You are a senior auditor at Zales and Brook LLP, a CPA firm. Bruno Drinks Inc. is a largepublicly traded firm based in California and has been audited by your firm for years. You areassigned 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, andother soft drinks in Canada, U.S., Mexico, and UK. Mexico, a growing market with a largepopulation, accounts for 35% of the total sales and Canada accounts for roughly 25%. UK is aminor market for BD and accounts for only 10% of the firm’s total revenue. It has its own Brunobrand, but sells most of its products (90%) to retailers under their private labels. Between 2002and 2005, BD expanded its production and distribution capacities through several acquisitions. In2006, after the retirement of the previous CEO, Jack London was picked by the board of directorsto be the new CEO. Jack soon adopted a new strategy of rationalizing its existing capacities: thefirm focuses on its best performing production facilities and started to close down some plantsand warehouses in North America.

BD sells most of its soft drinks to a group of very large customers, such as large chain grocerystores or discount retailers. For example, Mel-mart, accounts 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, aluminumcans, sweeteners, and flavoring additives. BD has annual contracts with its suppliers for most rawmaterials, so that it can renegotiate with the suppliers for better price. During 2006, the price ofaluminum cans rose substantially. Consequently, the management decided to enter a 5-yearagreement with one supplier at a fixed price established in January 2007. Then in 2007, the priceof aluminum declined substantially. Due to the Subprime Mortgage crisis and the subsequentturmoil associated with Bear Stearns, the future price of aluminum fell another 20% in the firstquarter of 2008. You learned from the CFO that BD does not use derivatives to hedge against rawmaterial price changes.

You also learn from permanent audit files that BD’s business is subject to many federal, state, andlocal laws and regulations with respect to manufacturing, distribution, labeling and safety.California also has local environmental protection laws that regulate storage, water use andtreatment, and waste disposal. Currently, BD is not in compliance with the California RecyclingAct requirement that demands a minimum percentage of its products that must be sold inrefillable containers. In 2007, the state government is not actively enforcing this law, but there isalready public pressure from some powerful environmentalist groups. The newly electedgovernor promised in December 2007 to set the enforcement as one of his priorities. You raisedthe non-compliance issue in a business meeting, but the BD management argued that complianceis too costly for the whole firm, despite the fact that California is BD’s major market given itslarge population.

During 2007, the client management identified two internal control weaknesses in the firm. Oneis related to inventory and the other is related to purchase function. Lack of segregation of dutiesbetween an account receivable clerk and a warehouse employee allows them to divert expensivebeverages from legitimate customer orders and use faked credit notes (a supporting documentused to write off accounts receivable) to cover up the shortage. Then the warehouse employee

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sold the stolen beverages to local small restaurants and pocketed the proceeds. BD’s controllertold you that BD has fired both employees and has re-engineered its inventory control and creditnote issuance process and he is confident that internal control weakness has been eliminated. Thesecond weakness was found in the purchasing function. It seems that weakness in theauthorization process might result in improper agreements by low-level purchasing staff. There isanecdotal evidence that some buyers in different countries have been compromised by localsuppliers with bribes.

BD has not released its 4th quarter report of 2007 yet. But you have noticed from the first threequarters of 2007 that the 2007 performance is not good. Its stock price fell 20% in 2007, and themanagement blamed the subprime-mortgage-related turmoil for the decline. Several analystsagreed with the management and recommended BD’s stock as “HOLD”. But two analysts fromMorgan Turley and Silverman Saches disagree with their peers: they predict that BD is close toviolating its debt covenants. Given the market turmoil and BD’s declining profitability, theybelieve 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 threecategories.

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 besubject to material misstatements. Explain clearly how the risks could result in materialmisstatements in the financial statements.