chapter 3 earthwear mini-case (9e)

EarthWear Hands-on Mini-caseChapter 3 - Client Acceptance© The McGraw-Hill Companies, Inc., 2014

INSTRUCTIONS:

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4Fields you are to complete on the form are colored yellow. The color will disappear as the field is completed.

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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.

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 3-4, which have already been completed.

Complete the remaining questions on Work Paper 3-5 using information from the background and financial statement information.

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 3-1Client Continuance Evaluation SAA

December 31, 2014 1/3/2015General

Legal Name: EarthWear Clothiers, Inc. Fiscal year-end (MM/DD): 12/31Address:City: Boise State: ID Zip: 79443Telephone: (208) 555-3242 Fax: (208) 555-3241Country: United StatesEntity Type: CorporationNature of Business:

Services Required: Integrated Audit Exchange: NASDAQ

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

© The McGraw-Hill Companies, Inc., 2014

2635 N. Devlin Ave.

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.

Public: Yes Ticker Symbol: EWCC________________Revenue (000's): $1,019,890___ Assets (000's): $389,428___ Net Worth (000's): $260,466___

Timing of services to be performed: Peak______________________

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SAA: Steve Alsop Senior Staff


December 31, 2014 1/3/2015Other Characteristics

Sub-prime lending operations:

Select type of operation:

A division of a regulated financial institution No

A commercial entity that sells all loans it originates No

A commercial entity that retains all or a portion of the loans it originates No

Select all that are applicable:

Company plans to go public or raise significant equity? No

Does the company intend to go public using a "back-door" registration? No

Contingent fee arrangement? No

Insured depository or institution? No

Is the institution subject to a cease and desist order? No

Has the institution entered into a memorandum of understanding with a regulatory agency? No

Insurance company (life, property, and casualty)? No

Public entity and local government risk pools? No

Government securities dealers? No

Internet companies engaged in morally questionable activities? No

Unregulated casinos? No

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)?

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December 31, 2014 1/3/2015

Management

Board of DirectorsOwnership Background

Title: Name: Home City: Home State: % Verification:Chairman James G. Williams Boise ID 25 YesAudit Comm. Chair Gary Amble Boise ID 0 Yes

Key ManagementCEO Calvin J. Rogers Boise ID 0 YesCFO James C. ("JC") Watts Boise ID 0 YesAccounting Officer Carol McKay Boise ID 0 Yes

Outside Advisors

Primary Law Firm Primary Banking RelationshipName: Leon, Leon & Dalton Name: First National BankAddress: 958 S.W. 77th Avenue Address: P.O. Box 1947

Boise, ID 79443 Boise, ID 79443

Telephone: (208) 525-6119 Telephone: (208) 543-5678Contact: David Leon Contact: JJ Harmner

Underwriters Other AdvisorName: Name: Felix & WallerAddress: Relationship: WebTrust Assurance Auditor

Address: 5055 E Broadway Blvd.Tucson, AZ 85711

Telephone: Telephone: (520) 747-7755Contact: Contact: Richard Waller

Service TeamEngagement Partner: Michael J. WillisEngagement Partner Email:Engagement Partner Telephone: (208) 545-6776Office: BoiseSenior Manager or Manager: Dianne R. MorrisEngagement Quality Review Partner: Karen MitchellDiscuss the service team's relevant industry experience:


[email protected]

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.

mailto:[email protected]

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December 31, 2014 1/3/2015

Background Investigation Overview

Select from the following:

All individuals/entities discussed above have been investigated. Yes

Background investigations have taken place for any newly hired key decision makers. Yes

A thorough background investigation has been completed. Yes

Summarize the results of the investigation below:


The Firm requires background investigations for all clients. Subjects of the background investigations include the clients and key decision makers. Key decision makers are normally the company's board and audit committee (if applicable) chairs, chief executive officer, chief financial officer and principal accounting officer, but should also include significant principal investors, shareholders or others who exercise significant influence over company operations. Significant company related entities and/or subsidiaries should also be considered as additional subjects.

In 1999, EarthWear's vice president of finance, Don Evans, was charged with a misdemeanor involving illegal gambling on local college basketball games. Charges were later dropped in return for Mr. Evans agreeing to pay a fine of $750 and perform 50 hours of community service. No other illegal or ethical problems were found with any other EarthWear executive.

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Name:

Class:

EARTHWEAR CLOTHIERS 3-5Client Continuance Evaluation Initial Here

December 31, 2014 4/19/2023

General Risk Indicators

No

No

Have any situations been noted that bear on the integrity of management?

Is there evidence that the business is financially distressed?

Is the client imposing on us any unreasonable scope or timing restrictions?No

No

No

No

No

Briefly explain your overall risk assessment of the client:Overall risk assessment of the client:

Instructions: Evaluate and answer the following unanswered questions regarding the risk of retaining EarthWear as an audit client. Click on the yellow boxes and select either "Yes" or "No" from the drop down menu.

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)

Does the client have any associated entities that are not audited or are being audited by firms outside of Willis and Adams?

Please select an answer from the drop down menu in the cell on the left


Is the client's industry or business characterized by significant operating, economic, product, of other commercial risk? (Examples of such risks include: development or start-up stage, high risk industry, an industry with relatively short product lives, or product(s) of unknown or doubtful commercial feasibility.)

Are there any pending enforcement matters or other investigations the outcome of which could adversely impact the viability or reputation of the business?

Has the information gathering process raised concerns about: unusual or contentious accounting policies, auditing procedures, internal controls, reporting, proper accounting records, tax or regulatory matters?

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?

Are there any internal conditions or trends that may raise concern, such as management turnover or new accounting information systems?


Are there any other risk concerns arising out of the information gathering process?



Based on the information gathered, and the above evaluation of engagement continuation risk, recommend whether or not to have Willis and Adams continue to provide service to this client. Click on the yellow box and select either "Retain" or "Dismiss" from the drop down menu.

EARTHWEAR CLOTHIERS 1-1 Consolidated Balance Sheets PBC

(In thousands) 12/31/2014

December 31

Assets2013 2012

Current Assets: Cash and cash equivalents $79,359 $48,978 $49,668 Receivables, net $8,643 $12,875 $11,539 Inventory $147,693 $122,337 $105,425 Prepaid advertising $10,212 $11,458 $10,772 Other prepaid expenses $5,435 $6,315 $3,780 Deferred income tax benefits $10,338 $7,132 $6,930 Total current assets $261,680 $209,095 $188,115 Property, plant and equipment, at cost Land and buildings $76,560 $70,918 $66,804 Fixtures and equipment $68,632 $67,513 $66,876 Computer hardware and software $75,400 $64,986 $47,466 Leasehold improvements $3,144 $3,010 $2,894 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 investmentCurrent 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


2014 (unaudited)

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PBC: Prepared by Client

EARTHWEAR CLOTHIERS 1-2 Consolidated Statements of Operations PBC

(In thousands, except per share data) 12/31/2014

For the period ended December 31

2013 2012

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 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 Income tax provision $26,658 $13,230 $18,337 Net income $43,495 $22,527 $31,222 Basic earnings per share 1.48 1.15 1.60Diluted earnings per share 1.45 1.14 1.56Basic weighted average shares outstanding 19,159 19,531 19,555Diluted weighted average shares outstanding 19,485 19,774 20,055


2014 (unaudited)

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EARTHWEAR CLOTHIERS 1-3 Consolidated Statements of Cash Flows PBC

(In thousands) 12/31/2014

For the period ended December 31

Cash flows from (used for) operating activities:2013 2012

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 subsidiaryNet 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


2014 (unaudited)

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EARTHWEAR CLOTHIERS 5-1 Ratio Analyses SAA

December 31, 2014 1/3/2015 December 31

2010 2011 2012 2013 2014 2014 Industry

(Audited) (Audited) (Audited) (Audited) Expected* Average

SHORT-TERM LIQUIDITY RATIOS:

Current Ratio 1.64 1.43 1.92 1.80 1.94 2.17 0.23 2.10 0.07current assets / current liabilities

Quick Ratio 0.39 0.44 0.62 0.53 0.65 0.73 0.08 0.80 -0.07liquid assets / current liabilities

Operating Cash Flow Ratio 0.69 0.42 0.81 0.34 0.40 0.40 0.00 N/A N/Acash flow from operations / current liabilities

ACTIVITY RATIOS:

Receivables Turnover 71.18 77.25 74.34 73.82 75.41 118.00 42.60 N/A N/Anet sales / net ending receivables

Days Outstanding in Accounts Receivable 5.13 4.73 4.91 4.94 4.84 3.09 -1.74 14.10 -11.01365 days / receivables turnover

Inventory Turnover 3.43 4.27 4.48 4.47 4.99 3.87 -1.12 6.20 -2.33cost of sales / inventory

Days of Inventory on Hand 106.41 85.51 81.40 81.72 69.22 94.99 25.78 58.70 36.29365 / (cost of sales / inventory)

PROFITABILITY / PERFORMANCE RATIOS:

Gross Profit Percentage 44.95% 44.91% 44.89% 42.51% 42.49% 43.90% 1.41% 38.80% 5.10%gross profit / net sales

Profit Margin 2.34% 3.61% 3.64% 2.37% 3.02% 4.26% 1.24% 3.30% 0.96%net income / net sales

Return on Assets 14.80% 6.84% 10.53% 6.83% 4.69% 11.17% 6.48% 7.40% 3.77%net income / total assets

Return on Equity 26.43% 12.86% 16.22% 11.03% 5.92% 16.70% 10.78% 17.50% -0.80%net income / total owners' equity

COVERAGE RATIOS:

Debt to Equity 0.79 0.88 0.58 0.61 0.51 0.50 -0.01 0.84 -0.34total liabilities / shareholders' investment

Times Interest Earned 53.88 26.31 26.41 23.92 10.19 50.57 40.38 N/A N/A(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).

Difference from

ExpectedActual (unaudited)

Difference (from 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.

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chapter 3 earthwear mini-case (9e)

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