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Major Case 4 Cendant Corporation
The Merger of HFS and CUC
HFS Incorporated (HFS) was principally a controller of franchise brand names in the hotel, real
estate brokerage, and car rental businesses, including Avis, Ramada Inn, Days Inn, and Century
21. Comp-U-Card (CUC) was principally engaged in membership-based consumer services such
as auto, dining, shopping, and travel “clubs.” Both securities were traded on the NYSE. Cendant
Overview of the Scheme
The Cendant fraud was the largest of its kind until the late 1990s and early 2000s. Beginning in
at least 1985, certain members of CUC’s senior management implemented a scheme designed to
ensure that CUC always met the financial results anticipated by Wall Street analysts. The CUC
senior managers used a variety of means to achieve their goals, including:
• Manipulating recognition of the company’s membership sales revenue to accelerate the
With respect to the last item, to hide the inadequate balances, senior management periodically
kept certain membership sales transactions off the books. In what was the most significant
category quantitatively, the CUC senior managers intentionally overstated merger and purchase
reserves and subsequently reversed those reserves directly into operating expenses and revenues.
SEC Filings against CUC and Its Officers
SEC complaints filed on June 14, 2000, alleged violations of the federal securities laws by four
former accounting officials, including Cosmo Corigliano, CFO of CUC; Anne M. Pember, CUC
controller; Casper Sabatino, vice president of accounting and financial reporting; and Kevin
Kearney, director of financial reporting. The allegations against Corigliano included his role as
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The commission alleged that Pember was the CUC officer most responsible for implementing
directives received from Corigliano in furtherance of the fraud, including implementing
directives that inflated Cendant’s annual income by more than $100 million, primarily through
improper use of the company’s reserves. According to the SEC, Pember profited from her own
wrongdoing by selling CUC and Cendant stock at inflated prices while the fraud she helped
implement was under way and undisclosed.
Sabatino and Kearney, without admitting or denying the commission’s allegations, consented to
the entry of final judgments settling the commission’s action against them. The commission’s
complaint alleged that Sabatino was the CUC officer most responsible for directing lower–level
CUC financial reporting managers to make alterations to the company’s quarterly financial
results.
In a fourth and separate administrative order the commission found that Cendant violated the
periodic reporting, corporate record-keeping, and internal controls provisions of the federal
securities laws, in connection with the CUC fraud. Among other things, the company’s books,
records, and accounts had been falsely altered, and materially false periodic reports had been
filed with the commission, as a result of the long-running fraud at CUC. Simultaneous with the
1995–1997 alone, pretax operating income reported to the public by CUC was inflated by an
aggregate amount of over $500 million. Specific allegations included:
• Forbes, CUC’s chair and CEO, directed the fraud from its beginnings in 1985. From at
least 1991 on, Shelton, CUC’s president and COO, joined Forbes in directing the scheme.
• Forbes and Shelton reviewed and managed schedules listing fraudulent adjustments to be
made to CUC’s quarterly and annual financial statements. CUC senior management used
the adjustments to pump up income and earnings artificially, defrauding investors by
creating the illusion of a company that had ever-increasing earnings and making millions
for themselves along the way.
Specific Accounting Techniques Used to Manage Earnings
Making Unsupported Postclosing Entries
In early 1997, at the direction of senior management, Hiznay approved a series of entries
reversing the commissions payable liability account into revenue at CUC. The company paid
commissions to certain institutions on sales of CUC membership products sold through those
institutions. Accordingly, at the time that it recorded revenue from those sales, CUC created a
liability to cover the payable obligation of its commissions. CUC senior management used false
schedules and other devices to support their understating of the payable liability of the
commissions and to avoid the impact that would have resulted if the liability had been properly
calculated. Furthermore, in connection with the January 31, 1997, fiscal year-end, senior
management used this liability account by directing postclosing entries that moved amounts from
the liability directly into revenue.
In February 1997, Hiznay received a schedule from the CUC controller setting forth the amounts,
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Keeping Rejects and Cancellations Off-Books: Establishing Reserves
During his time at CUC, Hiznay inherited, but then supervised, a longstanding practice of
keeping membership sales cancellations and rejects off CUC’s books during part of each fiscal
year. Certain CUC membership products were processed through various financial institutions
that billed their members’ credit cards for new sales and charges related to the various
membership products. When CUC recorded membership sales revenue from such a sale, it would
allocate a percentage of the recorded revenue to cover estimated cancellations of the specific
membership product being sold, as well as allocating a percentage to cover estimated rejects and
at each fiscal year-end. At its January 31, 1997, fiscal year-end, the balance in the CUC
membership cancellation reserve was $29 million; CUC accounting personnel were holding $100
million in rejects and $22 million in cancellations off the books. Failing to book cancellations
and rejects at each fiscal year-end also had the effect of overstating the company’s cash position
on its year-end balance sheet.
Accounting and Auditing Issues
Kenneth Wilchfort and Marc Rabinowitz were partners at Ernst & Young (EY), which was
responsible for audit and accounting advisory services provided to CUC and Cendant. During the
relevant periods, CUC and Cendant made materially false statements to the defendants and EY
about the company’s true financial results and its accounting policies. CUC and Cendant made
these false statements to mislead the defendants and EY into believing that the company’s
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materially false because the financial statements did not conform to GAAP, and, as discussed
further, the company’s management concealed material information from the defendants and EY.
Improper Establishment and Use of Merger Reserves
The company completed a series of significant mergers and acquisitions and accounted for the
majority of them using the pooling-of-interests method of accounting. In connection with this
merger and acquisition activity, company management purportedly planned to restructure its
operations. GAAP permits that certain anticipated costs may be recorded as liabilities (or
reserves) prior to their incurrence under certain conditions. However, here CUC and Cendant
routinely overstated the restructuring charges and the resultant reserves and would then use the
reserves to offset normal operating costs—an improper earnings management scheme. The
company’s improper reversal of merger and acquisition–related restructuring reserves resulted in
an overstatement of operating income by $217 million.
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GAAP. For example, CUC and Cendant provided EY with contradictory drafts of schedules
The company planned to use much of the excess Cendant reserve to increase operating results in
future periods improperly. During the year ended December 31, 1997, the company wrote off
Cash Balance from the Membership Cancellation Reserve
CUC and Cendant also inflated income by manipulating their membership cancellation reserve
and reported cash balance. Customers usually paid for membership products by charging them
on credit cards. The company recorded an increase in revenue and cash when it charged the
members’ credit card. Each month, issuers of members’ credit cards rejected a significant
amount of such charges. The issuers would deduct the amounts of the rejects from their
payments to CUC and Cendant. CUC and Cendant falsely claimed to EY auditors that when it
resubmitted the rejects to the banks for payment, it ultimately collected almost all of them within
three months. CUC and Cendant further falsely claimed that, for the few rejects that were not
collected after three months, it then recorded them as a reduction in cash and a decrease to the
cancellation reserve. The cancellation reserve accounted for members who canceled during their
membership period and were entitled to a refund of at least a portion of the membership fee, as
well as members who joined and were billed, but never paid for their memberships.
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The rejects, cancellation reserve balance, and overstatement of income amounts for the period
1996 to 1997 are as follows:
($ in millions)
Date
Rejects
Cancellation Reserve Balance
Understated Reserve/Overstated Income
01/31/96
$ 72
$37
$35
01/31/97
$100
$29
$28
12/31/97
$137
$37
$37
Membership Cancellation Rates
The company also overstated its operating results by manipulating its cancellation reserve. The
cancellation reserve accounted for members who canceled during their membership period. A
large determinant of the liability associated with cancellations was CUC and Cendant’s estimates
of the cancellation rates. During the audits, CUC and Cendant intentionally provided EY with
Audit Opinion
EY issued audit reports containing unqualified (i.e., unmodified) audit opinions on, and
conducted quarterly reviews of, the company’s financial statements that, as already stated, did
not conform to GAAP. The Securities Exchange Act requires every issuer of a registered security
Legal Issues
SEC Settlements
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Between Hiznay’s arrival at CUC in July 1995 and the discovery of the fraudulent scheme by
Cendant management in April 1998, CUC and Cendant filed false and misleading annual reports
with the commission that misrepresented their financial results, overstating operating income and
earnings and failing to disclose that the financial results were falsely represented.
The commission’s complaint alleged that Sabatino, by his actions in furtherance of the fraud,
violated, or aided and abetted violations of, the anti-fraud, periodic reporting, corporate record-
keeping, internal controls, and lying to auditors provisions of the federal securities laws.
Sabatino consented to entry of a final judgment that enjoined him from future violations of those
provisions and permanently barred him from acting as an officer or director of a public company.
In another administrative order, the commission found that Hiznay aided and abetted violations
of the periodic reporting provisions of the federal securities laws, in connection with actions that
he took at the direction of his superiors at CUC. Among other things, the commission alleged
that Hiznay made unsupported journal entries that Pember had directed. Additional orders were
entered against lower-level employees.
The final judgment against Forbes, to which he consented without admitting or denying the
commission’s allegations, enjoined him from violating relevant sections of the securities laws
and barred him from serving as an officer or director of a public company.
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Class Action Lawsuits
A class action suit by stockholders against Cendant and its auditors, led by the largest pension
funds, alleged that stockholders paid more for Cendant stock than they would have had they
known the truth about CUC’s income. The lawsuit ended in a record $3.2 billion settlement.
Details of the settlement follow.
Second, Cendant was required to institute significant corporate governance changes that were
far-reaching and unprecedented in securities class action litigation. Indeed, these changes
included many of the corporate governance structural changes that would later be included
within the Sarbanes-Oxley Act of 2002 (SOX). They included the following:
• The board’s audit, nominating, and compensation committees would be comprised
entirely of independent directors (according to stringent definitions, endorsed by the
institutional investment community, of what constituted an independent director).
• The majority of the board would be independent within two years following final
approval of the settlement.
The Settlement with EY
On December 17, 1999, it was announced that EY had agreed to settle the claims of the class for
$335 million. This recovery was and remains today as the largest amount ever paid by an
accounting firm in a securities class action case. The recovery from EY was significant because
it held an outside auditing firm responsible in cases of corporate accounting fraud. The claims
against EY were based on EY’s “clean” (i.e., unmodified) audit and review opinions for three
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Questions
1. Cendant manipulated the timing of write-offs and improperly determined charges
in an attempt to smooth net income. Is income smoothing 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 is a form of earnings management that 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 one
year, such as maintenance. However, some might argue this practice is unethical because it is
an operational manipulation which is just as wrong as an accounting manipulation (i.e.,
adjusting an allowance for maintenance each year based on smoothing considerations rather
than economic realities).
2. Analyze the actions taken by the company and its management from the perspective
of the Fraud Triangle.
Pressure/Incentive
• Meet or exceed financial analysts’ earnings expectations
• Greed; officers profited from their own wrongdoing by selling CUC and Cendant stock at
inflated prices
Opportunity
• Internal controls were either non-existent or overridden by management
o Deliberate overstatement of reserves
o Reversed commissions payable account into revenues
3. Describe the role of professional judgment in the audits by EY. Did the firm meet its
ethical obligations under the AICPA Code?
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At the very center of professional judgment is mindset. Auditors should approach matters
objectively and independently, with inquiring and incisive minds. Professional skepticism is
required by auditing standards. It requires an objective attitude that includes a questioning
mind and critical assessment of audit evidence. In the Cendant case, the Ernst & Young
auditors were too quick to accept management’s representations rather than critically
evaluate evidence provided. In other words, professional skepticism was sacrificed for
expedience.
Cendant management made materially false statements to the EY auditors that were accepted
at face value. Management’s representations were false and went unchallenged by EY. It
could be EY’s decisions were tainted by a desire to keep Cendant management happy as it
was a major client for the firm.
EY 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
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 EY with contradictory drafts of
schedules when EY requested support for the establishment of the Cendant Reserve. While
the component categories changed over the different drafts, the total amount of the reserve
never changed materially. Despite this evidence, the auditors did not obtain adequate
analyses, documentation, or support for changes they observed in the various revisions of the
schedules submitted to support the establishment of the reserves. Instead, they relied
excessively on frequently changing management representations.
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 EY 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 withheld rejects created a
temporary difference at year-end between the cash balances reflected in the company’s
general ledger and its bank statements. The rejects were clearly specified on reconciliations
4. Trust is a basic element in the relationship between auditor and client. Explain 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 not
have a fiduciary duty to the auditors, it is expected that the evidence provided is truthful and
can be verified through proper documentation.
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
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 2000s,
most boards of directors either looked the other way when fraud was occurring or tacitly
within SOX. The governance changes included:
• The board’s audit, nominating, and compensation committees would be comprised entirely of
independent directors (according to stringent definitions, endorsed by the institutional
investment community, of what constituted an independent director).
• The majority of the board would be independent within two years following final approval of
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