Willis & Adams, CPAs
Please Note:
While the content of this document is very similar to information found on the EarthWear and Willis & Adams, CPAs websites, it contains specific content related to the 2022 audit. This information is applicable to all EarthWear Mini-cases.
Background of EarthWear
EarthWear Clothiers was founded in Boise, Idaho, by James Williams and Calvin Rogers in 1973 to make high-quality clothing for outdoor sports, such as hiking, skiing, fly-fishing, and whitewater kayaking. Over the years, the company’s product lines have grown to include casual clothing, accessories, shoes, and soft luggage. EarthWear offers its products through three retailing options: catalogs, retail outlets, and its
website.
When EarthWear founders, Williams and Rogers, decided to incorporate their company in 1975, they searched for an accounting firm to conduct the company’s approaching year-end audit. They were referred to a bright, young auditor that had recently started his own CPA firm, Michael Willis. Williams and Rogers were immediately impressed with Mr. Willis, and agreed to have Willis and Company complete EarthWear’s upcoming audit. Ever since, EarthWear and Willis and Adams have had a strong relationship. EarthWear decided to go public in 1986. Although Willis and Adams audited very few other public companies at that time, EarthWear retained Willis and Adams as the company’s auditor.
Outdoor Clothing Industry
Over the past several years, the outdoor clothing industry has been growing at a steady, moderate pace.
The industry consists of a wide variety of manufacturers that sell products directly to customers or through
retail stores, including department stores, specialty shops, and catalog companies. The industry is highly
competitive. EarthWear’s direct competitors include Eddie Bauer, Land’s End, L. L. Bean, Patagonia, North
Face, Columbia, and Timberland. EarthWear competes primarily on merchandise value (quality and price),
its established customer list, and customer service, including fast order fulfillment and unqualified
guarantees.
Management
In late February of 2022, EarthWear’s chief accounting officer/controller Brad Norton unexpectedly left the
company to take a job with another clothes manufacturer. Mr. Norton had been with the company since
2012. In those ten years, the auditors from Willis and Adams had enjoyed their work association with Mr.
Norton. They found him to be a strong leader with a great deal of personal character. Mr. Norton cited
“personal reasons” for his sudden departure from the company. A new controller, Carol McKay, was
selected in November. Before her promotion, Ms. McKay had been the VP of External Reporting. In her
14 years with EarthWear, Ms. McKay spent the majority of her time in External Reporting. As a result,
some executives questioned if Ms. McKay had the broad skill-set needed for such a demanding position.
After interacting with her during some recent meetings, even some of Willis and Adams’ professionals
questioned Ms. McKay’s qualifications for the job.
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Accounting and Control Systems
With the complexity of EarthWear’s customer database reaching 21.1 million people, and sales occurring
through catalogs, retail outlets, and the internet, the company realized in early 2017 that it was in need of a
new, upgraded accounting information system. The company switched to a new, integrated central
accounting system in early 2018. The transition to the new system was overseen and implemented by the
former controller, Brad Norton. This new system maintains integrated inventory, accounts receivable,
payroll, and general ledger software modules. Although the implementation of the new system was
expensive and laden with problems, by the 3rd and 4th quarters of 2018 the problems were largely
resolved and the company began to see the benefits. The new system integrates the company’s
operations and accounting systems and allows EarthWear’s sales force to promise next day delivery to
telephone and internet customers. As a result, customer satisfaction has increased.
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Willis & Adams, CPAs
AUDIT MANUAL EXCERPT: MATERIALITY GUIDELINES
Overall Materiality and Tolerable Misstatement
Overall Materiality
This section provides general guidelines for determining overall 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., 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:
Profit Oriented Entity:
? Income Before Income Taxes – combined misstatements or omissions less than 3 percent of Income Before Income Taxes
are presumed to be immaterial and combined misstatements or omissions greater than 7 percent are presumed to be
material. For publicly traded companies, materiality is typically set at 5 percent of income before income taxes.
If pretax income is stable, predictable, and representative1 of the entity’s size and complexity, it is typically the preferred
base. However, if net income is not stable, predictable, representative, or if the entity is close to breaking even or
experiencing a loss, then other bases may need to be considered. If the entity has volatile earnings, including negative or
near zero earnings, it might be more appropriate to use the average of 3 to 5 years of pretax net income as the base
(referred to as “normalized earnings”) or Revenue.
Other possible bases to consider include:
? Total Revenue (less returns and discounts) – combined misstatements or omissions less than 0.5 percent of Total Revenue
are presumed to be immaterial, and combined misstatements or omissions greater than 3 percent are presumed to be
material. Publicly traded companies usually have profit, so this is not commonly used, but if used, materiality would
typically be set at 0.5 percent of revenue.
? Total Assets – combined misstatements or omissions less than 0.25 percent of Total Assets are presumed to be immaterial,
and combined misstatements or omissions greater than 2 percent are presumed to be material. (Note: Total Assets may
not be an appropriate base for service organizations or other organizations that have few operating assets.) For publicly
traded companies that measure their success with assets, materiality is typically set at 0.5 percent of assets.
1 By stable, predictable, and representative we mean that pretax income does not wildly or dramatically change from profit to loss
from year to year. If investors still view pretax income as a reliable measure of the entity’s performance then pretax income should
be used to determine materiality.
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Not-for-Profit Entity
? Total Revenue (less returns and discounts) – combined misstatements or omissions less than 0.5 percent of Total Revenue
are presumed to be immaterial, and combined misstatements or omissions greater than 3 percent are presumed to be
material.
? Total Assets – combined misstatements or omissions less than .25 percent of Total Expenses are presumed to be
immaterial, and combined misstatements or omissions greater than 2 percent are presumed to be material.
Mutual Fund Entity
? Net Asset Value – combined misstatements or omissions less than 3 percent of Net Asset Value are presumed to be
immaterial and combined misstatements or omissions greater than 5 percent are presumed to be material.
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 overall
materiality amount should be used. Conversely, if the client is substantially above the minimum current ratio requirement for a loan
agreement, it would be reasonable to use a higher overall materiality amount.
Tolerable Misstatement
In addition to establishing overall 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. It is an important input in determining the nature, timing and extent of audit procedures.
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 tolerable misstatement to be allocated to an account is 50 to 75 percent of overall materiality.
? Tolerable misstatement should not exceed 25% of the account balance.
? Tolerable misstatement should not exceed an amount that would influence the decision of reasonable users.
? Tolerable misstatement normally will be higher for accounts with a higher expectation of misstatement.2
? Willis & Adams limits the total amount of tolerable misstatement allocated to the balance sheet accounts to about ten times
materiality in order to limit aggregation risk.
2 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, sample sizes
can increase dramatically. However, as noted in the policy, in no case will we allocate more tolerable misstatement to an account
than a misstatement amount that would influence the decisions of reasonable users.
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