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Chapter 3 EarthWear Mini-Case (9e)
Chapter 3 EarthWear Mini-Case (9e)
In this mini-case you will use Willis and Adams' client acceptance/continuance forms to evaluate the
continuance decision for EarthWear as an audit client. One of the most important ways accounting
firms manage their risk is by being very careful about which companies they decide to associate with
as clients. In the first year, that decision is referred to as the client acceptance decision. In each
subsequent year, firms decide whether to continue their association with each client. This subsequent
decision process is referred to as the continuance decision. The factors that firms consider for the
continuance decision are usually very similar to those considered for the initial acceptance decision.
INSTRUCTIONS:
Read the background information on EarthWear to prepare to evaluate the company as a continuing
audit client. To open the background document please double-click on the following icon (a document
will open in Microsoft Word).
Review EarthWear's unaudited 2014 financial statements including the "Balance Sheet", "Income
Statement", and "Cash Flow" worksheets to obtain a better understanding of the client and to assess
its current financial condition. A senior auditor from your firm has already calculated some financial
and industry ratios to help with the continuance decision. Compare EarthWear's ratios to the industry
ratios provided on the "Ratios" worksheet. Pay particular attention to items that might be helpful in
determining whether or not to continue with EarthWear as an audit client.
Review the Willis and Adams' client acceptance/continuance forms Work Papers 3-1, 3-2, 3-3, and 34, which have already been completed.
Complete the remaining questions on Work Paper 3-5 using information from the background and
financial statement information.
Fields you are to complete on the form are colored yellow. The color will disappear as the field is completed.
When you've completed the above steps, enter your initials in the yellow box with title "Initial Here" on
Work Paper 3-5.
Please print a hard copy of Work Paper 3-5 for submission unless your instructor requests an
electronic version. The work paper is formatted to fit on one page.
EARTHWEAR CLOTHIERS
Client Continuance Evaluation
December 31, 2014
3-1
SAA
1/3/2015
General
Legal Name:
Address:
City:
Telephone:
Country:
Entity Type:
Nature of Business:
12/31
State:
Fax:
79443
ID
Zip:
(208) 555-3241
EarthWear produces high-quality clothing for outdoor sports, such as hiking, skiing, fly-fishing, and whitewater kayaking. Over
the years, the company's product lines have grown to include casual clothing, accessories, shoes, and soft luggage.
EarthWear offers its products through three retailing options: catalogs, retail outlets, and its website.
Services Required:
Integrated Audit
Public: Yes
Ticker Symbol: EWCC________________
Exchange:
NASDAQ
Revenue (000's): $1,019,890___ Assets (000's): $389,428___ Net Worth (000's): $260,466___
Estimated net fees:
$865,000
Bud. audit hrs @ std rate:
$962,500
Realization: 89.87%
Net Revenue per hour: $232
Describe proposed fee arrangements:
Fixed fee arrangement
Timing of services to be performed: Peak______________________
EARTHWEAR CLOTHIERS
Client Continuance Evaluation
December 31, 2014
3-2
SAA
1/3/2015
Other Characteristics
Sub-prime lending operations:
Select type of operation:
A division of a regulated financial institution
No
No
No
No
No
No
No
No
Has the institution entered into a memorandum of understanding with a regulatory agency?
No
No
No
No
No
Unregulated casinos?
No
Entity that is an agency or subdivision of the Federal government, entity receiving substantial
Federal funding or grants, or one subject to the Single Audit Act (excluding local governmental
entities)?
No
EARTHWEAR CLOTHIERS
Client Continuance Evaluation
December 31, 2014
3-3
SAA
1/3/2015
Management
Board of Directors
Title:
Chairman
Audit Comm. Chair
Name:
James G. Williams
Gary Amble
Home City:
Boise
Boise
Home State:
ID
ID
Ownership
%
25
0
Background
Verification:
Yes
Yes
Boise
Boise
Boise
ID
ID
ID
0
0
0
Yes
Yes
Yes
Key Management
CEO
CFO
Accounting Officer
Calvin J. Rogers
James C. ("JC") Watts
Carol McKay
Outside Advisors
Primary Law Firm
Name:
Address:
Telephone:
Contact:
(208) 525-6119
David Leon
Telephone:
Contact:
Underwriters
Name:
Address:
Other Advisor
Name:
Relationship:
Address:
Telephone:
Contact:
Telephone:
Contact:
(208) 543-5678
JJ Harmner
Service Team
Engagement Partner:
Michael J. Willis
Engagement Partner Email:
mjwillis@willisandadams.com
Engagement Partner Telephone:
(208) 545-6776
Office:
Boise
Senior Manager or Manager:
Dianne R. Morris
Engagement Quality Review Partner:
Karen Mitchell
Discuss the service team's relevant industry experience:
Michael has been the lead partner on this engagement for the past four years. Michael and Karen both have
extensive experience with manufacturing and retail companies. Dianne has been on the staff of this engagement
since she joined the firm in 2000 and became manager last year.
EARTHWEAR CLOTHIERS
Client Continuance Evaluation
December 31, 2014
3-4
SAA
1/3/2015
Yes
Background investigations have taken place for any newly hired key decision makers.
Yes
Yes
Name:
Class:
EARTHWEAR CLOTHIERS
Client Continuance Evaluation
December 31, 2014
If you selected 'Yes' on any of the questions to the left, provide and
explanation below:
Are there any concerns about undue reliance being placed on the results
of our work? (i.e. sale of the company, financing)
No
Does the client have any associated entities that are not audited or are
being audited by firms outside of Willis and Adams?
No
Have any situations been noted that bear on the integrity of management?
Please select an answer from the drop down menu in the cell
on the left
Please select an answer from the drop down menu in the cell
on the left
No
No
No
Are there any external conditions or trends that may have a significant
impact on the client, such as changes in buyers, changes in suppliers, or
new competitors?
No
No
Are there any internal conditions or trends that may raise concern, such as
management turnover or new accounting information systems?
Please select an answer from the drop down menu in the cell
on the left
Are there any other risk concerns arising out of the information gathering
process?
Please select an answer from the drop down menu in the cell
on the left
3-5
Initial Here
2/28/2015
EARTHWEAR CLOTHIERS
Consolidated Balance Sheets
(In thousands)
1-1
PBC
12/31/2014
December 31
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
2014
(unaudited)
2013
2012
$79,359
$8,643
$147,693
$10,212
$5,435
$10,338
$261,680
$48,978
$12,875
$122,337
$11,458
$6,315
$7,132
$209,095
$49,668
$11,539
$105,425
$10,772
$3,780
$6,930
$188,115
$76,560
$68,632
$75,400
$3,144
$223,737
$97,722
$126,014
$1,734
$389,428
$70,918
$67,513
$64,986
$3,010
$206,426
$85,986
$120,440
$423
$329,959
$66,804
$66,876
$47,466
$2,894
$184,040
$76,256
$107,784
$628
$296,527
$10,510
$54,186
$6,100
$30,492
$3,108
$16,222
$120,617
$8,345
$11,011
$62,509
$5,890
$26,738
$1,532
$8,588
$116,268
$9,469
$7,621
$48,432
$5,115
$28,440
$1,794
$6,666
$98,067
$5,926
$261
$5,460
$25,719
($36)
$2,173
$361,402
($134,512)
$260,467
$389,428
$261
$5,460
$20,740
($79)
$3,883
$317,907
($143,950)
$204,222
$329,959
$261
$5,460
$19,311
($153)
$1,739
$295,380
($129,462)
$192,535
$296,527
EARTHWEAR CLOTHIERS
Consolidated Statements of Operations
(In thousands, except per share data)
1-2
PBC
12/31/2014
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
2014
(unaudited)
$1,019,890
$572,153
$447,737
$374,180
$950,484
$546,393
$404,091
$364,012
$73,557
$40,729
$857,885
$472,739
$385,146
$334,994
($1,153)
$51,305
($878)
$989
($983)
$1,459
($1,229)
$573
($3,514)
($3,403)
$70,154
$26,658
$43,495
1.48
1.45
19,159
19,485
($4,798)
($4,322)
$35,757
$13,230
$22,527
1.15
1.14
19,531
19,774
($1,091)
($1,747)
$49,559
$18,337
$31,222
1.60
1.56
19,555
20,055
2013
2012
EARTHWEAR CLOTHIERS
Consolidated Statements of Cash Flows
(In thousands)
1-3
PBC
12/31/2014
For the period ended December 31
2014
(unaudited)
$43,495
2013
2012
$22,527
$31,222
$17,515
$42
($4,330)
$15,231
$75
$3,340
($1,153)
$13,465
$103
$5,376
$1,578
$284
$602
$4,232
($25,356)
$1,246
($818)
($8,323)
$210
$5,502
$1,576
$7,634
$4,979
($1,404)
$47,778
($1,336)
($16,912)
($686)
($2,534)
$14,078
$775
($709)
($262)
$1,923
$1,429
$2,144
$39,367
$2,165
$37,370
$3,110
$1,152
($8,718)
$439
($4,982)
$328
($2,810)
$1,765
$437
$79,871
($26,334)
($28,959)
($18,208)
($26,334)
($28,959)
($18,208)
($501)
($8,052)
$17,490
$8,937
$30,381
$48,978
$79,359
$3,390
($18,192)
$3,704
($11,097)
($690)
$49,668
$48,978
($17,692)
($2,935)
$4,317
($16,310)
$45,352
$4,317
$49,668
$878
$21,431
$987
$6,278
$1,229
$13,701
EARTHWEAR CLOTHIERS
Ratio Analyses
December 31, 2014
5-1
SAA
1/3/2015
December 31
2010
2011
2012
2013
2014
2014
Actual
(unaudited)
Difference
from
Expected
Industry
Average
Difference
(from 2014)
1.64
1.43
1.92
1.80
1.94
2.17
0.23
2.10
0.07
Quick Ratio
liquid assets / current liabilities
0.39
0.44
0.62
0.53
0.65
0.73
0.08
0.80
-0.07
0.69
0.42
0.81
0.34
0.40
0.40
0.00
N/A
N/A
71.18
77.25
74.34
73.82
75.41
118.00
42.60
N/A
N/A
5.13
4.73
4.91
4.94
4.84
3.09
-1.74
14.10
-11.01
Inventory Turnover
cost of sales / inventory
3.43
4.27
4.48
4.47
4.99
3.87
-1.12
6.20
-2.33
106.41
85.51
81.40
81.72
69.22
94.99
25.78
58.70
36.29
44.95%
44.91%
44.89%
42.51%
42.49%
43.90%
1.41%
38.80%
5.10%
Profit Margin
net income / net sales
2.34%
3.61%
3.64%
2.37%
3.02%
4.26%
1.24%
3.30%
0.96%
Return on Assets
net income / total assets
14.80%
6.84%
10.53%
6.83%
4.69%
11.17%
6.48%
7.40%
3.77%
Return on Equity
net income / total owners' equity
26.43%
12.86%
16.22%
11.03%
5.92%
16.70%
10.78%
17.50%
-0.80%
0.79
0.88
0.58
0.61
0.51
0.50
-0.01
0.84
-0.34
53.88
26.31
26.41
23.92
10.19
50.57
40.38
N/A
N/A
ACTIVITY RATIOS:
Receivables Turnover
net sales / net ending receivables
COVERAGE RATIOS:
Debt to Equity
total liabilities / shareholders' investment
Times Interest Earned
(net income + interest expense) / interest expense
* Expected values are obtained by using the forecast function in Excel (using the row of data from 2012 and 2013 to obtain the expected value for 2014).
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.