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Earth Wear Clothiers Audit Report Haley Celeste Aguirre Southern New Hampshire University

2 RUNNING HEAD: FINAL PROJECT Table of Contents I.

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V. VI.

Client Engagement: EarthWear Clothiers Corporate Structure.………………….………………….. 3 Willis & Adams…………...……………………………….…………………... 5 Evaluation & Decision.……………………………………….……………….. 7 Planning the Audit: Financial Statement Audit Plan…………………...………….………………... 8 Materiality Determination………………………………………………..…… 10 Internal Controls: Control Environment ……………………………………………………….…13 Risk Assessment ……………………………………………………………....14 Information System ……………………………………………………………16 Control Activities …...…………………………...…………………………….17 Monitoring Activities ………………………………………………………….19 Communication: Management Letter …………………………………………………………... 20 Opinions on the Financial Statements and Internal Control over Financial Reporting ………………………………………………………………….…..22 References ………………………………………………………………………….. 28 Tables…………………………………………………………………………..........30

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I. Client Engagement Earth Wear Clothiers Corporate Structure Earth Wear Clothiers is a producer and manufacturer of high-quality clothing designed to be worn for outdoor sporting. They aim to provide customers with the appropriate clothing for hiking, skiing, whitewater rafting, and more. (Earth Wear Annual Report 2015). Earth Wear Clothiers was founded in 1973 and became a corporation in 1975. As Earth Wear has matured, they have started to branch out into producing accessories, purses, and other outdoor sporting essentials. Customers are able to purchase Earth Wear’s products through a catalog order, in a brick and mortar store, or online. Earth Wear Clothiers has a total of three operating segments: core, business to business, and international. Their main international customers are located in Canada, Europe, and Japan. However, the firm has the most revenue from their United States transactions. Earth Wear sends out its catalog to their active customers on a monthly basis in the United States, Europe, and Japan. The firm also has 10 united states retail stores, 4 in the United Kingdom, 2 in Germany, and 2 in Japan. Presently, revenue from catalog sales, retail outlets, and online make up 74%, 5%, and 21% of total revenues, respectively. (Earth Wear Annual Report 2015). However, upper level management is expecting their volume of internet sales to have significant growth and may even end up replacing catalogs as Earth Wear’s major source of sales in the future. The outdoor clothing industry is highly competitive and is steadily growing. The firm’s main competition comes from retail stores, specialty shops, department stores, and other catalog companies. Eddie Bauer, Land’s End, LL Bean, Patagonia, and Timberland are the companies in

4 RUNNING HEAD: FINAL PROJECT the outdoor clothing industry they have the most competition from (EarthWear Annual Report 2015). Earth Wear’s customer database is an integral part of their business operations and structure and is vital to their financial success. Earth Wear has developed their own list of active customers, or those customers that have made at least one purchase in the last 24 months. Currently, Earth Wear has a total of 21.1 million people, with 7 million of those people being customers, logged into their database. The key to the customer databases’ success is that EarthWear routinely updates and refines the databases before mailing any catalogs (EarthWear Annual Report 2015). Earth Wear Clothiers was founded in Boise, Idaho by James Williams and Calvin Rogers. In 1986, they became a Delaware corporation when they when public. James Williams served as the chairman of the board and the CEO until he stepped down in 1999. Mr. Calvin Rogers assumed the position of president and CEO in 1999, and still holds those positions. Earth Wear Clothiers executive board and corporate structure is reinforced more by their remaining executives who have been with Earth Wear and in senior management positions since 1996. The only threat to Earth Wear’s senior level management structure and authority comes from Brad Norton. Mr. Norton is the former chief accounting officer/controller, who unexpectedly left EWC in February 2016 and now hold a position with another clothing manufacturer. Mr. Norton cites ‘personal reasons’ for leaving. While this setback isn’t devastating to EWC it did put a dent in their otherwise strong authority, since Brad Norton had worked for EWC since 2004. The outdoor sports clothing industry is affected easily by seasonality, which explains why EWC experiences the majority of its net sales and profits during the 4th quarter (EWC

5 RUNNING HEAD: FINAL PROJECT Annual Report 2015). The firm uses the LIFO system of inventory accounting and has no outstanding long-term debt. In this highly seasonal industry, Earth Wear must have competitive advantage in order to make a profit. EWC competes primarily on merchandise value (quality and price), their established customer list, and their customer service, including fast order fulfillment and unqualified guarantees. EWC has been successful in these efforts and has increased customer satisfaction over the years (EWC Annual Report 2015). Willis and Adams Willis and Adams have and continues to have independence when working with Earth Wear Clothiers. The Public Company Accounting Oversight Board (PCAOB) state that “the auditor must be free from any obligation to or interest in the client, its management, or its owners to be recognized as independent” (AS 1005.03). Willis and Adams is independent in all aspects of PCAOB standards, and committee of sponsoring organizations’(COSO) framework for conducting an audit of internal control over financial reporting (ICOFR). We constantly strive to maintain independence and uphold the PCAOB’s General Auditing Standards in addition to any applicable framework or standards, depending on the type of audit engagement. The PCAOB General Auditing Standards clearly state that the purpose of a financial statement audit is to form an opinion on “whether the financial statements are prepared and presented in accordance with GAPP, in all material respects” (AS 1000). In order for our firm to uphold this standard and issue an opinion, Willis and Adams must show independence, which enables our firm to express our opinion. An independent, or external auditor must have knowledge of the client industry in order to provide reasonable assurance. Willis and Adams has been Earth Wear’s external auditor since

6 RUNNING HEAD: FINAL PROJECT the beginning of EWC’s incorporation in 1975. Through our professional relationship with Earth Wear Clothiers over the past 41 years, we have gained extensive knowledge in the outdoor clothing industry. When an external audit firm continues to audit a client each year the auditor “should incorporate knowledge obtained during past audits performed” and use it to determine the “nature, timing, and extent of audit testing necessary” (AS 2201). Willis and Adams upholds this standard due to our historical relationship with EWC and we are able to plan the audit to be efficient and effective each year. In prior years, Earth Wear Clothiers has had no issues in regard to material misstatements in their financial statements, management integrity, or material misstatements in past audits. Willis and Adams are comprised of three auditing professionals. Michael Willis is the engagement partner and has a Bachelor’s in Business Administration from the University of Ohio. Mr. Willis formed Willis and Co in 1970, which became Willis and Adams in 1989, and has held the partner position since inception. Scott Adams is a graduate of the University of Ohio and majored in accounting with a concentration in finance. He is a member of the American Institute of Certified Public Accountants (AICPA) and is also a member of the Idaho Institute of Certified Public Accountants where he serves on the professional conduct committee. Karen Mitchell holds a bachelor’s degree in accounting and computer science and serves as Willis and Adams’ expert on computer technology. Specifically, she offers her expertise in installation, implementation, and training on a variety of accounting information systems that can be tailored to clients’ needs. Karen is also a member of the AICPA and joined Willis and Adams after extensive experience in public accounting and successfully developed and maintained her own practice before assuming the position at Willis and Adams.

7 RUNNING HEAD: FINAL PROJECT Evaluation and Decision Our decision to remain Earth Wear Clothier’s independent auditor and to retain EWC as a client is based on the evaluation of the internal and external factors previously discussed. In every audit engagement, risk is an unavoidable factor. Willis and Adams have been successful in getting risk to an acceptably low level in our previous engagements with EWC. This is primarily due to our constant maintenance of independence, which is a substantial risk when a smaller firm such as ours engages to perform an audit of a substantially larger company like EWC. Earth Wear Clothiers has been performing well in their highly competitive industry and maintained a steady position since our previous engagement. Earth Wear has some indication of elevated risk due to their implementation of and transition to a new accounting information system in early 2012, which was overseen by Brad Norton, EWC’s former chief accounting officer. Additionally, Earth Wear Clothiers is inherently risky due to their inventory valuation method, last in first out, LIFO. This is an increased risk because use of this inventory valuation method, results in understatement of inventory on the balance sheet. However, we are confident in our knowledge of EWC and its industry due to our history and previous 40 years of experience with this audit client. Other than the inherent risks discussed above, Earth Wear Clothiers is an appropriate audit engagement and EWC has no recent legal or ethical problems of their senior management. Willis and Adams will continue to serve as EWC’s external auditor and will engage in an audit of Earth Wear’s financial statements for the 2016 period.

8 RUNNING HEAD: FINAL PROJECT II. Financial Statement Audit Plan Willis and Adams have accepted client continuance of Earth Wear Clothiers after careful consideration and use of our preliminary review and evaluation of Earth Wear’s internal and external factors. In planning the audit of Earth Wear’s financial statements for the year ended December 31, 2016, we have prepared an audit plan that will address business risks, management assertions, audit risk, internal controls, and their effect on audit procedures. Willis and Adams will also take into consideration Earth Wear’s business objective of increasing their customer base by introducing a new extreme sports product line to attract younger customers. Business Risks In accordance with AS 12.14, “ the purpose of obtaining an understanding of the company's objectives, strategies, and related business risks is to identify business risks that could reasonably be expected to result in material misstatement of the financial statements”[ CITATION PCAOB \l 1033 ]. Willis and Adams have identified those business risks of Earth Wear that have a possibility of materially misstating the financial statements. Business risks are those that expose a firm to any factors that will hinder the achievement of business objectives. Earth Wear’s business objective of introducing a new product line to attract a younger customer base is inherently a business risk. AS 12.15 identifies “new products and services as a potential related business risk because the new product might not be successful” in achieving the business objective[ CITATION PCAOB \l 1033 ]. The introduction of the new extreme sports line is meant to attract a younger customer base. However, 50% of Earth Wear’s current customers are 35-54 years old and have a median income of $62,000, with about two thirds in managerial or professional occupations[CITATION willisadams \l 1033 ]. The risk of the new product line is that Earth Wear could drive away their current customers or younger consumers

9 RUNNING HEAD: FINAL PROJECT will not consider Earth Wear’s extreme sports line due to Earth Wear’s reputation of producing outdoor clothing to adults. In conducting preliminary analytical procedures Willis and Adams analyzed EWC’s inventory turnover and their gross profit percentage, as these two ratios have potential to be affected by Earth Wear’s business objective of introducing a new extreme sports product line. For the year 2016, Earth Wear’s inventory turnover is 3.88, and the industry avg inventory turnover is 6.20. Inventory turnover is “the number of times a business sells and replaces its stock of goods during a given period” [ CITATION Cor \l 1033 ]. A lower inventory turnover eludes to the conclusion that Earth Wear isn’t selling their inventory as fast as the industry currently is. Earth Wear’s inventory turnover might be low because they aren’t selling their products fast and they have excess inventory. In regard to the aforementioned business objective; the new line has a likelihood of decreasing Earth Wear’s inventory turnover. Due to the customer demographic that Earth Wear appeals to, the new product line could negatively impact their ratios. Willis and Adams will take a more inventory focused approach due to this risk and we will further collect audit evidence and increase audit testing on inventory balances, with a focus on obsolescence. Another business risk associated with Earth Wear’s proposed objective of a new extreme sports product line is the effect on product quality due to supplier costs. In analyzing Earth Wear’s gross profit percentage, we found that Earth Wear had a higher gross profit percentage of 43.90%, as compared to the industry average of 38.80%. Earth Wear has a higher gross profit percentage because their cost of goods sold is lower than their competitors in the industry. While this may be an advantage and gives Earth Wear more profits, “it poses the question of if Earth Wear can keep lower supplier prices in the long term without affecting quality”[CITATION

10 RUNNING HEAD: FINAL PROJECT McG172 \l 1033 ]. The new extreme sports line might cause supplier prices to increase for various reasons such as the cost of the material, and the time it takes to produce products in the new line. In consideration of the mentioned business risks along with our preliminary analytical procedures, Willis and Adams classifies Earth Wear’s overall risk to be low. Management Assertions When management prepares and presents the financial statements, they make implicit and explicit assertions “regarding the recognition, measurement, presentation, and disclosure of the various elements of financial statements” (AS 1105). These assertions are made through the firm’s use of internal controls to record, measure, and present transactions. A firm’s internal control system has the purpose of “providing reasonable assurance about the achievement of the entity’s objectives in reliability, timeliness, and transparency of internal and external reporting”[ CITATION Mes19 \l 1033 ]. Without use of an internal control system, the independent auditor is unable to obtain sufficient and appropriate evidence as required by AS1105. Earth Wear has asserted they have “established and maintained comprehensive systems of internal control that provide reasonable assurance as to consistency, integrity, and reliability” of the financial statements (EWC Mgmt Report on F/S). Management has also asserted their use of the LIFO inventory valuation method, which results in total inventory cost to be understated compared to the market. These assertions are of direct relevance to Earth Wear’s extreme sports product line objective. Due to the risks in inventory valuation due to LIFO and the risk of understatement of inventory on the financial statements, Willis and Adams will pay special attention to and test more extensively the inventory, shipping, purchasing, and sales account balances and transactions.

11 RUNNING HEAD: FINAL PROJECT Audit Risk PCAOB’S Auditing Standard 1101, defines audit risk as “the risk that the auditor expresses an inappropriate audit opinion when financial statements are not presented in conformity with the applicable financial reporting framework.” The independent auditor’s objective is to “conduct the audit of financial statements in a manner reduces audit risk to an appropriately low level” (AS 1101.03). Auditors decrease audit risk through the use of professional care through the application of audit procedures to enable the obtainment of sufficient and appropriate audit evidence. Earth Wear’s use of the last in first out inventory valuation method affects audit risk because there is a higher risk of inventory misstatement and obsolescence of inventory. When a firm uses LIFO, the products that were last placed in inventory are the ones that are shipped out first when customers purchase products. The risk of LIFO is that a shipment of products might not be used or entirely purchased, which could lead to the inventory becoming obsolete if it stays in inventory too long. To obtain more information and evidence on risk of obsolescence and valuation misstatement of inventory, Willis and Adams will use observation, and will pay special attention to inventories, inventory records, and their associated controls. Internal Controls The nature of Earth Wear’s business requires them to have a large amount of inventory and is therefore an inherent risk to this audit. During the course of our audit, Willis and Adams will give a special focus on inventory due to the inherent risk stated before, and also due to Earth Wear’s business objective to introduce a new product line. Earth Wear uses a computerized inventory system called an electronic data interchange (EDI) system, to order and pay for goods for manufacture, and the EDI system also handles the receipt of shipments from manufacturers. When the goods are received, the information is agreed to the purchase order and entered into the

12 RUNNING HEAD: FINAL PROJECT inventory control system by an employee in the receiving department. The sales representatives also use a computerized inventory control system by manually entering customer orders. Each night the computer processes all orders, and the shipping tickets are printed with bar codes. Earth Wear’s use of automated and manual controls to account for inventory, increases the audit risk and the associated effect on audit procedures which will be discussed below. Effect on Audit Procedures Willis and Adams will keep in consideration Earth Wear’s business objective when applying the audit procedures necessary to provide reasonable assurance about the financial statements. Due to the business objective, our audit will pay more attention to the inventory account, and its associated controls along with any other accounts that are affected by inventory. We must first ensure that the automated controls of the inventory system are efficient in recording transactions accurately and completely, and that each transaction is recorded in a timely manner. Specifically, audit procedures will include tracing and vouching of inventory transactions, and engagement team members will also use observation and comparison to obtain sufficient and appropriate evidence to reasonably assure that the financial statements are free of material misstatement. Materiality Statement of Financial Accounting Concepts No. 2, “Qualitative Characteristics of Accounting Information,” defines materiality as “ the magnitude of an omission or misstatement of accounting information that, in light of surrounding circumstances, makes it probably that the judgment of a reasonable user of information would have been changed or influenced by the omission or misstatement” of the information. Willis and Adams’ materiality guidelines state that “quantitative materiality is computed as a percentage of the most relevant base.” In Earth Wear’s case, the mo...