Ocean Manufacturing Inc.

Case Study
Question 1:
The client acceptance process can be rather complex. Identify five procedures
an auditor should perform in determining whether to accept a client. Which of
these five are required by auditing standards?

Answer:
Before accepting a new client, an auditor should establish reasonable
procedures to ascertain whether to accept a new engagement or not. First of
all, an auditor must determine the independence with potential client and
assess his own abilities to provide satisfactory services to prospective client.
The auditor should obtain background information about client’s business and
try to contact the departing auditor to discuss the relevant information. A new
client should only be accepted if auditor has necessary skills and expertise to
provide competent services.
After that, the auditor should also assess the integrity of management or
those charged with governance. The auditor should also consider any risks
identified with future client. The other factors that auditor needs to take into
his account include reputation of the potential client, professional clearance of
the client, fees, risk, resources and preconditions of an audit in accordance
with ISA 210 Terms of Engagement. Followings are some specific procedures
that are required by relevant auditing standards:
 Appraise the integrity of client management and those charged with
governance
 Communicate with outgoing auditor and obtain background information
including any disagreements between outgoing auditor and client
management on auditing or accounting issues.
 Assessing whether management imposes a limitation on the scope of
the auditor's work [ISA 210, 7]
 Evaluate independence and his skills and experience to accomplish this
audit competently
 Acquire an agreement that there is common understanding between the
auditor and management or those charged with governance [ISA 210, 3]
Question 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.

Answer:
To determine how Ocean Manufacturing Inc, is doing financially, we need to
calculate some ratios based on data from financial statements of year ended
December 31, 2009-2011. Some ratios can be calculated to aid the
interpretation of the financial statements. The followings are some ratios
calculated:
2009 2010 2011
Profitability Ratios:
Return on Assets (Net Profit/ Total Assets) x 100 4.55% 3.80% 3.42%
Return on Equity (Net Income/ Total Equity) x 100 8.89% 7.09% 6.30%
Profit margin (Operating Profit/ Sales Revenue). 5.51% 6.09% 4.81%
Liquidity Ratios:
Current ratio (current assets/ current Liabilities). 1.86 1.91 1.70
Receivables Turnover (Credit sales/ Receivables). 11.71 13.09 13.99
Inventory Turnover (Cost of Sales/ Inventory). 6.10 4.49 3.51
Receivables Days (Receivables/Sales) *365 32 28 26
Inventory Turnover Days (Inventory/COS) *365 60 81 105
Gearing Ratio:
Debt to Equity (Long-term loan/ Total Capital). 0.98 0.87 0.84

*some industry ratios for comparison are taken below

Industry Ratios for Comparison:
2010 2011
Return on Assets 6.62% 8.01%
Return on Equity 20.23% 26.3%
Current ratio 1.29 1.4
Asset to Equity 3.33 2.8
Receivable Turnover 7.4 6.97
Receivables Period 41.2 44.5
Debt to Equity 2.3 1.09
Inventory Period 38.1 43.6
Profit Margins 10.85% 10.28%

When comparing the calculated ratios of Ocean Inc. with industry ratios, a key
difference can be seen:
a. Return on assets appears only half as compared to industry averages.
From this we can interpret that management of Ocean Inc. has not
performed well when turning the assets into income.
b. Ocean Inc. also have very low Return on Equity comparative to industry
averages.
c. Profit margin of Ocean Inc. is also very low than industry ratio average.
d. Current ratio and receivable turnover are higher than industry norms.
This indicates that Ocean Inc. is manging short term assets efficiently by
collecting funds from credit customers on time.
e. Ocean Inc. has very low debt to equity ratio relative to industry because
they have low equity in comparison to liabilities. Hence, Ocean Inc. has
managed its long-term liabilities effectively.
Question 3:
What nonfinancial matters should be considered before accepting Ocean as a
client? How important are these issues to the client acceptance decision?
Why?

Answer:
When accepting a new client, an auditor must perform some reasonable
procedures as discussed earlier in question 1. There are some non-financial
matters relating to Ocean Inc. that must be considered before acceptance
decision. Following matters are very significant:
 One major matter is its high auditor turnover. Many auditors have
audited this organization in recent few years and this is not a right
emblem. The auditor should investigate the reason for this matter and
obtain sufficient evidence to reach conclusion.
 Client management is hesitant to allow the new auditor communicate
the outgoing auditor. This is a red signal to new auditor and should be
investigated.
 Ocean Inc. management has new controller which may or may not be a
problem. As he has little expertise and exposure of this job, which may
make this job difficult and slower the audit process.
 New IT system seems very complicated, this may make difficult for
auditors to obtain required information from the system. This could slow
down the auditor work and substantive testing will be required for new
IT system.
 Illegal gambling incident by Mr. Stevens is matter of serious concern as
he still represents the company. This raises an issue over management
integrity making it not trustworthy any longer or very less trustworthy.
 Ocean Inc. also have plans for initial public offering into national market.
If these plans are successful, this will make Ocean Inc. more attractive
client but at same time this increases business risk for auditor. So, these
factors should also be taken into account.
Question 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.

Answer:
The issue of offering both auditing and consulting services by CPA firm to the
same client is matter of substantial discussion for a long-time. The advantage
of providing these services to same client is that CPA firm already has deep
background knowledge and all relevant information of the business. There will
be cost and time savings for both client and firm. So, there will efficiency
gained as result of providing these services to same client.
The disadvantage of providing these services to same client is that it might
imposes a threat to objectivity of auditor. Firm should not provide these
services if objectivity is impaired however, if objectivity issue is dealt with, the
efficiencies gained overshadows any possible costs.
As Ocean Inc. is private organization rather than public organization, it falls
under American Institute of Certified public Accountants (AICPA) code of
conduct. under AICPA code of professional conduct, Barnes and Fischer can
deliver auditing services and also assist the Ocean Inc with implementing the
new IT system but cannot design the new IT system. These independence
requirements are also in line with ISA 200 about independence of auditor.

Question 4(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?
Answer:
The direct financial interest of an auditor is not tolerable in accordance with
Rule 101 of AICPA code of conduct. So, it is not permissible to hold direct
financial interest in client but it is permissible to hold indirect financial interest
in client under AICPA code. In this case of venture capital investment, there is
no direct financial interest although materiality needs to be considered. If
interest in Ocean Inc. is indirect and immaterial, there will be no violation of
independence of auditor of AICPA code (Rule 101).

Question 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.

Answer:
As client acceptance decision is matter of professional judgement and is very
subjective. In my opinion, I would recommend that Ocean Manufacturing Inc.
should not be accepted as a client of Barnes and Fischer. The Ocean Inc. deals
with many issues concerning the new IT system. This may lead to additional
substantive testing and other audit work. Recently vice president of Ocean Inc.
Mr. Steven is tangled in illegal gambling incident. The Ocean Inc. has changed
auditors many times in recent years which is matter of serious concern. The
new Controller of Ocean Inc. might create some problems because of lack of
experience.
There are some potential advantages of taking Ocean Inc. as a client of Barnes
and Fischer. By accepting this client, we can grow into new market and can
expand our services by offering the audit and consultation services. Ocean Inc.
has growth potential and plans an initial public offering in next two years
making us a listed firm in the future. However, these potential advantages do
not outweigh the potential disadvantages listed above.
Question 5(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.

Answer:
The following risk areas are of major significance when Barnes and Fischer
audits Ocean Inc.:
 The newly implemented IT system does not work well, so financial
statements figures are subjected to high risk of manipulation. The
auditor needs to gather additional evidence to support his conclusions.
 The new controller appointed by Ocean Inc. might require additional
audit checks by the auditor.
 The risk of material misstatements is very high in inventory tracking,
invoicing, payments and receipts because new IT system is not working
properly. More test of details and substantive testing will be required in
this area.
 As Ocean Inc. has high growth potential, this might cause its activities
and business process to change. So, its internal controls need to be
updated accordingly.
 Although receivable turnover is good, but appears to be worsening. It
recommends that auditor should pay more consideration to valuation of
receivables. Thus, more substantive procedures and test of details will
be required in this area.

References:
 AU 210 Terms of Engagement
 AU 300 Planning an Audit
 ISA 210 Terms of Engagement [ Section 3,7]
 AU 510 Opening Balances
 Initial Audit Engagements, ET Section 101 Independence, AICPA
 Initial Audit Engagements, ET Section 301 Confidential Client
Information.