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.
a. 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?
b. Evaluate and discuss whether sufficient audit work has been done with regard to
McMullan’s Montreal contract. If not, what more should be done?
c. 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)
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
• 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,
• Part VII—Design, perform, and evaluate results for tests of details of balances,
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.
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.
a. 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.
b. 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:
c. 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.
d. 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:
e. 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.
f. Explain whether you believe the information in requirement d. or e. provides the
most useful data for evaluating the potential for misstatements. Explain why.
g. 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.
h. Based on your calculations, assess the likelihood (high, medium, or low) that Pinnacle
is likely to fail financially in the next 12 months.
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
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
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.
2. 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
3. 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.
4. 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.
5. 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
6. 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.”
7. 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.”
8. 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.
a. 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
b. 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
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.
d. 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
Pinnacle #1 (Ch. 8)
RATIOS - 12/31/19
Short-Term Debt-Paying Ability
Liquidity Activity Ratios
Accounts receivable turnover
Days to collect accounts receivable
Days to sell inventory
Ability to Meet Long-Term Obligations
Debt to equity
Earnings per share
Gross profit percent
Return on assets
Return on common equity
Pinnacle Manufacturing Company’s cash, quick, and current ratio has steadily decreased from
2017 to 2019. This indicates that their ability to pay short term debt has worsened, as they may not
have cash or be able to convert current assets, such as inventory or accounts receivable into cash to
immediately pay for debts. This is also reflected in the liquidity activity ratios. Pinnacle’s accounts
receivable turnover ratio decreased and their days to collect on accounts receivable increase. This shows
they are less efficient at collecting sales and are less likely to have cash or cash like items to meet their
debt obligations. In regards to Pinnacle’s ability to meet long term obligations, their debt to equity has
increased each year from 2017 to 2019. This is showing that Pinnacle finances the company with more
debt than equity and are using leverage to their benefit. If this ratio gets too high, they may have used
all their borrowing capacity. Additionally, Pinnacle has become less profitable in 2019 compared to
2018. This reflected in the decrease in both gross profit percent and profit margin. The increase in
earnings per share was not consistent with the decrease in profit margins. The average common shares
outstanding stayed the same for 2018 and 2018, but net income did increase for the year. In comparison
to sales, they were less profitable. Overall, Pinnacle has high business risk; indicated by their low
liquidity, low ability to meet both long and short term debt obligations, and well as their decline in
Common-size financial statements allow for comparisons between companies or for the same
company over different time periods, revealing trends and providing insight into how different
companies compare. We believe providing a common-size income statement is extremely useful in
terms of comparing a company’s current to past financial position as well as to other companies in the
same or similar industry through a vertical analysis of each item on the financial statement. It is also
useful and easy to identify what is driving a company’s profits. However, we do not believe that a
common-size income statement is the most useful data for evaluating the potential for misstatements
because it does not show if the company is following the appropriate accounting standards/principles
consistently. It also does not represent the seasona ...
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