EarthWear Hands-on Mini-case

Chapter 5 - Preliminary Analytical Procedures

The McGraw-Hill Companies, Inc., 2012

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.

Complete all the fields on Work Paper 5-2 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.

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
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
Average

Difference
(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 2008 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.

Name:
Class:
EARTHWEAR CLOTHIERS
Preliminary Analytical Procedures
Summary of Ratio Analyses & Assessment of Financial Condition
December 31, 2012

5-2
Initial Here
2/16/2015

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"Days
indicate
if you believe
the auditor
would
need to revise
his ormerchandise
her typical audit
approach
to address
the risk.
For example,
of Inventory
on Hand"
increased
significantly
indicating
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 inventorySHORT-TERM LIQUIDITY RATIOS:
Enter your response here (This cell will expand automatically to fit your response - use ALT+ENTER to
ACTIVITY RATIOS:
Enter your response here (This cell will expand automatically to fit your response - use ALT+ENTER to
PROFITABILITY / PERFORMANCE RATIOS:
Enter your response here (This cell will expand automatically to fit your response - use ALT+ENTER to
COVERAGE RATIOS:
Enter your response here (This cell will expand automatically to fit your response - use ALT+ENTER to
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
Enter your response here (This cell will expand automatically to fit your response - use ALT+ENTER to
B. Identify ratios and trends, if any, that indicate a high likelihood that the client will continue successfully as a going concern
Enter your response here (This cell will expand automatically to fit your response - use ALT+ENTER to
C. Assess the client's financial condition as one of the following (select one from the drop down list in cell B35)
Click on the yellow cell above and the drop down list button will appear in the far right side of
the cell. Your selection will then appear in this box. You can change your selection using the
drop down list.
D. Briefly explain the reasoning behind your assessment.
Enter your response here (This cell will expand automatically to fit your response - use ALT+ENTER to

Name:
Class:

EARTHWEAR CLOTHIERS
Identification of Accounts with Unexpected Fluctuations
December 31, 2012

5-3
Initial Here
2/16/2015

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 2012 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)

Enter threshold here. Please enter number in thousands.

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
Account

Difference from
Expectations

Evaluation

Difference from
Expectations

Evaluation

B. Income Statement Accounts

Account

EARTHWEAR CLOTHIERS
Common-size Consolidated Balance Sheet
(In thousands)

5-4
SAA
1/3/2013
December 31

2010
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

Dollar Value

% of Total
Assets

Dollar Value

% of Total
Assets

Dollar Value

% of Total
Assets

Dollar Value

Difference
% of Total
Assets

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

Expected*

2011

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

Expected*

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%

Dollar Value
1,043,083
620,046
423,037
393,031
46,050
(737)
1,017
(2,947)
(3,037)
42,688
15,794
26,894
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

% of Sales
100.00%
59.44%
40.56%
37.68%
0.00%
4.41%
0.00%
-0.07%
0.10%
0.00%
-0.28%
-0.29%
4.09%
1.51%
2.58%

2012
Actual
Dollar Value
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

% of Sales
100.00%
56.10%
43.90%
36.69%
0.00%
7.21%
0.00%
-0.09%
0.10%
0.00%
-0.34%
-0.33%
6.88%
2.61%
4.26%

Difference
Dollar Value
(23,193)
(47,893)
24,700
(18,851)
0
27,506
0
(140)
(28)
0
(567)
(366)
27,466
10,864
16,602
0.10
0.10
(398)
(445)

% of Sales
0.00%
-3.34%
3.34%
-0.99%
0.00%
2.80%
0.00%
-0.02%
0.00%
0.00%
-0.06%
-0.04%
2.79%
1.10%
1.69%