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EarthWear Hands-on Mini-case
Chapter 3 - Overall Materiality and Tolerable Misstatement
AUDITING & ASSURANCE SERVICES 11e © The McGraw-Hill Companies, Inc., 2019

In this mini-case you will determine overall materiality as well as tolerable misstatement amounts for
balance sheet accounts of EarthWear Clothiers, Inc. Most auditing firms use a simple approach for
establishing planning materiality and tolerable misstatement similar to the one illustrated in your
textbook. This case illustrates such an approach, with some additional guidance from Willis & Adams
relating to the amount of tolerable misstatement to allocate to various balance sheet accounts based
on difficulty to audit and expected misstatement, and limiting the total amount of tolerable
misstatement to about ten times materiality.

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 input your answers into Connect or print hard copies of work papers 3-7 and 3-8 to submit
unless your instructor requests an electronic submission. The work papers are each formatted to fit
on one page.
Name:

Class:
EARTHWEAR CLOTHIERS 3-7
Planning Materiality Initial Here
December 31, 2019 2/16/2020
(In thousands)

Unaudited
1. Benchmark Data 2019 2018
Sales / Revenue $1,019,890 $950,484
Pre-tax income $70,154 $35,757
Total assets $389,428 $329,959
Materiality $1,800

2. Establish Planning Materiality Level

Measurement Base 70,154
Pre-tax income

Percentage Applied* 5.0%

Planning Materiality $3,508

Bases and Percentage Ranges:

Profit Oriented Entities
Pre-tax income 3 - 7%* Please use this template in conjunction with Willis & Adams
Materiality Guidelines. The materiality factors provided are guidelines
Total Revenue 0.5 - 3% only and should be used only as an aid as you use professional
Total Assets 0.25 - 2% judgment to determine planning materiality.
* For public companies, 5% is typically the maximum.
Not-for-Profit Entities
Total Revenue 0.5 - 3%
Total Assets 0.25- 2%
Mutual Fund Entities
Net Asset Value 3 - 5%

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:
Pre-tax income

Percentage:
5%
Name:

Class:

EARTHWEAR CLOTHIERS 3-8

Allocation of Materiality: Tolerable Misstatements Initial Here
December 31, 2019 2/16/2020
(In thousands)

Tolerable Misstatement as % of
2019 Unaudited Tolerable Planning Account
Account Name 2018 Trial Balance Misstatement Materiality * Balance ** Explanation
Cash and cash equivalents $48,978 $79,359 0% 0%
Receivables, net $12,875 $8,643 0% 0%
Inventory $122,337 $147,693 $2,631 75% 2% Large and complex account with misstatements expected, costly to audit
Prepaid expenses $17,772 $15,647 0% 0%
Deferred income tax benefits $7,132 $10,338 $2,631 75% 25% Relatively complex, estimation involved, related to Deferred Income Taxes
Property, Plant, & Equipment $206,426 $223,736 $1,754 50% 1% Relatively little change from prior year, not difficult to audit
Accumulated depreciation and amortization $85,986 $97,722 0% 0%
Intangibles, net $423 $1,734 0% 0%
Lines of credit $11,011 $10,510 $1,754 50% 17% Relatively little volume, not difficult to audit via 3rd party info
Accounts payable & Reserve for returns $68,399 $60,286 0% 0%
Accrued liabilities & Accrued profit sharing $28,270 $33,600 0% 0%
Income taxes payable & Deferred income taxes $18,057 $24,567 0% 0%
Common stock, 26,121 shares issued $261 $261 $65 2% 25% No change from prior year, easily verified
Donated capital $5,460 $5,460 $1,365 39% 25% No change from prior year, easily verified
Additional paid-in capital $20,740 $25,719 $1,754 50% 7% Little change from prior year, not difficult to audit
Deferred compensation ($79) ($36) $0 0% 0% Not difficult to audit, examine current year vesting activity
Accumulated other comprehensive income $3,883 $2,173 $543 15% 25% Involves some complex applications of GAAP
Retained earnings $317,907 $361,402 Not Applicable Not Applicable Not Applicable Not Applicable
Treasury stock, 6,546 and 6,706 shares at cost, respectively ($143,950) ($134,512) $1,754 50% 1% Little change from prior year, not difficult to audit
Total Amount of Tolerable Misstatement Allocated To Balance Sheet Accounts $14,250
Planning Materiality (from work paper 3-7) $3,508
Ratio of Total Tolerable Misstatement to Planning Materiality *** 4.1

Willis & Adams Tolerable Misstatement Guidelines

* Tolerable misstatement should be between 50% and 75% of planning materiality.
** Tolerable misstatement should not exceed 25% of the account balance
*** The total amount of tolerable misstatement allocated to balance sheet accounts should be below ten times materiality in order to limit aggregation risk.

© The McGraw-Hill Companies, Inc., 2019

 EARTHWEAR CLOTHIERS 1-1 PBC:
Consolidated Balance Sheets PBC Prepared by Client
(In thousands) 12/31/2019

December 31

2019 ### ###

Assets (unaudited)
Current Assets:
Cash and cash equivalents $79,359 $48,978 $49,668
Receivables, net $8,643 $12,875 $11,539
Inventory $147,693 $122,337 $105,425
Prepaid advertising $10,212 $11,458 $10,772
Other prepaid expenses $5,435 $6,315 $3,780
Deferred income tax benefits $10,338 $7,132 $6,930
Total current assets $261,680 $209,095 $188,115
Property, plant and equipment, at cost
Land and buildings $76,560 $70,918 $66,804
Fixtures and equipment $68,632 $67,513 $66,876
Computer hardware and software $75,400 $64,986 $47,466
Leasehold improvements $3,144 $3,010 $2,894
Total property, plant and equipment $223,737 $206,426 $184,040
Less - accumulated depreciation and amortization $97,722 $85,986 $76,256
Property, plant and equipment, net $126,014 $120,440 $107,784
Intangibles, net $1,734 $423 $628
Total assets $389,428 $329,959 $296,527

Liabilities and shareholder's investment

Current liabilities:
Lines of credit $10,510 $11,011 $7,621
Accounts payable $54,186 $62,509 $48,432
Reserve for returns $6,100 $5,890 $5,115
Accrued liabilities $30,492 $26,738 $28,440
Accrued profit sharing $3,108 $1,532 $1,794
Income taxes payable $16,222 $8,588 $6,666
Total current liabilities $120,617 $116,268 $98,067
Deferred income taxes $8,345 $9,469 $5,926
Shareholders' investment:
Common stock, 26,144 shares issued $261 $261 $261
Donated capital $5,460 $5,460 $5,460
Additional paid-in capital $25,719 $20,740 $19,311
Deferred compensation ($36) ($79) ($153)
Accumulated other comprehensive income $2,173 $3,883 $1,739
Retained earnings $361,402 $317,907 $295,380
Treasury stock, 6,654, 7,114, and 6,546 shares at cost, respectively ($134,512) ($143,950) ($129,462)
Total shareholders' investment $260,467 $204,222 $192,535
Total liabilities and shareholders' investment $389,428 $329,959 $296,527

© The McGraw-Hill Companies, Inc., 2019

 EARTHWEAR CLOTHIERS 1-2 PBC:
Consolidated Statements of Operations PBC Prepared by Client
(In thousands, except per share data) 12/31/2019

For the period ended December 31

2019 ### ###

(unaudited)
Net Sales $1,019,890 $950,484 $857,885
Cost of sales $572,153 $546,393 $472,739
Gross Profit $447,737 $404,091 $385,146
Selling, general and administrative expenses $374,180 $364,012 $334,994
Non-recurring charge (credit) ($1,153)
Income from operations $73,557 $40,729 $51,305
Other income (expense):
Interest expense ($878) ($983) ($1,229)
Interest income $989 $1,459 $573
Gain on sale of subsidiary
Other ($3,514) ($4,798) ($1,091)
Total other income (expense), net ($3,403) ($4,322) ($1,747)
Income before income taxes $70,154 $35,757 $49,559
Income tax provision $26,658 $13,230 $18,337
Net income $43,495 $22,527 $31,222
Basic earnings per share 1.48 1.15 1.60
Diluted earnings per share 1.45 1.14 1.56
Basic weighted average shares outstanding 19,159 19,531 19,555
Diluted weighted average shares outstanding 19,485 19,774 20,055

© The McGraw-Hill Companies, Inc., 2019

 EARTHWEAR CLOTHIERS 1-3 PBC:
Consolidated Statements of Cash Flows PBC Prepared by Client
(In thousands) 12/31/2019

For the period ended December 31

2019 ### ###

Cash flows from (used for) operating activities: (unaudited)
Net income $43,495 $22,527 $31,222
Adjustments to reconcile net income to
net cash flows from operating activities:
Non-recurring charge (credit) ($1,153)
Depreciation and amortization $17,515 $15,231 $13,465
Deferred compensation expense $42 $75 $103
Deferred income taxes ($4,330) $3,340 $5,376
Pretax gain on sale of subsidiary
Loss on disposal of fixed assets $1,578 $284 $602
Changes in assets and liabilities excluding
the effects of divestitures:
Receivables, net $4,232 ($1,336) $2,165
Inventory ($25,356) ($16,912) $37,370
Prepaid advertising $1,246 ($686) $3,110
Other prepaid expenses ($818) ($2,534) $1,152
Accounts payable ($8,323) $14,078 ($8,718)
Reserve for returns $210 $775 $439
Accrued liabilities $5,502 ($709) ($4,982)
Accrued profit sharing $1,576 ($262) $328
Income taxes payable $7,634 $1,923 ($2,810)
Tax benefit of stock options $4,979 $1,429 $1,765
Other ($1,404) $2,144 $437
Net cash from (used for) operating activities $47,778 $39,367 $79,871
Cash flows from (used for) investing activities:
Cash paid for capital additions ($26,334) ($28,959) ($18,208)
Proceeds from sale of subsidiary
Net cash flows used for investing activities ($26,334) ($28,959) ($18,208)
Cash flows from (used for) financing activities:
Proceeds from (payment of) short-term debt ($501) $3,390 ($17,692)
Purchases of treasury stock ($8,052) ($18,192) ($2,935)
Issuance of treasury stock $17,490 $3,704 $4,317
Net cash flows used for financing activities $8,937 ($11,097) ($16,310)
Net increase (decrease) in cash and cash equivalents $30,381 ($690) $45,352
Beginning cash and cash equivalents $48,978 $49,668 $4,317
Ending cash and cash equivalents $79,359 $48,978 $49,668
Supplemental cash flow disclosures:
Interest paid $878 $987 $1,229
Income taxes paid $21,431 $6,278 $13,701

© The McGraw-Hill Companies, Inc., 2019

 EARTHWEAR CLOTHIERS 1-4 PBC:
Consolidated Statements of Stockholders' Investment PBC Prepared by Client
(In thousands) 12/31/2019

Accumulated
Additional Other
Comprehensive Common Donated Paid-in Deferred Comprehensive Retained Treasury
Income Stock Capital Capital Compensation Income Earnings Stock Total
Balance, December 31, 2016 $261 $5,460 $17,546 ($257) $1,302 $264,158 ($130,844) $157,626
Purchase of treasury stock ($2,935) ($2,935)
Issuance of treasury stock $4,317 $4,317
Tax benefit of stock options exercised $1,765 $1,765
Deferred compensation expense $103 $103
Comprehensive income:
Net income $31,222 $31,222 $31,222
Foreign currency translation adjustments $60 $60 $60
Unrealized gain on forward contracts $377 $377 $377
Comprehensive income $31,659
Balance, December 31, 2017 $261 $5,460 $19,311 ($154) $1,739 $295,380 ($129,462) $192,534
Purchase of treasury stock ($18,192) ($18,192)
Issuance of treasury stock $3,704 $3,704
Tax benefit of stock options exercised $1,429 $1,429
Deferred compensation expense $75 $75
Comprehensive income:
Net income $22,527 $22,527 $22,527
Other comprehensive income:
Foreign currency translation adjustments ($1,151) ($1,151) ($1,151)
Unrealized gain on forward contracts $3,295 $3,295 $3,295
Comprehensive income $24,671
Balance, December 31, 2018 $261 $5,460 $20,740 ($79) $3,883 $317,907 ($143,950) $204,222
Purchase of treasury stock ($8,052) ($8,052)
Issuance of treasury stock $17,490 $17,490
Tax benefit of stock options exercised $4,979 $4,979
Deferred compensation expense $42 $42
Comprehensive income: $43,495
Net income $43,495 $43,495
Other comprehensive income:
Foreign currency translation adjustments ($221) ($221) ($221)
Unrealized gain on forward contracts ($1,489) ($1,489) ($1,489)
Comprehensive income $41,785
Balance, December 31, 2019 $261 $5,460 $25,719 ($36) $2,173 $361,402 ($134,512) $260,467

© The McGraw-Hill Companies, Inc., 2019

 EARTHWEAR CLOTHIERS 1-5 PBC:
Five-Year Consolidated Financial Summary (unaudited) PBC Prepared by Client
(In thousands, except per share data) 12/31/2019

For the period ended December 31

2019 ### ### ### ###

(unaudited)
Income statement data:
Net Sales 1,019,890 950,484 857,885 891,394 821,359
Pretax Income 70,154 35,757 49,559 32,175 66,186
Percent of net sales 6.9% 3.8% 5.8% 3.6% 8.1%
Net income 43,495 22,527 31,222 20,270 41,698

Per share of common stock:

Basic earnings per share 1.48 1.15 1.60 1.02 2.01
Diluted earnings per share 1.45 1.14 1.56 1.01 2.00
Common shares outstanding 19,159 19,531 19,555 19,806 20,703

Balance sheet data:

Current assets 261,680 209,095 188,115 191,297 194,445
Current liabilities 120,617 116,268 98,067 133,434 118,308
PPE and intangibles 127,748 120,864 108,412 105,051 87,312
Total assets 389,428 329,959 296,527 296,347 281,757
Noncurrent liabilities 8,345 9,469 5,926 5,286 5,686
Shareholders' investment 260,467 204,222 192,535 157,627 157,763

Other data:
Net working capital 141,063 92,827 90,048 57,863 76,136
Capital expenditures 26,334 28,959 18,208 30,388 31,348
Depreciation and amortization expense 17,515 15,231 13,465 12,175 9,833
Return on average shareholders' investment 19% 11% 18% 13% 28%
Return on average assets 12% 7% 11% 7% 16%

© The McGraw-Hill Companies, Inc., 2019