EarthWear Hands-on Mini-case

Chapter 3 - Client Acceptance

AUDITING & ASSURANCE SERVICES 11e © The McGraw-Hill Companies, Inc., 2019

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 2019 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 3-4,
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.

When you've completed the above steps, enter your initials in the yellow box with title " Initial Here" on Work
5 Paper 3-5.

6 Please input your answers into Connect or print a hard copy of Work Paper 3-5 to submit unless your
instructor requests an electronic submission. The work paper is formatted to fit on one page.
 EARTHWEAR CLOTHIERS 3-1
Client Continuance Evaluation SAA
December 31, 2019 1/3/2020
General

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., 2019

 EARTHWEAR CLOTHIERS 3-2
Client Continuance Evaluation SAA
December 31, 2019 1/3/2020
Other Characteristics

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 No
entities)?

© The McGraw-Hill Companies, Inc., 2019

 EARTHWEAR CLOTHIERS 3-3
Client Continuance Evaluation SAA
December 31, 2019 1/3/2020

Management

Board of Directors
Ownership Background
Title: Name: Home City: Home State: % Verification:
Chairman James G. Williams Boise ID 25 Yes
Audit Comm. Chair Gary Amble Boise ID 0 Yes

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

Outside Advisors
Primary Law Firm Primary Banking Relationship
Name: Leon, Leon & Dalton Name: First National Bank
Address: 958 S.W. 77th Avenue Address: P.O. Box 1947
Boise, ID 79443 Boise, ID 79443

Telephone: (208) 525-6119 Telephone: (208) 543-5678

Contact: David Leon Contact: JJ Harmner

Underwriters Other Advisor

Name: Name: Felix & Waller
Address: Relationship: WebTrust Assurance Auditor
Address: 5055 E Broadway Blvd.
Tucson, AZ 85711
Telephone: Telephone: (520) 747-7755
Contact: Contact: 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., 2019

 EARTHWEAR CLOTHIERS 3-4
Client Continuance Evaluation SAA
December 31, 2019 1/3/2020

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., 2019

Name:

Class:

EARTHWEAR CLOTHIERS 3-5

Client Continuance Evaluation Initial Here
December 31, 2019 2/16/2020
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" If you selected 'Yes' on any of the questions to the left, provide and
from the drop down menu. 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? In 1999, EarthWear's vice president of finance, Don Evans, was charged with a
misdemeanor involving illegal gambling on local college basketball games.
Yes 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.

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 No
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 No
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

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 No
new competitors?

Are there any internal conditions or trends that may raise concern, such as In late February of 2019, EarthWear’s chief accounting officer/controller Brad
management turnover or new accounting information systems? Norton unexpectedly left the company to take a job with another clothes
Yes manufacturer. The company switched to a new, integrated central accounting
system in early 2015. The transition to the new system was overseen and
implemented by the former controller, Brad Norton.

Are there any other risk concerns arising out of the information gathering Before her promotion, Ms. McKay had been the VP of External Reporting. In her
process? 14 years with EarthWear, Ms. McKay spent the majority of her time in External
Yes
Reporting. As a result, some executives questioned if Ms. McKay had the broad
skill-set needed for such a demanding position.

Briefly explain your overall risk assessment of the client:

There are still some doubtful and unclear points about the background
Overall risk assessment of the client: Medium information on EarthWear, such as Brad Norton's unexpected leave, and the new
controller, Carol Mckay's sudden promotion.

Based on the information gathered, and the above evaluation of Retain

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.
 EARTHWEAR CLOTHIERS 1-1
Consolidated Balance Sheets PBC
(In thousands) 12/31/2019

December 31

2019 ### ###

Assets (unaudited)
Current Assets:
Cash and cash equivalents $79,359 $48,978 $49,668
Receivables, net $8,643 $12,875 $11,539
Inventory $147,693 $122,337 $105,425
Prepaid advertising $10,212 $11,458 $10,772
Other prepaid expenses $5,435 $6,315 $3,780
Deferred income tax benefits $10,338 $7,132 $6,930
Total current assets $261,680 $209,095 $188,115
Property, plant and equipment, at cost
Land and buildings $76,560 $70,918 $66,804
Fixtures and equipment $68,632 $67,513 $66,876
Computer hardware and software $75,400 $64,986 $47,466
Leasehold improvements $3,144 $3,010 $2,894
Total property, plant and equipment $223,737 $206,426 $184,040
Less - accumulated depreciation and amortization $97,722 $85,986 $76,256
Property, plant and equipment, net $126,014 $120,440 $107,784
Intangibles, net $1,734 $423 $628
Total assets $389,428 $329,959 $296,527

Liabilities and shareholder's investment

Current liabilities:
Lines of credit $10,510 $11,011 $7,621
Accounts payable $54,186 $62,509 $48,432
Reserve for returns $6,100 $5,890 $5,115
Accrued liabilities $30,492 $26,738 $28,440
Accrued profit sharing $3,108 $1,532 $1,794
Income taxes payable $16,222 $8,588 $6,666
Total current liabilities $120,617 $116,268 $98,067
Deferred income taxes $8,345 $9,469 $5,926
Shareholders' investment:
Common stock, 26,144 shares issued $261 $261 $261
Donated capital $5,460 $5,460 $5,460
Additional paid-in capital $25,719 $20,740 $19,311
Deferred compensation ($36) ($79) ($153)
Accumulated other comprehensive income $2,173 $3,883 $1,739
Retained earnings $361,402 $317,907 $295,380
Treasury stock, 6,654, 7,114, and 6,546 shares at cost, respectively ($134,512) ($143,950) ($129,462)
Total shareholders' investment $260,467 $204,222 $192,535
Total liabilities and shareholders' investment $389,428 $329,959 $296,527

© The McGraw-Hill Companies, Inc., 2019

 EARTHWEAR CLOTHIERS 1-2
Consolidated Statements of Operations PBC
(In thousands, except per share data) 12/31/2019

For the period ended December 31

2019 ### ###

(unaudited)
Net Sales $1,019,890 $950,484 $857,885
Cost of sales $572,153 $546,393 $472,739
Gross Profit $447,737 $404,091 $385,146
Selling, general and administrative expenses $374,180 $364,012 $334,994
Non-recurring charge (credit) ($1,153)
Income from operations $73,557 $40,729 $51,305
Other income (expense):
Interest expense ($878) ($983) ($1,229)
Interest income $989 $1,459 $573
Gain on sale of subsidiary
Other ($3,514) ($4,798) ($1,091)
Total other income (expense), net ($3,403) ($4,322) ($1,747)
Income before income taxes $70,154 $35,757 $49,559
Income tax provision $26,658 $13,230 $18,337
Net income $43,495 $22,527 $31,222
Basic earnings per share 1.48 1.15 1.60
Diluted earnings per share 1.45 1.14 1.56
Basic weighted average shares outstanding 19,159 19,531 19,555
Diluted weighted average shares outstanding 19,485 19,774 20,055

© The McGraw-Hill Companies, Inc., 2019

 EARTHWEAR CLOTHIERS 1-3
Consolidated Statements of Cash Flows PBC
(In thousands) 12/31/2019

For the period ended December 31

2019 ### ###

Cash flows from (used for) operating activities: (unaudited)
Net income $43,495 $22,527 $31,222
Adjustments to reconcile net income to
net cash flows from operating activities:
Non-recurring charge (credit) ($1,153)
Depreciation and amortization $17,515 $15,231 $13,465
Deferred compensation expense $42 $75 $103
Deferred income taxes ($4,330) $3,340 $5,376
Pretax gain on sale of subsidiary
Loss on disposal of fixed assets $1,578 $284 $602
Changes in assets and liabilities excluding
the effects of divestitures:
Receivables, net $4,232 ($1,336) $2,165
Inventory ($25,356) ($16,912) $37,370
Prepaid advertising $1,246 ($686) $3,110
Other prepaid expenses ($818) ($2,534) $1,152
Accounts payable ($8,323) $14,078 ($8,718)
Reserve for returns $210 $775 $439
Accrued liabilities $5,502 ($709) ($4,982)
Accrued profit sharing $1,576 ($262) $328
Income taxes payable $7,634 $1,923 ($2,810)
Tax benefit of stock options $4,979 $1,429 $1,765
Other ($1,404) $2,144 $437
Net cash from (used for) operating activities $47,778 $39,367 $79,871
Cash flows from (used for) investing activities:
Cash paid for capital additions ($26,334) ($28,959) ($18,208)
Proceeds from sale of subsidiary
Net cash flows used for investing activities ($26,334) ($28,959) ($18,208)
Cash flows from (used for) financing activities:
Proceeds from (payment of) short-term debt ($501) $3,390 ($17,692)
Purchases of treasury stock ($8,052) ($18,192) ($2,935)
Issuance of treasury stock $17,490 $3,704 $4,317
Net cash flows used for financing activities $8,937 ($11,097) ($16,310)
Net increase (decrease) in cash and cash equivalents $30,381 ($690) $45,352
Beginning cash and cash equivalents $48,978 $49,668 $4,317
Ending cash and cash equivalents $79,359 $48,978 $49,668
Supplemental cash flow disclosures:
Interest paid $878 $987 $1,229
Income taxes paid $21,431 $6,278 $13,701

© The McGraw-Hill Companies, Inc., 2019

 EARTHWEAR CLOTHIERS 5-1
Ratio Analyses SAA
December 31, 2019 1/3/2020
December 31
2015 2016 2017 2018 2019 2019 Difference Industry
Actual from Difference
(Audited) (Audited) (Audited) (Audited) Expected* Average
(unaudited) Expected (from 2019)
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% ### 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% ### -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 2017 and 2018 to obtain the expected value for 2019).

† 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.