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Should auditors conceal materiality levels from audit clients?

Description:

Practice: Week 5 Discussion Question 1

 

Review case 7-9, The North Face, Inc.

Respond to the following:

Should auditors conceal materiality levels from audit clients?

 

 

Case 7-9 The North Face, Inc.

The North Face, Inc. (North Face) is an American outdoor product company specializing in outerwear, fleece, coats, shirts, footwear, and equipment such as backpacks, tents, and sleeping bags. North Face sells clothing and equipment lines catered toward wilderness chic, climbers, mountaineers, skiers, snowboarders, hikers, and endurance athletes. The company sponsors professional athletes from the worlds of running, climbing, skiing, and snowboarding.

North Face is located in Alameda, California, along with an affiliated company, Jan Sport. These two companies manufacture about half of all small backpacks sold in the United States. Both companies are owned by VF Corporation, an American apparel corporation.

The North Face brand was established in 1968 in San Francisco. Following years of success built on sales to a high-end customer base, in the 1990s North Face was forced to compete with mass-market brands sold by the major discount retailers. It was at that point the company engaged in accounting shenanigans that led to it being acquired by VF Corporation.

Barter Transactions1

Consumer demand for North Face products was steadily growing by the mid-1980s and the higher levels of demand for production were causing the manufacturing facilities to be overburdened. Pressure existed to maintain the level of production that was required. As North Face continued to grow in sales throughout the1980s and into the 1990s, the management team set aggressive sales goals. In the mid-1990s the team established the goal of reaching $1 billion in annual sales by the year 2003. The pressure prompted Christopher Crawford, the company’s chief financial officer (CFO), and Todd Katz, the vice president of sales, to negotiate a large transaction with a barter company and then proceed to improperly account for it in the financial statements.2

North Face entered into two major barter transactions in 1997 and 1998. The barter company North Face dealt with typically bought excess inventory in exchange for trade credits. The trade credits could be redeemed by North Face only through the barter company, and most often the trade credits were used to purchase advertising, printing, or travel services.

North Face began negotiating a potential barter transaction in early December 1997. The basic terms were that the barter company would purchase $7.8 million of excess inventory North Face had on hand. In exchange for that inventory, North Face would receive $7.8 million of trade credits that were redeemable only through the barter company.

Before North Face finalized the barter transaction, Crawford asked Deloitte & Touche, North Face’s external auditors, for advice on how to account for a barter sale. The auditors provided Crawford with the accounting literature describing GAAP relating to non-monetary exchanges. That literature generally precludes companies from recognizing revenue on barter transactions when the only consideration received by the seller is trade credits.

What Crawford did next highlights one of the many ways a company can structure a transaction to manage earnings and achieve the financial results desired rather than report what should be recorded as revenue under GAAP.

Page 493Crawford structured the transaction to recognize profit on the trade credits. First, he required the barter company to pay a portion of the purchase price in cash. Crawford agreed that North Face would guarantee that the barter company would receive at least a 60 percent recovery of the total purchase price when it resold the product. In exchange for the guarantee, the barter company agreed to pay approximately 50 percent of the total purchase price in cash and the rest in trade credits. This guarantee took the form of an oral side agreement that was not disclosed to the auditors.

Second, Crawford split the transaction into two parts on two days before the year-end December 31, 1997. One part of the transaction was to be recorded in the fourth quarter of 1997, the other to be recorded in the first quarter of 1998. Crawford structured the two parts of the barter sale so that all of the cash consideration and a portion of the trade credits would be received in the fourth quarter of 1997. The barter credit portion of the fourth quarter transaction was structured to allow profit recognition for the barter credits despite the objections of the auditors. The consideration for the 1998 first quarter transaction consisted solely of trade credits.

On December 29, 1997, North Face recorded a $5.15 million sale to the barter company. The barter company paid $3.51 million in cash and issued $1.64 million in trade credits. North Face recognized its full normal profit margin on the sale. Just 10 days later on January 8, 1998, North Face recorded another sale to the barter company, this time for $2.65 million in trade credits, with no cash consideration. North Face received only trade credits from the barter company for this final portion of the $7.8 million total transaction. Again, North Face recognized its full normal profit margin on the sale.

Materiality Issues

Crawford was a CPA and knew all about the materiality criteria that auditors use to judge whether they will accept a client’s accounting for a disputed transaction. He committed the fraud because he saw internal control weaknesses and believed no one would notice. Crawford realized that if he made sure the portion of the barter transaction recorded during the fourth quarter of fiscal 1997 was below a certain amount, the auditors would not look at it. He also believed that Deloitte & Touche would not challenge the profit recognized on the $3.51 million portion of the barter transaction because of the cash payment.

Crawford also realized that Deloitte would maintain that no profit should be recorded on the $1.64 million balance of the December 29, 1997, transaction with the barter company for which North Face would be paid exclusively in trade credits. However, Crawford was aware of the materiality thresholds that Deloitte had established for North Face’s key financial statement items during the fiscal 1997 audit. He knew that the profit margin of approximately $800,000 on the $1.64 million portion of the December 1997 transaction fell slightly below Deloitte’s materiality threshold for North Face’s collective gross profit. As a result, he believed that Deloitte would propose an adjustment to reverse the $1.64 million transaction but ultimately “pass” on that proposed adjustment since it had an immaterial impact on North Face’s financial statements. As Crawford expected, Deloitte proposed a year-end adjusting entry to reverse the $1.64 million transaction but then passed on that adjustment during the wrap-up phase of the audit.

In early January 1998, North Face recorded the remaining $2.65 million portion of the $7.8 million barter transaction. Crawford instructed North Face’s accountants to record the full amount of profit margin on this portion of the sale despite being aware that accounting treatment was not consistent with the authoritative literature. Crawford did not inform the Deloitte auditors of the $2.65 million portion of the barter transaction until after the 1997 audit was completed.

The barter company ultimately sold only a nominal amount of the $7.8 million of excess inventory that it purchased from North Face. As a result, in early 1999, North Face reacquired that inventory from the barter company.

Audit Considerations

The auditors did not learn of the January 8, 1998, transaction until March 1998. Thus, when the auditors made the materiality judgment for the fourth quarter transaction, they were unaware that a second transaction had taken place and unaware that Crawford had recognized full margin on the second barter transaction.

In mid-1998 through 1999, the North Face sales force was actively trying to resell the product purchased by the barter company because the barter company was unable to sell any significant portion of the inventory. North Face Page 494finally decided, in January and February 1999, to repurchase the remaining inventory from the barter company. Crawford negotiated the repurchase price of $690,000 for the remaining inventory.

Crawford did not disclose the repurchase to the 1998 audit engagement team, even though the audit was not complete at the time of the repurchase.

During the first week of March 1999, the auditors asked for additional information about the barter transaction to complete the 1998 audit. In response to this request, Crawford continued to mislead the auditors by failing to disclose that the product had been repurchased, that there was a guarantee, that the1997 and 1998 transactions were linked, and that the company sales force had negotiated almost all of the orders received by the barter company.

Crawford did not disclose any of this information until he learned that the auditors were about to fax a confirmation letter to the barter company that specifically asked if any of the product had been returned or repurchased. Crawford then called the chair of North Face’s audit committee, to explain that he had withheld information from the auditors. A meeting was scheduled for later that day for Crawford to make “full disclosure” to the auditors about the barter transactions.

Even at the “full disclosure” meeting with the auditors, Crawford was not completely truthful. He did finally disclose the repurchase and the link between the 1997 and 1998 transactions. He did not, however, disclose that there was a guarantee, nor did he disclose that the company’s employees had negotiated most of the orders for the product.

Deloitte & Touche

Richard Fiedelman was the Deloitte advisory partner assigned to the North Face audit engagement. Pete Vanstraten was the audit engagement partner for the 1997 North Face audit. Vanstraten was also the individual who proposed the adjusting entry near the end of the 1997 audit to reverse the $1.64 million barter transaction that North Face had recorded in the final few days of fiscal 1997. Vanstraten proposed the adjustment because he was aware that the GAAP rules generally preclude companies from recognizing revenue on barter transactions when the only consideration received by the seller is trade credits. Vanstraten was also the individual who “passed” on that adjustment after determining that it did not have a material impact on North Face’s 1997 financial statements. Fiedelman reviewed and approved those decisions by Vanstraten.

Shortly after the completion of the 1997 North Face audit, Vanstraten transferred from the office that serviced North Face. In May 1998, Will Borden was appointed the new audit engagement partner for North Face. In the two months before Borden was appointed the North Face audit engagement partner, Richard Fiedelman functioned in that role.

Fiedelman supervised the review of North Face’s financial statements for the first quarter of fiscal 1998, which ended on March 31, 1998. While completing that review, Fiedelman became aware of the $2.65 million portion of the $7.8 million barter transaction that Crawford had instructed his subordinates to record in early January 1998. Fiedelman did not challenge North Face’s decision to record its normal profit margin on the January 1998 “sale” to the barter company. As a result, North Face’s gross profit for the first quarter of 1998 was overstated by more than $1.3 million, an amount that was material to the company’s first-quarter financial statements. In fact, without the profit margin on the $2.65 million transaction, North Face would have reported a net loss for the first quarter of fiscal 1998 rather than the modest net income it actually reported that period.

In the fall of 1998, Borden began planning the 1998 North Face audit. An important element of that planning process was reviewing the 1997 audit workpapers. While reviewing those workpapers, Borden discovered the audit adjustment that Vanstraten had proposed during the prior year audit to reverse the $1.64 million barter transaction. When Borden brought this matter to Fiedelman’s attention, Fiedelman maintained that the proposed audit adjustment should not have been included in the prior year workpapers since the 1997 audit team had not concluded that North Face could not record the $1.64 million transaction with the barter company. Fiedelman insisted that, despite the proposed audit adjustment in the 1997 audit workpapers, Vanstraten had concluded that it was permissible for North Face to record the transaction and recognize the$800,000 of profit margin on the transaction in December 1997.

Borden accepted Fiedelman’s assertion that North Face was entitled to recognize profit on a sales transaction in which the only consideration received by the company was trade credits. Borden also relied on this assertion Page 495during the 1998 audit. As a result, Borden and the other members of the 1998 audit team did not propose an adjusting entry to require North Face to reverse the $2.65 million sale recorded by the company in January 1998.

After convincing Borden that the prior year workpapers misrepresented the decision that Vanstraten had made regarding the $1.64 million barter transaction, Fiedelman began the process of documenting this revised conclusion in the 1997 working papers that related to the already issued financial statements for 1997. The SEC had concluded in its investigation that Deloitte personnel prepared a new summary memorandum and proposed adjustments schedule reflecting the revised conclusion about profit recognition, and replaced the original 1997 working papers with these newly created working papers.

SEC Actions against Crawford

In the SEC action against Crawford and Katz, the SEC charged that Crawford tried to conceal the true nature of the improperly reported transactions from North Face’s accountants and auditors. He made, directly or indirectly, material misrepresentations and omissions to the auditors in an attempt to hide his misconduct. Katz also made, directly or indirectly, material misrepresentations and omissions to the accountants and auditors in an attempt to hide his misconduct.3 

The commission charged that Crawford committed a fraud because his actions violated Section 10(b) of the Exchange Act of 1934, in that he knew or was reckless in not knowing that (1) it was a violation of GAAP to record full margin on the trade credit portion of the sale and (2) that the auditors would consider the amount of the non-GAAP fourth quarter profit recognition immaterial and would not insist on any adjusting entry for correction.

A second charge was that Crawford aided and abetted violations of Section 13(a) of the Exchange Act that requires every issuer of a registered security to file reports with the SEC that accurately reflect the issuer’s financial performance and provide other information to the public.

A third charge dealt with record-keeping and alleged violations of Section 13(b) in that the Exchange Act requires each issuer of registered securities to make and keep books, records, and accounts that, in reasonable detail, accurately and fairly reflect the business of the issuer and to devise and maintain a system of internal controls sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit preparation of financial statements and to maintain the accountability of accounts.

The SEC asked the U.S. District Court of the Northern District of California to enter a judgment:

  • Permanently enjoining Crawford and the vice president of sales, Katz, from violating Sections 10(b) and 13(b)(5) of the Exchange Act;
  • Ordering Crawford to provide a complete accounting for and to disgorge the unjust enrichment he realized, plus prejudgment interest thereon;
  • Ordering Crawford and Katz to pay civil monetary penalties pursuant to Section 21(d)(3) of the Exchange Act; and
  • Prohibiting Crawford and Katz from acting as an officer or director of a public company pursuant to Section 21(d)(2) of the Exchange Act.

Crawford agreed to the terms in a settlement with the SEC that included his suspension from appearing or practicing before the commission as an accountant for at least five years, after which time he could apply to the commission for reinstatement.

Questions

  1. Use the fraud triangle to analyze the red flags that existed in the case and the role and responsibilities of the auditors at Deloitte & Touche in The North Face accounting fraud.
  2. Identify the general principles that dictate when revenue should be recorded. How did North Face violate those rules? 
  3. Page 496Evaluate the actions of Deloitte & Touche first proposing an audit adjustment on the $1.64 million balance of the December 29, 1997, transaction with the barter company and then passing on the adjustment based on it not having a material effect on the financial statements. In this regard, should auditors conceal materiality levels from audit clients? 

 



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