What’s been accomplished thus far
As you’ll recall, Excelsior CPAs was engaged as the new auditor for Redline Manufacturing, effective for the audit of the financial statements for the year ended December 31, 2023. As part of your staff auditor duties, you’ve completed an analytical review of Redline Manufacturing’s balance sheet and income statement, summarized your observations about their business, and assessed Redline’s (potential) business and, therefore, audit risk.
Previously provided information about Redline is also provided in the accordion below.
Client Overview
This week’s assignment
During the planning phase of the audit, your audit manager and some other members of the audit team have been gathering additional information. This information gathering included traveling to Detroit to meet with Redline’s management team. Your job this week is to review the provided findings and observations and identify inherent risks and whether you believe they are significant. Then, considering this new information, the results of your previous analytical procedures, and other client knowledge, you will continue your assessment of the overall audit risk.
Step 1: Review the following observations from the Redline Manufacturing audit team.
Be sure to toggle the accordions below to review the complete details associated with each observation.
1. News articles with implications for the Solar-Electro division?
Excelsior CPAs have an employee who reads and summarizes articles about issues that may affect key clients. They have shared two articles.
The first article is “EPA Regulations Encouraging Solar-Powered Engines Postponed?” It suggests the regulations Redline Manufacturing management is relying upon to increase sales of the Solar-Electro division might not go into effect for at least ten years.
The second article is “Stick to Diesel, Redline!” The article claims that although Redline has proven itself within the diesel engine industry, they lack the knowledge and people necessary to perform well in the solar-powered engine industry.
2. Supplier considering Chapter 11
In reading the footnotes of the previous year’s financial statements, an audit team member has discovered that one supplier, Auto-Electro, provides over 20 percent of the raw materials used by Redline. Further investigation revealed that Auto-Electro is considering entering Chapter 11 bankruptcy proceedings due to continuing cash flow difficulties.
3. Restrictive covenants in long-term debt agreements
Several restrictive covenants have been identified in Redline’s long-term debt agreements. Two requirements are to keep the current ratio above 2.0 and debt-to-equity below 1.0. The loans become immediately due if these covenants are not met.
4. New Solar-Electro division manufacturing plant investment
During a meeting with the facilities director, the audit team learned that Redline Manufacturing’s Board of Directors has decided to raise significant debt to finance the construction of a new manufacturing plant for the Solar-Electro division. The company also plans to invest considerably in modifying the property where the future plant will be situated.
5. Significant turnover in internal audit
An inquiry into Redline Manufacturing’s internal audit team has revealed significant turnover in the internal audit department. Upon further investigation, the Excelsior CPAs audit team has determined the turnover is only present at the higher-level positions.
6. Solar-Electro inventory anomaly?
The Excelsior CPAs audit team requested a tour of the Solar-Electro facilities. While touring the warehouse, a team member noted a section of solar-powered engines that looked different from the ones advertised on Redline’s Web site. When asked when those items were manufactured, the warehouse manager responded: “I am not sure. I have been here a year, and they were here when I first arrived.”
7. Todd-Machinery relationship?
While standing in line at a vending machine, an audit team member noted a Redline Manufacturing vice president wearing a golf shirt with the words “Todd-Machinery.” As the audit team member was familiar with the company and noticed some of its repair people working in the Redline plant earlier, they approached the VP and told him they liked his shirt. The VP’s response: “Thank you. My wife and I own the company, but we hire people to manage it.”
8. Ongoing dispute with IRS?
The engagement partner from Excelsior CPAs recently revealed that Brian Sioux, an industry specialist and senior tax manager from the firm’s Ontario office, will be coming onsite to Redline’s facilities to investigate an ongoing dispute between the Internal Revenue Service and Redline.
Step 2: Assess inherent risk associated with each situation above.
Identify any risk factors associated with each situation above and then categorize each of those risk factors as one of the following:
An overall financial statement-level risk potentially affecting multiple accounts
An assertion-level risk for one or more accounts (indicate the primary balance sheet account affected)
No effect on inherent risk
Be sure to explain your decision-making process.
Our earlier video regarding inherent riskLinks to an external site. will aid your ability to complete this step (as well as step 4).
Step 3: For each situation you judge to represent inherent risk, assess if it is significant.
Explain why it is (or is not) a significant risk and what audit test(s) you might perform to address the risk.
Our earlier video regarding identifying significant risks for an audit clientLinks to an external site. will aid your ability to complete this step.
Step 4: Assess acceptable audit risk as low, moderate, or high.
This assessment should be based on the situations above, your previous analytical procedures work, and other information provided to you about Redline Manufacturing.
In making your assessment, evaluate Redline Manufacturing on the three factors that make up acceptable audit risk:
External users’ reliance on financial statements
Likelihood of financial difficulties
Management integrity
Be sure to justify your response!
Step 5: Summarize your Step 2-4 work in a single document.
Your document should be structured as follows:
Situation assessments (steps 2 and 3)
1. The number and title of the scenario/situation (e.g., 1. News articles with implications for the Solar-Electro division?)
Discussion/assessment of inherent risks
Discussion/assessment of risk significance
Same information for situations 2-8.
Overall audit risk assessment (step 4)