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Yra Dessa T. Diansay August 1, 2013 Novah Mae B. Samar John Rey D.



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 1987 1991. 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.