Identification of factors influencing risks and the relationship of risks to audit evidence

After performing preliminary analytical procedures and planning activities for Pinnacle Manufacturing, I have found several factors influencing inherent risks and acceptable audit risk. I have categorized the determinants of acceptable audit risk into three different factors: external users’ reliance on financial statements, likelihood of financial difficulties, and management integrity. All the calculations in detail are listed at the end of this report.

External users’ reliance on financial statements
Pinnacle is a medium-sized corporation, with total assets of $115,434,790, which suggests a fairly large number of external users rely on the financial statements. The Board of Directors has considered selling the Machine-Tech division. This sparks up interest to the users as to find out the reason behind it. It currently has a debt-to-equity ratio of 0.66. But, 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. This would increase the debt-to-equity ratio, which could generate concerns to investors. It is sensible to assess a low acceptable audit risk when the external users rely greatly on the financial statements, which is the case in this audit.

Likelihood of financial difficulties
Its 2012 current ratio and quick ratio are 1.93 and 0.75 respectively. Its 2013 current ratio and quick ratio are 1.75 and 0.69 respectively. This suggests the company is still healthy in terms of carrying cash and cash equivalents, even though its current liabilities have increased in 2013. Its Income before Income Tax for 2013, 2012, and 2011 are $2,093,162, $1,897,352, and $3,059,187 respectively. There is no significant trend of lowering income. Large amount of debt can bring solvency issues to the company. It currently has $2,067,643 of short-term debt and $24,420,090 of long-term debt. It also has two restrictive covenants of keeping the current ratio above 2.0 and debt-to-equity ratio below 1.0 at all times. As mentioned above, its current ratio is not above 2.0.

So, this has the potential of bringing financial difficulties to the company. One of its divisions, Solar-Electro, is in an inherently risky business as it falls under the technology category. Things turn obsolete very fast in this industry, so this could lead to financial difficulties as well. Plus, the regulations of EPA, management is relying upon to increase sales of the Solar-Electro division, is potentially not going into effect for at least ten years. With the above-mentioned factors for financial difficulties being considered, it is reasonable to assess a medium acceptable audit risk.

Management Integrity
Pinnacle has an ongoing dispute with the Internal Revenue Service. Also, during the tour of the warehouse, I noticed a section of solar-powered engines that do not look like the ones advertised on their website. Finally, there is significant turnover at the higher-level positions in the internal audit department. This could potentially bring controls issues, so we need to do more research on this matter. Aside from these three issues, there does not seem to be any problem with the management. Overall, after considering all the three factors, and the fact that we are auditing Pinnacle Manufacturing for the first time, I believe it is reasonable to assess a low acceptable audit risk. The major reasons as to why we should assess a low acceptable audit risk are: Its Solar-Electro division could potentially not be meeting its sales forecasts for the upcoming ten years.

Its Board of Directors has considered selling the Machine-Tech division; however the vice president is committed to making it profitable. It has not been able to meet one of the loan covenant requirements of keeping the current ratio above 2.0, which could entice management to manipulate account receivables and payables valuation. So, valuations done for account receivables and payables should be carefully examined. Inherent risk is the measurement of auditor’s assessment of the likelihood of material misstatements being present in an account balance, class of transaction, or disclosure before considering the effectiveness of internal control (AICPA, AU-C 200). I will go over individual transactions and balances in relation to inherent risk in the next few paragraphs. So, using my professional judgment, I have decided some areas of the audit to be inherently riskier than others.

The inherent risk with inventory is that it can turn obsolete quickly, especially in an environment of technology. Since the EPA regulations are not going into effect for at least ten years, its inventory of Solar-powered engines could very well turn obsolete. Also, inventory needs to be recorded at lower of cost or market, which impacts the valuation of inventory, and this has a direct relationship with current assets. This affects the inventory and cost of goods sold account, and it deals with existence and valuation objectives. The computerized manufacturing equipment at Solar-Electro has a Welburn stamp, which suggests this is a related party transaction. This requires disclosure of the transaction in the footnotes. This affects the equipment account and deals with valuation and classification objectives. Pinnacle employees did a significant amount of construction work for a building addition. This is a non-routine transaction for the company.

Management could try to capitalize construction expenses which is clearly salary and wages expenses. This affects the building account and salary expense account. This deals with accuracy and classification objectives. A customer, Auto-Electro, accounts for nearly 15% of the company’s accounts receivable balance and it has not made any payments for several months. This affects the collection cycle and account receivable turnover ratio. This could entice management not to increase allowance for doubtful account; while it should be recording this as bad debt expense; which leads to an increase in the allowance account. The accounts affected are accounts receivable, allowance for doubtful accounts, and bad debt expense. This deals with realizable value objective.

The repairmen of Todd-Machinery are working in the Pinnacle plant, which suggests another related-party transaction. This requires disclosure of the transaction in the footnotes. This affects maintenance/repair expense account and deals with completeness, valuation, and classification objectives.

Significant turnover of higher-level positions in the internal audit department is a sign of control risk. This enhances inherent risk in all the balances and transactions of the company as a whole.

Pinnacle’s long term debt agreement has several restrictive covenants, which requires them to keep the current ratio above 2.0 and debt-to-equity ratio below 1.0 at all times. This could entice management to create fictitious revenues in the account receivables balance. Other forms of material misstatement or fraudulent activities could be attempted by management in this scenario, so they can meet their requirements of the restrictive covenants. This affects the account receivable, account payable, total debt and equity balances. This deals with existence and valuation objective.

There is an ongoing dispute between the IRS and Pinnacle. So, based on the outcome, this could potentially impact income tax expense/payable account. The objectives affected are existence and completeness.

There is an intercompany loan from Welburn to Solar-Electro. This is a related-party transaction as well, and this affects the notes payable/receivable accounts, and the interest payable/receivable accounts. This requires a disclosure in the footnotes, and this deals with completeness and valuation objectives.

So, these are the factors influencing acceptable audit risk and inherent risk. This requires collection of evidence that is sufficient and appropriate to the audit for us to issue an opinion on the financial statements of the Pinnacle Manufacturing Company.

References
AICPA. “AU-C 200.” Overall Objectives of the Independent Auditor. AICPA, n.d. Web. 20 Apr. 2014.