EarthWear Hands-on Mini-case

Chapter 3 - Client Acceptance

The McGraw-Hill Companies, Inc., 2014

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:

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).

Review EarthWear's unaudited 2014 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.

Review the Willis and Adams' client acceptance/continuance forms Work Papers 3-1, 3-2, 3-3, and 34, which have already been completed.

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 Paper 3-5.

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.

EARTHWEAR CLOTHIERS
Client Continuance Evaluation
December 31, 2014

3-1
SAA
1/3/2015

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):

12/31

State:
Fax:

79443

ID
Zip:
(208) 555-3241

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., 2014

EARTHWEAR CLOTHIERS
Client Continuance Evaluation
December 31, 2014

3-2
SAA
1/3/2015

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
entities)?

No

The McGraw-Hill Companies, Inc., 2014

EARTHWEAR CLOTHIERS
Client Continuance Evaluation
December 31, 2014

3-3
SAA
1/3/2015

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:
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., 2014

EARTHWEAR CLOTHIERS
Client Continuance Evaluation
December 31, 2014

3-4
SAA
1/3/2015

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., 2014

Name:
Class:
EARTHWEAR CLOTHIERS
Client Continuance Evaluation
December 31, 2014

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?

Please select an answer from the drop down menu in the cell
on the left

Is there evidence that the business is financially distressed?

Please select an answer from the drop down menu in the cell
on the left

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?

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

No

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

Please select an answer from the drop down menu in the cell
on the left

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

Please select an answer from the drop down menu in the cell
on the left

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.

Briefly explain your overall risk assessment of the client:

Please select an answer from the drop down menu in the cell
on the left

3-5
Initial Here
2/28/2015

EARTHWEAR CLOTHIERS
Consolidated Balance Sheets
(In thousands)

1-1
PBC
12/31/2014
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., 2014

2014
(unaudited)

2013

2012

$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
12/31/2014

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., 2014

2014
(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

2013

2012

EARTHWEAR CLOTHIERS
Consolidated Statements of Cash Flows
(In thousands)

1-3
PBC
12/31/2014
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., 2014

2014
(unaudited)
$43,495

2013

2012

$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, 2014

5-1
SAA
1/3/2015
December 31

2010

2011

2012

2013

2014

(Audited) (Audited) (Audited) (Audited) Expected*

2014
Actual
(unaudited)

Difference
from
Expected

Industry
Average

Difference
(from 2014)

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 2012 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.