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 energies 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.
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 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.
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 skepticism in auditing and analyse whether TT exercised sufficient professional skepticism 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?
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