978-0077862213 Chapter 7 Case North Face

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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 towards 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, JanSport. 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

ransactions

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, Christopher Crawford, the company’s CFO, 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.

Crawford 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% recovery of the total purchase price when it re-sold the product. In exchange for

the guarantee, the barter company agreed to pay approximately 50% 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 ten 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 realized that Deloitte & Touche would not challenge the profit

recognized on the $3.51 million portion of the barter transaction recorded during the fourth quarter of fiscal 1997

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 slight 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 re-sell the product purchased by the

barter company because the barter company was unable to sell any significant portion of the inventory. North Face

finally decided, in January and February of 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 the 1997 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

ouche

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 during 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, 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 which 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 which, 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 United States District Court of the Northern District of California to enter a judgment:

• permanently enjoining Crawford and the vice president of sales, Todd 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. A variety of definitions of earnings management are given in this chapter. Discuss the accounting

techniques used by North Face by evaluating whether and why earnings management existed using

the definitions provided by: Schipper, Healy & Wahlen, Dechow & Skinner, and McKee.

There are a variety of definitions of earnings management. Schipper defines it as a “purposeful intervention in the

external reporting process, with the intent of obtaining some private gain (as opposed to say, merely facilitating the

neutral operation of the process).” Healy and Wahlen define it as “when managers use judgment in financial

Dechow and Skinner note the difficulty of operationalizing earnings management based on the reported

accounting numbers because they center on managerial intent, which is unobservable. Dechow and Skinner offer

their own view that a distinction should be made between making choices in determining earnings that may comprise

aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent accounting practices that

Schipper views earnings management as a purposeful act by management as might be the case when earnings are

manipulated to get the stock price up in advance of cashing in stock options.

Thomas E. McKee wrote a book on earnings management from the executive perspective. He defines earnings

management as “reasonable and legal management decision making and reporting intended to achieve stable and

predictable financial results.” McKee believes earnings management reflects a conscious choice by management to

North Face accounted for barter transactions with full normal profit margin on the sale, which is precluded under

GAAP. This is an example of earnings management in accordance of the definition by Schipper and Haley & Wahlen.

North Face split the barter transaction into two parts, one with part cash recorded in December 1997, and one

completely barter transaction recorded in January 1998. Crawford understood how auditors set materiality and how the

2. An important issue in this case is the application of materiality standards to revenue recognition on

the barter transaction. Evaluate the ethics 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. Be

sure to include both quantitative and qualitative materiality considerations.

As discussed above, Crawford designed the 1997 barter transaction to be just beneath the materiality threshold of the

auditors. In the final review of the audit and their workpapers. auditors should evaluate the materiality threshold, taking

into account both quantitative and qualitative factors. The auditors reassess the materiality to confirm whether it

remains appropriate in context of the client’s actual financial results. They should consider the quantitative and

qualitative effects of uncorrected misstatements on relevant classes of transactions, accounts, and disclosures. The

Deloitte auditors did propose an adjustment for the barter transaction in December 1997 and then passed on requiring

the entry, just as Crawford thought. It is hard to tell from the details of the case whether the materiality was reassessed

3. Deloitte & Touche made audit decisions related to the barter transactions that can be criticized

from an ethics perspective because of violations of the AICPA Code of Professional Conduct.

Evaluate those decisions and explain the nature of the criticisms.

In 1998, Deloitte went along with the accounting treatment even though it is not in accordance with GAAP. The

auditors do not seem to be skeptical enough in considering the barter transactions. Deloitte changed the workpapers

According to PCAOB Auditing Standard No. 3, circumstances may require additions to audit documentation after the

report release date. Audit documentation must not be deleted or discarded after the documentation completion date,

however, information may be added. Any documentation added must indicate the date the information was added, the

name of the person who prepared the additional documentation, and the reason for adding it. Deloitte violated this

standard in changing the workpapers that had included a proposed adjustment of $1.64 million on the barter transaction

that North Face had recorded in the final days of fiscal 1997. Vanstraten had proposed the adjustment because GAAP