Chapter 9 Materiality and Risk - HCC Learning Web

Integrated Case Application9-37PINNACLE MANUFACTURING―PART IIa. 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 ofdebt, therefore the financial statements will be used fairlyextensively. Also, management is considering selling theMachine-Tech division, which has the potential to result inextensive use of the statements by the buyers.2. Item 4 in the planning phase indicates plans for additionaldebt financing.Likelihood of financial difficulties:1. The solar power engine business revolves around constantlychanging technology, thus making it inherently more riskythan other businesses, with a better chance of subsequentbankruptcy. Item 1 in the planning issues raises a concernabout the viability of the Solar-Electro division, but notnecessarily the entire company.2. The conclusion in Part I of the case was that the likelihood offinancial failure is low, even considering the issue with Solar-Electro.3. Item 7 in the planning phase indicates there is a debt covenantrequiring a current ratio above 2.0 and a debt-to-equity ratiobelow 1.0. The current ratio has fallen below 2.0. This couldresult in the loan being called unless a waiver of the loancovenant is granted.Management integrity:No major issue exists that would cause the auditor to questionmanagement integrity, but the auditor should have done extensiveclient acceptance procedures before accepting the client. It ispossible that Item 6 in the planning phase, turnover of internal auditpersonnel, could be intentional and increases the risk of fraudulentfinancial reporting.b. Acceptable audit risk is likely to be medium to low because of thefactors listed previously, especially the planned increase infinancing and the potential violation of the debt covenant agreement.Some might prefer an even lower acceptable risk because it is afirst year audit.9-22