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5
EarthWear Hands-on Mini-case
Chapter 5 - Preliminary Analytical Procedures
© The McGraw-Hill Companies, Inc., 2014

In this mini-case you will complete the preliminary analytical procedures for the audit of EarthWear
Clothiers, Inc.

INSTRUCTIONS:

Review the ratio analyses contained on Work Paper 5-1. You can read the Advanced Module: Selected
Financial Ratios in Chapter 5 of the text for a description of these ratios.You will be asked to provide
further analyses of these ratios as you complete Work Paper 5-2.

Fields you are to complete on work papers are colored yellow. The color will disappear when the field is completed.

Complete all the fields on Work Paper 5-3 indicated in yellow. Additionally, EarthWear Common-Size
Financial Statements have been included to aid you in your decisions.
Fields you are to complete on work papers are colored yellow. The color will disappear when the field is completed.

When completed with the work papers, enter your initials in the yellow box in the upper right-hand
corner of Work Paper 5-2 and 5-3 (box indicates "Initial Here").

Please print hard copies of work papers 5-2 and 5-3 to submit unless your instructor requests an
electronic submission. The work papers are each formatted to fit on one page.
 EARTHWEAR CLOTHIERS 5-1
Ratio Analyses SAA
December 31, 2014 1/3/2015
December 31
2010 2011 2012 2013 2014 2014 Difference Industry
Actual from Difference
(Audited) (Audited) (Audited) (Audited) Expected* Average
(unaudited) Expected (from 2014)
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 2013 to obtain the expected value for 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.

Name:

Class:
EARTHWEAR CLOTHIERS 5-2
Preliminary Analytical Procedures RC
Summary of Ratio Analyses & Assessment of Financial Condition 4/2/2021
December 31, 2014

1. Comments and Summary

Based on your review of work paper 5-1, list one or two ratios in each of the following categories that you believe increase the risk of potential misstatement. Explain why you believe the risk is increased and identify
possible causes of a potential misstatement and indicate if you believe the auditor would need to revise his or her typical audit approach to address the risk.
For example, "Days of Inventory on Hand" increased significantly indicating merchandise is held in inventory for a longer period than prior years and it is also held for a longer period than the industry average. This
increases the risk of obsolete inventory and/or the market value dropping below recorded cost. The auditor should increase the extent of inventory-valuation testing and/or change the nature of the testing to address
the increased risk.
SHORT-TERM LIQUIDITY RATIOS:
Current ratio is a measure of the ability of a firm to meet its short-term obligations. In general, a ratio of 2 to 3 is usually considered good. Too small ratio indicates that there is some potential difficulty in covering
obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use of them. Earthware has a relative high Current ratio of 2.17 for the actual but unaudited
year of 2014. Prior years show current ratios of less than 2. For this reason, I believe that this ratio increases the risk of misstatement. For instance, the increase in the current ratio could be a red flag for revenue
recognition, understatement of liabilities and expenses. If the current ratio decreased, which is not the case here, the misstatement would indicate that there is a possibility fictitious receivables. Additionally, the industry
average provides a current ratio of 2.10 higher than Earthware clothes. This may be questionable and can lead to misstatement but then we need to consider that the industry average is just an average and that there
could be slight differences in the nature of the business.
Quick ratio - includes those assets that can be converted to cash quickly. Often inventory will take time to sell even in a flash sales, thus excluded. This ratio is a more stringent measure of liquidity and only liquid assets
are taken into account. The quick ratio may provide a better picture of the entity's liquidity position if inventory contains obsolete or slow moving items. A ratio greater than one and generally indicates that the entities
liquid assets are sufficient to meet the cash requirements for paying current liabilities. Earthware has a relative high quick ratio of .73 for the actual but unaudited year of 2014.

ACTIVITY RATIOS:
Receivable turnover ratio A high receivable turnover will indicate that the company collects it's dues from its customers quickly. If this ratio is too high compared to the industry, this may indicate that the company does
not offer its clients a long enough credit facility, As a result may be losing sales. A decreasing receivable turnover ratio may indicate that the company is having difficulties collecting cash from customers, and may be a
sign that sales are perhaps overstated. Earthware has a relative high receivable ratio of 118 for the actual but unaudited year of 2014. This could indicate that the company collects its dues from its customers quickly
but doesn't extend the credit terms of credit lines enough to its customers. Which could mean a decrease in sales. Inflating the AR turnover ratio indicated possible revenue recognition fraud. The decrease in the AR
turnover ratio would indicate fictitious receivables an inflating the values of the receivables.
Inventory turnover provides an indication of how efficiently the company’s inventory is utilized by management. A high inventory ratio is an indicator that the company sells its inventory rapidly

PROFITABILITY / PERFORMANCE RATIOS:

Gross profit margin has declined 43.90% in 2014 from 44.95% in 2010. However, on comparing with industry average of 38.80% it has improved significantly throughout the periods. The reason could be decline in sales
volume or increase in cost of goods sold.

COVERAGE RATIOS:
Debt to equity ratio Shows the debt structure of the company in example how much that is financed externally and internally. A high debt to equity ratio shows the company acquired a lot off debt and since payments are
fixed, it can put a constraint in cash. Compared to the industry, for 2014 the ratio was .50 compared to the industry ratio of .84.

2. Assessment of Financial Position

Based on your review of work paper 5-1, assess the client's ability to continue as a going concern (to stay in business) by responding to the following questions.

A. Identify ratios and trends, if any, that cause concern about the client's ability to continue as a going concern
Coverage ratios appear to have a high risk of misstatements and can be a concern of a going concern

B. Identify ratios and trends, if any, that indicate a high likelihood that the client will continue successfully as a going concern
Short-term liquidity ratios show are above average for Earthwear, not a concerm

C. Assess the client's financial condition as one of the following (select one from the drop down list in cell B35)
Moderate possibility that the company will NOT successfully continue in business for at least one year and be able to pay its debts as they become due.

Moderate possibility that the company will NOT successfully continue in business for at least one year and be able to pay its debts as they become due.

D. Briefly explain the reasoning behind your assessment.

Earthwear receivables can potentially be a possible misstatement concerning revenue recognition. The receivables turnover indicates a dramatic increase compared to prior years and the industry average.
Name:

Class: EARTHWEAR CLOTHIERS 5-3

Identification of Accounts with Unexpected Fluctuations RC
December 31, 2014 4/2/2021

1. Establish Threshold for Unexpected Fluctuations

To begin identifying accounts with unexpected fluctuations auditors must establish a threshold for account difference. All accounts whose actual 2014 unaudited account balance differs from the
expected balance by a value greater than the threshold established will be shown in the charts below. As a general rule the threshold should not exceed materiality. For the purposes of this exercise we
assume planning materiality is $3.1 million. Enter this value in the field below as 3100.

A. Set threshold for account difference in thousands (e.g., 3100) $3,100

2. Evaluate Unexpected Fluctuations

Lists of Balance Sheet and Income Statement accounts have been generated below based on your threshold for account difference. In the "Evaluation" column please identify 2 or more balance sheet
and 2 or more income statement accounts where you believe the difference presents increased risk of material misstatement that may require a change in the nature, timing or extent of planned audit
procedures. Please indicate possible reasons for the difference, potential risks, and suggested audit plan revisions.

A. Balance Sheet Accounts

Difference from
Account Evaluation
Expectations
Cash and cash equivalents $31,071 This large difference in expectation has to probably do with the fact that the company has expanded
its economic resources and are expected to provide future cash inflows. The potential risk includes
not being able to cover or meet its current liabilities.
Receivables, net ($5,568) this increase difference in expectation has to do with the company has enough capital to acquire the
fixed assets to conduct the normal courses of business. Any error in the physical count at the end of
the accounting. Will misstatate inventory shrinkage and the cost of merchandise sold. Retained
earnings as well as total assets will be misstated

Inventory $8,444 Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

Other prepaid expenses ($3,414) Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

Computer hardware and software ($7,107) Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

Lines of credit ($3,892) Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

Accounts payable ($22,401) Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

Accrued liabilities $5,456 Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

Income taxes payable $5,711 Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

Deferred income taxes ($4,666) Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

Additional paid-in capital $3,550 Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

Accumulated other comprehensive income ($3,855) Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

Treasury stock, 6,654, 7,114, and 6,546 shares at cost, respectively $23,926 Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

B. Income Statement Accounts

Difference from
Account Evaluation
Expectations
Net Sales ($23,193) This increases the difference in the total charge customers for merchandise sold, including cash
sales and sales on account both sales returns and allowances and sales discounts are subtracted
in arriving to net sales. The company increased its accounts receivable an is likely to contain
misstatements

Cost of sales ($47,893) the cost for goods sold represents the outflow of purchase is caused by the sale of inventory in is
the most important expense on the income statement of companies that sell goods instead of
services. This explains why cogs is match against net sales
Selling, general and administrative expenses ($18,851) Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.

Income tax provision $10,864 Indicate possible reasons for difference, potential risks, and suggested audit plan revisions here.
 EARTHWEAR CLOTHIERS 5-4
Common-size Consolidated Balance Sheet SAA
(In thousands) 1/3/2015

December 31
2014
2012 2013 Expected* Actual Difference
Dollar Value % of Total Dollar Value % of Total Dollar Value % of Total Dollar Value % of Total Dollar Value % of Total
Assets Assets Assets Assets Assets 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 2012 and 2013 to obtain the expected value for 2014).

© The McGraw-Hill Companies, Inc., 2014

 EARTHWEAR CLOTHIERS 5-5
Common-size Statements of Operations SAA
(In thousands, except per share data) 1/3/2015

For the period ended December 31

2014
2012 2013 Expected* Actual Difference
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 2012 and 2013 to obtain the expected value for 2014).

© The McGraw-Hill Companies, Inc., 2014