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Notes on Major Case 4
Cendant Corporation
Ethical Issues:
This case centers on a variety of accounting issues that illustrate the lengths to which a
company can go to manipulate earnings. Cendant manipulated membership revenue;
improperly recorded merger and purchase reserves; improperly accounted for
restructuring reserves and used it to smooth net income; improperly accountant for
rejects and cancellations; and it used the commissions payable liability account as a
cookie jar reserve to smooth net income. The actions of management were deliberate and
intended to make the company look like it was meeting financial analysts’ earnings
projections. The statements did not reflect economic reality or the underlying basics of
Cendant’s business. It failed to meet the representational faithfulness test in that the
statements did not truly measure what it purported to measure and report.
Investors rely on the accuracy of the financial statement information. If revenue is
deliberately overstated, then these users will be making investment decisions based on
incorrect information. The SEC expects a public company to report truthful information
in all of its filings with the Commission. The public is harmed when an audit fails to
uncover fraud because the underlying elements of the audit are deficient, as in the
Cendant case, including a lack of due care, professional skepticism, and integrity.
Questions
1. A statement is made in the case that Cendant manipulated the timing of
write-offs and improperly determined charges in an attempt to smooth net
income. Is income smoothly an ethical practice? Are there circumstances
where it might be considered ethical and others where it would not? What
motivated Cendant to engage in income smoothing practices in this case?
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Income smoothing or earnings management occurs when companies artificially inflate or
deflate their revenues or profits or earnings per share in order to show a consistent trend
in earnings. Although it may be argued that income smoothing can be ethical, most
examples are unethical. An ethical example could be delaying discretionary expenses in
Income smoothing practices in the late 1990s and early 2000s were largely unethical as
illustrated by the Cendant case. Common techniques are accelerating revenue into an
earlier period (i.e., MicroStrategy), delaying expenses by capitalizing costs that should be
expensed (WorldCom), and adjusting reserves to smooth net income over time (Cendant).
Cendant management was motivated to smooth income to meet the financial results
2. Representational faithfulness is a critical component of having a high quality
of financial reporting. Evaluate the accounting techniques used by Cendant
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from the perspective of representational faithfulness and the usefulness of the
financial information to users of its financial statements.
Cendant used aggressive accounting to shift current marketing expenses to a later period
by capitalizing the costs; this is shenanigan number 4. Cendant also shifted future
The statements were not at all useful to the users because they did not represent economic
reality and the fundamentals of Cendant’s business. The numbers did not measure what
3. Describe the failings of E&Y with respect to conducting an audit in
accordance with GAAS. Include in your discussion any violations of the
AICPA Code of Professional Conduct.
Cendant made materially false statements to E&Y to mislead the auditors into believing
the Company’s financial statements conformed to GAAP. These materially false
statements were included in the management representation letters and signed by the
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E&Y provided consulting as well as audit services to Cendant in connection with the
establishment and use of restructuring reserves. Therefore, it had a self-review threat that
compromised its independence (Rule101). The auditors excessively relied on
It appears quite clear that the auditors failed to exercise the level of care required and
professional skepticism needed (Rule 201) to conduct an audit in accordance with GAAS
Perhaps the biggest failure of EY was in its evidence gathering. Auditors are expected
to gather sufficient competent evidential matter to warrant the expression of an opinion.
The auditors failed to recognize evidence that the company's creation and use of the
Cendant Reserve did not conform to GAAP. Cendant provided E&Y with contradictory
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The company planned to use much of the excess Cendant Reserve to improperly
increase operating results in future periods. During the year ended December 31, 1997,
the company wrote off $104 million of assets that it characterized as impaired as a result
Cendant also inflated income by manipulating the membership cancellation reserve
and reported cash balance. At the end of each fiscal year, the company failed to record
three months of rejects, i.e., it did not reduce its cash and decrease its cancellation reserve
for these rejects. Cendant falsely claimed to E&Y that it did not record rejects for the
final three months of the year because it purportedly would collect most of the rejects
within three months of initial rejection. According to Cendant, the three months of
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4. Trust is a basic element in the relationship between auditor and client.
Evaluate why and how trust broke down in the Cendant case including
shortcomings in corporate governance.
Cendant management did not meet their fiduciary duties to shareholders. While they do
During the audit periods, CUC and Cendant made materially false statements to
EY about the company’s true financial results and its accounting policies. These
statements were made to mislead EY auditors into believing the financial statements
conformed to GAAP. The managers also signed written representations about the
conformity with GAAP even though they knew that wasn’t the case. Cendant and its
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The corporate governance system at Cendant seemed virtually nonexistent. There
does not appear to have been any measure of internal controls or an active and diligent
audit committee. This is not surprising because in the frauds of the late 1990s and early
200s, most board either looked the other way when fraud was occurring or tacitly went
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