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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.