EarthWear Hands-on Mini-case

Chapter 5 - Preliminary Analytical Procedures

The McGraw-Hill Companies, Inc., 2010

In this mini-case you will complete the preliminary analytical procedures for the audit of EarthWear Clothiers, Inc. INSTRUCTIONS: ratio analyses contained Paper 5-1. can read the 1 Review theModule: Selected Financialon Workin Chapter 5Youthe text for a Advanced Ratios of

description of these ratios.You will be asked to provide further analyses of these ratios as you complete Work Paper 5-2.

Fields you are to complete decisions. you in your on work papers are colored yellow. The color will disappear when the field is completed

Work Paper 5-2 indicated 2 Complete all the fields on Financial Statements havein yellow. Additionally, EarthWear Common-Size been included to aid Work Paper 5-3 indicated 3 Complete all the fields on Financial Statements havein yellow. Additionally, EarthWear Common-Size been included to aid with the work papers, enter your initials 4 When completed right-hand corner of Work Paper 5-2 and in the yellow box in the upper 5-3 (box

Fields you are to complete decisions. you in your on work papers are colored yellow. The color will disappear when the field is completed

indicates "Initial Here"). 5 Please print hard copies of work papers 5-2 and 5-3 to submit unless your instructor requests an electronic submission. The work papers are each formatted to fit on one page.

EARTHWEAR CLOTHIERS Ratio Analyses December 31, 2010

December 31

5-1 SAA 1/3/2011 Differe nce from Expecte d 0.23 0.08 0.00 Industry Differen Averag ce (from e 2010) 2.10 0.80 N/A 0.07 -0.07 N/A

2006 2007 2008 2009 2010 2010 (Audite (Audite (Audite (Audite Expect Actual d) d) d) d) ed* (unaudited) SHORT-TERM LIQUIDITY RATIOS: Current Ratio current assets / current liabilities Quick Ratio liquid assets / current liabilities 1.64 0.39 1.43 0.44 0.42 1.92 0.62 0.81 1.80 0.53 0.34 1.94 0.65 0.40 2.17 0.73 0.40

Operating Cash Flow Ratio 0.69 cash flow from operations / current liabilities ACTIVITY RATIOS: Receivables Turnover net sales / net ending receivables 71.18

77.25 4.73 4.27 85.51

74.34 4.91 4.48 81.40

73.82 4.94 4.47 81.72

75.41 4.84 4.99 69.22

118.00 3.09 3.87 94.99

42.60 -1.74 -1.12 25.78

N/A 14.10 6.20 58.70

N/A -11.01 -2.33 36.29

Days Outstanding in Accounts Receivable5.13 365 days / receivables turnover Inventory Turnover cost of sales / inventory Days of Inventory on Hand 365 / (cost of sales / inventory) 3.43 106.41

PROFITABILITY / PERFORMANCE RATIOS: Gross Profit Percentage gross profit / net sales Profit Margin net income / net sales Return on Assets net income / total assets Return on Equity net income / total owners' equity COVERAGE RATIOS: Debt to Equity 0.79 total liabilities / shareholders' investment 0.88 0.58 26.41 0.61 23.92 0.51 10.19 0.50 50.57 -0.01 40.38 0.84 N/A -0.34 N/A 44.95% 44.91% 44.89% 42.51% 42.49% 2.34% 14.80% 3.61% 3.64% 2.37% 6.83% 3.02% 4.69% 5.92% 43.90% 4.26% 11.17% 1.41% 1.24% 6.48% 38.80% 3.30% 7.40% 17.50% 5.10% 0.96% 3.77% -0.80%

6.84% 10.53%

26.43% 12.86% 16.22% 11.03%

16.70% 10.78%

Times Interest Earned 53.88 26.31 (net income + interest expense) / interest expense

* Expected values are obtained by using the forecast function in Excel (using the row of data from 2006 and 2009 to obtain the expected value for 2010). Industry Source: Dun & Bradstreet (D&B). The median values of the industry ratios are used for comparison purposes. For ratios not specifically included on D&B, ratios were calculated from average financial statement data provided. N/A = not available or could not be calculated from financial data.

Name: Class: EARTHWEAR CLOTHIERS Preliminary Analytical Procedures Summary of Ratio Analyses & Assessment of Financial Condition December 31, 2010 1. Comments and Summary Based on your review of work paper 5-1, list one or two ratios in each of the following categories that you believe increase the risk of potential misstatement. Explain why you For example, "Days of Inventory on Hand" increased significantly indicating merchandise is held in inventory for a longer period than prior years and it is also held for a longer SHORT-TERM LIQUIDITY RATIOS: Current ratio is a measure of the ability of a firm to meet its short-term obligations. In general, a ratio of 2 to 3 is usually considered good. Too small a ratio indicates that there is some potential difficulty in covering obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them. In this particular case, EarthWear Clothes has a relatively high current ratio of 2.17 for the actual but unaudited year of 2010. Prior years shown current ratios of less than 2. For this reason, I believe that this ratio increases the risk of misstatement. For instance, the increase in the current ratio could be a red flag for revenue recognition, understatement of liabilities and expenses. If the current ratio decreased, which is not the case here, the misstatement would indicate that there is a possibility of a cash skimming scheme or fictitious receivables. Additionally, the industry average provides a current ratio of 2.10 higher than EarthWear Clothes current ratio. This maybe questionable and lead to a misstatement but than we need to consider that the industry average is just an average and that there could be slight differences in the nature of businesses, which is why indusrty average is important or reliable as looking into a company's year-to-year financial ratios. Quick ratio (or acid-test) ratio is a more stringent measure of liquidity. Only liquid assets are taken into account. Inventory and other assets are excluded, as they may be difficult to dispose of. The quick ratio may provide a better picture of the entity's liquidity position if inventory contains obsolete or slow-moving items. A ratio greater than 1 generally indicates that the entity's liquid assets are sufficient to meet the cash requirements for paying current liabilities. In case, EarthWear Clothes has a relatively high quick ratio of 0.73 for the actual but unaudited year of 2010. Prior years ACTIVITY RATIOS: Receivable tunover ratio provides an indicator of the effectiveness of a company's credit policy. The high receivable turnover will indicate that the company collects its dues from its customers quickly. If this ratio is too high compared to the industry, this may indicate that the company does not offer its clients a long enough credit facility, and as a result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers, and may be a sign that sales are perhaps overstated. In this particular case, EarthWear Clothes has a relatively high receivable ratio of 118 for the actual but unaudited year of 2010. This could indicate that the company collects its dues from its customers quickly but doesn't extend the credit terms or credit lines enough to its customers - which could mean a decrease in sales. However, prior years have shown slight to moderate changes but than a large difference in 2010 makes this ratio increase the risk of misstatement. Inflating the a/r turnover ratio indicates a possible revenue recognition fraud. Which is the probable case here. If the opposite were true, the decrease in the a/r turnover ratio would indicate fictitious receivables and inflating the value of receivables. Inventory turnover provides an indication of how efficiently the company's inventory is utilized by management. A high inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not languish, which may mean there is less risk that the inventory reported has decreased in value. Too high a ratio could indicate a level of inventory that is too low, perhaps resulting in frequent shortages of stock and the potential of losing customers. It could also indicate inadequate production levels for meeting customer demand. In this case, with EarthWear Clothes has a low inventory ratio of 3.87 in the actual and unaudited year of 2010. Prior years showed a steady increase higher than 3. This could mean that EarthWear Clothes has too much inventory on hand and it could signal to the auditor that the inventory contains obsolete or slow-moving goods PROFITABILITY / PERFORMANCE RATIOS: Gross profit margins shows the average amount of profit considering only sales and the cost of the items sold. This tells how much profit the product or service is making without overhead considerations. As such, it indicates the efficiency of operations as well as how products are priced. Wide variations occur from industry to industry. In the case of EarthWear Clothes, gross profit margin is 43.90% for the actual and unaudited year of 2010 - greater than the previous year.The gross profit margin also indicates that there is a 5.10% increase from the Industry average -which may indicate that the company is doing well and above average. However, the increase in the risk of potential misstatement is evident because with an increase in gross profit margin, there is increased risk that fictitious revenue fraud is also occurring. There is an increased risk for fictitious revenue when the increase in gross profit margin is accompanied by an increase in sales and a decrease or constant trend in cost of sales. Other errors include if the client has failed to record sales, the gross profit will be less than in previous years. Simiarly, any errors that affect the inventory account can distort this ratio. For example, if the client has omitted goods from the ending inventory, this ratio will be smaller than in previous years. Profit Margin indicates the profitability of a company's operations. While the gross profit percentage ratio measures profitability after costs of goods sold is deducted, the profit margin ratio measures the entity's profitability after all expenses are considered. Significant fluctations in this ratio may indicate that misstatements exist in the selling, general, or administrative expenses. In the case of EarthWear Clothes, the risk of potential misstatement is high because the ratio shows a 4.26% in the actual and unaudited COVERAGE RATIOS: Debt to equity ratio indicates what portion of the entity's capital comes from debt. In the case of EarthWear clothes, 0.50 was the actual and audited ratio for the year 2010. Compared to previous years, it has steadily decreased - which means that there is less debt pressure on the company. Additionally, its 0.34 down from the industry average, which is a strong indicator that the company is not highly leveraged and that it can meet its debt obligations on a long-term basis. This ratio increases the risk of misstatement because EarthWear clothes could be under-reporting/understating or hidding the debt. Times interest earned indicates the degree of protection available to creditors by measuring the extent to which earnings available for interest covers required interest payments. The increase risk of potential misstatement is evident because the of abnormal fluctuations in the ratio throughout the five year period. It's reported that the unaudited and actual ratio for the year 2010 was 50.57 - that's a 40.38 jump from what is was in the year 2009. The more times the interest is earned, the better the entity's ability to service the interest on longterm debt. But because there is reasonable assurance to believe that Earth Wear Clothes is 2. Assessment of Financial Position Based on your review of work paper 5-1, assess the client's ability to continue as a going concern (to stay in business) by responding to the following questions. A. Identify ratios and trends, if any, that cause concern about the client's ability to continue as a going concern As mentioned previously, the coverage ratios appear to have a high risk if misstatements that are largely co-exist with the question if the company can continue as a growing B. Identify ratios and trends, if any, that indicate a high likelihood that the client will continue successfully as a going concern The short-term liquidity ratios indicate positive results for EarthWear Clothes. They can meet their current obligations and cn continue successfully as a going concern. C. Assess the client's financial condition as one of the following (select one from the drop down list in cell B35) Moderate possibility that the company will NOT successfully continue in business for at least one year and be able to pay its debts as they become due. D. Briefly explain the reasoning behind your assessment. EarthWear Clothes's receviables are questionable given that there is possible misstatement concerning revenue recognition. Their receivable turnover indicate a dramatic increase compared to prior years and the industry average - this can say that customers pay back on credit quickly - but they maye limited in other aspects; which could hurt EarthWear Clothes's sales. The inventory turnover is low of a ratio demonstrating that is not only slowmoving but is counterproductive to the effectiveness and efficiency of the operations. 5-2 DB 8/20/2011

Name: Class: EARTHWEAR CLOTHIERS Identification of Accounts with Unexpected Fluctuations December 31, 2010 5-3 DB 8/20/2011

1. Establish Threshold for Unexpected Fluctuations To begin identifying accounts with unexpected fluctuations auditors must establish a threshold for account difference. All accounts whose actual 2010 unaudited account balance differs from the expected balance by a value greater than the threshold established will be shown in the charts below. As a general rule the threshold should not exceed materiality. For the purposes of this exercise we assume planning materiality is $3.1 million. Enter this value in the field below as 3100. A. Set threshold for account difference in thousands $3,100

2. Evaluate Unexpected Income Statement accounts have been generated below based on your threshold for account difference. In the Lists of Balance Sheet and Fluctuations "Evaluation" column please identify 2 or more balance sheet and 2 or more income statement accounts where you believe the difference presents increased risk of material misstatement that may require a change in the nature, timing or extent of planned audit procedures. Please indicate possible reasons for the difference, potential risks, and suggested audit plan revisions. A. Balance Sheet Accounts Account Cash and cash equivalents Difference from Expectations $31,071

Evaluation This large difference in expectations has to probably due with the fact that the company has expanded it's economic resources owned and are expected to provide future cash inflows. The potential risk include not being able to cover or meet its current liabilites. Understating cash and equivalents could be a potential risk when used for tax purposes. Indicate possible reasons for difference, potential risks, and suggested audit plan This increase difference in expectations has to do with the fact that company has enough capital to acquire the fixed assets to conduct the normal courses of business. Any error in the physical count at the end of the accounting period will misstate inventory shrinkage and the cost of merchandise sold. Retained earnings as well as total assets will for difference, potential risks, and suggested audit plan Indicate possible reasons be misstated. Indicate possible reasons for difference, potential risks, and suggested audit plan Indicate possible reasons for difference, potential risks, and suggested audit plan Indicate possible reasons for difference, potential risks, and suggested audit plan Indicate possible reasons for difference, potential risks, and suggested audit plan Indicate possible reasons for difference, potential risks, and suggested audit plan Indicate possible reasons for difference, potential risks, and suggested audit plan Indicate possible reasons for difference, potential risks, and suggested audit plan Indicate possible reasons for difference, potential risks, and suggested audit plan

Receivables, net Inventory

($5,568) $8,444

Other prepaid expenses ($3,414) Computer hardware and software ($7,107) Lines of credit ($3,892) Accounts payable ($22,401) Accrued liabilities $5,456 Income taxes payable $5,711 Deferred income taxes ($4,666) Additional paid-in capital $3,550 Accumulated other comprehensive income ($3,855) Treasury stock, 6,654, 7,114, and 6,546 shares at cost, respectively $23,926

B. Income Statement Accounts Account Net Sales Cost of sales Selling, general and administrative expenses Income tax provision

Difference from Expectations ($23,193) ($47,893) ($18,851) $10,864

Evaluation This increase in this difference in the total amount charged customers for merchandise sold, including cash sales and sales on account. Both sales returns and allowance and sales discounts are substracted in arriving at net sales. The company increased its account receivables and ispurchases caused by the sale of The costs fof goods sold represent the outflow of likely to contain misstatements. inventory and is the most important expense on the income statement of companies that sell goods instead of services. This explains why cogs is matched against net sales.reasons for difference, potential risks, and suggested audit plan Indicate possible Indicate possible reasons for difference, potential risks, and suggested audit plan

EARTHWEAR CLOTHIERS Common-size Consolidated Balance Sheet (In thousands)

December 31

5-4 SAA 1/3/2011 2010 Actual Dollar % of Total Value Assets 20.38% 2.22% 37.93% 2.62% 1.40% 2.65% 67.20% 19.66% 17.62% 19.36% 0.81% 57.45% 25.09% 32.36% 0.45% 100.00%

Assets Current Assets: Cash and cash equivalents Receivables, net Inventory Prepaid advertising Other prepaid expenses Deferred income tax benefits Total current assets Property, plant and equipment, at cost Land and buildings Fixtures and equipment Computer hardware and software Leasehold improvements Total property, plant and equipment Less - accumulated depreciation and amortization Property, plant and equipment, net Intangibles, net Total assets

2008 Dollar % of Total Value Assets $49,668 $11,539 $105,425 $10,772 $3,780 $6,930 $188,115 $66,804 $66,876 $47,466 $2,894 $184,040 $76,256 $107,784 $628 $296,527 16.75% 3.89% 35.55% 3.63% 1.27% 2.34% 63.44% 22.53% 22.55% 16.01% 0.98% 62.07% 25.72% 36.35% 0.21% 100.00%

2009 Dollar % of Total Value Assets $48,978 $12,875 $122,337 $11,458 $6,315 $7,132 $209,095 $70,918 $67,513 $64,986 $3,010 $206,426 $85,986 $120,440 $423 $329,959 14.84% 3.90% 37.08% 3.47% 1.91% 2.16% 63.37% 21.49% 20.46% 19.70% 0.91% 62.56% 26.06% 36.50% 0.13% 100.00%

Expected* Dollar % of Total Value Assets $48,288 $14,211 $139,249 $12,143 $8,849 $7,335 $230,075 $75,031 $68,150 $82,507 $3,125 $228,812 $95,716 $133,097 $218 $363,390

Difference Dollar % of Total Value Assets $31,071 ($5,568) $8,444 ($1,932) ($3,414) $3,003 $31,604 $1,529 $482 ($7,107) $20 ($5,076) $2,007 ($7,082) $1,516 $26,038 7.09% -1.69% -0.39% -0.72% -1.04% 0.64% 3.88% 0.00% -0.99% -1.13% -3.34% -0.05% -5.51% -1.25% -4.27% 0.39% 0.00%

13.29% $79,359 3.91% $8,643 38.32% $147,693 3.34% $10,212 2.44% $5,435 2.02% $10,338 63.31% $261,680 20.65% $76,560 18.75% $68,632 22.70% $75,400 0.86% $3,144 62.97% $223,737 26.34% $97,722 36.63% $126,014 0.06% $1,734 100.00% $389,428

Liabilities and shareholder's investment Current liabilities: Lines of credit $7,621 2.57% $11,011 Accounts payable $48,432 16.33% $62,509 Reserve for returns $5,115 1.72% $5,890 Accrued liabilities $28,440 9.59% $26,738 Accrued profit sharing $1,794 0.61% $1,532 Income taxes payable $6,666 2.25% $8,588 Total current liabilities $98,067 33.07% $116,268 Deferred income taxes $5,926 2.00% $9,469 Shareholders' investment: Common stock, 26,144 shares issued $261 0.09% $261 Donated capital $5,460 1.84% $5,460 Additional paid-in capital $19,311 6.51% $20,740 Deferred compensation ($153) -0.05% ($79) Accumulated other comprehensive income $1,739 0.59% $3,883 Retained earnings $295,380 99.61% $317,907 Treasury stock, 6,654, 7,114, and 6,546 shares at cost, respectively ($129,462) -43.66% ($143,950) Total shareholders' investment $192,535 64.93% $204,222 Total liabilities and shareholders' investment $296,527 100.00% $329,959

3.34% 18.94% 1.78% 8.10% 0.46% 2.60% 35.24% 2.87%

$14,401 $76,587 $6,664 $25,035 $1,270 $10,511 $134,469 $13,011

3.96% $10,510 21.08% $54,186 1.83% $6,100 6.89% $30,492 0.35% $3,108 2.89% $16,222 37.00% $120,617 3.58% $8,345 0.07% $261 1.50% $5,460 6.10% $25,719 0.00% ($36) 1.66% $2,173 93.68% $361,402 -43.60% ### 59.42% $260,467 100.00% $389,428

2.70% 13.91% 1.57% 7.83% 0.80% 4.17% 30.97% 2.14% 0.07% 1.40% 6.60% -0.01% 0.56% 92.80% -34.54% 66.88% 100.00%

($3,892) ($22,401) ($565) $5,456 $1,838 $5,711 ($13,853) ($4,666) $0 $0 $3,550 ($33) ($3,855) $20,968 $23,926 $44,557 $26,038

-1.26% -7.16% -0.27% 0.94% 0.45% 1.27% -6.03% -1.44% 0.00% -0.10% 0.50% -0.01% -1.10% -0.88% 9.06% 7.47% 0.00%

0.08% $261 1.65% $5,460 6.29% $22,170 -0.02% ($4) 1.18% $6,027 96.35% $340,434 -43.63% ($158,438) 61.89% $215,910 100.00% $363,390

* Expected values are obtained by using the forecast function in Excel (using the row of data from 2008 and 2009 to obtain the expected value for 2010).

The McGraw-Hill Companies, Inc., 2010

EARTHWEAR CLOTHIERS Common-size Statements of Operations (In thousands, except per share data)
For the period ended December 31

5-5 SAA 1/3/2011

2008 Dollar Value % Net Sales 857,885 Cost of sales 472,739 Gross Profit 385,146 Selling, general and administrative expenses 334,994 Non-recurring charge (credit) (1,153) Income from operations 51,305 Other income (expense): Interest expense (1,229) Interest income 573 Gain on sale of subsidiary Other (1,091) Total other income (expense), net (1,747) Income before income taxes 49,559 Income tax provision 18,337 Net income 31,222 Basic earnings per share 1.60 Diluted earnings per share 1.56 Basic weighted average shares outstanding 19,555 Diluted weighted average shares outstanding 20,055

of Sales 100.00% 55.11% 44.89% 39.05% -0.13% 5.98% 0.00% -0.14% 0.07% 0.00% -0.13% -0.20% 5.78% 2.14% 3.64%

2010 Expected* Actual 2009 Dollar Value % of Sales Dollar Value % of Sales Dollar % of Sales 950,484 100.00% 1,043,083 100.00% 1,019,890 100.00% 546,393 57.49% 620,046 59.44% 572,153 56.10% 404,091 42.51% 423,037 40.56% 447,737 43.90% 364,012 38.30% 393,031 37.68% 374,180 36.69% 0.00% 0.00% 0.00% 40,729 4.29% 46,050 4.41% 73,557 7.21% 0.00% 0.00% 0.00% (983) -0.10% (737) -0.07% (878) -0.09% 1,459 0.15% 1,017 0.10% 989 0.10% 0.00% 0.00% 0.00% (4,798) -0.50% (2,947) -0.28% (3,514) -0.34% (4,322) -0.45% (3,037) -0.29% (3,403) -0.33% 35,757 3.76% 42,688 4.09% 70,154 6.88% 13,230 1.39% 15,794 1.51% 26,658 2.61% 22,527 2.37% 26,894 2.58% 43,495 4.26% 1.15 1.38 1.48 1.14 1.35 1.45 19,531 19,558 19,159 19,774 19,930 19,485

Difference Dollar % of Sales (23,193) 0.00% (47,893) -3.34% 24,700 3.34% (18,851) -0.99% 0 0.00% 27,506 2.80% 0 0.00% (140) -0.02% (28) 0.00% 0 0.00% (567) -0.06% (366) -0.04% 27,466 2.79% 10,864 1.10% 16,602 1.69% 0.10 0.10 (398) (445)

* Expected values are obtained by using the forecast function in Excel (using the row of data from 2008 and 2009 to obtain the expected value for 2010).

The McGraw-Hill Companies, Inc., 2010