The North
Face Inc.
A Case Study
Table of Contents
CASE BRIEF .................................................................................................................................. 3
CASE ABSTRACT: ................................................................................................................... 3
AUDITOR’S DILEMMA: .......................................................................................................... 3
AUDITOR’S QUESTION: ......................................................................................................... 3
Research Questions: .................................................................................................................... 3
CASE CONTEXT ........................................................................................................................... 4
Understanding of the North Face Entity ..................................................................................... 4
Understanding of the Entity’s Environment ............................................................................... 6
INDUSTRY CONDITIONS ................................................................................................... 6
INDUSTRY LIFE CYCLE: .................................................................................................... 8
The Apparel Commodity Chain: ............................................................................................. 9
Demand and Competition ....................................................................................................... 9
Regulatory Environment: ...................................................................................................... 10
Revenue Recognition ............................................................................................................ 11
Other External Factors: ......................................................................................................... 12
Answer to Questions ..................................................................................................................... 13
Figure 1- The Apparel Creation-to-Sales Cycle ............................................................................. 7
Figure 2 - The Fraud Triangle ....................................................................................................... 14
Table 1 - Rules for Revenue Recognition in Manufacturing Industry
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CASE BRIEF
CASE ABSTRACT:
Financial accountants and independent auditors commonly face challenging technical and ethical
dilemmas while carrying out their professional responsibilities. This case profiles an accounting and
financial reporting fraud orchestrated by the chief financial officer (CFO) of a major public company
and his subordinates. The CFO, who was a CPA, took extreme measures to conceal the fraud from
his company’s audit committee and independent auditors. Despite those measures, the
independent auditors identified suspicious entries in the company’s accounting records that were a
result of the CFO’s fraudulent scheme but did not properly investigate those items. Shortly before
the fraud was publicly revealed, a partner of the company’s audit firm instructed his subordinates
to alter prior year audit workpapers for the client to conceal improper decisions made by himself
and his firm.
AUDITOR’S DILEMMA:
The auditor’s dilemma in the case presented is to either alter the prior-year workpapers to conceal
questionable decisions made by an audit partner, decisions that involved several large barter
transactions that inflated the audit client’s reported operating results or incorporate in the
succeeding audit that the audit partners failed to investigate thoroughly the barter transaction thus
making its previous audit opinion inappropriate.
AUDITOR’S QUESTION:

How will the auditors maintain the integrity of the working papers and how will they
maintain professional skepticism relative recurring audit engagement?
Research Questions:
1. What is the proper treatment of misstatement of amounts that falls below the materiality
threshold set by the auditors?
2. What are the principal objectives and characteristics of audit workpapers? What are the
implications of altering the working papers without documenting the changes?
3. How will the auditor investigate allegations of improper revenue recognition whether it is
indicative of fraud?
4. How is recurring audit engagement in relation to professional skepticism affects audit
procedures?
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CASE CONTEXT
Understanding of the North Face Entity
North Face Inc. is a retail and manufacturing corporation of outdoor apparel and
equipment. It serves the specialty market of extreme athletes characterized by the young, highincome earners that are willing to pay high prices for quality outdoor apparel.
The North Face legend begins, on a beach; more precisely on San Francisco’s North Beach
neighborhood, at an altitude of only 150 feet above sea level. It was here in 1966 that two hiking
enthusiasts resolved to follow their passions and founded a small mountaineering retail store.
Soon thereafter, that little shop became known as The North Face, a retailer of highperformance climbing and backpacking equipment. In 1968, The North Face moved to the other
side of San Francisco Bay, to the unbridled possibilities of the Berkeley area, and began designing
and manufacturing its own brand of technical mountaineering apparel and equipment.
Through the 1970s, The North Face brand cherished a following amongst avid outdoor
athletes and began sponsoring expeditions to some of the most far-flung, still largely untouched
corners of the globe. This launched a proud tradition which continues in full force today and
constantly reinforces The North Face mantra, Never Stop Exploring™.
By the early 1980s, The North Face was taking exploration to the outer limits of the ski
world, adding extreme skiwear to the product offering. These were the days of pastels, neons, hair
dye, and mohawks; they laid the groundwork for today’s free-spirited snowsports athletes. By the
end of the decade, The North Face became the only supplier in the United States to offer a
comprehensive collection of high-performance outerwear, skiwear, sleeping bags, packs and tents.
The 1990s ushered in an era during which The North Face further broadened the outdoor
world it helps athletes to explore. The decade saw our debut in the sportswear market with the
launch of Tekware®, an innovative collection designed to provide rock climbers, backpackers,
hikers, trail runners, and outdoor enthusiasts with the ultimate fit and function. The North Face half
dome logo began to appear with greater regularity on ultramarathon courses, high-country trails,
and big walls. And, as the calendar clicked toward a new millennium, The North Face launched its
own line of trekking and trail-running shoes to ultimately address the head-to-toe needs of those
always striving for the next horizon.
The company’s goal is to offer the most technically advanced products in the world that
establish the industry standard in each of the company’s product categories. In achieving this goal,
the company continually evaluates trends, monitors the needs and desires of the consumers and
works with its materials suppliers to develop new materials and products to enhance product
designs. It regularly reviews its product lines and actively seeks input from a variety of sources.
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The company’s marketing and promotion goal is to increase brand awareness by projecting
a top-quality, technical, extreme and authentic image that appeals to professionals and serious
outdoor enthusiasts. In relation to that, the North Face management employed the world class
professional athletes to promote their products and sponsored many of the world’s most
challenging expeditions. This promotional campaign is chosen because the company recognized
that the product choice of professional athletes influence consumer preference.
Competitive advantage of the entity derives primarily from brand, beauty and performance.
Brands embody key messages and beliefs about the culture of a company and its products.
Innovation in the industry is derived from better performing, more ―beautiful products and from
building brand. Brands assure customers that products will be perceived by others as beautiful. Selfimage and social or peer group acceptance are often central to fashion trends, and brands look to
key in to these trends in developing their products.
To preserve the integrity of The North Face image and reputation, the company limits its
distribution to retailers that market products that are consistent with the company’s technical
standards and that provide a high level of customer service and technical expertise. The company
sells its products to a select group of specialty mountaineering, backpacking and skiing retailers,
premium sporting goods retailers and major outdoor specialty retail chains. The company does not
sell its products to national general sporting goods chains or to the discount stores.
The company sources most of its products through unaffiliated manufacturers in North
America, Asia and Europe. To ensure that products manufactured by others are consistent with its
standards, the company manages all key aspects of the production process, including establishing
product specifications, selecting materials to be used to produce its products and the suppliers of
such materials, and negotiating the prices for such materials. The entity maintains staffs of quality
control specialists which conducts on-site inspections throughout the production process. The
company has no long-term contracts with its manufacturing sources, and it competes with other
companies for production facilities and import quota capacity. Thus, any disruption in the
company’s ability to obtain manufacturing services could have a material adverse effect on the
entity’s business.
The company does not only market its products in the United States but also to other areas
of the globe. International sales accounted for approximately 26% of the company’s net sales in
1997. In 1996, the North Face implemented an integrated world-wide approach to product
development, sourcing and marketing in order to reduce costs, ensure consistent worldwide
operations and create a unified global brand.
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Understanding of the Entity’s Environment
INDUSTRY CONDITIONS
The rapidly changing culture, politics and economics of modern life deeply affect the
industrial environment, especially consumer industries such as textiles and clothing. One of the
impacts is that the contemporary North American and European textile and apparel industries
suffer immense competition from foreign producers. As early as the mid-1980s, imports were
estimated to account for close to 50% of consumption. As most imported textiles are produced with
very low labor expense, huge amounts of inexpensive products can be supplied in the domestic
market. Considering this situation, competitiveness in cost and quality continue to key issues for
textile manufacturers.
The apparel industry has served as a crucial stepping-stone in the economic development of
all advanced industrialized nations and it has also been an important engine of growth for the
successful newly industrializing economies. Apparel manufacturing is traditionally one of the largest
sources of industrial employment for most countries. In addition, apparel is a quintessential global
industry. It exemplifies, more than any other industry, the process by which firms have relocated
their labor-intensive manufacturing operations from high-wage regions in the advanced
industrialized countries to low-cost production sites in industrializing nations. This industry is
identified as a buyer-driven value chain that contains three types of lead firms: retailers, marketers
and brand manufacturers. With the globalization of apparel production, competition between the
leading firms in the industry has intensified as each type of lead firms has developed extensive
global sourcing capabilities.
Innovation in the global apparel value chain is primarily associated with the shift from
assembly to fully-package production. Full-package production changes fundamentally the
relationship between buyer and supplier giving more autonomy to the supplying firm and creating
more possibilities for innovation and learning.
Athletic and outdoor products are mostly non-durable goods, with a lifetime measured in
months or a few years. Many athletic and outdoor products have a substantial fashion component,
and consumers regularly replace footwear and apparel, and to a lesser extent gear. Apparel and
footwear have strong seasonal sales cycles, and regular style changes. Consequently, firms in the
athletic and outdoor industry are regularly developing new products and designs to anticipate
market and fashion trends. Predicting, responding to, and shaping market trends is a key driver of
success in the industry. One critical element of success is speed: shortening the cycle of designing
new products, and reducing the amount of time between production and delivery, can be the
difference between profit and loss. Going forward, the industry needs to continually develop new
products and new designs in order to be successful, and the challenge has grown greater over time
with the proliferation of competitors, market niches, and product diversity. Athletic and outdoor
companies are continually developing new products. While much innovation is around style, and
fashion trends, there is also continual effort to improve the performance characteristics of
products. Thus, research and development in this industry is very rapid.
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Design consists of the creating the technical and fashion aspects of footwear, apparel and
outdoor gear. Design is a key differentiator among athletic and outdoor firms. Firms develop
products to meet the specific technical needs of end users and or the tastes of different consumer
groups. Product design and development is usually a collaborative process integrating designers (to
develop ideas) marketing (to identify customer interests), and manufacturing (to assure products
can be manufactured economically. Large companies produce hundreds of thousands of distinct
products, varying by size, color, and features. Rapid and continuing changes to product designs are
an important competitive factor. Because it is difficult to accurately forecast customer demand for
every single product months in advance, speed and flexibility in responding to customer demand is
important. Companies invest in information technology to track inventory, and quickly identify hot
selling products. Insights from what is selling well also drive the development of new products. As a
result, the speed with which a firm can alter its designs and get new designs to stores in volume is
one source of competitive advantage.
The core value proposition of most athletic and outdoor firms is creating and marketing new
products, not producing or moving them. Almost all firms are continually developing and producing
new designs and new models, emphasizing performance, style or both. Large firms get patents to
protect their intellectual property; most smaller firms do not patent their designs, but continually
refine and upgrade them to maintain a competitive edge. Because most firms rely on a common set
of manufacturing partners – contract suppliers in Asia – there are not significant production cost
differences among firms.
Figure 1- The Apparel Creation-to-Sales Cycle
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The industry makes use of a range of supporting industries, especially professional and
creative services. There are freelance designers who develop new products for firms. There are
attorneys who specialize in trademarks, patents, intellectual property, organizational structure,
mergers & acquisitions, fundraising, trademarks, patents and intellectual property as well as
launching a new business. Advertising and public relations firms help design promotional
campaigns. Human resource companies help find and place the right talent. And companies that
handle distribution & logistics domestically and globally. This makes the entire outdoor apparel
industry a very challenging and competitive sector of retail and manufacturing industry.
INDUSTRY LIFE CYCLE:
Firms in the athletic and outdoor cluster tend to follow a distinctive life cycle. Most start out
as small startup firms with a few products. Most of these stay small or fail, but a few grow to
become relatively large players in the industry and/or the firms or their technology may be acquired
by medium-large sized firms.
Startups. There are relatively low barriers to entry in the athletic and outdoor cluster. Firms can
start with a few products, arrange for production overseas, and then sell or distribute their
products. Most firms are started without formal venture capital. Many small firms reported that
availability of capital was a limiting factor on growth, but not a barrier to starting a small firm.
Small/Growing Firms. A majority of firms in the athletic and outdoor business are smaller firms, i.e.
with fewer than 100 employees and sales of less than $100 million. As a general rule these firms are
privately held, and self-financed (i.e. not from formal venture capital).
Large Scale. A few firms are large firms with annual sales of more than $100 million. Of the publicly
traded firms based in the region, four have annual sales of this level or higher: Nike, Adidas,
Columbia, and Danner/LaCrosse . Several other companies that are privately-held, including
Leatherman and Leupold Stevens, are likely in this category, but do not publicly disclose annual
sales data.
Exits/Acquisitions and Legacy Brands. Firms that falter or fail to keep growing frequently become
acquisition targets for one of the large scale firms in the industry. Reebok, which was a principal
rival of Nike in the 1980s, was acquired by Adidas in 2004. Nike acquired one-time basketball shoe
rival Converse for $300 million in 2003. Jantzen, once a free-standing local company, was acquired
by Blue Bell (later VF), and then sold to Perry Ellis. North Face is similarly acquired by the VF
Corporation after its downfall in 1999. Typically these acquisitions reflect the purchase of the brand
equity built up by the firm. A large firm like Perry Ellis then uses its established and larger scale
capability to source, market and distribute products to continue to extract market value from these
―legacy brands. (Perry Ellis operates a design center in Portland, but manages production and
distribution from multi-brand corporate locations elsewhere). New Balance pursues a similar
strategy with PF Flyers a brand originated in the 1930s by B.F. Goodrich, and popular in the 1950s
and 1960s. LaCrosse similarly acquired the rights to the Red Ball line of sneakers originally popular
in the 1960s.
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The Apparel Commodity Chain:
Like other industries, there is a value chain in athletic and outdoor—different tasks involved
in imagining and creating the product, manufacturing it and distributing it to the end consumer.
Athletic and outdoor is characterized by a global division of labor in these tasks, with different
aspects of the value chain taking place in different parts of the world.
In global capitalism, economic activity is not only international in scope; it is also global in
organization. "Internationalization" refers to the geographic spread of economic activities across
national boundaries. As such, it is not a new phenomenon. Indeed, it has been a prominent feature
of the world economy since at least the seventeenth century when colonial empires began to crave
up the globe in search of raw materials and new markets for their manufactured exports.
"Globalization" is more recent, implying functional integration between internationally dispersed
activities.
Industrial and commercial firms have both promoted globalization, establishing two types of
international economic networks. One is "producer-driven and the other "buyer-driven". In
producer-driven value chains, large, usually transnational, manufacturers play the central roles in
coordinating production networks. This is typical of capital- and technology-intensive industries
such as automobiles, aircraft, computers, semi-conductors and heavy machinery. Buyer-driven
value chains are those in which large retailers, marketers and branded manufacturers play the
pivotal roles in setting up decentralized production networks in a variety of exporting countries,
typically located in developing countries. This pattern of trade-led industrialization has become
common in labor-intensive, consumer electronics. Tiered networks of third-world contractors that
make finished goods for foreign buyers carry out production. Large retailers or marketers that order
the goods supply the specifications.
Firms that fit the buyer-branded model generally design and/or market but do not make the
branded products they order. They are manufacturers without factories, with the physical
production of goods separated from the design and marketing.
The lead firms in producer-driven chains usually belong to international oligopolies. Buyerdriven value chains, by contrast are characterized by highly competitive and globally decentralized
factory systems with low entry barriers. The companies that develop and sell brand-name products
have considerable control over how, when and where manufacturing will take place, and how much
profit accrues at each stage. Thus, large manufacturers control and the producer-driven value
chains at the point of production, while marketers and merchandisers exercise the main leverage in
buyer-driven value chains at the design and retail stages.
A notable feature of buyer-driven chains has been the creation since the mid1970s prominent marketers with well-known brands but which carry out little or no production at
all. These companies are known "born global" since their sourcing has always been overseas. As
pioneers in global sourcing, branded marketers were instrumental in providing overseas suppliers
with knowledge that subsequently allowed them to upgrade their position in the apparel chain.
Demand and Competition
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Consumer demand for outdoor apparel products may be adversely affected if consumer
interest in outdoor activities does not grow or declines. Thus, in maintaining customers each
company in the industry invest heavily on research and development in order to introduce new
products and improvements to existing products on an ongoing basis.
The market for the outdoor apparel and equipment products are highly competitive. Recent
growth in these markets have encouraged the entry of many new competitors as well as increased
competition from established companies. Companies believe that it does not compete directly with
any single company with respect to its entire range of products but each company does have
significant competitors within each product category.
Regulatory Environment:
Where the U.S. Government has intervened in textile and apparel trade, its interventions
have tended to be ad hoc and reactive rather than comprehensive. While most major textile and
apparel producing nations have implemented sectoral industrial policies featuring industry
promotion subsidies and import protection, the U.S. Government has played a comparatively
passive role, seeking to patch up particular problem areas as they develop rather than implement a
more systematic approach.
The surge of textile and apparel imports into the U.S. market is a reflection of an export
drive by developing nations trying to bolster their domestic economies, and of a defensive response
by number of industrialized nations. They impetus for these developments has been provided by
foreign governments. This is one way of ensuring that they share in the growth of worldwide
demand for apparel products.
In 1995 members of the World Trade Organization (WTO) agreed to phase out agreements
that have controlled trade in textiles and apparel for more than 30 years. On January 1, 2006, the
worldwide system of textile and apparel quotas came to an end. Because the quota system had
forced buyers to purchase goods where quota is available, not where goods were most efficiently
produced.
Preferential trade agreements and arrangements have stimulated apparel production and
sometimes accelerated growth in textile and apparel exports, especially in beneficiary countries
outside South and Southeast Asia and China. Free trade agreements, such as the North American
Free Trade Area (NAFTA), the Dominican Republic-Central America-United States Free Trade
Agreement (CAFTA-DR), and US-Jordan Free Trade Agreement provide reciprocal market access, so
both benefit parties from lower tariffs. Preferential arrangements, such as the EU Everything Arm
Program and the United States African Growth and Opportunity Act, provide unilateral benefits that
the granting country can revoke while free trade agreements provide long-term security access.
Restrictions on textile and apparel trade resulted in a steady stream of orders to firms that
had little to offer other than access to quota rights. Government used quota allocations to prop up
inefficient producers in remote areas so as to boost rural employment and to stem labor migration
to production centers and cities.
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Revenue Recognition
Revenue is recognized in the manufacturing industry pursuant to the dictates of FASB
Concepts Statement (CON) No. 5, Recognition and Measurement in Financial Statements of
Business Enterprises, and SEC Staff Accounting Bulletins (SABs) No. 101, Revenue Recognition in
Financial Statements, and No. 104, Revenue Recognition. For example, consider 3M's revenue
recognition policy:
Revenue is recognized when the risks and rewards of ownership have substantively
transferred to customers, regardless of whether legal title has transferred. This condition is
normally met when the product has been delivered or upon performance of services.
The rules for revenue recognition in the manufacturing industry are summarized below (see also
the discussion in Chapter FIN-I C.2.a.iv).
Sales Event
Delivery FOB, Factory
Consignment
Buyback
High Rates of Return
Installment
Foreign
When Is Revenue Recognized?
At time of actual delivery or at time of delivery to common carrier
At time consignor (seller) is paid and notified by consignee (agent) of sale
At time buyback period expires.
At time return period expires (assumes rate of return cannot be
estimated)
At time of delivery if installment receivable has reasonable collection
estimate; otherwise not until actual collection.
At time of delivery if irrevocable letter of credit; otherwise at time of
actual collection.
Table 1 - Rules for Revenue Recognition in Manufacturing Industry
The manufacturing and retail industry usually sold on bulk to its retail store, thus, the FAS
48, “Revenue Recognition When Right of Return Exists” apply mostly. This standard provides that if
an enterprise sells its product but gives the buyer the right to return the product, revenue from the
sales transaction [is] recognized at time of sale only if all of the following conditions are met:
1. The seller’s price to the buyer is substantially fixed or determinable at the date of sale.
2. The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is
not contingent on resale of the product.
3. The buyer’s obligation to the seller would not be changed in the event of theft or physical
destruction or damage of the product.
4. The buyer acquiring the product for resale has economic substance apart from that provided
by the seller.
5. The seller does not have significant obligations for future performance to directly bring about
the resale of the product by the buyer.
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If all of the above conditions are met, the seller recognizes revenue from the sales
transaction at the time of the sale and any costs or losses expected in connection with returns are
accrued.
Other External Factors:
As a manufacturing business, the company is subject to the risks generally associated with
doing business abroad. The company imports more of its merchandise from contract manufacturers
located outside of the United States, primarily in the Far East. From time to time, the U.S.
government has considered imposing punitive tariffs on apparel and other exports from other
countries. The imposition of any such tariffs could disrupt the supply of the company’s products,
which could have a material adverse effect on the company’s results of operations.
Most companies’ purchases from contract manufacturers in the Far East are denominated
in United States dollars; however, purchase prices for the company’s products may be impacted by
fluctuations in the exchange rate between the United States dollar and the local currencies of the
contract manufacturers, which may have the effect of increasing the company’s cost of goods. In
addition, the company’s sales in other countries are denominated in the local currencies of the
applicable specialty retailer, which may have negative impact on profit margins or the rate of
growth of sales in those countries if the U.S. dollar were to strengthen significantly.
Since the entity purchases and distribute goods all over the globe, risks associated with
operating in the international arena include:





Economic instability, including possible revaluation of currencies
Extreme currency exchange fluctuations where the company has not entered into
foreign currency forward and option contracts to manage exposure to certain foreign
currency commitments hedged ay forward transactions
Changes to import or export regulations including quotas
Labor or civil unrest
In certain parts of the world, political instability.
Athletic and outdoor products are highly differentiated and customized, and different firms
produce different products targeted to a wide range of market niches and end-users. Indeed, the
process of growth in this industry is driven by segmentation: firms develop products and brands
that are targeted to increasingly more finely disaggregated groups of consumers. The categories
that define the industry change over time as firms define and develop new markets.
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Answer to Questions
1. What is the proper treatment of misstatement of amounts that falls below the materiality
threshold set by the auditors?
International Standard on Auditing (ISA) 320 on Audit Materiality defines materiality in the
following terms: Information is material if its omission or misstatement could influence the
economic decisions of users taken on the basis of the financial statements. Materiality depends on
the size of the item or error judged in the particular circumstances of its omission or misstatement.
Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative
characteristic which information must have if it is to be useful. Materiality is an expression of the
relative significance or importance of a particular matter in the context of the financial statement as
a whole. International Standard on Auditing 450 on Evaluation of Misstatement Identified during
the Audit also defines misstatement as a difference between the amount, classification,
presentation, or disclosure of a reported financial statement item and the amount, classification,
presentation, or disclosure that is required for the item to be in accordance with the applicable
financial reporting framework. Misstatements can arise from error or fraud.
In the case presented on North Face Inc. the amount of identified misstatement pertaining
to the revenue that the company recognizes on 1997 barter agreement which the company only
receives trade credits that as assessed by the auditors’ falls below the materiality threshold they set
should be adjusted. The auditors should demand adjustment on such misstatement because even
though the amount is quantitatively immaterial; the nature of the misstatement which arises in
violating the revenue recognition principle on Accounting for Nonmonetary Transactions which
generally precludes companies from recognizing revenue on barter transactions when the only
consideration received by the seller is trade credits is an action of fraud. It is fraud since there is an
intentional act as manifested by the Chief Financial Officer of not abiding into the standard to
obtain unjust advantage such as boasting revenues for higher compensation of the top level officers
including the his compensation.
The adjustment is based on the provision of International Standards on Auditing 110, which
states that in considering the proper treatment of the immaterial misstatement the auditor should
first considers the nature of the identified misstatements and the circumstances of their occurrence
because it may indicate that other misstatements may exist that when aggregated could be
material. The nature of the misstatement also provides information whether the misstatement is
due to fraud or error. The term error refers to an unintentional misstatement in financial
statements, including the omission of an amount or a disclosure while the term fraud refers to an
intentional act by one or more individuals among management, those charged with governance,
employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage.
An auditor is responsible for obtaining reasonable assurance that the financial statements as a
whole are free from material misstatement, whether caused by fraud or error. Accordingly, the
auditor is primarily concerned with the misstatements that have material effect on the financial
statements. However, in conducting the audit, the auditor may identify misstatements that do not
affect materially on the financial statements. Thus if the auditor identifies such misstatement, the
auditor should evaluate whether the misstatement is indicative of fraud. If such an indication exists,
the auditor should evaluate the implications of the misstatement in relation to other aspects of the
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audit, particularly the auditor’s evaluation of materiality, management and employee integrity, and
the reliability of management representations. Such misstatements if proven to be caused by fraud
should be adjusted because even though misstatements are primarily considered material based on
their peso value, they could also be material based on the nature in which they exist.
Secondly, the adjustment is based on the International Standard on Auditing 450 which is
the Evaluation of Misstatements Identified during the Audit which states that the auditor shall
communicate on a timely basis all misstatements accumulated during the audit with the
appropriate level of management, unless prohibited by law or regulation. In relation to this
provision the auditor should identify the appropriate level of management in which their report
should be addressed such as the stockholders of the corporation so that appropriate measures
could be acted upon.
The auditor shall request management to correct those misstatements even classified as
immaterial. Thus, the auditors should request management for adjustments even if the
misstatement identified is immaterial in relation to the financial statement as a whole. If
management refuses to correct some or all of the misstatements communicated by the auditor, the
auditor shall obtain an understanding of management’s reasons for not making the corrections.
Even if those corrections are below the materiality threshold the auditor should consider them in
relation to other factors such as whether it affects the compliance of the company to regulatory
requirements or whether it has the effect of increasing management compensation, for example,
by ensuring that the requirements for the award of bonuses or other incentives are satisfied.
If after an adjustment is badly needed but the management refused to implement it, the
auditors should document it and obtain a representation letter from management that they refused
to implement such adjustment. In doing so, the resposibility that rest to the auditor conserning
such needed adjustment is transferred to the management.
Misstatements that might escape adjustment because they fall below general quantitative
benchmarks for materiality may affect future decisions if not evaluated effectively. It may relate to
the incorrect selection or application of an accounting policy that has an immaterial effect on the
current period’s financial statements but is likely to have a material effect on future periods’
financial statements. Take for example the case of North Face Inc., the misstatement resulting from
the recognition of revenue from a barter transaction falls below the materiality level set by the
auditors during the conduct of the 1997 audit. It signifies that the 1997 financial statement is not
misstated if taken as a whole upon the undiscovered oral side agreement initiated by the firm’s
Chief Financial Officer. A proposed audit adjustment was recommended by the auditor but was
ignored by the north face management. In the succeeding years, only substantial amount of the
goods in the barter transaction was sold and thus the goods unsold were returned to the north face
company. This imply that the revenue recognized in 1997 should have not been there and proposed
audit adjustments should be followed to correctly state the income earned during that period and
so with the affected retained earnings. In effect, the succeeding balance of the retained earnings is
incorrect so with the other related accounts.
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2. What are the principal objectives and characteristics of audit workpapers? What are the
implications of altering the working papers without documenting the changes?
Audit workpapers should be prepared to achieve the following purposes as provided by the
International Standards on Auditing 230 - Audit Documentation:
• Evidence of the auditor’s basis for a conclusion about the achievement of the overall
objectives of the auditor
• Evidence that the audit was planned and performed in accordance with ISAs and applicable
legal and regulatory requirements.
• Assisting the engagement team to plan and perform the audit.
• Assisting members of the engagement team responsible for supervision to direct and
supervise the audit work, and to discharge their review responsibilities in accordance with
ISA 220
• Enabling the engagement team to be accountable for its work.
• Retaining a record of matters of continuing significance to future audits.
• Enabling the conduct of quality control reviews and inspections in accordance with ISQC 13
or national requirements that are at least as demanding.
• Enabling the conduct of external inspections in accordance with applicable legal, regulatory
or other requirements.
Because audit workpapers serve a variety of important objectives, auditors need to exercise
care when preparing them. Thus, five essential characteristics of workpapers should be considered
throughout the audit process.
1. Completeness - each workpaper should be completely self-standing and self-explanatory. If
a workpaper is separated from the engagement file, readers should be able to ascertain the
purpose, work performed, and results based solely on information included on that single
workpaper. Because internal and external parties reviewing audit documentation may only
select a sample of files, all individual documents must provide adequate evidence of the
work performed.
2. Accuracy - high-quality workpapers include statements and computations that are accurate
and technically correct. Errors included in final workpapers certainly will shed doubt on the
procedures performed and results noted from an internal or external review perspective.
One way to verify that workpapers contain accurate computations is to evidence additions
of data using defined tick marks and to cross-reference computation data to source
documentation. Auditors should also clearly differentiate statements based on facts from
those based on inquiry or matters of judgment.
3. Organization - logical system of numbering and a reader friendly layout so a technically
competent person unfamiliar with the project could understand the purpose, procedures
performed, and results. The workpapers should be arranged logically and cross-referenced
from source documentation to test grids and audit work steps. The cross-referencing should
extend to an issue summary that links to the audit report, thus clearly communicating the
derivation of audit observations.
4. Relevance & Conciseness - Audit workpapers and items included on each workpaper should
be relevant to meeting the applicable audit objective. Writing concise notes and removing
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unnecessary pages of bulky policies will also help improve the efficiency of review and
ultimately the quality of the documentation.
The working papers should contain the following key elements for easy use and reference:
a. Source. The name and title of the individual providing the documentation should be
recorded to facilitate future follow-up questions or audits.
b. Scope. The nature, timing, and extent of procedures performed should be included on each
workpaper for completeness. It is also helpful to include a statement describing the purpose
of the particular document with respect to the audit objective.
c. Reference. A logical workpaper number cross-referenced to audit program steps and issues
should be included.
d. Sign-off. The preparer's signature provides evidence of completion and accountability,
which is an essential piece of any third-party quality review.
e. Tick mark legend. A concise definition of all tick marks should be included on each audit
workpaper or at a central location to clearly describe the work performed during the
engagement.
f.
Exceptions. Audit exceptions should be documented and explained clearly on each
workpaper using logical numbering that cross-references to other workpapers.
B.)
The principal objective of work paper preparation is the documentation of the audit
procedures performed. From those procedures flow the information and conclusions that will be
contained in the final audit report. Thorough, credible, and accurate workpapers are the foundation
of the audit process, and provide the basis for subsequent reporting. In the workpapers, staff
auditors describes the work performed, methods used, and conclusions drawn, which are subject to
review by a supervising auditor.Furthermore, the workpapers serve as the connecting link between
the audit assignment, the auditor's fieldwork, and the final report. In connection with this, altering
of the workpapers without documentation of the changes makes succeeding auditors reviewing the
papers come-up to a different understanding.
Modifications of the working paper without proper documentation should not be permitted
because as the standard states any addition, deletion, or modification to the working papers after
they had been finalized in connection with the completion of the audit may be made only with
appropriate supplemental documentation, including an explanation of the justification for the
addition, deletion, or modification. This is because changing of the working papers without
documentation means modifying the contents of the document which portrays the planning and
performance of the audit (including the nature, timing and extent of audit procedures);supervision
and review of audit work;audit evidence (including oral representations) obtained to support the
audit opinion (including conclusions drawn). Thus, it makes the opinion about the financial
statement questionable since the workpapers are manipulated to achieve such opinion. This is
because the workpapers should be the basis in achieving the audit opinion and not the audit
opinion be the basis in preparing for the audit workpapers.
The above stated objectives of the audit workpapers were undercut by the decision of the
Deloitte auditors to alter North Face’s 1997 audit workpapers. First, by modifying the 1997
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workpapers and not documenting the given revisions in those workpapers, the Deloitte auditors
destroyed audit evidence, evidence that demonstrated that the 1997 audit team had properly
investigated the authoritative literature relevant to barter transactions and proposed an audit
adjustment consistent with the requirements of that literature. Second, the alteration of the 1997
workpapers affected the decisions made on the 1998 audit. That is, the auditors during the 1998
audit relied on the apparent decisions made during the 1997 audit and thus reached an improper
decision on the accounting treatment that would be appropriate for the barter transaction
recorded by North Face in January 1998.
3. How will the auditor investigate allegations of improper revenue recognition whether it is
indicative of fraud?
Inquiries into alleged improper revenue recognition usually begin with a review of the
entity’s revenue recognition policies and customer contracts. The auditor considers the
reasonableness of the company’s normal recognition practice and whether the company has done
everything necessary to comply. The investigation begins with a detailed reading of the contract
terms and provisions. Particular attention should be focused upon terms governing (i) payment and
shipment, (ii) delivery and acceptance, (iii) risk of loss, (iv) terms requiring future performance on
the part of the seller before payment, (v) payment of up-front fees, and (vi) other contingencies.
The auditor must consider timing – particularly as it relates to the company’s quarter and year-end
periods. These involves periods in which the sales agreements are obtained, the period in which
the product or services are delivered, the period in which the obligation of the buyer to pay arises
and whether additional services are required from the seller. In the absence of a written
agreement, the auditor should consider other evidence of the transaction, e.g. purchase orders,
shipping documents, payment records, etc. The auditor should also consider SAB 101 or the New
Revenue Recognition Guideline as pronouncements specific to the particular business, as
accounting literature often contains relevant examples and issues. Being aware of the applicable
authority governing the facts and circumstances can assist the auditor in his determination of
recognition violations.
Next, the auditor should inquire to the management and other relevant personnel as to the
existence factors causing the auditor to believe that the scheme exists. This procedure enables the
auditor to obtain additional evidence as to whether the improper revenue recognition is in place
and whether it is intentional in nature or the person that recognized the revenue just overlooked
the proper treatment for such transaction. Proper inquiry procedure is of at most importance in
obtaining the right information because if fraud is committed it is surely properly concealed. The
basic premise of the inquiry process is that auditors often find individuals are more likely to provide
valuable information when directly questioned about fraud, rather than voluntarily coming forward
with such information. Lack of appropriate consideration for inquiry procedures may have adverse
consequences as the individuals involved may have premature notice of the investigation, morale of
other employees may he compromised, customer relations may be strained, or critical evidence
may be destroyed before the investigation has been completed.
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When making such inquiries, auditors should realize that management is often in the best
position to perpetrate fraud, and use professional judgment in determining whether corroborating
responses are necessary. Auditors should obtain additional evidence to resolve any inconsistencies
in responses, as well as make inquiries of audit committees, internal auditors, and others that might
have information helpful in identifying fraud risks. Auditors should obtain an understanding of how
the audit committee exercises fraud oversight, and must directly ask the audit committee, or its
chair, about fraud risks or knowledge of actual or suspected fraud. Internal auditors should be
asked about procedures performed during the year to identify or detect fraud, and the adequacy of
management's responses to such procedures.
Depending on the responses obtained, the auditor may change the involving nature, timing,
and extent of procedures to address the identified risks. For example, an auditor might change the
nature of testing to obtain more reliable evidence or additional corroborative information from
external sources, including public-record information about key customers or counterparties to a
major transaction. Finally, auditors should inquire of individuals outside of financial reporting areas
about the existence or suspicion of fraudulent activities. These inquiries might serve to corroborate
management responses, and may provide information regarding possible management override of
controls, or information that is useful in evaluating the effectiveness of management's policies
regarding ethical behavior. Auditors might also make inquiries of employees in various
management levels; of in-house and legal counsel; and of persons involved in initiating, recording,
or processing complex or unusual transactions. Additional evidence should be obtained to resolve
any inconsistent responses to inquiries.
Where potential improper revenue recognition schemes raise the risk of material
misstatement due to fraud, an auditor might consider the following items:
 Analytical procedures specifically related to revenue using disaggregated data, and
 Confirmation from customers of the absence of side agreements, such as acceptance and
delivery or payment terms.
Statement on Auditing Standards 99 which talks about consideration of fraud in the financial
statement audit also introduces the following considerations:



The inquiry of sales and marketing personnel or in-house legal counsel concerning unusual
terms or conditions, especially if related to sales or shipments near year-end;
Auditor presence at various locations at year-end to observe shipment of goods or returns
awaiting processing and performance of other appropriate sales and inventory cutoff tests;
When revenue transactions are electronically processed, the testing of related controls to
provide assurance that revenue transactions occurred and were properly recorded.
Computer-assisted techniques can help identify unusual or unexpected revenue
circumstances.
Auditors focus on activities that result in materially misstated financial statements. Intent
determines whether such activities are fraudulent or due to error. In addition to incentives,
pressures, and opportunities, many auditors consider rationalization a key element. Some persons'
attitudes or ethical values allow them to knowingly and intentionally perpetrate fraud.
Furthermore, even fundamentally honest persons can rationalize committing fraud under intense
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pressure. The statement on auditing standards categorizes fraud conditions into three namely:
incentives and pressures that will form part in their motives to perform the fraudulent act,
opportunities, and rationalizations.
MOTIVE
OPPORTUNITY
RATIONALIZATION
Figure 2 - The Fraud Triangle
SAS 99 states that auditors should ordinarily presume the risk of material misstatement due
to fraud with regard to revenue recognition and should perform analytical procedures related to
revenue accounts. Incentives and pressures can give rise to risk of material fraudulent
misstatements. Even absent specific fraud risks, auditors should consider the possibility that
management might override controls and evaluate that risk without regard to other conclusions or
previous experience. Auditors should ascertain whether identified fraud risks are pervasive to the
financial statements or related to specific account balances, transaction classes, or assertions. This
determination should help an auditor when designing appropriate testing procedures.
The fraud triangle above would be useful to the investigation of the revenue recognition of
the North Face Inc. in relation to the barter transactions of the company since the higher level of
management particularly their Chief Financial Officer has motives of increasing the revenue since
his compensation is directly tied to the financial performance. He would be the one to be suspected
because he is the one who initiated such barter transaction. He also has the opportunity being of a
higher position to conceal the frauds committed and to instruct the persons who is responsible in
recording revenue to recognize revenue from those things that should not have revenue
recognized. He can also rationalize fraudulent actions since he is also a CPA and obtained the same
training and education that the cops of accounting fraud has. Additionally, he inquire first from the
independent auditors on how to treat such transactions, consequently knowing how and when to
recognized revenue on such. Furthermore, he knows the materiality threshold of the audit team
thus making the revenue recognized in 1997 barter transaction to fit below the materiality level.
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Auditors should also determine whether management has established programs and
controls addressing identified fraud risks, and whether such programs and controls are both
suitably designed and operating effectively. The auditor should also consider whether such
programs and controls mitigate, or exacerbate, fraud risks. Even when controls appear to be
operating effectively, management can direct employees to help perpetrate fraud. Additionally, an
auditor should consider whether client accounting principles and policies, considered collectively,
create a possible bias leading to material misstatement.
Examination of journal entries would also be of great help to the auditors. An auditor should
obtain an understanding of controls over journal entries and other adjustments, identify and select
such entries for testing, and determine the timing of testing. An auditor should obtain an
understanding of the entity's financial reporting process, including identification of the type,
number, and usual monetary value of journal entries and other typical adjustments. He should also
determine who can initiate such entries, what approvals are required, and how journal entries are
recorded. The testing of journal entries should usually be concentrated at the end of the reporting
period, because fraudulent journal entries or other adjustments typically occur then.
Evaluating Audit Evidence
Auditors may be able to identify previously unrecognized risks of material fraudulent
misstatement by performing analytical procedures as substantive tests or by performing required
overall review stage analytics. Auditors must perform analytical procedures related to revenue
recognition through the end of the reporting period, and should be particularly wary of
uncharacteristically large amounts of income reported toward the end of the reporting period from
unusual transactions, as well as income that is inconsistent with previous periods or with cash flow
from operations. Additionally, some fraudulent activities might cause unexpected analytical
relationships because perpetrators find themselves unable to manipulate related variables to create
seemingly normal or expected relationships. Finally, auditors should evaluate whether responses to
analytical procedure inquiries have been vague, implausible, or inconsistent with evidential matter
obtained directly in the audit.
Near the end of fieldwork, an auditor should qualitatively evaluate whether accumulated
evidence and observations affect the earlier assessment of the risk of material fraudulent
misstatement. This evaluation may provide insight about whether additional or different audit tests
are needed. The auditor with final audit responsibility should ascertain that appropriate
communication regarding conditions or information indicative of material misstatement due to
fraud occurred among audit team members throughout the audit.
If misstatements are or may be the result of fraud perpetrated by higher-level management
but the effects are immaterial, an auditor should nevertheless reevaluate the initial fraud risk
assessment because such misstatements might indicate other problems related to management
integrity. Consequently, the auditor should consider how such findings affect the nature, timing,
and extent of testing, and assess the effectiveness of controls where control risk had been assessed
to be less than maximum.
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CONDITIONS THAT MIGHT CHANGE OR SUPPORT AUDITOR ASSESSMENT OF FRAUD RISKS
Discrepancies in the Accounting Records
 Transactions not recorded in a complete or timely manner, or the amount, accounting
period, or classification improperly recorded
 Unsupported or unauthorized balances or transactions
 Last-minute adjustments that significantly affect financial results
 Evidence of unauthorized employee access to systems and records
Conflicting or Missing Evidential Matter
 Missing documentation
 Documents that appear to have been altered
 Only photocopied or electronically transmitted documents are available, where originals
are expected
 Significant unexplained items on reconciliations
 Inconsistent, vague, or implausible responses regarding analytical procedure or other
inquiries
 Unusual discrepancies between entity records and confirmation replies
 Missing inventory or physical assets of significant magnitude
 Unavailable or missing electronic evidence, inconsistent with retention policies
Lastly, the auditor should investigate whether oral side agreements exist. This oral side
agreement are normally prepared and agreed to recognize revenues outside the normal reporting
channels of the business. Management often employs side arrangements to boost sales figures or
to meet sales targets or to obtain undeserved commissions. The existence of numerous side
agreements should raise red flags to the auditor and require further detailed inquiry as to the facts
and circumstances surrounding how, when and why the agreements were entered into.
4. How is recurring audit engagement in relation to professional skepticism affects audit
procedures?
Auditing Standards defined professional skepticism as an attitude that includes a
questioning mind, being alert to conditions which may indicate possible misstatement due to error
or fraud, and a critical assessment of audit evidence. This definition suggests that skepticism
influences the scope of the work, helps the auditor evaluate audit findings and ultimately conclude
whether sufficient appropriate audit evidence has been obtained to enable a ‘true and fair view’
opinion to be expressed on an entity’s financial statement.
According to ISA 240 which states that the auditor shall maintain professional skepticism
throughout the audit, recognizing the possibility that a material misstatement due to fraud could
exist, notwithstanding the auditor’s past experience of the honesty and integrity of the entity’s
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management and those charged with governance indicates that even in recurring audit
engagements the auditor should be always on the questioning mind when it comes to evaluating
audit evidence and on the evaluation of the financial statement as a whole.
Recurring audit engagement affect professional skepticism in that first, the past experience
of the competence, honesty and integrity of the entity’s management and those charged with
governance is in the mind of the auditor and he will keep it as it is until evidence to the contrary
exist. Moreover, risk assessment procedures will be affected as past experience suggest that there
is low level of risk that the management will commit fraud or manipulate transactions as suggested
by past audit.
Second, an inverse relationship between skepticism and trust exist. As the auditor-client
relationship lengthens, a behavioral bond develops between the auditor and the audited company
and as they become more familiar with each other, mutual trust replaces the auditor’s necessary
professional skepticism. At some point, it is argued, the degree of trust can become so great that
violations will not be challenged as auditors instinctively favor evidence that confirms their prior
beliefs. Thus, in an audit which discovers flaws in the financial statement of the client, the auditor
may neglect to perform additional substantive test that will confirm whether such inconsistency is
due to fraud or error.
Lastly, the belief that management and those charged with governance are honest and have
integrity reduces the critical assessment of the auditor towards the audit evidence gathered. This
includes questioning contradictory audit evidence and there liability of documents and responses to
inquiries and other information obtained from management and those charged with governance. It
also includes consideration of the sufficiency and appropriateness of audit evidence obtained in the
light of the circumstances. This makes the auditors to be satisfied with less persuasive evidence
when obtaining reasonable assurance. Professional skepticism is reduced by recurring audit as in
the case of discovering immaterial misstatement in the current period. Recurring auditors tend to
not thoroughly investigate it and recommend small audit adjustments as when they are personally
involved in waiving an immaterial audit adjustment in the prior year, they behave as though they
are committed to permitting the waived adjustment to roll over into the current year and offset
current year audit adjustments.
On the recurring audit engagement of the Deloitte and Touché, the auditors of such
engagement team tends to lower there professional skepticism in relation to evaluating evidences
of such engagement. We’ve say this because even though evidences of fraud are clearly on hand,
that is Richard Fiedelman, the senior and recurring partner discovered the revenue recognized on
the 2nd part of the barter agreement, he did nothing about it. In that transaction, the north face
company received only pure trade credits unlike on the first transaction in 1997 where the
company received cash as part payment but subject of course to some oral side agreements which
are concealed from the auditors. Fiedelman did not question nor challenge the revenue recognized
in such transaction. Moreover, he corroborate with the management in their assertions that
recognizing revenue from barter is correct even though it is not. He accomplished this by altering
the previous year’s workpapers which proposed an adjustment on the 1997 financial statement.
Moreover, Fiedelman as a recurring audit partner also failed to exercise due professional care in
connection with the review of The North Face's March 31, 1998 quarterly financial statements. The
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North Face recorded the 1998 barter transaction directly contrary to the conclusion reached by
Deloitte in its 1997 year-end audit, and yet Fiedelman failed to take steps to reconcile the 1997
conclusion with the company's treatment of the 1998 transaction.
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