Ocean Manufacturing Inc. The New Client Acceptance Decision
The accounting firm of Barnes and Fischer, LLP, is a medium-sized, national CPA firm. The partnership, partnership, formed in 19!, no" has more than #,$$$ professionals professionals on the pa%roll. pa%roll. The firm mainl% pro&ides auditing and ta' ser&ices, (ut it has recentl% had success in (uilding the information-s%stems-consulting side of the (usiness for non-audit clients and audit clients that are not pu(licl% held. )t is mid-*anuar% +$$9, and %ou are a ne"l% promoted audit manager in an office of Barnes and Fischer, located in the Pacific orth"est. ou ha&e (een a senior auditor for the past three %ears of %our fi&e %ears "ith Barnes and Fischer. our first assignment as audit manager is to assist an audit partner on a client acceptance decision. The partner e'plains to %ou that the prospecti&e client, cean /anufacturing, )nc. is a medium-sized manufacturer of small home appliances. The partner recentl% met the compan%0s president at a local cham(er of commerce meetin meeting. g. e indica indicated ted that, that, after after som somee diffic difficult ult negoti negotiati ations ons,, the compan% compan% has decide decided d to terminate terminate its relationsh relationship ip "ith its current current auditor. auditor. The president e'plained e'plained that the main reason for the s"itch is to esta(lish a relationship "ith a more nationall% 2no"n CPA firm (ecause the compan% plans to ma2e an initial pu(lic offering 3)P4 of its common stoc2 "ithin the ne't fe" %ears. cean0s annual financial statements ha&e (een audited each of the past 1+ %ears in order to compl% "ith de(t co&enants and to recei&e fa&ora(le interest rates on the compan%0s e'isting line of credit. Because the compan%0s 5ecem(er 61 fiscal %ear-end has alread% passed, time is of the essence for the compan% to contract "ith a ne" auditor to get the audit under "a%. The partner is intrigued "ith the idea of ha&ing a client in the home appliance industr%, especiall% one "ith the fa&ora(le mar2et position and gro"th potential of cean /anufacturing. Although there are se&eral small home appliance manufacturers in the area, %our office has ne&er had a client in the industr%. /ost of Barnes and Fischer0s current audit clients are in the healthc healthcare are ser&ic ser&ices es indust industr% r%.. Thus, Thus, the partne partnerr feels feels the engagem engagement ent presen presents ts an e'celle e'cellent nt opportunit% for Barnes and Fischer to enter a ne" mar2et. n the other hand, 2no"ing the ris2s in&ol&ed, the partner, *ane unter, "ants to ma2e sure the client acceptance decision is carefull% considered. 777 cean /anufacturing, )nc. manufactures small- to medium-sized home appliances. The compan% compan%0s 0s product productss includ includee items items li2e li2e toaste toasters, rs, (lender (lenders, s, and trash trash compact compactors ors.. Altho Although ugh cean0s common stoc2 is not pu(licl% traded, the compan% is planning an )P in the ne't fe" %ears in hopes that the% "ill (e a(le to trade the stoc2 on the A85A. ou ha&e (een assigned to gather information in order to ma2e a recommendation on "hether %our firm should accept cean /anufacturing as a client. cean "ants to hire %our firm to issue an opinion on their 5ecem(er 61, +$$:, financial statem statements ents and has e'press e'pressed ed interes interestt in o(tain o(taining ing help help in gettin getting g their their recent recentl% l% instal installed led information technolog% 3)T4 s%stem in (etter shape. The% also "ant %our firm0s ad&ice and guidance on getting e&er%thing in order for the upcoming )P. 5uring the initial meeting "ith
cean0s management, the follo"ing information "as o(tained a(out the industr% and the compan%. The ome Appliances )ndustr% &er the past se&eral %ears, the domestic home appliances industr% has (een gro"ing at a stead%, moderate pace. The industr% consists of a "ide &ariet% of manufacturers 3domestic and foreign4 "ho sell to a large num(er of "holesale and retail outlets. Though responsi&e to technological impro&ements, product mar2eta(ilit% is lin2ed to gro"th in the housing mar2et. ;etail outlets are ser&ed (% (oth "holesale and manufacturer representati&es. cean /anufacturing, )nc. cean0s unaudited 5ecem(er 61, +$$:, financial statements report total assets of <=# million, sales re&enues of <1! million, and net profit of <6.! million. )n the past, the compan% has not attempted to e'pand aggressi&el% or de&elop ne" product lines. ;ather, it has concentrated on maintaining a stead% gro"th rate (% pro&iding relia(le products "ithin a moderate to lo" price range. o"e&er, cean hopes to use the capital from the upcoming )P to aggressi&el% e'pand from a regional to a national mar2et. cean primaril% sells its products in small >uantities to indi&iduall% o"ned appliance stores. &er the last fe" %ears the compan% has (egun to suppl% larger >uantities to three national retail chains. T"o of these larger retailers started (u%ing cean0s products a(out t"o %ears ago. )n order to handle the increased sales, cean significantl% e'panded its manufacturing capacit%. Though sha2en (% recent management turno&er and ongoing difficulties "ith the compan%0s ne" accounting s%stem, management feels that cean is in a position to gro" considera(l%. The% note that earnings ha&e increased su(stantiall% each %ear o&er the past three %ears and that cean0s products ha&e recei&ed increasing acceptance in the small appliance mar2etplace. Three %ears ago the compan% recei&ed a >ualified audit opinion relating to re&enues and recei&a(les. cean has changed auditors three times during the past 1+ %ears. /anagement )n cto(er +$$:, the compan% e'perienced significant management turno&er "hen (oth the &ice president of operations and the controller resigned to ta2e ?o(s in other cities. @ The reason for their lea&ing "as disclosed (% management as (eing related to personal issues.@ A ne" &ice president, *essica ood, "as hired in o&em(er, and the ne" controller ?oined earl% last month. *essica is an /BA "ith almost 1+ %ears of e'perience in the industr%. Theodore *ones, the ne" controller, has little rele&ant e'perience and seems frustrated "ith the compan%0s ne" )T s%stem. The compan% president, Andre" Cole, has a BBA and, as the founder, has "or2ed at all le&els of the (usiness. /r. acher%, "ho is principall% in charge of the compan%0s procurement and manufacturing functions, meets "ee2l% "ith /r. Cole, as does Fran2 8te&ens, "ho has ser&ed as &ice president o&er finance for the past eight %ears. Accounting and Control Systems The compan% s"itched to a ne", integrated computer-
(ased central accounting s%stem in earl% +$$:. This ne" s%stem maintains integrated in&entor%, accounts recei&a(le, accounts pa%a(le, pa%roll, and general ledger soft"are modules. The transition to the ne" s%stem throughout last %ear "as handled mainl% (% the former controller. nfortunatel%, the transition to this s%stem "as not "ell managed, and the compan% is still "or2ing to modif% it to (etter meet compan% needs, to retrain the accounting staff, and to adapt the compan%0s accounting controls to (etter complement the s%stem.
Pro(lems still e'ist in in&entor% trac2ing and cost accumulation, recei&a(les (illing and aging, pa%roll ta' deductions, pa%a(les, and (alance sheet account classifications. The compan% stopped parallel processing the old accounting s%stem in April +$$:. 5uring se&eral (rief periods throughout +$$:, con&entional audit trails "ere not 2ept intact due to s%stem failures and errors made (% untrained personnel. The compan%0s accounting staff and management are frustrated "ith the situation (ecause, among other pro(lems, internal management (udget reports, in&entor% status reports, and recei&a(les (illings are often late and inaccurate, and se&eral shipping deadlines ha&e (een missed. our office has ne&er audited a compan% "ith the specific (rand of )T s%stem in place at cean. o"e&er, %our local office0s )T team is fairl% confident the% "ill (e a(le to diagnose cean0s control "ea2nesses and help cean o&ercome current difficulties. Accounts Receivable, Cash, and Inventories The salesDrecei&a(les s%stem handles a
&olume ranging from +,9$$ to 6,!$$ transactions per month, including sales and pa%ments on account for a(out 1,+$$ acti&e credit customers. The si' largest customers currentl% account for a(out 1E of accounts recei&a(le, "hereas the remainder of the accounts range from <1,$$ to <6+,$$$, "ith an a&erage (alance around <:,$$$. Finished goods in&entories are organized and "ell protected, (ut in-process in&entories appear some"hat less organized. The compan% uses a complicated h%(rid form of process-costing to accumulate in&entor% costs and to account for interdepartmental in-process in&entor% transfers for its four ma?or product lines. Predecessor Auditor hen %ou approached Fran2 8te&ens, cean0s &ice-president of
finance, to re>uest permission to spea2 "ith the pre&ious auditor, he seemed hesitant to discuss much a(out the prior audit firm. e e'plained that, in his opinion, the pre&ious auditor did not understand cean0s (usiness en&ironment &er% "ell and "as not technicall% competent to help the compan% "ith its ne" )T s%stem. e further indicated that the predecessor auditor and cean0s management had disagreed on minor accounting issues during the prior %ear 0s audit. )n /r. 8te&ens0 opinion, the disagreement "as primaril% due to the auditor0s lac2 of understanding of cean0s (usiness and industr% en&ironment. According to /r. 8te&ens, the pre&ious auditor felt that (ecause of the accounting issues, he "ould (e una(le to issue a clean opinion on the financial statements. )n order to recei&e an un>ualified opinion, cean had to record certain ad?ustments to re&enues and recei&a(les. /r. 8te&en (elie&ed the ad?ustments "ere unnecessar% (ut felt forced to ma2e them to recei&e a clean audit opinion. /r. 8te&ens noted that cean0s management feels confident that %our firm0s personnel possess (etter (usiness ?udgment s2ills and ha&e the 2no"ledge and a(ilit% to understand and help impro&e cean0s )T s%stem. /r. 8te&ens also indicated that cean "ants to s"itch auditors at this time to prepare for the upcoming )P, noting that companies often s"itch to larger accounting firms "ith national reputations in preparation for going pu(lic. our firm has (een highl% recommended to him (% a friend "ho is an administrator of a hospital audited (% Barnes and Fischer. After some discussion (et"een /r. 8te&ens and /r. Cole, cean0s president, %ou are granted permission to contact the pre&ious auditor.
5uring %our &isit "ith the pre&ious auditor, he indicated that the pro(lems his firm had "ith cean primaril% related to 314 the comple'ities and pro(lems "ith cean0s ne" )T s%stem and 3+4 management0s tendenc% to aggressi&el% reflect %ear-end accruals and re&enue in order to meet creditors0 re>uirements. The auditor also disclosed that the dissolution of the relationship "ith cean "as a mutual agreement (et"een the t"o parties and that his firm0s relationship "ith management had (een some"hat difficult almost from the (eginning. Apparentl% the final stra" that (ro2e the relationship in&ol&ed a disagreement o&er the fee for the upcoming audit. Client Background Check A chec2 on the (ac2ground of cean0s management re&ealed
that fi&e %ears ago cean0s &ice-president of finance "as charged "ith a misdemeanor in&ol&ing illegal gam(ling on local college foot(all games. According to the ne"s reports, charges "ere later dropped in return for /r. 8te&ens0 agreeing to pa% a fine of <$$ and perform 1$$ hours of communit% ser&ice. The (ac2ground chec2 re&ealed no other legal or ethical pro(lems "ith an% other cean e'ecuti&es. Independence Review As part of Barnes and Fischer0s >ualit% control program, e&er% three
months each emplo%ee of Barnes and Fischer is re>uired to file "ith the firm an updated disclosure of their personal stoc2 in&estments. ou as2 a staff auditor to re&ie" the disclosures as part of the process of considering cean as a potential client. 8he reports to %ou that there appears to (e no stoc2 o"nership issue e'cept that a partner in Barnes and Fischer0s 8alt La2e Cit% office o"ns shares in a &enture capital fund that in turn holds in&estments in cean common stoc2. The &enture capital fund holds $,$$$ shares of cean stoc2, currentl% &alued at appro'imatel% <1: a share. This in&estment represents ?ust o&er a half of one percent of the &alue of the fund0s total holdings. The partner0s total in&estment in the mutual fund is currentl% &alued at a(out <#,$$$. Financial Statements ou ha&e ac>uired the past three %ears0 financial statements from
cean, including the unaudited statements for the most recent %ear ended 5ecem(er 61, +$$:. This financial information is pro&ided on the pages that follo". The partner "ho "ill (e in charge of the cean engagement, *ane unter, "ants %ou to loo2 them o&er to see "hat information %ou can dra" from them, pa%ing particular attention to items that might (e helpful in determining "hether or not to accept cean as a ne" audit client.