Question

*Please only answer #3*

Jupiler Inc. (A Business Risk Case)

You are a senior auditor at Zales and Brook LLP, a CPA firm. Jupiler Drinks Inc. is a large publicly traded firm based in California and has been audited by your firm for years. You are assigned to lead the FY2007 audit of Jupiler 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, and other soft drinks in Canada, U.S., Mexico, and UK. Mexico, a growing market with a large population, accounts for 35% of the total sales and Canada accounts for roughly 25%. UK is a minor market for BD and accounts for only 10% of the firm’s total revenue. It has its own Jupiler brand, but sells most of its products (90%) to retailers under their private labels. Between 2002 and 2005, BD expanded its production and distribution capacities through several acquisitions. In 2006, after the retirement of the previous CEO, Jack London was picked by the board of directors to be the new CEO. Jack soon adopted a new strategy of consolidating its existing capacities: the firm focuses on its best performing production facilities and started to close down some plants and warehouses in Canada, USA, and UK.  

BD sells most of its soft drinks to a group of very large customers, such as large chain grocery stores 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, aluminum cans, sweeteners, and flavoring additives. BD has annual contracts with its suppliers for most raw materials, so that it can renegotiate with the suppliers for better price. During 2006, the price of aluminum cans rose substantially. Consequently, the management decided to enter a 5-year agreement with one supplier at a fixed price established in January 2007. Then in 2007, the price of aluminum declined substantially. Due to the Subprime Mortgage crisis and the subsequent turmoil associated with Bear Stearns, the future price of aluminum fell another 20% in the first quarter of 2008 and then collapsed by another 30% in 2009. You learned from the CFO that BD does not use derivatives to hedge against raw material price changes.  

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

During 2007, the client management identified two internal control weaknesses in the firm. One is related to inventory and the other is related to purchase function. Lack of segregation of duties between an account receivable clerk and a warehouse employee allows them to divert expensive beverages from legitimate customer orders and use faked credit notes (a supporting document used to write off accounts receivable) to cover up the shortage. Then the warehouse employee sold the stolen beverages to local small restaurants and pocketed the proceeds. BD’s controller told you that BD has fired both employees and has re-engineered its inventory control and credit note issuance process and he is confident that internal control weakness has been eliminated. The second weakness was found in the purchasing function. It seems that weakness in the authorization process might result in improper agreements by low-level purchasing staff. There is anecdotal evidence that some buyers in different countries have been compromised by local suppliers with bribes.  

BD has not released its 4th quarter report of 2007 yet. But you have noticed from the first three quarters of 2007 that the 2007 performance is not good. Its stock price fell 20% in 2007 (S&P 500 index went up by 6% in comparison), and the management blamed the subprime-mortgage-related turmoil for the decline. Several analysts agreed with the management and recommended BD’s stock as “HOLD”. But two analysts from Morgan Turley and Silverman Saches disagree with their peers: they predict that BD is close to violating its debt covenants. Given the market turmoil and BD’s declining profitability, they believe that BD might have difficulty in refinancing its current bank loans.  

Required:

1. Please search Wikipedia and explain “debt covenant” to your professor. Accounting ratios are often used in covenants. Please cite two commonly used accounting ratios, based on your Wiki or Google search.  

2. Identify key business risk factors in the BD case. You can group all factors into three categories.  

a. Industry, regulatory, and other external risk factors

b. Nature of BD’s drink business (operation, investments, financing)

c. BD’s business strategy

  

3. Link the business risk factors identified above to some specific accounts from balance sheet or income statement which might be subject to material misstatements. Explain clearly how the risks could result in material misstatements in the financial statements. (Tip: Critical skill in audit planning)

Answer 1

Solution:

Debt Covenants are restrictions in debt agreements ( indenture) that aim to protect the lender ( creditor , debt holder , or investor) by restricting the activities of the borrower (debtor). Debt covenants benefit both the lender and the borrower: Debt restrictions could protect the lendor by requiring or prohibiting certain activities of the lender. In other words , debt covenants should restrict the borrower from making decisions that would be detrimental to the lender and debt restrictions could benefit the borrower by reducing the cost of borrowing(eg, through lower interest rates and higher credit ratings.

Debt covenants do not aim to place a burden on the borrower. Debt covenants are used to solve the agency problems among the management(ie., of the borrowing company), debt holders , and shareholders that arise due to the differences in the objectives of the borrower and the lender. Debt covenants can be either postive or negative. Negative debt covenants state what the borrower cannot do and may include enter into certain types of lease, compensate or increase salaries of certain employees, business combinations, incur additional lomg-term debt, sell certain assets (eg., sell accounts receivables) etc. Postive debt covenants state what the borrower must do and may include maintain certain minimum financial ratios, maintain accounting records in accordance with the generally accepted accounting principles , provide audited financial statements, pay taxes and other liabilities when due, maintain all facilities in good working condition etc.

The most common financial ratios used in debt covenants include Debt to Equity ratio and Current ratio.