Ocean Manufacturing

Ocean Manufacturing

Case 1. 1 – Client Acceptance Question # 1: Identify 5 procedures an auditor should perform in determining whether to accept a client. Which of these five are required by the auditing standards? a. (AU 314) The auditor should obtain an understanding of the entity and its environment in the following areas: i. Client’s application of accounting policies ii. The industry, regulation and other factors affecting the client iii. Client’s objectives , strategies, and related business risks iv.

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Methods used by the client to measure and review performance v. The client’s internal control The second standard of fieldwork requires that the auditor obtain a sufficient understanding of the entity and its environment, including internal control, in order to assess the risk of material misstatements. The auditor should assess the inherent risk factors about the client by learning about the industry, regulations, etc as listed above. The auditor should also try to assess the control risk factors. Were transactions subject to management override?

If they were, then internal controls are less effective. Thus, internal control is less reliable and internal control should be high. Further, it may take more work to reduce the audit risk to an acceptable level. b. (AU 315. 09) The successor auditor should make specific and reasonable inquiries of the predecessor auditor regarding matters that will assist the successor auditor in determining whether to accept the engagement. vi. Management integrity. vii. Disagreements with management and prior auditors. viii. Communications to audit committees. ix.

Reasons for the change of auditors. Material errors and irregularities are more likely to exist when the management is dishonest. The auditors are required to document their communication to the prior auditors. c. Proper supervision and assess competence to perform the audit. x. The CPA firm must assess its ability to perform the audit. xi. It must assign proper staff and provide supervision. xii. It should identify if third-party professional help is needed. xiii. It should evaluate whether the engagement is a good fit for the CPA firm’s expertise.

The first general standard requires that the audit be performed by a person or persons having adequate technical training and proficiency as an auditor. The second one states that the engagement shell be performed by a practitioner having adequate knowledge in the subject matter. d. Evaluate independence xiv. Independence in mental attitude is required by the third general standard of GAAS. xv. Do audit (covered) members possess direct or indirect financial interest in the audit client? xvi. Do members, managers or partners have direct relative working in the management position for the audit client? . Audit purpose. xvii. State the character of the engagement as required by auditing standard of reporting. The auditor should consider whether the client has had its financial statements audited before, which would typically carry lower audit risk versus a client, which has never had its financial statements audited that carries a higher audit risk. Engagement letter would provide mutual understanding and divide responsibility of the auditors and the management. It states the purpose of audit, what needs to be audited and timing of the audit.

The auditor preferably in writing should communicate clearly to the client about the objective of the engagement before accepting to do the work and have the client accept the terms set forward. Question # 2: Calculate relevant preliminary analytical procedures to obtain a better understanding of the prospective client and to determine how Ocean is doing financially. Compare with industry ratio provided. Identify any major differences and briefly list any concerns that arise from this analysis. | 2011|  | 2010| | Ocean| Industry|  | Ocean| Industry|

Return of Equity| 8. 94%| 20. 33%|  | 7. 11%| 26. 22%| Return on Assets| 4. 54%| 6. 62%|  | 3. 78%| 8. 10%| Assets to Equity| 1. 97| 3. 3|  | 1. 88| 2. 82| AR Turnover| 10. 27| 7. 49|  | 9. 82| 6. 96| Average Collection Period| 35. 55| 41. 25|  | 37. 15| 44. 35| Inventory Turnover| 9. 22| 8. 09|  | 6. 79| 6. 9| Days in Inventory| 39. 59| 38. 16|  | 53. 79| 43. 86| Debt to Equity| 0. 97| 2. 38|  | 0. 88| 1. 9| Times Interest Earned| 2. 26| 1. 62|  | 2. 04| 2. 37| Current Ratio| 1. 85| 1. 29|  | 1. 92| 1. 44| Profit Margin| 2. 39%| 10. 58%|  | 2. 43%| 10. 82%| 1.

Assets to equity ratio for 2011 and 2010 are significantly lower than industry average. An asset to equity ratio less than 2 indicates Ocean uses less debt than equity to finance its assets. 2. Debt to equity ratio is significantly lower than industry average. It indicates Ocean is not heavily leveraged, so it probably uses more conservative financing plan. However, issuing bonds might provide tax break for Ocean. Ocean should reconsider its debt-capital structure. 3. Times interest earned is higher than industry average. It indicates Ocean has the ability to pay its dues when they become mature. . Profit margin for 2011 and 2010 is significantly lower than industry average. Large sales are offset by low net profit, resulting in low profit margin. Ocean is incurring large operating expense, indicating its lack of control over its costs. 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? a. Client’s reputation. Does the client have good reputation in the industry? Is the prospective client the type of client the firm wants to be associated with? b.

The type of business the client operates. The more complex the transaction is, the auditors would need to spend more time in collecting evidence. c. The client’s relationship with previous CPA firm. The successor firm should understand the reason for changing auditors, as well as inquire about any disputes over fees, accounting principles disagreement, management’s integrity. d. Are all accounting records made available to auditors. Incomplete accounting records would constitute a scope limitation. Thus, auditors could only issue qualified or disclaimer opinion, depending on materiality. e.

Type of risks to consider when accepting a client. xviii. Fraud risk xix. Audit risk xx. Business risk xxi. Control risk xxii. Inherent risk Question # 4 a. Advantages and disadvantages of having the same CPA firm provide both auditing and consulting services. Advantages: i. CPA firm will have a better understanding of the company’s operation; therefore can provide advice on improvement that will benefit different levels of operation within the company. ii. Cost savings: the cost for hiring one firm for both services will be cheaper than hiring separate firms for each service. Disadvantages: . Potential violation of Independence Rule. ii. Auditor may not give fair audit over the area they are providing consulting services. Currently, Ocean Manufacturing Inc. is not Publicly Traded, therefore, its Audit and Internal Controls have been more relaxed but still in accordance with PCAOB. Until the IPO occurs, Barnes and Fischer will be able to offer consulting advice, and according to the PCAOB, will be allowed to engineer the IT Control system after the IPO. b. 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? According to Rule 101 of the AICPA Code of Professional Conduct, independence is considered to be impaired if: “During the period of the professional engagement, a partner or professional employee of the firm, his or her immediate family, or any group of such persons acting together owned more than 5 percent of a client’s outstanding equity securities or other ownership interests. ” In our case, the partner in Salt Lake City office total investment in the mutual fund is valued at $56,000.

The mutual fund owns 50,000 shares of Ocean stock, which is only 0. 5% of total outstanding stocks. Ocean stocks is currently valued at $18 per share, which means that the total mutual fund’s investment in Ocean is valued at 50,000 x $18 = $900,000 (which is only 2. 3% of total Ocean shareholders’ equity). Given that no other independence issues were noted (immediate family of the partner do not hold any shares in Ocean), we can conclude that this situation does not constitute a violation of independence according to the AICPA Code of Professional Conduct.

However, Barnes and Fischer should make sure immediate family of the partner do not hold shares in Ocean, and if they do, total holdings does not exceed 5% of Ocean’s outstanding equity, before deciding to accept Ocean as a client. MEMO DATE: August 30, 2011 TO:Jane Hunter, CPA – Partner at Barnes and Fischer, LLP FROM:Lan Tran, Yu Shun Cheng, Alexander Ray – Senior Auditors ————————————————- RE:Ocean Manufacturing, Inc – Client Acceptance Based on the overall analysis we concluded that the potential rewards outweigh the potential problems around Ocean Manufacturing.

Barnes and Fischer, LLP should accept Ocean Manufacturing, Inc. as an audit client. Reasons for acceptance: I. Financial issues: a. Bring more revenue to the company. b. Ocean’s accounts receivable turnover is high relative to the industry, meaning that the company is getting paid fast and effectively for its services to good, reliable clients. II. Nonfinancial issues: c. We have the opportunity to enter a new industry market. There are similar companies in the same industries but are serviced by our competitors. d.

We could acquire of a new promising client with favorable market position and growth potential. e. Ocean is seeking a more nationally established CPA firm because the plans to make an initial public offering of its common stock in a few years. That could secure us to provide the company steady services in the future. f. Ocean has been successful in aggressively expanding from regional to national market, with three recent accounts with large retail chains. Reasons against acceptance: I. Financial issues: ??? II. Nonfinancial issues: a.

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. Charges were later dropped in return for Mr. Stevens’ agreeing to pay a fine of $500 and perform 100 hours of community service. b. Management has a high turnover. Both the vice president of operations and the controller resigned to take on jobs in other cities. That resulted in new management with not enough relevant experience. c. The company implemented a new central accounting system.

The transition from the old system was not well managed. The new management is still modifying the system and training the accounting staff to adapt to it. d. There were frequent changes in three auditors in the past 12 years. There are appears to be some disagreements with the most recent auditor. Recommendations: 1. Evaluate the problems the predecessor auditor indicated with Ocean. Understanding should be reached prior to beginning the engagement. 2. Negotiate the fee for the audit service since there was a disagreement with the predecessor. 3.

Seek references from others than just the predecessor auditor about Ocean Manufacturer. Thus, any bias toward the client would be diminished. 4. Investigate further why the company’s management would be interested in increasing equity through public offering when the company would be better off borrowing money. 5. Consider the use of specialist with the new IT accounting system in place. MEMO DATE: August 30, 2011 TO:Jane Hunter, CPA – Partner at Barnes and Fischer, LLP FROM:Lan Tran, Yu Shun Cheng, Alexander Ray – Senior Auditors ————————————————-

RE:Ocean Manufacturing, Inc – Client Acceptance We concluded there were six most important factors or risk areas that would likely affect how the audit was conducted if the Ocean engagement were accepted. 1. The company is under levered. Aggressive accounting practices with year-end accruals in order to meet creditors’ requirements. 2. The company is not getting loans in the market because of disrepute not known to us. It plans to initiate a public offering in the near future. 3. There might be integrity issues related to the vice- president involved in gambling but kept underground and secret.

The Barnes and Fischer should be vigilant on the activities of the main executives of Ocean. 4. The percentage of profit earned by the company is lower than the industry norm. Barnes and Fischer should keep a close watch on the profit margin of the company and in case of anomalistic behavior should mention it in the auditor’s report. 5. New software development and problems still exist in inventory tracking and cost accumulation, receivable billing and aging, payroll tax deductions, payables, and balance sheet account classifications. 6. Conventional audit trails were not kept due to system failures and errors made by untrained personnel.


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