EARTHWEAR CLOTHIERS

Audit Planning Memorandum

December 31, 2019

ENGAGEMENT OBJECTIVES, DELIVERABLES, AND KEY DATES

Typically, in this section the auditors will discuss the scope of the upcoming audit. The auditor will list the deliverables that will result from their work (e.g., debt covenant letters, quarterly reviews, etc). Lastly, the auditor will typically list or attach a schedule of when each of those deliverables will be completed.

UNDERSTANDING THE BUSINESS

A short history of the company is typically given in this section. Some detail pertaining to the location(s) of the business will be provided, along with an organizational chart of the company and its entities. An overview of the companys strategy may be provided as well. Related parties will be listed and an industry overview is also typically included, along with any regulatory developments which have taken/are taking place in relation to the company or industry. From a financial standpoint, preliminary analytics will be performed to provide a high-level perspective of the companys development over time and relation to the industry as a whole. Finally, this section may conclude with an initial assessment of the company as a going concern.

BACKGROUND INFORMATION

Business Strategy and Target Customers

EarthWear Clothiers generates revenue mainly through the sale of high quality clothing for outdoor sports, such as hiking, skiing, fly-fishing, and white-water kayaking. The companys product lines also include casual clothes, accessories, shoes, and soft luggage. The companys key customers are the 18.8 million persons on its mailing list, approximately 6.8 million of whom are viewed as current customers because they have purchased from the company in the last 24 months. Market research as of January 2018 indicates that approximately 50 percent of customers are in the 35-54 age group and had a median income of $62,000. Almost two-thirds are in professional or managerial positions.

Suppliers

Address at least two key points about issues relating to EarthWear Clothiers' suppliers. Keep in mind that the points you identify should have important implications for understanding EarthWear as an audit client.

Competition

Address at least two key points about EarthWear Clothiers' competitors or the mail order clothing industry. Keep in mind that the points you identify should have important implications for understanding EarthWear as an audit client.

Social Factors

The companys results can be affected by changing fashion trends .

Analytical Procedures

*Days Outstanding in Accounts Receivable is 3.09 and the industry average is 14.10. This ratio indicates that EarthWear collects on sales much more quickly than the rest of the industry. It also represents a significant improvement relative to prior years for EarthWear and is better than expected for this year. This ratio is consistent with a relatively low allowance for doubtful accounts. Controller explains that fast collection rate is a result of increased focus on collection activities and newly implemented incentives for early payment. We will corroborate the client's explanation as a part of our testing in the sales & collection cycle.

Planning Materiality

This section provides general guidelines for determining planning materiality and tolerable misstatement for audits performed by Willis & Adams. The application of these guidelines requires professional judgment and the facts and circumstances of each individual engagement must be considered.

Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information, defines materiality as follows:

Materiality is the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.

The reasonable person, approach means that the magnitude and nature of financial statement misstatements or omissions will not have the same influence on all financial statement users. For example, a 7 percent misstatement with current assets may be more relevant for a creditor than a stockholder, while a 7 percent misstatement with net income before income taxes may be more relevant for a stockholder than a creditor.

While qualitative factors need to be considered, it is not practical to design audit procedures to detect all misstatement that potentially could be qualitatively material. Therefore, as a starting point, we typically compute a quantitative materiality determined as a percentage of the most relevant base (e.g., Net Income Before Taxes, Total Revenue, Total Assets). Relevant financial statement bases and presumptions on the effect of combined misstatements or omissions that would be considered immaterial and material are provided below:

Balance Sheet Materiality Even if the planning materiality is based on the income statement, a balance sheet-based calculation is useful for evaluating the materiality of misclassifications between balance sheet accounts. For current assets and current liabilities, the balance-sheet materiality guidelines are 3 to 8 percent. For total assets, the guidelines are 1 to 3 percent.

The specific value within the above ranges for a particular base is determined by considering the primary users as well as qualitative factors. For example, if the client is close to violating the minimum current ratio requirement for a loan agreement, a smaller planning materiality amount should be used for current assets and liabilities. Conversely, if the client is substantially above the minimum current ratio requirement for a loan agreement, it would be reasonable to use a higher planning materiality amount for current assets and current liabilities.

Planning materiality should be based on the smallest amount established from relevant materiality bases to provide reasonable assurance that the financial statements, taken as a whole, are not materially misstated for any user.

Tolerable Misstatement

In addition to establishing planning materiality for the overall financial statements, materiality for individual financial statement accounts should be established. The materiality amount established for individual accounts is referred to as tolerable misstatement. Tolerable misstatement represents the amount an individual financial statement account can differ from its true amount without affecting the fair presentation of the financial statements taken as a whole.

Establishment of tolerable misstatement for individual accounts enables the auditor to design and execute an audit strategy for each audit cycle.

Tolerable misstatement should be established for all balance sheet accounts (except retained earnings because it is the residual account). Tolerable misstatement need not be allocated to income statement accounts because many misstatements affect both income statement and balance sheet accounts and misstatements affecting only the income statement are normally less relevant to users.

The objective in setting tolerable misstatement for individual balance sheet accounts is to provide reasonable assurance that the financial statements taken as a whole are fairly presented in all material respects at the lowest cost. Factors to consider when setting tolerable misstatement for accounts include:

• The maximum tolerable misstatement to be allocated to any account is 75 percent of planning materiality.
• The combined tolerable misstatement allocated to all accounts should not exceed four times planning materiality.[2] The aggregated sum of tolerable misstatements should be lower as the expectation for management fraud increases.
• Tolerable misstatement should not exceed an amount that would influence the decision of reasonable users.
• Tolerable misstatement normally will be higher for balance sheet accounts that cost more to audit (e.g., larger accounts that are difficult to audit).
• Tolerable misstatement normally will be higher for accounts with a higher expectation of misstatement.[3]
• Tolerable misstatement normally will be higher if the principle substantive evidence to be obtained for an account will be obtained via substantive analytical procedures.

Tolerable misstatement is an important input in determining the nature, timing and extent of audit procedures. The above guidelines are based on important considerations such as:

• The lower the tolerable misstatement, the more extensive the required audit testing.
• As a planning tool, tolerable misstatement can be viewed as a precious resource that should be carefully allocated. If an account is relatively easy to audit and the expected misstatement is little to none (e.g., Notes Payable or Stockholders Equity), then we would allocate a small amount of tolerable misstatement to such an account in order to have a greater amount available to allocate to other accounts that are more difficult and costly to audit.
• In no case will we allocate more tolerable misstatement to an account than an amount that would influence the decision of reasonable users.

[1] By stable, predictable, and representative we mean that pretax net income does not wildly or dramatically change from profit to loss from year to year. If investors still view pretax net income as a reliable measure of the entitys performance then pretax net income should be used to determine materiality.

[2] 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 so that students get hands-on practice at allocating tolerable misstatement to accounts.

[3] This assumes the expected misstatements are not due to fraud. If we have an increased fraud risk, we would utilize fraud-related procedures, see fraud policy guidelines. The reason we will normally utilize a higher tolerable misstatement for accounts with higher expectation of misstatement is related to the costliness of auditing such accounts. For example accounts like accounts receivable, inventory, or accounts payable will often have some degree of misstatement in them and they typically are large balances. Tolerable misstatement is basically a reasonable margin for error. If we set tolerable misstatement too low it can increase sample sizes dramatically. However, as noted in the policy, in no case will we allocate more tolerable misstatement to an account than an amount that would influence the decision of reasonable users.

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