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:
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
Audit Planning Memorandum
December 31, 2012
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 company’s
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 company’s
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 company’s product lines also include casual clothes,
accessories, shoes, and soft luggage. The company’s 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
During 2011, one manufacturer and one intermediary accounted for about 14 and 29 percent of the Company's
received merchandise exposing Earthwear to supplier risk. In addition, Earthwear purchases about 80% of
their merchandise from Asia, Central America, Mexico, and Central America which introduces foreign currency
risk.
· Competition
EarthWear Clothier's faces strong competition from established brands and from various channels including
retail stores, internet stores, and mail order clothing companies. Mail order clothing companies rely heavily on
their reputation and their operational efficiencies, including customer service, to compete with the
aforementioned various sources of competition.
· Social Factors
The company’s 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
*Quick Ratio is 0.73 and the industry average is 0.80. Analysis of the quick ratio provides insight into the
company's ability to pay its current liabilities. 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.
The increasing amount of net sales from liquidiations 2009-2011 (8%,11%,12%) suggests that EarthWear's
products are losing appeal in the market.
EarthWear's Inventory Turnover is 3.88 and the industry average is 6.20
*Inventory Turnover is 3.88 and the industry average is 6.20. Inventury turnover indicates the frequency with
which inventory is consumed in a year. Earthwear's inventory turnover of 3.88 is significantly lower than the
industry average and may suggest that the company's inventory contains obsolete or slow-moving goods.
EarthWear's Gross Profit Percentage is 43.90% and the industry average is 38.80%
Prepared by:
Reviewed by:
Date:
2/16/2013
*Gross Profit Percentage is 43.90% and the industry average is 38.80%. Gross Profit Percentage is a good
indicator of potential misstatements as companies within an industry have similar figures. EarthWear's
industry leading gross profit percentage indicates raises concerns and indicates a need to examine for
potential misstatements.
EarthWear's Debt to Equity ratio is 0.50 and the industry average is 0.84
*Debt to Equity ratio is 0.50 and the industry average is 0.84. This ratio indicates the portion of the entity's
capital that comes from debt. 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.
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
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.
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
Name:
Class:
EARTHWEAR CLOTHIERS
Audit Planning Memorandum
December 31, 2012
PRINT OUT
· Suppliers
During 2011, one manufacturer and one intermediary accounted for about 14 and 29 percent of the Company's received merchandise exposing
Earthwear to supplier risk. In addition, Earthwear purchases about 80% of their merchandise from Asia, Central America, Mexico, and Central America
which introduces foreign currency risk.
· Competition
EarthWear Clothier's faces strong competition from established brands and from various channels including retail stores, internet stores, and mail
order clothing companies. Mail order clothing companies rely heavily on their reputation and their operational efficiencies, including customer service,
to compete with the aforementioned various sources of competition.
· Analytical Procedures
*Quick Ratio is 0.73 and the industry average is 0.80. Analysis of the quick ratio provides insight into the company's ability to pay its current liabilities.
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. The increasing amount of net sales from liquidiations 2009-2011 (8%,11%,12%) suggests that EarthWear's products are losing
appeal in the market.
*Inventory Turnover is 3.88 and the industry average is 6.20. Inventury turnover indicates the frequency with which inventory is consumed in a year.
Earthwear's inventory turnover of 3.88 is significantly lower than the industry average and may suggest that the company's inventory contains obsolete
or slow-moving goods.
*Gross Profit Percentage is 43.90% and the industry average is 38.80%. Gross Profit Percentage is a good indicator of potential misstatements as
companies within an industry have similar figures. EarthWear's industry leading gross profit percentage indicates raises concerns and indicates a need
to examine for potential misstatements.
*Debt to Equity ratio is 0.50 and the industry average is 0.84. This ratio indicates the portion of the entity's capital that comes from debt. 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.
Prepared by:
Reviewed by:
Date:
2/16/2013
EARTHWEAR CLOTHIERS
Ratio Analyses
December 31, 2012
6-Mar
SAA
1/3/2013
December 31
2008
2009
2010
2011
2012
(Audited) (Audited) (Audited) (Audited) Expected*
2012
Actual
(unaudited)
Difference
from
Expected
Industry
Difference
Average
(from 2012)
SHORT-TERM LIQUIDITY RATIOS:
Current Ratio
current assets / current liabilities
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
Operating Cash Flow Ratio
cash flow from operations / current liabilities
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
Days Outstanding in Accounts Receivable
365 days / receivables turnover
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
Gross Profit Percentage
gross profit / net sales
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
Days of Inventory on Hand
365 / (cost of sales / inventory)
PROFITABILITY / PERFORMANCE RATIOS:
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 2010 and 2011 to obtain the expected value for 2012).
† 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.
EARTHWEAR CLOTHIERS
Common-size Consolidated Balance Sheet
(In thousands)
5-4
SAA
1/3/2013
December 31
2010
Dollar Value
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
2011
% of Total
Assets
Dollar Value
% of Total
Assets
Expected*
Dollar Value
% of Total
Assets
Difference
Dollar Value
% of Total
Assets
$49,668
$11,539
$105,425
$10,772
$3,780
$6,930
$188,115
16.75%
3.89%
35.55%
3.63%
1.27%
2.34%
63.44%
$48,978
$12,875
$122,337
$11,458
$6,315
$7,132
$209,095
14.84%
3.90%
37.08%
3.47%
1.91%
2.16%
63.37%
$48,288
$14,211
$139,249
$12,143
$8,849
$7,335
$230,075
13.29%
3.91%
38.32%
3.34%
2.44%
2.02%
63.31%
$79,359
$8,643
$147,693
$10,212
$5,435
$10,338
$261,680
20.38%
2.22%
37.93%
2.62%
1.40%
2.65%
67.20%
$31,071
($5,568)
$8,444
($1,932)
($3,414)
$3,003
$31,604
$66,804
$66,876
$47,466
$2,894
$184,040
$76,256
$107,784
$628
$296,527
22.53%
22.55%
16.01%
0.98%
62.07%
25.72%
36.35%
0.21%
100.00%
$70,918
$67,513
$64,986
$3,010
$206,426
$85,986
$120,440
$423
$329,959
21.49%
20.46%
19.70%
0.91%
62.56%
26.06%
36.50%
0.13%
100.00%
$75,031
$68,150
$82,507
$3,125
$228,812
$95,716
$133,097
$218
$363,390
20.65%
18.75%
22.70%
0.86%
62.97%
26.34%
36.63%
0.06%
100.00%
$76,560
$68,632
$75,400
$3,144
$223,737
$97,722
$126,014
$1,734
$389,428
19.66%
17.62%
19.36%
0.81%
57.45%
25.09%
32.36%
0.45%
100.00%
$1,529
$482
($7,107)
$20
($5,076)
$2,007
($7,082)
$1,516
$26,038
7.09%
-1.69%
-0.39%
-0.72%
-1.04%
0.64%
3.88%
0.00%
-0.99%
-1.13%
-3.34%
-0.05%
-5.51%
-1.25%
-4.27%
0.39%
0.00%
$7,621
$48,432
$5,115
$28,440
$1,794
$6,666
$98,067
$5,926
2.57%
16.33%
1.72%
9.59%
0.61%
2.25%
33.07%
2.00%
$11,011
$62,509
$5,890
$26,738
$1,532
$8,588
$116,268
$9,469
3.34%
18.94%
1.78%
8.10%
0.46%
2.60%
35.24%
2.87%
$14,401
$76,587
$6,664
$25,035
$1,270
$10,511
$134,469
$13,011
3.96%
21.08%
1.83%
6.89%
0.35%
2.89%
37.00%
3.58%
$10,510
$54,186
$6,100
$30,492
$3,108
$16,222
$120,617
$8,345
2.70%
13.91%
1.57%
7.83%
0.80%
4.17%
30.97%
2.14%
($3,892)
($22,401)
($565)
$5,456
$1,838
$5,711
($13,853)
($4,666)
-1.26%
-7.16%
-0.27%
0.94%
0.45%
1.27%
-6.03%
-1.44%
$261
$5,460
$19,311
($153)
$1,739
$295,380
($129,462)
$192,535
$296,527
0.09%
1.84%
6.51%
-0.05%
0.59%
99.61%
-43.66%
64.93%
100.00%
$261
$5,460
$20,740
($79)
$3,883
$317,907
($143,950)
$204,222
$329,959
0.08%
1.65%
6.29%
-0.02%
1.18%
96.35%
-43.63%
61.89%
100.00%
$261
$5,460
$22,170
($4)
$6,027
$340,434
($158,438)
$215,910
$363,390
0.07%
1.50%
6.10%
0.00%
1.66%
93.68%
-43.60%
59.42%
100.00%
$261
$5,460
$25,719
($36)
$2,173
$361,402
($134,512)
$260,467
$389,428
0.07%
1.40%
6.60%
-0.01%
0.56%
92.80%
-34.54%
66.88%
100.00%
$0
$0
$3,550
($33)
($3,855)
$20,968
$23,926
$44,557
$26,038
0.00%
-0.10%
0.50%
-0.01%
-1.10%
-0.88%
9.06%
7.47%
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
2012
Actual
Dollar Value
% of Total
Assets
EARTHWEAR CLOTHIERS
Common-size Statements of Operations
(In thousands, except per share data)
5-5
SAA
1/3/2013
For the period ended December 31
2010
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
Dollar Value
857,885
472,739
385,146
334,994
(1,153)
51,305
(1,229)
573
(1,091)
(1,747)
49,559
18,337
31,222
1.60
1.56
19,555
20,055
2011
% of Sales
100.00%
55.11%
44.89%
39.05%
-0.13%
5.98%
0.00%
-0.14%
0.07%
0.00%
-0.13%
-0.20%
5.78%
2.14%
3.64%
Dollar Value
950,484
546,393
404,091
364,012
40,729
(983)
1,459
(4,798)
(4,322)
35,757
13,230
22,527
1.15
1.14
19,531
19,774
% of Sales
100.00%
57.49%
42.51%
38.30%
0.00%
4.29%
0.00%
-0.10%
0.15%
0.00%
-0.50%
-0.45%
3.76%
1.39%
2.37%
Expected*
Dollar Value
% of Sales
1,043,083
100.00%
620,046
59.44%
423,037
40.56%
393,031
37.68%
0.00%
46,050
4.41%
0.00%
(737)
-0.07%
1,017
0.10%
0.00%
(2,947)
-0.28%
(3,037)
-0.29%
42,688
4.09%
15,794
1.51%
26,894
2.58%
1.38
1.35
19,558
19,930
* 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
2012
Actual
Dollar Value
% of Sales
1,019,890
100.00%
572,153
56.10%
447,737
43.90%
374,180
36.69%
0.00%
73,557
7.21%
0.00%
(878)
-0.09%
989
0.10%
0.00%
(3,514)
-0.34%
(3,403)
-0.33%
70,154
6.88%
26,658
2.61%
43,495
4.26%
1.48
1.45
19,159
19,485
Difference
Dollar Value
% of Sales
(23,193)
0.00%
(47,893)
-3.34%
24,700
3.34%
(18,851)
-0.99%
0
0.00%
27,506
2.80%
0
0.00%
(140)
-0.02%
(28)
0.00%
0
0.00%
(567)
-0.06%
(366)
-0.04%
27,466
2.79%
10,864
1.10%
16,602
1.69%
0.10
0.10
(398)
(445)