group case

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-to-equity 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