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Ocean Manufacturing, Inc.

The new client acceptance decision

Mark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt l ea r n ing o bje C t ive s
After completing and discussing this case you should be able to [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

Identify and evaluate factors important to the
client acceptance decision
[4] Understand the process of making and justifying
a recommendation regarding client acceptance
[3]

INTRODUCTION
The accounting firm of Barnes and Fischer, LLP, is a medium-sized, national CPA firm. The partnership, formed in 1954, now has over 6,000 professionals on the payroll. The firm mainly provides auditing and tax services, but it has recently had success 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 of your five years with Barnes and Fischer. Your first assignment as audit manager is to assist an audit partner

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on a client acceptance decision. The partner explains to you that the prospective client, Ocean Manufacturing, 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 build a relationship with a more nationally established 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 manufacturers of small home appliances in the area, your office has never had a client in the industry. Most of your office’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. The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, 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.

Copyright © 2012 by Pearson Education, Inc., Upper Saddle River, NJ 07458

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section 1: client acceptance

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 and other securities are not publicly traded, the company is planning an IPO in the next few years in hopes that it 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 its December 31, 2011 financial statements and has expressed interest in obtaining help to get its recently installed information technology (IT) system in better shape. Ocean also wants 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 over the past 12 years.

Management

In October 2011, the company experienced significant management turnover when both the vicepresident 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 & Control Systems

The company switched to a new, integrated 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 4

Case 1.1: Ocean Manufacturing, Inc.
by the former controller. Unfortunately, the transition to this new system was not well managed. 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 both 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 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 audit 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 believed 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, they granted you 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 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. 5

section 1: client acceptance

Client Background Check

A check on the background of Ocean’s management revealed that five years ago Ocean’s vice president 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 which in turn holds a private equity investment 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.

6

Case 1.1: Ocean Manufacturing, Inc.
r eQ u ir e d
[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 its 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.

7

section 1: client acceptance
Ocean Manufacturing, Inc.
Balance Sheets as of December 31, 2009-2011
(In Thousands)
(Unaudited)
2011

2010

2009

$ 3,008
12,434
11,907
3,853
1,286
32,488

$ 2,171
7,936
10,487
4,843
1,627
27,064

$ 1,692
6,621
10,684
7,687
1,235
27,919

53,173
11,199
41,974

46,664
9,009
37,655

39,170
7,050
32,120

714
1,216
1,930

547
1,555
2,102

339
735
1,074

$76,392

$66,821

$61,113

LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES
Accounts payable and accrued expenses
$12,285
Current portion of long-term debt
3,535
Income tax payable
865
872
Other current liabilities
Total Current Liabilities
17,557

$ 9,652
3,054
565
847
14,118

$12,309
2,899
295
988
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.)
Additional paid-in capital
Retained earnings
Total Shareholders’ Equity

10,675
5,388
22,772
38,835

10,675
5,388
19,406
35,469

10,675
5,388
16,885
32,948

$76,392

$66,821

$61,113

ASSETS
CURRENT ASSETS
Cash
Accounts receivable (net of allowance)
Raw & in-process inventories
Finished goods inventories
Other current assets
Total Current Assets
PROPERTY, PLANT, & EQUIPMENT
Less accumulated depreciation
Net PP&E
OTHER ASSETS
Deferred income taxes
Other noncurrent assets
Total Other Assets
TOTAL ASSETS

TOTAL LIABILITIES AND EQUITY

8

Case 1.1: Ocean Manufacturing, Inc.
Ocean Manufacturing, Inc.
Statement of Earnings for Years Ended December 31, 2009-2011 (In Thousands)
(Unaudited)
2011

2010

$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

Sales

2009

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

$3,472

$2,521

$2,073

Net Earnings

Ocean Manufacturing, Inc.
Statement of Retained Earnings as of December 31, 2009-2011
(In Thousands)
(Unaudited)
2011
Balance, beginning of year

$19,406

2010

2009

$16,885

$14,812

Cash dividends paid

(106)

0

0

Net earnings for year

3,472

2,521

2,073

Balance, end of year

$22,772

$19,406

$16,885

Average Industry Ratios for Comparison
Return on Equity (ROE)
Return on Assets (ROA)
Assets to Equity
Accounts Receivable Turnover
Average Collection Period
Inventory Turnover
Days in Inventory
Debt to Equity
Times Interest Earned
Current Ratio
Profit Margin

2011
20.33%
6.62%
3.30
7.49
41.25
8.09
38.16
2.38
1.62
1.29
10.58%

2010
26.22%
8.10%
2.82
6.96
44.35
6.90
43.86
1.90
2.37
1.44
10.82%

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