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EarthWear Hands-on Mini-case
Preliminary Analytical Procedures

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. The work papers are each formatted to
fit on one page.
 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% 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 2015 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.

Name:

Class:
EARTHWEAR CLOTHIERS 5-2
Preliminary Analytical Procedures
Summary of Ratio Analyses & Assessment of Financial Condition 25/3/2021
December 31, 2019

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
For example,and indicate
"Days if you believe
of Inventory the auditor
on Hand" would
increased need to revise
significantly his ormerchandise
indicating her typical audit approach
is held to address
in inventory the risk.
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
SHORT-TERM LIQUIDITY RATIOS:
"Quick Ratio" lower than industry's average indicating company is not easy to liquidate its
current assets to pay down short-term liabilities. This increases the risk of being overwhelmed by
debt in the near-term. The auditor should invoice its customers promptly and enforce prompt
payment on these invoices to increase cash flow and increase the amount of cash available to pay
current liabilities.
ACTIVITY RATIOS:
"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.
PROFITABILITY / PERFORMANCE RATIOS:
"Return on equity" lower than industry's average indicating company is not easy to
generate income with equity capital. This increases the risk of capital scarcity. The
auditor should use more financial leverage.
COVERAGE RATIOS:
"Times Interest Earned" increased significantly indicating company is not utilizing
excess income for reinvestment in the company through expansion or new projects, but
rather paying down debt obligations too quickly.. This increases the risk of lose favor
with long-term investors. The auditor should utilizing excess income for reinvestment.

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
Short-term liquidity ratios

B. Identify ratios and trends, if any, that indicate a high likelihood that the client will continue successfully as a going concern
Activity ratios, profitability ratios, coverage ratios

C. Assess the client's financial condition as one of the following (select one from the drop down list in cell B35)
High probability that the company will successfully continue in business for at least one year and be able to pay its debts as they become due.
High probability that the company will 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 Clothiers¡¦s profitability is stable as its profit margins had decreased from
44.95% to 42.51% from 2015 to 2018, but increased to 43.90% in 2019. Although its
inventory turnover decreased from 4.99 to 3.87 from 2018 to 2019, it increases from
3.43 to 3.87 from 2015 to 2019, showing Earthwear using its inventory still effectively.
Name:

Class: EARTHWEAR CLOTHIERS 5-3

Identification of Accounts with Unexpected Fluctuations
December 31, 2019 25/3/2021

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 2019 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 Cash receipts are not recorded for funds actually received by the company
may be the possible reasons for difference. There are a potential risk of
lapping of accounts receivable. Suggested audit plan revision is to trace cash
receipts journal entries to the bank statement.
Receivables, net ($5,568) Cutoff may be the possible reasons for difference. There are a potential risk
of overstatement or understatement of accounts receivable. Suggested audit
plan revision is to review large sales returns and allowances before and after
the balance sheet date to determine whether they are recorded in the correct
period.
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) Omitted sales transactions may be the possible reasons for difference. There
are a potential risk of lapping of accounts receivable. Suggested audit plan
revision is to trace selected shipping documents to the sales journal to be
sure that each one is included.
Cost of sales ($47,893) Detail tie-in may be the possible reasons for difference. There are a potential
risk of overstatement or understatement of cost of sales. Suggested audit plan
revision is to trace the total to the general ledger.
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.