Real Good Food company lost money in 2014, in comparison with turning a profit in 2013. One of the red flags that an auditor should look for is when a company records better performance -- there is little incentive to be gained from losing money. The gross margin in 2014 was 12.2% and in 2013 it was 14%. Because the company lost money, it did not pay the same rate of tax as when it made money, but that should not be the biggest red flag in the world -- again, losing money is not usually considered to be desirable. The company noted an increase in inventories, from ?15 million to ?19.1 million. Thus, the inventory turnover went from 17.7 times to 14.2 times. Trade payables were ?21.28 million in 2013, but ?29.82 million in 2014. This is a significant increase, much larger than the increase in revenue that the company experienced. Normally a company will see a corresponding increase in payables, not a dramatic jump. This is an area that the auditor might have an interest in, because the numbers seem misaligned. The inventories have increased 27%, the payables 40%, but the revenue just 2.5%. Why is the company ramping up inventory levels, and not paying for this inventory.

The plant, property and equipment has increased significantly, from ?17.68 million to ?22.29 million. The auditor will want to ensure that there has been an asset purchase to justify such an increase. There was no corresponding increase in borrowings or share capital increase. The company did record the purchase of new plant, property and equipment on its cash flow statement (?4.3 million more than last year), but it appears to have financed this from "net movements on revolving credit facilities." (Real Good Food Annual Report).

The first issue, therefore, is the plant, property and equipment, along with that revolving credit facility. The incremental investment is noted on the first page of the annual report -- it is a ?4.3 million investment in Sugar Hub. The Stallingborough Sugar Hub was completed in the fiscal year. The company notes on page 5 that this is expected to generate long-term returns. There is nothing wrong this in principle, but there is something worth investigating in how this was financed. The company has not increased its borrowing, other than in the "trade and other payables" category, which as noted above grew quite a bit more than would be expected for a company whose revenues increased only 2.5%. Otherwise, the only financing would have been from a decline in retained earnings. Given that Sugar Hub is expected to generate returns for many years, and that most companies prefer to align their borrowing term with the term on the inflows, there is something strange about the company using revolving credit for a capital project. Real Good Food can do that if they want, but it is unorthodox and worthy of further investigation.

The increase in inventory and trade payables should be looked at as well, as a second area of audit risk. These may have occurred in the last quarter, when the Sugar Hub opened, which would have increase the size of inventory and payables, prior to the new facility having an impact on revenues. It is reasonable, therefore, that these figures could have changed. The company could well be delaying those payables until income from Sugar Hub starts to flow. However, the auditor should ensure that this is the case. Under normal operating circumstances, it would be unusual for a company to ramp up its inventories and payables at rates so much greater than the rate of increase in revenues. Having a better sense of what Sugar Hub is, and how much incremental revenue it is expected to generate, can provide better clarity here.

Another area of audit risk is with the company's distribution costs, which were 5% in 2014, compared with just 4.38% in 2013. This increase in distribution cost had a negative effect on the bottom line for the company, especially when combined with the decline in the gross margin. Signs to look for when expenses are rising would be if the company has sought to diminish its tax burden by adding expenses out of period, or if they had sought to boost their profits in the prior year (2013) by pushing some expenses into 2014. The auditor would probably not think the numbers presented are unreasonable, but might wish to have statements going back a few more years to take into account the historic numbers on these figures. It seems a little bit strange, at least, that the distribution costs would go up relative to revenues during a year when the...

Today's statements might reveal something about last year's, highlighting areas of audit risk that were not apparent at the time, but which are apparent in retrospect. There is benefit to looking at dramatic and possibly unrealistic changes to the income statement that can change a company's tax obligations, just as there is justification in examining unusual use of credit to make capital purchases.
Part B.

Substantive Procedures

To examine more closely the increases in inventory and payables, and ensure that these are related to the Sugar Hub opening, there are a few things that the auditor should do. The first will be simply to gather all of the pertinent information. This means getting statements of operations, and support documentation, re: this project. If management contends that these increases are not related to Sugar Hub, that stands as even more interesting for the auditor. Quarterly statements, and unit statements will be required in order to more effectively evaluate here -- the group statements can cover up a number of things that might only affect a single unit at the company. Management's assertions are being tested, so it will be important to sit down with management and hear what their assertions are, prior to testing for them.

Analytical Procedures

With a new plant opening, one of the important aspects is to understand the month-by-month changes that are occurring within the financial structure of the company. With inventory and payables, these should be aligned with the facility coming online, and they should be matched with future revenues. The auditor should have records of the new inventory, and be able to match that not only with management's projections for sales, but with actual sales as well, once they occur. There should be supporting documents for all purchases and payments. The size of the facility will need to be evaluated -- if inventories have jumped by ?4.1 million, and payables by ?8.54 million, this should match up with the size and scope of the facility -- what is the amount of inventory that would make sense for that facility?

Completeness/classification/accuracy

The auditor will need to ensure that the records correspond with the management assertions about the nature of the new operation. The records in particular will need to include all costs associated with Sugar Hub. If revenues have yet to be booked even though it has been online for an entire quarter, why is that? The auditor will want to see records, and ensure that revenues are being accounted for -- that when inventory is sold, there are corresponding records and journal entries outlining what the revenue for that was.

Occurrence

When there are discrepancies over what would make sense, the auditor needs to test for occurrence. The documentation provided should not be fictitious -- there should be actual, physical inventory held when there is record of inventory having been purchased but not sold. The revolving credit should be evaluated as well -- looking at the withdrawals of cash from that credit account, and aligning those with the expenses of the new facility. There is concern that this credit facility will not be as transparent as other methods of financing, or that some of this debt will go down as payables when it is capital spending. But physical checks of the facilities, and to ensure that there actually has been an explosion in inventory levels, will help the auditor to determine the veracity of the financial statements.

Cut Off

There was a potential cut off issue, in particular with the 2013 statements and how they looked much better than the 2014 ones. The auditor should ensure that the transactions at the beginning of 2014 were recorded appropriately, and were not simply expenses from 2013 that were deferred. If there are adjustments that need to be made, the auditor should order that, but also examine what the overall impact to the financial statements will be. Remember that audit risk is reduced by ensuring that any situation that could constitute fraud is subject to closer evaluation. With the new facility, one of the risks is that the inventories purchased -- but not yet paid for -- for this facility are well in excess of what the facility will need in the short run. By purchasing inventory well in advance so that…