CASE 7.1 Anne Aylor, Inc.
Determination of Planning Materiality and Performance Materiality
Mark S. Beasley • Frank A. Buckless • Steven M. Glover • Douglas F. Prawitt
LEARNING OBJECTIVES
After completing and discussing this case you should be able to
[1] Determine planning materiality for an audit client
[2] Provide support for your materiality decisions
[3] Allocate planning materiality to financial statement elements
INTRODUCTION
Anne Aylor, Inc. (Anne Aylor) is a leading national specialty retailer of high-quality women’s apparel, shoes, and accessories sold primarily under the “Anne Aylor” brand name. Anne Aylor is a highly recognized national brand that defines a distinct fashion point of view. Anne Aylor merchandise represents classic styles, updated to reflect current fashion trends. Company stores offer a full range of career and casual separates, dresses, tops, weekend wear, shoes and accessories coordinated as part of a total wardrobing strategy. The company places a significant emphasis on customer service. Company sales associates are trained to assist customers in merchandise selection and wardrobe coordination, helping them achieve the “Anne Aylor” look while maintaining the customers’ personal styles.
The company follows the standard fiscal year of the retail industry, which is a 52- or 53-week period ending on the Saturday closest to January 31 of the following year. Net revenue for the year ended February 1, 2014 (referred to as fiscal 2014) was $1.2 billion and net income was $50.8 million.
At the end of fiscal 2014, the company operated approximately 584 retail stores located in 46 states under the name Anne Aylor. The company’s core business focuses on relatively affluent, fashion-conscious professional women with limited shopping time. Substantially all of the company’s merchandise is developed in-house by its product design and development teams. Production of merchandise is sourced to 131 independent manufacturers located in 19 countries. Approximately 45 percent, 16 percent, 13 percent, 12 percent, and 9 percent of the company’s merchandise is manufactured in China, Philippines, Indonesia, India, and Vietnam, respectively. Merchandise is distributed to the company’s retail stores through a single distribution center, located in Louisville, Kentucky.
Anne Aylor stock trades on The New York Stock Exchange and Anne Aylor is required to have an integrated audit of its consolidated financial statements and its internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). As of the close of business on March 14, 2014 Anne Aylor had 48,879,663 shares of common stock outstanding with a trading price of $22.57.
The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. Anne Aylor, Inc. is a fictitious company. All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental.
BACKGROUND
Your firm, Smith and Jones, PA., is in the initial planning phase for the fiscal 2015 audit of Anne Aylor, Inc. (i.e., the audit for the year that will end on January 31, 2015). As the audit manager, you have been assigned responsibility for determining planning materiality and performance materiality for key financial statement accounts. Your firm’s materiality and performance materiality guidelines have been provided to assist you with this assignment (see Exhibit 1).
Donna Fontain, the audit partner, has performed a preliminary analysis of the company and its performance and believes the likelihood of management fraud is low. Donna’s initial analysis of the company’s performance is documented in the memo referenced as G-3 (top right hand corner of the document). Additionally, Donna has documented current events/issues noted while performing the preliminary analysis in a separate memo, G-4. You have recorded the audited fiscal 2014 and projected fiscal 2015 financial statement numbers on audit schedule G-7. The company’s accounting policies are provided in Exhibit 2. Assume no material misstatements were discovered during the fiscal 2014 audit.
REQUIRED
[1] Review Exhibits 1 and 2; audit memos G-3 and G-4; and audit schedules G-5, G-6 and G-7. Based on your review, answer each of the following questions:
[a] Why are different materiality bases considered when determining planning materiality?
[b] Why are different materiality thresholds relevant for different audit engagements?
[c] Why is the materiality base that results in the smallest threshold generally used for planning purposes?
[d] Why is the risk of management fraud considered when determining performance materiality?
[e] Why might an auditor not use the same performance materiality amount or percentage of account balance for all financial statement accounts?
[f] Why does the combined total of individual account performance materiality commonly exceed the estimate of planning materiality?
[g] Why might certain trial balance amounts be projected when considering planning materiality?
[2] Based on your review of the Exhibits (1 and 2) and audit memos (G-3 and G-4), complete audit schedules G-5, G-6 and G-7.
EXHIBIT 1
Smith and Jones, PA.
Policy Statement: Planning Materiality
This policy statement provides general guidelines for firm personnel when establishing planning materiality and performance materiality for purposes of determining the nature, timing, and extent of audit procedures. The intent of this policy statement is not to suggest that these materiality guidelines must be followed on all audit engagements. The appropriateness of these materiality guidelines must be determined on an engagement by engagement basis, using professional judgment.
Planning Materiality Guidelines
Planning materiality represents the maximum, combined financial statement misstatement or omission that could occur before influencing the decisions of reasonable individuals relying on the financial statements. The magnitude and nature of financial statement misstatements or omissions will not have the same influence on all financial statement users. For example, a 5 percent misstatement with current assets may be more relevant for a creditor than a stockholder, while a 5 percent misstatement with net income before income taxes may be more relevant for a stockholder than a creditor. Therefore, the primary consideration when determining materiality is the expected users of the financial statements.
Relevant financial statement elements and presumptions on the effect of combined misstatements or omissions that would be considered immaterial and material are provided below:
■ Net Income Before Income Taxes – combined misstatements or omissions less than 2 percent of Net Income Before Income Taxes are presumed to be immaterial and combined misstatements or omissions greater than 7 percent are presumed to be material. (Note: Net Income Before Income Taxes may not be an appropriate base if the client’s Net Income Before Income Taxes is substantially below other companies of equal size or is highly variable.)
■ Net Revenue – combined misstatements or omissions less than 0.5 percent of Net Revenue are presumed to be immaterial, and combined misstatements or omissions greater than 2 percent are presumed to be material.
■ Current Assets – combined misstatements or omissions less than 2 percent of Current Assets are presumed to be immaterial, and combined misstatements or omissions greater than 7 percent are presumed to be material.
■ Current Liabilities – combined misstatements or omissions less than 2 percent of Current Liabilities are presumed to be immaterial and combined misstatements or omissions greater than 7 percent are presumed to be material.
■ Total Assets – combined misstatements or omissions less than 0.5 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.)
The specific amounts established for each financial statement element must be 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.
Performance Materiality Guidelines
In addition to establishing materiality for the overall financial statements, materiality for individual financial statement accounts should be established. The amount established for individual accounts is referred to as “performance materiality.” Performance materiality represents the amount individual financial statement accounts can differ from their true amount without affecting the fair presentation of the financial statements taken as a whole. Establishment of performance materiality for particular accounts enables the auditor to design and execute an audit strategy for each audit cycle.
The objective in setting performance materiality for particular financial statement accounts is to provide reasonable assurance that the financial statements taken as a whole are fairly presented in all material respects.
To provide reasonable assurance that the financial statements taken as a whole do not contain material misstatements, the performance materiality established for particular financial statement accounts/transactions should not exceed 75 percent of planning materiality. The percentage threshold should be lower as the expectation for management fraud increases. In many audits it is reasonable to expect that individual financial statement account misstatements identified will be less than performance materiality and that misstatements across accounts will offset each other (some identified misstatements will overstate net income and some identified misstatements will understate net income). This expectation is not reasonable when the likelihood of management fraud is high. If management is intentionally trying to misstate the financial statements, it is likely that misstatements will be systematically biased in one direction across accounts.
The performance materiality percentage threshold should not exceed:
■ 75 percent of planning materiality if low likelihood of management fraud
■ 50 percent of planning materiality if reasonably low likelihood of management fraud, and
■ 25 percent of planning materiality if moderate likelihood of management fraud
Finally a lower performance materiality may be required for specific accounts because of the relevance of the account to users. Performance materiality for a specific account should not exceed that amount that would influence the decision of reasonable users.
Approved: April 24, 2012
EXHIBIT 2
Anne Aylor, Inc.
Accounting Policies
Revenue Recognition – The Company records revenue as merchandise is sold to clients. The Company’s policy with respect to gift certificates and gift cards is to record revenue as they are redeemed for merchandise. Prior to their redemption, these gift certificates and gift cards are recorded as a liability. While the Company honors all gift certificates and gift cards presented for payment, management reviews unclaimed property laws to determine gift certificate and gift card balances required for escheatment to the appropriate government agency. Amounts related to shipping and handling billed to clients in a sales transaction are classified as revenue and the costs related to shipping product to clients are classified as cost of sales. A reserve for estimated returns is established when sales are recorded. The Company excludes sales taxes collected from customers from net sales in its Statement of Operations.
Cost of Sales and Selling, General and Administrative Expenses – The following table illustrates the primary costs classified in each major expense category:
Cost of Sales
Selling, General and Administrative Expenses
• Cost of merchandise sold;
• Freight costs associated with moving merchandise from our suppliers to our distribution center;
• Costs associated with the movement of merchandise through customs;
• Costs associated with the fulfillment of online customer orders;
• Depreciation related to merchandise management systems;
• Sample development costs;
• Merchandise shortage; and
• Client shipping costs.
• Payroll, bonus and benefit costs for retail and corporate associates;
• Design and merchandising costs;
• Occupancy costs for retail and corporate facilities;
• Depreciation related to retail and corporate assets;
• Advertising and marketing costs;
• Occupancy and other costs associated with operating our distribution center;
• Freight expenses associated with moving merchandise from our distribution center to our retail stores; and
• Legal, finance, information systems and other corporate overhead costs.
Advertising – Costs associated with the production of advertising, such as printing and other costs, as well as costs associated with communicating advertising that has been produced, such as magazine ads, are expensed when the advertising first appears in print. Costs of direct mail catalogs and postcards are fully expensed when the advertising is scheduled to first arrive in clients’ homes.
Leases and Deferred Rent Obligations – Retail stores and administrative facilities are occupied under operating leases, most of which are non-cancelable. Some of the store leases grant the right to extend the term for one or two additional five-year periods under substantially the same terms and conditions as the original leases. Some store leases also contain early termination options, which can be exercised by the Company under specific conditions. Most of the store leases require payment of a specified minimum rent, plus a contingent rent based on a percentage of the store’s net sales in excess of a specified threshold. In addition, most of the leases require payment of real estate taxes, insurance and certain common area and maintenance costs in addition to the future minimum lease payments. Rent expense under non-cancelable operating leases with scheduled rent increases or free rent periods is accounted for on a straight-line basis over the initial lease term beginning on the date of initial possession, which is generally when the Company enters the space and begins construction build-out. Any reasonably assured renewals are considered. The amount of the excess of straight-line rent expense over scheduled payments is recorded as a deferred liability. Construction allowances and other such lease incentives are recorded as deferred credits, and are amortized on a straight-line basis as a reduction of rent expense beginning in the period they are deemed to be earned, which often is subsequent to the date of initial possession and generally coincides with the store opening date. The current portion of unamortized deferred lease costs and construction allowances is included in “Accrued tenancy”, and the long-term portion is included in “Deferred lease costs” on the Company’s Balance Sheets.
Cash and Cash Equivalents – Cash and short-term highly liquid investments with original maturity dates of 3 months or less are considered cash or cash equivalents. The Company invests excess cash primarily in money market accounts and short-term commercial paper.
Merchandise Inventories – Merchandise inventories are valued at the lower of average cost or market, at the individual item level. Market is determined based on the estimated net realizable value, which is generally the merchandise selling price. Merchandise inventory levels are monitored to identify slow-moving items and broken assortments (items no longer in stock in a sufficient range of sizes) and markdowns are used to clear such merchandise. Merchandise inventory value is reduced if the selling price is marked below cost. Physical inventory counts are performed annually in January, and estimates are made for any shortage between the date of the physical inventory count and the balance sheet date.
Store Pre-Opening Costs – Non-capital expenditures, such as rent, advertising and payroll costs incurred prior to the opening of a new store are charged to expense in the period they are incurred.
Property and Equipment – Property and equipment are recorded at cost. Depreciation and amortization are computed on a straight-line basis over the following estimated useful lives:
Building
40 years
Leasehold improvements
10 years or term of lease, if shorter
Furniture, fixtures and equipment
2-10 years
Software
5 years
Accounting for the Impairment or Disposal of Long-Lived Assets – The assessment of possible impairment is based on the Company’s ability to recover the carrying value of the long-lived asset from the expected future pre-tax cash flows (undiscounted and without interest charges). If these cash flows are less than the carrying value of such assets, an impairment loss is recognized for the difference between estimated fair value and carrying value. The primary measure of fair value is based on discounted cash flows. The measurement of impairment requires management to make estimates of these cash flows related to long-lived assets, as well as other fair value determinations.
Goodwill and Indefinite-lived Intangible Assets – The Company performs annual impairment testing related to the carrying value of the Company’s recorded goodwill and indefinite-lived intangible assets.
Deferred Financing Costs – Deferred financing costs are amortized using the effective interest method over the term of the related debt.
Self Insurance – The Company is self-insured for certain losses related to its employee point of service medical and dental plans, its workers’ compensation plan and for short-term disability up to certain thresholds. Costs for self-insurance claims filed, as well as claims incurred but not reported, are accrued based on management’s estimates, using information received from plan administrators, third party activities, historical analysis, and other relevant data. Costs for self-insurance claims filed and claims incurred but not reported are accrued based on known claims and historical experience.
Income Taxes – The Company accounts for income taxes using the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized, and income or expense is recorded, for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.
Treasury Stock Repurchases – The Company repurchases common stock from time to time, subject to market conditions and at prevailing market prices, through open market purchases or in privately negotiated transactions. Repurchased shares of common stock are recorded using the cost method.
Stock-based Compensation – The Company uses the modified prospective method to record stock-based compensation. The calculation of stock-based compensation expense requires the input of highly subjective assumptions, including the expected term of the stock-based awards, stock price volatility, and pre-vesting forfeitures. The Company estimates the expected life of shares granted in connection with stock-based awards using historical exercise patterns, which is assumed to be representative of future behavior. The volatility of common stock at the date of grant is estimated based on an average of the historical volatility and the implied volatility of publicly traded options on the common stock. In addition, the expected forfeiture rate is estimated and expense is only recorded for those shares expected to vest. Forfeitures are estimated based on historical experience of stock-based awards granted, exercised and cancelled, as well as considering future expected behavior.
Savings Plan – Substantially all employees of the Company and its subsidiaries who work at least 30 hours per week or who work 1,000 hours during a consecutive 12 month period are eligible to participate in the Company’s 401(k) Plan. Under the plan, participants can contribute an aggregate of up to 75% of their annual earnings in any combination of pre-tax and after-tax contributions, subject to certain limitations. The Company makes a matching contribution of 100% with respect to the first 3% of each participant’s contributions to the 401(k) Plan and makes a matching contribution of 50% with respect to the second 3% of each participant’s contributions to the 401(k) Plan.
Other Liabilities – Other liabilities includes liabilities associated with borrowings for the purchase of fixed assets and obligation for excess corporate office space.
purchase of fixed assets and obligation for excess corporate office space.
Anne Aylor, Inc.
Memo: Analysis of Performance First Quarter
Year Ended: January 31, 2015
Reference:
G 3
Prepared by:
DF
Date:
6/14/15
Reviewed by:
_________
Net sales for the first quarter of fiscal 2015 increased 1.5 percent from the first quarter of fiscal 2014. Comparable store sales for the first quarter of fiscal 2015 increased 0.5 percent, compared to a comparable store sales decrease of 0.2 percent in the first quarter of fiscal 2014. Despite soft customer traffic across the industry, the Company saw improvement in same store sales as a result of a targeted promotional strategy and improved product offerings that helped drive increased traffic to Company stores. Based on their current strategy and performance to date, the company expects to achieve net sales growth of approximately 5 percent for the 2015 fiscal year compared to 3.5 percent for fiscal 2014. Net sales growth for the company’s market sector is expected to be approximately 3 percent for the 2015 fiscal year.
Gross margin as a percentage of net sales increased to 51.5 percent in the first quarter of fiscal 2015, compared to 51.0 percent in the first quarter of fiscal 2014. The increase in gross margin as a percentage of net sales for the first quarter of fiscal 2015 as compared to the comparable fiscal 2014 period was due primarily to higher full price sales as a percentage of total sales coupled with higher margin rates achieved on both full price and non-full price sales at stores. This performance was the result of improved product offerings and effective targeted marketing initiatives.
Selling, general and administrative expenses as a percentage of net sales decreased to 47.2 percent, in the first quarter of fiscal 2015, compared to 48.0 percent of net sales in the first quarter of fiscal 2014. The decrease in selling, general and administrative expenses as a percentage of net sales was primarily due to improved operating leverage as a result of higher net sales, tenancy related savings associated with the store remodel program, and continued focus on cost savings initiatives. The decrease in selling, general and administrative expenses was partially offset by higher marketing and performance-based compensation expenses.
Net income as a percentage of net sales increased to 2.6 percent in the first quarter of fiscal 2015, compared to 1.8 percent in the first quarter of fiscal 2014. The increase in net income as a percentage of net sales is due to improved full price selling at Company stores and improved operating efficiencies. Based on their current strategy and performance to date, the company expects to achieve net earnings before taxes growth of approximately 23 percent for the 2015 fiscal year compared to 18 percent for fiscal 2014.
Anne Aylor, Inc.
Memo: Current Events/Issues
Year Ended: January 31, 2015
Reference:
G 4
Prepared by:
DF
Date:
6/14/15
Reviewed by:
________
The company plans to focus on optimizing store productivity and enhancing the instore environment of existing stores. Last year the Company remodeled 4 stores with updated aesthetics and reducing the square footage 30-40%. The Company intends to remodel an additional 25 stores during fiscal 2015 following the remodeled prototype developed last year. The remodeling will be funded with operating cash flows.
On March 18, 2015 the Company entered into the credit facility with First Bank and a syndicate of lenders, which amended its existing $150 million senior secured revolving credit facility which was due to expire in October 2015. The credit facility provides the Company with an option to increase the total facility and the aggregate commitments thereunder up to $200 million, subject to the lenders’ agreement to increase their commitment for the requested amount. The credit facility expires on September 30, 2020 and may be used for working capital, letters of credit and other general corporate purposes. Should certain liquidity and other requirements not be met, as defined in the credit facility, no additional funds can be borrowed and any outstanding borrowings may become immediately payable. The credit facility requires that the Company maintain a working capital balance of $125 million and quick ratio of 0.65. Additionally, the Company is only allowed to repurchase common stock up to $100,000 in any fiscal year.
Anne Aylor, Inc.
Planning Materiality Assessment
Year Ended: January 31, 2015
Reference: G 5
Prepared by: _____________
Date: _________
Reviewed by: _________
Anne Aylor, Inc.
Performance Materiality Assessment
Year Ended: January 31, 2015
Reference: G 6
Prepared by: ___________
Date: _____________
Reviewed by: ____________
Likelihood of Management Fraud (check one):
___________ Low Likelihood of Management Fraud
___________ Reasonably Low Likelihood of Management Fraud
___________ Moderate Likelihood of Management Fraud
Anne Aylor, Inc.
Planning Materiality Financial Information
Year Ended: January 31, 2015
Reference:
G 7
Prepared by:
_______
Date:
______
Reviewed by:
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