THE LESLIE FAY COMPANIES

CASE 1.5

THE LESLIE FAY COMPANIES

Synopsis FredPomerantz founded Leslie Fay in the mid-1940s and built the company into one of the leading firms in thehighlycompetitive women’s apparel industry over the next four decades. Fred’s son, John, took over the company in 1982 after his father’s death. Over the next ten years, the younger Pomerantz added to his father’s legacy by maintaining Leslie Fay’s prominent position in its industry. In January 1993, John Pomerantz’s world was rocked when his company’s CFO, Paul Polishan, told him of a large accounting fraud that had inflated Leslie Fay’s operating results during the previous few years. Polishan had learned of the fraud from his top subordinate, Donald Kenia, Leslie Fay’s controller. Kenia revealed the fraud to Polishan and, at the same time, reportedly confessed that he was the mastermind behind the fraud.Public disclosure of the large-scale fraud sent Leslie Fay’s stock price into a tailspin and prompted the press to allege that Pomerantz and Polishan must have either participated in the various accounting scams or, at a minimum, been aware of them. Within a few months, Leslie Fay was forced to file for protection from its creditors in federal bankruptcy court. In the meantime, investigations by law enforcement authorities corroborated Pomerantz’s repeated denials that he was involved in, or aware of, the fraud. However, those same investigations implicated Polishan in the fraud. Another party tainted by the investigations was Leslie Fay’s former audit firm, BDO Seidman. One investigative report noted that negligence on the part of the accounting firm had likely prevented it from uncovering the fraud.In July 1997, BDO Seidman contributed $8 million to a settlement pool to resolve several lawsuits stemming from the Leslie Fay fraud. In thesummer of 2000, federal prosecutors obtained an eighteen-count felony conviction against Paul Polishan. The key witness who sealed Polishan’s fate was his former subordinate, Donald Kenia. During the contentious criminal trial, Kenia admitted that Polishan was the true architect of the Leslie Fay fraud. Kenia had initially accepted responsibility for the fraud only after being coerced to do so by Polishan. In early 2002, Polishan began serving a nine-year sentence in a federal prison. Kenia received a two-year sentence for helping his superior perpetrate and conceal the fraud. Leslie Fay emerged from bankruptcy court in 1997 but was bought out by another firm in 2001.32 Contemporary Auditing 10th Edition Knapp Solutions Manual Visit TestBankDeal.com to get complete for all chapters

Case 1.5 The Leslie Fay Companies33 The Leslie Fay Companies--Key Facts 1.Under the leadership of Fred and John Pomerantz, Leslie Fay ranked as one of the leading firms in the very competitive women’s apparel industry during the latter decades of the twentieth century.

2.One of John Pomerantz’s closest associates was Paul Polishan, Leslie Fay’s CFO who ruled the company’s accounting function with an iron fist.

3.John Pomerantz insisted on doing business the “old-fashioned way,” which meant that the company’s accounting function was slow to take advantage of the speed and efficiency of computerized dataprocessing.

4.A growing trend toward more casual fashions eventually createdfinancialproblems for Leslie Fay, its principal customers (major department stores), and its leading competitors, problems that were exacerbated by a nationwide recession inthe late 1980s and early 1990s.

5.Despite the slowdown experienced by much of the women’s apparel industry in the late 1980s and early 1990s, Leslie Fay continued to report impressive sales and earnings during that timeframe.

6.In January 1993, Paul Polishan informed John Pomerantz of a large-scaleaccounting fraud over the previous three years that had materially inflated Leslie Fay’s reported sales and earnings, a fraud allegedly masterminded by Donald Kenia.

7.Upon learning of the accounting fraud, BDO Seidman withdrew its unqualified audit opinions on Leslie Fay’s 1990 and 1991 financial statements and subsequently resigned as the company’s audit firm after being named as a co-defendant in civil lawsuits filed againstLeslie Fay’s executives.

8.The centerpiece of the Leslie Fay fraud was intentional overstatements of period-ending inventories, although several other financial statement items were also intentionally distorted.

9.John Pomerantz was never directly implicated in the fraud, although many critics, including BDO Seidman, insisted that he had to share some degree of responsibility for it.

10.BDO Seidman ultimately agreed to pay $8 million to a settlement pool to resolve numerous civil lawsuits stemming from the Leslie Fay fraud that named the accounting firm as a defendant.

11.Paul Polishan was convicted in 2000 of engineering the Leslie Fay fraud, principally due to the testimony of Donald Kenia.

12.Leslie Fay emerged from federal bankruptcy court in 1997 but disappeared afew years later when it was purchased by a large investment firm.

Case 1.5 The Leslie Fay Companies34 Instructional Objectives 1.To provide students with an opportunity to use analytical procedures as an audit planning tool.

2.To demonstrate the need for auditors to monitor key trends affecting the overall health of a client’s industry and to assess the resulting implications for a client’s financial condition and operating results.

3.To highlight the internal control issues posed for an audit client when its accounting functionis dominated by one individual.Suggestions for Use Several of the Section 1 or Comprehensive cases in this text, including the Leslie Fay case, contain exhibits that present multi-year financial statement data for a given company. These data provide students an opportunity to apply analytical procedures as a planning tool. Although a central theme of this casebook is the “people” aspect of independent audits, I believe it is also important that students be exposed to the more mundane, number-crunching aspects of an independent audit. One way that you can extend Question 1 is to require different groups of students to collect and present (for the same time frame) the financial ratios shown in Exhibit 2 for several of Leslie Fay’s key competitors. Quite often, auditors can learn more about the plausibility (or implausibility) of apparent trends in a client’s financial data by comparing those data with financial information for a key competitor rather than with industry norms.For example, Leslie Fay’s gross margin percentage was generally consistent with that of its overall industry. However, if you compared the company’s gross margin percentages over the time frame of the accounting fraud withthose of its direct competitors, it would have been apparent that the margins being reported by Leslie Fay were “out of line” with those of its direct competitors.A key feature of this case is the impact that Paul Polishan’s domineering personality had on the accounting function of Leslie Fay. This “red flag” is among the most common associated with problem audit clients. Published reports never indicatedexactlyhow Polishanwas able to psychologically control and manipulateDonald Kenia and his other subordinates in “Poliworld.” Apparently, Polishan was one of those individuals who had an innate and enormous ability to impose his will on subordinates. You might ask students how they would deal with such a domineering superior. Since many of our students will have an “opportunity” to work for one or more strong- willed individuals during their careers, they need to have appropriate coping mechanisms to ensure that they do not find themselves in the unfortunate situation that faced Donald Kenia, thatis, spending two years in a federal correctional facility. (You might discourage students from taking the “easy way out” by suggesting that they would simply choose not to work for such an individual.Seldomdowehave the freedom to choose the disposition and personality traits of our boss.)

Case 1.5 The Leslie Fay Companies35 Suggested Solutions to Case Questions 1.Following are common-sized financial statements and the requested financial ratios for Leslie Fay for the period 1987-1991.

1991 1990 1989 1988 1987

Current Assets:

Cash 1.2 1.1 1.4 1.5 1.3 Receivables (net) 30.0 31.8 30.3 30.3 27.1 Inventories 32.0 33.7 31.3 29.5 27.2 Prepaid Expenses, etc. 5.0 5.1 5.0 4.5 5.2 Total Current Assets 68.2 71.7 68.0 65.8 60.8 PP&E 9.9 6.8 7.0 7.1 7.9 Goodwill 20.5 20.1 23.5 25.9 29.6 Deferred Charges, etc. 1.4 1.4 1.5 1.2 1.7 Total Assets 100.0 100.0 100.0 100.0 100.0

Current Liabilities:

Notes Payable 8.8 10.9 5.9 8.0 5.1 Current Portion--LTD 0.0 0.0 0.0 0 .0 .5 Accounts Payable 8.1 9.9 10.0 12.6 10.3 Acc. Int. Payable .8 .9 1.1 1.1 1.2 Accrued Compensation 4.3 3.4 5.0 4.6 3.5 Acc. Expenses, etc. 1.1 1.5 1.5 2 .0 2.4 Income Taxes Payable.4 .5 1.3 1.6 .6 Total Curr. Liabs. 23.4 27.1 24.8 29.9 23.6 Long-term Debt 21.3 29.6 33.2 32.0 38.2 Deferred Credits, etc. .7 .6 .71.2 1.6

Stockholders’ Equity:

Common Stock 5.1 4.6 5.2 5.5 6.6 Capital in Excess of PV 20.8 18.7 21.2 22.6 26.9 Retained Earnings 39.6 29.1 25.4 20.1 16.5 Other(8.7) (7.2) (8.3) (8.8) (10.4) Treasury Stock(2.2)(2.5)(2.2)(2.5)(3.0) Total Stock. Equity 54.6 42.7 41.3 36.9 36.6 Total Liab. & SE 100.0 100.0 100.0 100.0 100.0