Pinnacle Manufacturing Part II

a. Identif specific considerations from part I and II of the cas that affect your assessments of engagement risk and acceptable audit risk. use each of the three factors in the text to categorize your conclusions:

External users' reliance on financial statements

likelihood of financial difficulties

Management integrity

Acceptable Audit Risk and Engagement Risk Issues:

External users’ reliance on financial statements:

1. The company is privately held, but there is a large amount of debt, therefore the financial statements will be used fairly extensively. Also, management is considering selling the Machine-Tech division, which has the potential to result in extensive use of the statements by the buyers.

2. Item 4 in the planning phase indicates plans for additional debt financing.

Likelihood of financial difficulties:

1. The solar power engine business revolves around constantly changing technology, thus making it inherently more risky than other businesses, with a better chance of subsequent bankruptcy. Item 1 in the planning issues raises a concern about the viability of the Solar-Electro division, but not necessarily the entire company.

2. The conclusion in Part I of the case was that the likelihood of financial failure is low, even considering the issue with Solar-Electro.

3. Item 7 in the planning phase indicates there is a debt covenant requiring a current ratio above 2.0 and a debt-to-equity ratio below 1.0. The current ratio has fallen below 2.0. This could result in the loan being called unless a waiver of the loan covenant is granted.

Management integrity: No major issue exists that would cause the auditor to question management integrity, but the auditor should have done extensive client acceptance procedures before accepting the client. It is possible that Item 6 in the planning phase, turnover of internal audit personnel, could be intentional and increases the risk of fraudulent

financial reporting.

b. Acceptable audit risk is likely to be medium to low because of the factors listed previously, especially the planned increase in financing and the potential violation of the debt covenant agreement. Some might prefer an even lower acceptable risk because it is a first year audit.

c. Inherent risks are addressed by examining each of the 11 items in the

planning phase.

1. Inherent Risk: No effect on inherent risk

2. Inherent Risk: The primary concern is the possibility of obsolete

inventory, which affects the valuation of inventory at the lower of

cost or market.

Accounts Affected: Inventory, cost of good sold

3. Inherent Risk: There is a potential related party transaction, which

could affect the valuation of the transaction and may require

disclosure as a related party transaction.

Accounts Affected: Manufacturing equipment, footnote

disclosures

4. Inherent Risk: No effect on inherent risk

5. Inherent Risk: There is a potential related party transaction, which

could affect the valuation of the transaction and may require

disclosure as a related party transaction.

Accounts Affected: Repairs and maintenance expense and

accounts payable.

6. Inherent Risk: Although this does not directly affect inherent risk, it

is possible that turnover of internal audit personnel could