North Face Accounting Fraud
The North Face, Inc. is an outdoor product company
specializing in outerwear, fleece, coats, shirts, footwear, and equipment such
as backpacks, tents, and sleeping bags. This case interested me because their
products are extremely popular on college campuses and most students own at
least one of their items. Prior to reading this case I was unaware of their
fraudulent past and was interested to learn more about it.
Case Summary
Hap Klopp founded North Face in the mid-1960s to provide a
line of hiking and camping gear. At first, North Face faced a dilemma of
maintaining its image as a high-end segment of the retail market, while at the
same time trying to ease its way into the mainstream retail market.
In the 1990’s Klopp left the company and a new management
team took North Face public, listing the company’s stock on the NASDAQ
exchange. By early 1999, North Face’s stock prices dramatically declined due to
rumors that North Face’s management had enhanced the company’s reported
revenues and profits by channel stuffing.
In May 1999, North Face revealed that their company’s
auditing financial statements for 1997 and 1998 have been distorted by
violating revenue recognition. The new Chief Financial Officer and Vice
President of Sales inflated North Face’s revenue because they wanted to meet
management’s expectations so they took matters into their own hands. In
December 1997, North Face began negotiating a large fraudulent transaction with
a barter company. In 1998, Todd Klatz, North Face’s vice president of sales,
arranged two large sales to inflate the company’s revenues. These two
transactions were actually consignments rather than sales. The first
transaction involved a $9.3 million transaction to a wholesaler in Texas and
the second involved a $2.6 million transaction to a wholesaler in California.
Fraudulent Methods Used
· Large barter transactions with Texas and California – In
December 1997, North Face began negotiating a large fraudulent transaction with
a barter company. Under the terms, the barter company would purchase $7.8
million of excess inventory and in exchange North Face would receive $7.8
million of trade credits. Christopher Crawford, the company’s chief financial
officer, was told by North Face’s independent auditors to not recognize revenue
on barter transactions when the only consideration received is trade credits.
However, Crawford realized that Deloitte & Touche, North Face’s
auditors, would not challenge the $3.51 million portion of the barter
transaction recorded during the fourth quarter of fiscal 1997 since they were
being paid in cash. Also, Crawford knew the auditors would not challenge
the reporting of revenue for the $1.64 component of the barter transaction for
which North Face would be paid by trade credits because it is not material.
Crawford reported the rest of the trade credits received in 1998.
· Accounting treatment for transactions was inconsistent with
authoritative literature Crawford instructed North Face to record the entire
profit margin on the $7.8 million barter transaction, regardless of the fact
that it was inconsistent with authoritative literature. He then did not inform
the Deloitte auditors of the $2.65 million portion of the barter transaction
until after the 1997 audit was complete.
· North Face utilized channel stuffing to wrongfully boost
their accounts receivable.
Deloitte and Touch’s Audit History
For several years, three of Deloitte’s auditors knew the
fraudulent practices North Face was practicing but yet did not turn them in.
Richard Fiedelman was the advisory partner for
North Face audit engagement.
·
In 1997, the audit engagement partner, Pete
Vanstraten, proposed an adjustment entry to reverse the barter transaction made
but then changed his mind because it was immaterial.
·
Fiedelman allowed North Face to improperly
recognize profit on the 1998 barter transaction.
·
In May 1998, Will Bordon was appointed as the
new audit engagement partner.
Bordon noticed Vanstraten’s concern in the 1997 work papers so he
brought it to Fiedelman’s attention.
·
Fiedelman convinced Bordon that Vanstraten had
not concluded that it was right for North Face to recognize profit on the 1997
barter transaction.
·
Due to Fiedelman’s guidance, Bordon didn’t
propose and adjustment to reverse the 1998 barter transaction that was approved
by Fieldelman.
·
As a result, Richard Fiedelman was sanctioned by the SEC for failing to
document the changes that his subordinates had made in the work papers for the
1997 audit of North Face.
After
reading this case, problems with the fraud triangle, tone at the top, and
internal controls came to mind.
Fraud
Triangle:
In
regards to the fraud triangle I saw there was high pressure and opportunity.
Pressure: High pressure resulted from too-aggressive sales goals set by management.
· North Face insisted on manufacturing all of their products
in their own facilities because company executives thought this was the best
way to maintain the highest quality in outdoor sporting equipment and apparel.
Consumer demand for their products was steadily growing by the mid-1980’s and
the higher levels of demand for production were causing the manufacturing
facilities to be overburdened. Additional problems from the limited production
capacity and mounting quality control problems included shipping products to
stores after their peak selling seasons. This also resulted in a large
inventory of flawed merchandise, which was sold as “seconds” in a series of outlet
stores North Face opened in the late 1980’s. This decision angered their
primary customers who saw this as a decrease in the brand image. North Face
quickly closed the stores in order to please their primary customers.
o
This is an example of
pressure because they were unable to maintain the level of production that was
required of them. Environments such as these are prone to poor workmanship, as
identified above, and also fraud. This series of poor management decisions led
to more pressure on the financial situation as well as the image of North Face.
This could have contributed to the pressure the company felt to begin channel
stuffing and other illegal practices.
· As North Face continued to grow in sales throughout the
1980’s and into the 1990’s the management team set aggressive sales goals. In
the mid 1990’s they established the goal of reaching $1 billion in annual sales
by the year 2003. In early 1999 North Face’s stock price plunged from its
all-time high amidst rumors of channel stuffing and other questionable or
illegal practices by management. These complications created a lot of pressure
to attain the $1 billion sales goal in the next 4 years. The pressure prompted
Christopher Crawford, the company’s chief financial officer (CFO), and 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.
o
This is a common
example of a high-pressure situation being created as a result of management
setting overly aggressive goals.
Opportunity: The CFO, Christopher Crawford, committed the fraud
because he saw internal control weaknesses and believed no one would notice.
· Christopher 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. This
opportunity presented itself to Crawford because he was aware of the
materiality thresholds that Deloitte & Touche had established for North Face’s
key financial statement items during the audit.
Tone at the Top
The issue of tone at the top became a problem with North
Face when the new management team in the mid-1990s established a goal of
reaching $1 billion in sales per year by 2003. Unfortunately, the actual
financials for North Face did not reflect their goal, prompting the company’s
CFO and other areas of management decided to literally take matters into their
own hands. In doing so the company resorted to engaging in shady transactions
and they were dishonest to their auditors as well as the general public.
Another example of the issues with the tone at the top was
with Todd Katz. As the vice president of sales he set a poor tone at the top
when he arranged the two large sales to wrongfully inflate North Face’s
revenues. While these transactions with the Texas and California wholesalers
were actually consignment sales, Christopher Crawford insisted they were to be
treated as consummated sales despite his knowledge that this is inconsistent
with authoritative literature on such matters. Actions such as these do not
provide a positive tone at the top and are a red flag for fraudulent
activities.
Internal Controls
The company’s CFO, Crawford, knew that Deloitte &
Touche, their auditors would pass by the $800,000 profits on the $1.64 million
barter transaction since it fell below the auditor’s materiality. Crawford was
aware of their materiality thresholds from the fiscal 1997 audit and he was
sure the auditors would only suggest an adjusting entry and nothing further
since the item was immaterial on the company’s financials. Crawford was correct
in his assumptions, Deloitte & Touche did just as he had expected.
This brings up the issue of independence. If the audit was
in full compliance with being completely independent, Crawford might not have
known what the threshold for materiality was. This would have prevented him
from taking advantage of this opportunity to act deceptively.
This fraud should have been detected sooner. There were various red flags, which
should have raised concerns amongst the auditing teams. After reading and analyzing this fraud
many questions came to mind:
1.
How did North Face’s
management become aware of the materiality thresholds? Isn’t it pertinent to
keep such information from clients, so audit evidence is not tampered with?
2.
What made you decide
to neglect recording the changes that were made in the prior year?
3.
What happens when
clients do not take your advice in making adjusting entries? Are these steps
different if the adjustments are material vs. immaterial? How should a
situation such as this be recorded?
***Feel free to visit the website listed below if
you would like to learn more about North Face accounting fraud!! http://www.sec.gov/litigation/complaints/comp17978.htm
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