On March 3, 1993 the common stock price of Leslie Fay, the nation’s second largest maker of women’s apparel, dropped from 12 3/8 to 5 1/4, when it was discovered that reported profits of $23.9 million were actually losses of $13.7 million. Hundreds of angry shareholders imme¬ diately filed suit against both the company’s management, headed by CEO John Pomerantz, and the external auditor—Arthur Andersen and Co. REQUIRED:

a. In the context of this case explain the economic rationale behind conservatism.

b. We noted in the chapter that certain foreign countries encourage conservative accounting practices in an effort to protect creditors. How could Leslie Fay’s shareholders have been protected if the company had used conservative accounting practices?

c. Explain why it may have been difficult for Arthur Andersen to insist that Leslie Fay report conservatively.