Case 1.5 The Leslie Fay Companies
Vahida Yacub
Ana Lopez
Luminita Tanase
Accounting 6355
Seminar in Auditing Standards and Application
Professor: Dr. Yonghong Jia
September 12, 2012
Written Case Aalysis
Leslie Fay Companies (1.5)
Synopsis
The Leslie Fay Companies, which is a manufacturer of women’s 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 developed a moderated priced and a
conservative style dresses for women aged 30 through 35. The company is 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 1980’s 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 women’s apparel was
going downhill due to the recession from the 1980’s through the 1990’s. Its major competitor,
Liz Claiborne, whose revenue faced slowing sales from its major product lines, was eventually
forced to take large inventory write-downs. Despite the economic trend towards casual clothing
affecting the women’s apparel industry, Leslie Fay reported impressive sales and earnings. In
early 1993, a large accounting fraud was revealed, and investigators determined that Leslie Fay’s
earnings were overstated by $80 million from 1990 – 1992. Analyzing the financial statements
can be seen there is a huge constant increase of net income from 1987–1991. According to
PCAOB Audit Standard No. 12, the auditor needs to have knowledge of the company which
includes being knowledgeable of what industry the company is in, knowledge of the company’s
creditors, suppliers, customers, in addition, knowledge of industry. The Standards of Field Work
under GAAS, statement #2 requires auditors to have knowledge about the company’s
environment, “The auditor must obtain a sufficient understanding of the entity and its
environment, including its internal control, to assess the risk of material misstatement of the
financial statements whether due to error or fraud, and to design the nature, timing, and extent of
further audit procedures”.
Key Issues Related to Auditing
1.Auditors should always be aware of industrial situations pertaining to the company they
are auditing (AS#9), When Leslie Fay reported net sales of 836.6 million when the rest of
the industry competitors were struggling to make profit indicates that the sales account
has to be substantially tested and verified for material misstatement.
2. During recession when the competitors were forced to take large inventory write-offs,
this company had none, which has been overlooked by the auditors.
3.When Leslie Fay reported an increase in sales from 582 million in 1987 to 836.6
million in 1991 and their cost of sales account increased only from 403.1 million in 1987
to 583.1 million in 1991 which is proportionately less, makes the account susceptible of
material misstatement. The auditors should have examined the internal control, sent
letters to the customers to verify the sales, as in Accounting standard no. 13
3.Inventory, in retail business has always been analyzed as a potential threat for
misrepresentation, in this case the period end inventory has been inflated from 83 million
in 1987 to 126.8 million in 1991, which is a red flag and has to be further examined by
the auditors.
4.Orders received from customers were recorded as sales, the company failed to
recognize write-offs, ignored discount on receivables, which can be an inherent risk for
such companies where the accounting system was maintained in old fashioned way of
recording the entries manually, which can be easily manipulated by one person, the
auditors has to examine the internal control and accuracy of such transactions as one of
the audit risk.(AS # 8)
Responses to case Questions
1. Prepare common-size 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 firm’s 1991 audit of Leslie Fay? Explain.
Common size Balance Sheet The Leslie Fay Companies
ASSETS
Current Assets:
Cash
Receivable(net)
Inventories
Prepaid Expenses & Other Current
Assets
Total Current Assets
Property, Plant and Equipment
Goodwill
Deferred Charges and Other Assets
Total assets
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Notes payable
Current Maturities of Long-term Debt
Accounts Payable
Accrued Interest Payable
Accrued compensation
Accrued Expenses & Other
Income Taxes Payable
Total Current Liabilities
Long Term Debt
Deferred Credits & Other Noncurrent Liabilities
Total Shareholders' Equity
Total Liabilities and Shareholders' Equity
1991
1990
1989
1988
1987
1%
30%
32%
1%
32%
34%
1%
30%
31%
2%
30%
29%
1%
27%
27%
5%
68%
5%
72%
5%
68%
5%
66%
5%
61%
10%
21%
1%
100%
7%
20%
1%
100%
7%
24%
1%
100%
7%
26%
1%
100%
8%
30%
2%
100%
9%
0%
8%
1%
4%
1%
0%
23%
11%
0%
10%
1%
3%
1%
1%
27%
6%
0%
10%
1%
5%
1%
1%
25%
8%
0%
13%
1%
5%
2%
2%
30%
5%
0%
10%
1%
3%
2%
1%
24%
21%
1%
55%
100%
30%
1%
43%
100%
33%
1%
41%
100%
32%
1%
37%
100%
38%
2%
39%
100%
Common size Income Statement The Leslie Fay Companies
Net Sales
Cost of Sales
Gross Proft
Operating Expenses:
Selling, Warehouse, General and Administrative
Total Operating Expenses
Operating Income
Interest Expense
Income Before Taxes on Income
Income Taxes
Net Income
1991
100%
70%
30%
1990
100%
69%
31%
1989
100%
68%
32%
1988
100%
68%
32%
1987
100%
69%
31%
22%
23%
7%
2%
5%
2%
4%
23%
24%
8%
2%
6%
2%
3%
23%
24%
8%
2%
6%
2%
3%
23%
23%
8%
3%
6%
2%
3%
23%
23%
7%
3%
5%
2%
3%
Industry
Liquidity
Current Ratio
Quick Ratio
Solvency:
Debt to Assets
Times Interest Earned
Long-term Debt to Equity
Activity:
Inventory Turnover
Age of Inventory
Accounts Receivable Turnover
Age of Accounts Receivable
Total Asset Turnover
Profitability:
Gross Margin
Profit Margin on Sales
Return on Total assets
Return on Equity
The Leslie Fay Companies
1.8
0.9
2.91
1.33
2.64
1.21
2.75
1.28
2.20
1.06
2.58
1.21
0.53
4.2
0.14
0.45
3.42
0.83
0.45
3.61
1.35
0.57
3.27
1.43
0.63
3.13
1.71
0.63
2.60
1.73
6.7
53.7 days
8
45.5 days
3.1
6.60
55.3 days
6
60.7 days
2.1
5.81
62.85 days
6.69
54.57 days
1.96
6.49
56.21 days
6.92
52.73 days
2.03
6.38
57.21 days
7.08
51.54 days
1.88
7.01
52.05 days
7.02
51.99 days
1.91
31.50%
2.20%
6.00%
14%
30.06%
3.51%
15.8%
13.62%
31.37%
3.39%
15.38%
15.51%
31.73%
3.28%
16.29%
16.16%
31.70%
3.27%
15.67%
16.67%
30.74%
3.38%
13.95%
17.61%
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 has 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.
According to PCAOB – AS 12, auditors should obtain an understanding of the company and its
environment - paragraphs 7-17.
2. 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:
- 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 is customers, and to understand the company policy and procedures with regard of sales.
-Any documentation with its customer regarding its orders. Fictios 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 analize company’s policy of write-off. All other major competitors had to writeoff while LESLIE Fay announced a record sales for the same period.
The other financial information about the company falls under the Standards of Field Work
under GAAS, statement # 3, “The auditor must obtain sufficient appropriate1 audit evidence by
performing audit procedures to afford a reasonable basis for an opinion regarding the financial
statements under audit.” According with PCAOB -AS 3, the audit documentation should “be
prepared in sufficient detail to provide a clear understanding of its purpose, source, and the
conclusions reached.” Also, according to PCAOB AS 15, auditors should “plan and perform the
audit to obtain appropriate audit evidence that is sufficient to support the opinion expressed in
the auditor's report.”
3. List nonfinancial variables or factors regarding the industry that auditors should
consider when planning an audit and its audit implications:
As mentioned in AS No. 9 “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 company’s expected growth and its profit margin level
pertaining to the industry standards.
The auditor should be aware of laws and regulations that has 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 company’s 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
company’s performance and thus resulting in misrepresentation of accounts.
The auditor’s preliminary judgment about materiality and factors relating to material
weakness and effectiveness of internal control should be considered in the planning stage.
4. Auditor’s consideration when planning an audit:
Company’s independent auditors should establish an overall strategy and communicate
the objective and also set forth the nature of communications required from the
company’s personnel as per PCAOB standards.
The auditor should consider the public information about the company and evaluate the
possibility of material misstatement and the companys internal control over fianancial
reporting.
5.Explain why the SEC ruled that BDO Seidman’s independence was jeopardized by the
lawsuits that named the accounting firm, Leslie Fay, and top executives of Leslie Fay as codefendants.
BDO Seidman had served as Leslie Fay’s audit firm since the –1970s and issued unqualified
opinions each year on the company’s financial statements. Following Pomerantz’s disclosure of
the fraud, BDO Seidman withdrew its audit opinions on the company’s 1990 and 1991 financial
statements. In the ensuing weeks, Leslie Fay stockholders filed several large lawsuits naming the
company’s management team and BDO Seidman as defendants.
In April 1993, BDO Seidman officials contacted the Securities and Exchange
Commission (SEC), and inquired regarding to the status of their firm’s independence from Leslie
Fay given the pending lawsuits. The SEC informed BDO Seidman that its independence was
jeopardized by those lawsuits, which forced the firm to resign as Leslie Fay’s auditor in early
May 1993. Company management immediately appointed Arthur Anderson as Leslie Fay new
auditor.
In September 1993, Leslie Fay’s audit committee completed its eight-month investigation of the
accounting fraud. The resulting 600-page report was reviewed by members of Leslie Fay’s board
and then submitted to the SEC and federal prosecutors. Although the report was not released
publicly, several of its key findings were leaked to the press. The most startling feature of the
fraud was its pervasive nature. According to the company insider who read the report, “there
wasn’t an error entry on the cost side of the company’s ledgers for those years that wasn’t
subject to some type of rejiggering”.
BDO Seidman was reckless in auditing company’s periodic financial statements and did not
evaluate the red flags such as implausible trend lines in the company’s financial data ,
implausible relationship between key financial statement items and unreasonably generous
bonuses paid to the top executives.
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