EarthWear Hands-on Mini-case

Chapter 3 - Audit Planning Memo

The McGraw-Hill Companies, Inc., 2012

In this case you will complete the audit planning memo for the EarthWear engagement. Additional information to help you prepare this memo can be obtained from the EarthWear and Willis & Adams websites. A planning memo is typically used to summarize the considerations and conclusions involved in several of the audit planning phases youve read about in Chapter 3. INSTRUCTIONS:

Willis and Adams, CPAs uses the template shown in the "Audit Planning Memorandum" worksheet tab to prepare the planning memo. Some portions have already been completed or begun. These portions are indicated in plain text. Portions highlighted in green will be completed by other auditors; however, brief descriptions of what will be included in these sections of the planning memo are included in the template for instructional purposes. For each of the memo topics that remain to be completed (areas highlighted in yellow), you should address at least two key points about EarthWear Clothiers or the mail order clothing industry. Keep in mind that the points you identify should have important implications for the audit. Address each topic using information from the EarthWear and Willis & Adams websites, the textbook, the work papers provided in this workbook, and prior mini-cases.
Fields you are to complete on the form are colored yellow. The color will disappear as the field is completed.

In addition to the analytical procedures already listed in the memo, analyze an additional four that are useful in the planning process for the EarthWear audit (see area highlighted in yellow in "Audit Planning Memorandum" tab). Discuss the meaning of the analytical procedures included and how they may affect your audit plan/procedures. Work Paper 3-6 and the Common Size Balance Sheet and Income Statement for EarthWear have been provided to assist you. Print a copy of the Print Out to submit in class unless otherwise indicated by your instructor.

EARTHWEAR CLOTHIERS Audit Planning Memorandum December 31, 2012 ENGAGEMENT OBJECTIVES, DELIVERABLES, AND KEY DATES Typically, in this section the auditors will discuss the scope of the upcoming audit. The auditor will list the deliverables that will result from their work (e.g., debt covenant letters, quarterly reviews, etc). Lastly, the auditor will typically list or attach a schedule of when each of those deliverables will be completed. UNDERSTANDING THE BUSINESS A short history of the company is typically given in this section. Some detail pertaining to the location(s) of the business will be provided, along with an organizational chart of the company and its entities. An overview of the companys strategy may be provided as well. Related parties will be listed and an industry overview is also typically included, along with any regulatory developments which have taken/are taking place in relation to the company or industry. From a financial standpoint, preliminary analytics will be performed to provide a high-level perspective of the companys development over time and relation to the industry as a whole. Finally, this section may conclude with an initial assessment of the company as a going concern. BACKGROUND INFORMATION Business Strategy and Target Customers EarthWear Clothiers generates revenue mainly through the sale of high quality clothing for outdoor sports, such as hiking, skiing, fly-fishing, and white-water kayaking. The companys product lines also include casual clothes, accessories, shoes, and soft luggage. The companys key customers are the 18.8 million persons on its mailing list, approximately 6.8 million of whom are viewed as current customers because they have purchased from the company in the last 24 months. Market research as of January 2011 indicates that approximately 50 percent of customers are in the 35-54 age group and had a median income of $62,000. Almost two-thirds are in professional or managerial positions. Suppliers During 2011, one manufacturer and one intermediary accounted for about 14 and 29 percent of the Company's received merchandise exposing Earthwear to supplier risk. In addition, Earthwear purchases about 80% of their merchandise from Asia, Central America, Mexico, and Central America which introduces foreign currency risk. Competition EarthWear Clothier's faces strong competition from established brands and from various channels including retail stores, internet stores, and mail order clothing companies. Mail order clothing companies rely heavily on their reputation and their operational efficiencies, including customer service, to compete with the aforementioned various sources of competition. Social Factors The companys results can be affected by changing fashion trends . Analytical Procedures *Days Outstanding in Accounts Receivable is 3.09 and the industry average is 14.10. This ratio indicates that EarthWear collects on sales much more quickly than the rest of the industry. It also represents a significant improvement relative to prior years for EarthWear and is better than expected for this year. This ratio is consistent with a relatively low allowance for doubtful accounts. Controller explains that fast collection rate is a result of increased focus on collection activities and newly implemented incentives for early payment. We will corroborate the client's explanation as a part of our testing in the sales & collection cycle. Analyze 4 additional analytical procedures that were completed in the planning process. EarthWear's Quick Ratio is 0.73 and the industry average is 0.80 *Quick Ratio is 0.73 and the industry average is 0.80. Analysis of the quick ratio provides insight into the company's ability to pay its current liabilities. EarthWear's industry-lagging ratio suggests that EarthWear may be more at risk of defaulting on current liabilities if they are unable to sell obsolete or slow-moving inventory. The increasing amount of net sales from liquidiations 2009-2011 (8%,11%,12%) suggests that EarthWear's products are losing appeal in the market. EarthWear's Inventory Turnover is 3.88 and the industry average is 6.20 *Inventory Turnover is 3.88 and the industry average is 6.20. Inventury turnover indicates the frequency with which inventory is consumed in a year. Earthwear's inventory turnover of 3.88 is significantly lower than the industry average and may suggest that the company's inventory contains obsolete or slow-moving goods. EarthWear's Gross Profit Percentage is 43.90% and the industry average is 38.80%

Prepared by: Reviewed by: Date:

2/16/2013

*Gross Profit Percentage is 43.90% and the industry average is 38.80%. Gross Profit Percentage is a good indicator of potential misstatements as companies within an industry have similar figures. EarthWear's industry leading gross profit percentage indicates raises concerns and indicates a need to examine for potential misstatements. EarthWear's Debt to Equity ratio is 0.50 and the industry average is 0.84 *Debt to Equity ratio is 0.50 and the industry average is 0.84. This ratio indicates the portion of the entity's capital that comes from debt. EarthWear's lower than average debt to equity ratio suggests that Earthwear faces less debt pressure than other companies within the industry which is probably a function of many companies within the industry not being public. INTERNAL CONTROL ENVIRONMENT In this section, the auditors will discuss the control environment, including company-level controls. Prior audit results pertaining to the control environment may also be reported, in addition to the amount of control reliance expected throughout the audit.

AUDIT SCOPE CONSIDERATIONS Typically, in this section the auditors will discuss the scope of the procedures to be performed. Materiality for the audit and tolerable misstatement for accounts or business processes will be established. These scoping decisions will affect audit program preparation at a more detailed level. For example, tolerable misstatement will affect sample sizes involved in tests of details, with lower levels of tolerable misstatement leading to larger sample sizes. Materiality Materiality for the 2012 audit is calculated on work paper 3-7. COMMUNICATION AND COORDINATION With regards to communication and coordination, the auditor will discuss how specialists/experts will be used throughout the audit. In addition, the auditor may list the locations that will be visited so that the audit may be more efficiently coordinated. Lastly, the auditor may create a review schedule so the entire audit team knows the timetable for the audit and the work that needs to be performed.

SUMMARY OF AUDIT PLAN In this section, a summary of all the previously addressed issues will be provided. Key issues, such as the scope of the audit, the main risks which need to be addressed, and the schedule of the audit will all be reviewed and included. AUDIT PLANNING MEMORANDUM APPROVALS The audit partners and managers will sign off on the planning memo as evidence that they are in agreement as to the documented understanding of the client and its risks, as well as the scope and plan of the audit, as presented in this memorandum.

The McGraw-Hill Companies, Inc., 2012

Name: Class: EARTHWEAR CLOTHIERS Audit Planning Memorandum December 31, 2012 PRINT OUT Suppliers During 2011, one manufacturer and one intermediary accounted for about 14 and 29 percent of the Company's received merchandise exposing Earthwear to supplier risk. In addition, Earthwear purchases about 80% of their merchandise from Asia, Central America, Mexico, and Central America which introduces foreign currency risk. Competition EarthWear Clothier's faces strong competition from established brands and from various channels including retail stores, internet stores, and mail order clothing companies. Mail order clothing companies rely heavily on their reputation and their operational efficiencies, including customer service, to compete with the aforementioned various sources of competition. Analytical Procedures *Quick Ratio is 0.73 and the industry average is 0.80. Analysis of the quick ratio provides insight into the company's ability to pay its current liabilities. EarthWear's industry-lagging ratio suggests that EarthWear may be more at risk of defaulting on current liabilities if they are unable to sell obsolete or slow-moving inventory. The increasing amount of net sales from liquidiations 2009-2011 (8%,11%,12%) suggests that EarthWear's products are losing appeal in the market. *Inventory Turnover is 3.88 and the industry average is 6.20. Inventury turnover indicates the frequency with which inventory is consumed in a year. Earthwear's inventory turnover of 3.88 is significantly lower than the industry average and may suggest that the company's inventory contains obsolete or slow-moving goods. *Gross Profit Percentage is 43.90% and the industry average is 38.80%. Gross Profit Percentage is a good indicator of potential misstatements as companies within an industry have similar figures. EarthWear's industry leading gross profit percentage indicates raises concerns and indicates a need to examine for potential misstatements. *Debt to Equity ratio is 0.50 and the industry average is 0.84. This ratio indicates the portion of the entity's capital that comes from debt. EarthWear's lower than average debt to equity ratio suggests that Earthwear faces less debt pressure than other companies within the industry which is probably a function of many companies within the industry not being public. Prepared by: Reviewed by: Date:

2/16/2013

EARTHWEAR CLOTHIERS Ratio Analyses December 31, 2012

December 31

6-Mar SAA 1/3/2013 2012 2012 Actual (unaudited) 2.17 0.73 0.40 Difference from Expected 0.23 0.08 0.00 Industry Difference Average (from 2012) 2.10 0.80 N/A 0.07 -0.07 N/A

2008

2009

2010

2011

(Audited) (Audited) (Audited) (Audited) Expected* SHORT-TERM LIQUIDITY RATIOS: Current Ratio current assets / current liabilities Quick Ratio liquid assets / current liabilities Operating Cash Flow Ratio cash flow from operations / current liabilities ACTIVITY RATIOS: Receivables Turnover net sales / net ending receivables Days Outstanding in Accounts Receivable 365 days / receivables turnover Inventory Turnover cost of sales / inventory Days of Inventory on Hand 365 / (cost of sales / inventory) 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 total liabilities / shareholders' investment Times Interest Earned (net income + interest expense) / interest expense 0.79 53.88 0.88 26.31 0.58 26.41 0.61 23.92 0.51 10.19 44.95% 2.34% 14.80% 26.43% 44.91% 3.61% 6.84% 12.86% 44.89% 3.64% 10.53% 16.22% 42.51% 2.37% 6.83% 11.03% 42.49% 3.02% 4.69% 5.92% 71.18 5.13 3.43 106.41 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 1.64 0.39 0.69 1.43 0.44 0.42 1.92 0.62 0.81 1.80 0.53 0.34 1.94 0.65 0.40

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

43.90% 4.26% 11.17% 16.70%

1.41% 1.24% 6.48% 10.78%

38.80% 3.30% 7.40% 17.50%

5.10% 0.96% 3.77% -0.80%

0.50 50.57

-0.01 40.38

0.84 N/A

-0.34 N/A

* Expected values are obtained by using the forecast function in Excel (using the row of data from 2010 and 2011 to obtain the expected value for 2012). 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.

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

December 31

5-4 SAA 1/3/2013

2010 Dollar Value 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 Liabilities and shareholder's investment Current liabilities: Lines of credit Accounts payable Reserve for returns Accrued liabilities Accrued profit sharing Income taxes payable Total current liabilities Deferred income taxes Shareholders' investment: Common stock, 26,144 shares issued Donated capital Additional paid-in capital Deferred compensation Accumulated other comprehensive income Retained earnings Treasury stock, 6,654, 7,114, and 6,546 shares at cost, respectively Total shareholders' investment Total liabilities and shareholders' investment % of Total Assets 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% Dollar Value

2011 % of Total Assets 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 Value % of Total 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 13.29% 3.91% 38.32% 3.34% 2.44% 2.02% 63.31% 20.65% 18.75% 22.70% 0.86% 62.97% 26.34% 36.63% 0.06% 100.00%

2012 Actual Dollar Value % of Total Assets $79,359 $8,643 $147,693 $10,212 $5,435 $10,338 $261,680 $76,560 $68,632 $75,400 $3,144 $223,737 $97,722 $126,014 $1,734 $389,428 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%

Difference Dollar Value % of Total 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%

$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

$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

$7,621 $48,432 $5,115 $28,440 $1,794 $6,666 $98,067 $5,926 $261 $5,460 $19,311 ($153) $1,739 $295,380 ($129,462) $192,535 $296,527

2.57% 16.33% 1.72% 9.59% 0.61% 2.25% 33.07% 2.00% 0.09% 1.84% 6.51% -0.05% 0.59% 99.61% -43.66% 64.93% 100.00%

$11,011 $62,509 $5,890 $26,738 $1,532 $8,588 $116,268 $9,469 $261 $5,460 $20,740 ($79) $3,883 $317,907 ($143,950) $204,222 $329,959

3.34% 18.94% 1.78% 8.10% 0.46% 2.60% 35.24% 2.87% 0.08% 1.65% 6.29% -0.02% 1.18% 96.35% -43.63% 61.89% 100.00%

$14,401 $76,587 $6,664 $25,035 $1,270 $10,511 $134,469 $13,011 $261 $5,460 $22,170 ($4) $6,027 $340,434 ($158,438) $215,910 $363,390

3.96% 21.08% 1.83% 6.89% 0.35% 2.89% 37.00% 3.58% 0.07% 1.50% 6.10% 0.00% 1.66% 93.68% -43.60% 59.42% 100.00%

$10,510 $54,186 $6,100 $30,492 $3,108 $16,222 $120,617 $8,345 $261 $5,460 $25,719 ($36) $2,173 $361,402 ($134,512) $260,467 $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%

* Expected values are obtained by using the forecast function in Excel (using the row of data from 2010 and 2011 to obtain the expected value for 2012).

The McGraw-Hill Companies, Inc., 2012

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

5-5 SAA 1/3/2013

2010 Net Sales Cost of sales Gross Profit Selling, general and administrative expenses Non-recurring charge (credit) Income from operations Other income (expense): Interest expense Interest income Gain on sale of subsidiary Other Total other income (expense), net Income before income taxes Income tax provision Net income Basic earnings per share Diluted earnings per share Basic weighted average shares outstanding Diluted weighted average shares outstanding Dollar Value 857,885 472,739 385,146 334,994 (1,153) 51,305 (1,229) 573 (1,091) (1,747) 49,559 18,337 31,222 1.60 1.56 19,555 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%

2011 Dollar Value 950,484 546,393 404,091 364,012 40,729 (983) 1,459 (4,798) (4,322) 35,757 13,230 22,527 1.15 1.14 19,531 19,774 % of Sales 100.00% 57.49% 42.51% 38.30% 0.00% 4.29% 0.00% -0.10% 0.15% 0.00% -0.50% -0.45% 3.76% 1.39% 2.37%

Expected* Dollar Value % of Sales 1,043,083 100.00% 620,046 59.44% 423,037 40.56% 393,031 37.68% 0.00% 46,050 4.41% 0.00% (737) -0.07% 1,017 0.10% 0.00% (2,947) -0.28% (3,037) -0.29% 42,688 4.09% 15,794 1.51% 26,894 2.58% 1.38 1.35 19,558 19,930

2012 Actual Dollar Value % of Sales 1,019,890 100.00% 572,153 56.10% 447,737 43.90% 374,180 36.69% 0.00% 73,557 7.21% 0.00% (878) -0.09% 989 0.10% 0.00% (3,514) -0.34% (3,403) -0.33% 70,154 6.88% 26,658 2.61% 43,495 4.26% 1.48 1.45 19,159 19,485

Difference Dollar Value % 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 2010 and 2011 to obtain the expected value for 2012).

The McGraw-Hill Companies, Inc., 2012