Case 1.3 Just for Feet, Inc.

TABLE OF CONTENTS

Issues 1

Facts 1

Analysis 1

Conclusions 6

Bibliography 8

Issues

• Prepare common-sized balance sheet and income statements for Just for Feet for the period 1996-1998. Also compute key liquid, solvency, activity, and profitability ratios for 1997 and 1998. Given these data, comment on what you believe were the high-risk financial statements items for the 1998 Just for Feet audit.

• Just for Feet operated large, high-volume retail stores. Identify internal control risks common to such businesses. How should these risks affect the audit planning decisions for such a client?

• Just for Feet operated in an extremely competitive industry, or subindustry. Identify inherent risk factors common to business facing such competitive conditions. How should these risks affect the audit planning decisions for such a client?

• Prepare a comprehensive list, in a bullet format, of the risk factors present for the 1998 Just for Feet audit. Identify the five audit risk factors that you believe were most critical to the successful completion of that audit. Rank these risk factors from least to most important and be prepared to defend your rankings. Briefly explain whether or not you believe that the Deloitte auditors responded appropriately to the five critical audit risks factors that you identified.

• Put yourself in the position of Thomas Shine in this case. How would you have responded when Don-Allen Ruttenberg asked you to send a false confirmation to Deloitte & Touche? Before responding, identify the parties who will be affected by your decision.

Facts

Just for FEET, INC was started in Birmingham, Alabama in 1988. South African entrepreneur Harold Ruttenberg believed the market for athletic shoes was vulnerable to a new business model. He was right, and ten years later his “store-within-a-store” model had 300 locations and sales just shy of $775 million (Knapp, 2015). Impressively, Just for FEET continued to increase profits and sales in the late 1990s in spite of similar companies struggling in the increasingly competitive athletic shoe retail market. While continuing to promote the prospects of the company, Harold, his wife, and his son all sold much of their stock in the company in 1996. Three years later, Harold resigned as CEO and was replaced by a recovery expert after Just for FEET defaulted on a large interest payment (Knapp, 2015). Shortly after, the company filed for bankruptcy, which lead to investigations of both Just for FEET and their independent auditors, Deloitte & Touche. Many of the senior executives at Just for FEET were found guilty of intentionally misstating inventory values as well as improperly inflating revenue in a variety of ways. The top two auditors on the engagement were suspended and Deloitte & Touche was fined $375,000 by the SEC for ignoring obvious red flags over the course of the engagement (Knapp, 2015). Perhaps the biggest red flag was the “huge increase in vendor allowance receivables between the end of fiscal 1997 and fiscal 1998” (Knapp, 2015, p. 48). Deloitte sent receivables confirmations to Just for FEET’s suppliers to confirm the amounts, but the executive vice president at Just for FEET convinced many of the suppliers to sign the confirmations even though the amounts had been artificially inflated. Eight of the 13 confirmations that were sent back to Deloitte in non-standard letters with ambiguous statements and information, but Deloitte accepted the confirmations as valid anyways.

Analysis

• Prepare common-sized balance sheet and income statements for Just for Feet for the period 1996-1998. Also compute key liquid, solvency, activity, and profitability ratios for 1997 and 1998. Given these data, comment on what you believe were the high-risk financial statements items for the 1998 Just for Feet audit.

Common-size balance sheet

Common size balance sheet shows both the numerical values and the percentage of each account in relation to the total assets and total liabilities. It makes easier to analyze the chance of a company’s balance sheet over multiple time periods. A common-size balance sheet provides the financial position of a company.

To prepare a common size balance sheet for Just for Feet Inc for 1997-1999, each of the asset were converted to the equivalent common-size amount by dividing the value of the asset by the value of the total assets and multiplied with 100, then a percentage of asset value is determined. Same way was used for Liabilities, each individual liability was divided by the total liabilities and shareholder’s equity value and multiplied by 100.

The Just for Feet balance sheet shown in Exhibit 1 summarizes the common-size equivalents calculations for cash and cash equivalents and repeat the calculation for each of the assets and liabilities amounts from 1997 to 1999. The items that stand out in 1999 balance sheet as being potentially problematic are: Drop in cash equivalents from 36.9% of assets in 1997 to 1.8% in 1999; Increase in inventory from 35.5% of assets in 1997 to 58% in 1999; Increase in Accounts Payables from 10.3% of liabilities in 1997 to 14.46% of liabilities in 1999; Increase in Long Term debt from 2.8% in 1997 to 33.5% in 1999.

Common-size income statement

The common-size income statement for Just for Feet Inc was prepared by converting each of expenses listed to the equivalent common-size amount by dividing the value of expenses by the value of the total revenues. The calculation of the cos of sale was performed using cost of sale value and total sale value multiplied by 100. Each expense was divided by the net sales as denominator to get the percentage on sales.

The exhibit 2 shows a summarization of the common size equivalent calculation in the income statement. The item that stand out in the income statement as being potentially problematic are subtle, but they are meaningful when one considers that the company has very low net profit margins (ranging from 5% in 1997 to 3% in 1999). Increase in store operating cost from 27% of sale in 1997 to 30% in 1999.

Key Ratios for liquidity, solvency, activity and profitability ratios for 1998 and 1999

• Key liquidity ratios include the current ratio and the quick ratio:

• Current Ratio was calculated by dividing the current asset by current liabilities

Current ratio 1997

=

Current Asset 1997

Current Liabilities 1997

 

 

 

=

314,743

 

146,914

 

 

 

=

2.14

Current ratio 1998

=

Current Asset 1998

Current Liabilities 1998

 

 

 

=

311,167

 

155,706

 

 

 

=

2.00

• Quick ratios were calculated by dividing the sum of cash and equivalents, marketable securities and account receivable and other current assets (if they are liquid) by current liabilities.

Quick ratio 1997

=

Cash and Eq. + Marketable sec. + Accts. Rec. + Other Current Assets

Current Liabilities

 

 

 

=

138,785+33,961+6,553+2,121

 

146,914

 

 

 

=

181,420

 

146,914

 

=

1.235

Quick ratio 1998

=

Cash and Eq. + Marketable sec. + Accts. Rec. + Other Current Assets

Current Liabilities

 

 

 

=

82,490+0+15,840+6,709

 

155,706

 

 

 

=

105,039

 

155,706

 

 

0.67

• Key solvency ratios include debt-to-assets, time interest earned:

• Debt to Equity ratio was calculated by dividing the total debt by total assets. It is a ratio of debt over the equity.

Debt-to-Assets 1997

=

Long term Debt + Current Liabilities

Total Assets

 

 

 

=

10,364 + 146,914

 

375,834

 

 

 

=

157,278

 

375,834

 

=

0.42

Debt-to-Assets 1998

=

Long term Debt + Current Liabilities

Total Assets

 

 

 

=

24,562 + 155,706

 

448,352

 

 

 

=

180,268

 

448,352

 

=

0.40

• Times-interest-earned was calculated by dividing earnings before interest and taxes by interest charges.

Time-Interest-Earned 1997

=

Earnings before Taxes + Interest Expenses

Interest Expenses

 

 

 

=

24,743 + 832

 

832

 

 

 

=

25,575

 

832

 

=

30.7

Time-Interest-Earned 1998

=

Long term Debt + Current Liabilities

Total Assets

 

 

 

=

34,220 + 1,446

 

1,446

 

 

 

=

35,666

 

1,446

 

=

24.7

• Activity ratios include inventory turnover, age of inventory, accounts receivable turnover, and total assets turnover:

• Inventory turnover ratio was calculated by dividing the cost of goods sold by the average inventory for the period.

Inventory Turnover 1998

=

COGS 1998

(Inventory 1998 + Inventory 1997)/2

 

 

 

=

279,816

 

(206,128 + 133,323)/2

 

 

 

=

279,816

 

169,726

 

=

1.65

Inventory Turnover 1997

=

COGS 1997

Inventory 1997

 

 

 

=

147,526

 

133,323

 

=

1.11

• Accounts receivable turnover was calculated by dividing sales by average account receivable.

Account Receivable Turnover 1998

=

Sales 1998

(Acc. receivable for 1997 + Acc. Receivable for 1998)/2

 

 

 

=

478,368

 

(6,553 + 15,840)/2

 

 

 

=

478,368

 

11,197

 

=

42.72

Account Receivable Turnover 1997

=

Sales 1997

Account receivable for 1997

 

 

 

=

256,397

 

6,553

 

=

39.13

• Total Asset turnover was calculated by dividing net sales by average total assets

Total asset Turnover 1998

=

Net Sales 1998

(Total Assets 1997 + Total Assets 1998)/2

 

 

 

=

478,368

 

(375,834 + 448,352)/2

 

 

 

=

478,368

 

412,093

 

=

1.16

Total asset Turnover 1997

=

Net Sales 1997

Total Assets 1997

 

 

 

=

256,397

 

375,834

 

=

0.68

• Profitability Ratios include profit margin on sales and return on total assets:

• Profit margin on sales is calculated by dividing net income by net sales.

Net Profit Margin 1997

=

Net Income

*100

Sales

 

 

 

=

13,919

*100

 

256,397

 

=

5.43%

 

Net Profit Margin 1998

=

Net Income

*100

Sales

 

 

 

=

21,403

*100

 

478,638

 

=

4.47%

 

• Return on total assets was calculated by dividing net income plus interest expenses by average total assets.

Return on Total Assets 1998

=

Net Income 2018 + Interest Expense 2018

(Total Assets 1998 + Total Assets 1997)/2

 

 

 

=

21,403 + 1,446

 

(448,352 + 375,834)/2

 

 

 

=

22,849

 

412,093

 

=

0.055

Return on Total Assets 1997

=

Net Income 2017 + Interest Expense 2017

Total Assets 1997

 

 

 

=

13,919 + 832

 

375,834

 

 

 

=

14,751

 

375,834

 

=

0.039

Based on the above calculations I can state that several red flags appear for different items in Just for Feet Inc:

Inventory Item:

• Inventory increased from 35.5% of asset in 1997 to 58% of asset by 1999.

• Inventory was growing much more rapidly than other financial statement items.

• The age of the inventory went from 218 days to 241 days from 1998 to 1999, raising concern about obsolescence issues.

Cash:

• Client’s cash resources dwindled considerably from 37% of assets in 1997 to less than 2% by 1999. In absolute amounts, cash dropped from $138.7 M to $12.4 M the same timeframe.

• According to the cash flow statement, FEET had negative operating cash flow each year from 1997 to 1999.

• The company’s quick ratio was 0.37 in 1999, down from 0.67 at 1997

Debt:

• Just for Feet Inc’s long-term debt increased sharply in FY 1999, the long-term debt ratio rose from 0.09 at the end on 1998 to 0.71 at the end of 1999.

Relative Growth Rates for Ratios:

• Inventory and accounts payables growth should track each other. In this case inventory grew more than 200% from 1997 to 1999, while accounts payable increased a more modest 157%.

• While Just for Feet Inc’s gross margin remained relatively stable from 1997 to 1999, this seems suspicious as many of the Company’s financial ratios deteriorated during the same timeframe.

• Just for Feet operated large, high-volume retail stores. Identify internal control risks common to such businesses. How should these risks affect the audit planning decisions for such a client?

Large, high-volume store create unique auditing challenges one of them is revenue recognition where a large number of transactions (particularly in a business where training tends to be minimal and employee turnover is usually high), increases the likelihood that a number of transactions are incorrectly processed. This would increase further if the store used any number of promotional deals such as buy one get one free transaction. On the other hand, cash may be used for a disproportionate amount of transactions, creating additional opportunities for skimming at the register.

In the case of Expense/Inventory Recognition a large portion of inventory in the store was easily accessible to both customers, and employees increase the risk of theft or shrinkage.

Also, the multiple display approach for shoes – by brand, by function etc., complicated the any physical inventory process and the associated controls.

Organization was very decentralized in terms of store operations; further complicates the process of ensuring that financial controls are adequate and consistent across the organization and organizations also creates opportunities for less senior management to potentially take advantage of the lack of central oversight.

As control issues become more complex, so does the difficulty of conducting an effective audit. In a decentralized, high-volume, retail organization, a prudent auditor would increase their sampling methods for audit tests as a way of reducing the risk of overlooking a problem.

• Just for Feet operated in an extremely competitive industry, or subindustry. Identify inherent risk factors common to business facing such competitive conditions. How should these risks affect the audit planning decisions for such a client?

Retail business present a number of unique challenges in terms of establishing internal controls, large number of transactions, cash transactions, employee turnover etc. These challenges are made more complex when a retailer operates in a highly competitive sector or retailing such as trendy clothing or athletic shoes.

Inventory can quickly become obsolete, and it would impact negatively on the difficulty to predict the correct amount of inventory to maintain and also contribute that forecasting the margin at which that inventory will sell become more difficult.

Obsolete inventory and reduce margin sales may have a negative impact on cash flow and increase the need for additional financing beyond plan. In a decentralized organization, store and district level management may seek to dress up their financial reports in order to maintain their chances of receiving the best inventory.

In the case of any additional financing were needed above plan run the risk of violating debt covenants or sources of vendor financing particularly if sale of a certain trend do not go as planned.

Other aspect is that turnover in management (particularly at the store level) both within the company and between companies, may further complicate ability of an auditor to correctly assess a firm’s financial status.

• Prepare a comprehensive list, in a bullet format, of the risk factors present for the 1998 Just for Feet audit. Identify the five audit risk factors that you believe were most critical to the successful completion of that audit. Rank these risk factors from least to most important and be prepared to defend your rankings. Briefly explain whether or not you believe that the Deloitte auditors responded appropriately to the five critical audit risks factors that you identified.

The text cites a number of issues that may have been audit risk factors for Just for feet Inc in its 1998 audit:

• Management style and approach to managing Investor Expectations. Management was particularly interested in its short-term share price as a measure of its success or failure, management placed significant emphasis on meeting short-term earning goals, go big or go home approach towards expansion even if changes in the business environment warranted a more moderate approach and dominant personality of CEO.

• General retail sector risk. Decentralized management approach in industry known to have factors, high-volume of transactions, large amount of transactions conducted in cash, significant employee turnover, and ease of customer and employee access to inventory (shrinkage and theft).

• Highly-competitive subsector of retailing. Trend-driven merchandise increases likelihood of incorrect ordering, incorrect pricing and/or a significant chance of obsolescence, rapid change in trends make it more difficult to recognize and respond to problems, and long lead times for inventory orders reduce operating flexibility.

• Financial Condition Flags/Concerns. Large increase in inventory in proportion to historic norms, consistently negative operating cash flow (indicating a continued need to raise capital and to keep reporting results that will attract investors), increase in vendor allowance receivable, slow growth of accounts payable relative to inventory gains, increase in financial leverage, declining cash on balance sheet and consistently steady gross and operating margins in a business that has a meaningful level os fixed costs and that is highly seasonal in terms of sales.

Of the factors listed above, the five factors that would likely increase the likelihood of potential problems at Just for Feet Inc in 1998 are:

• Consistently negative operating cash-flow indicate that reported results are not self-sustaining and that the company may well need new financing.

• Large increase in inventory could suggest that company failed to correctly identify a number of trend and that it has a significant amount of inventory that would require a write-down.

• Declining cash on the balance sheet in a business where high inventory turnover and favorable supplier credit terms could potentially result in a negative working investment requirement.

• Management’s dogged focus on meetings short-term investor expectations and maintaining a high share price regardless of market conditions.

• Consistenly steady quartely gross and operating margins in a business that would be expected to be highly seasonal in sales and with a meaninful level of costs that do no fluctuate seasonally.

• Increase in vendor allowance receivable, without standard supporting documentation.

Deloitte appears to have been cognizant of the potetial audit risk at Just for feet Inc; The auditor took steps to increase senior management oversight on its high risk accounts and identified vendor alowances as a potential issue for all audit clients.

Where Deloitte fell short was being persuaded by Just for Feet Inc management to accept the non standars vendor allowance letters and other explanations, for plrblems in the business. Deloitte should have followed through with its concern to the Board of Directors and the Audit Committee and perhaps included some commentary in its audit report.

• Put yourself in the position of Thomas Shine in this case. How would you have responded when Don-Allen Ruttenberg asked you to send a false confirmation to Deloitte & Touche? Before responding, identify the parties who will be affected by your decision.

• Shine should have rejected Ruttenberg’s request. Shine need to explain the situation to Ruttenberg regarding ethical issues, and impact of this false confirmation.

• Although Just for Feet Inc was likely a large customer, Shine had a responsibility to his Board and shareholders.

• Shine is clearly liable for abetting the fraud. Shine should have reported the request to Just for Feet Inc’s audit committee as well as its auditors.

• Shine should also have made the information available to his Board and auditors as Ruttenberg’s request would likely have an impact on Shine’s firm audit as well.

Conclusions

While earnings increased and the company’s current ratio increased from 1997 to 1998, the company’s operations generated an increasing deficit cash flow level; and the company’s current liquidity index shows a lack of any liquid resources relative to the current level of debt due. The company is in a significant liquidity crisis.

Bibliography

Gartland, D. J., C.P.A. (2017). The importance of audit planning. Journal of Accountancy, 224(3), 14-15. Retrieved from http://ezproxy.liberty.edu/login?url=https://search-proquestcom.ezproxy.liberty.edu/docview/1933270057?accountid=12085

Jensen, M. C. (1993). The modern industrial revolution, exit, and the failure of internal control systems. the Journal of Finance, 48(3), 831-880.

Knapp, M. (2015). Contemporary Auditing: Real Issues and Cases. Boston: Cengage Learning.

Laksmana, I., & Yang, Y. (2015). Product market competition and corporate investment decisions. Review of Accounting & Finance, 14(2), 128-148. Retrieved from http://ezproxy.liberty.edu/login?url=https://search-proquestcom.ezproxy.liberty.edu/docview/1675841097?accountid=12085

Yücel, E. (2013). Effectiveness of red flags in detecting fraudulent financial reporting: An application in turkey. Muhasebe Ve Finansman Dergisi, (60) Retrieved from http://ezproxy.liberty.edu/login?url=https://search-proquestcom.ezproxy.liberty.edu/docview/1808803726?accountid=12085

JUST FOR FEET, INC.

BALANCE SHEETS (000s omitted)

January 31,

1999

1998

1997

Amount ($)

%

Amount ($)

%

Amount ($)

%

Current assets:

Cash and cash equivalents

12,412

1.8%

82,490

18.4%

138,785

36.9%

Marketable securities

available for sale

–

0.0%

–

0.0%

33,961

9.0%

Accounts receivable

18,875

2.7%