fresh Essence Ltd had previously been audited by King & Co, a Chartered Accountants firm, Miller has recently become aware of BOD Craig, Chartered Accountants, an accounting firm, from reading several advertisements. Her interest in the accounting firm was heightened when she discovered that BOD Craig audited the primary bank with which she did business. In March 206, Miller contacted her bankers who arranged for a lunch meeting with one of the CA firms partners. At that time, a wide-ranging conversation was held concerning Fresh Essence Ltd as well as BOD Craig. Miller discussed the history of the company along with her hopes for the future. The partner, in turn, described many of the attributes possessed by his CA firm. Subsequently, Miller requested a formal appointment with Richard Craig, the managing partner of BOD Craig, in hopes of arriving at a final conclusion concerning Fresh Essence Ltds 206 audit engagement. On June 1, a meeting was held at the accounting firms Auckland office and was attended by Craig, Miller and you, Gary Wallace, an audit manager with BOD Craig who would be assisting in the investigation of this prospective client. Both auditors were quite interested in learning as much as possible about the hand-made toiletries and cosmetics business. Although a number of similar operations are located in the Auckland area, BOD Craig has never had a client in this field. Thus, the engagement offers an excellent opportunity to break into a new market. During a rather lengthy conversation with Miller, Craig and Wallace were able to obtain a significant quantity of data about the company and the possible audit engagement. Included in this information are the following facts: 1. Miller originally began Fresh Essence Ltd in 1987 as a wholesale distributor of hand-made soaps. Today, the company handles an expanded line of fruit scented crmes, lotions, oils, colognes, and spray perfumes. The company purchases large quantities of its products from various factory locations both locally and internationally. The product is re-packed and distributed to retailers throughout the North Island. In 1994, the marketing of hand-made soaps was dropped by Fresh Essence in a move to concentrate on the sale of fruit scented product lines. With the expansion in business, the company started setting up retail stores to market its products in addition to wholesale distributions. 2. This business did well and the company expanded thereafter at the rate of one new store every two or three years. Presently six stores are in operation, three in Auckland with one in each of the three nearby cities. The first five were set up in rented spaces within small shopping centres. However, the most recent store was located in a building constructed by Fresh Essence itself, adjacent to a new shopping mall on the east side of Auckland. In addition, Fresh Essence Ltd owns a two stories building in East Tamaki Auckland. The ground floor is a warehouse, packaging lines and office area for packaging staff and sales personnel, and the upstairs provide office space for the companys administrative staff, a kitchen and a meeting room. 3. During early 200, Fresh Essence became the sole distributor of Cypress Products in New Zealand. Cypress is the manufacturer of organic hand-made cosmetics located in Australia. Shortly thereafter, the Fresh Essence stores began to carry Cypress products almost 70% of its total stock. Despite the quality of Cypress Products, the brand was not well known, in the Auckland area and store revenues began to decline. Sales did rebound somewhat in 204 and 205, although Miller admitted to Craig that all the stores had suffered 2 from intense competition within the local market. She even indicated that a small scented perfume company, consisting of two stores, had gone bankrupt in Auckland during the past six months. However, she was not certain about the specific cause of that failure. 4. To market the Cypress Products brand, Fresh Essence hired six sales representatives to visit department stores, gift stores and beauty salons. These retailers could then order merchandise by telephoning the Auckland headquarters/warehouse. After a credit check, requested inventory is delivered to these customers and invoiced. Up to 20% of the merchandise can be returned to Fresh Essence within four months as long as the goods have not been damaged. In the past, returns have been low. Miller indicated that distributor-ship sales had initially been disappointing but had risen materially in the last two years as the Cypress reputation began to spread. 5. Organic cosmetics inventory is purchased periodically from Cypress. Regional distributors such as Fresh Essence are allowed 90 days terms but Cypress encourages quick payment by offering large cash discounts. In hopes of maintaining a high profit margin, Miller has chosen to take all available discounts. To meet the payment terms, Fresh Essence holds bank credit lines with two Auckland banks totalling $750 000. Interest on this debt is based on the floating prime rate of the respective banks and has averaged just 6%-7% during recent years. 6. The companys warehouse, as well as the sixth store, was constructed with funds provided by loans from the National Insurance Co. The first of these obligations was obtained at 7.25% annual interest rate while the second holds a rate of 7.75%. 7. Miller stated that she was quite unhappy with the services of her present CA firm, King & Co. She listed three grievances that she had with that firm. First, she felt the firm had provided little assistance in updating the companys accounting systems. Fresh Essence was simply outgrowing the control features of its current systems and, Miller asserted, King & Co had not provided the needed input for upgrading them. Second, Miller believed that King & Co was charging an excessive fee for its annual audit. She stated that she was no longer willing to pay that much money for, what she termed were, inferior services. 8. Millers final problem with King & Co revolved around the audit opinion for the companys financial statements for the year ending December 31, 205. An additional paragraph was added by the auditors to draw attention to an uncertainty. King & Co was not satisfied that the company would be able to recover the $186 000 investment in its latest store. This sixth store, which opened in November of 204, was constructed adjacent to a shopping centre that had proven to be very unsuccessful. To date, the shopping centre had leased less than 40% of its available space. The Fresh Essence store had, consequently, never been able to generate the customer traffic necessary to even come close to a break-even point. The continuing failure of the shopping centre made the fate of the Fresh Essence store appear quite uncertain to King & Co. 9. Fresh Essence Ltd is owned by a group of eight investors. Miller (who is 46 years old) owns 30 % of the outstanding stock while the remaining seven shareholders individually possess between 6% and 22 % of the companys shares. Although all of the investors live in the Auckland area, only Miller in involved actively in the day-to-day operations of the business. The Board of Directors is comprised of Miller, two other owners, and a local lawyer. When the company was first established, all eight shareholders agreed that an audit by an independent CA firm would be held annually. This same requirement was also a requirement of the banks participating in the companys financing. 10. Each of the six stores is operated by a manager and an assistant manager. Normally, three to six sales clerks also work at each store on a part-time basis. In hopes of improving lagging store sales, Miller initiated a bonus system during 205 which already appears to be boosting revenues. Under this plan, every manager and assistant manager will receive a cash bonus each January based on the income earned by their store 3 during the previous year. The bonus figure is a percentage of the gross profit of the store less any directly allocable expenses. 11. Fresh Essence is in the process of opening a new store which will begin operations by December of 208. Earlier this year Miller formed her own separate company to construct this latest facility. Upon completion, the building will be leased to Fresh Essence Ltd. Although Miller was confident that this new store would do well, she wanted to avoid any further accounting problems associated with the uncertainty of success. 12. Miller indicated to Craig that growth was one of her primary business objectives. She stated that the Cypress distributorship offered unlimited opportunity and that, once firmly established, each of the Fresh Essence stores was a sound financial investment. Required: The chartered accounting firm of BOD Craig has decided to accept the appointment as auditors of Fresh Essence Ltd for the year ended 31. December 206. Following the above conference with Miller, Craig asks you (Wallace) to review the unaudited financial statement (at the bottom) and to produce the audit planning memorandum (APM) discussing the potential problems that the firm might encounter in this audit. Your APM must cover the following: a) Identify the risk factors for the company b) Determine the potential impact of each of the identified risk factor on the financial statement or the audit c) Determine the audit strategies or procedures that should address the identified risks. Use the following format to present your answer. Identify the risks (facts) (a) Potential impact on the financial statements or the audit. (b) Audit strategies or procedures to address the risks (c)FRESH ESSENCE LTD WORKING TRIAL BALANCE INCOME STATEMENT BALANCE DATE 31.12.6 Per Per WP ref Audit Books 31.12.5 31.12.6 Revenue 701 Sales 2424250 3103243 703 Sales returns & allowances -26530 -31110 Net sales 2397720 3072133 Expenses 801 Cost of goods sold 1420933 1803479 Gross margin 976787 1268654 Operating Expenses 820 Wages 477815 617086 821 PAYE 52712 64716 822 Depreciation 64422 78269 823 Rental 3750 11738 824 Office supplies 8615 11625 825 Small tools 2988 6110 826 Advertising 11313 28870 827 Insurance 25737 30413 828 Repairs and maintenance 17869 19560 829 Rates 13463 18675 830 Power 10670 12700 831 Professional fees 11875 13100 832 General expenses 457 3595 833 Bad debts 9925 22790 834 Freight and transport 28150 33714 Total operating expenses 739761 972961 Net income from operation 237026 295693 OTHER INCOME AND [EXPENSE] 901 Interest expense -27500 -30646 910 Gain[loss] on sale of investments 32219 920 Income from investments 8344 5435 930 Gain[loss] on sale of fixed assets 18638 950 Miscellaneous income -15270 Total other income/loss -518 -8262 net income before tax 236508 287431