The Leslie Fay Companies was a women’s apparel manufacturer established by Fred Pomerantz, a former Women’s Army Corps uniform maker during World War II. Despite the “volatile and intensely competitive” (Knapp 34) nature of the industry, Leslie Fay grew to have the second largest annual sales compared to any of the other publicly owned women’s apparel manufacturers, only behind Liz Claiborne. Fred Pomerantz hired Paul Polishan for a position in the accounting department where Polishan befriended Pomerantz’s son, John.
After Fred Pomerantz’s death in 1982, John Pomerantz became CEO and chairman of the board, having been president of the company and overseeing operations ten years prior. Polishan was also promoted and became the company’s CFO and senior vice president of finance. Although Leslie Fay’s headquarters was situated in New York City’s garment district, the accounting office was off-site in Wilkes-Barre, Pennsylvania. Polishan was known for his “strict and autocratic” (33) rule in this location, demanding much from his employees and tolerating very little.
In Polishan’s absence, the accounting office was run by Donald Kenia, the company controller. Contrary to Polishan’s demeanor, Kenia was meek and soft-spoken.
The women’s apparel industry suffered during the late 80s and early 90s due to the “casualization” (Knapp 35) of American fashion as well as the economic recession. The desire for more casual-looking clothes led to declining sales of dresses and other high-end attire. The recession also caused “many consumers to curtail their discretionary expenditures, including the purchase of new clothes” (35).
This was a major blow to Leslie Fay’s principal customers—department stores. When some of these department stores filed for bankruptcy, Leslie Fay incurred material losses. “In October 1991, John Pomerantz announced that Leslie Fay had achieved record earnings for the third quarter of the year” (36). These earnings were achieved despite the crippling economic situation and John Pomerantz’s old-fashioned business practices that shunned “extensive market testing” (35) and the use of computers. While many competitors were financially struggling, Leslie Fay was growing. On January 29, 1993, Polishan informed Pomerantz of a major financial issue; apparently Kenia had “secretively carried out” (Knapp 36) an accounting hoax for several years, overstating earnings “by approximately $80 million from 1990 through 1992” (33) and submitting “approximately $130 million of bogus entries” (39). Leslie Fay’s inventory was inflated, understating cost of goods sold and therefore increasing the gross profit margin.
In addition to the forging of “inventory tags for nonexistent products” (39) and the fabrication of “large amounts of bogus in-transit inventory” (39), orders were prerecorded, discounts were omitted from financial statements, and expenses and liabilities at the period-end were not reported. Almost all of Leslie Fay’s journal entries relating to cost were tampered with in some way. Donald Kenia claimed full responsibility for the fraud, but because of his compliant nature and low stakes in the company, many believed this to be false. Polishan, as CFO, “was directly responsible for the integrity of Leslie Fay’s accounting records” (Knapp 37), and since he ruled the accounting office with an iron fist, he was thought to have played a greater role in the scam. Kenia lacked an obvious incentive in orchestrating this large-scale fraud since he was not compensated based on earnings, but other executives, such as Polishan and Pomerantz, who owned a significant amount of shares in company stock, did benefit. They received “substantial year-end bonuses, in some cases bonuses larger than their annual salaries, as a result of Kenia’s alleged scam” (34).
Pomerantz and Polishan claimed to have known nothing about these accounting errors. After the fraud was uncovered, the audit committee investigated and released a report that exonerated Pomerantz (40), but Kenia later confessed, in opposition to his original testimony, that Polishan “had overseen and directed every major facet of the fraud” (42). Polishan and Kenia were convicted. In 1997, Leslie Fay was ruled to pay $34 million in settlements and filed for bankruptcy, but the company was able to return to a “profitable condition” (42) before being bought out in 2001. The role of Leslie Fay’s external auditor in the midst of this fraud naturally comes into question. BDO Seidman had been Leslie Fay’s “audit firm since the mid-1970s and issued unqualified opinions each year on the company’s financial statements” (Knapp 39).
After the revealing of the fraud, BDO Seidman withdrew these unqualified opinions for 1990 and 1991. The accounting firm took on a similar defense to that of John Pomerantz, claiming themselves as victims of deception. Leslie Fay stockholders sued BDO Seidman for reckless auditing in 1993. Leslie Fay’s financial statements had been “replete with red flags” (40), contributing to the lawsuits. These pending legal battles led to questionable auditor independence, thus causing BDO Seidman to resign as Leslie Fay’s auditor. Numerous misstatements in almost all cost and liability line items leads to the question of whether the lack of sufficient internal controls was largely responsible for the fraud and if the external auditor’s failure to check Leslie Fay’s internal controls caused them to miss such errors.
The Leslie Fay Companies was a publicly traded firm on the New York Stock Exchange in the business of manufacturing women’s apparel. From its inception, Leslie Fay’s focus was on producing “moderately priced and conservative dresses for women aged 30 through 55” (Knapp, 34). In 1982, John Pomerantz, son of Fred, became the company’s CEO and chairman of the board following a leveraged buyout after the death of his father. The firm re-listed on the NYSE in 1986. Pomerantz, Polishan, and other company executives held large portions of company stock, and as a result, they had a direct financial interest in the continued financial success of Leslie Fay. Top executives were also the recipients of frequent and large year-end bonuses. In some cases, these bonuses were greater than their annual salaries.
Structurally, the company CFO and controller, Polishan and Kenia, had large overriding powers over financial data. Internal controls were severely lacking, allowing management to skew almost all transactions related to cost. Polishan “‘dominated’ Kenia through intimidation and fear” (Knapp 42), convincing Kenia to inflate Leslie Fay’s gross margins. Until the fraud was uncovered, Leslie Fay produced the second largest earnings in the industry, placing the company in the leaderboard.
To understand the position of Leslie Fay in the late 1980s and early 1990s, it is important to look at the state of the women’s fashion industry at that time. Leslie Fay’s key competitors included Oscar de la Renta, Donna Karan, and others. However, the firm’s top rival was Liz Claiborne, “the only publicly owned women’s apparel manufacturer in the late 1980s that had larger annual sales than Leslie Fay” (Knapp 34). The firm’s principal customers, which were also shared by its competitors, were the large department store chains. Several industry trends contributed to economic hardship. The most impactful of these trends was the “casualization” (Knapp 35) of America. This was a trend that had developed a few years earlier and was in full force by the late ’80s. Millions of consumers began to shun the traditional notions of women’s fashion and opted instead to dress in more comfortable clothing. This movement began with younger women but then hit women in the 30 to 55 year-old segment, Leslie Fay’s target market. More specifically, this shift toward casual clothing significantly impacted women’s dress sales.
In the early 1970s dress sales began to decline as a result of the popularity of pantsuits, and by the late 1980s the shift toward casualwear had permanently damaged the sales of dresses. All of this was bad news for Leslie Fay. Since they were a manufacturer of “stylishly conservative dresses,” (Knapp 34) they were stuck in a current towards casual clothing with a business model attempting to swim upstream. The culture of deregulation in the United Sates that began in the 1970s, took off in the 1980s, and flourished in the 1990s and early 2000s had an affect on the financial and accounting departments of many companies. Specifically regarding accounting, the PCAOB did not exist until 2002. This meant the lack of a regulatory body to oversee the creation of and compliance with accounting and auditing standards. In addition, law did not yet require the modern, SOX-created version of the audit committee, responsible for the hiring and firing of the external auditors among other things.
The CFO and CEO were not required to personally attest (with a signature) to the accuracy of the company’s financial statements, giving them less accountability. The overall lack of accountability for CFOs and CEOs and the more laid-back approach that auditors took during that time period enabled Leslie Fay’s scandal to pass through unnoticed for that long. A variety of external factors influenced Leslie Fay. Most important was the recession of the late 1980s and early 1990s. The recession only heightened the problems in the women’s fashion industry, as consumers began to watch their spending and spent less on new clothes.
There was an overall economy-wide decline in retail spending, which hurt business for the major department stores that were Leslie Fay’s customers. As a result of weak retail sales, many department store chains were forced to either merge with competitors or to liquidate. This hurt Leslie Fay because the surviving department stores, with which the firm did business, “wrangled financial concessions from their suppliers” (Knapp 35). As Leslie Fay’s primary customers took hits during the economic recession, the manufacturing firm also suffered great losses.
From the information presented in the case by Knapp, it is evident that Leslie Fay did not have an effective system of internal controls. First and foremost is the fact that the firm’s accounting offices were located 100 miles away from corporate headquarters. Being this far away from the Garment District in Manhattan would have made it difficult for internal and external auditors to have a complete understanding of how Leslie Fay’s business operated since they could not physically observe it. In addition, most accounting personnel located in PA could not discuss issues face-to-face with people in corporate headquarters. Paul Polishan made frequent trips to New York, however he was ultimately responsible for orchestrating the accounting fraud, and his autocratic leadership style exacerbated the issue.
Anyone who asked for records had to immediately answer to Polishan, providing a reason why they needed to know that information. This gave Polishan the possible ability to cover up information before anyone else could see them. Leslie Fay also had a lack of any type of information technology system. In an age where it had become commonplace in the industry to use computer networks to monitor daily sales, the firm was still making calls to customers on a weekly basis to record sales numbers (Knapp 35).
This made it easier to manipulate sales and inventory numbers towards the end of accounting periods, especially when considering Polishan’s conviction, because a lack of IT meant less-precise numbers. In addition, the accounting offices in PA were not up to speed with modern data processing; rather they did more work by hand. Lastly, the extent of the influence that Polishan had over Kenia, the controller, and ultimately the entire accounting process, indicated a lack of checks and balances within the system. Knapp states in the case that Kenia and other subordinates followed any order given by Polishan simply due to his intimidation factor. A good system of internal controls would guard against this, a key arrangement Leslie Fay clearly lacked.
Leslie Fay had received complaints from consumers that its clothing line was too “old-fashioned,” “matronly,” and “overpriced” (Knapp, 36). Given these circumstances, the firm should have sought to revamp their product line and manufacture more trendy clothing while staying true to the basic ideas about fashion that Leslie Fay was known for. Unfortunately for the company, John Pomerantz insisted on doing business the old-fashioned way and relied on himself and his designers to forecast fashion trends. This might have worked had Pomerantz known what the overall trend in the women’s fashion industry was, but he did not make use of market testing to see what women were really looking for in clothing. The firm faced many business risks during this time period. The recession heightened competition as many firms were all targeting the same market segment that was spending less on new clothing.
There was also pressure to overcome Liz Claiborne as the sales leader in the industry. Leslie Fay was also pushed to develop trendier clothing in a changing set of consumer demands. The liquidation and mergers of department stores led to many write-offs and loss of income for the manufacturing firm. Leslie Fay was also subject to less-advantageous sales terms forced upon them by the stores such as longer payment terms, more lenient return policies, and increased financial assistance (Knapp 35).
As always, the pressure is on keeping costs down in the market they are in. Since they aimed for moderately priced clothing, the firm needed to drive down costs in order to make a profit on their merchandise. The firm had to keep sales and profits up all while factoring in these changes in the economy and in their specific marketplace. Leslie Fay faced the pressures of meeting analysts’ projections, since they were a publicly traded company. If they did not meet projections, they were subject to a loss of investor capital. Healthy financial numbers were also important to maintain for the sake of keeping creditors happy. The firm needed financing from both lenders and investors in its common stock to support the design and manufacture of its clothing.
The state of the economy and industry in the late 1980s and early 1990s led to reduced spending, which would have translated to lower sales and earnings for most firms in the fashion industry. However, as noted in the case and as seen by Leslie Fay’s financials, the firm was achieving record earnings despite a slow retail industry (Knapp 36). Some key financial ratios and observations are presented in Exhibit 1. An analysis of these ratios shows that, according to Leslie Fay’s doctored financial statements, they were more liquid than the industry average, but less solvent.
They had lower inventory, accounts receivable, and asset turnover ratios than the industry, and the ages of their inventory and accounts receivable were higher than the industry average. Their gross margin percentage was about on par with industry average, however they showed a higher profit margin on their sales (by 1.31%) as well as a significantly higher ROA (9.79% higher). Their ROE was lower than the industry average. A higher profit margin on sales, together with decreased sales from 1990 to 1991, suggests that Leslie Fay manipulated cost-side entries.
Changes in consumer behavior of the women’s apparel industry pressured Leslie Fay as it suffered a decline in customers in the 1970s and 1980s. During this time, fashion trends were shifting to become more casual, and new styles included more comfortable, well-worn garments like jeans and t-shirts. Even Leslie Fay’s target market of women between the ages of 30 and 55 were dressing more casually and purchasing less dresses. As one-third of Leslie Fay’s total sales are attributed to dresses, Leslie Fay felt the pressure of the change in the apparel industry (The Leslie Fay Company Inc. History). It was also affected by the economic recession of the late 1980s and early 1990s. The company’s major customers, department store chains, experienced a decline in retail spending due to this recession (Knapp 35).
The financial strain on department stores caused them to demand financial concessions from suppliers like Leslie Fay. The company was asked to allow the department stores longer payment terms and more lenient return policies, and to provide more financial assistance for in-store displays, kiosks, and apparel boutiques (Knapp 35). Retailers criticized Leslie Fay of manufacturing clothes that were overpriced and old-fashioned. The company was forced to give rebates to wholesale customers that could not sell all of the apparel they had purchased. Pressure from retailers created an environment that burdened Leslie Fay with finding new ways to keep up profits.
Executive compensation is another incentive to commit fraud. Executives including Pomerantz and Polishan had substantial interests in the Leslie Fay Companies as they owned large blocks of the company’s stock. In addition, executive bonuses were extremely generous, sometimes exceeding annual salaries (Knapp 34). Top executives whose financial interests were heavily invested in Leslie Fay through stock ownership and these large bonuses were more likely to commit fraud for their own personal benefit.
A significant aspect of Leslie Fay’s operations was the geographical difference between corporate headquarters and the accounting offices. Corporate headquarters were located in Manhattan, while the accounting offices were 100 miles northwest in Wilkes-Barre, Pennsylvania. Paul Polishan dominated the Wilkes-Barre office, nicknamed “Poliworld,” as the CFO and senior vice president of finance. This physical separation between the accounting department and other executives and top management created an opportunity for fraud. Finance and accounting employees were not as closely supervised as those in the corporate headquarters due to this geographical disconnect.
This also limited the internal controls that could be implemented over the accounting department (Knapp 33). Public accounting firms were not yet regulated by Sarbanes-Oxley, creating an opportunity for Leslie Fay Companies to commit Fraud. SOX mandates that public companies obtain an integrated audit, including an audit of financial statements and internal controls over financial reporting (Messier 43). BDO Seidman was not required to conduct an audit of internal controls as there was no existing regulation. This means that management’s actions relating to financial reporting were not necessarily being investigated by its external auditor. This lack of regulation affected the audit procedures performed by BDO Seidman, which left the internal control system unchecked.
Paul Polishan’s dominating personality made him a powerful influence over his subordinates, especially Donald Kenia. Polishan strictly ruled the Wilkes-Barre offices and when senior managers from the corporate headquarters asked him for financial information he often demanded the reason they needed the information (Knapp 33). This defensiveness which should have been a red flag created an environment where people were hesitant to question Polishan. The relationship between Kenia and Polishan was also closely examined during the investigation of Leslie Fay. Kenia claimed to have been “dominated” by Polishan through intimidation and fear (Knapp 42). Polishan’s daunting personality allowed him to intimidate Kenia and his staff into falsifying financial transactions and commit fraud. Polishan’s dominance at Leslie Fay put a strain on internal controls.
A walkthrough and inspection of documents and activities would reveal that much of the inventory reported was falsely recorded because there would be no organic process in which actual inventory entered the warehouse and was recorded—since they were fabricated, the observer would have recognized this key step. A test of account balances would also show that the inventory on hand did not match up to the reported amounts. Substantive analytical procedures are key in this case. Due to poor economic circumstances and competitor struggles, a red flag should have been raised when Leslie Fay continued to report earnings growth but failed to explain how.
Since bonuses were tied to earnings, executives had incentive to inflate their numbers. Pomerantz’s “total salary and bonuses of “3.6 million [was] three times more than the 1991 compensation of Liz Claiborne’s CEO, whose company reported sales more than double those of Leslie Fay’s” (Knapp 40). BDO should have compared Leslie Fay to other companies in the women’s apparel industry, noting differences in trend lines. The gargantuan bonuses may have indicated that company operations were not management’s largest concern.
The accounting fraud engineered by Paul Polishan, CFO and SVP of finance at Leslie Fay, undoubtedly tarnished the reputation of Leslie Fay and its management, as well as BDO Seidman as its auditor. Many factors ultimately contributed to the $80 million accounting hoax that was finally uncovered in the early 1990s. One of the major factors included a severe lack of internal controls. No employee would contest the domineering Polishan, especially the second-in-command at the office, Donald Kenia, the controller. In addition, whenever an employee or management at the corporate headquarters would request financial information from Polishan, he would question them about why they needed the information, which should have been a sign that perhaps something illegal was happening behind the scenes. Not only was there a large communication problem between the executives of the company, but also the lack of transparency between executives was astounding, as other executives were in the dark concerning the fraud. Leslie Fay’s continued success in a struggling women’s fashion industry should have sparked BDO Seidman to look more closely into the financial information provided by Polishan, and perhaps conduct substantive analytical procedures on a more detailed level.
BDO Seidman also should have actively compared Leslie Fay to its close competitors, and the industry as a whole, to see that key financial ratios did not match the general trend. The opportunity and incentives for Paul Polishan to commit fraud were both present. The physical distance of Polishan from headquarters opened up a large opportunity for him to commit fraud. In addition, he had an employee willing to take the fall for him when the fraud was uncovered. With this opportunity, Polishan was able to evade bad financial statements that the declining women’s fashion industry would have given him and increase his bonus, which was tied directly to the earnings of Leslie Fay. Had the Sarbanes-Oxley (SOX) legislation been implemented prior to the accounting scandal at Leslie Fay, the fraud would have been more easily detectable. SOX would have held executives accountable for the accuracy of financial statements The external auditor would also have been held to a higher standard of providing reasonable assurance as to the accuracy of the company financial statements.
Even though BDO Seidman only provided an “unqualified opinion” on the accuracy of the statements, SOX would have prevented BDO Seidman from being so careless in their auditing of Leslie Fay. Lastly, SOX would have required an in-depth review of internal controls, which Leslie Fay was lacking. The lack of internal controls at Leslie Fay, and BDO Seidman’s ignorance of this problem, was a major contribution to the fraudulent accounting scheme that took place. If the external auditor, BDO Seidman, had performed a proper review of Leslie Fay’s internal controls, they would have uncovered a complete lack of said controls, including a lack of checks and balances between top management. This deficiency caused a major disconnect between the CFO and other company executives, with the critical problem being information asymmetry between the two parties.
The accounting offices of Leslie Fay were located a hundred miles from the corporate headquarters, furthering the gap between the CFO and other top management, and not allowing the accounting team to physically see the operations of the company. Additionally, Leslie Fay lacked any type of information technology system, and instead tracked daily sales and inventory counts by hand. This allowed for easier manipulation of data linked to the earnings process of the company. As seen through the situation at Leslie Fay, strong internal controls, and the regulation of these controls, is essential to the uncovering and prevention of fraud within any company. The effectiveness of the internal controls should be tested by the external auditor, as well as periodically evaluated by executives of the company.