Essay: Assessment of business and audit risks associated with the audit of Pinnacle Manufacturing

Introduction
The Agency was engaged as to provide an assessment of the business and audit risks associated with Pinnacle Manufacturing, a medium-sized corporation with its headquarters in Detroit, Michigan. Pinnacle is comprised of three divisions: Welburn, Solar-Electro, and Machine-Tech. Welburn produces diesel engines for boats, trucks, and commercial farming equipment. Solar-Electro, was recently acquired, makes solar-powered engines and is expected to be very profitable in future years. Similar to Solar-Electro, Machine-Tech is also new to Pinnacle Manufacturing. It supports a variety of machine service and repair operations. The Board of Directors have recently pondered selling Machine-Tech but have agreed to assess its operating results before making a final recommendation.
A. Acceptable Audit Risk and Engagement Risk Issues
External user’s dependence on financial statements
Pinnacle’s financial statements a large amount of debt; the financial statements will be used to a great extent. The fact that the Board of Directors is considering selling Machine-Tech is also noteworthy because it will mostly likely result in significant use of the business’ financial statements by external users.
During the audit it was discovered that the board of directors have a plan to raise a significant amount to debt to finance the construction of a new plant for the Solar-Electro division; there are also plans to make extensive modifications to the property where the plant will be constructed (Item 6).
Probability of Financial Difficulties
An employee of The Agency supports research about issues that may affect key clients. According to the article EPA regulations that support solar-powered engines may be postponed and the increase in sales anticipated in the Solar-Electro division may not be realized for at least ten years. This knowledge makes the solar-powered engine business innately more risky, bankruptcy is conceivable (Item 1).
The Agency previously concluded that the probability that Pinnacle Manufacturing will fail financially in the next twelve months is low.
Upon review of Pinnacle’s long-term debt agreements several restrictive covenants are found. The agreements specify that there are two requirements: the current ratio must be maintained above 2.0 and the debt-to-equity below 1.0 at all times. The current ratio for 2011 is 1.75 so there is cause for concern.
Management Integrity
The Agency did not discover any issues that justify it to question the integrity of Pinnacle’s management. However, it is noted (Item 8) that there has been significant turnover in the internal audit department in high-level positions. If the turnover in personnel is involuntary the risk of fraudulent financial reporting is augmented.
B. Pinnacle’s acceptable audit risk is medium to low because of the plan to increase its financing and the violation of the debt covenant agreement.
C. Identification of Inherent Risks
1. Inherent Risk: None.
a. Account Affected: Not applicable.
2. Inherent Risk: The presence of a section of solar-powered engines that do not look like the ones advertised on Pinnacle’s Website raising the concern of inventory obsolesce which will have an effect on the valuation of inventory.
a. Account Affected: Cost of Goods Sold, Inventory.
3. Inherent Risk: There is a potential related party transaction that may affect the valuation of the transaction and need disclosure as a related party transaction.
a. Account Affected: Manufacturing Equipment.
4. Inherent Risk: Pinnacle employees performing construction work during idle time to save costs is a non-routine transaction that may result in materials, labor and/or overhead being incorrectly applied to the property accounts.
a. Account Affected: Inventory, Cost of Sales, Property Accounts.
5. Inherent Risk: There is a receivable that has been outstanding for several months from a customer that makes up 15% of the outstanding accounts receivable balance indicating a collection issue and the potential understatement of Pinnacle’s allowance for uncollectible accounts.
a. Account Affected: A/R, Bad Debt Expense, Allowance for Uncollectible Accounts.
6. Inherent Risk: None.
a. Account Affected: Not applicable.
7. Inherent Risk: Pinnacle VP wearing a golf shirt with Todd-Machinery and his assertion that he and his wife owns the company but hires others to manage it raises concern of a potential related party transaction that may influence the assessment of the transaction and necessitate disclosure as such.
a. Account Affected: Repairs and maintenance expense and accounts payable.
8. Inherent Risk: The turnover of high-level audit personnel may be intentional and increases the likelihood of fraudulent financial reporting; the turnover may also influence the auditor’s assessment of control risk.
a. Account Affected: This risk affects all accounts.
9. Inherent Risk: The presence of the restrictive covenants affects acceptable audit risk and raises concern about the risk of fraudulent financial reporting due to managerial incentive to make certain the covenants have been met.
a. Account Affected: This risk affects all accounts.
10. Inherent Risk: Existing dispute with the Internal Revenue Service may require and adjustment to the company’s income tax liability or a disclosure in its footnotes depending on the significance of the argument.
a. Account Affected: This risk affects income taxes payable and income tax expense.
11. Inherent Risk: The discovery of the intercompany loan from Welburn to Solar-Electro is considered a related-party transaction and it is possible that the related receivable and payable was not eliminated properly on Pinnacle’s consolidated financial statements.
a. Account Affected: Interest expense, Interest income, Notes Payable, Notes Receivable.