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.

MEMORANDUM
To: Jane Hunter
From: EG

Date: October 15, 2018

Subject: Ocean Manufacturing Inc. audit engagement acceptance

Ocean Manufacturing, a medium-sized manufacturer of small home appliances, is our

prospective client. First, we should decide whether to accept this client. The purpose is to
minimize the likelihood that Ocean’s management will act in a similar way as with the
predecessor auditing firm(s). Ocean’s management could question our auditors’competence and
we should ensure that all accesses will be granted by them to their new and complex IT system.
The auditing fee might also be an issue, since the engagement partner at the predecessor firm has
encountered these issues with Ocean’s management in the past.

In order to come to a conclusion to accept the audit of Ocean, my team and myself have
conducted the following preliminary analytical procedures:

1. Obtained and reviewed client financial information such as annual reports and income tax
returns:
2. Evaluated the integrity of client management
3. Communicated with the predecessor auditor, about management integrity and any disagreements
about accounting or auditing issues they may have had (after receiving permission from the client)
4. Determined the independence of our firm with respect to the client.
5. Inquired of third parties about the client (banks, attorneys, credit agencies, etc.).
6. Have taken various steps to obtain an understanding of the client and its industry (e.g., on-site tour,
reviewing industry publications), and determined if our firm has or can reasonably expect to obtain
the technical skills and industry knowledge needed to perform the audit properly.
7. Considered whether the client has any unusual or special circumstances that will require special
attention by our firm. Also considered whether issues such as litigation or going-concern problems
exist for the client.
8. Performed preliminary analytical procedures to obtain an understanding of the prospective client
and its industry.
Some major differences to be noted are:

a) Ocean has a low return on equity relative to the industry.

b) Ocean has a low return on assets relative to the industry.
c) Ocean’s accounts receivable turnover is high relative to the industry.
d) Ocean’s inventory turnover is low relative to the industry.
 e) Ocean’s profit margin is low relative to the industry.
There are many issues that would have potentially important implications for conducting the
audit. I have listed below some of the more important implications:
a) As a result of Ocean’s recent IT implementation, some audit trails have not been
successfully maintained. We would need to determine how to gain comfort on the
items for which traditional audit trails were not maintained. Depending on the nature
of the items, we may be able to gather evidence by backing in to the missing
periods using the data from before and after the breakdown of the trails. Additionally,
analytical procedures to test for reasonableness may become more important due to the
audit trail breakdowns.
b) As a result of Ocean’s recent IT implementation, risk of material misstatement is
high in inventory tracking and cost accumulation, receivables billing and aging, payroll
deductions, payables balances, and balance sheet account classifications. Applicable
procedures with fairly large sample sizes will probably play an important role in these
areas, with particular weight on tests of specifics of balances.
c) Internal controls appear to be lacking. Consequently, we will likely have to rely heavily
on substantive procedures. This will in turn have implications for staffing budgets and
the cost of the audit.
d) Several interesting trends should be noted in the ratios. Accounts Receivable turnover, while
relatively good, is deteriorating. This suggests that we may want to pay special attention to the
valuation of receivables. Inventory turnover, while still poor relative to the industry, has
improved dramatically over the past three years. This could be due to more effective inventory
management, but may also be due to misstatements in the inventory account. This
suggests that we may want to emphasize the completeness, valuation, and accuracy
objectives for inventory. Since the client is a manufacturer with relatively large inventory
balances, the audit of inventory will be a major focus of the audit.
e) Ocean’s profit margin percentage and return on equity are low relative to the industry.
Our auditors should identify and corroborate a viable explanation. These factors are
likely related to Ocean’s cost structure or the competitiveness of Ocean’s region or
product set. However, the issue is worth investigating as these ratios may be seen as red
flags for fraud risk.
f) The predecessor auditor indicated that Ocean’s management tended to become aggressive
in the treatment of accruals and revenue recognition toward the year-end. This is clearly
an area where we will want to focus a great deal of attention, increasing the
extent of cut-off tests, reasonableness of accruals, etc. Frequent material fourth-quarter
adjustments are also considered a red flag for fraud, so the audit program should probably
consider a heightened risk of fraud, in accordance with auditing standards.
g) Since we would take on the audit subsequent to year-end, some cut-off and inventory issues
arise. For ending inventory in particular, we will either have to rely on the work of the
predecessor auditor (if the predecessor observed the client’s ending inventory procedures) or
gain comfort by “backing into” the ending inventory balance via alternative procedures, such as
roll-backs and tests of transactions.

Since the predecessor auditor indicated that there had been some disagreement over the
proposed audit fee, we can refer to the fee in the engagement letter before all the auditing work
begin.
I am inclined to recommend accepting Ocean Manufacturing Inc. as a new client.
We don’t have a client in the home appliance industry and the industry has been growing at a
steady peace. Therefore, the engagement will be a great opportunity for our company to enter a
new market. According to the financial reports, we can get some information: On December 31,
2011, the financial report indicates a net profit of $3.4 million and the net earnings are increasing
steadily from 2009 to 2011, which means the company has potential to some extent. With respect
to the issue of providing both IT systems consulting and auditing services to Ocean, the company
being privately held it meets AICPA independence requirements, as long as we assist them in
implementing their computer software package, not designing it, hence it should not have impair
our objectivity, and the efficiencies gained would outweigh the potential costs, and by providing
both kinds of services our firm would have a better understanding of the potential client and its
information system.

Last but not least, Ocean’s management and our firm must come to an agreement on the various
issues that I listedabove, and, we should ensure cooperation of their personnel and determine the
anticipated audit start and end dates, and an estimated audit fee.

Looking forward to your reply,

Sincerily,

EG
Senior Auditor

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.

Memorandum

To: Jane Hunter, Audit Partner

From: EG
Date: October 18, 2018
Subject: Audit Engagement Acceptance of Ocean Manufacturing, Inc.

I am writing this memorandum to inform you of my recommendation as to whether to accept the

audit engagement of Ocean Manufacturing, Inc. or decline. The argument below elaborates about
the use of client acceptance factors significant in arriving at my conclusion. It is my
recommendation to not accept Ocean Manufacturing, Inc. (Ocean) as an audit client based on the
significant client acceptance factors in conjunction with the analysis of both financial
information and nonfinancial matters.

Relevant Facts :
 Ocean Manufacturing, Inc. will be Barnes and Fisher’s first home appliance industry client.
 Ocean asked Barnes and Fisher to assist in continuing the development of Ocean’s IT
system.
 Ocean is having issues maintaining a proper inventory and cost tracking system,
receivables billing and aging, payroll tax deduction, payables, and balance sheet account
classifications.
 Barnes and Fisher is unfamiliar with Ocean’s IT system.
 Ocean is requesting the firm’s services after its December 31 fiscal year –end.
 Ocean has had some management turn over by both the vice president of operations and
controller due to “personal issues.”
 Ocean has changed auditing firms three times over the past 12 years. Ocean audit trails
during 2014 were not kept intact due to system failures and errors made by untrained
personnel.
 The new vice president of finance, Frank Stevens was charged with a misdemeanor
involving illegal gambling on local college football games.
 Frank Stevens, Ocean’s vice president of finance, was hesitant to allow us to speak to the
previous auditor.
 The previous auditor and Ocean’s management had disagreements on minor accounting
issues in the previous
To the partner of Barnes and Fischer

Subject: 5-6 most important factors/risk areas affecting B&F‘s audit engagement if accepted

In my opinion Barnes and Fischer should not accept Ocean Manufacturing, Inc., because the
risks associated with this client outweigh the benefits of accepting the engagement. I feel as
though, after a conducting a thorough investigation on Ocean, accepting the client would
elevate our engagement risk which could ultimately harm our firm.

The risks associated with this client include: Ocean Manufacturing has had problems with their
auditors. Over the past 12 years Ocean Manufacturing switched auditors three times and had
problems agreeing on auditing fees.
The previous auditor had two major problems with Ocean: Ocean’s complex IT system and
managements’ tendency to aggressively reflect year-end accruals and revenue in order to meet
creditor requirements.

In addition, there have been many problems with tracking and recording transactions that occur
within the entity. All of these risk factors can lead to known or likely material misstatements
being present within the company’s financials, and ultimately they have the potential to cause
engagement complications.

Judging from the past, if we ask Ocean to change or alter any aspects regarding their business, it
is likely they will drop our firm’s services and search for another auditor.

There have also been problems related to Ocean’s management: The previousController, who
poorly managed the company’s IT system, resigned from the company; the present Controller
lacks the experience the company needs; and the Vice-President of the company was charged
with a misdemeanor and was involved with illegal activity. Not to mention, Ocean’s President
was hesitant in letting our firm communicate with the previous auditor.