PINNACLE MANUFACTURING: PART I

CASE

8-38 (OBJECTIVES 8-2, 8-3) Winston Black was an audit partner in the firm of Henson, Davis

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& Company. He was in the process of reviewing the audit files for the audit of a new client,

McMullan Resources. McMullan was in the business of heavy construction. Black was

conducting his first review after the audit was substantially complete. Normally, he would

have done an initial review during the planning phase as required by his firm’s policies;

however, he had been overwhelmed by an emergency with his largest and most important

client. He rationalized not reviewing audit planning information because (1) the audit was

being overseen by Sarah Beale, a manager in whom he had confidence, and (2) he could

“recover” from any problems during his end-of-audit review.

Now Black found that he was confronted with a couple of problems. First, he found

that the firm may have accepted McMullan without complying with its new-client acceptance

procedures. McMullan came to Henson, Davis & Company on a recommendation

from a friend of Black’s. Black got “credit” for the new business, which was important to

him because it would affect his compensation from the firm. Because Black was busy, he

told Beale to conduct a new-client acceptance review and let him know if there were any

problems. He never heard from Beale and assumed everything was okay. In reviewing

Beale’s preaudit planning documentation, he saw a check mark in the box “Contact prior

auditors” but found no details indicating what was done. When he asked Beale about this,

she responded with the following:

“I called Gardner Smith [the responsible partner with McMullan’s prior audit firm] and left

a voicemail message for him. He never returned my call. I talked to Ted McMullan about

the change, and he told me that he informed Gardner about the change and that Gardner

said, ‘Fine, I’ll help in any way I can.’ Ted said Gardner sent over copies of analyses of fixed

assets and equity accounts, which Ted gave to me. I asked Ted why they replaced Gardner’s

firm, and he told me it was over the tax contingency issue and the size of their fee. Other

than that, Ted said the relationship was fine.”

The tax contingency issue that Beale referred to was a situation in which McMullan

had entered into litigation with a bank from which it had received a loan. The result of the

litigation was that the bank forgave several hundred thousand dollars in debt. This was a

windfall to McMullan, and they recorded it as a gain, taking the position that it was nontaxable.

The prior auditors disputed this position and insisted that a contingent tax liability

existed that required disclosure. This upset McMullan, but the company agreed in order to

receive an unmodified opinion. Before hiring Henson, Davis & Company as their new auditors,

McMullan requested that the firm review the situation. Henson, Davis & Company

believed the contingency was remote and agreed to the elimination of the disclosure.

The second problem involved a long-term contract with a customer in Montreal. Under

accounting standards, McMullan was required to recognize income on this contract using the

percentage-of-completion method. The contract was partially completed as of year end and

had a material effect on the financial statements. When Black went to review the copy of the

contract in the audit files, he found three things. First, there was a contract summary that set

out its major features. Second, there was a copy of the contract written in French. Third, there

was a signed confirmation confirming the terms and status of the contract. The space requesting

information about any contract disputes was left blank, indicating no such problems.

Black’s concern about the contract was that to recognize income in accordance

with accounting standards, the contract had to be enforceable. Often, contracts contain

a cancellation clause that might mitigate enforceability. Because he was not able to read French, Black couldn’t tell whether the contract contained such a clause. When he asked

Beale about this, she responded that she had asked the company’s vice president for the

Canadian division about the contract and he told her that it was their standard contract.

The company’s standard contract did have a cancellation clause in it, but it required mutual

agreement and could not be cancelled unilaterally by the buyer.

  1. Evaluate and discuss whether Henson, Davis & Company complied with auditing

standards in their acceptance of McMullan Resources as a new client. What can they

do at this point in the engagement to resolve deficiencies if they exist?

  1. Evaluate and discuss whether sufficient audit work has been done with regard to

McMullan’s Montreal contract. If not, what more should be done?

  1. Evaluate and discuss whether Black and Beale conducted themselves in accordance

with auditing standards.

INTEGRATED CASE APPLICATION —

PINNACLE MANUFACTURING: PART I

8-39 (OBJECTIVES 8-3, 8-4)

Introduction

This case study is presented in seven parts. Each part deals largely with the material in the

chapter to which that part relates. However, the parts are connected in such a way that in

completing all seven, you will gain a better understanding of how the parts of the audit are

interrelated and integrated by the audit process. The parts of this case appear in the following

textbook chapters:

  • Part I—Perform analytical procedures for different phases of the audit, Chapter 8.
  • Part II—Understand factors influencing risks and the relationship of risks to audit

evidence, Chapter 9.

  • Part III—Conduct fraud brainstorming and assess fraud risks, Chapter 10.
  • Part IV—Understand internal control and assess control risk for the acquisition and

payment cycle, Chapter 12.

  • Part V—Design tests of controls and substantive tests of transactions, Chapter 14.
  • Part VI—Determine sample sizes using audit sampling and evaluate results,

Chapter 15.

  • Part VII—Design, perform, and evaluate results for tests of details of balances,

Chapter 16.

 

Background Information

Your audit firm has recently been engaged as the new auditor for Pinnacle Manufacturing,

effective for the audit of the financial statements for the year ended December 31, 2019.

Pinnacle is a medium-sized corporation, with its headquarters located in Detroit, Michigan.

The company is made up of three divisions. The first division, Welburn, has been in

existence for 35 years and creates powerful diesel engines for boats, trucks, and commercial

farming equipment. The second division, Solar-Electro, was recently acquired from a hightech

manufacturing firm based out of Dallas, Texas. Solar-Electro produces state-of-the-art,

solar-powered engines. The solar-powered engine market continues to mature, and Pinnacle’s

top management believes that the Solar-Electro division will be extremely profitable

in the future as the focus on global climate change continues and anticipated regulations

make solar-powered engines mandatory for certain public transportation vehicles. Finally,

the third division, Machine-Tech, engages in a wide variety of machine service and repair

operations. This division, also new to Pinnacle, is currently in its second year of operations.

Pinnacle’s board of directors has recently considered selling the Machine-Tech division in

order to focus more on core operations—engine manufacturing. However, before any sale

will be made, the board has agreed to evaluate this year’s operating results. Excellent operating

results may have the effect of keeping the division as part of Pinnacle for the next few

years. The vice president for Machine-Tech is committed to making it profitable.

PART I

The purpose of Part I is to perform preliminary analytical procedures as part of the audit

planning process. You have been asked to focus your attention on two purposes of analytical

procedures: obtaining an understanding about the client’s business and indicating

where there is an increased likelihood of misstatements.

  1. Go to the Pinnacle link on the textbook website (www.pearsonhighered.com/arens) and

open the Pinnacle_Financials Excel file. The financial statement data is also shown in

Figure 8-9. Using the Excel file, compute percent changes in all Pinnacle Income Statement

and Pinnacle Balance Sheet account balances from 2017–2018 and 2018–2019.

  1. The Excel file also includes a tab with the common ratios shown in Chapter 7 on

pages 206–208. Selected ratios for prior years have already been calculated. Calculate

at least five common ratios described in Chapter 7, including at least one ratio from

each category. Document the ratios in a format similar to the following:

  1. Based on the analytical procedures calculated in parts a. and b., summarize your observations

about Pinnacle’s business, including your assessment of the client’s business risk.

  1. Open the Pinnacle income statement worksheet of the Pinnacle_Financials Excel file.

Use the income statement information to prepare a common-size income statement

for all three years. See Figure 8-4 (p. 243) for an example. Use the information to identify

accounts for which you believe there is a concern about material misstatements.

Use a format similar to the following:

 

  1. Use the three divisional income statements in the Pinnacle_Financials Excel file on the

website to prepare a common-size income statement for each of the three divisions for

all three years. Each division’s income statement is in a separate worksheet in the Excel

file. Use the information to identify accounts for which you believe there is a concern

about material misstatements. Use a format similar to the one in requirement d.

  1. Explain whether you believe the information in requirement d. or e. provides the

most useful data for evaluating the potential for misstatements. Explain why.

  1. Analyze the account balances for accounts receivable, inventory, and short/current

long-term debt. Describe any observations about those accounts and discuss additional

information you want to consider during the current-year audit.

  1. Based on your calculations, assess the likelihood (high, medium, or low) that Pinnacle

is likely to fail financially in the next 12 months

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