Ethical Obligations and Decision Making in Accounting, 4/e 1
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.
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 the 1980s 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
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.
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.
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
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
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
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$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
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 finally 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.
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
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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
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
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.
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 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
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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.
Pressure/incentives
Management set overly aggressive sales goals that applied pressure on the CFO, Christopher
Crawford, to financially structure the barter transactions in a way that would enable the company
to record as much as revenue as possible early on in the process even though The North Face
Opportunity
Top management overrode internal controls and did pretty much anything it wanted through its
structured revenue transaction. It even contacted Deloitte to explain how barter revenue should
be recorded and received an answer that did not conform to what the company wanted to do so it
ignored Deloitte’s advice. It had the barter company pay down some cash with the hope it would
satisfy Deloitte about the legitimacy of revenue recorded.
Rationalization
There is not much in the case about rationalizations by Crawford for why the company recorded
the revenue the way it did because Deloitte was all too accommodating. We can imagine that
Crawford would have insisted it was common practice to do what he did with barter transactions
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and trade credits received. He would probably try to convince the auditors it was standard
industry practice.
Deloitte missed numerous red flags that something was amiss at The North Face. Crawford was
2. Identify the general principles that dictate when revenue should be recorded. How
did North Face violate those rules?
Generally speaking, barter transactions should be broken down into individual pieces. When you
barter, two transactions occur: 1) you sell something and 2) you buy something. The most
confusing factor can be determining the value of the transaction. Typically, a company in a
complete.
North Face utilized channel stuffing to wrongfully boost their accounts receivable.
3. Evaluate 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?
Crawford, knew that Deloitte & Touche would pass by the $800,000 profits on the $1.64 million
barter transaction since it fell below the auditor’s materiality criteria. Crawford was aware of
their materiality thresholds from the fiscal 1997 audit and he was sure the auditors would only
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Deloitte violated its ethical obligations by essentially telling the client how to structure a
transaction to fail the materiality standards established by the firm.