Auditing Analysis of Herbalife

Audit Quality and Standards

Conducting quality audits is essential to maintaining a stable economy. I result in the public trusting what they are being told. It allows for creditors and investors to make decisions and rely on the financial statements for this information. In the world of big data, there are four environmental conditions that will result in an increase in user demand for relevant and reliable information, which include complexity, remoteness, time sensitivity, and consequences. As more and more information becomes available, the environment becomes more complex, and this results in there being more content to look through and understand. Therefore, someone outside the business might miss something that is off due to the complexity of it, which is why audits are crucial. Remoteness is referring to the fact that decision makers are not in the company and are often physically far away. They can’t just stop by to check in, which is why auditors are there to do so. It is rare for anything in business to not be time sensitive, therefore, financial information needs to be shared quickly while still being effective. Finally, the consequences go back to the idea that if the quality of the financial information being put forth is not being audited, there can be drastic consequences to the economy.

The main governing standards of auditing are the General Accepted Accounting Standards. These are the “auditing standards that identify necessary qualifications and characteristics of auditors and guide the conduct of the audit examination”. These set the expectation and rules for how and audit should be carried out. These standards are set in order to carry out the objective of obtain reasonable assurance that the financials are free from material misstatement and that they at a quality that can be trusted by the users. The auditing standards are not identically among different types of entities. Public entities are governed by the Public Company Accounting Oversight Board (PCAOB). Nonpublic entities are governed by the AICPA Auditing Standards Board. Governments are governed by the Government Auditing Standards, set by the Government Accountability Office. Lastly, Foreign Entities follow International Standards on Auditing, set by the International Auditing and Assurance Standards Board. Auditors must be versed in these different standards and pay attention to when to use what standards. This could be the difference between misleading the public or not. 

There are three fundamental principles of auditing: responsibilities, performance, and reporting. The responsibilities principle states that auditors are responsible for being competent to complete the audit, complete their work ethically, and maintain professional skepticism throughout the entirety of the audit. This requirement essentially says the state of mind and skills one must have to complete a quality audit. This includes being independent both in fact and appearance in order to make unbiased opinions. The performance principle states the general expectation of what is to be done in order to complete a quality audit. This includes, but is not limited to planning the work, determining the materiality threshold, identifying risk, and what evidence and testing needs to be collected or completed. Essentially, the audit should provide reasonable assurance that the financials are free from material misstatement. Finally, the reporting principle states that the auditor must issue an opinion on the quality of the financial statements based on their audit.

Risk Assessment

Herbalife is a nutrition company that targets the areas of weight management and wellness for both fitness and sport goals. They do business in over 90 countries and had revenue of $4,891 million in 2018. They are headquartered in Los Angeles, but are incorporated in the Cayman Islands. The Cayman Islands law does not establish shareholder rights in as much depth as the United States does, which may result in shareholders having difficulty protecting their interests. Currently, Michael Johnson is their acting chairman and CEO, and he was originally before Richard Goudis. Upon the chaos and conflict that occurred, he has taken over again. Herbalife is structured with upper level management, a board of directors, and then their 2.3 million distributors. The distributors the are responsible for selling the product to customers. They consider them to be “independent entrepreneurs” and call this the Direct Selling Model. The process starts when distributors purchase the Herbalife products at a discounted rate, they then sell the products at full price, and earn commission on the transactions. Distributors are also responsible for recruiting new distributors to become a part of their team. You can only become a distributor through an existing one.

The film “Betting on Zero”, documents how Bill Ackman looked into Herbalife and exposed them for being a pyramid scheme. A pyramid scheme is defined as, “a form of investment in which each paying participant recruits further participants, with returns being given to early participants using the money contributed by later ones.” From this description it become obvious from the information presented in the documentary, and Herbalife’s own financial information and business organization that they are essentially a pyramid scheme. Within the film it is stated that only 17% of these distributors actually earn any commission. In these situations, people are losing money by heavily investing into Herbalife by purchasing product, but if they can’t recruit enough new distributors, they’ll end with a loss. The film highlights the devastating effect this had on people who invested their life savings into buying products, and losing it all. The Latino community was specifically targeted due to their hope to achieve the American dream and lack of understanding of the company. Only the people who were original, early distributors were able to actually make a profit, and they were getting paid because of new distributors getting recruited, not because products were actually being sold.

In 2016, Herbal life was charged with deceptive business practices and was fined $200 million as a settlement with the Federal Trade Commission. They were also required to restructure so that commissions were based on products sold, not recruitment. It is now required that 2/3 of compensation must be for dales. This can be seen on their website, although recruitment is still part of their responsibilities. Essentially this settlement allowed Herbalife to remain in business as long as they removed the pyramid scheme aspects of their company.

Based on Herbalife’s past business practices and company structure, it causes them to have high risk of materially misstating their financial information.  A high-risk area would be sales because Herbalife sells their products to distributors, who then sell the products to others. This could create a risk area because they have to recognize revenue when it is earned. Herbalife uses retail value to report gross sales, which is a non-GAAP method and is not the amount they are actually being paid. They have another line item called distributor allowances, which is the discount distributors received. The net of the retail value sales and distributor allowance gets the actual amount actually paid by members. They also state in their 10K that they recognize revenue when the distributor member receives the products. Another area of concern is inventory. This is because they are selling product at multiple levels and product also will expire. They have obsolete inventory adjusted down $29.8 million and slow-moving inventory written down $30.8 million. Ensuring they are accurately writing down inventory is important to reasonably assuring there are no material misstatements.

Audit Procedures

Prior to doing testing, a materiality threshold should be established. Net Sales is one of the largest accounts, and highest risk, especially considering their past history, and thus is what will be used to calculate materiality. Net sales for 2018 were $4,891.8 million.

Plan

Works Cited

• Braun, T. (Director). (2017). Betting on Zero [Motion Picture].
• Herbalife Will Restructure Its Multi-level Marketing Operations and Pay $200 Million For Consumer Redress to Settle FTC Charges, Federal Trade Commission, 15 July 2016, Accessed 8 Dec. 2019.
• Louwers, Timothy J. Auditing and Assurance Services, Seventh Edition. New York: McGraw Hill Education, 2018. Print.
• “2018 Annual Report.” Herbalife LTD, 2018 Form 10-K 2018.