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EarthWear Hands-on Mini-case

Chapter 3 - Client Acceptance


The McGraw-Hill Companies, Inc., 2012

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: the background information on EarthWear to prepare to evaluate the company as a continuing 1 Read audit client. To open the background document please double-click on the following icon (a document will open in Microsoft Word).

Document

EarthWear's unaudited 2012 financial statements including the "Balance Sheet", "Income 2 Review 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.

the Willis and Adams' client acceptance/continuance forms Work Papers 3-1, 3-2, 3-3, and 33 Review 4, which have already been completed. the remaining questions on Work Paper 3-5 using information from the background and 4 Complete financial statement information.
Fields you are to complete on the form are colored yellow. The color will disappear as the field is completed.

you've completed the above steps, enter your initials in the yellow box with title " Initial Here" on 5 When Work Paper 3-5. print a hard copy of Work Paper 3-5 for submission unless your instructor requests an 6 Please electronic version. The work paper is formatted to fit on one page.

EARTHWEAR CLOTHIERS Client Continuance Evaluation December 31, 2012

3-1 SAA 1/3/2013

General
Legal Name: Address: City: Telephone: Country: Entity Type: Nature of Business: EarthWear Clothiers, Inc. 2635 N. Devlin Ave. Boise (208) 555-3242 United States Corporation Fiscal year-end (MM/DD): State: Fax: ID Zip: (208) 555-3241 12/31 79443

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______________________

The McGraw-Hill Companies, Inc., 2012

EARTHWEAR CLOTHIERS Client Continuance Evaluation December 31, 2012

3-2 SAA 1/3/2013

Other Characteristics
Sub-prime lending operations: Select type of operation: A division of a regulated financial institution A commercial entity that sells all loans it originates A commercial entity that retains all or a portion of the loans it originates Select all that are applicable: Company plans to go public or raise significant equity? Does the company intend to go public using a "back-door" registration? Contingent fee arrangement? Insured depository or institution? Is the institution subject to a cease and desist order? Has the institution entered into a memorandum of understanding with a regulatory agency? Insurance company (life, property, and casualty)? Public entity and local government risk pools? Government securities dealers? Internet companies engaged in morally questionable activities? Unregulated casinos? 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 No No No No No No No No No No No No No

No

The McGraw-Hill Companies, Inc., 2012

EARTHWEAR CLOTHIERS Client Continuance Evaluation December 31, 2012

3-3 SAA 1/3/2013

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

Key Management
CEO CFO Accounting Officer Calvin J. Rogers James C. ("JC") Watts Carol McKay Boise Boise Boise ID ID ID 0 0 0 Yes Yes Yes

Outside Advisors
Primary Law Firm Name: Address: Leon, Leon & Dalton 958 S.W. 77th Avenue Boise, ID 79443 (208) 525-6119 David Leon Primary Banking Relationship Name: First National Bank Address: P.O. Box 1947 Boise, ID 79443 Telephone: Contact: Other Advisor Name: Relationship: Address: Telephone: Contact: (208) 543-5678 JJ Harmner

Telephone: Contact: Underwriters Name: Address:

Telephone: Contact:

Felix & Waller WebTrust Assurance Auditor 5055 E Broadway Blvd. Tucson, AZ 85711 (520) 747-7755 Richard Waller

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.

The McGraw-Hill Companies, Inc., 2012

EARTHWEAR CLOTHIERS Client Continuance Evaluation December 31, 2012

3-4 SAA 1/3/2013

Background Investigation Overview


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. Select from the following: All individuals/entities discussed above have been investigated. Background investigations have taken place for any newly hired key decision makers. A thorough background investigation has been completed. Summarize the results of the investigation below: 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. Yes Yes Yes

The McGraw-Hill Companies, Inc., 2012

Name: Class: EARTHWEAR CLOTHIERS Client Continuance Evaluation December 31, 2012 3-5 Initial Here 8/19/2013

General Risk Indicators


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. 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? Have any situations been noted that bear on the integrity of management? No

If you selected 'Yes' on any of the questions to the left, provide and explanation below:

No 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

Yes

Is there evidence that the business is financially distressed?

No

Is the client imposing on us any unreasonable scope or timing restrictions?

No

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?

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

No

Yes

In late February of 2012, EarthWears chief accounting officer/controller Brad Norton unexpectedly left the company to take a job with another clothes manufacturer. The company also switched to a new, integrated central accounting system in early 2010. The transition to the new system was overseen and implemented by the former controller, Brad Norton. Carol McKay had been the VP of External Reportin prior to her promotion to Controller. Some EarthWare executives question if McKay has the broad skill-set needed for her new position. Briefly explain your overall risk assessment of the client: Some uncertainties exist in the background information on Brad Norton, his sudden departure, and the promotion of Carol McKay.

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

Yes

Overall risk assessment of the client:

Medium

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.

Retain

EARTHWEAR CLOTHIERS Consolidated Balance Sheets (In thousands)


December 31

1-1 PBC 12/31/2012

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

2012 (unaudited) $79,359 $8,643 $147,693 $10,212 $5,435 $10,338 $261,680 $76,560 $68,632 $75,400 $3,144 $223,737 $97,722 $126,014 $1,734 $389,428

2011

2010

$48,978 $12,875 $122,337 $11,458 $6,315 $7,132 $209,095 $70,918 $67,513 $64,986 $3,010 $206,426 $85,986 $120,440 $423 $329,959

$49,668 $11,539 $105,425 $10,772 $3,780 $6,930 $188,115 $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 $261 $5,460 $25,719 ($36) $2,173 $361,402 ($134,512) $260,467 $389,428

$11,011 $62,509 $5,890 $26,738 $1,532 $8,588 $116,268 $9,469 $261 $5,460 $20,740 ($79) $3,883 $317,907 ($143,950) $204,222 $329,959

$7,621 $48,432 $5,115 $28,440 $1,794 $6,666 $98,067 $5,926 $261 $5,460 $19,311 ($153) $1,739 $295,380 ($129,462) $192,535 $296,527

The McGraw-Hill Companies, Inc., 2012

EARTHWEAR CLOTHIERS Consolidated Statements of Operations (In thousands, except per share data)
For the period ended December 31

1-2 PBC 12/31/2012

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

2012 (unaudited) $1,019,890 $572,153 $447,737 $374,180 $73,557 ($878) $989 ($3,514) ($3,403) $70,154 $26,658 $43,495 1.48 1.45 19,159 19,485

2011 $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

2010 $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

The McGraw-Hill Companies, Inc., 2012

EARTHWEAR CLOTHIERS Consolidated Statements of Cash Flows (In thousands)


For the period ended December 31

1-3 PBC 12/31/2012

Cash flows from (used for) operating activities: Net income Adjustments to reconcile net income to net cash flows from operating activities: Non-recurring charge (credit) Depreciation and amortization Deferred compensation expense Deferred income taxes Pretax gain on sale of subsidiary Loss on disposal of fixed assets Changes in assets and liabilities excluding the effects of divestitures: Receivables, net Inventory Prepaid advertising Other prepaid expenses Accounts payable Reserve for returns Accrued liabilities Accrued profit sharing Income taxes payable Tax benefit of stock options Other Net cash from (used for) operating activities Cash flows from (used for) investing activities: Cash paid for capital additions Proceeds from sale of subsidiary Net cash flows used for investing activities Cash flows from (used for) financing activities: Proceeds from (payment of) short-term debt Purchases of treasury stock Issuance of treasury stock Net cash flows used for financing activities Net increase (decrease) in cash and cash equivalents Beginning cash and cash equivalents Ending cash and cash equivalents Supplemental cash flow disclosures: Interest paid Income taxes paid

2012 (unaudited) $43,495

2011 $22,527

2010 $31,222

$17,515 $42 ($4,330) $1,578

$15,231 $75 $3,340 $284

($1,153) $13,465 $103 $5,376 $602

$4,232 ($25,356) $1,246 ($818) ($8,323) $210 $5,502 $1,576 $7,634 $4,979 ($1,404) $47,778 ($26,334) ($26,334) ($501) ($8,052) $17,490 $8,937 $30,381 $48,978 $79,359 $878 $21,431

($1,336) ($16,912) ($686) ($2,534) $14,078 $775 ($709) ($262) $1,923 $1,429 $2,144 $39,367 ($28,959) ($28,959) $3,390 ($18,192) $3,704 ($11,097) ($690) $49,668 $48,978 $987 $6,278

$2,165 $37,370 $3,110 $1,152 ($8,718) $439 ($4,982) $328 ($2,810) $1,765 $437 $79,871 ($18,208) ($18,208) ($17,692) ($2,935) $4,317 ($16,310) $45,352 $4,317 $49,668 $1,229 $13,701

The McGraw-Hill Companies, Inc., 2012

EARTHWEAR CLOTHIERS Ratio Analyses December 31, 2012


December 31

5-1 SAA 1/3/2013 2012 2012 Actual (unaudited) 2.17 0.73 0.40 Difference from Expected 0.23 0.08 0.00 Industry Average 2.10 0.80 N/A Difference (from 2012) 0.07 -0.07 N/A

2008

2009

2010

2011

(Audited) (Audited) (Audited) (Audited) Expected* SHORT-TERM LIQUIDITY RATIOS: Current Ratio current assets / current liabilities Quick Ratio liquid assets / current liabilities Operating Cash Flow Ratio cash flow from operations / current liabilities ACTIVITY RATIOS: Receivables Turnover net sales / net ending receivables Days Outstanding in Accounts Receivable 365 days / receivables turnover Inventory Turnover cost of sales / inventory Days of Inventory on Hand 365 / (cost of sales / inventory) PROFITABILITY / PERFORMANCE RATIOS: Gross Profit Percentage gross profit / net sales Profit Margin net income / net sales Return on Assets net income / total assets Return on Equity net income / total owners' equity COVERAGE RATIOS: Debt to Equity total liabilities / shareholders' investment Times Interest Earned (net income + interest expense) / interest expense 0.79 53.88 0.88 26.31 0.58 26.41 0.61 23.92 0.51 10.19 44.95% 2.34% 14.80% 26.43% 44.91% 3.61% 6.84% 12.86% 44.89% 3.64% 10.53% 16.22% 42.51% 2.37% 6.83% 11.03% 42.49% 3.02% 4.69% 5.92% 71.18 5.13 3.43 106.41 77.25 4.73 4.27 85.51 74.34 4.91 4.48 81.40 73.82 4.94 4.47 81.72 75.41 4.84 4.99 69.22 1.64 0.39 0.69 1.43 0.44 0.42 1.92 0.62 0.81 1.80 0.53 0.34 1.94 0.65 0.40

118.00 3.09 3.87 94.99

42.60 -1.74 -1.12 25.78

N/A 14.10 6.20 58.70

N/A -11.01 -2.33 36.29

43.90% 4.26% 11.17% 16.70%

1.41% 1.24% 6.48% 10.78%

38.80% 3.30% 7.40% 17.50%

5.10% 0.96% 3.77% -0.80%

0.50 50.57

-0.01 40.38

0.84 N/A

-0.34 N/A

* 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.