INTEGRATED CASE APPLICATION—PINNACLE

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

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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.

  1. 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.

  1. 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.

  1. 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.

  1. 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.

  1. 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.”

  1. 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.”

  1. 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.

 

  1. 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
  1. 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
  1. 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.

  1. 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.

 

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