English Case Studies

, r i

sEcnoN oNE CouPReuENstvE Ca.sns

in a Birmingham mall and a few months later opened Hang Ten Sports V/orld, a

retail store that marketed children's sportswear proclucts. Thanks largel'y to his

work ethic and intense desire to succeed, Ruttenberg's busines's prospered over

the next decade. In 1ggg, Ruttenberg decided to take a gamble on a new business venture. Ruttenberg

had come to believe that there was an opportunity to rnak,e large profits im ttre retail

shoe business. At the time, the market for high-pricecl athletic shoes-bar;ketball

shoes, in particular-was growing dramatically and becoming ztn ever-larger seg-

ment of the retail shoe industry. The principal retail ouLtlets for the shoes produced

by Adidas, Nike, Reebok, and other major athletic shoe manufactul€rs were relatively

small stores located in thousands of suburban mallls scattered ar3ross the country'

meaning that the retail athletic shoe "subindustry" was highly fragmented.'fhe five

largest rituil"rc in this market niche accounted for less l.han 10 petcent of the: annual

sales of athletic shoes. Ruttenberg realized that the relatively small floor space of retail shoe store:s in sub-

urban malls limited a retailer's ability to display the widle and growing array of prod-

ucts being produced by the major shoe manufacturers. Likewisr:, the highi cost of

floor rpu.L in malls wittr heavy traffic served to limit the profitabilil.y of shoe retailers.

To overcome these problems, Ruttenberg decided that he would build frees;tanding .,Just for FEET" superstores located near malls. To lure: consumers away frOm mall-

based shoe stores, Ruttenberg developed a three-pronged business strategy locusing

on "selection," "service," and "entertainment'"

Ruttenberg's business plan for his superstores involved a stores-withirr-a-store

concept; that is, he intended to create several mini-stores within lhis large retail out-

lets, eich of which would be devoted exclusively to th,e products of individual shoe

manufacturers. He believed this store design would appeal to bc'th consumers and

vendors. Consumers who were committed to one parl.icr,rlar brand would not have

to search through store displays that included a wide assortment of brandr:d prod-

ucts. Likewise, his proposed floor design would provicle major vendors an opportu-

nity to participate in marketing their products. Ruttenberg hoped that his plannec

floor design would spur the major vendors to compete with each other in provid-

ing so-cdfed vendor allowances to his superstores to rnake their individual displays

more appealing than those of competitors. Customer service was the second major element of f{uttenberg's business plan for

his shoe superstores. Ruttenberg planned to staff his stores so that there vrould be

an unusually large ratio of sales associates to custome:rs. Sales associates vrould be

required to complete an extensive training course in "footwear technology'" so that

they would be well equipped to answer any questions posed b)'customers. When

a customer chose to try on a particular shoe product, he or she would harre to ask

a sales associate to retrieve that item from the "back shop." Sales associates were

trained to interact with customers in such a way that they would r:arn their lirust and

thus create a stronger bond with them. Just for Feet's 1gg8 Form 10-K described the third featrure of l:larold Rutlenberg's

business plan as creating an "Entertainment Shoppirrg Experiertce." Rock.and-roll

music and brigfttly colored displays greeted customers;when they entered tlhe super-

stores. When they tired of shopping, customers could play a game of "horse" on

an enclosed basketball half-court located near the strlre's entrance or sit tlack and

enjoy a multiscreen video bank in the store's custorner loungel. Frequent promo-

tional events included autograph sessions with maior,sports celebrities such as Bart

Starr, the former Green Bay Packers quarterback who was also' on the company's

board of directors.

cAsE L3 Jusr Fon FEET, Inc.

Ruttenberg wourd eventually include two other key features in the iiio'r plans of his

superstores. Although Just for Feet did not target price-conscious customers' Rutte'nberg

added a ,.combat zone" to each superstore where such customers could rummage

through piles of discontinued shoe iin*r, f'seconds," and other djrsco,unted items. For

those customers who simply wanted a pair of shoes and did not lhavre a strong Prefer-

ence for a given brand, Ruttenberg incoiporated a "Great wau' into his superstores that

contained a wide array of shoes sorted not by brand but rather by function. In thris large

display, customers .oltO quickly compare ind contrast the key features of doz'ens of

different types of running shoes, walking shoes, basketball shoes, andcross-trainiers'

QUiIC q FEET

Just for Feet's initial superstore in Birmingham proved to be a huge financial success'

That success .onuin."d Harold Ruttenberg to open similar retail outllets in several

major metropolitan areas in the southern united states and to develop a sho'wcase

superstore within the glitzy caesar's Forum shopping mall on the Las Vegas' Strip'

By 1992, Just for Feet owned and operated five superstores and had sold franchise

rights for several additional stores. The company's annual sales were approaching

$20 million, but that total accounted for a small fraction of the rretail shoe industry's

estimated $15 billion of annual sales' To become a maior force in the shoe industry, Ruttenberg knew

thrat he would have

to expand his retail chain nationwide, which would require large amounts of addi-

tional capital. To acquire that capital, Ruttenberg decided to take his company pub-

Iic. On g March 1gg4, Just for Feet's common stock began trading; on the NhSDAQ

exchange under the ricker symbol FEET. The stock, which sold initially for $6'22 per

share, would quickly rise ovlr the next two years to more than {i37 per share'

Ruttenberg used the funds produced by just for Feet's initial pubrlic offerinSl 0PO)

to pursue an aggressive expansion progiu.. The company opened dozens of new

superstores during the mid-lggOs and alquired several smaller competitors, includ-

ing Athletic Atticln March 19g7 and Sneiker stadium in July 19918. Fbr fiscal 1996,

which ended 31 January 1997, the company reported a profit of !l!

S million on sales

of $250 million. Two yeirs later, the company earned a profit of $26.7 rniilion on sales

of nearly $775 million. By the end of 19b8, iust for Feet was the second largr:st ath-

letic shoe retailer in the United states with 300 retail outlets.

During the mid-1990s, Just for Feet's common stock was amon51 the most closely

monitored and hyped securities on wail street. Analysts and- inverstors tracking the

stock marveled uiir," company's ability to consistently outperform its maior competi-

tors. By the late 1990s, tark.t satr-lration and declining profit margins were becom-

ing major concerns within the athletic shoe segment of the slhoe industry' Despite

the lackluster profits and faltering revenues of other athletic shor: retailers' Harold

Ruttenberg continued to issue pt""tt releases touting his company':; record profits

and steadily growing sales. Mosi irnpressive was the company's 21 stnaight quarterly

increases in same-store sales through the fourth quarter of fiscal 1998'

In November 1gg7, Delphi Investments released a lengthy analy'tical report focus-

ing on Just for Feet's future prospects. In that report, which included a strong "buy"

recommendation for the company'S common stock, Delphi comrnented on the

,,Harold Ruttenberg factor.' The report largely attributed the company's financiai

success and rosy fr]ture to "the larier-than-tit" founder and inventor of the Just for

Feet concePt." In frequent interviews with business iournalists, Harold

Ruttenlberg was not mod-

est in discussing the huge challe'ges tirat he had personally.overcome to establish

himself as one of the leading corpJrate executivesln the retail apparel indur;try' Nor

sEcnoN oNE ConapRsHsNsryn Ctsns

was Ruttenberg reluctant to point out that he had sketched out l,he $eneraLl frame-

work of Just for Feet's successful business plan over a three-day I'acation in the late

lg3gs. After being named one of 1996's Retail Entrepreneurs of the Year, Ruttenberg

noted that Just for Feet had succeeded principally because of the' unique marketing

strategies he,had developed for the company. "Custolners love clur stores because

they are so unique. We are not a copycat retailer. Nobody doe,s what we do, the

*uy *" do it. The proof is in our performance."i In this same intr:rview, Ruttenberg

reported that he had never been tempted to check out a competitor's stores. "l have

nothing to learn from them. I'm certainly not going to copy anything they are doing."2

Finally, Ruttenberg did not dispute, or apologize f.or, his; reputationr as a domineering,

if notimposing, superior. "l can be a very demandirng, difficult boss. But I know how

to build i"u*t. And I have made a lot of people very rich."3

Ruttenberg realized that one of his primary resporrsibilities was traininLg a new

management team to assume the leadership of the c:ompany following his retire-

ment.-'As the founder, my job is to put the right peop'le in placer for the future. I'm

preparing this company for 25 years down the road r,l'hen Iwon't be here."4 One of

the individuals who Ruttenberg handpicked to lead the compan)'into its future was

his son, Don-Allen Ruttenberg, who shared his father's single-minded determination

and tenacious business temperament. In 1997, at the age of 29, Don-Allen RuLttenberg

was named Just for Feet's vice president of new store rCevelopment. Two years later,

the younger Ruttenberg was promoted to the position of executivtl vice president.

Similar to most successful companies, Just for Feet's path to success was not with-

out occasional pitfalls. In 1995, Wall Street's zeal for Just for Feet's common stock was

tempered somewhat by an accounting controversy in'rolving "store opening" costs.

Throughout its existence, Just for Feet had accumulated such costs for each new

store in an asset account and then amortized the costs; over the 12-month p,eriod fol-

lowing the store's grand opening. A more common practice within the retail industry

was to expense such costs in the month that a new stot'e opened. Criticism of Just for

Feet's accounting for store opening costs goaded company management to adopt the

industry convention, which resulted in the cornpany recording a $;2.1 million cumula- tive effect of a change in accounting principle during fiscal 1996.

In the summer of 1996, Wall Street took notice when Harold Ruttenberg; his wife, Pamela; and their son, Don-Allen, sold large blocks of their Jus't for Feet r:ommon

stock in a secondary offering to the generalpublic. Collecl.ively, the three mermbers of

the Ruttenberg family received nearly $49.5 million frc'm the sale of those sr:curities. Major investors and financial analysts questioned why the Ruttenb'ergs would dispose

of much of their Just for Feet stock while, at the same time, the senior Ruttenberg was

issuing glowing projections regarding the company's future prosprsqf5.

Cloy Feet No one could deny the impressive revenue and profit trends that Just for Feet estab- lished during the mid- and late 1990s. Exhibit 1 and Exhibit 2, which present the

company's primary financialstatements for the three-year period fiscal 1996 through

fiscal 1998, document those trends. However, hidden rvithin the company's financial data for that three-year period was a red flag. Notice in the statements of cilsh flows

7. Chain Store Age, "Retail Entrepreneurs of the Year: Harold Ruttenberg," Decernber 1996, 681-

2. Ibid.

3. Ibid. 4. Ibid.

CASE I.3 JUST FON FEET, INC.

shown in Exhibit 2 that despite the rising profits Just for Feet reported in the la.te

1gg0s, the company's operating cash flows during that period were nega'tive. By early

1999, these negative operating cash flows posed a huge liquidity problem for the

company. To address this problem, Just for Feet sold $200 million of high-yield "junk"

bonds in April 1999. A few weeks after selling the junk bonds, Just for Feet issued an earnings warn-

ing. This press release alerted investors that the company would likely post its first-

"ui, quuiterly loss during the second quarter of fiscal 1999. One month later, Just lfor

Feet shocked its investors and creditors when it announced that it mig;ht default on

its first interest payment on the $200 million of junk bonds. Investors received mclre

disturbing news in July 1999 when Harold Ruttenberg unexpectedly resigned as

Just for Feet's CEO. The company replaced Ruttenberg with a corporate turnaround

dtr eas*apryr:rr.11T+riTrliita:;r*"r,,1;11.rr1"1i':t:o1T;**1o,n::*.1i|,,1a,11,,;. ':illTTf:TT.i:l*i:ilt|lll"l-:11,:

EXHIBIT I

' ' Jl,|T FOR, FIET; INC.' .' .. I ,

: BALANGE SHEEiS (000s,oryilted) '

Jusr loR FEET. Inc., t996.-1998 B,q;,A.rucE SHssrs

Current,assets:- , ' ',

, Cash and cash equivqlents M a r : k e t a b l e s e c u r i t i e s ' : '

avaitabte for sale :

Accounts receivable ':

. , ,Invenlory, ,,' , Other cufre1t,assetl.. ', , , Tolat crlrrent bs$€tS ,

I nropelty, and: equiPment, net Goodwill, net ,I

' , o t h e r

* . , r , , 1' Total asset ' i, ,

C u r r e . n t L i a b i l ' i t i e s : ] , ' ,

Sh'ort-term :borrowi n9s ' Rccounti payabte

"' -

4 c c i u e d e x P e h i e s , , , , - InCome,taie-s PaYabLe' . '

' Curtent maturities 6f , ,' :'

, , Long-term debt Totat cuirqnt tiabitities

Long-term debt a nd.obtig gtio.ns Tital. tiabitities ,

'

Snarenlfaersr equity:. C o m m o ' n s l b c k , , , ,' Paid-in Capital ' , l Retained eaini,ngs

TotaI shareholdersi equitY

TotaL Habilities'and'' I : ihareholders'equitY

: , , ' . 1 q ' - 9 , . 9 ' , r

' . 1 - : ' ,

, $ 12,4,72 ''

' . . : ' ,

. lr I ,

, . : , . , . , , l

. r , 1 8 , 8 7 5 ' , , 3 9 ! ; 9 0 1 1 , , , '

: , , 1 9 ; , 3 0 2 , . t , ,, .44!,490 ,

'

' 760;5,92 . , ! , | i 0 8 4 ,, g ; 2 3 0 , ; -

,.$689,396,. .r' T , . : t

t . , i .

, $ , - i , ,

, ' . . 7 p 0 ' ! 3 2 2 , ,' 24,829 ',, , , - 9 a 2 ,

' l. 6,,6i8,9: ' ' M ) F Q

,

", 2ro,nn', '' gfri6fr, ' -

Janul{V,,31,, '199-8 i

Tl $ az.+s0

, : - . . - , . : ' i 1 5 g f 6

,

,206,72,8 ,

" 6r709,;,,,,,,f!fl ,,. ' g;i4,lzg

, , 36.106 : ,

6 ; , 5 5 0 ' , i44L,3sz . ''.l'' $ gb,o.oi ',

, , , i ! , i 6 2 " '': g,,ig.z

' ' t . ; ' : 0 S ' '

3,,,2122'

Yry.. ?4"562 ,

$lE_oEE'' T l

: : , t i ' 278,676

' 49-;4.65 : <

26s:084 :

Srtr+A,SSZ - :

' i;,r; i ffii E ' ir;uu,. j

; , 6 , 5 5 . 3 , t

, ,133,;,37'.3',; i :?",12\- !

37,41,7.4i :l

, , s+,,iv2 ti,

" i-i.n, 1'$ffiFZ i

ffii ..' , 1}rBsi

',,1

*iil: 4

2,10t5 i '

tA!,gi,l4 " '

t , ' r ' .

' 1 0 , 3 6 i 4 , , .

ifrfin::, -=

' ,

, t

. ' . ,

' , 3 , ts;gi,+92 2 8 , 0 ( i 1 i l

;ffi$1fi.. ,to*,riinli T6;113,'uffi

" ' , , . r .

: t ' , , ' '

$6s..9;' s:o-' : : #

';-.1 ,:.j : . , t : 1, ,, t ,,a.,"4

$315,8.1:+

sEcTroN oNE CotupnnuENstvr C.qsus

specialist, Helen Rockey. Upon resigning, Ruttenberg insisted that Juist for Feet's

financial problems were only temporary and that the: company would likely post a

profit during the third quarter of fiscal 1999. Harold Ruttenberg's statement did not reassure inves;tors. lltre company's stock

price went into a freefall during the spring and summer of 19119, slipping to near

$+ p"r share by the end of July. In September, the company announced tlhat it had

lost $25.9 million during the second quarter of fiscal 19199, a much larger loss than

had been expected by Wall Street. Less than two months later, on 2 November 1999,

the company shocked its investors and creditors once more when it filed for Chapter

11 bankruptcy protection in the federal courts. Just for Feet's startling collapse over a period of a few monthrs sparked a flurry of

lawsuits against the company and its executives. Allegations of financial mismanage-

ment and accounting irregularities triggered investigations of the company's finan-

cial affairs by state and federal law enforcement a,uthorir;is5, including the Alabama

Securities Commission, the FB[, the Securities and Excha]nge Connmission (SEC), and

the U.S. Department of Justice. In May 2003, the Justice DepartmLent announced that

a former Just for Feet executive, Adam Gilburne, had pJleaded guilty to conspiracy

EXHIBII2

Jusr roR FEET, Irvc., 1996-1998 Ivcoun SrErEMsNts AND SrlrellsNrs or Casu Fr,ows

i'i-=:.=r:,1 il .]:'':i #ffifi ;i ':iiii .',.' t' -''1

i''', ","io*ffi ffiffi u*ffiffi ; ;it

il;**ffi": ;##*,* ffi '#;.'#u;

ii'trfi1ft11i'i'ffi * ;+, r','',''',li:l''t' Ll sifai*tl,oi-$i#ttj tt

-ryiffif#*i#i*lffi'l@l*"tt, f,,, r,' i,r,,', ii,r i;i'.'11;i, i

r.f*ff*fiItfgfi+ff*-- ffi*t

cAsE 1.3 Jusr Fon FEET, INc.

,:if,ir)"i:iiliit:rrr-.:i:,:rir,tli: ijiirT:;:i,,,.'fr,$llllii.rrl'is rrir],i:r:.fliTl::i,:iriilll-i.,:i'irT,: i

to commit wire and securities fraud. Gilburne, who had served iin various executive

positions with Just for Feet, revealed that he and other members c'f the company's

top management had conspired to inflate the company's reported earnings from

1996 through 1999.

The information ftestimony prouided by Gitburne] alleges that beginning tn about

1996, Just for feif s CfO filorold RutteibergJ would conduct meettngs at the end of

enery quarter in which he would loy out analysts' expectations of tlte comp1tryb eorn-

ingi, and then draw up o list of "goods"-itnryt which produced or added income-

ond ,,bad.s,'--those which reduc'ed income. The information allege,s that the CEO

[xHtBtT 2- continued

.lusr roR FEET, llNc., 1996-199E llNcovre SrntnMsivrs AND SrlrEranh{rs oF' C.qsH Fr.ows

i'- ;$$$$ffi 'ffi-ffiir-' i''r'' |!'iati'i

*'**ffiffi -ffi i,,., :' i,::.i: ,(usi.ng) lea ii.,n i;'t'i';., 11xffi d)i',.,.i{i[_lffi *ffiL r,, r ;' ;, i;i,,'(I1t 0ieaS"g) itiilt-+ffi

lffi

il=ffi**'fiffi* ***ffi#*ffiffiil ;iil

i," ffiffffi

cAsE 1.3 Jusr Fon FEET, INc.

!:.r'iit+

liir,j;{

to commit wire and securities fraud. Gilburne, who had served in various exersutive

positions with Just for Feet, revealed that he and other members Of the company's

top management had conspired to inflate the company's reported earnings; from

1996 through 1999.

The information [testimony prouided by Gtlburne] otleges that begi'nning in about

1996, Just for feits CEO [Horotd Rutteiberg] would cohduct meet[ngs ut the end of

et)ery quorter in which he'would lay out ano$sg' expectotions of .the c'omporty's eorn'

ingi, and then drow up a list of "goods" itirns_which produced .or added income-

and ,bads,,-fi1sss which reduiecl income. The infoimotion all]eges that the CEO

IixHllBtr 2- continued

Jusl ron FEET, Ir.rc., 1996-1998 h.icovE Srxrsnanxrs AND, SrxrnMsl.trs or CmH Flows

sEcTloN oNE corr{pnuHsNstvE c.AsEs

directed Just for Feet's employees to increase the "goods" atnd. decreas;e the "bads" in order to meet his own earnings expectations and those of lVatl Street a;nalysts.s

Approximately two years following Gilburne's guilty plea, the SEC issued a serries of

enforcement releases that documented the three key facets of the fra.udulent scheme

perpetrated by Just for Feet's management team. 'Just for Feet falsified its finilncial

statements by (1) improperly recognizing unearned and fictitious receivables; from

its vendors, (2) failing to properly account for excess inventory, ancl (3) improperly recording as income the value of display booths provided by its vendors."6

The stores-within-a-store floor plan developed by Harc,ld Ruttenberg provided an

opportunity for Just for Feet's vendors to become directly involved jn the marl<eting

of their products within the company's superstores. Each year, Just I'or Feet received

millions of dollars of "vendor allowances" or "advertisingi co-op" frc,m its major sup- pliers. These allowances were intended to subsidize Just for lieet's aclvertising expen-

ditures for its superstores. Despite the large size of the vendor allowances, in most cases there was not a writ-

ten agreement that documented the conditions under which Just for lFeet was errtitled to an allowance or the size of a given allowance. After JuslL for Feet hzrd run a series of advertisements or other promotional announcements for a vendor's product, copies

of the advertising materials would be submitted to the vendor. An account lrloro$er

for the vendor would then approve an allowance for Just for Feet based upon the

amount of the advertised products that the company had purchasedl.

Generally accepted accounting principles (GAAP) dictate thett vendor iallow-

ances not be offset against advertising expense until the given advertisement:s have

been run or other promotional efforts have been completed. Howe,ver, Just for Feet

began routinely recording anticipated vendor allowances as receivables and adver-

tising expense offsets well before the related advertisinr3 or promc,tional programs

had been completed. Just for Feet's management team rruas particularly aggressive

in "front-loading" vendor allowances during fiscal 199ti. At the errd of fiscal 1997,

Just for Feet had slightly more than $400,000 of outstanding vendor allorvance

receivables; 12 months later, at the end of fiscal 1998, that total had soared to almost

$29 million.T During fiscal 1998, Just for Feet's merchandise inventory nearll'doubled, rising

from $206 million on 31 January 1998, to almost $400 rnillion on 131 January 1999'

Although Just for Feet had a large amount of slow-moving inventory, the company's

management team refused to properly apply the lower of cost or market rule in arriv-

ing at a year-end valuation reserve for that important a;sset. As a result, at the end

of both fiscal 1997 and fiscal 1998, the company's allowance for inventory otrsoles-

cence stood at a nominal $150,000. The major athletic shoe vendors erected promotional diisplays or booths in tlhe Just

for Feet superstores. These booths were maintained by sales representatives of the

vendors and were the property of those vendors. In early i998, Don-Allen Ruttr:nberg

concocted a fraudulent scheme to produce millions of d,cllars of "booth incorne" for

5. U.S. Department of Justice, "Former Just for Feet, Inc.' Executive Pleads Guilty to Conspiracy to

Commit Wire, Securities Fraud," www.usdoj-gov, 12 May 2003.

6. U.S. Securities and Exchange Commission, "SEC Charges Deloitte di Touche and Two of Its Personnel

for Failures in Their Audits of Just for Feet," www.sec.gov, 26 April 2005.

Z. Although technically receivables, the vendor allowances purportedly due to Jusll for Feet were

netted against the given vendor's accounts payable balance, which ex.piains why thLese receivables do

not appear explicitly in the company's baiance sheets shown in Exhib'it I'

sEcTtoN oNE ConapRpunNslvn C.Lsns

directed Just for Feet's employees to increase the "goods" atnd decrease the "bqd.s" in order to meet his own earnings expectattons and those of lValt Street a,nalysts.s

Approximately two years following Gilburne's guilty pleil, the SEC issued a series of

enforcement releases that documented the three key facets of the frerudulent scheme perpetrated by Just for Feet's management team.

'Tust for Feet falsified its finiencial statements by (1) improperly recognizing unearned and fictitious receivable:; from its vendors, (2) failing to properly account for excess inventory, and (3) improperly

recording as income the value of display booths providedl by its vendors."6 The stores-within-a-store floor plan developed by Harold Ruttenberg provided an

opportunity for Just for Feet's vendors to become directly involved jin the marJketing

of their products within the company's superstores. Each year, Just lor Feet received

millions of dollars of "vendor allowances" or "advertisingl co-op" from its major sup- pliers. These allowances were intended to subsidize Just for Feet's aclvertising expen- ditures for its superstores.

Despite the large size of the vendor allowances, in mosl. cases there was not a writ- ten agreement that documented the conditions under which Just for lFeet was errtitled to an allowance or the size of a given allowance. After Just for Feet had run a series of

advertisements or other promotional announcements for a vendor's product, copies of the advertising materials would be submitted to the verndor. An account msLna.$€r for the vendor would then approve an allowance for Just for Feet based upon the amount of the advertised products that the company had purchasecj..

Generally accepted accounting principles (GAAP) dictate thzrt vendor ;allow-

ances not be offset against advertising expense until the given adv<lrtisements have been run or other promotional efforts have been cornpleted. Howe,ver, Just for Feet began routinely recording anticipated vendor allowances as receivables and adver-

tising expense offsets well before the related advertising or promc,tional programs

had been completed. Just for Feet's management team rnrras particrilarly aggressive

in "front-loading" vendorallowances during fiscal 199ti. Atthe errd of fiscal 1997,

Just for Feet had slightly more than $400,000 of outstanding vendor allowance

receivables; 12 months later, at the end of fiscal 1998, that total had soared to almost

$29 million.T During fiscal 1998, Just for Feet's merchandise inventory nearly'doubled, rising

from $206 million on 31 January 1998, to almost $400 rnillion on i31 January 1999'

Although Just for Feet had a large amount of slow-movinLg inventory, the company's

management team refused to properly apply the lower of cost or market rule in arriv-

ing at a year-end valuation reserve for that important asset. As a result, at the end

of both fiscai i997 and fiscal 1998, the company's allowance for inventory obsoles-

cence stood at a nominal $150,000. The major athletic shoe vendors erected promotional displays or tlooths in the Just

for Feet superstores. These booths were maintained by sales repr€:sentatives of the

vendors and were the property of those vendors. In early 1998, Don-Allen Ruttenberg

concocted a fraudulent scheme to produce millions of dollars of "booth incorne" for

5. U.S. Department of Justice, "Former Just for Feet, Inc.' Executive Pl,aads Guilty tc'Conspiracy to

Commit Wire, Securities Fraud," wwwusdoj.gov, 12 May 2003.

6. U.S. Securities and Exchange Commission, "SEC Charges Deloitte 8i Touche and Two of lts Personnel

for Failures in TheirAudits of Just for Feet," www.sec.gov, 26 April 2005.

7. Although technically receivables, the vendor allowances purporteclly clue to Jusl- for Feet were

netted agiinst the given vendor's accounts payable balance, which explains why these receivables do

not appear explicitly in the company's balance sheets shown in Exhibit L

OASE I,3 Jusr Fon FEET, INc.

Just for Feet. without the knowledge of its vendors, Just for Feet began recording inL

its accounting records monthly booth income amounts allegedly earned from those:

vendors. The offsets to these revenue amounts for accounting purposes were bookecl

(_debited) to a booth assets u..ount.d By the end of fiscar 1ggg, Just f'r Feet hacl

recorded $g milion of bogus assets and ierated revenues as a result of this scheme'

rVlore than B0 percent of these bogus transactions were recorded duriing the final

two quarters of fiscar 1ggg, ort.nr"iuty to ailow Just for Feet to reach its; previousl-1

announced earnings targets for those two periods'

A n i m p o r t a n t f l a t u r e o f t h e J u s t f o r F e e t a c c o u n t i n g f r a u d w a s D o n - A l l e n

Ruttenberg,s crose rerationship *itr, key executives of the maior athletiLc shoe

verr

dors. since Just for Feet was among therargest customers of each of th.se vendors,

the company had a significant amtunt of economic leverage on their executives.

The young", n,rii"nUeig used this leverage to persuade those executir"es to return

false confirmations to Just for Feet's indlpendent audit firm, Deloitttl & Touche'

Those confirmations were sent to J,st for Feet's vendors to confirm bogus recei'v-

abres that were a product of the .*puny's fraudurent accounting scherme' In mo'st

cases, the bogus ieceivables resuttei rrom infrated or otherwise improper vendor

ailowances booked by Just for Feet. one of the five vendor executives who capit'u-

Iated to Don-Alien Ruttenberg's demands was Thomas Shine' the senior executive

of Logo Athretic. Executive, of fou, Just for Feet vendors steadfastly refused to pro-

vide false confirmations to Deloitte. Those executives were employed b'y Asics{iger,

New Balance, Reebok, and Timberland. Ironically, in 2001, Thomas Shine became an

executive of Reebok when that company purchased Logo Athletic'

Footing & Cross-Footfing Deloitte & Touche served as Just for Feet's independent

audit firm from 1992 through

early December 1g9g, one month after the company filed for chapter 1ll bankruptcy'

Deloitte issued unquarified audit opinions each year on Just for Feet's financial state-

ments, including the financial starements in the s-1 registration statement the com-

Ount titea witft the SEC when it went public in 1994'

Steven Barry served as Just for Feeis engagement partner for the fiscal 1998 autlit'

Barry was initially an employee of Touche Ross & co' and was promol'ed to partner

with that firm in lggg. The next year, Barry became a Deroitte & Touctre partner fol-

lowing the merger of Touche Ross with Deloitte, Haskins, & sells' In 1996' Barry was

p r o m o t e d t o m a n a g i n g p a r t n e r o f D e l o i t t e ' s B i r m i n g h a m , A l a b a m a , o f f i c e . B a r r y ' s principal subordinaiu Jn the lggg Just for Feet audit

*as Karen Baker, who had beren

assigned to the company,s audit engagement team since 1993. Initially the audit

senior on that engagement team, she"blcame the engagement audit rnanager arlter

being promoted to that rank in 1995'

Deroitte assigned a .greater th; normaf' lever of audit risk to the fiscill

1998 Just for

Feet audit during the planning phase of that engagemlt T",|"lp

monitor high-r:isk

audit engagements, Deioitte had estabrished a "riat]onal Risk Management Program'"

In both 1gg7 and 1ggg, Just for Feet was included in that program. F.ach client invol'ued

in this program was assigned a ,.National Review partner." This pzrrtner's duties

included "discussing specific risk areas and plans to respond to them " ' reviewing the

audit workpapers concerning risk areas of the engagement'.and reviewing the finan-

cial statements and Deloitte,s audit reports with a"n emprtasis on the icler'rtification of

8 . T h i s f r a u d u l e n t s c h e m e a c t u a l l y r e p l a c e d a s i m i l a r b u t s m a l l e r . s c a l e s c a m t h a t t h e ] / o u n g e r Ruttenberg had used since Decemnei tgge to

inflate Just for Feet's operating results'

ia

sEcnoN oNE CoNapRsl.rEr.rsrvs Casns

specific risk areas as well as the adequacy of the audit report and disclosures regard- ing these risk areas."e

The audit workpapers for the fiscal 1997 audit identified sevenl specific audit risk factors. These factors included "management accegrts high lerrels of risk,," "places significant gmphasis on earnings," and "has historicatly tinterpreted accounting stan- dards aggressively." Another lgg7 workpaper noted thLat the company', *unug".ment team placed a heavy emphasis on achieving previously released earning, Lrg.tr, expressed an "excessive" interest in maintaining tJhe company's stock pricii ut u Lign level, and engaged in "unique and highly complex" transactions near fiscalyear-erfo. A summary 1997 workpaper entitled "Risk Factors Wo:rksheet" also note<J thrat Harold Ruttenberg exercised "one-man rule (autocrat)" over Just for Fer:t and that the com- pany practiced "creative accounting."

For both the 1997 and 1998 audit engagements, Dek:itte personnel prepared a "Client Risk Profile." This workpaper for those two a.udits identified venclor allow- ances and inventory valuation as key audit risk arear;. In 1996, Deloitte's headquar- ters office had issued a firm-wide "Risk Alert" informing practice offices that vendor allowances should be considered a "high-risk area' for retail clients.

During the l99B audit, the Deloitte engagement team identified several far:tors that, according to the SEC, should have caused both Barry and Bal<er to have "height- ened professional skepticism" regarding Just for Feet's vendor allorvances. The most important of these factors was the huge increase in ther vendor allowance receivables between the end of fiscal lggT and fiscal 1998. In the final few ureeks of fis;cal lgg8. Just for Feet recorded $14.4 million of vendor allowances, accounLting for alrnost one_ half of the year-end balance of that account. Deloitte was never provided with sup- porting documentation for $11.3 million of those vendor allowan,ces, althourgh a Juit for Feet executive had promised to provide that documentation. Deloitte crilnpleted its fieldwork for the fiscal 1998 audit on 23 April 1999, ialmost three months following the fiscal year-end. As of that date, Just for Feet had not received any payments from its suppliers for the $11.3 million of undocumented vendon allowances.

In March 1999, Deloitte mailed receivables confirmations to 13 of Just tfor Feet's suppliers. Collectively, those vendors accounted for $:22 rrnillion ,cf the $28.g million of year-end vendor allowances. Again, Don-Allen Rutteniberg perrsuaded e>recutives of five Just for Feet vendors to sign and return confirmations to Deloitte even though the vendor allowance receivables listed on those confirmations did not exist or were grossly inflated. The confirmations returned by the other eight vendors were gen- erally "nonstandard," according to the SEC. That is, these confirmations iLncluded caveats, disclaimers, oll"other statements that should hirve alerted Deloitte tc, the pos- sibility that the given receivable balances were unreliable. "Five vendors returned nonstandard letters that, instead of unambiguously confirming amounts owgd to Just for Feet at the end of the fiscal lg98 year, as requested by the auditors, provided ambiguous information on amounts of co-op [vendor erllowances'l that the -ompany had earned, accrued, or had available during the /€01r" [emphasis added ny SgCi. Another of the returned confirmations explicitly noted that "n6 additionzrl funds" were due to Just for Feelt.

The eight nonstandard confirmations accounted for approxim,ately $lG million of the $22 million of vendor allowance receivables that Deloitte attempted to confirm at year-end. "Despite these and other flaws, the Rr:sponclents fDeloitte, Berrry, and

9. Securities and Exchange Commission, Accounting and Audittng Einforcement Release Nct. Zl3B,26 May 2005. Unless noted otherwise, the remaining quotations in this case were tal:en from this source.

cAsE 1.3 Jusr Fon FEET, INc'

Baker] nonetheiess accepted these letters as confirming approlT3t"ty

$16 millio:n in

receivables craimed by Just for Feet." The sEc's investig"atitn of Deloittt:'s

Just for lreet

audits reveared that arthough Barry and Baker acceptJd these flawed

confirmations,

two subordinates assigned to the tbgs

"ngugement i"u. continued to investigate the

obvious discrepanciei in those ;;li;,iiL:til after the completion of that ar'rdit'

These two individuais, who were audit seniors, twice contacted a Just for

Feet ex3cu-

tive in the months folrowing the .o-prution of the 1g9B audit in an

at'empt to ob'tain

prausible explanations foi tr," "igr,i nonstandard and suspicious

r:onfirmations'

That executive did not respond i" it

" audit seniors and neither Barry,

nor Baker,

apparently, insistea ir,ut t " prouii" ufpropriute documentation and/or

explanations

regarOingthe amounts in question'

Just for Feet,s rarge increase rn inventory during fiscai 19g8 raisedL seV€ral

intpor-

tant issues that tr,ebetoitte audiiors had tl aadre"ss during the 1gg8 audit,

the most

important being whether the client,s reserve for irwentor! obsorescence

was suffi-

cient. The primiry audit pro.edu.e used by Deloitte during the 1998; audit

to a:;sess

the reasonuUr.nurrot tfr" client's inventory valuation reserve was

to obtain an<1 test

an inventory "r"r"ive unalysis" prepared !y

a company vice presirlent' This latter

document was supposed to incrirJ" tr,* foliowing tirree classes of inventory

i'tems

for which company policy required apprication oi th* rower of cosr or

market ruie:

(1) shoe styles tor w'f,i.ft ih. .otpuny f,ua foYt-:t fewer pairs' (2) shoes

and other

apparel that were selling for lesstlian tost, and (3) any inventory styles

for whir:h no

items had been sord during the frevious 12 months. The reserve analysis for

1998'

however, excluded those inventJry styles for wjrich no sales had be:en

made during

the previous 12 months, un ou"rrigr,tinut the Deroitte auditors nev(3r questionLed

or

investigat*0. r-t . outoiti* auditor*rso discovered that a rarge am.unt of

inventory

incruded in a Just for Feet warehouse had been excruded from the res;erve

an'alysis

prepared by the company vice fresident' Again' the auditors chose not to

qur:stion

client personnel regarding this oversight

After completing their inu"ntory uuiit procedures, the Deroitte auditors co.ciuded

that Just for Feet's year-end ,.r",u" foi inventory obsolesggnc3 rnras

signifir:antiY

understated. The sEC noted that this concrusion,"u, reached by the Deloitte

auditors

despite the ouvious deficiencies in arait procedures applied to Just for Feet's r'|eserve

for inventorY obsolescence: . , , -., )

Euen using the flawed inuentory analysis prouided by the -vice

President und

the deficient inuentory inforiitfon halexciuded the goods from the New Jersey

warehouse, the Respondents" cincluded that Just for Feet's obsolescence reserue

s h o u l d h a u e b e e n i n t h e r a n g e o f $ 4 4 1 , 0 0 0 t o o u e r $ l m i l l i ' o n ,

T h e D e } o i t t e a u d i t t e a m p r o p o s e d a n a u d i t a d l u s t m e n t t o i n c r e a s e t h e r e s e : r v e f o r inventory obsolescence by more than $400'006;

however' the client reiectr:d that

audit adjustment, meaning tfrai tfre year-end balance of that account remained

at a

-X1rt"Jj;f,t;t"?:r"cirically identiried as a

*key audit risk area" during the 1998 audit'

the Deroitte auditors focused considerable attention on Just for Feet's accounting

decisions for the approxim"r"rv sg ""rillion of "uootrr income" the conrpany

re:corded

during that year. The Deroitte auditors discovered the monthrLy bool.h incorne iour-

nar entries recorded by Just for Feet during fiscar lggg and prepared

a workpaper

documenting those entries. ,nn unutyri, uitr,. end of the workpaper'

which Baker

reviewed, showed that the n"i"ttu.t of Just for Feet's booth-rerated lournal

entries

was to increase assets with atorr.rponding increase in income' The Respondents

[ D e i o i t t e , B a r r y , a n d B a k e r ] p " r t o r * - e d n o f u r t h e r a n a i y s i s t o d r : t e r m i n e t h e b a s i s ind propriety of these lournal entdes'"

1so, t I

SECTION ONE COIVIPREHENSIVE C,q.SSS

Instead of independently investigating these entriers, the Deloitte audito1-s acceptedi the representation of a Just for Feet executive that the entries had no effect on the company's net income. According to this executive, the monthly boo,th income amounts were offset by preexisting "co-op" or ad,rertising credits thal had been granted to,Just for Feet by its major vendors. In other words, instead of using those advertising credits to reduce reported advertising e.Kpenses, Jgst for Feet wai alleg- edly converting those credits into booth income or rravenue amounts.

By the end of 1998, the bogus booth income jourrral entries lhad produ,c€d $9 mil- lion of nonexistent "booth assets" in Just for Feet's accounting records. Since "nei- ther the Company nor the auditors had internal evidence supporting the recording of $9 million of booth assets," the Deloitte engagement t.eam decided to corroborate the existence and ownership assertions for those assets by obtaining confirmations from the relevant Just for Feet vendors. These confirmations were prepared witlh the assis- tance of certain Just for Feet executives who were a,^/are of ther fraudulenLt nature of the booth income/booth assets amounts. Apparently, these executives contacted the vendor representatives to whom the confirmations were mailed and told them how to respond to the confirmations. The booth assets confirmations returned by the vendors to Deloitte were replete with errors and ambiguous statements. A frustrated audit senior who reviewed the confirmations brouglit this matter to the attention of both Barry and'Baker.

An audit senior reuiewed these confirmations ond info'rmed Barry and Boker that she was in some coses sending multiple confirmation re,quests to th:e uendors fiecause many of their tnitiol requests come back in forms diflerent from tttat requested. The Respondents failed to discouer from these tndicqtions that Just for Feet mipht not octually .. [ownJthe booths as claimed.

iji '.,i'

t $ #f f i f f i $ In February 2000, after realizing that Just for Feet was no longer salvageable, Helen Rockey began the process of liquidating the company u n d e r C h a p t e r 7 o f t h e f e d e r a l b a n k r u p t c y c o d e . O v e r t h e n e x t f e w y e a r s , s e t t l e m e n t s were announced to a number of large lawsuits l i n k e d t o t h e J u s t f o r F e e t a c c o u n t i n g f r a u d a n d t h e c o m p a n y ' s s u b s e q u e n t b a n k r u p t c y . Just for Feet's former executives and Deloitte were among the principal defendants in those l a w s u i t s . O n e o f t h o s e c a s e s , a c l a s s - a c t i o n lawsuit filed by Just for Feet's former stockhold- e r s , w a s s e t t l e d f o r a r e p o r t e d $ g Z . q m i l l i o n i n 2 0 0 2 .

Several of Just for Feet's former executives p l e a d e d g u i l t y t o c r i m i n a l c h a r g e s f o r t h e i r r o l e s i n t h e c o m p a n y ' s m a s s i v e a c c o u n t i n g f r a u d . A m o n g t h e s e i n d i v i d u a l s w a s D o n - A l l e n R u t t e n b e r g . I n A p r i l 2 0 0 5 , a f e d e r a l

j u d g e s e n t e n c e d R u t t e n b e r g t o 2 0 m o n t h s i n f e d e r a l p r r i s o n a n d f i n e d h i m $ 5 0 , 0 0 0 . A t t h e same timLe that the younger Ruttenberg's sen- tence woLs &nnounr:ed, a Justice Department official reported that Harold Ruttenberg, who was grav(:ly ill with brain cancer, would not be charged in the case. In January 2006, F{arold Ruttenberrg died at tlhe age of 63.

Five executives of Just for Feet's former ven- d o r s a l s o p i e a d e d g u i l t y t o v a r i o u s c r i m i n a l charges for providing false confirmations to the company's auditors. Most of these individuals, including Thomas Shine, receilred probationary sentencer;. An exception was Timothy McCool, the formelr director,of apparel sales for Adidas, who received a four-month "noncustodial" sen- tence. Wrhile sentencing McCool, U.S. District Judge C. Lynwood Simith, Jr., noted, " Life is so fragile. A single bad choice in a single moment

cAliE 1.3 Jusr Fon FEET, INc'

can cause a life to turn irrevocably 180 degrees'

il;k that is where you find yourself'"l0

' 'AtguuUly, the putiy to the Just for Feet scan-

o"itiiit ,uceiu"d the most condemnation from

ir," .""us and the business press was Deloitte.

il^tt* ioos, the SEC berated the promin-ent

accounting firm for the poor quality of its Just

f o r F e e t a u d i t s \ n A c c o u n t i n g a n d A u d i t i n g'iifontr.ent Release /Vo' 2238' ln that same

enforcement release' the SEC fined Deloitte

6 s ? s , o o o a n d s u s p e n d e d S t e v e n B a r r y f r o m

r"t"t,tg on audit "ngug"*entsjnvoiving SEC

registrants for two yitl; Karen Baker received

a On€)-Year Suspenslon' On the ,u*"-Jute that ihe

SEC announced

the sa.nctions thaiit had imposed on Deloitte for

its Just for Feet audits' the federal agency aiso

revealed the sanctions that Deloitte received for

io .ff.g"Oly deficient audits of a large telecommu-

nicaliions company, Adelphia Communications'

Similar to Just for'Feet' the once high-flying

Adelphia had suddenly collapt-"d in 2002 follow-

ing revelations'ftu' i" pteviolsty issued financial

statements thai had been audited by Deloitte

were riddled *ith t"ors' The SEC stunned the

public accounting prof essio.n ny f ining- Deloitte

650 miffion tor itsiie in the huge Adelphia scan-

dal, which *ut ""tify

the iargest fint tuer imposed

on,tn accounting firm by the federal agency'

Shortly after the SEC anlnounced the sanc-

tions tfrit it had levied on Deloitte for its Just

iot f"., and Adelphia Communications audits'

.rl*", Quigley, Deloitte's CEO' issued a press

;;i;;;" i"tionoing to those sanctions' Quiglev

n o t e d i n h i s p r e s s r e l e a s e t L r a t , . . A n l o n g o u r *or, significant challenges is

the early detec-

tion of Iraud, particularly when the client' its

management and others collude spec:ifically to

deceive a company's auditrlrs.,ll This statement

intutiut.O SEC officials' An SEC spokespers-on

r"tp"tO.d to Quigley's press release by stating

lh;, "Deloitte wJs not dercelved in this case'

The findings in the order slhow that thLe relevant

information was right in front of their eyes'

Deloitte lust didn't d"o rts !ob' plain and simple'

ih.t iidn't *iti red flags' Thev pullr:d ll: 1?g ou"t,ft"it head and claimed

they couldn't see"'"'

T h e S E C a } s o s u g g e s t e c l t h a t Q u i g l e y ' s p r e s s i release violated tt" t"ttnt

of the agreemen'[

that the ug"nty had reached with Deloitte irt

,"rifi"g th; Ju;t for Feet and Adelphia cases'

Under the terms of that agreement, Deloittr:

was not ,"q"i'"d to "adrnii' to the SEC's findl-

ings, nor was ii attowed to "deny" those finct-

ings. Deloitte sGequently rescinderd Quigley's

press reiease unO i"u*d another that eiimi-

nated some, bui not ail' of the statr:ments that

had offended the SEC'

l";r|'f,::1or*on_sized baiance sheers and income sratements

f'r Just for Feer

for the perioalogg-rgsg. ,qrro.o*pute key.liquidity, solvency' activity'

and

profitabiiity ralios for 1gg7 una igsg. Giventhese data, comment

on whaty<lu

beiieve were the high-risk finanJaistatement items for the lggg Just for

Fee't

"tOir. z. Just for Feet operated large,

high-vorume retail stores. Identify internal control

risks .o**on to such uurin"r?*r.;;;hluiJ 'rt"te risks affecl. the audit

planning decisions for such a client?

$. The Associated Press State & Local Wire'

'Adidas America Executive Sentencecl in Just for Feet

. . ' Case," 22 March 2004'- d s e ' L L r v r q r L r r l v v '

c F o ' c o m ' 2 8 A p r i l 2 0 0 5 '

i1. S. Laub, "Deloitte Statement Irks SEC"'

. r r - t - L i ^ A ' r A i f

ll : i#;":'"i?:";"Tff:ilii:i:::", ro,n or Aderphia,quiit," rhe Associateat Press

state 3i Local

Wire,27 APril2005'

3.

4 .

5.

sEcnoN oNE CoupRnHENsrvE Casrs

Just for Feet operated in an extremely competitiver industry, or subindustry. Identify inherent risk factors common to businessres 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 audit risk factors present for the 1998 Just for Feet audit. Identify the five aurdit 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 ther Deloitte auditors responded appropriately to the five critical audit risk factors that you identified.

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