Based on the qualitative and quantitative information gathered, prepare aone to two page memo to the audit partner with your recommendation as to whether Barnes and Fisher should or should not accept Ocean as an audit client.
Based on the qualitative and quantitative information gathered, prepare aone to two page memo to the audit partner with your recommendation as to whether Barnes and Fisher should or should not accept Ocean as an audit client. Be sure to include reasons for and against acceptance
Ocean Manufacturing, Inc.[1]
The New-Client Acceptance Decision
Learning Objectives
[1] Understand the types of information relevant to evaluating a prospective audit client
[2] List some of the steps an auditor should take in deciding whether to accept a prospective client
[3] Identify and evaluate factors important to the client acceptance decision
[4] Understand the process of making and justifying a recommendation regarding client acceptance
INTRODUCTION
The accounting firm of Barnes and Fischer, LLP, is a medium-sized, national CPA firm. The partnership, formed in 1954, now has more than 6,000 professionals on the payroll. The firm mainly provides auditing and tax services, but it has recently had success in building the information systems consulting side of the business for non-audit clients and for audit clients that are not publicly traded.
It is mid-January 2012, and you are a newly promoted audit manager in an office of Barnes and Fischer, located in the Pacific Northwest. You have been a senior auditor for the past three years of your five years with Barnes and Fischer. Your first assignment as audit manager is to assist an audit partner on a client acceptance decision. The partner explains to you that the prospective client, Ocean Manufacturing, Inc. is a medium-sized manufacturer of small home appliances. The partner recently met the company’s president at a local chamber of commerce meeting. The president indicated that, after some difficult negotiations, the company has decided to terminate its relationship with its current auditor. The president explained that the main reason for the switch is to establish a relationship with a more nationally known CPA firm because the company plans to make an initial public offering (IPO) of its common stock within the next few years. Ocean’s annual financial statements have been audited each of the past 12 years in order to comply with debt covenants and to receive favorable interest rates on the company’s existing line of credit. Because the company’s December 31 fiscal year-end has already passed, time is of the essence for the company to contract with a new auditor to get the audit under way.
The partner, Jane Hunter, is intrigued with the idea of having a client in the home appliance industry, especially one with the favorable market position and growth potential of Ocean Manufacturing. Although there are several small home appliance manufacturers in the area, your office has never had a client in the industry. Most of Barnes and Fischer’s current audit clients are in the healthcare services industry. Thus, the partner feels the engagement presents an excellent opportunity for Barnes and Fischer to enter a new market. On the other hand, knowing the risks involved, the partner wants to make sure the client acceptance decision is carefully considered.
BACKGROUND
Ocean Manufacturing, Inc. manufactures small- to medium-sized home appliances. The company’s products include items like toasters, blenders, and trash compactors. Although Ocean’s common stock is not publicly traded, the company is planning an IPO in the next few years in hopes that they will be able to trade Ocean’s common stock on the NASDAQ. You have been assigned to gather information in order to make a recommendation on whether your firm should accept Ocean Manufacturing as a client.
Ocean wants to hire your firm to issue an opinion on their December 31, 2004, financial statements and has expressed interest in obtaining help to get its recently installed information technology (IT) system in better shape. Ocean also want your firm’s advice and guidance on getting everything in order for the upcoming IPO. During the initial meeting with Ocean’s management, the following information was obtained about the industry and the company.
The Home Appliances Industry Over the past several years, the domestic home appliances industry has been growing at a steady pace. The industry consists of a wide variety of manufacturers (domestic and foreign) who sell to a large number of wholesale and retail outlets. Though responsive to technological improvements, product marketability is linked to growth in the housing market. Retail outlets are served by both wholesale and manufacturer representatives.
Ocean Manufacturing, Inc. Ocean‘s unaudited December 31, 2011, financial statements report total assets of $76 million, sales revenues of $145 million, and net profit of $3.4 million. In the past, the company has not attempted to expand aggressively or develop new product lines. Rather, it has concentrated on maintaining a steady growth rate by providing reliable products within a moderate to low price range. However, Ocean hopes to use the capital from the upcoming IPO to aggressively expand from a regional to a national market. Ocean primarily sells its products in small quantities to individually owned appliance stores. Over the last few years the company has begun to supply larger quantities to three national retail chains. Two of these larger retailers started buying Ocean‘s products about two years ago. In order to handle the increased sales, Ocean significantly expanded its manufacturing capacity.
Though shaken by recent management turnover and ongoing difficulties with the company’s new accounting system, management feels that Ocean is in a position to grow considerably. Management notes that earnings have increased substantially each year over the past three years and that Ocean’s products have received increasing acceptance in the small appliance marketplace. Three years ago the company received a qualified audit opinion relating to revenues and receivables. Ocean has changed auditors three times during the past 12 years.
Management In October 2011, the company experienced significant management turnover when both the vice president of operations and the controller resigned to take jobs in other cities. The reason for their leaving was disclosed by management as being related to “personal issues.” A new vice president, Jessica Wood, was hired in November, and the new controller joined early last month. Jessica is an MBA with almost 12 years of experience in the industry. Theodore Jones, the new controller, has little relevant experience and seems frustrated with the company‘s new IT system. The company’s president, Andrew Cole, has a BBA and, as the founder, has worked at all levels of the business. Mr. Zachery, who is principally in charge of the company’s procurement and manufacturing functions, meets weekly with Mr. Cole, as does Frank Stevens, who has served as vice president over finance for the past eight years.
Accounting and Control Systems The company switched to a new, integrated computer-based central accounting system in early 2011. This new system maintains integrated inventory, accounts receivable, accounts payable, payroll, and general ledger software modules. The transition to the new system throughout last year was handled mainly by the former controller. Unfortunately, the transition to this system was not well managed, and the company is still working to modify it to better meet company needs, to retrain the accounting staff, and to adapt the company’s accounting controls to better complement the system.
Problems still exist in inventory tracking and cost accumulation, receivables billing and aging, payroll tax deductions, payables, and balance sheet account classifications. The company stopped parallel processing the old accounting system in April 2011. During several brief periods throughout 2011, conventional audit trails were not kept intact due to system failures and errors made by untrained personnel.
The company’s accounting staff and management are frustrated with the situation because, among other problems, internal management budget reports, inventory status reports, and receivables billings are often late and inaccurate, and several shipping deadlines have been missed.
Your office has never audited a company with the specific brand of IT system in place at Ocean. However, your local office’s IT team is fairly confident they will be able to diagnose Ocean’s control weaknesses and help Ocean overcome current difficulties.
Accounts Receivable, Cash, and Inventories The sales/receivables system handles a volume ranging from 2,900 to 3,400 transactions per month, including sales and payments on account for about 1,200 active credit customers. The six largest customers currently account for about 15% of accounts receivable, whereas the remainder of the accounts range from $1,500 to $32,000, with an average balance around $8,000.
Finished goods inventories are organized and well protected, but in-process inventories appear somewhat less organized. The company uses a complicated hybrid form of process-costing to accumulate inventory costs and to account for interdepartmental in-process inventory transfers for its four major product lines.
Predecessor Auditor When you approached Frank Stevens, Ocean‘s vice president of finance, to request permission to speak with the previous auditor, he seemed hesitant to discuss much about the prior audit firm. He explained that, in his opinion, the previous auditor did not understand Ocean’s business environment very well and was not technically competent to help the company with its new IT system. He further indicated that the predecessor auditor and Ocean‘s management had disagreed on minor accounting issues during the prior year‘s audit. In Mr. Stevens‘ opinion, the disagreement was primarily due to the auditor’s lack of understanding of Ocean‘s business and industry environment. According to Mr. Stevens, the auditor partner indicated that because of the accounting issues, he would be unable to issue a clean opinion on the financial statements. In order to receive an unqualified opinion, Ocean had to record certain adjustments to revenues and receivables. Mr. Stevens believes the adjustments were unnecessary but felt forced to make them to receive a clean audit opinion.
Mr. Stevens noted that Ocean’s management feels confident that your firm’s personnel possess better business judgment skills and have the knowledge and ability to understand and help improve Ocean’s IT system. Mr. Stevens also indicated that Ocean wants to switch auditors at this time to prepare for the upcoming IPO, noting that companies often switch to larger accounting firms with national reputations in preparation for going public. Your firm has been highly recommended to him by a friend who is an administrator of a hospital audited by Barnes and Fischer. After some discussion between Mr. Stevens and Mr. Cole, Ocean’s president, you are granted permission to contact the previous auditor.
During your visit with the previous auditor, he indicated that the problems his firm had with Ocean primarily related to (1) the complexities and problems with Ocean’s new IT system and (2) management’s tendency to aggressively reflect year-end accruals and revenue in order to meet creditors’ requirements. The auditor also disclosed that the dissolution of the relationship with Ocean was a mutual agreement between the two parties and that his firm’s relationship with management had been somewhat difficult almost from the beginning. Apparently the final straw that broke the relationship involved a disagreement over the fee for the upcoming audit.
Client Background Check A check on the background of Ocean’s management revealed that five years ago Ocean’s V.P. of finance was charged with a misdemeanor involving illegal gambling on local college football games. According to the news reports, charges were later dropped in return for Mr. Stevens’ agreeing to pay a fine of $500 and perform 100 hours of community service. The background check revealed no other legal or ethical problems with any other Ocean executives.
Independence Review As part of Barnes and Fischer’s quality control program, every three months each employee of Barnes and Fischer is required to file with the firm an updated disclosure of their personal stock investments. You ask a staff auditor to review the disclosures as part of the process of considering Ocean as a potential client. She reports to you that there appears to be no stock ownership issue except that a partner in Barnes and Fischer’s Salt Lake City office owns shares in a venture capital fund that in turn holds investments in Ocean common stock. The venture capital fund holds 50,000 shares of Ocean stock, currently valued at approximately $18 a share. The stock is not publicly traded, so this value is estimated. This investment represents just over a half of one percent of the value of the fund’s total holdings. The partner’s total investment in the mutual fund is currently valued at about $56,000. No other independence issues were noted.
Financial Statements You acquired the past three years’
financial statements from Ocean, including the unaudited statements for the
most recent year ended December 31, 2011. This financial information is
provided on the pages that follow. The partner who will be in charge of the
Ocean engagement, Jane Hunter, wants you to look them over to see what
information you can draw from them, paying particular attention to items that
might be helpful in determining whether or not to accept Ocean as a new audit
client.
REQUIRED
[1] The client acceptance process can be quite complex. Identify five procedures an auditor should perform in determining whether to accept a client. Which of these five are required by auditing standards?
[2] Using Ocean’s financial information, calculate relevant preliminary analytical procedures to obtain a better understanding of the prospective client and to determine how Ocean is doing financially. Compare Ocean’s ratios to the industry ratios provided. Identify any major differences and briefly list any concerns that arise from this analysis.
[3] What nonfinancial matters should be considered before accepting Ocean as a client? How important are these issues to the client acceptance decision? Why?
[4] [a] Ocean wants Barnes and Fischer to aid in developing and improving their IT system. What are the advantages and disadvantages of having the same CPA firm provide both auditing and consulting services? Given current auditor independence rules, will Barnes and Fischer be able to help Ocean with its IT system and still provide a financial statement audit? Support your conclusion with appropriate citations to authoritative standards if your instructor indicates that you should do so.
[b] As indicated in the case, one of the partners in another office has invested in a venture capital fund that owns shares of Ocean common stock. Would this situation constitute a violation of independence according to the AICPA Code of Professional Conduct? Why or why not?
[5] [a] Prepare a memo to the partner making a recommendation as to whether Barnes and Fischer should or should not accept Ocean Manufacturing, Inc. as an audit client. Carefully justify your position in light of the information in the case. Include consideration of reasons both for and against acceptance and be sure to address both financial and nonfinancial issues to justify your recommendation.
[b] Prepare a separate memo to the partner briefly listing and discussing the five or six most important factors or risk areas that will likely affect how the audit is conducted if the Ocean engagement is accepted. Be sure to indicate specific ways in which the audit firm should tailor its approach based on the factors you identify.
| Ocean Manufacturing, Inc. | |||
| Balance Sheets as of December 31, 2009-2011 | |||
| (In Thousands) | |||
| ASSETS | |||
| (Unaudited) | |||
| 2011 | 2010 | 2009 | |
| CURRENT ASSETS | |||
| Cash | $ 3,008 | $ 2,171 | $ 1,692 |
| Accounts receivable (net of allowance) | 12,434 | 7,936 | 6,621 |
| Raw & in-process inventories | 11,907 | 10,487 | 10,684 |
| Finished goods inventories | 3,853 | 4,843 | 7,687 |
| Other current assets | 1,286 | 1,627 | 1,235 |
| Total Current Assets | 32,488 | 27,064 | 27,919 |
| PROPERTY, PLANT, & EQUIPMENT | 53,173 | 46,664 | 39,170 |
| Less accumulated depreciation | 11,199 | 9,009 | 7,050 |
| Net PP&E | 41,974 | 37,655 | 32,120 |
| OTHER ASSETS | |||
| Deferred income taxes | 714 | 547 | 339 |
| Other noncurrent assets | 1,216 | 1,555 | 735 |
| Total Other Assets | 1,930 | 2,102 | 1,074 |
| TOTAL ASSETS | $76,392 | $66,821 | $61,113 |
| LIABILITIES AND SHAREHOLDERS’ EQUITY | |||
| CURRENT LIABILITIES | |||
| Accounts payable and accrued expenses | $12,285 | $ 9,652 | $12,309 |
| Current portion of long-term debt | 3,535 | 3,054 | 2,899 |
| Income tax payable | 865 | 565 | 295 |
| Other current liabilities | 872 | 847 | 988 |
| Total Current Liabilities | 17,557 | 14,118 | 16,491 |
| LONG-TERM DEBT | 20,000 | 17,234 | 11,674 |
| TOTAL LIABILITIES | 37,557 | 31,352 | 28,165 |
| SHAREHOLDERS’ EQUITY | |||
| Common stock (10,000,000 shares auth.) | 10,675 | 10,675 | 10,675 |
| Additional paid-in capital | 5,388 | 5,388 | 5,388 |
| Retained earnings | 22,772 | 19,406 | 16,885 |
| Total Shareholders’ Equity | 38,835 | 35,469 | 32,948 |
| TOTAL LIABILITIES AND EQUITY | $76,392 | $66,821 | $61,113 |
| Ocean Manufacturing, Inc. | ||
| Statement of Earnings for Years Ended December 31, | 2009-2011 | |
| (In Thousands) | ||
| (Unaudited) | ||
| 2011 | 2010 | 2009 |
| Sales $145,313 | $104,026 | $92,835 |
| Cost of sales 95,906 | 69,177 | 63,870 |
| Gross profit 49,407 | 34,849 | 28,965 |
| Operating expenses: 41,414 | 28,607 | 24,601 |
| Operating income 7,993 | 6,242 | 4,364 |
| Interest expense 1,700 | 1,473 | 699 |
| Provision for income taxes 2,821 | 2,246 | 1,592 |
| Net Earnings $ 3,472 | $ 2,521 | $ 2,073 |
| Ocean Manufacturing, Inc. | ||
| Statement of Retained Earnings | ||
| (In Thousands) | ||
| (Unaudited) | ||
| 2011 | 2010 | 2009 |
| Balance, beginning of year $19,406 | $16,885 | $14,812 |
| Cash dividends paid (105) | 0 | 0 |
| Net earnings for year 3,472 | 2,521 | 2,073 |
| Balance, end of year $22,772 | 519,406 | $16,885 |
| Industry Ratios for Comparison | ||
| 2011 | 2010 | |
| Return on Equity (ROE) 20.33% | 26.22% | |
| Return on Assets (ROA) 6.22% | 8.10% | |
| Assets to Equity 3.30 | 2.82 | |
| Accounts Receivable Turnover 7.49 | 6.96 | |
| Average Collection Period 41.25 | 44.35 | |
| Inventory Turnover 8.09 | 6.90 | |
| Days in Inventory 38.16 | 43.86 | |
| Debt in Equity 2.38 | 1.09 | |
| Times Interest Earned 1.62 | 2.37 | |
| Current Ratio 1.29 | 1.44 | |
| Profit Margin 10.58% | 10.82% |
[1] This case was prepared by Frank A. Buckless, Ph.D. and Mark S. Beasley, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. Ocean Manufacturing is a fictitious company. All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental.