INTEGRATED CASE APPLICATION—PINNACLE MANUFACTURING: PART II
In Part I of the case, you performed preliminary analytical procedures for Pinnacle (pp. 267–269). The purpose of Part II is to identify factors influencing risks and the relationship of risks to audit evidence.
During the planning phase of the audit, you meet with Pinnacle’s management team and perform other planning activities. You encounter the following situations that you believe may be relevant to the audit:
1. Your firm has an employee who reads and saves articles about issues that may affect key clients. You read an article in the file titled, “EPA Regulations Encouraging Solar-Powered Engines Postponed?” After reading the article, you realize that the regulations management is relying upon to increase sales of the Solar-Electro division might not go into effect for at least 10 years. A second article is titled, “Stick to Diesel, Pinnacle!” The article claims that although Pinnacle has proven itself within the diesel engine industry, they lack the knowledge and people necessary to perform well in the solar powered engine industry.
2. While reading the footnotes of the previous year’s financial statements, you note that one supplier, Auto-Electro, provides over 20 percent of the raw materials used by Pinnacle. You investigate Auto-Electro and discovered that the company is considering entering Chapter 11 bankruptcy proceedings due to continuing cash flow difficulties.
3. While reviewing Pinnacle’s long-term debt agreements, you identify several restrictive covenants. Two requirements are to keep the current ratio above 2.0 and debt-to-equity below 1.0 at all times. The loans become immediately due if the covenants are not met.
4. During a meeting with the facilities director, you learn that the board of directors has decided to raise a significant amount of debt to finance the construction of a new manufacturing plant for the Solar-Electro division. The company also plans to make a considerable investment in modifications to the property on which the plant will be built.
5. After inquiry of the internal audit team, you realize there is significant turnover in the internal audit department. You conclude the turnover is only present at the higher-level positions.
6. You ask management for a tour of the Solar-Electro facilities. While touring the ware- house, you notice a section of solar-powered engines that do not look like the ones advertised on Pinnacle’s Web site. You ask the warehouse manager when those items were first manufactured. He responds, “I’m not sure. I’ve been here a year and they were here when I first arrived.”
7. While standing in line at a vending machine, you see a Pinnacle vice president wearing a golf shirt with the words “Todd-Machinery.” You are familiar with the company and noticed some of its repairmen working in the plant earlier. You tell the man you like the shirt and he responds by saying, “Thank you. My wife and I own the company, but we hire people to manage it.”
8. The engagement partner from your CPA firm called today notifying you that Brian Sioux, an industry specialist and senior tax manager from the firm’s Ontario office, will be coming onsite to Pinnacle’s facilities to investigate an ongoing dispute between the Internal Revenue Service and Pinnacle.
a. Assess acceptable audit risk as low, moderate, or high using the information provided in this assignment and information provided in Part I in Chapter 8 (pp. 267–269). Justify your response. In making your assessment, include your evaluation of the company on the three factors that make up acceptable audit risk.
• External users’ reliance on financial statements
• Likelihood of financial difficulties
• Management integrity
b. For each of the eight situations listed above, identify any inherent risks for the audit of Pinnacle. Indicate whether the situation indicates the following:
• An overall financial statement-level risk potentially affecting multiple accounts
• An assertion-level risk for one or more accounts—indicate the primary balance sheet account affected
• No effect on inherent risk
c. For each risk identified in part b., indicate whether you believe the risk represents a significant risk. Explain why it is a significant risk and what test(s) you might per- form to address the risk.
d. You will be assigned to perform the audit of Pinnacle’s accounts payable. For any of the risks that you identified as affecting accounts payable, identify the relevant audit objective(s) affected
