8-40 (Objectives 8-3, 8-4, 8-5)

Introduction

This case study is presented in seven parts. Each part 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 seven, you will gain a better understanding of how the parts of the audit are interrelated and integrated by the audit process. The parts of this case appear in the following textbook chapters:

Part IPerform analytical procedures for different phases of the audit, Chapter 8.

Part IIUnderstand factors influencing risks and the relationship of risks to audit evidence, Chapter 9.

Part IIIUnderstand internal control and assess control risk for the acquisition and payment cycle, Chapter 10.

Part IVConduct fraud brainstorming and assess fraud risks, Chapter 11.

Part VDesign tests of controls and substantive tests of transactions, Chapter 14.

Part VIDetermine sample sizes using audit sampling and evaluate results, Chapter 15.

Part VIIDesign, perform, and evaluate results for tests of details of balances, Chapter 16.

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, 2011. Pinnacle is a medium-sized corporation, with its headquarters located in Detroit, 245246Michigan. 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 Dallas, Texas. Solar-Electro produces state-of-the-art, solar-powered engines. The solar-powered engine market is relatively new, and Pinnacles 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 EPA 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. Pinnacles board of directors has recently considered selling the Machine-Tech division in order to focus more on core operationsengine manufacturing. However, before any sale will be made, the board has agreed to evaluate this years 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 1

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 clients business and indicate where there is an increased likelihood of misstatements.

Required

a. Refer to the financial statement data in Figure 8-9 for the current year and prior two years. Analyze the year-to-year 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 2012 2013	% Change 20112012
Net sales

Pinnacle Manufacturing Company

Income Statement

For the Year ended December 31

2013 2012 2011

Net Sales $150,737,628 $148,586,037 $144,686,413

Cost of goods sold 109,284,780 106,255,499 101,988,165

Gross Profit 41,452,848 42,330,528 42,698,248

Operating expenses 37,177,738 38,133,969 37,241,108

Income from operations 4,275,110 4,196,569 5,457,140

Other revenues and gains - - -

Other expenses and losses 2,181,948 2,299,217 2,397,953

Income before income tax 2,093,162 1,897,352 3,059,187

Income tax 883,437 858,941 1,341,536

Net income for the year 1,209,725 1,038,411 1,717,651

Earnings per share 1.21 1.04 1.72

Pinnacle Manufacturing Company

Balance Sheet

As of December 31

Assets 2013 2012 2011

Current Assets

Cash and Cash Equivalents $7,721,279 $7,324,846 $8,066,545

Net Receivables 13,042,165 8,619,857 7,936,409

Inventory 32,236,021 25,537,198 25,271,503

Other Current Assets 172,278 143,206 131,742

Total Current Assets 53,171,743 41,625,107 41,406,199

Property, Plant and Equp. 62,263,047 61,635,530 58,268,732

Total Assets $115,434,790 $103,260,637 $99,674,931

Liabilities

Current Liabilities

Accounts Payable $12,969,686 $9,460,776 $7,586,374

Short/Cur. Long Term Debt 15,375,819 10,298,668 9,672,670

Other Current Liabilities 2,067,643 1,767,360 1,682,551

Total Current Liabilities 30,413,148 21,526,804 18,941,595

Long Term Debt 24,420,090 22,342,006 22,379,920

Total Liabilities 54,833,238 43,868,810 41,321,515

Stockholders' Equity

Common Stock 1,000,000 1,000,000 1,000,000

Additional paid-in capital 15,717,645 15,717,645 15,717,645

Retained Earnings 43,883,907 42,674,182 41,635,771

Total Stockholders' Equity 60,601,552 59,391,827 58,353,416

Total Lia. & Stock Equity $115,434,790 $103,260,637 $99,674,931

b. Calculate at least five common ratios shown on pages 230-232 and document them in a format similar to the following:

CALCULATED RATIO

Ratio 2013 2012 2011

Current Ratio 1.75 1.93 2.19

Debt Equity Ratio 0.40 0.38 0.38

Operating Profit Ratio 2.84 2.82 3.77

Net Profit Ratio 0.80 0.70 1.19

Return on Equity 2 1.75 2.94

c. Based on the analytical procedures calculated in parts a. and b., summarize your observations about Pinnacles business, including your assessment of the clients business risk.

d. Go to the Pinnacle link on the textbook Web site (www.prenhall.com/arens) 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 8-7 (p. 227) 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 Web site to prepare a common-size income statement for each of the three divisions for all three years. Each divisions 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.