Pinnacle Case 4

A. Review Part II and identify information that affects your assessment of acceptable audit risk. Note that only some of the situations in Part II will relate to acceptable audit risk. Classify the information based on the three factors that affect acceptable audit risk.
• External users’ reliance on financial statements o There is a large amount of debt for a publically held company, and the financial statements will be used rather extensively. o Situation 6: the board of directors has decided to raise significant amount of debt to finance the construction of the new manufacturing plant for the Solar-Electro division. This would draw more attention in regards to the financial statements.

• Likelihood of financial difficulties o The solar
power engine business rotates around frequently changing technology, therefore making it distinctively more uncertain than other businesses, with a better chance of subsequent bankruptcy in regards to situation 3. o Situation 2: the machines that had been produced longer than a year were not sold, indicating that pinnacle is having trouble moving inventory. o Situation 5: one company makes up 15% of Pinnacle’s accounts receivable balance and this company hasn’t paid for months, indicating that Pinnacle isn’t able to collect a considerable portion of their accounts receivable.
o Situation 9: several restrictive covenants were identified. Two requirements were to keep the current ratio above the 2.0 and debt to equity below 1.0 at all times. If the current ratio falls that could cause the loans to be called.

• Management integrity o Situation 8: there is a high turnover most notably at the higher level position in the internal audit departments. This turnover may be intentional therefore an increase the risk of fraudulent financial reporting is a must. o Situation 7: the vice president of Pinnacle owns a company that was hired to work at the plant doing repairs. This could result in a conflict of interest against the shareholders. o Situation 10: a conflict with the IRS may point towards a problem with management
integrity

B. The acceptable audit risk is low as indicated from the information above. Pinnacle is taking on a large amount of debt, therefore the accurateness of the financial statement is important to creditors. There are also many situations that indicate possible financial difficulties for example the postponement of the EPA regulation, stagnant inventory, large amount of uncollected receivables and the violation of the debt covenant. The honesty of management is also suspect as made clear by the intercompany dealings with Welburn and the top executive ownership Todd machinery.
C. Inherent risk accounts or accounts affected
1. No inherent risk
2.
Obsolete inventory will have an effect on the valuation of inventory. Account affected would be cost of goods sold and inventory.
3. Related party transaction that could be material to the transaction valuation and needs to be disclosed as a related party transaction. Accounts affected would be equipment.
4. Employees performing work during idle time to save costs is a non-routine transaction that may end in materials, labor and overhead being incorrectly used on accounts. Account affected would be inventory, cost of goods sold.
5. Outstanding receivable, past due for several months that makes up 15% of the outstanding account receivable indicating that there is a collection issue and potential understatement of allowance for doubtful accounts. Account receivables, bad debt expense, allowance for doubtful accounts.
6. No inherent risk
7. The Vice President stating that he and his wife owns the company but hires others to manage it brings up worries of potential related party transaction that may sway the assessment of the transaction and require admission as such. Account affected would be accounts payable
8. Turnover of high level audit personnel may be deliberate and raises the probability of fraudulent financial reporting. The turnover could affect the auditor’s assessment of control risk. Accounts affected are all
accounts.
9. The restrictive covenants affects acceptable audit risk and raises alarm about the risk of fraudulent financial reporting from managerial incentive to make sure the covenants have happened. All of the accounts are at risk.
10. Existing disagreements with the IRS may require an adjustment to the company’s income tax liability or a disclosure in its footnotes depending on the discussion of the arguments. Accounts affected would be income taxes payable and income tax expense.
11. The intercompany loan from Wilburn to Solar-Electro is regard as a related party transaction. Accounts affected would be notes payable and notes receivable.