Executives of The North Face, Inc., faced a troubling dilemma during the 1990s. For decades, those executives

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Executives of The North Face, Inc., faced a troubling dilemma during the 1990s. For decades, those executives had struggled to develop and maintain an exclusive brand name for their company’s extensive line of outdoor apparel and sporting equipment products. By positioning those products for the ‘“high-end” segment of the retail market, North Face’s management had consciously chosen to ignore the much larger and more lucrative mainstream market. This decision kept the company’s primary customers happy. Those customers, principally small, independent specialty sporting goods store, did not want North Face to market its merchandise to major discount retailers such as Walmart and Costco. Economic realities eventually forced North Face’s executives to begin selling the company’s products to the mainstream market via backdoor marketing channels. Unfortunately, the company’s relatively high-priced merchandise did not compete effectively with the mass-market brands sold by the major discount retailers.

Making matters worse, as the company’s merchandise began appearing on the shelves of discount retailers, those products quickly lost their exclusive brand name appeal, which caused North Face’s sales to its principal customers to drop sharply. North Face’s change in marketing strategies, the company’s decision to spend millions of dollars to relocate its headquarters from northern California to Colorado, and other gaffes by its management team caused Chief Executive magazine to include North Face among the nation’s five “worst-managed” corporations. A short time later, North Face’s public image and reputation on Wall Street would be damaged even more by public revelations that the company’s reported operating results had been embellished with various accounting and marketing gimmicks. Adventurers, Inc. Hap Klopp founded North Face in the mid-1960s to provide a ready source of hiking and camping gear that he and his any free-spirited friends and acquaintances needed to pursue their “back to nature’ quest. Initially, the business operated from a small retail store in San Francisco's North Beach neighborhood.

The company quickly added a mail-order sales operation. In 1970, North Face began designing and manufacturing its own line of products after opening a small factory in nearby Berkeley. Over the next decade, North Face endeared itself to outdoor enthusiasts by sponsoring mountain climbing expeditions across the globe, including successful attempt to scale Mount Everest, Mount McKinley, China’s K-2, and the highest peaks in South America. The name recognition and goodwill generated by these expeditions allowed North Face to establish itself as the premier supplier of top-quality parkas, tents, backpacking gear, and other apparel and equipment demanded by “professional” mountain climbers. Adding even more credibility to North Face’s merchandise was the lifetime warranty that Hap Klopp attached to each item his company sold and the fact that the United States Marine Corps purchased tents and other bivouac supplies from North Face.

North Face’s sterling reputation for rugged and durable hiking, camping, and mountaineering gear prompted company management to begin marketing related lines of apparel and sporting equipment for skiers, whitewater daredevils, and other outdoor types. Among the most popular items marketed by the company were tis Mountain Jacket, Snow Leopard Backpack, and Tadpole tent. The company’s expanding product line triggered rapid sales growth during the 1970s and 1980s. Similar to the management teams of many growth companies, North Face’s executives confronted several imposing challenges that could undermine their company’s financial success. The most critical challenges was maintaining quality control in North Face’s cramped production facilities.

2 Company executives prided themselves on producing only the highest-quality outdoor sporting equipment and apparel. To maintain the quality of that merchandise, they insisted on manufacturing all of North Face’s products in-house, rather than outsourcing some of the company’s manufacturing facilities could not satisfy the mid-1980s, North Face’s overburdened manufacturing facilities could not satisfy the steadily growing demand for the company’s merchandise or maintain the high-quality production standards established by management. North Face’s limited production capacity and mounting quality control problems caused the company to routinely deliver merchandise to retail stores after the peak selling seasons for its high seasonal products. The quality control problems also caused North Face to accumulate a large inventory of “seconds,” that is, merchandise items having minor flaws. In the late 1980s, North Face’s management made a decision it would soon regret. The company opened several outlet stores to dispose of obsolete and second-grade merchandise. This decision angered the specialty sporting goods stores that had been North Face’s primary customers since the company's inception. To pacify those customers, North Face did a quick about0face and closed the outlet stores.

Over the next several years, North Face continued to struggle with maintaining its image as the leading producer of high-quality outdoor apparel and sporting equipment, while at the same attempting to gradually ease into the mainstream retail market. By this time, Hap Klopp had left the company to become an author - one of his books was entitled The Complete Idiot’s Guide to Business Management. In fact, the company experienced several changes in company management and ownership during the late 1980s and throughout the 1990s. In July 1996, a new management team took North Face public, listing the company’s common stock on the NASDAQ exchange. Sold initially at $14 per share, the company’s stock price peaked at nearly $30 per share in February 1998, fueled by the company’s steadily increasing sales and profits. In fiscal 1994, North Face reported total sales of $89 million; four years later in fiscal 1998, the company's sales had nearly tripled, rising to approximately $250 million. Despite the company’s strong operating results, by early 1999 North Face’s stock price had plunged from its all-time high.

Persistent rumors that North Face’s management had enhanced the company's reported revenues and profits by “channel stuffing” and other questionable, if not illegal, practices caused the sharp decline in the stock price. To squelch those rumors, North Face’s board of directors attempted to purchase the company in a leveraged buyout underwritten by a large investment banking firm. That effort failed in March 1999 when NASDAQ officials halted public traded of North Face’s stock following an announcement that the company would be restating its previously reported operating results due to certain “bad bookkeeping.” In May 1999, North Face officials publicly revealed that their company’s audited financial statements for 1997 and the company’s pre audited operating results for 1998, which had been released in January 1999, had been distorted by fraudulent accounting schemes.

The principal schemes involved violations of the revenue recognition principle. For 1997, North Face’s reported revenues of $208.4 million had been overstated by approximately $5 million, while the company’s net income of $11.2 million had been overstated by $3.2 million. In January 1999, the company had reported unaudited revenue and net income of $263.3 million and $9.5 million, respectively, for fiscal 1998. The company’s actual 1998 revenues were $247.1 million, while the company’s actual net income for the year was $3.6 million. Bartering for Success at North Face The management team that took over North Face in the mid-1990s established a goal of reaching annual sales of $1 billion by 2003. Many Wall Street analysts believed North Face could reach that goal, given the 3 company’s impressive operating results over the previous several years. When the actual revenues and profits of North Face failed to meet management’s expectations, the company’s chief financial officer (CFO) and vice president of sales took matters into their own hands, literally. In December 1997, North Face began negotiating a large transaction with a barter company. Under the terms of this transaction, the barter company would purchase $7.8 million of excess inventory North Face had on hand near the end of fiscal 1997. In exchange for that inventory, North Face would receive $7.8 million of trade credits that were redeemable only through the barter company.

Historically, companies have used such trade credits to purchase advertising or travel services. Before North Face finalized the larger barter transaction, Christopher Crawford, the company’s chief financial officer, asked North Face’s independent auditors how to account for the transaction. The auditors referred Crawford to the appropriate authoritative literature for nonmonetary exchanges. That literature generally precludes companies from recognizing revenue on barter transactions when the only consideration received by the seller is trade credits. To circumvent the authoritative literature, Crawford restricted the transaction. The final agreement with the barter company included an oral “side agreement” that was concealed from North Face’s independent auditors.

Crawford, however, structured the transaction to recognize a profit on the trade credits. First, he required the barter company to pay a portion of the trade credits in cash. Crawford agreed that The North Face would guarantee that the barter company would receive at least 60 percent recovery of the total purchase price when it resold the product. In exchange for the guarantee, the barter company agreed to pay approximately 50 percent of the total purchase price in case and the rest in trade credits. This guarantee took the form of an oral side agreement that was not disclosed to the auditors. To further obscure the true nature of the large barter transaction, Crawford split it into two parts. On 29 December 1997, two days before the end of North Face’s fiscal 1997 fourth quarter,

Crawford recorded a $5.15 million sale to the barter company. For this portion of the barter deal, North Face received $3.51 million in cash and trade credits of $1.64 million. Ten days later, during North Face's first quarter of fiscal 1998, the company’s accounting staff booked the remaining $2.65 million portion of the barter transaction. North Face received only trade credits from the barter company for this final portion of the $7.8 million transaction. North Face recognized its normal profit margin on each segment of the barter transaction. Crawford, who was a CPA, realized that Deloitte & Touche, North Face’s auditors, would not challenge the $3.51 million portion of the barter transaction recorded during the fourth quarter of fiscal 1997. There was no reason for the auditors to challenge that component of the transaction since North Face was being paid in cash. Crawford also realized that Deloitte would disagree with the company’s decision to recognize revenue for the $1.64 million component of the barter transaction for which North Face would be paid exclusively in trade credits.

However, Crawford was aware of the materiality thresholds that Deloitte had established for North Face’s key financial statement items during the fiscal 1997 audit. He knew that the gross profit of approximately $800,000 on the $1.64 million component of the barter transaction fell slightly below Deloitte’s materiality threshold for North Face’s collective gross profit. As a result, he believed that Deloitte would propose an adjustment to reverse the $1.64 million item but ultimately “pass” on that proposed adjustment since it had an immaterial impact on North Face’s financial statements. In fact, that is exactly what Deloitte did. In early January 1998, North Face recorded the remaining $2.65 million portion of the $7.8 million barter transaction. Again, Crawford instructed North Face’s accountants to record the full amount of profit 4 margin on this “sale” despite being aware that accounting treatment was not consistent with the authoritative literature. Crawford did not inform the Deloitte auditors of the $2.65 million portion of the barter transaction until after the 1997 audit was completed.

The barter company ultimately sold only a nominal amount of the $7.8 million of excess inventory that it purchased from North Face. As a result in early 1999, North Face reacquired that inventory from the barter company. In the third and fourth quarters of fiscal 1998, Todd Katz, North Face’s vice president of sales, arranged two large sales to inflate the company’s revenues, transactions that were actually consignments rather than consummated sales. The first of these transactions involved $9.3 million of merchandise “sold” to a small apparel wholesaler in Texas. During the previous year, this wholesaler had purchased only $90,000 of merchandise from North Face. The Terms of this transaction allowed the wholesaler to return any of the merchandise that he did not resell and required North Face to pay all of the storage and handling costs for the merchandise. In fact, North Face arranged to have the large amount of merchandise stored in a warehouse near the wholesaler's business. Katz negotiated a similar $2.6 million transaction with a small California wholesaler a few months later.

Provide the debits and credits for North Face’s accounting of the first, $7.8 million transaction. Be certain to include the inventory component.

You are the auditor. Determine if NF correctly recorded the transaction referenced in A-1. If you determine they were not correct with the entry, how would you have recorded the transaction (not an AJE, the original transaction)? Provide the debits and credits. Assume for this question the recorded cost of the inventory in the transaction is $12.0 million.