A Case Study
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Table of Contents
Understanding of the North Face Entity
Understanding of the E
INDUSTRY LIFE CYCLE:
The Apparel Commodity Chain:
Demand and Competition
Other External Factors:
Answer to Questions
The Apparel Creation
The Fraud Triangle
Rules for Revenue Recognition in Manufacturing Industry
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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 financ
ial 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.
the fraud was publicly revealed, a partner of the company’s audit firm instructed his sub
to alter prior year audit workpapers for the client to conceal improper decisions made by himself
and his firm.
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 tho
roughly the barter transaction thus
making its previous audit opinion inappropriate.
How will the auditors maintain the integrity of the working papers and how will they
maintain professional skepticism relative
recurring audit engag
What is the proper treatment of misstatement of amounts that falls below the materiality
threshold set by the auditors?
What are the principal objectives and characteristics of audit workpapers? What are the
implications of alte
ring the working papers without documenting the changes?
How will the auditor investigate allegations of improper revenue recognition whether it is
indicative of fraud?
How is recurring audit engagement in relation to professional skepticism affects audit
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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
income 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 high
performance climbing and backpacking e
quipment. 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, T
he 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
nstantly 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
e, 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, sleep
ing 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 des
igned 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
and big wal
ls. 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
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 consu
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 g
oal is to increase brand awareness by projecting
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
tes 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.
dvantage 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
building brand. Brands assure customers that products will be perceived by others as beautiful. Self
image 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 techn
ical 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 g
eneral 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
andards, 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 fa
cilities and import quota capacity. Thus, any disruption in the
company’s ability to obtain manufacturing services could have a material adverse effect on the
The company does not only market its products in the United St
ates 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
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
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 inexpens
ive products can be supplied in the domestic
market. Considering this situation, competitiveness in cost and quality continue to key issues for
The apparel industry has served as a crucial stepping
stone in the economic development
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
intensive manufacturing operations from high
wage regions in the advanced
industrialized countries to
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, competitio
n 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 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
ble 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 seaso
nal 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 d
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 i
ndustry 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 conti
nually developing new products. While much innovation is around style, and
fashion trends, there is also continual effort to improve the performance characteristics of
Thus, research and development in this industry is very rapid.
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sts 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 diff
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.
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
y 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.
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. L
arge 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
act suppliers in Asia
there are not significant production cost
differences among firms.
The Apparel Creation
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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 fo
r 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 pub
lic 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 challe
nging 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
large sized firms.
There are relatively low barriers to entry in the athletic and outdoor cluster. Fi
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, b
ut not a barrier to starting a small firm.
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
y held, and self
financed (i.e. not from formal venture capital).
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,
Columbia, and Danner/LaCrosse . Several other companies that
Leatherman and Leupold Stevens, are likely in this category, but do not publicly disclose annual
Exits/Acquisitions and Legacy Brands.
hat 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
l 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 acquisi
tions 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
. (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 popula
r 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 involve
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.
is more recent, implying functional integration between internationally dispersed
Industrial and commercial firms have both promoted globalization, establishing two types of
international economic networks. One is "producer
driven and the othe
driven value chains, large, usually transnational, manufacturers play the central roles in
coordinating production networks. This is typical of capital
such as automobiles, aircraft, comput
conductors and heavy machinery. Buyer
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,
y located in developing countries. This pattern of trade
led industrialization has become
intensive, consumer electronics. Tiered networks of third
world contractors that
make finished goods for foreign buyers carry out production. Large re
tailers 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
on of goods separated from the design and marketing.
The lead firms in producer
driven chains usually belong to international oligopolies. Buyer
driven value chains, by contrast are characterized by highly competitive and globally decentralized
stems with low entry barriers. The companies that develop and sell brand
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 pr
chains at the point of production, while marketers and merchandisers exercise the main leverage in
driven value chains at the design and retail stages.
A notable feature of buyer
driven chains has been the creation since the mid
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 i
n 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 acti
vities 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 ou
tdoor 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 w
any single company with respect to its entire range of products but each company does have
significant competitors within each product category.
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 f
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 a
nd 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 provi
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
eferential 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
United States Free Trade
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 te
xtile 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 ste
m labor migration
to production centers and cities.
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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
nterprises, and SEC Staff Accounting Bulletins (SABs) No. 101, Revenue Recognition in
Financial Statements, and No. 104, Revenue Recognition. For example, consider 3M's revenue
Revenue is recognized when the risks and rewards of ownersh
ip 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 i
ndustry are summarized below (see also
the discussion in Chapter FIN
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 da
te 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 phy
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 br
the resale of the product by the buyer.
When Is Revenue Recognized?
Delivery FOB, Factory
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.
High Rates of Return
At time return period expires (assumes rate of return cannot be
At time of delivery if installment receivable has
estimate; otherwise not until actual collection.
At time of delivery if irrevocable letter of credit; otherwise at time of
Rules for Revenue Recognition in Manufacturing
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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
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 produ
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
ency 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 incl
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
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
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 d
efines 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 i
n 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 o
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 differenc
e 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 f
ramework. 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 cre
dits 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
ing 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 ident
ified 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 fra
ud 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 wi
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
rially 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 misstatemen
t 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 b
ecause 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
he 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 m
anagement 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
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 con
sider 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 fut
ure 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 signif
ies 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 fa
ce 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
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 b
International Standards on Auditing 230
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
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 respon
sibilities in accordance with
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
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, auditor
s need to exercise
care when preparing them. Thus, five essential characteristics of workpapers should be considered
throughout the audit process.
each workpaper should be completely self
standing and self
a workpaper is sep
arated 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
a sample of files, all individual documents must provide adequate evidence of the
quality workpapers include statements and computations that are accurate
and technically correct. Errors included in final workpapers certai
nly 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
nce computation data to source
documentation. Auditors should also clearly differentiate statements based on facts from
those based on inquiry or matters of judgment.
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
from source documentation to test grids and audit work steps. The cross
extend to an issue summary that links to the audit report, thus clearly communicating the
derivation of audit observations.
Relevance & Conciseness
Audit workpapers and items included on each workpaper should
be relevant to meeting the applic
able 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 e
asy use and reference:
Source. The name and title of the individual providing the documentation should be
recorded to facilitate future follow
up questions or audits.
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.
Reference. A logical workpaper number cross
referenced to audit program steps and issues
off. The preparer's signature provides evidence of completion and accountability,
which is an essential piece of any third
party quality review.
Tick mark legend. A concise definition of all tick marks should be included on each audit
per or at a central location to clearly describe the work performed during the
Exceptions. Audit exceptions should be documented and explained clearly on each
workpaper using logical numbering that cross
references to other workpapers.
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 workpap
ers 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.Furthermo
re, 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
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
ocumentation 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 representat
ions) 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 basi
s 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 wo
rkpapers. 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 l
iterature 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 19
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 c
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 b
e 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.
itor must consider timing
particularly as it relates to the company’s quarter and year
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 obl
igation 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 recor
ds, 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
y governing the facts and circumstances can assist the auditor in his determination of
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 tre
atment 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 individual
s 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, audito
rs 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
sponses, 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 di
rectly 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
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 evid
ence 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
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 effective
ness 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 transa
ctions. 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:
lytical 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 shipment
s near year
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.
assisted techniques can help identify unusual or unexpected revenue
uditors 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 ration
alization 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.
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
ccounts. 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
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 wh
en designing appropriate testing procedures.
would be useful to the investigation of the revenue recognition of
the North Face Inc.
in relation to the barter transactions of the
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 s
uch barter transaction.
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
He can also
e fraudulent actions
since he is also a CPA and obtained the same
training and education that the cops of accounting
Additionally, he inquire first from the
independent auditors on how to treat such transactions, consequ
ently 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.
The Fraud Triangle
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Auditors should also determine wh
ether 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 mitig
ate, or exacerbate, fraud risks. Even when controls appear to be
operating effectively, management can direct employees to help perpetrate fraud.
auditor should consider whether client accounting principles and policies, considered collect
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 selec
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 typi
cal 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 perfo
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 towa
rd 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 p
erpetrators 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 wit
h 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
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
fraud occurred among audit team members throughout the audit.
If misstatements are or may be the result of fraud perpetrated by higher
but the effects are immaterial, an auditor should nevertheless reevaluate the initial fraud ris
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 wh
ere 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, accou
period, or classification improperly recorded
Unsupported or unauthorized balances or transactions
minute adjustments that significantly affect financial results
Evidence of unauthorized employee access to systems and records
Missing Evidential Matter
Documents that appear to have been altered
Only photocopied or electronically transmitted documents are available, where originals
Significant unexplained items on reconciliations
, vague, or implausible responses regarding analytical procedure or other
Unusual discrepancies between entity records and confirmation replies
Missing inventory or physical assets of significant magnitude
Unavailable or missing electronic eviden
ce, 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. Man
agement 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 fact
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
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, hel
ps 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 t
hat 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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ement 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.
ng 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 evi
dence 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 r
elationship between skepticism and trust exist. As the auditor
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 neces
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
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 m
anagement 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
ining 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.
e 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
ly on hand,
that is Richard Fie
, 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 un
like on the first transaction in 1997 where the
company received cash as part payment but subject of course to some oral side agreements which
ncealed from the auditors. Fiedel
man did not question nor challenge the revenue recognized
in such transact
ion. 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
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 d
irectly 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.