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,

Chapter 8 / AUDIT PLANNING AND ANALYTICAL PROCEDURES 245

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Michigan. 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 I

Required

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 analyti- cal procedures: obtain an understanding about the clients business and indicate where there is an increased likelihood of misstatements.

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:

% Change % Change

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Account Balance 20102011 20092010

Net sales

b. Calculate at least five common ratios shown on pages 232233 and document them in a format similar to the following: Ratio 2011 2010 2009

Current ratio

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 infor- mation to prepare a common-size income statement for all three years. See Figure 8-7 (p. 229) 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:

Estimate of $ Amount Account Balance 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.

Part 2 / THE AUDIT PROCESS

246

FIGURE 8-9

Pinnacle Manufacturing Financial Statements

Pinnacle Manufacturing Company Income Statement For the Year ended December 31

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Net sales Cost of goods sold

Gross profit Operating expenses

Income from operations Other revenues and gains Other expenses and losses Income before income tax

Income tax Net income for the year Earnings per share

2011

$ 150,737,628 109,284,780 41,452,848 37,177,738 4,275,110

2,181,948 2,093,162

883,437 1,209,725 $1.21

2010

$ 148,586,037 106,255,499 42,330,538 38,133,969 4,196,569

2,299,217 1,897,352

858,941 1,038,411 $1.04

2009

$ 144,686,413 101,988,165 42,698,248 37,241,108 5,457,140

2,397,953 3,059,187 1,341,536 1,717,651

$1.72

Assets Current assets

$ 7,721,279 13,042,165 Inventory 32,236,021 Other current assets 172,278 Total current assets 53,171,743 Property, plant and equipment 62,263,047 $ 115,434,790

Pinnacle Manufacturing Company Balance Sheet As of December 31

2011

2010

7,324,846

2009

8,066,545

7,936,409 25,271,503 131,742 41,406,199 58,268,732 99,674,931

Cash and cash equivalents Net receivables

$

$

$

Total assets

8,619,857 25,537,198 143,206 41,625,107 61,635,530 $ 103,260,637

Liabilities Current liabilities

Accounts payable Short/current long-term debt Other current liabilities

Total current liabilities Long-term debt Total liabilities

Stockholders equity Common stock Additional paid-in capital Retained earnings

Total stockholders equity Total liabilities & stockholders equity

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$ 12,969,686 15,375,819 2,067,643 30,413,148 24,420,090 54,833,238

1,000,000 15,717,645 43,883,907 60,601,552

$ 115,434,790

$

9,460,776 10,298,668 1,767,360 21,526,804 22,342,006 43,868,810

1,000,000 15,717,645 42,674,182 59,391,827

$

7,586,374 9,672,670 1,682,551

18,941,595 22,379,920 41,321,515

1,000,000 15,717,645 41,635,771 58,353,416

$ 103,260,637

$ 99,674,931

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.

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