Michigan State University Accounting Audit Paper

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CASE
8-38 (OBJECTIVES 8-2, 8-3) Winston Black was an audit partner in the firm of Henson, Davis
& Company. He was in the process of reviewing the audit files for the audit of a new client,
McMullan Resources. McMullan was in the business of heavy construction. Black was
conducting his first review after the audit was substantially complete. Normally, he would
have done an initial review during the planning phase as required by his firm’s policies;
however, he had been overwhelmed by an emergency with his largest and most important
client. He rationalized not reviewing audit planning information because (1) the audit was
being overseen by Sarah Beale, a manager in whom he had confidence, and (2) he could
“recover” from any problems during his end-of-audit review.
Now Black found that he was confronted with a couple of problems. First, he found
that the firm may have accepted McMullan without complying with its new-client acceptance
procedures. McMullan came to Henson, Davis & Company on a recommendation
from a friend of Black’s. Black got “credit” for the new business, which was important to
him because it would affect his compensation from the firm. Because Black was busy, he
told Beale to conduct a new-client acceptance review and let him know if there were any
problems. He never heard from Beale and assumed everything was okay. In reviewing
Beale’s preaudit planning documentation, he saw a check mark in the box “Contact prior
auditors” but found no details indicating what was done. When he asked Beale about this,
she responded with the following:
“I called Gardner Smith [the responsible partner with McMullan’s prior audit firm] and left
a voicemail message for him. He never returned my call. I talked to Ted McMullan about
the change, and he told me that he informed Gardner about the change and that Gardner
said, ‘Fine, I’ll help in any way I can.’ Ted said Gardner sent over copies of analyses of fixed
assets and equity accounts, which Ted gave to me. I asked Ted why they replaced Gardner’s
firm, and he told me it was over the tax contingency issue and the size of their fee. Other
than that, Ted said the relationship was fine.”
The tax contingency issue that Beale referred to was a situation in which McMullan
had entered into litigation with a bank from which it had received a loan. The result of the
litigation was that the bank forgave several hundred thousand dollars in debt. This was a
windfall to McMullan, and they recorded it as a gain, taking the position that it was nontaxable.
The prior auditors disputed this position and insisted that a contingent tax liability
existed that required disclosure. This upset McMullan, but the company agreed in order to
receive an unmodified opinion. Before hiring Henson, Davis & Company as their new auditors,
McMullan requested that the firm review the situation. Henson, Davis & Company
believed the contingency was remote and agreed to the elimination of the disclosure.
The second problem involved a long-term contract with a customer in Montreal. Under
accounting standards, McMullan was required to recognize income on this contract using the
percentage-of-completion method. The contract was partially completed as of year end and
had a material effect on the financial statements. When Black went to review the copy of the
contract in the audit files, he found three things. First, there was a contract summary that set
out its major features. Second, there was a copy of the contract written in French. Third, there
was a signed confirmation confirming the terms and status of the contract. The space requesting
information about any contract disputes was left blank, indicating no such problems.
Black’s concern about the contract was that to recognize income in accordance
with accounting standards, the contract had to be enforceable. Often, contracts contain
a cancellation clause that might mitigate enforceability. Because he was not able to read French, Black
couldn’t tell whether the contract contained such a clause. When he asked
Beale about this, she responded that she had asked the company’s vice president for the
Canadian division about the contract and he told her that it was their standard contract.
The company’s standard contract did have a cancellation clause in it, but it required mutual
agreement and could not be cancelled unilaterally by the buyer.
a. Evaluate and discuss whether Henson, Davis & Company complied with auditing
standards in their acceptance of McMullan Resources as a new client. What can they
do at this point in the engagement to resolve deficiencies if they exist?
b. Evaluate and discuss whether sufficient audit work has been done with regard to
McMullan’s Montreal contract. If not, what more should be done?
c. Evaluate and discuss whether Black and Beale conducted themselves in accordance
with auditing standards.
INTEGRATED CASE APPLICATION —
PINNACLE MANUFACTURING: PART I
8-39 (OBJECTIVES 8-3, 8-4)
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 I—Perform analytical procedures for different phases of the audit, Chapter 8.
• Part II—Understand factors influencing risks and the relationship of risks to audit
evidence, Chapter 9.
• Part III—Conduct fraud brainstorming and assess fraud risks, Chapter 10.
• Part IV—Understand internal control and assess control risk for the acquisition and
payment cycle, Chapter 12.
• Part V—Design tests of controls and substantive tests of transactions, Chapter 14.
• Part VI—Determine sample sizes using audit sampling and evaluate results,
Chapter 15.
• Part VII—Design, 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, 2019.
Pinnacle is a medium-sized corporation, with its headquarters located in Detroit, 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 hightech
manufacturing firm based out of Dallas, Texas. Solar-Electro produces state-of-the-art,
solar-powered engines. The solar-powered engine market continues to mature, 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 anticipated 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 as 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: obtaining an understanding about the client’s business and indicating
where there is an increased likelihood of misstatements.
a. Go to the Pinnacle link on the textbook website (www.pearsonhighered.com/arens) and
open the Pinnacle_Financials Excel file. The financial statement data is also shown in
Figure 8-9. Using the Excel file, compute percent changes in all Pinnacle Income Statement
and Pinnacle Balance Sheet account balances from 2017–2018 and 2018–2019.
b. The Excel file also includes a tab with the common ratios shown in Chapter 7 on
pages 206–208. Selected ratios for prior years have already been calculated. Calculate
at least five common ratios described in Chapter 7, including at least one ratio from
each category. Document the ratios in a format similar to the following:
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. Open 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 8-4 (p. 243) 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:
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.
9-39 (OBJECTIVES 9-5, 9-6, 9-7) Whitehead, CPA, is planning the audit of a newly obtained
client, Henderson Energy Corporation, for the year ended December 31, 2019. Henderson
Energy is regulated by the state utility commission, and because it is a publicly traded
company the audited financial statements must be filed with the Securities and Exchange
Commission (SEC).
Henderson Energy is considerably more profitable than many of its competitors,
largely due to its extensive investment in information technologies used in its energy
distribution and other key business processes. Recent growth into rural markets, however,
has placed some strain on 2019 operations. Additionally, Henderson Energy
expanded its investments into speculative markets and is also making greater use of
derivative and hedging transactions to mitigate some of its investment risks. Because
of the complexities of the underlying accounting associated with these activities,
Henderson Energy added several highly experienced accountants within its financial
reporting team. Internal audit, which has direct reporting responsibility to the audit
committee, is also actively involved in reviewing key accounting assumptions and
estimates on a quarterly basis.
Whitehead’s discussions with the predecessor auditor revealed that the client has experienced
some difficulty in correctly tracking existing property, plant, and equipment
items. This largely involves equipment located at its multiple energy production facilities.
During the recent year, Henderson acquired a regional electric company, which expanded
the number of energy production facilities.
Whitehead plans to staff the audit engagement with several members of the firm who
have experience in auditing energy and public companies. The extent of partner review of
key accounts will be extensive.
Based on the above information, identify factors that affect the risk of material misstatements
in the December 31, 2019, financial statements of Henderson Energy. Indicate
whether the factor increases or decreases the risk of material misstatements. Also, identify
which audit risk model component is affected by the factor. Use the format below:
INTEGRATED CASE APPLICATION—PINNACLE
MANUFACTURING: PART II
9-40 (OBJECTIVES 9-6, 9-7) In Part I of the case, you performed preliminary analytical procedures
for Pinnacle (pp. 267–269). The purpose of Part II 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 affect
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 considering
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 manufacturing
plant for the Solar-Electro division. The company also plans to make a considerable
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 warehouse,
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 wearing
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. Assess acceptable audit risk as low, moderate, or high using the information provided
in this assignment and information provided in Part I in Chapter 8 (pp. 267–269).
Justify your response. In making your assessment, include your evaluation of the
company on the three factors that make up acceptable audit risk.
• External users’ reliance on financial statements
• Likelihood of financial difficulties
• Management integrity
b. 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
c. 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.
d. You will be assigned to perform the audit of Pinnacle’s accounts payable. For any of
the risks that you identified as affecting accounts payable, identify the relevant audit
objective(s) affected.
Part A
The acceptable audit risk for Pinnacle is low.
External users’ reliance on financial statements:
The information in part one stated that Pinnacle is a medium-sized corporation, meaning the
statements are used a moderate amount, as the statements are used more widely the larger a
client is. Pinnacle has a large amount of debt, meaning the statements are likely to be used more
extensively by creditors compared to if they had less liabilities. They plan to take on more debt
too, as finding 4 states that they are going to raise a significant amount of debt to finance the
construction of a new manufacturing plant for the Solar-Electro division.
Likelihood of financial difficulties
Liquidity is an issue for Pinnacle. Net income and cash and cash equivalents were highest in
2017, decreased in 2018, and came up slightly in 2019. Pinnacle relies on debt as a means of
financing, so this means a greater risk of financial difficulty if the client’s operating success
declines. Also, if covenants are not met, loans become immediately due. This is a large risk that
could cause extreme financial difficulties in the future. Finding 1 leads us to believe that
Pinnacle will have financial difficulties in the solar-powered engine industry due to lack of
knowledge to build them and the environmental regulations being postponed. Because the
chance of financial loss is high, acceptable audit risk should be reduced.
Management integrity
Lastly, finding 5 states that there is significant turnover of higher-level positions in the internal
audit department. This is cause for suspicion of questionable management integrity, which will
lower acceptable audit risk. Finding 8 states that there is an ongoing dispute between Pinnacle
and the Internal Revenue Service, which will decrease acceptable audit risk as well.
Part B
1. Overall, this situation deals with the nature of the client’s business, which could signal an
inherent risk with multiple accounts having the potential of being affected. Management is
currently relying on regulations that could potentially not go into effect for 10 years, so
accounts such as inventory, property, plant, and equipment, and investments will have an
impact due to this specific risk.
2. There is a chance of an overall financial statement-level risk that could affect many
accounts if Auto-Electro files Chapter 11 bankruptcy. Auto-Electro provides over 20% of
Pinnacle’s raw materials, so accounts that would be affected, especially inventory and
revenue. Management should consider looking into another supplier so that this inherent risk
could be slowed down and not affect the business that greatly.
3. There is a chance of an overall financial statement-risk level with the situation that
Pinnacle must keep two requirements stable, otherwise all their debts are owed. This risk
could lead to management committing fraud to ensure that their current ratio and debt-toequity ratio remain at a consistent level. Accounts that are affected by this inherent risk
include accounts payable, total assets, and stockholder’s equity.
4. For this situation, there is no effect on inherent risk. By management deciding to raise debt
to finance construction of a new plant, this does not fall into one of the major factors when
assessing inherent risk. If in the future management is unable to repay these debts, then there
would be a risk that management could commit fraud and lead to an overall financial
statement-level risk.
5.
There is a chance of an overall financial statement-level risk potentially affecting
multiple accounts. The significant turnover of high level internal audit employees could increase
the risk that there is an issue within the company that spurs the decision of these employees to
leave, or necessitates their removal. It is possible that management is removing high level
internal audit employees in order to reduce the chance that they identify fraudulent activity.
There is also an increased impact on control risk.
6.
There is a chance for an assertion level risk for one or more accounts. The inventory in
question should have been recorded properly regardless of whether it is an advertised product,
and since the new manager has no record — there could be fraud involved. Therefore, there is a
risk primarily to Inventory accounts, but also potentially to related Revenue accounts if these
inventory are being sold off-book.
7.
Because the VP owns the company that hires out repairmen, there is a related party
transaction occurring which may provide a benefit to Pinnacle through advantageous pricing that
differs from the fair value (or possibly to the VP). If not disclosed properly on the financial
statements, it represents an assertion level risk for one or more accounts, including Accounts
Payable and Repairs and Maintenance Expense.
8.
If there is an “ongoing dispute” between the IRS and Pinnacle, this could signal an
inherent risk with the amount of tax liability reflected on the balance sheet. This would impact
Income Taxes Payable and Income Tax Expense accounts.
Part C
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
.
Group 3 Pinnacle – Chapter 8
Part A
Part B
Ratio
2019
2018
2017
Current Ratio
1.73
1.93
2.19
Quick Ratio
0.42
0.74
0.84
Inventory
Turnover
3.96
–
–
Debt to Equity
0.89
0.74
0.71
Times Interest
Earned
2.04
1.83
2.28
Profit Margin
2.9%
2.8%
3.8%
Part C
A client’s business risk is the risk that the client will fail to achieve reliability of
financial reporting, effectiveness of operations, and compliance with laws and
regulations. These reasons may be within or not within the client’s control and also
includes the risk that the client will fail to repay the debts for any reason.
Overall, Pinnacle Manufacturing has had a positive net income increase from 2018 to
2019, which gives Pinnacle a positive outlook on the company after acquiring their two
new sectors. From 2017-2019, Pinnacle’s current ratio decreased, which shows that the
ability for Pinnacle Manufacturing to generate cash has decreased. This could have
been caused by many factors, but this should be pointed out as a business risk. The
addition of the two sectors did have an effect on operations, which is a reason that
stems from management’s decision to acquire these two sectors. Looking at the debt to
equity ratio, Pinnacle Manufacturing may have business risk in the ability to pay off their
debts. Pinnacle Manufacturing has acquired two new divisions the the company, which
increased their debts and if these two sectors aren’t profitable (Solar-Electro is,
however, most likely to be profitable), then Pinnacle may not be able to pay off any
debts that they have. A low quick ratio also falls into this business risk. With a low quick
ratio, a company will have a harder time paying off their debts. Overall, based on the
analytical procedures above, the company does have significant business risk,
especially in the risk of the client failing to repay their debts.
Part F
The common-size financial statements reveal trends and differences over time more
fully than standard financial statements.
We believe that a common-size income statement provides useful data for evaluating
the potential for misstatements. The common-size income statement is shown as a
percentage of the common base, such as revenue and sales. Common-size income
statements use the vertical analysis, comparative analysis of the same company in
different time periods. It can clearly reflect the financial position and company
performance – comparison with the percentage of other competitors in the same
industry.
Common-size income statements make it easier to identify what drives company’s
profit, and the percentages for each division can be compared more specifically. If the
trend of an item increases positive or negative against our expectation, we can target it
more quickly and accurately.
Part G
After analyzing Pinnacle’s balance sheet, there were noticeably large increases
in Receivables, Inventory, and Current portion of long-term debt. For accounts
receivable, there was roughly a 43% increase from 2018 to 2019. For inventory, there
was a roughly 25% increase from 2018 to 2019. For current long-term debt, there was
an abnormally large increase of 9436.74% from 2018 to 2019. These three accounts
appear to have an increased likelihood of misstatement in the future. Therefore,
additional information that we want to consider is further explanation and corroborating
evidence from Pinnacle for the large increases in Receivables, Inventory, and Current
portion of long-term debt.
Part H
Based on our calculations, we believe that the likelihood that Pinnacle will fail
financially in the next 12 months is high. As we previously identified in Part C, the
company does have significant business risk, especially in that client’s may not repay
their debts. Though this is not in Pinnacle’s control, this is still a client business risk.
Their current ratio is decreasing, meaning they are having trouble generating cash.
There is also a decreasing quick ratio from 2017-2019, meaning that Pinnacle may have
trouble paying back their debts. Another reason we believe this is because of rapidly
increasing short/current long-term debt ($9.6 million in 2017 to $15.4 million in 2019)
with only slowly increasing sales ($144.7 million in 2017 to $151.1 million in 2019). We
do not believe the Pinnacle will have the cash to pay their liabilities in the next 12
months, and this will cause them to fail financially.

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