American Eagle Outfitters, Inc

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Company background

American Eagle Outfitters, Inc. (NYSE:AEO), is a pioneering retailer in clothing and accessories industry founded in 1977. As of January 30, 2016, AEO operates 1,114 stores which in 141 sites and online stores in over 80 countries. AEO mainly can be divided into three parts participating in different market. American Eagle Outfitters Brand (AEO Brand), which offers high-quality and diversified-style of clothing, footwear and accessories, operates 949 stores and online ae.com. Aerie Brands is specialized in providing underwear and swimsuit for girls. Aerie products are sold in 164 stores and online at aerie.com. The third part are the Tailgate brand, a sports clothing brands, and Todd Snyder New York brand, a premium menswear brands. Those brands were created by Tailgate Clothing Company, which was acquired by AEO on November 2, 2015. Their products were sold in one store and online at TailgateClothing.com and ToddSnyder.com. (AEO Form 10K, 2016)

Industry environment

The Apparel Industry is made up of the companies that design and sell clothing, shoes and accessories. It grows and changes much faster than other industries and is highly competitive. There are many sophisticated designers and producers, as well as a lot of small companies that pay particular attention to specific customers. Foreign apparel retailers also bring the industry more competition. In order to survive the challenging apparel industry, companies have to be highly efficient and to keep pace with the fashion and consumer preference.

Related regulations

Since AEO is a public traded company, it should conform to Sarbanes-Oxley Act of 2002, the SEC and NYSE rules. Besides, the company is subject to a bunch of domestic and foreign regulations that relate to employment, consumer protection, and anti-corruption, such as Foreign Corrupt Practices Act.

Auditor’s audit risk assessment

Before we decided to accept AEO, Inc. as our new client, we should perform a couple of preliminary procedures by analyzing the audit risk, which is formulated as audit risk = inherent risk * control risk * detection risk. We need to devote much time to ensure that the potential audit client will not become the next Enron. To reduce the risk of accepting a prospective client, we initially obtained information from the preceding auditor with regard to the issues of integrity of management. For example, we inquired previous auditor of the reason why he terminated the engagement with AEO. Furthermore, we ensured that no senior manager has criminal record; we inquired related bankers, legal counsel, and underwriters who currently do business with AEO; we considered if our audit would incur particular attention or uncertain risks, and we did not find AEO showing the trend of loss. Although AEO has to face the challenge of constantly changing consumer preferences, fashion trend, and highly competitive environment, expanding business, and relying on IT system and competitive advantage of company, AEO could reach sustainable development. Through our inquiry, analysis, and professional judgement, we also did not find any fraud in prior years, red flags of potential problems and probable going-concern issue. Finally, we evaluated our independence with the prospective client. To sum up, we calculated audit risk model = 0.5*0.2*0.3=0.03, which indicates the risk is relatively low. We believed that AEO has no significant risk so far and we would love to accept an industry leading company as our new client.        

Engagement Letter

November 10, 2016

Dear Jay L. Schott:

This letter will confirm our understanding of the terms of our engagement as independent accountants of American Eagle Outfitters, Inc.

Service and Scope

We will audit the Company’s balance sheet at January 31, 2016, and the related statements of income, comprehensive income, stockholders’ equity, and cash flows for the year then ended, for the purpose of expressing an opinion on them. We will also audit whether American Eagle Outfitters, Inc. maintained effective internal control over financial reporting as of January 31, 2016, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO criteria).

Management’s responsibilities

American Eagle Outfitters, Inc.’s management is responsible for these financial statements and for maintaining effective internal control over financial reporting. Management is also responsible for making financial records and related information available for audit and for identifying and ensuring that the company complies with the laws and regulations that apply to its activities. Lastly, management is responsible for adjusting the financial statements to correct material misstatements and for affirming to us in the representation letter that the effects of any uncorrected misstatements aggregated by us during the current engagement and pertaining to the latest period presented are immaterial, both individually and in the aggregate, to the financial statements taken as a whole.

Our responsibilities and limitations

Our responsibility is to express an opinion on these financial statements and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audits. If, for any reason, we are unable to complete the audit or are unable to form or have not formed an opinion, we may decline to express an opinion or decline to issue a report as a result of the engagement.

We will conduct our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

Audit fees

Our fees are based on the time required by the individuals assigned to the engagement. We estimate our fees for this integrated audit engagement will range from $ 800,000 to $ 1,000,000. The fee estimate assumes that we incur 650 to 750 hours in performing our integrated audit, based on an assumed mix of staff. We will update you on significant changes in our fee estimate as the audit progresses. If actual hours incurred exceed this range or the mix of staff necessary to perform the work varies significant, we will notify you as soon as possible. If actual hours incurred are less than this range, we will adjust our fee accordingly.

We also will bill the Company for our out-of-pocket expenses.

If this letter correctly expresses your understanding, please sign the enclosed copy where indicated and return it to us.

Very truly yours,

BL&RZ, LLP

American Eagle Outfitters, Inc.

By _______________________

Date ______________________

Staffing Schedule

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Process of the selected accounting cycles: Revenue, Account receivable, and Inventory cycle

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Materiality level

We estimated the materiality level for each cycle based on our professional judgement. The calculations are listed as following:

Perform tests of controls

In general, we inquired related key employees of management, such as staff accountants, accounting managers, and warehouse administrator with respect to their feelings about working environment and their job responsibilities. To be noticed, inquiry is not limited to the stage of tests of controls. It should be involved during the entire audit process. What’s more, we inspected company’s charter and policy to obtain a better understanding of AEO’s organizational structure and industrial characteristics. We also reviewed the company’s staff listing and got to know their job descriptions and responsibilities. We attached much attention to segregation of duties. Through observation and walkthrough, we ensured that only authorized employees have access to separate parts of IT system and the authorizations are appropriate based on their job responsibilities.

In revenue cycle and accounts receivable cycle, typically, we attached our attention to such management assertions as occurrence, completeness, cutoff, and accuracy.

1. Occurrence: we need to ensure that recorded sales have actually happened before year-end and relate to the company. Also, invoices should be evidenced by sales orders, bills of lading and other shipping documents. In doing so, we inspected AEO’s sales contract with its several “big” customers to make sure those customers are actually existing and currently doing business with AEO. We also checked sales contract to make sure the customer’s name, product description, dates, and quantities that are showed on FOB invoices, shipping documents, and sales orders are consistent. Also, we need to ensure that accounts receivable corresponds to sales invoices.
2. Completeness: we scanned files to ensure that they are sequentially numbered. Moreover, we traced shipping documents to the records in detailed sales documents.
3. Accuracy: we examined whether prices used in preparing invoices are from authorized price listing. Additionally, we recalculated price extension and sales discounts. Here, we consulted with engagement partner and verified previous audit working paper, then decided to specifically select top 30 sales and randomly select 300 sales as our sample size.
4. Cutoff: we compared the shipping document date with billing date and also checked FOB “shipping terms”.

Test results: through our tests of controls in revenue and A/R cycle, we have not discovered any material weakness of internal control.

Observation

We observed physical security of inventories and environment in which they are held. To illustrate, we performed the following procedures:

1. We obtained warehouse employee listing and examined whether only authorized employees are allowed to enter warehouse and shipping area. For example, no any employee from accounting department can manipulate the warehouse management.
2. We checked whether there is a fence around the inventory and the warehouse is locked.
3. We visited all storage locations and make sure that all storage locations have been numbered and each inventory item could be identified, so we could track these items by location.
4. We entered the warehouse to check if each item of inventory in the warehouse has been tagged, and if the tag includes product description, qualification, units, and quantity. Otherwise, it would be difficult to identify and recognize inventory items.
5. If an inventory on-site is owned by customer, the warehouse administrator would probably think the company owns it, so we observed whether the company labeled these items as customer-owned before they are shipped, and put them separately in another specific area of the warehouse.
6. We tested that if a warehouse staff picks an item from the shelf in the warehouse, for sales to customers, whether there is another staff recording the process as soon as inventory items are removed from the shelf in the warehouse and whether the inventory items can only be carried out through a specific authorized gate. We also checked that whether the removal has been approved and signed off by an authorized staff.

Inspection

1. We physically counted the inventory before another batch of inventory was received and recorded rather than believe the supplier’s statement that the quantity showed on the delivery note is correct. In this way, we are able to prevent mistakes from entering into the inventory master data.
2. We inspected upcoming inventory. Namely, to inspect that all upcoming goods are conformed with what the company exactly ordered and are not impaired. Also, we tested that whether all items that failed inspection has been returned immediately and whether the A/P staff has been notified that the returned items should not be paid for.
3. We randomly selected some shipping documents, compared the date when the goods issued with the date when the accountant actually recorded the sales revenue and receivables. In this way, we can ensure the accounting management did not record sales revenue and receivables until the goods are shipped and did not record cash/bank until the payments were received from customers.

Re-performance

1. We recalculated the ending balance of inventory by using FIFO, LIFO, and perpetual inventory method, and then compare our results with the year-end balance of accounting book.
2. We re-performed inventory account reconciliation to verify if the balance of inventory master accounts matches with auxiliary inventory records.

Test results: through our tests of controls in inventory cycle, we’ve got to conclude that the internal control has been well designed and operate effectively.

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