PINNACLE MANUFACTURING: PART I
CASE
8-38 (OBJECTIVES 8-2, 8-3) Winston Black was an audit partner in the firm of Henson, Davis
& 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.
- 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?
- Evaluate and discuss whether sufficient audit work has been done with regard to
McMullan’s Montreal contract. If not, what more should be done?
- 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.
- 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.
- 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:
- 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.
- 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:
- 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.
- Explain whether you believe the information in requirement d. or e. provides the
most useful data for evaluating the potential for misstatements. Explain why.
- 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.
- Based on your calculations, assess the likelihood (high, medium, or low) that Pinnacle
is likely to fail financially in the next 12 months
