978-0077862213 Major Case Teaching Note Cendant

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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?

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

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

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

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

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

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