1. 1. 1998 Audit Daniel ReynoldsUniversity of Texas at Arlington July 2011 1
2. 2. Just For Feet Superstores 1988 opens first superstore inBirmingham, AL1 1994 initial public offering(IPO) 1 1997 - expands intomall/specialty segment withAthletic Attic & Imperial Sportsacquisitions1 1998 expands into northeastU.S. with Sneaker Stadiumacquisition1 2
3. 3. Rapid growth 1991-1998 1Amounts in $ millions1991 1992 1993199419951996 1997 1998Revenues 817 2456 120 256479775Net income 0003 10 14 21 27Superstores235 15 27 50 73132 3
4. 4. Key eventsNovember 1998 February 1999 November 16 announces first national advertising campaignto cost $25-30 million2 December 10 announces $200 million three-year creditfacility3 January 21 announces change in fiscal year end fromJanuary 31 to January 304 January 22 announces Super Bowl TV commercial andHummer giveaway promotion5 January 31 - begins new fiscal year with Super Bowl TV6commercial/promotion February 2 - announces 1998 fourth quarter record sales74
5. 5. Why change fiscal year-end? January year-ends arecommon in the retailindustry 52/53 week years endingSaturday or Sunday arecommon in the retailindustry Just For Feet also coulddefer into fiscal 1999 about$6.7 million in costs for theSuper Bowl TV commercial 5
6. 6. 1998 audit8 Firm Deloitte & Touche LLP,Birmingham, AL Partner Steven H. Barry with firm since 1976 partnersince 1988 managingpartner since 1996 Manager Karen T. Baker with firm since 1989 2011 Deloitte Global Services Limitedmanager since 1995 6
7. 7. Fraud Risk Factors9 AU 316.85 7
8. 8. Attitudes/rationalizations 9 Nonfinancial managements determination ofsignificant estimates Excessive interest in maintaining stock price orearnings trend Practice of committing to analysts, creditors toachieve aggressive or unrealistic forecasts 8
9. 9. Opportunities 9 Assets, liabilities, revenues or expenses based onsignificant estimates or subjective judgments thatare difficult to corroborate Significant transactions, especially those close toperiod end that pose substance over formquestions Domination of management by a single person Ineffective oversight over the financial reportingprocess9
10. 10. Oversight over financial reporting 10 Good Audit Committee comprised of two outside directors Not so good One member was president of clients primary bank towhom client owed $189 million Worse Audit Committee only met once during 1998 10
11. 11. Incentives/pressures 9 Recurring negative cash flows from operationswhile reporting earnings and earnings growth Need to obtain additional debt or equityfinancing for capital expenditures Marginal ability to meet debt repayment orother debt covenant requirements 11
12. 12. Negative cash flows 1Amounts in $ millions 1994 1995 1996 1997 1998Net income 3 10 14 21 27Cash flow from operations-11 -6-42-26-82Cash on hand36 97139 82 12Current liabilities 69 85147156133Quick ratio 0.52 1.14 0.95 0.53 0.0912
13. 13. Zone of InsolvencyAmounts in $ millionsCash on hand 12.4Annual revenues 774.9Cash flow from operations (82.1) 857.0Divide by 365Daily cash requirement2.3Number of days cash on hand5.313
14. 14. Debt covenants1 Borrowed $189 million December 1998 1 Borrowed $80 million February 1999 11 Required by bank to maintain Leverage ratio 3.00 to 1.00 Fixed charge coverage ratio 1.75 to 1.00 Minimum tangible net worth - $230 million Funded debt to capitalization 0.50 to 1.00 Capital expenditures limit - $25 million 14
15. 15. Accounting misstatements8 8 Advertising co-op credits receivable $28.9 million ($19 million net of tax)8 Vendor booth displays $9 million ($6 million net of tax) 8 Allowance for inventory obsolescence $0.4 million ($0.3 million net of tax)12 Advertising rebate receivable $5.3 million ($3.6 million net of tax) 15
16. 16. Advertising co-op credits receivable Common in retail industry Manufacturers help pay for advertising costs To incentive retailers to buy their products and To promote them in their local markets Accounting varies Some companies credit advertising expense tooffset cost of advertising Others credit inventory purchases to ultimatelyoffset cost of goods sold 16
17. 17. Advertising co-op credits receivable8 Balance of receivable $28.9 million compared to $0.4 million prior year Client executive caused accounting to record $23.8 million, of which $14.4 million was booked in March 1999 17
18. 18. Advertising co-op credits receivable 8 Sufficient appropriate audit evidence is to be9obtained (AU 326.01) No supporting documentation for the year-end entries was provided to test the Existence 8assertion (AU 326.15.b.ii) None of the purported receivables collected8by the Report Date April 2318
19. 19. Advertising co-op credits receivable Auditors attempted to confirm balances with8vendors (AU 330.04) 13 vendors owing $22 million of the $28.9 million8 Most of the vendors returned ambiguous orcontradictory confirmations8 Some of the vendors returned false confirmations8 At least one false confirmation was received April22 - one day before the report date13 19
20. 20. Advertising co-op credits receivable8 For confirmation evidence to be appropriate it must 9be reliable and relevant (AU 330.11) When the auditor has not received replies to positiveconfirmation requests, he or she should apply 9alternative procedures (AU 330.31) Auditors apparently evaluated the results of theconfirmation procedure as having provided"sufficient audit evidence" (AU 330.33); therefore, 8 The balance was accepted without adjustment 20
21. 21. Vendor booth displays8 Vendors setup their own merchandise boothsinside the stores to feature their own products No written contracts and little documentation Prior to 1996 the booths were simply providedat no charge21
22. 22. Vendor booth displays, 1996-19978Vendor invoiced client forpurchase of booth DR Booth Assets CR Accounts PayableVendor then issued credit forcost of booth to be usedagainst other purchases DR Accounts PayableCR Expenses22
23. 23. Vendor booth displays, 19988 Eliminated vendor involvement Client executive simply estimated annual boothvalue, then divided by 12 for monthly journal entryDR Booth Assets$174,000 CR Expenses$174,000 Result First 8 months ($174,000 x 8) $1.4 million October 31, 1998$5.4 million November 1998 January 1999$2.2 million Total for year$9.0 million 23
24. 24. Vendor booth displays audit8 Since there was no evidence supporting $9 millionassets, auditors decided to confirm the value ofbooths (AU 330.11.d)9 Sent confirmations for $8.4 million of Booth Assetsto vendors Auditors received and accepted ambiguous replies tothese confirmations The response of at least one vendor promptedauditors to propose an adjustment (AU 330.33)9,which was rejected by client24
25. 25. Allowance for inventory obsolescence Just For Feet was in the fashion retail industry Inventory had almost doubled $400 million, from $206 million prior year1 Leaving almost one-year supply on hand Cost of goods sold was $452 million for 19981 Yet, allowance for obsolescence Only $150,000 (0.0375%) Same amount as prior year8 25
26. 26. Allowance for inventory obsolescence Auditor evaluated reasonableness of estimate (AU9342.09) Based on incomplete analysis prepared by client thatwas apparently overlooked by the auditors (AU8342.10) Auditor proposed $441,000 increase to allowance8(AU 342.14) ; however, 8 Management refused to record the adjustment In June 1999 client announced that it had14 $50 million excess inventory as of May 1 26
27. 27. Advertising rebate receivable This scam was not cited in SEC action regardingauditors8 A client executive: Arranged a fiscal 1999 rebate with outside advertising agency, then Caused that amount to be accrued as receivable for fiscal 1998, then Arranged to have agency overbill client by $250,000, so The agency would have the funds, to then Make a partial payment on the bogus receivable, to Deceive the auditors into accepting the balance13 27
28. 28. National review partner As a high-risk audit the workpapers weresupposed to be reviewed by the NationalOffice prior to report issuance8 Intended to provide reasonable assurance that 9the audit conformed with GAAS (AU 161.02) ;however, There was no documentation that this reviewwas done for the 1998 audit828
29. 29. 1999 SEC filings madeWhich included auditor consent The SEC becomes involved when the auditorconsents to having his/her opinion included in aclient filing under the 1933 and/or 1934 Acts April 27 1 Form 10-K annual report Form S-8 to register stock for employee benefit 15plan June 4 16 Form S-4 to register junk bonds 29
30. 30. Key events post-audit June 14 Form 10-Q17 Disclosure of $50 million excess inventory Disclosure of possible loan covenant violations June 16 - announcement14 Expected 2nd quarter loss Credit frozen by bank due to covenant violations November 4- announcement18 Chapter 11 bankruptcy reorganization December 7 Form 8-K19 Auditor resignation January 27, 2000 announcement20 Bankruptcy converted to Chapter 7 liquidation30
31. 31. Criminal and civil penalties 31
32. 32. Criminal penalties 21 Just For Feet executives Don-Allen Ruttenberg Adam Gilburne Stephen Davis Vendor executives Jonathan Epstein, Fila USA Timothy McCool, Adidas Thomas Shine, Logo Athletic Steven Dodge, Converse32
33. 33. SEC civil penalties Just For Feet executives Eric Tyra, chief financial officer Fined $67,500; 10-year suspension by SEC22 Peter Berman, controller Fined $51,32723 Deloitte & Touche8 Firm paid $375,000 fine Steven Barry suspended for 2 years Karen Baker suspended for 1 year33
34. 34. Bankruptcy settlement 24Ruttenberg Estate $15.0 millionDeloitte & Touche $24.0 millionOutside directors $41.5 millionTotal $80.5 million34
35. 35. 1999 Super Bowl TV commercial25 35
36. 36. References1 Just For Feet, Inc. (1999). Form 10-K for the Fiscal Year Ended January 30, 1999 (CIK: 00000918111). Retrieved11 July 2011 from Securities and Exchange Commission www.sec.gov.2 Just For Feet, Inc. (1998). Just For Feet Hires Agency To Create Launch Ad For National Branding Campaign ToPremiere On Superbowl. Retrieved 11 July 2011 from PR Newswire www.prnewswire.com.3 Just For Feet, Inc. (1998). Just For Feet, Inc. Closes $200,000,000 Credit Facility. Retrieved 11 July 2011 from PRNewswire www.prnewswire.com.4 Just For Feet, Inc. (1999). Just For Feet, Inc. Announces Comparable Store Sales for Quarter toDate, Preliminary Estimates and Change in Fiscal Year. Retrieved 11 July 2011 from PR Newswirewww.prnewswire.com.5 Just For Feet, Inc. (1999). Just For Feet To Give Away a New Hummer During Super Bowl. Retrieved 11 July2011 from PR Newswire www.prnewswire.com.6 Stuart Elliott (1999). At $1.6 million for 30 seconds, few commercials proved worthy of their Super Bowlspotlight. The New York Times February 2, 1999. Retrieved 11 July 2011 from PR Newswirewww.nytimes.com.7 Just For Feet, Inc. (1999). Just For Feet, Inc. Announces Record Sales and Comp Store Sales For The FourthQuarter. Retrieved 11 July 2011 from PR Newswire www.prnewswire.com.8 Securities and Exchange Commission (2005). Accounting and Auditing Enforcement Release No. 2238, April26, 2005, in the Matter of Deloitte & Touche LLP, Steven H. Barry, CPA and Karen T. Baker, CPA, Respondents.Retrieved 11 July 2011 from www.sec.gov. 36
37. 37. References9AICPA (2010). Professional Standards, Volume 1, as of June 1, 2010.10Just For Feet, Inc. (1999). Proxy Statement Pursuant to Section 14(a) of the Securities Exchange Act of 1934(CIK: 00000918111). Retrieved 11 July 2011 from Securities and Exchange Commission www.sec.gov.11Just For Feet, Inc. (1999). Credit Agreement dated as of December 10, 1998 among Just For Feet, Inc. asBorrower, and The Lenders Named Herein, Compass Bank, et al. (Exhibit 10.5 to 1999 Form 10-K, CIK:00000918111). Retrieved 11 July 2011 from Securities and Exchange Commission www.sec.gov.12 Securities and Exchange Commission (2003). Securities and Exchange Commission v. Adam Gilburne.Litigation Release No. 18139, May 15, 2003. Retrieved 11 July 2011 from www.justice.gov.13United States District Court for the Northern District of Alabama (2004). United States of America v. JonathanG. Epstein, Defendant. Retrieved 11 July 2011 from www.justice.gov.14Just For Feet, Inc. (1999). Just For Feet, Inc. Responds to News Releases and Elaborates on Specialty StoreDifficulties. Retrieved 11 July 2011 from PR Newswire www.prnewswire.com.15Just For Feet, Inc. (1999). Form S-8 Registration Statement under the Securities Act of 1933. CIK:00000918111. Retrieved 11 July 2011 from www.sec.gov.16Just For Feet, Inc. (1999). Form S-4 Registration Statement under the Securities Act of 1933. CIK:00000918111. Retrieved 11 July 2011 from www.sec.gov.17Just For Feet, Inc. (1999). Form 10-Q for the Quarter Ended May 1, 1999 (CIK: 00000918111). Retrieved 11July 2011 from Securities and Exchange Commission www.sec.gov. 37
38. 38. References18Just For Feet, Inc. (1999). Just For Feet, Inc. Announces Filing for Relief Under Chapter 11 of the BankruptcyCode. Retrieved 11 July 2011 from PR Newswire www.prnewswire.com.19Just For Feet, Inc. (1999). Form 8-K Current Report as of December 7, 1999 (CIK: 00000918111). Retrieved 11July 2011 from Securities and Exchange Commission www.sec.gov.20 Just For Feet, Inc. (2000). Just For Feet, Inc. Announces Asset Auction. Retrieved 11 July 2011 from PRNewswire www.prnewswire.com.21United States Department of Justice (2004). Corporate Fraud Task Force Second Year Report to the President.Retrieved 11 July 2011 from www.justice.gov.22Securities and Exchange Commission (2005). Securities and Exchange Commission v. Eric Tyra, Scott Wynne,Peter Berman and Scott Carey. Litigation Release No. 19438, October 20, 2005. Retrieved 11 July 2011 fromwww.sec.gov.23Securities and Exchange Commission (2005). Securities and Exchange Commission v. Eric Tyra, Scott Wynne,Peter Berman and Scott Carey. Litigation Release No. 19163, March 31, 2005. Retrieved 11 July 2011 fromwww.sec.gov.23Lattman, Peter (2007). Settlement in Just For Feet Case May Fan Board Fears. The Wall Street Journal April23, 2007. Retrieved 11 July 2011 from www.wsj.com.25 Just For Feet, Inc. (1999). Super Bowl TV Commercial. Retrieved 11 July 2011 from YouTubewww.youtube.com. 38
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