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The recent management turnover issue in the company Ocean could pose certain potential problems to the audit. This is because the happening of management turnover may due to the internal frauds committed by the president of operations or the controller. It could also because the controller's inability in handling the new accounting system. However, this issue remains unclear since the reason for their leaving was disclosed as being related to "personal issues". In addition, whether or not to resign, the two management individuals would also have to depend on how the company evaluate their performance in terms of the ownership concentration.
In this case, there are some indications that the management is willing to manipulate the financial statements via year-end accruals and revenue recognition to achieve relatively low interest rates from creditors. Some potential management integrity issues would be raised and these issues should be looked into carefully in the fact that the management may have given greater incentive for the resigned controller to manipulate the system in order to produce healthy financial statements. This issue could further affect the upcoming IPO which it may give the management even greater incentive to manipulate the financial statements.
On the other hand, the resignation of the controller is then lead to problems with the company's new accounting system. The new controller who has relatively little experience, may slower down the process of audit work as he is facing difficulties in handling the system. Furthermore, the complicated new computer system would also causes problems to the auditors. The auditors may have a hard time retrieving the important information from the system and their auditability would be questioned. Perhaps, the amount of substantial testing would be required as there are inadequate controls over the new system.
Due to the difficulties faced in the new accounting system, many auditors would prefer not to work for the company because they did not have a sound understanding of Ocean's business and was not competent in helping Ocean with its new IT system. This could be one of the reasons why the company has a high auditor turnover rate. However, personality issues can also play a role in this case. The auditors should look into why Ocean has employed so many different auditors in such a few years and the company's negative relationship with the predecessor auditor is also a concern.
This concern is related to the hesitance of the clients to allow new auditor to speak with the previous auditor. This issue should be highly concerned by the successor auditor and a careful examination of the issue, including careful consideration of management integrity, should ensue. Furthermore, the apparent differences over the current year's audit fee should be a concern to Barnes and Fischer.
The illegal gambling incident is a matter of concern as it raises the management integrity issue. What the vice president of finance did was definitely wrong, but the impact on the overall integrity of management is a matter of judgment. However, this issue can remain being debated. On one hand, a management individual is likely said to be dishonest in others if he dishonest in one thing (in this case illegal gambling). However, on the other hand, since there are no other known incidents, then the incident mentioned above would have little to do with the business and its management. At a minimum, this factor creates an opportunity to raise and discuss the central role of management integrity in the client acceptance decision.
Despite all the issues mentioned above, accepting Ocean would also create the opportunity for the audit firm to expand into a new industry provide significant consulting services relating to Ocean's new IT system as well as to Ocean's internal controls. The company is a pretty stable and well-established in the small appliances industry. It is also well positioned in the small appliances market.
Furthermore, if the Ocean's plan of going public and aggressively expand into national market is successful, Ocean will then become a larger and more attractive client for Barnes and Fisher. But of course this would also pose certain level of risks to the auditors' business. These risks may include the reliance of the audit firm as well as litigation risks. However, in the business world today, there is no prospective client who comes without some concerns and problems. Ocean certainly presents some issues and concerns, but would like be accepted by most of the accounting firms.
Barnes and Fischer, LLP
20th January 2009
To: The Partner**
From: Audit Manager
Subject: Acceptance of Ocean Manufacturing, Inc as Audit Client
The purpose of this memorandum is to provide an overview of certain considerations concerning the acceptance of Ocean Manufacturing, Inc as our audit client. After looking into the various checks and considerations carried out in Ocean, in my opinion, we should accept Ocean as our client. In the real world today, it is very common to find that firms are involved in certain internal and external issues as well as engaged in business risks. However, it is also very important for us to have a clear and better understanding of Oceans business and the industry environment.
The various checks and considerations carried out in Ocean include:
The Business Risk of Ocean Manufacturing
The management was prone to engage in speculative ventures and accept abnormally high risks. The management is engaging in complex transactions or innovative deals that make the determination of the effect on the financial statements highly subjective and hard to assess. For instance, the company's new accounting system is complex and undergoing modifications which resulted in problems of inventory tracking, late and inaccurate billings. All of these negative issues were seemed evasive and uncooperative to the audit team of Barnes and Fischer. Furthermore, the management has been reluctance to introduce us to its previous auditors. In this part, I will include both risks existing in the company itself and within the industry.
The Entity Itself
Ocean has launched certain new products few years ago. Although Ocean's new products has increasingly received acceptance in the small market appliances, the products that are still consider new and not known in the national market. Therefore, Ocean can only depend on a limited number of customers. For example, the company only started to supply large quantities of products to two large retail chains two years ago. No one can predict what is going to happen to it if these retail chains are to stop buying from Ocean.
During year 2007, Ocean has been experiencing liquidity crisis. Although it is in recovery process, it is still subjected to any uncertainties that could raise substantial doubt about its ability to continue the business as an ongoing concern. The financial statements of Ocean showed us that the company is currently has inadequate capital base and this caused the company to be highly leveraged. This may further cause the company to face difficulties in meeting its debts. Meanwhile, Ocean is investing cash from short-term borrowings in long-term assets. In addition, Ocean has publicly traded debt outstanding which is below the investment grade. This was found when a staff auditor reported that a partner owns Ocean common stock which possibly overvalued.
The Manufacturing Industry
The emerging and maturing manufacturing industry is undergoing going rapid change. Ocean is a low tier firm in an emerging or maturing manufacturing industry where weak competitors are exiting the market. If Ocean proceeds further in the industry, it may be subjected to high competition, market saturation, product obsolescence or even declining demand due to oversupply by the firms within the industry. It is also subjected to unpredictable changes in price and availability of product inputs that cause significant variance in profitability. Besides, it is also vulnerable to rapid changing technology. Therefore, the market for manufacturing is highly cyclical and this could pose certain risks to Ocean to further expand in the industry. Ocean is also possibly facing government regulations that will adversely impact on its profitability throughout the industry. The trends mentioned above are some of the consideration. However, it is also possible that not all of these trends are present currently.
Barnes and Fischer's Business Risk
There are certain business risks we may face if we accept Ocean as our client. Ocean is prone to a high number of lawsuits or controversies. For example, there a frequent changes in the entity's auditors. Ocean has changed auditors three times over the past 12 years. In addition, Ocean planned to engage initial public offering or in other words, it is trying to use the company's financial statements to engage in a debt equity offering. Consequently, the financial statements will be used in connection with an acquisition or disposal of a business segment.
Despite all these issues, accepting Ocean would create the opportunity for the audit firm to expand into a new industry provide significant consulting services relating to Ocean's new IT system as well as to Ocean's internal controls. If the Ocean's plan of going public and aggressively expand into national market is successful, Ocean will then become a larger and more attractive client for Barnes and Fisher. However, in the business world today, there is no prospective client who comes without some concerns and problems. Ocean certainly presents some issues and concerns, but would likely be accepted by most of the accounting firms.