Ocean Manufacturing: Standards; Analytical Ratios; Financial Statement Audit

CASE Study:

Ocean Manufacturing, Inc.

The New-Client Acceptance Decision

INTRODUCTION

The accounting firm of Barnes and Fischer, LLP, is a medium-sized, CPA
firm. The partnership, formed in 1954, now has over 6000 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.

It is mid-January 2003, 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, is a
medium-sized manufacturer of small home appliances. The partner
recently met the company’s president at a local chamber of commerce
meeting. He 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 favourable 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 is intrigued with the idea of having a client in the home
appliance industry, especially one with the favourable 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, Jane Hunter, wants to make sure the
client acceptance decision is carefully considered.

BACKGROUND ABOUT OCEAN MANUFACTURING

Ocean Manufacturing, Inc. manufactures small- to medium-sized home
appliances. 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 the stock on the stock market. 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,
2002 financial statements and has expressed interest in obtaining help
in getting their recently installed information technology (IT) system
in better shape. They 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, moderate 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, 2002 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. The company’s products include items like toasters,
blenders, and trash compactors.

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. They note 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 2002, 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, Jack Zachery, was hired in November, and the new
controller joined early last month. Jack 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 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 2002. 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 new 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 2002. During several
brief periods throughout 2002, 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 V.P. 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 previous auditor felt 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
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 vice president of finance was charged with a
misdemeanour 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 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.

Financial Statements

You acquired the past three years’ financial statements from Ocean,
including the unaudited statements for the most recent year ended
December 31, 2002. This financial information is provided on the pages
that follow. The partner who will be in charge of the Ocean engagement
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.

Ocean Manufacturing, Inc.

Balance Sheets as of December 31, 2000-2002

(in Thousands)

ASSETS

(Unaudited)



2002 2001 2000

CURRENT ASSETS



Cash $3,008 $2,171 $1,692

Accounts receivable(net of allowance for doubtful debts) 12,434 7,936
6,621

Raw & in-process inventories 11,907 10,487 10,685

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 27,920





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 61,114



Ocean Manufacturing, Inc.

Balance Sheets as of December 31, 2000-2002

(in Thousands)

LIABILITIES AND SHAREHOLDERS’ EQUITY

(Unaudited)



2002 2001 2000

CURRENT LIABILITIES



Accounts payable and accrued expenses $12,284 $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 17,556 14,118 16,491





LONG TERM DEBT 20,000 17,234 11,675





TOTAL LIABILITIES 37,556 31,352 28,166





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 profits 22,773 19,406 16,885

Total Shareholders’ Equity 38,836 35,469 32,948





TOTAL LIABILITIES AND EQUITY $76,392 $66,821 $61,114







Ocean Manufacturing, Inc.

Profit and Loss Statement for Years Ended December 31, 2000-2002

(in Thousands)

(Unaudited)



2002 2001 2000

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 1,474 699

Provision for income taxes 2,821 2,247 1,595

Net Profits $3,472 $2,521 $2,070



Ocean Manufacturing, Inc.

Statement of Retained Profits as of December 31, 2000-2002

(in Thousands)

(Unaudited)



2002 2001 2000

Balance, beginning of year $19,406 $16,885 $14,815

Cash dividends paid (105) 0 0

Net profit for year 3,472 2,521 2,070





Balance, end of year $22,773 $19,406 $16,885



Industry Ratios for Comparison:

2002 2001

Return on Equity (ROE=Net profit after tax /Total Shareholders’ Equity
* 100) 22.10% 28.50%

Return on Assets (ROA=Net profit after tax / Total Assets * 100) 7.20%
8.80%

Assets to Equity (Total Assets / Total Shareholders’ Equity) 3.59 3.06

Accounts Receivable Turnover (Sales / Account receivable) 8.14 7.57

Average Collection Period (Account receivable / Sales * 365) 44.84 48.21

Inventory Turnover (Cost of sales / Inventory) 8.8 7.5

Days in Inventory (Inventory / Cost of sales * 365) 41.48 47.67

Debt Ratio (Total Liabilities / Total Assets)



Debt to Equity (Total Liabilities / Total Shareholders’ Equity) 2.58
2.06

Times Interest Earned (Profit before interest and tax / Interest
expense) 1.5 2.2

Current Ratio (Current assets / Current liabilities) 1.2 1.3

Profit Margin (Net Profit before interest and tax / Sales * 100) 9.80%
10.00%



REQUIREMENTS:

1. The client acceptance process can be quite complex. Discuss five
procedures an auditor should perform in determining whether to accept a
client. Which of these five are required by auditing standards and
identify the applicable standards?

2. Using Ocean’s financial information, calculate relevant preliminary
analytical ratios 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.

3. What non-financial 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 audit firm provide both auditing and consulting services?
Given current rules on professional independence in the Joint Code of
Professional Conduct, will Barnes and Fischer be able to help Ocean with
their IT system and still provide a financial statement audit?

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 Joint 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
non-financial issues to justify your recommendation. (

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.



(Case Study adapted from Beasley, M et al. 2003, Auditing cases- an
interactive learning approach, 2nd edn, Pearson Education, New Jersey.)