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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 youve read about in Chapter 3.
INSTRUCTIONS:
1
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.
2
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.
3
Print a copy of the Print Out to submit in class unless otherwise indicated by your instructor.
EARTHWEAR CLOTHIERS Prepared by:
Audit Planning Memorandum Reviewed by:
December 31, 2012 Date: 6/10/2014
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
Address at least two key points about issues relating to EarthWear Clothiers' suppliers. Keep in mind that the
points you identify should have important implications for understanding EarthWear as an audit client.

Competition
Address at least two key points about EarthWear Clothiers' competitors or the mail order clothing industry.
Keep in mind that the points you identify should have important implications for understanding EarthWear as
an audit client.
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
Discuss the meaning of the analytical procedure and how it may affect risks relating to the EarthWear audit or
your planned audit procedures.
EarthWear's Inventory Turnover is 3.88 and the industry average is 6.20
Discuss the meaning of the analytical procedure and how it may affect risks relating to the EarthWear audit or
your planned audit procedures.
EarthWear's Gross Profit Percentage is 43.90% and the industry average is 38.80%
Discuss the meaning of the analytical procedure and how it may affect risks relating to the EarthWear audit or
your planned audit procedures.
EarthWear's Debt to Equity ratio is 0.50 and the industry average is 0.84
Discuss the meaning of the analytical procedure and how it may affect risks relating to the EarthWear audit or
your planned audit procedures.
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
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
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.
Name:
Class:
EARTHWEAR CLOTHIERS Prepared by:
Audit Planning Memorandum Reviewed by:
December 31, 2012 Date: 6/10/2014
PRINT OUT
Suppliers
Enter your answer on the Audit Planning Memorandum.

Competition
Enter your answer on the Audit Planning Memorandum.
Analytical Procedures
Enter your answer on the Audit Planning Memorandum.
Enter your answer on the Audit Planning Memorandum.
Enter your answer on the Audit Planning Memorandum.
Enter your answer on the Audit Planning Memorandum.
6-Mar
SAA
1/3/2013
2008 2009 2010 2011 2012 2012
(Audited) (Audited) (Audited) (Audited) Expected*
Actual
(unaudited)
Average
Difference
(from 2012)
SHORT-TERM LIQUIDITY RATIOS:
Current Ratio 1.64 1.43 1.92 1.80 1.94 2.17 0.23 2.10 0.07
current assets / current liabilities
Quick Ratio 0.39 0.44 0.62 0.53 0.65 0.73 0.08 0.80 -0.07
liquid assets / current liabilities
Operating Cash Flow Ratio 0.69 0.42 0.81 0.34 0.40 0.40 0.00 N/A N/A
cash 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/A
net 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 -11.01
365 days / receivables turnover
Inventory Turnover 3.43 4.27 4.48 4.47 4.99 3.87 -1.12 6.20 -2.33
cost of sales / inventory
Days of Inventory on Hand 106.41 85.51 81.40 81.72 69.22 94.99 25.78 58.70 36.29
365 / (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 -0.34
total 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 2010 and 2011 to obtain the expected value for 2012).
N/A = not available or could not be calculated from financial data.
Industry
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.
EARTHWEAR CLOTHIERS
Ratio Analyses
December 31, 2012
December 31
Difference
from
Expected
5-4
SAA
1/3/2013
Assets
Dollar Value % of Total
Assets
Dollar Value % of Total
Assets
Dollar Value % of Total
Assets
Dollar Value % of Total
Assets
Dollar Value % of Total
Assets
Current Assets:
Cash and cash equivalents $49,668 16.75% $48,978 14.84% $48,288 13.29% $79,359 20.38% $31,071 7.09%
Receivables, net $11,539 3.89% $12,875 3.90% $14,211 3.91% $8,643 2.22% ($5,568) -1.69%
Inventory $105,425 35.55% $122,337 37.08% $139,249 38.32% $147,693 37.93% $8,444 -0.39%
Prepaid advertising $10,772 3.63% $11,458 3.47% $12,143 3.34% $10,212 2.62% ($1,932) -0.72%
Other prepaid expenses $3,780 1.27% $6,315 1.91% $8,849 2.44% $5,435 1.40% ($3,414) -1.04%
Deferred income tax benefits $6,930 2.34% $7,132 2.16% $7,335 2.02% $10,338 2.65% $3,003 0.64%
Total current assets $188,115 63.44% $209,095 63.37% $230,075 63.31% $261,680 67.20% $31,604 3.88%
Property, plant and equipment, at cost 0.00%
Land and buildings $66,804 22.53% $70,918 21.49% $75,031 20.65% $76,560 19.66% $1,529 -0.99%
Fixtures and equipment $66,876 22.55% $67,513 20.46% $68,150 18.75% $68,632 17.62% $482 -1.13%
Computer hardware and software $47,466 16.01% $64,986 19.70% $82,507 22.70% $75,400 19.36% ($7,107) -3.34%
Leasehold improvements $2,894 0.98% $3,010 0.91% $3,125 0.86% $3,144 0.81% $20 -0.05%
Total property, plant and equipment $184,040 62.07% $206,426 62.56% $228,812 62.97% $223,737 57.45% ($5,076) -5.51%
Less - accumulated depreciation and amortization $76,256 25.72% $85,986 26.06% $95,716 26.34% $97,722 25.09% $2,007 -1.25%
Property, plant and equipment, net $107,784 36.35% $120,440 36.50% $133,097 36.63% $126,014 32.36% ($7,082) -4.27%
Intangibles, net $628 0.21% $423 0.13% $218 0.06% $1,734 0.45% $1,516 0.39%
Total assets $296,527 100.00% $329,959 100.00% $363,390 100.00% $389,428 100.00% $26,038 0.00%
Liabilities and shareholder's investment
Current liabilities:
Lines of credit $7,621 2.57% $11,011 3.34% $14,401 3.96% $10,510 2.70% ($3,892) -1.26%
Accounts payable $48,432 16.33% $62,509 18.94% $76,587 21.08% $54,186 13.91% ($22,401) -7.16%
Reserve for returns $5,115 1.72% $5,890 1.78% $6,664 1.83% $6,100 1.57% ($565) -0.27%
Accrued liabilities $28,440 9.59% $26,738 8.10% $25,035 6.89% $30,492 7.83% $5,456 0.94%
Accrued profit sharing $1,794 0.61% $1,532 0.46% $1,270 0.35% $3,108 0.80% $1,838 0.45%
Income taxes payable $6,666 2.25% $8,588 2.60% $10,511 2.89% $16,222 4.17% $5,711 1.27%
Total current liabilities $98,067 33.07% $116,268 35.24% $134,469 37.00% $120,617 30.97% ($13,853) -6.03%
Deferred income taxes $5,926 2.00% $9,469 2.87% $13,011 3.58% $8,345 2.14% ($4,666) -1.44%
Shareholders' investment:
Common stock, 26,144 shares issued $261 0.09% $261 0.08% $261 0.07% $261 0.07% $0 0.00%
Donated capital $5,460 1.84% $5,460 1.65% $5,460 1.50% $5,460 1.40% $0 -0.10%
Additional paid-in capital $19,311 6.51% $20,740 6.29% $22,170 6.10% $25,719 6.60% $3,550 0.50%
Deferred compensation ($153) -0.05% ($79) -0.02% ($4) 0.00% ($36) -0.01% ($33) -0.01%
Accumulated other comprehensive income $1,739 0.59% $3,883 1.18% $6,027 1.66% $2,173 0.56% ($3,855) -1.10%
Retained earnings $295,380 99.61% $317,907 96.35% $340,434 93.68% $361,402 92.80% $20,968 -0.88%
Treasury stock, 6,654, 7,114, and 6,546 shares at cost, respectively ($129,462) -43.66% ($143,950) -43.63% ($158,438) -43.60% ($134,512) -34.54% $23,926 9.06%
Total shareholders' investment $192,535 64.93% $204,222 61.89% $215,910 59.42% $260,467 66.88% $44,557 7.47%
Total liabilities and shareholders' investment $296,527 100.00% $329,959 100.00% $363,390 100.00% $389,428 100.00% $26,038 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 Consolidated Balance Sheet
(In thousands)
December 31
Difference 2010 2011 Expected* Actual
2012
5-5
SAA
1/3/2013
Dollar Value % of Sales Dollar Value % of Sales Dollar Value % of Sales Dollar Value % of Sales Dollar Value % of Sales
Net Sales 857,885 100.00% 950,484 100.00% 1,043,083 100.00% 1,019,890 100.00% (23,193) 0.00%
Cost of sales 472,739 55.11% 546,393 57.49% 620,046 59.44% 572,153 56.10% (47,893) -3.34%
Gross Profit 385,146 44.89% 404,091 42.51% 423,037 40.56% 447,737 43.90% 24,700 3.34%
Selling, general and administrative expenses 334,994 39.05% 364,012 38.30% 393,031 37.68% 374,180 36.69% (18,851) -0.99%
Non-recurring charge (credit) (1,153) -0.13% 0.00% 0.00% 0.00% 0 0.00%
Income from operations 51,305 5.98% 40,729 4.29% 46,050 4.41% 73,557 7.21% 27,506 2.80%
Other income (expense): 0.00% 0.00% 0.00% 0.00% 0 0.00%
Interest expense (1,229) -0.14% (983) -0.10% (737) -0.07% (878) -0.09% (140) -0.02%
Interest income 573 0.07% 1,459 0.15% 1,017 0.10% 989 0.10% (28) 0.00%
Gain on sale of subsidiary 0.00% 0.00% 0.00% 0.00% 0 0.00%
Other (1,091) -0.13% (4,798) -0.50% (2,947) -0.28% (3,514) -0.34% (567) -0.06%
Total other income (expense), net (1,747) -0.20% (4,322) -0.45% (3,037) -0.29% (3,403) -0.33% (366) -0.04%
Income before income taxes 49,559 5.78% 35,757 3.76% 42,688 4.09% 70,154 6.88% 27,466 2.79%
Income tax provision 18,337 2.14% 13,230 1.39% 15,794 1.51% 26,658 2.61% 10,864 1.10%
Net income 31,222 3.64% 22,527 2.37% 26,894 2.58% 43,495 4.26% 16,602 1.69%
Basic earnings per share 1.60 1.15 1.38 1.48 0.10
Diluted earnings per share 1.56 1.14 1.35 1.45 0.10
Basic weighted average shares outstanding 19,555 19,531 19,558 19,159 (398)
Diluted weighted average shares outstanding 20,055 19,774 19,930 19,485 (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
EARTHWEAR CLOTHIERS
Common-size Statements of Operations
(In thousands, except per share data)
Difference Actual Expected* 2010 2011
For the period ended December 31
2012

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