Procedures Auditors Must Perform before Accepting a Client

There are many procedures auditors must perform before accepting a client. The first procedure is to evaluate Ocean Manufacturing’s management. The reason the auditors must do this is because a management without integrity will make it tougher for the auditors to do their job and the audit risk increases. The auditors will not be able to perform sufficient work to compensate for the increased audit risk when the client’s management lacks integrity. Since no major issues where discovered besides the vice president’s old gambling habits, it is safe to assume the management has sufficient integrity. The second procedure is to talk with the previous auditor by asking for client’s permission to talk about confidential information with them. In the conversation with the previous auditors, the current auditors will need to talk about the client’s integrity, any issues they faced with the client and why their relationship dissolved with the client. It was discovered that one of the main reason the relationship dissolved between the previous auditor and Ocean is because of the complexities and problems with the new IT system. Since the current auditors have a confident IT team, this is a reason for accepting the client. Another reason their relationship dissolved was because Ocean wanted to aggressively adjust year end transactions and this could be a point against accepting them because it could mean the client is difficult to work with. The third procedure is to evaluate the independence of the auditors with respect to Ocean’s holding. Since the only independence issue discovered is a partner indirectly holding $2800 and even than not have any control over Ocean’s business, it is safe to assume there is no independence issue. Another procedure that should be done is to get an understanding of the client’s business and the industry it is in. This can be done by on-site tour of its offices and facilities, reviewing the industry publications, and what factors impact the industry and the client’s business. The last procedure that is needed for accepting a client is to determine if the auditors have or can get the technical skills and industry knowledge to perform the audit to standard. These five procedures are all required by auditing standard.

There are many non-financial matters that should be considered before accepting Ocean as a client. The first one is looking into the recent management turnover. If the turnover occurred because they had conflicts within the firm, it could signify other problems in the client’s firm which could increase audit risk. Also because of the recent management turnover, the new controller might not know enough about the firm, its operations, and might not have enough experience to help with the audit which could mean the audit takes longer to complete. Another important matter to look at is the auditor turnover rate. When a client switches many auditors in a short period of time, this is a big red flag for not accepting the client. Barnes and Fischer, LLP, needs to find out why the auditor turnover rate is high. Third matter to look into is the new IT system. The IT system poses many problems like not getting the information they need from the system and if there are even adequate controls over the new system. If the controls are lacking in the IT system, the amount of substantive testing required will increase. Forth matter is the fact that Ocean is planning an IPO. If the IPO does occur, Ocean will be a valued client but since there will be more users of the financial statement, there could be increased legal risk. The reason for the increased legal risk is because now that there are more users of the financial statement, if a user loses money from Ocean, they could come after the auditors. Fifth matter is the relationship with the previous auditors. Since Ocean was reluctant to set up a meeting for the new auditors and the previous auditors, it could raise concerns if Ocean is trying to hide something. Since the relationship with the previous auditor and Ocean had many difficulties, the new auditors will have to take into account. Also, there were problems regarding audit fees with the last auditors, which means Barnes and Fischer, LLP, should be cautious about this. There are however some positive non-financial matters like the fact that with Ocean as a client, Barnes and Fischer, LLP could expand into another industry. As mentioned before, if Ocean does go IPO, they could become a bigger firm and thus become an even more valued and attractive client.

There are also some financial matters that should be taken into account when deciding the acceptance of a new client. Refer to the appendix for more details. The reason financial matters are important is because they help understand the potential client better and the auditors can get a better understanding as to how the client sits with respect to the rest of the industry. The first financial matter that is discovered is that ROE is much lower than the industry. This could suggest that management might want to aggressively adjust year end transactions to better match with the industry to please its equity holders. Another matter is that accounts receivable is much higher than the industry. This could potentially mean that they are overvaluing their accounts receivable. Another major financial concern is the fact that inventory has increased by a lot over the last three years. This means the auditor will have to find out if it is due to better inventory systems or if there are misstatements in the financials. The last major financial concern is that the profit margin is very low compared to the industry. The again could suggest that Ocean might want to aggressively adjust year end transactions to improve their profit margin.

Since one of the partners indirectly has invested in Ocean, materiality should be looked into. If the investment was direct, then the issue is not acceptable but since the investment is indirect, materiality should be looked into. In the case it says that the partner’s holding in the venture fund is $56,000 and the venture fund holds 0.5% of Ocean in its fund. This means indirectly he owns $2800 which is not material. Therefore, the issue is acceptable.

The first important factor and risk area that will affect how the audit is conducted if the Ocean is accepted as a client is the fact that many audit trails were not managed properly. Depending on the type of audit trails that were missing, the auditor will have to gather evidence by going back into the missing periods and using the data from there and after the breakdown of the missing trails. Furthermore, the auditor will have to do analytical procedures to test the reasonableness since the audit trails were missing. Another important factor is the implementation of the new IT system. This is because since the IT system tracks inventory and cost accumulation, receivables billing and aging, payroll, etc. the risk of material misstatement has increased. The auditor will have to take larger sample sizes to test the balances. Another important factor is that in the case it says that internal controls are not the best. The auditors will have to do a lot of substantive testing which could mean higher audit costs. As mentioned before, the inventory turnover ratio has increased dramatically over the last three years. The auditors will need to check the completeness, valuation, and accuracy of the inventory accounts to make sure the inventory turnover ratios are accurate. The fourth major factor is that profit margin and ROE are really low compared to the industry. The auditors will need to talk to Ocean about this and understand why this is happening. If they cannot give a viable answer, auditors will need to keep a close eye on this because it could mean Ocean will try to increase these ratios to seem more attractive to their investors and creditors. The last major factor is that since the previous auditor said that Ocean is aggressive in their year end transactions, the new auditors will need to keep a close eye on cut-off testing and the reasonableness of accruals.