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 Just 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 Just for Feet in the form of a credit memo offsetting expenses on Just for Feet's merchandise purchases from that vendor.
• In the last few weeks of fiscal year 1998, the company's CFO, controller, and VP of operations directed the company's accounting department to book $14.4 million in co-op receivables and related revenues that they knew were not owed by certain vendors, including Adidas, Asics, New Balance, Nike, and Reebok. The entry represented one half of the total accounts receivable balance at year-end. The auditors requested supporting documentation regarding the journal entry; however, client management never provided any. The auditors had mailed out confirmations to 13 vendors (representing 76 percent of the total accounts receivable balance). Five of the returned confirmations confirmed the amount owing, eight had ambiguous information regarding the amount owing, and one clearly stated that "no additional funds" were due to Just for Feet. The auditors completed their fieldwork three months after yearend and, as of that date, Just for Feet had not received any payments for the undocumented vendor allowances.
• Subsequently, it was revealed that the vendor allowances were fictitious and that the VP of operations had convinced the five vendors to sign and return the confirmations. These fraudulent practices, along with others, 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, some vendor representatives, and the auditors. Ultimately, the auditors were fined and sanctioned by the SEC. In response to the sanctions, the auditors issued a press release stating: "Among our most significant challenges is the early detection of fraud, particularly when the client, its management and others collude specifically to deceive a company's auditors." 2
REQUIRED
a. What does it mean to approach an audit with an attitude of professional skepticism?
b. Refer to the professional judgment framework from Chapter 4 to answer the next three questions:
i What circumstances related to the accounting treatment of the vendor allowances should have increased an auditor's professional skepticism? Why?
ii 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?
iii 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.
c. Based upon the case facts, do you agree with the auditors' statement regarding their inability to detect frauds involving collusion between client management and outsider parties?