Leslie Fay discovered in 1992 that the company’s corporate controller, along with some other employees, had committed a serious auditing fraud that showed inflated profits. When these irregularities were found, the company had already been knee-deep in debt as there were losses of around $81 million dollars. This led to the company filing bankruptcy to protect itself against creditors.
If the Sarbanes-Oxley Act (SOX) had been enacted during the Leslie Fay’s era it would have been able to discover the irregularities much sooner. First, SOX, which was enacted in 2002, requires CEOs and CFOs of public companies to take explicit responsibility for their company’s financial statement and for establishing and maintaining internal control.
Therefore, if SOX has been around the major provision that executives and financial officers had to sign off on financial statements would mean that Polishan and Pomerantz could not argue that it was Kenia himself who perpetrated the fraud, as it would be their responsibility to vouch for the veracity of the financial statements. Additionally, the steeper penalties for committing such fraud could potentially have dissuaded Polishan from pursuing the fraud in the first place (as it is he was only fined $900 and sentenced to 9 years in prison).
Second, SOX has mandatory auditing practices of having an internal control system and independent auditors checking the presence of those controls. With internal controls such as random checking of transaction and running them through controls, irregularities such as the entries on the cost side that had been doctored to show profits can be detected. Also the requirement that large companies have their internal control policies regularly certified by an external auditor may have prevented the fraud. Further, the requirement of performing a Business Risk Assessment could also possibly have helped BDEO Seidman identify that Leslie Fay was a riskier client.
However, it must not be forgotten that this is how SOX is meant to work in theory, while how SOX actually fares in practice can only be seen after implementation of the law. The reason for this statement is because every company has a different culture and a different way of conducting business, which in some cases may actually affect proper implementation of SOX. Additionally, unethical behavior can occur at all levels and therefore some people may still be able to penetrate the many layers of auditing protection provided by SOX to doctor financial statements. Hence some people have argued that it is debatable whether accounting irregularities would be prevented or identified sooner with SOX.
There are 3 general types of audit test that would have capture the errors and the fraud: risk assessment procedures, test of controls, and substantive procedures. Since the main fraudulent activities was Leslie Fay’s overstating in inventory at the end of the period and Polishan’s forging of inventory tag for nonexistent products, increasing the number of dresses on hand, and fabricating bogus in-transit inventory to overstate inventory, the best way to find these irregularities is on sight inspection.
The auditors should have taken it upon themselves to personally verify that the inventory that was claimed to exist was actually in stock. Another issue is that Leslie Fay had been ignoring sales discount on outstanding receivables to boost revenues. Interviews of manufacturing personnel or even sales personnel would have help capture this error.
Finally, an overall analysis of Leslie Fay’s suspiciously healthy ratios and financials could have indicated to auditors that there would be significant misstatements. If the auditor were doing Lesley Fay’s ratios from multiple years, it would help detect the suspicious ratios such as the constant gross margins over the 5 year period (1987-1991) as well as the fact that low total asset turnover was recorded while still generating a high return on assets (ROA).