INTRODUCTION

This case study focuses on the risk assessment stage of the audit. Each of the four parts deals largely with the material in the chapter to which that part relates. However, the parts are connected in such a way that in completing all four, you will gain a better understanding of how a risk assessment is performed. The parts of this case are as follows:

• Part I -Perform analytical procedures for different phases of the audit ( Chapter 6 )

• Part II -Understand factors influencing risks and the relationship of risks to audit evidence ( Chapter 7 ).

• Part III -Understand internal control and assess control risk for the acquisition and payment cycle ( Chapter 8 ).

• Part IV -Conduct fraud brainstorming and assess fraud risks ( Chapter 10 ).

BACKGROUND INFORMATION

Your audit firm has recently been engaged as the new auditor for Pinnacle Manufacturing effective for the audit of the financial statements for the year ended December 31, 2015. Pinnacle is a medium-sized corporation, with its headquarters located in Windsor, Ontario. The company is made up of three divisions. The first division, Welburn, has been in existence for 35 years and creates powerful diesel engines for boats, trucks, and commercial farming equipment. The second division, Solar-Electro, was recently acquired from a high-tech manufacturing firm based out of Vancouver, British Columbia. Solar-Electro produces state-of-the-art, solar- powered engines.

The solar-powered engine market is relatively new, and Pinnacle's top management believes that the Solar- Electro division will be extremely profitable in the future as the focus on global climate change continues and when highly anticipated Environment Canada regulations make solar- powered engines mandatory for certain public transportation vehicles. Finally, the third division, Machine-Tech, engages in a wide variety of machine service and repair operations. This division, also new to Pinnacle, is currently in its second year of operations. Pinnacle's board of directors has recently considered selling the Machine-Tech division in order to focus more on core operations-engine manufacturing. However, before any sale will be made, the board has agreed to evaluate this year's

operating results. Excellent operating results may have the effect of keeping the division a part of Pinnacle for the next few years. The vice president for Machine-Tech is committed to making it profitable.

PART I

The purpose of Part I is to perform preliminary analytical procedures as part of the audit planning process. You have been asked to focus your attention on two purposes of analytical procedures: obtain an understanding about the client's business, and indicate where there is an increased likelihood of misstatements.

REQUIRED

a. Refer to the financial statement data in Figure 6-8 for the current year and prior two years. Analyze the year-toyear change in account balance for at least five financial statement line items. Document the trend analysis in a format similar to the following:

Account Balance.............%Change 2014-2015............%Change2012-2014

Net Sales

b. Calculate at least five common ratios and document them in a format similar to the following:

Ratio...........2015...........2014..........2013

Current

c. Based on the analytical procedures calculated in parts (a) and (b), summarize your observations about Pinnacle's business, including your assessment of the client's business risk.

d. Go to the Pinnacle link on the textbook website ( pearsonmylabandmastering.com ) and open the Pinnacle income statement, which is located in the Pinnacle Income Statement worksheet of the Pinnacle_Financials Excel file. Use the income statement information to prepare a common-size income statement for all three years. See Figure 6-5 for an example. Use the information to identify accounts for which you believe there is a concern about material misstatements. Use a format similar to the following:

Account Balance.....Estimate of $ Amount of Potential Misstatement

e. Use the three divisional income statements in the Pinnacle_ Financials Excel file on the website to prepare a common-size income statement for each of the three divisions for all three years. Each division's income statement is in a separate worksheet in the Excel file. Use the information to identify accounts for which you believe there is a concern about material misstatements. Use a format similar to the one in requirement (d).

f. Explain whether you believe the information in requirement (d) or (e) provides the most useful data for evaluating the potential for misstatements. Explain why.

g. Analyze the account balances for accounts receivable, inventory, and short/current long-term debt. Describe any observations about those accounts and discuss additional information you want to consider during the current year audit.

h. Based on your calculations, assess the likelihood (high, medium, or low) that Pinnacle is likely to fail financially in the next 12 months.