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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 you’ve read about in Chapter 3. INSTRUCTIONS:

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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.

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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.

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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.80 *Quick Ratio is 0. The increasing amount of net sales from liquidiations 2009-2011 (8%. Earthwear purchases about 80% of their merchandise from Asia. Finally. BACKGROUND INFORMATION · Business Strategy and Target Customers EarthWear Clothiers generates revenue mainly through the sale of high quality clothing for outdoor sports. and mail order clothing companies. Analysis of the quick ratio provides insight into the company's ability to pay its current liabilities.88 and the industry average is 6. and white-water kayaking.8 million of whom are viewed as “current customers” because they have purchased from the company in the last 24 months. etc…). 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. fly-fishing. accessories. and soft luggage.g. the auditor will typically list or attach a schedule of when each of those deliverables will be completed.8 million persons on its mailing list.12%) suggests that EarthWear's products are losing appeal in the market. · Social Factors The company’s results can be affected by changing fashion trends . along with an organizational chart of the company and its entities. Lastly. 2012 ENGAGEMENT OBJECTIVES. Some detail pertaining to the location(s) of the business will be provided. quarterly reviews. This ratio indicates that EarthWear collects on sales much more quickly than the rest of the industry. · Competition EarthWear Clothier's faces strong competition from established brands and from various channels including retail stores. such as hiking. Earthwear's inventory turnover of 3. We will corroborate the client's explanation as a part of our testing in the sales & collection cycle.EARTHWEAR CLOTHIERS Audit Planning Memorandum December 31. Controller explains that fast collection rate is a result of increased focus on collection activities and newly implemented incentives for early payment. Analyze 4 additional analytical procedures that were completed in the planning process. internet stores. skiing. Central America.88 and the industry average is 6. The company’s key customers are the 18..11%. shoes.73 and the industry average is 0.88 is significantly lower than the industry average and may suggest that the company's inventory contains obsolete or slow-moving goods. · Suppliers During 2011. in this section the auditors will discuss the scope of the upcoming audit. In addition. Related parties will be listed and an industry overview is also typically included. Mexico. including customer service. one manufacturer and one intermediary accounted for about 14 and 29 percent of the Company's received merchandise exposing Earthwear to supplier risk. along with any regulatory developments which have taken/are taking place in relation to the company or industry. this section may conclude with an initial assessment of the company as a going concern. AND KEY DATES Typically. approximately 6.73 and the industry average is 0. EarthWear's Quick Ratio is 0. It also represents a significant improvement relative to prior years for EarthWear and is better than expected for this year. From a financial standpoint.80% Prepared by: Reviewed by: Date: 2/16/2013 . Almost two-thirds are in professional or managerial positions.10.90% and the industry average is 38. Mail order clothing companies rely heavily on their reputation and their operational efficiencies. EarthWear's Gross Profit Percentage is 43.09 and the industry average is 14. DELIVERABLES. The company’s product lines also include casual clothes.000. and Central America which introduces foreign currency risk. preliminary analytics will be performed to provide a high-level perspective of the company’s development over time and relation to the industry as a whole.20 *Inventory Turnover is 3. An overview of the company’s strategy may be provided as well. to compete with the aforementioned various sources of competition. · Analytical Procedures *Days Outstanding in Accounts Receivable is 3. This ratio is consistent with a relatively low allowance for doubtful accounts.80. EarthWear's Inventory Turnover is 3.20. The auditor will list the deliverables that will result from their work (e. Inventury turnover indicates the frequency with which inventory is consumed in a year. debt covenant letters. UNDERSTANDING THE BUSINESS A short history of the company is typically given in this section.

the auditors will discuss the control environment. . 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. Gross Profit Percentage is a good indicator of potential misstatements as companies within an industry have similar figures. INTERNAL CONTROL ENVIRONMENT In this section.80%. Prior audit results pertaining to the control environment may also be reported.90% and the industry average is 38. This ratio indicates the portion of the entity's capital that comes from debt. in addition to the amount of control reliance expected throughout the audit. including company-level controls.*Gross Profit Percentage is 43.84.50 and the industry average is 0.50 and the industry average is 0.84 *Debt to Equity ratio is 0. EarthWear's Debt to Equity ratio is 0. EarthWear's industry leading gross profit percentage indicates raises concerns and indicates a need to examine for potential misstatements.

Key issues. · Materiality Materiality for the 2012 audit is calculated on work paper 3-7. 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. the main risks which need to be addressed.. COMMUNICATION AND COORDINATION With regards to communication and coordination. 2012 . Inc. a summary of all the previously addressed issues will be provided. Materiality for the audit and tolerable misstatement for accounts or business processes will be established. as well as the scope and plan of the audit. tolerable misstatement will affect sample sizes involved in tests of details.AUDIT SCOPE CONSIDERATIONS Typically. and the schedule of the audit will all be reviewed and included. © The McGraw-Hill Companies. the auditor may list the locations that will be visited so that the audit may be more efficiently coordinated. in this section the auditors will discuss the scope of the procedures to be performed. Lastly. 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. SUMMARY OF AUDIT PLAN In this section. These scoping decisions will affect audit program preparation at a more detailed level. In addition. For example. with lower levels of tolerable misstatement leading to larger sample sizes. such as the scope of the audit. as presented in this memorandum. the auditor will discuss how specialists/experts will be used throughout the audit.

one manufacturer and one intermediary accounted for about 14 and 29 percent of the Company's received merchandise exposing Earthwear to supplier risk.20. *Gross Profit Percentage is 43. Prepared by: Reviewed by: Date: 2/16/2013 .80. *Debt to Equity ratio is 0.80%.11%.50 and the industry average is 0. Analysis of the quick ratio provides insight into the company's ability to pay its current liabilities. and Central America which introduces foreign currency risk. 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. Inventury turnover indicates the frequency with which inventory is consumed in a year. This ratio indicates the portion of the entity's capital that comes from debt.Name: Class: EARTHWEAR CLOTHIERS Audit Planning Memorandum December 31. to compete with the aforementioned various sources of competition.88 is significantly lower than the industry average and may suggest that the company's inventory contains obsolete or slow-moving goods. internet stores. Earthwear purchases about 80% of their merchandise from Asia. 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.88 and the industry average is 6. In addition. The increasing amount of net sales from liquidiations 2009-2011 (8%. Gross Profit Percentage is a good indicator of potential misstatements as companies within an industry have similar figures. Mexico.84.12%) suggests that EarthWear's products are losing appeal in the market. including customer service.90% and the industry average is 38. Mail order clothing companies rely heavily on their reputation and their operational efficiencies. Central America. · Analytical Procedures *Quick Ratio is 0. *Inventory Turnover is 3. EarthWear's industry leading gross profit percentage indicates raises concerns and indicates a need to examine for potential misstatements.73 and the industry average is 0. · Competition EarthWear Clothier's faces strong competition from established brands and from various channels including retail stores. and mail order clothing companies. Earthwear's inventory turnover of 3. 2012 PRINT OUT · Suppliers During 2011.

12 25.39 0.53 0.61 23. .31 0.40 73.37% 6.80% 26.53% 16.22 1.40 Difference from Expected 0.95% 2.41 4.38 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 0.91% 3.07 -0.47 81.80 N/A 0.34 4.74 -1.92 0.10% 0.51 10.19 44.40% 17.25 4.65 0.87 94. 2012 December 31 6-Mar SAA 1/3/2013 2012 2012 Actual (unaudited) 2.69 1.73 4.88 0.48% 10.10 6.26% 11.41 0.41% 1.64% 10.79 53.70 N/A -11.83% 11.43 0.22% 42.23 0.51 74.33 36.80% 0.94 4.70% 1.40 118.20 58.48 81.42 1.58 26.27 85.61% 6.62 0. † Industry Source: Dun & Bradstreet (D&B).13 3.77% -0.91 4.EARTHWEAR CLOTHIERS Ratio Analyses December 31.02% 4.88 26.57 -0.84 N/A -0.03% 42. ratios were calculated from average financial statement data provided.30% 7.96% 3.00 3.81 1.34 1.92% 71.17% 16.84 4.43% 44.78 N/A 14.50% 5.18 5.44 0. N/A = not available or could not be calculated from financial data.86% 44.60 -1.92 0.09 3.82 4.80% 3.10 0.78% 38.69% 5.34 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).72 75.99 69.50 50.89% 3. The median values of the industry ratios are used for comparison purposes.51% 2.73 0.29 43.90% 4.99 42.64 0.80 0. For ratios not specifically included on D&B.94 0.00 Industry Difference Average (from 2012) 2.41 77.08 0.34% 14.17 0.01 -2.43 106.49% 3.84% 12.01 40.24% 6.

03% -1.853) ($4.071 ($5.35% 2.16% -0.37% 21.604 $1.51% -1.668 $11.25% -4.04% 0.65% 67.930 $188.222 $329.60% 35.460 $19.621 $48.65% 18.784 $628 $296.402 ($134.438) $215.932) ($3. Inc.532 $8.00% ($3.84% 3.13% -3.719 ($36) $2.17% 30.173 $361.335 $230.568) $8.467 $389.68% -43.66% 17.06% 36.425 $10.711 ($13.507 $3.918 $67.72% 9.00% $10.80% -34.968 $23.69% -0.07% 25.72% 36.440 $423 $329.588 $116.50% -0.56% 92.401 $76.36% 0.08% 3.51% -0.011 $261 $5.91% 1.25% 33.10% 0.654.469 $261 $5.02% 63.794 $6.400 $3.550 ($33) ($3.390 3.00% 0.256 $107.72% -1.93% 2.907 ($143.07% 1.666 $98.560 $68.47% 0.075 $75.892) ($22.722 $126.65% 6.432 $5.00% 1. respectively Total shareholders' investment Total liabilities and shareholders' investment % of Total Assets 16.978 $12.54% 66.00% $11.428 20.125 $228.39% 0.00% Dollar Value 2011 % of Total Assets 14.875 $122.288 $14.00% 3.50% 0.510 $54.94% 1.55% 3.01% 0.89% 37.270 $10.007 ($7.00% $49.838 $5.27% 0. at cost Land and buildings Fixtures and equipment Computer hardware and software Leasehold improvements Total property.311 ($153) $1.00% Difference Dollar Value % of Total Assets $31.accumulated depreciation and amortization Property.693 $10.57% 16.62% 19..70% 0.40% 6.812 $95. net Intangibles.492 $3.115 $66.003 $31.466 $2.315 $7.39% -0. plant and equipment Less .61% -43.50% 6.10% 0.737 $97.81% 57.05% -5.01% -1.91% 62.66% 64.88% 9.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.83% 0.00% Expected* Dollar Value % of Total Assets $48.509 $5.380 ($129.959 $7.666) $0 $0 $3.08% 1.132 $209.26% -7.546 shares at cost.61% 2.40% 2. 2012 .34% 18.34% 63. 26.31% 20.435 $10.75% 3.338 $261.34% 2.45% 100.926 $44.738 $1.804 $66.27% 0.011 $62.095 $70.63% 0.89% 0. plant and equipment.35% -43.45% 1.143 $8.337 $11.16% 63.035 $1.440 $1.222 $120.80% 4.44% 0.64% 3.63% 1.02% 1.42% 100.434 ($158.107) $20 ($5.643 $147.097 $218 $363.13% 100.10% -0.90% 37.62% 1.469 $13.739 $295.527 $48.86% 62.516 $26.14% 0.89% 100.740 ($79) $3.883 $317.959 3.35% 0.513 $64.950) $204.97% 26.359 $8.031 $68.29% -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).268 $9.34% -0.97% 2.456 $1.07% 2.00% -0.345 $261 $5.539 $105.58% 0.557 $26.29% 3.33% 1.876 $47.734 $389.027 $340.772 $3.390 13.462) $192.529 $482 ($7.460 $22.09% -1.98% 62.849 $7.91% 2.60% 59.010 $206.144 shares issued Donated capital Additional paid-in capital Deferred compensation Accumulated other comprehensive income Retained earnings Treasury stock.44% 2.426 $85.84% 6.55% 16.460 $20.00% $14.910 $363.46% 19.27% 2.014 $1.75% 22.05% 0.114.20% 19.632 $75.458 $6.96% 21.06% 100.076) $2.150 $82.038 -1.34% 36.18% 96.27% -6. 7.401) ($565) $5.88% 0.94% 0.78% 8.93% 100.91% 38.45% 25.66% 93.680 $76. 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.926 $261 $5.59% 0.49% 20.082) $1.63% 61.067 $5.00% -0.170 ($4) $6.47% 1. and 6.212 $5.53% 22.527 2.100 $30.89% 35.186 $6.36% 0.07% 1.38% 2.56% 26.57% 7.70% 0.512) $260.780 $6.249 $12.87% 0.09% 1.587 $6.46% 2.24% 2.10% 0.99% -1.890 $26.32% 3.108 $16.986 $120.01% 0.09% 32.617 $8. 6. plant and equipment.664 $25.428 2.894 $184. net Inventory Prepaid advertising Other prepaid expenses Deferred income tax benefits Total current assets Property.460 $25.444 ($1.88% 100.535 $296.22% 37.038 7.70% 13.21% 100.115 $28.986 $3.511 $134.44% 22.855) $20.08% 1.00% 2012 Actual Dollar Value % of Total Assets $79.06% 7.414) $3.60% -0. © The McGraw-Hill Companies.83% 6.211 $139.040 $76.59% 99.716 $133.144 $223.

00% (2.50% -0.994 (1.78% 2.10 0.012 40.10% 0.35 19.798) (4.700 3.885 472.484 546.894 2. 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).04% 27.88% 26.61% 43.947) -0.159 19.00% 572.180 36.14% 3. 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.557 7.37% Expected* Dollar Value % of Sales 1.305 (1.729 (983) 1.58% 1.083 100.00% 73.14 19.527 1. 2012 .037 40.89% 39.13% 5.09% 15.794 1.658 2.558 19.00% -0.02% (28) 0.459 (4.193) 0.890 100.043..00% -0.60 1.466 2.337 31.531 19.757 13.737 43.48 1.154 6.403) -0.091) (1.33% 70.602 1.00% 620.76% 1.00% 46.34% (3.29% 0.05% -0.00% 55.15% 0.28% (3.34% 24.79% 10.41% 0.10% 16.10% 0.29% 42.506 2.00% (47.80% 0 0.00% 4.90% 374. Inc.44% 423.00% 57.031 37.050 4. 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 857.091 364.69% 0.864 1.00% (140) -0.00% (3.98% 0.07% 1.45 19.046 59.15 1.055 % of Sales 100.30% 0.07% 0.559 18.00% 27.688 4.56 19.20% 5.893) -3.393 404.230 22.69% 0.495 4.68% 0.017 0.09% 989 0.00% (567) -0.11% 44.774 % of Sales 100.10% 0.EARTHWEAR CLOTHIERS Common-size Statements of Operations (In thousands.146 334.00% 0 0.00% (878) -0.21% 0.56% 393.13% -0.26% 1.019.747) 49.153) 51.555 20.00% -0.485 Difference Dollar Value % of Sales (23.38 1.739 385.153 56.00% (737) -0.51% 38. © The McGraw-Hill Companies.99% 0 0.930 2012 Actual Dollar Value % of Sales 1.10% 447.51% 26.229) 573 (1.222 1.00% -0.322) 35.45% 3.14% 0.514) -0.49% 42.851) -0.037) -0.06% (366) -0.34% (18.64% 2011 Dollar Value 950.10 (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).39% 2.