INTEGRATED CASE APPLICATION:

PART II

REQUIRED (a):

• External User’s reliance on financial statements

Pinnacle Manufacturing is a privately held company, incurring a large amount
of debt. Since it has a high amount of debt, its financial statements would be
relied upon and used by potential users.
One of Pinnacle’s Division, Machine Tech, which engages in a variety of
machine service and repair operations, is been decided to be sold in order to
focus more on its core operations. In order to sell Machine tech, financial
statements would be extensively relied upon by potential buyers.
Moreover, in Item 4, the board of directors has decided to raise significant
amount of debt to finance the construction of the new manufacturing plant. This
would create more attention towards the financial statements.

• Likelihood of financial difficulties

Pinnacle’s second division Solar Electro incurs changing technology, thus a
more risky business then others with a chance of bankruptcy. Item 1 in the
planning activities, state about the articles concerning about the existence of
Pinnacle’s Solar Electro division.
As indicated in Item 7 in the planning activities, several restrictive
covenants were identified. Two requirements of the covenants were to keep the
current ratio above 2.0 and debt- to –equity below 1.0 at all the times. As
calculated in Part 1, the current ratio has fallen from 2.06 to 1.72. This could
result the loan to be called.

• Management integrity
Client evaluation is an important element of quality control ASA 220 Quality
Control for Audits of Historical Financial Information. When management lacks
integrity, there is a greater likelihood that material errors and irregularities
may occur in the accounting process from which the financial statements are
prepared.
Item 6 in the planning phase, indicates that there is a high turnover
especially at the higher-level position in the internal audit departments. This
turnover may be intentional and increases the risk of fraudulent financial
reporting. For example, the internal auditors who were at a higher position were
fired because the auditor found out about the managements financial interest in
the entity.

REQUIRED (b):

Item 4: Since Pinnacle Manufacturing is a risky client; the auditors have to

perform more checking of the documents, account, etc. Therefore, the audit risk
for the project will be low. As the auditors would like to be sure that all the
accounts are properly checked and verified.

Item 1: the auditors would be required to obtain sufficient appropriate evidence

in order to determine if the article is material. Therefore, the acceptable audit
risk for this project will be medium.
Item 7: Audit risk will be low since it’s a risky client, the auditors will do
more checking. As the requirements state to keep the current ratio above 2.0 (as
calculated in Part 1 its 1.72) and the Debt- to- Equity should be below 1 (0.84 as
calculated in Part 1). To maintain these requirements, the management can either
increase or decrease current assets to satisfy the criteria thus the auditors
would do more checking on these.

Item 6: Since the management is changing its internal audit personnel, new members
would take time to understand the audit environment and lack experience. While in
the process the auditor can get critical information about the company and when
it’s put forward in the meeting, the auditor gets fired.
So the audit risk would be low since the auditors would not rely on management
representation, as the figures would be high or misrepresented.