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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 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 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 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 write-downs. 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. Analyzing the financial statements can be seen there is a huge constant increase of net income from 19871991. 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 companys creditors, suppliers, customers, in addition, knowledge of industry. The Standards of Field Work under GAAS, statement #2 requires auditors to have knowledge about the companys 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 firms 1991 audit of Leslie Fay? Explain.
C m s eB om on iz alance S heet The L lie F C panies es ay om

19 91 AS E S ST Current Assets: Cash Receivable(net) Inventories Prepaid Expenses & Other Current Assets Total Current Assets Property, Plant and Equipment Goodwill Deferred Charges and Other Assets T la ota ssets L IL IE ANDS OC H D R ' E IAB IT S T K OL E S QUIT Y Current Liabilities: Notes payable Current Maturities of Long-termDebt Accounts Payable Accrued Interest Payable Accrued compensation Accrued Expenses & Other Income Taxes Payable T l Current L bilities ota ia Long Term Debt Deferred Credits & Other Noncurrent Liabilities Total Shareholders' Equity T lL ota iabilitiesa S reholders' E nd ha quity

19 90

18 99

18 98

18 97

1% 30% 32% 5% 68% 10% 21% 1% 100%

1% 32% 34% 5% 72% 7% 20% 1% 100%

1% 30% 31% 5% 68% 7% 24% 1% 100%

2% 30% 29% 5% 66% 7% 26% 1% 100%

1% 27% 27% 5% 61% 8% 30% 2% 100%

9% 0% 8% 1% 4% 1% 0% 23% 21% 1% 55% 100%

11% 0% 10% 1% 3% 1% 1% 27% 30% 1% 43% 100%

6% 0% 10% 1% 5% 1% 1% 25% 33% 1% 41% 100%

8% 0% 13% 1% 5% 2% 2% 30% 32% 1% 37% 100%

5% 0% 10% 1% 3% 2% 1% 24% 38% 2% 39% 100%

C m s e Incom S om on iz e tatem The Les F C panies ent lie ay om

19 91 100% 70% 30% 22% 23% 7% 2% 5% 2% 4% 19 90 100% 69% 31% 23% 24% 8% 2% 6% 2% 3% 18 99 100% 68% 32% 23% 24% 8% 2% 6% 2% 3% 18 98 100% 68% 32% 23% 23% 8% 3% 6% 2% 3% 18 97 100% 69% 31% 23% 23% 7% 3% 5% 2% 3%

Net Sales Cost of Sales G ross Proft Operating Expenses: Selling, Warehouse, General and Administrative Total Operating Expenses Operating Income Interest Expense Income Before Taxes on Income Income Taxes Net Income

Industry L iquidity Current Ratio Quick Ratio S olvency: Debt to Assets Times Interest Earned Long-termDebt 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 1.8 0.9 0.53 4.2 0.14 6.7 53.7 days 8 45.5 days 3.1 31.50% 2.20% 6.00% 14% 2.91 1.33 0.45 3.42 0.83 6.60 55.3 days 6 60.7 days 2.1 30.06% 3.51% 15.8% 13.62%

T L he eslie F Com nies ay pa 2.64 1.21 0.45 3.61 1.35 5.81 62.85 days 6.69 54.57 days 1.96 31.37% 3.39% 15.38% 15.51% 2.75 1.28 0.57 3.27 1.43 6.49 56.21 days 6.92 52.73 days 2.03 31.73% 3.28% 16.29% 16.16% 2.20 1.06 0.63 3.13 1.71 6.38 57.21days 7.08 51.54days 1.88 31.70% 3.27% 15.67% 16.67% 2.58 1.21 0.63 2.60 1.73 7.01 52.05 days 7.02 51.99 days 1.91 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 companys 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 companys 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 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. 4. Auditors consideration when planning an audit: 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 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 Seidmans 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 Fays audit firm since the 1970s and issued unqualified opinions each year on the companys financial statements. Following Pomerantzs disclosure of the fraud, BDO Seidman withdrew its audit opinions on the companys 1990 and 1991 financial statements. In the ensuing weeks, Leslie Fay stockholders filed several large lawsuits naming the companys 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 firms 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 Fays auditor in early May 1993. Company management immediately appointed Arthur Anderson as Leslie Fay new auditor. In September 1993, Leslie Fays audit committee completed its eight-month investigation of the accounting fraud. The resulting 600-page report was reviewed by members of Leslie Fays 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 wasnt an error entry on the cost side of the companys ledgers for those years that wasnt subject to some type of rejiggering. 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.