The following information was obtained from several accounting and auditing enforcement releases issued by the Securities and Exchange Commission (SEC) after its investigation of fraudulent financial reporting involving lust for Feet, Inc.:
Just for Feet, Inc., was a national retailer of athletic and outdoor footwear and apparel based in Birmingham, AL. The company incurred large amounts of advertising expenses and most vendors offered financial assistance through unwritten agreements with Just for Feet to help pay for these advertising expenses. If Just for Feet promoted a particular vendor's products in one of its advertisements, that vendor typically would consider agreeing to provide an “advertising co-op credit” to the Company to share the costs of the advertisement Just for Feet offset this co-op revenue against advertising expense on its income statement, thereby increasing its net earnings. Although every vendor agreement was somewhat different, Just for Feet’s receipt of advertising co-op revenue was contingent upon subsequent approval by the vendor. If the vendor approved the advertisement, it would usually issue the co-op payment to lust for Feet in the form of a credit memo offsetting expenses on Just for Feet’s merchandise purchases from that vendor. During fiscal year 1998, die company’s CFO, controller, and VP of Operations directed the Company's accounting department to book co—op receivables and related revenues that they knew were not owed by certain vendors, including Asics, New Balance, Nike, and Reebok. These fraudulent practices resulted in over $19 million in fictitious pretax earnings being reported, out of total pretax income of approximately $43 million. The SEC ultimately brought charges against a number of senior executives at Just for Feet and some vendor representatives.
1. What does it mean to approach an audit with an attitude of professional skepticism?
2. What circumstances related to the accounting treatment of the vendor allowances should increase an auditor’s professional skepticism?
3. What factors might have caused the auditor to inappropriately accept the assertions by management that the vendor allowances should be reflected in the financial statements?
4. Develop three probing questions related to the vendor allowances that the auditor should have asked in the audit of Just for Feet’s financial statements.