Executives of The North Face, Inc., faced a troubling dilemma during the 1990s.1 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 stores, did not want North Face to market its merchandise to major discount retailers such as Wal-Mart 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.

Hap Klopp founded North Face in the mid-1960s to provide a ready source of hiking and camping gear that he and his many 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 attempts 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 Hal 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 its 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 of those challenges was maintaining quality control in North Face’s cramped production facilities.

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 operations to third parties. By 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 highly 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 about-face 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 profi ts. 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........

Questions

1. Should auditors insist that their clients accept all proposed audit adjustments, even those that have an “immaterial” effect on the given financial statements?
Defend your answer.

2. Should auditors take explicit measures to prevent their clients from discovering or becoming aware of the materiality thresholds used on individual audit engagements? Would it be feasible for auditors to conceal this information from their audit clients?

3. Identify the general principles or guidelines that dictate when companies are entitled to record revenue. How were these principles or guidelines violated by the \($7.8\) million barter transaction and the two consignment sales discussed in this case?

4. Identify and briefly explain each of the principal objectives that auditors hope to accomplish by preparing audit workpapers. How were these objectives undermined by Deloitte’s decision to alter North Face’s 1997 workpapers?

5. North Face’s management teams were criticized for strategic blunders that they made over the course of the company’s history. Do auditors have a responsibility to assess the quality of the key decisions made by client executives? Defend your answer.