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:
1
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).
2
Review EarthWear's unaudited 2012 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.
3
Review the Willis and Adams' client acceptance/continuance forms Work Papers 3-1, 3-2, 3-3, and 34, which have already been completed.
4
Complete the remaining questions on Work Paper 3-5 using information from the background and financial statement information. Fields you are to complete on the form are colored yellow. The color will disappear as the field is completed.
5
When you've completed the above steps, enter your initials in the yellow box with title "Initial Here" on Work Paper 3-5.
6
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.
General
EARTHWEAR CLOTHIERS Client Continuance Evaluation December 31, 2012
3-1 SAA 1/3/2013
Legal Name: EarthWear Clothiers, Inc. Fiscal year-end (MM/DD): 12/31 Address: 2635 N. Devlin Ave. City: Boise State: ID Zip: 79443 Telephone: (208) 555-3242 Fax: (208) 555-3241 Country: United States Entity Type: Corporation Nature of Business: 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
Other Characteristics
EARTHWEAR CLOTHIERS Client Continuance Evaluation December 31, 2012
3-2 SAA 1/3/2013
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
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
© 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
Boise Boise Boise
ID ID ID
0 0 0
Yes Yes Yes
Key Management CEO CFO Accounting Officer
Calvin J. Rogers James C. ("JC") Watts Carol McKay
Outside Advisors Primary Law Firm Name: Address:
Telephone: Contact:
Leon, Leon & Dalton 958 S.W. 77th Avenue Boise, ID 79443
Primary Banking Relationship Name: First National Bank Address: P.O. Box 1947 Boise, ID 79443
(208) 525-6119 David Leon
Telephone: Contact:
Underwriters Name: Address:
Other Advisor Name: Relationship: Address:
Telephone: Contact:
Telephone: Contact:
(208) 543-5678 JJ Harmner
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:
[email protected] 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.
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: 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.
© The McGraw-Hill Companies, Inc., 2012
Name: Class: EARTHWEAR CLOTHIERS Client Continuance Evaluation December 31, 2012
3-5 S.S. and S.S 4/15/2012
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.
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)
No
Does the client have any associated entities that are not audited or are being audited by firms outside of Willis and Adams?
No
Have any situations been noted that bear on the integrity of management?
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.)
No
Are there any pending enforcement matters or other investigations the outcome of which could adversely impact the viability or reputation of the business?
No
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?
In 1999, EarthWear's vice president of finance, Don Evans, was charged with a misdemeanor involving illegal gambling local college basketball games. Charges were later dropped in return for Mr. Evans agreeing to pay a fine of $750 and
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?
No
Are there any internal conditions or trends that may raise concern, such as management turnover or new accounting information systems?
Yes
Former Controller Brad Norton left Earthware in 2010 and went to another clothing company. He also oversaw the new accounting software update.
Yes
Carol McKay was VP of external reporting prior to her promotion to Controller. Earthware expressed concern about her skill set to do the job of controller.
Are there any other risk concerns arising out of the information gathering process?
Overall risk assessment of the client: 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.
Medium Retain
Briefly explain your overall risk assessment of the client: Due to background information on Brad Norton and the promotion of Carol McKay there are some uncertainties.
EARTHWEAR CLOTHIERS Consolidated Balance Sheets (In thousands)
1-1 PBC 12/31/2012 December 31
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
© The McGraw-Hill Companies, Inc., 2012
2012 (unaudited)
2011
2010
$79,359 $8,643 $147,693 $10,212 $5,435 $10,338 $261,680
$48,978 $12,875 $122,337 $11,458 $6,315 $7,132 $209,095
$49,668 $11,539 $105,425 $10,772 $3,780 $6,930 $188,115
$76,560 $68,632 $75,400 $3,144 $223,737 $97,722 $126,014 $1,734 $389,428
$70,918 $67,513 $64,986 $3,010 $206,426 $85,986 $120,440 $423 $329,959
$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
$11,011 $62,509 $5,890 $26,738 $1,532 $8,588 $116,268 $9,469
$7,621 $48,432 $5,115 $28,440 $1,794 $6,666 $98,067 $5,926
$261 $5,460 $25,719 ($36) $2,173 $361,402 ($134,512) $260,467 $389,428
$261 $5,460 $20,740 ($79) $3,883 $317,907 ($143,950) $204,222 $329,959
$261 $5,460 $19,311 ($153) $1,739 $295,380 ($129,462) $192,535 $296,527
EARTHWEAR CLOTHIERS Consolidated Statements of Operations (In thousands, except per share data)
1-2 PBC 12/31/2012
For the period ended December 31
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
© The McGraw-Hill Companies, Inc., 2012
2012 (unaudited) $1,019,890 $572,153 $447,737 $374,180
$950,484 $546,393 $404,091 $364,012
$73,557
$40,729
$857,885 $472,739 $385,146 $334,994 ($1,153) $51,305
($878) $989
($983) $1,459
($1,229) $573
($3,514) ($3,403) $70,154 $26,658 $43,495 1.48 1.45 19,159 19,485
($4,798) ($4,322) $35,757 $13,230 $22,527 1.15 1.14 19,531 19,774
($1,091) ($1,747) $49,559 $18,337 $31,222 1.60 1.56 19,555 20,055
2011
2010
EARTHWEAR CLOTHIERS Consolidated Statements of Cash Flows (In thousands)
1-3 PBC 12/31/2012 For the period ended December 31
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
© The McGraw-Hill Companies, Inc., 2012
2012 (unaudited) $43,495
2011
2010
$22,527
$31,222
$17,515 $42 ($4,330)
$15,231 $75 $3,340
($1,153) $13,465 $103 $5,376
$1,578
$284
$602
$4,232 ($25,356) $1,246 ($818) ($8,323) $210 $5,502 $1,576 $7,634 $4,979 ($1,404) $47,778
($1,336) ($16,912) ($686) ($2,534) $14,078 $775 ($709) ($262) $1,923 $1,429 $2,144 $39,367
$2,165 $37,370 $3,110 $1,152 ($8,718) $439 ($4,982) $328 ($2,810) $1,765 $437 $79,871
($26,334)
($28,959)
($18,208)
($26,334)
($28,959)
($18,208)
($501) ($8,052) $17,490 $8,937 $30,381 $48,978 $79,359
$3,390 ($18,192) $3,704 ($11,097) ($690) $49,668 $48,978
($17,692) ($2,935) $4,317 ($16,310) $45,352 $4,317 $49,668
$878 $21,431
$987 $6,278
$1,229 $13,701
EARTHWEAR CLOTHIERS Ratio Analyses December 31, 2012
5-1 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.
