INTEGRATED CASE APPLICATION —PINNACLE MANUFACTURING:

PART I

Requirement no. a

Account Heads 2011 2010 2009  11-10 %  10-9 %
Net sales 150,737,628 148,586,037 144,686,413         2,151,591 1%         3,899,624 3%
Cost of goods sold 109,284,780 106,255,499 101,988,165         3,029,281 3%         4,267,334 4%
GP 41,452,848 42,330,538 42,698,248          (877,690) -2%          (367,710) -1%
Operating expenses 37,177,738 38,133,969 37,241,108          (956,231) -3%           892,861 2%
Income from operations          4,275,110          4,196,569          5,457,140             78,541 2%       (1,260,571) -23%
Other revenues and gains                    –                   –
Other expenses and losses 2,181,948 2,299,217 2,397,953          (117,269) -5%           (98,736) -4%
Income before tax 2,093,162          1,897,352          3,059,187            195,810 10%       (1,161,835) -38%
Income tax 883,437 858,941 1,341,536             24,496 3%          (482,595) -36%
                  –
Net income for the year 1,209,725       1,038,411       1,717,651          171,314 16%        (679,240) -40%

 

Requirement no. b

Five Common Ratios required are as follows

Ratios 2011 2010 2009
Current Ratio 1.75 1.93 2.19
Cash Ratio 0.68 0.74 0.84
Quick Ratio 0.68 0.74 0.84
Debt to equity 0.90 0.74 0.71
Accounts receivable Turnover 20.04 19.31 18.23
Days to collect receivables 18.22 18.90 20.02

 

Requirement no. c

From the information extracted from the requirement a and b we can observe that company’s liquidity position is unsatisfactory as the current, cash and quick ratios are falling from the previous couple of years and debt to equity ratio has also been increased which means company is relying significantly on its credit facility to operate. Accounts receivable turnover has also been increasing which may also be the reason of emerging liquidity issues. As per income statement revenue has increased but increase in cost of goods are more than increase in revenue which may reflect that either revenue is understated or expenses are overstated. If the company has not overcome the liquidity problems and improve liquidity ratios lenders might demand immediate payment of loans causing company not a going concern.

Requirement no. d

Common Size Income Statements

Account Heads 2011 2010 2009
Net sales 100.00% 100.00% 100.00%
Cost of goods sold 72.50% 71.51% 70.49%
GP 27.50% 28.49% 29.51%
Operating expenses 24.66% 25.66% 25.74%
Income from operations 2.84% 2.82% 3.77%
Other revenues and gains 0.00% 0.00% 0.00%
Other expenses and losses 1.45% 1.55% 1.66%
Income before tax 1.39% 1.28% 2.11%
Income tax 0.59% 0.58% 0.93%
Net income for the year 0.80% 0.70% 1.19%

Interpretations: From the above mentioned comparison we extracted that cost of goods sold has been increasing over the period that has caused reduction in gross profit, this may be because of manipulation of expenses or understatement of revenue. Although company has increased its credit facility which should be resulted increase in operating expense but there is reduction so there may be chances that interest expenses are not being accurately calculated or other expenses are not recorded appropriately. Income tax has been significantly reduced so we should get assurance whether correct rate has been applied.

Account Balance Estimate of $ Amount of Potential Misstatement
Cost of goods sold         3,031,167
GP         2,197,596
Operating expenses         445,748
Income tax         7,140

Requirement no. f

Yes it is truth as it covers the accounting structure adopted by the company. Any increase in revenue should also be configured with the increase in cost of goods sold as with every increase in units produced cost has also been increased unless there is some other justification like increase in sale prices or reduction in unit cost due to effective production utilization. Any significant change triggers the presence of potential misstatement which can easily be diagnosed and inquired from the management. Classifications and cut offs errors can easily be identified which are the important assertions in auditing financial statements. All the assertions are checked analytically basis on common size financial statements as they provide the best comparative basis.

Requirement no. g

Account Heads 2011 2010 2009  11-10 %  10-9 %
Net receivables        13,042,165          8,619,857          7,936,409         4,422,308 51%           683,448 9%
Inventory        32,236,021        25,537,198        25,271,503         6,698,823 26%           265,695 1%
Short/current long-term debt        15,375,819        10,298,668          9,672,670         5,077,151 49%           625,998 6%
Long-term debt        24,420,090        22,342,006        22,379,920         2,078,084 9%           (37,914) 0%

From the above information it is evident increase in receivables are 51% as compared to last year which means there are chances that old outstanding balances are not provided for or written off so debtor aging analysis need to be analyzed carefully. External confirmations are sent to confirm the existence. Inventory balance has also significantly increased it should be insured through stock count working and test of details purchases subsequently. NRV working should be checked too. Increase in liabilities is checked through agreement with the banks and verification from the bank statements. It is also important to check that company is in compliance with all the compulsory covenants of the banks.

Requirement no. h

Pinnacle has started to rely heavily on credit so there is a great risk that company may not be going concern in the future as all the current, cash and liquidity ratios are deteriorating over the three years. In case of noncompliance with the compulsory covenants and non-payments of interest and principal on time may cause the company unable to fulfill all current liabilities.

Part II:

(a)

Reliance of External User’s on financial statements:

As the company is relying overly on debt and also planning to get more debt then financial statements are very important for the lenders. One of Pinnacle’s Division, Machine Tech, which engages in a variety of machine service and repair operations, is been decided to be sold in order to focus more on its core operations. In order to sell Machine tech, financial statements would be extensively relied upon by potential buyers.

Likelihood of financial difficulties

Pinnacle’s second division Solar Electro incurs changing technology, thus a more risky business then others with a chance of bankruptcy. Item 1 in the planning activities, state about the articles concerning about the existence of Pinnacle’s Solar Electro division. As indicated in Item 7 in the planning activities, several restrictive covenants were identified. Two requirements of the covenants were to keep the current ratio above 2.0 and debt- to –equity below 1.0 at all the times. As calculated in Part 1, the current ratio has fallen from 2.06 to 1.72. This could result the loan to be called.

Management integrity:

Client evaluation is an important element of quality control ASA 220 Quality Control for Audits of Historical Financial Information. When management lacks integrity, there is a greater likelihood that material errors and irregularities may occur in the accounting process from which the financial statements are prepared. Item 6 in the planning phase, indicates that there is a high turnover especially at the higher-level position in the internal audit departments. This turnover may be intentional and increases the risk of fraudulent financial reporting. For example, the internal auditors who were at a higher position were fired because the auditor found out about the managements financial interest in the entity.

(b)

Item 1: the auditors would be required to obtain sufficient appropriate evidence in order to determine if the article is material. Therefore, the acceptable audit risk for this project will be medium.

Item 4: Since Pinnacle Manufacturing is a risky client; the auditors have to perform more checking of the documents, account, etc. Therefore, the audit risk for the project will be low. The auditors would like to be sure that all the accounts are properly checked and verified.

Item 7: Audit risk will be low since it’s a risky client, the auditors will do more checking. As the requirements state to keep the current ratio above 2.0 (as calculated in Part 1 its 1.72) and the Debt- to- Equity should be below 1 (0.84 as calculated in Part 1). To maintain these requirements, the management can either increase or decrease current assets to satisfy the criteria thus the auditors would do more checking on these.

Item 6: Since the management is changing its internal audit personnel, new members would take time to understand the audit environment and lack experience. While in the process the auditor can get critical information about the company and when it’s put forward in the meeting, the auditor gets fired. So the audit risk would be low since the auditors would not rely on management representation, as the figures would be high or misrepresented.

(c)

Inherent Risk Account or Accounts Affected

Item 2: There is significant risk that inventory is overstated and this cause misstatement of

  1. Inventory;
  2. Cost of Goods Sold

Item 3: Miss Classification of Computerized Equipment that will cause misstatement in

  1. manufacturing equipment

Item 5: Accounts receivable are overstated causing misstatements in

  1. Receivable
  2. Bad Debt
  • Allowance for Uncollectible Accounts

Item 6: New manufacturing plant loan may cause misstatements in

  1. Interest Expense,
  2. Long-term Liabilities plant

Item 7: Todd-Machinery, risk that following accounts are misstated

  1. Accounts Payable
  2. Repairs and Maintenance

Item 8: Internal audit turnover might be the reason of discovery of any fraud or any other irregularity affecting all account balances.

Item 9: Current ratio misstatement can hurt the credibility of all accounts

Item 10: IRS dispute may cause misstatement in

  1. Income Tax Payable,
  2. Cash,
  • Retained Earnings

Item 11: Non-disclosure of intercompany loan will potentially hurt the reliability of

  1. Accounts Payable
  2. Cash

References:

David V.  Budescu,  Mark E. Peecher and Ira Solomon. (2012) The Joint Influence of the Extent and Nature of Audit Evidence, Materiality Thresholds, and Misstatement Type on Achieved Audit Risk. AUDITING: A Journal of Practice & Theory 31:2, 19-41.
Online publication date: 1-Feb-2012.

David V. Budescu, Mark E. Peecher and Ira Solomon. (2012) The Joint Influence of the Extent and Nature of Audit Evidence, Materiality Thresholds, and Misstatement Type on Achieved Audit Risk. AUDITING: A Journal of Practice & Theory 31:2, 19-41.
Online publication date: 1-Feb-2012.