EarthWear Hands-on Mini-case

Chapter 3 - Materiality and Tolerable Misstatement

© The McGraw-Hill Companies, Inc., 2014

In this mini-case you will determine planning materiality as well as tolerable misstatement amounts
for balance sheet accounts of EarthWear Clothiers, Inc. While many auditing firms use a simple
approach for establishing planning materiality and tolerable misstatement similar to the one
illustrated in your textbook, some firms use more detailed guidelines that involve allocating a
multiple of planning materiality to balance sheet accounts. This case illustrates one such approach.

Materiality
Guidelines
INSTRUCTIONS:

1 Read the Materiality Guidelines for Willis & Adams CPAs. To open the guidelines document please
double-click on the following icon. A document will open in Microsoft Word.

2 Following the Materiality Guidelines for Willis & Adams CPAs, complete all the fields on Work Paper
3-7 indicated in yellow (Work Paper 3-7 is found on the next tab of this worksheet). For your
convenience, EarthWear Financial Statements have been included in worksheet tabs after the
working papers.
Fields you are to complete on work papers are colored yellow. The color will disappear when the field is completed.

3 Following the Materiality Guidelines for Willis & Adams CPAs, complete all the fields on Work Paper
3-8 indicated in yellow.
Fields you are to complete on work papers are colored yellow. The color will disappear when the field is completed.

4 When completed with the work papers, enter your initials in the yellow box with title
"Initial Here".

5 Please print hard copies of work papers 3-7 and 3-8 for submission unless your instructor requests
an electronic submission. The work papers are each formatted to fit on one page.
Name:

Class:
EARTHWEAR CLOTHIERS 3-7
Planning Materiality RC
December 31, 2014 4/2/2021
(In thousands)

Unaudited
1. Benchmark Data 2014 2013
Sales / Revenue $1,019,890 $950,484
Expenses $572,153 $546,393
Pre-tax income $70,154 $35,757
Current assets $261,680 $209,095
Current liabilities $120,617 $116,268
Total assets $389,428 $329,959
Materiality $1,800

2. Establish Planning Materiality Level

Measurement Base 70,154
Pre-tax income

Percentage Applied* 4.5%

Planning Materiality $3,157

Bases and Percentage Ranges:

Profit Oriented Entities
Pre-tax income 3 - 7%* Please use this template in conjunction with Willis & Adams Materiality
Guidelines. The materiality factors provided are guidelines only and
Total Revenue ½ - 1% should be used only as an aid as you use professional judgment to
Current Assets or Liabilities 2 - 5% determine planning materiality.
Total Assets ½ - 1%
* For public companies, 5% is typically the maximum.
Not-for-Profit Entities
Total Revenue ½ - 2%
Total Expenses ½ - 2%
Mutual Fund Entities
Net Asset Value ½ - 1%

3. Justify/Support Your Level of Planning Materiality

State the factors that you considered to determine the appropriate measurement base and percentage to determine
planning materiality.

Measurement Base:
Earthwear Clothiers has reported fluctuations in net income over the five-year of -51%, +.54%, -.27%, and +96% during
2011, 2012, 2013, 2014 respectively. However, revenues have been fairly stable with 6% change in average over the
five year periods given. Due to relative small fluctiation, net income before taxes is a good measurement base for
materiality.

Percentage:
For publicly traded companies, materiality is typically not greater than 5 percent of net income before income taxes.
Due to the company being a public company in NASDAQ it is appropriate to select a percentage below 5%, the
company has some risk since it has reported some fluctuations in net income before taxes, although it has reported
negative net income before taxes, it is appropriate to go with a 4.5% as the materiality percentage.
Name:

Class:
EARTHWEAR CLOTHIERS 3-8
Allocation of Materiality: Tolerable Misstatements RC
December 31, 2014 4/2/2021
(In thousands)

Planning Materiality from work paper 3-7: $3,157

2014 Unaudited Trial Tolerable Misstatement Percentage of Explanation

Account Name 2013 Balance Account % change
Cash and cash equivalents $48,978 $79,359 $427 1% Easy to verify with bank statements 62%
Receivables, net $12,875 $8,643 $1,200 14% large account with expected misstatements -33%
Inventory $122,337 $147,693 $2,300 2% Large and complex account with misstatements expected, costly to audit
Prepaid advertising $11,458 $10,212 $200 2% Relatively little change from prior year (-11%), not difficult to audit -11%
Other prepaid expenses $6,315 $5,435 $200 4%
Relatively routine accounting, tested largely via reasonableness analytical procedures
Deferred income tax benefits $7,132 $10,338 $250 2% Relatively complex, estimation involved, related to Deferred Income Taxes
Land and buildings $70,918 $76,560 $750 1% Relatively little change from prior year, not difficult to audit
Fixtures and equipment $67,513 $68,632 $750 1% Relatively little change from prior year, not difficult to audit
Computer hardware and software $64,986 $75,400 $500 1% impairment considerations, not difficult to audit 16%
Leasehold improvements $3,010 $3,144 $100 3% Relatively little change (4%) from prior year, not difficult to audit 4%
Accumulated depreciation and amortization $85,986 $97,722 $950 1% Accounting estimate, tested largely via substantive analytical procedure 14%
Intangibles, net $423 $1,734 $250 14% impairment considerations, not difficult to audit 310%
Lines of credit $11,011 $10,510 $300 3% Relatively little volume, not difficult to audit via 3rd party info
Accounts payable $62,509 $54,186 $1,200 2% difficult to audit, some differences expected -13%
Reserve for returns $5,890 $6,100 $350 6% Accounting estimate, tested largely via substantive analytical procedure
Accrued liabilities $26,738 $30,492 $1,200 4% Somewhat costly to audit, some differences expected 14%
Accrued profit sharing $1,532 $3,108 $200 6% Somewhat costly to audit, some differences expected
Income taxes payable $8,588 $16,222 $800 5% Easy to verify, but complex calculations. Large change from prior year (89%) 89%
Deferred income taxes $9,469 $8,345 $250 3% Relatively complex, estimation involved, related to Deferred Income Tax Benefits
Common stock, 26,121 shares issued $261 $261 $0 0% No change from prior year, easily verified
Donated capital $5,460 $5,460 $0 0% No change from prior year, easily verified
Additional paid-in capital $20,740 $25,719 $200 1% Little change from prior year, not difficult to audit
Deferred compensation ($79) ($36) $1 3% Not difficult to audit, examine current year vesting activity
Accumulated other comprehensive income $3,883 $2,173 $150 7% Involves some complex applications of GAAP
Retained earnings $317,907 $361,402 NA
Treasury stock, 6,546 and 6,706 shares at cost, respectively ($143,950) ($134,512) $100 0% Little change from prior year, not difficult to audit
Combined Tolerable Misstatement (column 3) $12,628 Combined Tolerable Misstatement Exceeds Limits
Maximum Allowable For Combined Tolerable Misstatement* $12,628
Net Remaining Allowance For Combined Tolerable Misstatement ($0)

*Four Times Planning Materiality. In the textbook, a more general approach to allocate no more than 75% of planning
materiality to accounts as tolerable misstatement is followed. However, as noted in the discussion on materiality in
Chapter 3 of the text, some firms do use a multiple approach. This mini-case uses the multiple approach to provide
hands-on practice at allocating tolerable misstatement to accounts.

© The McGraw-Hill Companies, Inc., 2014

 EARTHWEAR CLOTHIERS 1-1
PBC:
Consolidated Balance Sheets PBC Prepared by Client
(In thousands) 12/31/2014

December 31
### ###
Assets 2014 (unaudited)
Current Assets:
Cash and cash equivalents $79,359 $48,978 $49,668 Cash and cash equivalents
Receivables, net $8,643 $12,875 $11,539 Receivables, net
Inventory $147,693 $122,337 $105,425 Inventory
Prepaid advertising $10,212 $11,458 $10,772 Prepaid advertising
Other prepaid expenses $5,435 $6,315 $3,780 Other prepaid expenses
Deferred income tax benefits $10,338 $7,132 $6,930 Deferred income tax benefits
Total current assets $261,680 $209,095 $188,115
Property, plant and equipment, at cost
Land and buildings $76,560 $70,918 $66,804 Land and buildings
Fixtures and equipment $68,632 $67,513 $66,876 Fixtures and equipment
Computer hardware and software $75,400 $64,986 $47,466 Computer hardware and software
Leasehold improvements $3,144 $3,010 $2,894 Leasehold improvements
Total property, plant and equipment $223,737 $206,426 $184,040
Less - accumulated depreciation and amortization $97,722 $85,986 $76,256
Property, plant and equipment, net $126,014 $120,440 $107,784
Intangibles, net $1,734 $423 $628
Total assets $389,428 $329,959 $296,527

Liabilities and shareholder's investment

Current liabilities:
Lines of credit $10,510 $11,011 $7,621
Accounts payable $54,186 $62,509 $48,432
Reserve for returns $6,100 $5,890 $5,115
Accrued liabilities $30,492 $26,738 $28,440
Accrued profit sharing $3,108 $1,532 $1,794
Income taxes payable $16,222 $8,588 $6,666
Total current liabilities $120,617 $116,268 $98,067
Deferred income taxes $8,345 $9,469 $5,926
Shareholders' investment:
Common stock, 26,144 shares issued $261 $261 $261
Donated capital $5,460 $5,460 $5,460
Additional paid-in capital $25,719 $20,740 $19,311
Deferred compensation ($36) ($79) ($153)
Accumulated other comprehensive income $2,173 $3,883 $1,739
Retained earnings $361,402 $317,907 $295,380
Treasury stock, 6,654, 7,114, and 6,546 shares at cost, respectively ($134,512) ($143,950) ($129,462)
Total shareholders' investment $260,467 $204,222 $192,535
Total liabilities and shareholders' investment $389,428 $329,959 $296,527

© The McGraw-Hill Companies, Inc., 2014

 EARTHWEAR CLOTHIERS 1-2
PBC:
Consolidated Statements of Operations PBC Prepared by Client
(In thousands, except per share data) 12/31/2014

For the period ended December 31

### ###
2014 (unaudited)
Net Sales $1,019,890 $950,484 $857,885
Cost of sales $572,153 $546,393 $472,739
Gross Profit $447,737 $404,091 $385,146
11% 5% ok
Selling, general and administrative expenses $374,180 $364,012 $334,994
Non-recurring charge (credit) ($1,153)
Income from operations $73,557 $40,729 $51,305
Other income (expense):
Interest expense ($878) ($983) ($1,229)
Interest income $989 $1,459 $573
Gain on sale of subsidiary
Other ($3,514) ($4,798) ($1,091)
Total other income (expense), net ($3,403) ($4,322) ($1,747)
Income before income taxes $70,154 $35,757 $49,559
96% -28%
Income tax provision $26,658 $13,230 $18,337
Net income $43,495 $22,527 $31,222
93% -28%
Basic earnings per share 1.48 1.15 1.60
Diluted earnings per share 1.45 1.14 1.56
Basic weighted average shares outstanding 19,159 19,531 19,555
Diluted weighted average shares outstanding 19,485 19,774 20,055

© The McGraw-Hill Companies, Inc., 2014

 EARTHWEAR CLOTHIERS 1-3
PBC:
Consolidated Statements of Cash Flows PBC Prepared by Client
(In thousands) 12/31/2014

For the period ended December 31

### ###
Cash flows from (used for) operating activities: 2014 (unaudited)
Net income $43,495 $22,527 $31,222
Adjustments to reconcile net income to
net cash flows from operating activities:
Non-recurring charge (credit) ($1,153)
Depreciation and amortization $17,515 $15,231 $13,465
Deferred compensation expense $42 $75 $103
Deferred income taxes ($4,330) $3,340 $5,376
Pretax gain on sale of subsidiary
Loss on disposal of fixed assets $1,578 $284 $602
Changes in assets and liabilities excluding
the effects of divestitures:
Receivables, net $4,232 ($1,336) $2,165
Inventory ($25,356) ($16,912) $37,370
Prepaid advertising $1,246 ($686) $3,110
Other prepaid expenses ($818) ($2,534) $1,152
Accounts payable ($8,323) $14,078 ($8,718)
Reserve for returns $210 $775 $439
Accrued liabilities $5,502 ($709) ($4,982)
Accrued profit sharing $1,576 ($262) $328
Income taxes payable $7,634 $1,923 ($2,810)
Tax benefit of stock options $4,979 $1,429 $1,765
Other ($1,404) $2,144 $437
Net cash from (used for) operating activities $47,778 $39,367 $79,871
Cash flows from (used for) investing activities:
Cash paid for capital additions ($26,334) ($28,959) ($18,208)
Proceeds from sale of subsidiary
Net cash flows used for investing activities ($26,334) ($28,959) ($18,208)
Cash flows from (used for) financing activities:
Proceeds from (payment of) short-term debt ($501) $3,390 ($17,692)
Purchases of treasury stock ($8,052) ($18,192) ($2,935)
Issuance of treasury stock $17,490 $3,704 $4,317
Net cash flows used for financing activities $8,937 ($11,097) ($16,310)
Net increase (decrease) in cash and cash equivalents $30,381 ($690) $45,352
Beginning cash and cash equivalents $48,978 $49,668 $4,317
Ending cash and cash equivalents $79,359 $48,978 $49,668
Supplemental cash flow disclosures:
Interest paid $878 $987 $1,229
Income taxes paid $21,431 $6,278 $13,701

© The McGraw-Hill Companies, Inc., 2014

 EARTHWEAR CLOTHIERS 1-4
PBC:
Consolidated Statements of Stockholders' Investment PBC Prepared by Client
(In thousands) 12/31/2014

Accumulated
Additional Other
Comprehensive Common Donated Paid-in Deferred Comprehensive Retained Treasury
Income Stock Capital Capital Compensation Income Earnings Stock Total
Balance, December 31, 2011 $261 $5,460 $17,546 ($257) $1,302 $264,158 ($130,844) $157,626
Purchase of treasury stock ($2,935) ($2,935)
Issuance of treasury stock $4,317 $4,317
Tax benefit of stock options exercised $1,765 $1,765
Deferred compensation expense $103 $103
Comprehensive income:
Net income $31,222 $31,222 $31,222
Foreign currency translation adjustments $60 $60 $60
Unrealized gain on forward contracts $377 $377 $377
Comprehensive income $31,659
Balance, December 31, 2012 $261 $5,460 $19,311 ($154) $1,739 $295,380 ($129,462) $192,534
Purchase of treasury stock ($18,192) ($18,192)
Issuance of treasury stock $3,704 $3,704
Tax benefit of stock options exercised $1,429 $1,429
Deferred compensation expense $75 $75
Comprehensive income:
Net income $22,527 $22,527 $22,527
Other comprehensive income:
Foreign currency translation adjustments ($1,151) ($1,151) ($1,151)
Unrealized gain on forward contracts $3,295 $3,295 $3,295
Comprehensive income $24,671
Balance, December 31, 2013 $261 $5,460 $20,740 ($79) $3,883 $317,907 ($143,950) $204,222
Purchase of treasury stock ($8,052) ($8,052)
Issuance of treasury stock $17,490 $17,490
Tax benefit of stock options exercised $4,979 $4,979
Deferred compensation expense $42 $42
Comprehensive income: $43,495
Net income $43,495 $43,495
Other comprehensive income:
Foreign currency translation adjustments ($221) ($221) ($221)
Unrealized gain on forward contracts ($1,489) ($1,489) ($1,489)
Comprehensive income $41,785
Balance, December 31, 2014 $261 $5,460 $25,719 ($36) $2,173 $361,402 ($134,512) $260,467

© The McGraw-Hill Companies, Inc., 2014

 EARTHWEAR CLOTHIERS 1-5
PBC:
Five-Year Consolidated Financial Summary (unaudited) PBC Prepared by Client
(In thousands, except per share data) 12/31/2014

For the period ended December 31

2014 ### ### ### ###

(unaudited)
Income statement data:
Net Sales 1,019,890 950,484 857,885 891,394 821,359
7% 11% -4% 9%
Pretax Income 70,154 35,757 49,559 32,175 66,186
96% -28% 54% -51%
Percent of net sales 6.9% 3.8% 5.8% 3.6% 8.1%
Net income 43,495 22,527 31,222 20,270 41,698

Per share of common stock:

Basic earnings per share 1.48 1.15 1.60 1.02 2.01
Diluted earnings per share 1.45 1.14 1.56 1.01 2.00
Common shares outstanding 19,159 19,531 19,555 19,806 20,703

Balance sheet data:

Current assets 261,680 209,095 188,115 191,297 194,445
Current liabilities 120,617 116,268 98,067 133,434 118,308
PPE and intangibles 127,748 120,864 108,412 105,051 87,312
Total assets 389,428 329,959 296,527 296,347 281,757
Noncurrent liabilities 8,345 9,469 5,926 5,286 5,686
Shareholders' investment 260,467 204,222 192,535 157,627 157,763

Other data:
Net working capital 141,063 92,827 90,048 57,863 76,136
Capital expenditures 26,334 28,959 18,208 30,388 31,348
Depreciation and amortization expense 17,515 15,231 13,465 12,175 9,833
Return on average shareholders' investment 19% 11% 18% 13% 28%
Return on average assets 12% 7% 11% 7% 16%

© The McGraw-Hill Companies, Inc., 2014