Business Finance
ACC 411 Michigan State University Auditing Pinnacle Case Study

ACC 411

Michigan State University


Question Description

I’m stuck on a Accounting question and need an explanation.

The case study and the questions are in the CH9 Case word document, and after you read the case, you have to finish the question B and C, and for question B, the 8 situations are also listed just above the question A. To answer the questions, you will need information from chapter 8, so I will also upload what we have already done in chapter 8 and the case of chapter 8 (which are CH8 Case and pinnacle 1 word documents), I will also upload what we are doing in this ch9 case study( which is the pinnacle 2 word document), and it has already contained answers for part A and part of the answers for part B, so I want you to follow the same formats as what we did please. Let me know if you have any questions. Thank you so much.

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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. 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) 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. a. Go to the Pinnacle link on the textbook website ( 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 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. 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 difficulties. 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 higher-level positions. 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 objective(s) affected. Pinnacle #1 (Ch. 8) A. B. RATIOS - 12/31/19 Short-Term Debt-Paying Ability Cash ratio Quick ratio Current ratio 0.25 0.67 1.73 Liquidity Activity Ratios Accounts receivable turnover Days to collect accounts receivable Inventory turnover Days to sell inventory 12.98 28.13 3.80 95.98 Ability to Meet Long-Term Obligations C. Debt to equity 0.89 Profitability Ratios Earnings per share Gross profit percent Profit margin Return on assets Return on common equity 1.57 27.7% 2.9% 2.1% 3.8% 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 profitability. F. 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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Final Answer

Kindly use this one named Final Audited

Pinnacle #2 (Ch. 9)
Part A
We assessed acceptable audit risk as moderate.
● External users reliance on financial statements
○ Client Size: Pinnacle is currently a medium-sized corporation. When Pinnacle's
operations grow, and their financial statements will be used more, the assessed
acceptable audit risk will be lowered.
○ Distribution of ownership: public or private?
■ If publicly held, there are normally more users that rely on Pinnacle’s
financial statements, such as the SEC, the public audience, and stock
○ Nature and amount of liabilities: Pinnacle’s total liabilities increased 13.65%
between 2017 and 2018 and 29.22% between 2018 and 2019. Pinnacle only has
current liabilities and long term debt, which are not complex.
● Likelihood of financial difficulties
○ Situation #2: "Auto-Electro" is a supplier that provides over 20% of Pinnacle's raw
materials and is considering entering bankruptcy proceedings due to continuing
cash flow difficulties. Because a significant supplier is having difficulty to survive,
it may be more difficult for Pinnacle to run its operations in the future and continue
to grow profitably.
○ Situation #8: Industry specialist and senior tax manager from the firm's Ontario
office coming onsite to investigate an ongoing dispute between the IRS and
Pinnacle potentially indicates tax problems. If it is common for Pinnacle to have
tax compliance problems, it makes their company riskier.
○ Situation #3: Pinnacle has requirements to keep their current ratio above 2.0 and
debt-to-equity below 1.0 at all times. If these debt covenants are not met, the loans
will become immediately. For the past two years, the current ratio has been less
than 2.0 and has been decreasing...

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