Alex Pugh

U12296693
Pinnacle Manufacturing: Part II
a. External users reliance on financial statements:
6.
The board of directors decided to raise a significant amount of debt. Creditors will need
to rely on the financial statements to assess Pinnacle's creditworthiness
Likelihood of financial difficulties:
1.
The postponement of the EPA regulations encouraging solar powered engines was
postponed and management of Pinnacle was relying on this regulation to increase sales. Sales
now may not meet expectations and may cause financial troubles.
2.
The machines that had been produced longer than a year ago were not sold, which
indicates that Pinnacle is having difficulty moving inventory.
5.
One company accounts for 15% of Pinnacle's accounts receivable balance and this
company has not made payments in several months, indicating that Pinnacle is unable to collect
a significant portion of their accounts receivable.
9.
Pinnacle has a debt covenant that requires them to keep a current ratio above 2.0. Their
current ratio has dropped below 2.0, violating the debt covenant. The lender may require a
penalty such as a penalty payment, higher rate, increased collateral, or immediate repayment.
Management integrity:
7.
The vice president of Pinnacle owns a company that was contracted to do repairs in the
plant. This may present a conflict of interest against the shareholders.
8.
Significant turnover in the upper levels in the internal audit department may indicate a
problem with the integrity of management.
10.

A conflict with the IRS may indicate a problem with management integrity.

11.
An inter-company loan between a Pinnacle and their supplier of machinery, Welburn,
may indicate that Pinnacle is receiving a favorable loan that may include below market interest
rate.
b.

The acceptable audit risk is low based on the information above. Pinnacle is taking on
significant debt, therefore the accuracy of the financial statement is important to creditors. Also
there are a number of situations that indicate likely financial difficulties such as the
postponement of the EPA regulation, stagnant inventory, and large amount of uncollected
receivables and the violation of the debt covenant. The integrity of management is also
questionable as evidenced by the inter-company dealings with Welburn and Todd-Machinery,
the latter of which a top executive own.

c.

1.

Because of the delay in the EPA regulation sales are not going to be what management

expected so they may try and make their sales look higher than they are by creating non-existent
balances of accounts receivable.
4.
The valuation of the building may be inaccurate because the employees of Pinnacle did a
significant amount of the construction work, which may inaccurately portray labor costs in the
construction of the addition to the building. This would affect the accuracy of the plant,
property, equipment account.
5.
15% of Pinnacles accounts receivables being unpaid for several months indicates a
collection problem and a possible understatement to bad debt or doubtful accounts.
7.
The related party transaction could mean a misrepresentation of expenses on the
financial statements.
9.
Pinnacle may alter balance sheet account balances to maintain the needed current ratio
as mandated by the debt covenant.
11.
The related party transaction with Welburn could result in improper recording of
payables or expenses.