INTEGRATED CASE APPLICATION-PINNACLE

MANUFACTURING: PART II

9-40 (OBJECTIVES 9-6, 9-7) In Part I of the case, you performed preliminary analytical proce-

dures for Pinnacle (pp. 267-269). The purpose of Part Il 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 af-

fect 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 con-

sidering 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 man-

ufacturing plant for the Solar-Electro division. The company also plans to make a con-

siderable 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 wear-

ing 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. 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

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 perform to address the risk.