In the winter months, you will often find college students wearing parkas, pullovers, or long-sleeved t-shirts that sport the North Face label. Over the past four decades, North Face has established itself as a leading supplier of apparel for "run-of-the-mill" outdoors "types." The company also markets a wide range of apparel and sporting gear for more adventurous souls including mountain climbers, whitewater daredevils, ski bums, and the like.
Despite North Face's prominence in the two markets that it serves, the company has had an "up and down" history. Various gaffes made by the many management teams that North Face has had over the years have resulted in inconsistent operating results and subjected the company's executives to public ridicule. During the late 1990s, a business periodical included North Face among the five "worst-managed" corporations in the United States. A few years later, North Face's executives were red-faced once more when the Securities and Exchange Commission (SEC) revealed that the company had embellished its reported operating results.
This case examines the accounting gimmicks North Face executives used to enhance the company's revenues and profits. These gimmicks primarily involved violations of the revenue recognition rule for certain barter and consignment transactions arranged by the company's chief financial officer (CFO) and vice-president of sales. Deloitte served as North Face's auditors during the period when the company's operating results were manipulated. The SEC's investigation revealed that personnel of the prominent accounting firm altered North Face's audit workpapers to conceal a critical judgment error made by a Deloitte audit partner.
The North Face, Inc.-Key Facts
1. North Face was founded in the mid-1960s by Hal Klopp who wanted to provide a source of high-quality hiking and camping gear for avid outdoorsmen-and outdoorswomen.
2. A new team of executives that took over control of North Face in the mid-1990s failed to meet aggressive revenue and earnings goals they had established for the company.
3. To conceal the company's actual operating results, North Face's CFO and vice-president of sales recorded a series of fraudulent sales transactions.
4. In December 1997, North Face's CFO negotiated a large fraudulent barter transaction to "pump up" the company's revenues and profits for both that year and the following year.
5. In late 1998, North Face's vice-president of sales arranged two large transactions with small wholesalers, transactions recorded as consummated sales although they were actually consignments.
6. Deloitte served as North Face's independent auditor during the time frame that the company's operating results were being misrepresented.
7. During the 1997 North Face audit, the Deloitte audit engagement partner documented in the client workpapers that the company had improperly accounted for the large barter transaction-although he never discovered that the transaction was fraudulent.
8. That audit partner proposed an adjusting entry for the barter transaction but then "passed" on the adjustment after concluding that it had an immaterial impact on North Face's financial statements.
9. The individual who became the North Face audit engagement partner in early 1998 allowed the company to improperly account for that portion of the large barter transaction recorded in January 1998.
10. This second partner then instructed his subordinates to make undocumented changes in the 1997 audit workpapers to conceal the fact that the previous audit partner had contested North Face's accounting treatment for the 1997 portion of the barter transaction.
11. The SEC sanctioned the two North Face executives who had masterminded the fraud and the Deloitte partner who had instructed his subordinates to make the undocumented changes in the 1997 audit workpapers.
12. In May 2000, North Face's turbulent history as a public company ended when it was purchased by VF Corporation, the world's largest apparel company.
Instructional Objectives
1. To demonstrate the need to document each important decision made during an audit engagement in the audit workpapers and to maintain that documentation for the benefit of future audit engagement teams.
2. To demonstrate the need for auditors to thoroughly investigate questionable or suspicious transactions and to not rely exclusively on a colleague's opinion regarding the proper treatment of such transactions.
3. To allow students to discuss the application of the revenue recognition rule to nonstandard sales transactions.
Suggestions for Use
The importance of maintaining the integrity of audit workpapers and other audit-related documentation is the key theme of this case. Consider having your students discuss the following hypothetical situation: What would they do if a senior audit partner instructed them to alter opinions expressed in a set of prior year audit workpapers and told them not to document that those alterations had been made?
An even more egregious example of improper alterations of audit workpapers is documented in the NextCard case. In that case, an audit partner instructed two audit managers to make extensive changes in a set of prior year workpapers that were later scrutinized by a team of federal investigators. In addition to altering the workpapers, one of the audit managers was instructed by the partner to change the electronic time stamp on them to conceal the fact that they had been altered. The partner in that case was eventually sentenced to one year in jail for his indiscretions. Of course, in the Enron case the shredding of audit workpapers and related documents proved to be a critical misstep on the part of the company's Andersen audit team that contributed to the eventual demise of that prominent firm. I typically use these additional examples to convey to students the "sanctity" of audit workpapers and the serious consequences that auditors can face if they make undocumented changes in, or destroy, workpapers.
Suggested Solutions to Case Questions
1. The professional standards urge auditors to be cautious when they are considering "uncorrected misstatements" in a client's financial statements. AU Section 312 discusses such items at length. Following is an excerpt from that discussion.
If the auditor concludes that the effects of uncorrected misstatements, individually or in the aggregate, do not cause the financial statements to be materially misstated, they could still be materially misstated because of further misstatements remaining undetected. As the aggregate misstatements approach materiality, the risk that the financial statements may be materially misstated also increases; consequently, the auditor should also consider the effect of undetected misstatements in concluding whether the financial statements are fairly stated. [AU 312.65]
AU Section 312 notes that if the auditor concludes that the client's financial statements are materially misstated, then "the auditor should request management to make the necessary corrections" (312.64). This section goes on to discuss the documentation standards for "uncorrected misstatements" (see paragraphs 69-70). For example, auditors must document in their workpapers "whether uncorrected misstatements, individually or in the aggregate, do or do not cause the financial statements to be materially misstated, and the basis for that conclusion."
In summary, auditors' lives would be considerably less complicated if clients would prepare an adjusting entry for each proposed audit adjustment, even those that are immaterial. Nevertheless, it is not reasonable for auditors to "insist" that clients record adjusting entries for immaterial proposed audit adjustments.
2. To the greatest extent possible, auditors should not provide clients with access to the critical parameters or facets of audit engagements, including materiality limits. Similar to what transpired in this case, unethical client personnel can use that information to subvert the intent of individual audit procedures or even the integrity of the entire audit engagement. However, it is often not feasible to conceal information such as materiality limits from client personnel. For example, to mitigate the cost of an audit, auditors typically have client personnel "pull" documents, prepare various schedules to which audit procedures will be applied, and perform other important audit-related tasks. In completing these tasks, client personnel can often determine the auditor's intent and/or the scope or materiality limit of a given audit test. Likewise, clients have access to the professional auditing literature and professional publications that discuss the general guidelines that auditors use in making important strategic decisions during the course of an audit, including the selection of materiality limits for individual accounts or financial statement items.
3. Statement of Financial Accounting Concepts No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises" (pre-codification) established a two-part revenue recognition rule for accountants to follow in deciding when to record revenues. Before revenue is recognized (recorded) in an entity's accounting records, it should be both realized and earned, according to the following excerpt from SFAC No. 5.
Revenues and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. . . . revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.
Generally, for barter transactions involving the receipt of trade credits, it is often extremely difficult to determine the fair value or ultimately realizable value of the trade credits. As a result, any profit on such transactions should generally be deferred until the trade credits are effectively "cashed in." [Note: You might refer your students to the following article that discusses the proper accounting treatment for barter transactions that include the exchange of "trade credits": "Accounting for Barter Transactions Involving Barter [trade] Credits" (Journal of Accountancy, May 2004, pp. 101-102).]
As pointed out in a footnote appended to several of the SEC enforcement releases issued for this case, Statement of Financial Accounting Standards No. 48 (pre-codification), "Revenue Recognition When Right of Return Exists," prohibits a seller from recognizing revenue (or profit, of course) when the given customer can return the product and the ultimate payment to be received by the seller hinges on the customer reselling the product. Both features of the revenue recognition rule were violated by the decision of North Face to record the large consignment sales: there was not a true exchange since the two customers did not pay for the merchandise and the given transactions were not finalized until the customers resold the merchandise.
4. Note: The PCAOB has established the documentation requirements for the audits of publicly owned companies in PCAOB Auditing Standard No. 3, "Audit Documentation." The documentation requirements that pertain to audits of other organizations can be found in Statement on Auditing Standards No. 103, "Audit Documentation," that became effective for audits of financial statements for periods ending on or after December 15, 2006.
SAS No. 103:
This standard has been integrated into AU Section 339. Paragraph .03 of AU 339 provides the following general guidance to independent auditors.
"The auditor must prepare audit documentation in connection with each engagement in sufficient detail to provide a clear understanding of the work performed (including the nature, timing, extent, and results of audit procedures performed), the audit evidence obtained and its source, and the conclusions reached. Audit documentation:
a. Provides the principal support for the representation in the auditor's report that the auditor performed the audit in accordance with generally accepted auditing standards.
b. Provides the principal support for the opinion expressed regarding the financial information or the assertion to the effect that an opinion cannot be expressed."
Paragraph .32 of AU 339 notes that the "auditor should adopt reasonable procedures to retain and access audit documentation for a period of time sufficient to meet the needs of his or her practice and to satisfy any applicable legal or regulatory requirements for records retention." This paragraph goes on to note that the retention period for audit documentation "should not be shorter than five years from the report release date."
PCAOB No. 3:
This standard defines audit documentation as "the written record of the basis for the auditor's conclusions that provides the support for the auditor's representations, whether those representations are contained in the auditor's report or otherwise" (para. .02). "Examples of audit documentation include memoranda, confirmations, correspondence, schedules, audit programs, and letters of representation. Audit documentation may be in the form of paper, electronic files, or other media" (para. .04).
PCAOB No. 3 notes that there are three key objectives of audit documentation: "demonstrate that the engagement complied with the standards of the PCAOB, support the basis for the auditor's conclusions concerning every major relevant financial statement assertion, and demonstrate that the underlying accounting records agreed or reconciled with the financial statements" (para. .05).
Application to this case:
The objectives of obtaining audit documentation (workpapers) identified by the ASB and the PCAOB were undercut by the decision of the Deloitte auditors to alter North Face's 1997 audit workpapers. For example, by modifying the 1997 workpapers and not documenting the given revisions in those workpapers, the Deloitte auditors destroyed audit evidence that provided an explicit record of important issues considered and key decisions reached on the 1997 audit. The alteration of the 1997 workpapers also destroyed evidence that demonstrated that the 1997 audit team had complied with professional auditing standards.
5. AU Section 316.07 identifies the three conditions that are generally present when an accounting fraud occurs. One of those conditions is the "incentive" of management or other employees to commit fraudulent acts. Clearly, major strategic blunders by client management can create an environment in which client executives and their key subordinates have a strong incentive to distort their entity's accounting records and financial statements. More generally, the overall quality of top management's decisions affects the "inherent risk" present during a given audit. For example, a factor that increases inherent risk is the potential for technological developments that would result in a given audit client's inventory or other assets becoming obsolete. One would certainly expect that a "high-quality" management team would be more capable of forecasting such potential developments and taking the appropriate steps to mitigate the risk posed by those developments than would a "low quality" management team. So, I would suggest that although you will likely not see "Assess the quality of key decisions made by client executives" as an explicit audit procedure within an audit program, auditors need to be cognizant of the competence of top management and the wide-ranging implications of that competence, or lack thereof, to all facets of an audit.
