CASE STUDY: THE LESLIE FAY COMPANIES

Summary:
The Leslie Fay Companies, which was a manufacturer of womens
apparel, was founded by Fred Pomerantz. The company was named after his
daughter. From the beginning, Pomerantz focused Leslie Fay on one key
segment of the industry, by developing a moderated priced and a
conservative style dresses for women aged 30 through 35. The company
was based out of New York, and Fred Pomerantz made the company public in
1952. However, Fred Pomerantz ended up taking the company back to a
private entity for a few years in the 1980s due to a buy out from his son
John Pomerantz. The Leslie Fay Companies became public again in 1986. In
late 1980s and early 1990s, the economy decline, and the recession caused
many consumers to limit their discretionary expenditures, including buying
new clothes. After John Pomerantz had taken over the company, profits
started climb sharply even though the market for womens apparel was
going downhill due to the recession from the 1980s through the 1990s. Its
major competitor, Liz Claiborne, whose revenue faced slowing sales from its
major product lines, was eventually forced to take large inventory writedowns. Despite the economic trend towards casual clothing affecting the
womens apparel industry, Leslie Fay reported impressive sales and earnings.
In early 1993, a large accounting fraud was revealed, and investigators
determined that Leslie Fays earnings were overstated by $80 million from
1990 1992. Through analyzing the financial statements, it can be seen that
there was a huge constant increase of net income from 19871991. It was
reported that Kenia, a subordinate of the strict CFO Polishan, was responsible
for plotting the fraud and conniving other work members. Together with
Kenia, the auditor BDO Seiman was pulled out of his job as a punishment for
conducting an unreliable and incomplete audit. After several massive
investigations for years, the truth that Polishan was the real perpetrator of
fraud was revealed. Because of his dominant and ambitious attitude, he had
managed to the put the blame on Kenia. With this, the fraud seemed
reasonable due to the rationale that CFOs and CEOs had large bonuses
during year-ends.
QUESTIONS:
1. In addition to the data shown in Exhibit 1 and Exhibit 2, what other
financial information would you have obtained if you had been
responsible for planning the 1991 Leslie Fay audit?

Other financial info that the auditor might have obtained are: all
contracts or agreements of Leslie Fay and department stores
to verify the Accounts Receivable and Liabilities. Auditors need
to understand the relation that Leslie Fay Company had with its
customers, and to understand the company policy and procedures with
regard of sales; any documentation with its customer regarding
its orders. Fictious customers can be created and inflate the sale and
that will result in an increase in the accounts receivable; any credit
and bad debt write-off policy. Since the industry suffered of the
downhill sales, the auditors should analyze companys policy of writeoff. All other major competitors had to write-off while Leslie Fay
announced a record of sales for the same period. The auditor must
obtain sufficient appropriate audit evidence by performing audit
procedures to afford a reasonable basis for an opinion regarding the
financial statements under audit. The audit documentation should be
prepared in sufficient detail to provide a clear understanding of its
purpose, source, and the conclusions reached.
2. Prepare common-sized financial statements for Leslie Fay for the
period 1987-1991. For that same period, compute for Leslie Fay the
ratios shown in Exhibit 2. Given these data, which financial statement
items do you believe should have been of particular interest to BDO
Seidman during that firms 1991 audit of Leslie Fay? Explain.
After reviewing the common size financial statements and the key
ratios of Leslie Fay, there some of the financial statement item that
should have been of particular interest to BDO Seidman:
Sales have been growing steadily except the slight drop in 1991,
which is contrary to the industry recession.
Inventory. Leslie Fay has been known for not catching up the
fashion, as a result there should be inventory write-off issue in
the apparel industry, but it hasn't been reflected in the inventory
account.
Accounts Receivables are always in a question because of its
nature of hiding fraud.
Other assets account. As the current and quick ratio of Leslie Fay
show, these ratios are significantly higher than the industry
norm.
Liability accounts. Accounts Payable and debt could be
understated.

3. Paul Polishan apparently dominated Leslie Fays accounting and

financial reporting functions and the individuals who were his
subordinates. What implications do such circumstances pose for a
companys independent auditors? How should auditors take such
circumstances into consideration when planning an audit?

When planning an audit, it is important to consider the credibility

of the client. In a perfect world it would be in the audit firms best
interest to have unethical clients. As we all know even the reputable
firms get caught up in a fraud scandal. In the case of Leslie Fay, Paul
Polishan had a reputation of being a strict executive that even had
rules for what you could have at your desk. He kept a close watch on
his subordinates with his tough rules and long hours.
The auditor neither assumes that management is dishonest nor
assumes unquestioned honesty. In exercising professional skepticism,
the auditor should not be satisfied with less than persuasive evidence
because of a belief that management is honest. BDO should have been
more skeptic of the executives at Leslie Fay especially Paul Polishan.
Especially because of the reputation Polishan was known for. When you
have someone micromanaging everything it makes it easy for collusion
even if it is by force. Polishans strict character left no room for
transparency. BDO should have been more thorough when interviewing
employees. We believe that when planning for an audit, the audit risk
should always be raised when dealing with a micromanaging CFO that
has everything in his hands. Like we saw in the case, when a chief
executive is strict and manipulative, it becomes easier to collude on a
fraud such as Leslie Fay. The perpetrator of the fraud would have
gotten away if it werent for the intense questioning from the federal
government. It is important for audit teams to increase their
professional skepticism and be able to identify the heightened risk.
Companys independent auditors should establish an overall
strategy and communicate the objective and also set forth the nature
of communications required from the companys personnel as per the
standards. The auditor should consider the public information about
the company and evaluate the possibility of material misstatement and
the companys internal control over financial reporting.
4. Explain why the SEC ruled that BDO Seidmans independence was
jeopardized by the lawsuits that named the accounting firm, Leslie Fay,
and top executives of Leslie Fay as co-defendants.
An auditor must be in independent in fact and in
appearance. An accountant is not considered independent when the
accountant has a mutual or conflicting interest with the audit client,
audits his or her own firm's work, functions as management or an
employee of the audit client, or acts as an advocate for the audit
client. As to the situation, BDO Seidman had gone through
consideration number one. The auditing firm could not be denied by a

conflicting interest towards Leslie Fay due to the lawsuit already filed
by the company. The S.E.C. found that Leslie Fay's original auditor,
BDO Seidman of New York, was too close to the accounting scandal
and could not be considered independent within the meaning of S.E.C.
regulations. The independence issue would have been solved if BDO
Seidman had quality controls. For the largest public accounting firms,
the basic controls must include, among others, written independence
policies and procedures, automated systems to identify financial
relationships that may impair independence, training, internal
inspection and testing, and a disciplinary mechanism for enforcement.
Also, the violation must had corrected promptly once the issue became
apparent. But BDO Seidman was reckless in auditing companys
periodic financial statements and did not evaluate the red flags such as
implausible trend lines in the companys financial data, implausible
relationship between key financial statement items and unreasonably
generous bonuses paid to the top executives.
5. List nonfinancial variables or factors regarding a clients industry that
auditors should consider when planning an audit. For each of these
items, briefly describe their audit implications.
An auditor should establish overall audit strategy for developing
an audit plan which includes planned responses to the risk of material
misstatement. The auditor should consider the matters affecting the
industry in which the company operates, such as financial reporting
practices that pertain to the industry, economic conditions that
affects the overall performance of the industry, which gives
auditor an overall opinion about the companys expected growth and
its profit margin level pertaining to the industry standards. The auditor
should be aware of laws and regulations that have to be followed
and the one that has been changed has to be considered in audit
planning and noncompliance with regulations may have an impact of
dollar value or legal issues which the auditor should consider.
Technological changes have to be considered in audit planning
stage. Matters relating to companys business, its operating
characteristics, capital structure, recent changes in its operation,
control deficiencies that has been previously communicated has to be
considered in the planning stage, which can affect the companys
performance and thus resulting in misrepresentation of accounts. The
auditors preliminary judgment about materiality and factors relating to
material weakness and effectiveness of internal control should be
considered in the planning stage.