EarthWear Hands-on Mini-case

Chapter 3 - Materiality and Tolerable Misstatement

The McGraw-Hill Companies, Inc., 2012

In this mini-case you will determine planning materiality as well as tolerable misstatement amounts
for balance sheet accounts of EarthWear Clothiers, Inc. While many auditing firms use a simple
approach for establishing planning materiality and tolerable misstatement similar to the one
illustrated in your textbook, some firms use more detailed guidelines that involve allocating a
multiple of planning materiality to balance sheet accounts. This case illustrates one such approach.

INSTRUCTIONS:

Read the Materiality Guidelines for Willis & Adams CPAs. To open the guidelines document please
double-click on the following icon. A document will open in Microsoft Word.

Following the Materiality Guidelines for Willis & Adams CPAs, complete all the fields on Work Paper
3-7 indicated in yellow (Work Paper 3-7 is found on the next tab of this worksheet). For your
convenience, EarthWear Financial Statements have been included in worksheet tabs after the
working papers.
Fields you are to complete on work papers are colored yellow. The color will disappear when the field is completed.

Following the Materiality Guidelines for Willis & Adams CPAs, complete all the fields on Work Paper
3-8 indicated in yellow.
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 with title
"Initial Here".

Please print hard copies of work papers 3-7 and 3-8 for submission unless your instructor requests
an electronic submission. The work papers are each formatted to fit on one page.

Name:
Class:
EARTHWEAR CLOTHIERS
Planning Materiality
December 31, 2012
(In thousands)
Unaudited
2012
$1,019,890
$572,153
$70,154
$261,680
$120,617
$389,428

1. Benchmark Data
Sales / Revenue
Expenses
Pre-tax income
Current assets
Current liabilities
Total assets
Materiality

3-7
Initial Here
6/13/2016

2011
$950,484
$546,393
$35,757
$209,095
$116,268
$329,959
$1,800

2. Establish Planning Materiality Level

Measurement Base

Select Measurement Base Using The Yellow Cell on the Left

Percentage Applied*

Input a Percentage Here Based on the Guidelines Below

Planning Materiality

Please Complete Cells Above

Bases and Percentage Ranges:

Profit Oriented Entities
Pre-tax income
Total Revenue
Current Assets or Liabilities
Total Assets

3 - 7%*
- 1%
2 - 5%
- 1%

Please use this template in conjunction with Willis & Adams Materiality
Guidelines. The materiality factors provided are guidelines only and
should be used only as an aid as you use professional judgment to
determine planning materiality.

* For public companies, 5% is typically the maximum.

Not-for-Profit Entities
Total Revenue
Total Expenses
Mutual Fund Entities
Net Asset Value

- 2%
- 2%
- 1%

3. Justify/Support Your Level of Planning Materiality

State the factors that you considered to determine the appropriate measurement base and percentage to determine
planning materiality.
Measurement Base:
Enter your response here

Percentage:
Enter your response here

Name:
Class:
EARTHWEAR CLOTHIERS
Allocation of Materiality: Tolerable Misstatements
December 31, 2012
(In thousands)

3-8
Initial Here
6/13/2016

Planning Materiality from work paper 3-7:Complete Work Paper 3-7

Account Name
Cash and cash equivalents
Receivables, net
Inventory

2012 Unaudited
Trial Balance

2011

Tolerable Misstatement

$48,978
$12,875
$122,337

$79,359
$8,643
$147,693

$2,300

$11,458
$6,315

$10,212
$5,435

$200

$7,132

$10,338

$250

Land and buildings

Fixtures and equipment
Computer hardware and software
Leasehold improvements
Accumulated depreciation and amortization
Intangibles, net
Lines of credit
Accounts payable
Reserve for returns

$70,918
$67,513
$64,986
$3,010
$85,986
$423
$11,011
$62,509
$5,890

$76,560
$68,632
$75,400
$3,144
$97,722
$1,734
$10,510
$54,186
$6,100

$750
$750

Accrued liabilities
Accrued profit sharing
Income taxes payable
Deferred income taxes

$26,738
$1,532
$8,588
$9,469

$30,492
$3,108
$16,222
$8,345

$261
$5,460
$20,740
($79)
$3,883
$317,907
($143,950)

$261
$5,460
$25,719
($36)
$2,173
$361,402
($134,512)

Prepaid advertising
Other prepaid expenses
Deferred income tax benefits

Common stock, 26,121 shares issued

Donated capital
Additional paid-in capital
Deferred compensation
Accumulated other comprehensive income
Retained earnings
Treasury stock, 6,546 and 6,706 shares at cost, respectively
Combined Tolerable Misstatement (column 3)
Maximum Allowable For Combined Tolerable Misstatement*
Net Remaining Allowance For Combined Tolerable Misstatement

*Four Times Planning Materiality. In the textbook, a more general approach to allocate no more than 75% of planning
materiality to accounts as tolerable misstatement is followed. However, as noted in the discussion on materiality in
Chapter 3 of the text, some firms do use a multiple approach. This mini-case uses the multiple approach to provide
hands-on practice at allocating tolerable misstatement to accounts.

The McGraw-Hill Companies, Inc., 2012

$300
$400

$200
$250
$0
$0
$200
$1
$50
NA
$200
$5,851
Complete Work Paper 3-7

Percentage of
Explanation
Account
0%
0%
2% Large and complex account with misstatements expected, costly
to audit
0%
4% Relatively routine accounting, tested largely via reasonableness
analytical procedures
2% Relatively complex, estimation involved, related to Deferred
Income Taxes
1% Relatively little change from prior year, not difficult to audit
1% Relatively little change from prior year, not difficult to audit
0%
0%
0%
0%
3% Relatively little volume, not difficult to audit via 3rd party info
0%
7% Accounting estimate, tested largely via substantive analytical
procedure
0%
6% Somewhat costly to audit, some differences expected
0%
3% Relatively complex, estimation involved, related to Deferred
Income Tax Benefits
0% No change from prior year, easily verified
0% No change from prior year, easily verified
1% Little change from prior year, not difficult to audit
3% Not difficult to audit, examine current year vesting activity
2% Involves some complex applications of GAAP
0% Little change from prior year, not difficult to audit

EARTHWEAR CLOTHIERS
Consolidated Balance Sheets
(In thousands)

1-1
PBC
12/31/2012
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., 2012

2012
(unaudited)

2011

2010

$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

PBC:
Prepared by Client

EARTHWEAR CLOTHIERS
Consolidated Statements of Operations
(In thousands, except per share data)

1-2
PBC
12/31/2012

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., 2012

2012
(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

2011

2010

PBC:
Prepared by Client

EARTHWEAR CLOTHIERS
Consolidated Statements of Cash Flows
(In thousands)

1-3
PBC
12/31/2012
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., 2012

2012
(unaudited)
$43,495

2011

2010

$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

PBC:
Prepared by Client

EARTHWEAR CLOTHIERS
Consolidated Statements of Stockholders' Investment
(In thousands)

Comprehensive
Income
Balance, December 31, 2009
Purchase of treasury stock
Issuance of treasury stock
Tax benefit of stock options exercised
Deferred compensation expense
Comprehensive income:
Net income
Foreign currency translation adjustments
Unrealized gain on forward contracts
Comprehensive income
Balance, December 31, 2010
Purchase of treasury stock
Issuance of treasury stock
Tax benefit of stock options exercised
Deferred compensation expense
Comprehensive income:
Net income
Other comprehensive income:
Foreign currency translation adjustments
Unrealized gain on forward contracts
Comprehensive income
Balance, December 31, 2011
Purchase of treasury stock
Issuance of treasury stock
Tax benefit of stock options exercised
Deferred compensation expense
Comprehensive income:
Net income
Other comprehensive income:
Foreign currency translation adjustments
Unrealized gain on forward contracts
Comprehensive income
Balance, December 31, 2012

The McGraw-Hill Companies, Inc., 2012

Common
Stock
$261

Donated
Capital
$5,460

Additional
Paid-in
Capital
$17,546

1-4
PBC
12/31/2012

Deferred
Compensation
($257)

Accumulated
Other
Comprehensive
Income
$1,302

Retained
Earnings
$264,158

Treasury
Stock
($130,844)
($2,935)
$4,317

$1,765
$103
$31,222
$60
$377
$31,659

$31,222

$31,222
$60
$377

$60
$377
$261

$5,460

$19,311

($154)

$1,739

$295,380

($129,462)
($18,192)
$3,704

$1,429
$75
$22,527

$22,527

($1,151)
$3,295
$24,671
$5,460

$20,740

($79)

$3,883

($1,151)
$3,295
$317,907

($143,950)
($8,052)
$17,490

$4,979
$42
$43,495

$192,534
($18,192)
$3,704
$1,429
$75
$22,527

($1,151)
$3,295
$261

Total
$157,626
($2,935)
$4,317
$1,765
$103

$204,222
($8,052)
$17,490
$4,979
$42
$43,495

$43,495

($221)
($1,489)
$41,785

($221)
($1,489)
$261

$5,460

$25,719

($36)

$2,173

($221)
($1,489)
$361,402

($134,512)

$260,467

PBC:
Prepared by Client

EARTHWEAR CLOTHIERS
Five-Year Consolidated Financial Summary (unaudited)
(In thousands, except per share data)

1-5
PBC
12/31/2012

For the period ended December 31

2012
(unaudited)

2011

2010

2009

2008

1,019,890
70,154
6.9%
43,495

950,484
35,757
3.8%
22,527

857,885
49,559
5.8%
31,222

891,394
32,175
3.6%
20,270

821,359
66,186
8.1%
41,698

1.48
1.45
19,159

1.15
1.14
19,531

1.60
1.56
19,555

1.02
1.01
19,806

2.01
2.00
20,703

Balance sheet data:

Current assets
Current liabilities
PPE and intangibles
Total assets
Noncurrent liabilities
Shareholders' investment

261,680
120,617
127,748
389,428
8,345
260,467

209,095
116,268
120,864
329,959
9,469
204,222

188,115
98,067
108,412
296,527
5,926
192,535

191,297
133,434
105,051
296,347
5,286
157,627

194,445
118,308
87,312
281,757
5,686
157,763

Other data:
Net working capital
Capital expenditures
Depreciation and amortization expense
Return on average shareholders' investment
Return on average assets

141,063
26,334
17,515
19%
12%

92,827
28,959
15,231
11%
7%

90,048
18,208
13,465
18%
11%

57,863
30,388
12,175
13%
7%

76,136
31,348
9,833
28%
16%

Income statement data:

Net Sales
Pretax Income
Percent of net sales
Net income
Per share of common stock:
Basic earnings per share
Diluted earnings per share
Common shares outstanding

The McGraw-Hill Companies, Inc., 2012

PBC:
Prepared by Client