Case: Cendant corporation assessing the control environment and evaluating risk of financial statement fraud by Mark S. Beasley, Frank A. Buckless, Steven M. Glover, Douglas F. Prawitt
LEARNING OBJECTIVES
After completing and discussing this case you should be able to
[1] Describe the auditor's responsibility for considering a client's internal controls [2] Describe the auditor's responsibility to detect material misstatements due to fraud
[3] Identify red fags present during the audits of CUC International, Inc.'s fnancial statements, which suggest weaknesses in the company's control environment (CUC International, Inc. was the predecessor company to Cendant Corporation)
[4] Identify red flags present during the audits of CUC International, Inc.'s financial statements suggesting a higher likelihood of financial statement fraud
[5] Identify management assertions violated as a result of the misstatements included in CUC International, Inc.'s 1995 through 1997 financial statements (prior to its merger with HFS, Inc.)
[6] Identify audit procedures that could have been performed to detect misstatements that occurred INTRODUCTION One can only imagine the high expectations of investors when the boards of directors of CUC International, Inc. (CUC) and HFS, Inc. (HFS) agreed to merge in May 1997 to form Cendant Corporation. The $14 billion stock merger of HFS and CUC, considered a marriage of equals, united two large service organizations. CUC was a direct marketing giant with shopping, travel, automobile, and entertainment clubs serving over 68 million members worldwide while HFS was a franchisor of brand-name chains such as Ramada, Days Inn, Avis, and Century 21, with over 100 million consumers worldwide. The cross-marketing opportunities between CUC and HFS were expected to create synergies that would further increase the revenue and earnings growth of the newly formed entity, Cendant. The senior executives of CUC and HFS noted that the merger would enhance shareholder value by establishing one world-class consumer and business services organization that would compete on a global scale with superior revenue and earnings growth potential (Form 8-K, CUC International, Inc., May 27, 1997).
1 THE NEW COMPANY: CENDANT CORPORTION
The merger of CUC and HFS was finalized in December 1997. Henry Silverman was named CEO, and Walter Forbes was named chairman of the board. The positions of the two officers were scheduled to switch on January 1, 2000, with Henry Silverman assuming the role of chairman of the board and Walter Forbes assuming the role of CEO. The merger created a service company headquartered in Parsippany, New Jersey with operations in more than 100 countries involving over 30,000 employees. The market value of Cendant's approximately 900 million shares of outstanding common stock at the time of the merger was estimated to be $29 billion, making it one of the 100 largest U. S. corporations. Senior management believed that Cendant, as a global service provider, was uniquely positioned to provide superior growth and value opportunities for its owners (Form 8-K, CUC International, Inc., December 18, 1997). Initially, Ernst & Young, LLP, CUC's auditor, was retained to complete the audit of CUC's 1997 financial statements, and Deloitte & Touche, LLP, HFS's auditor, was retained to complete the audit of HFS's 1997 financial statements. Deloitte & Touche, LLP was selected as the successor auditor for the newly formed company. Cendant's 8-K filing with the Securities and Exchange Commission announcing the selection of Deloitte & Touche, LLP as the successor auditor noted that during the past two years there were no material disagreements between the company and Ernst & Young, LLP on accounting principles or practices, financial statement disclosures, auditing scope, or procedures. Management organized Cendant's operations around three business segments: travel services, real estate services, and alliance marketing. The travel services segment facilitated vacation timeshare exchanges, manages corporate and government vehicle fleets, and franchises car rental and hotel businesses. Franchise systems operated by Cendant in this business segment included: Days Inn, Ramada, Howard Johnson, Super 8, Travelodge, Villager Lodge, Knights Inn, Wingate Inn, Avis, and Resort Condominiums International, LLC. The real estate services segment assisted with employee relocation, provides homebuyers with mortgages, and franchises real estate brokerage offices. Franchise systems operated by Cendant in this business segment included: Century 21, Caldwell Banker, and ERA. The origination, sale, and service of residential mortgage loans were handled by the company through Cendant Mortgage Corporation. The alliance marketing segment provided an array of value-driven products and services through more than 20 membership clubs and client relationships. Cendant's alliance marketing activities were conducted through subsidiaries such as FISI Madison Financial Corporation, Benefits Consultants, Inc., and Entertainment Publications, Inc. Individual membership programs included Shoppers Advantage, Travelers Advantage, Auto Advantage, Credit Card Guardian, and PrivacyGuard. As a franchisor of hotels, residential real estate, brokerage offices, and car rental operations, Cendant licensed the owners and operators of independent businesses to use the Company's brand names. At that time, Cendant did not own or operate these businesses. Rather, the company provided its franchisee customers with services designed to increase their revenue and profitability. ANNOUNCEMENT OF FRUD The high expectations of management and investors were severely deflated in April 1998, when Cendant announced a massive financial reporting fraud affecting CUC's 1997 financial statements, which were issued prior to the merger with HFS. The fraud was discovered when responsibility for Cendant's accounting functions was transferred from former CUC personnel to former HFS personnel. Initial estimates provided by senior Cendant management were that CUC's 1997 earnings would need to be reduced by between $100 and $115 million. To minimize the fallout from the fraud, Cendant quickly hired special legal counsel who in turn hired Arthur Andersen, LLP, to perform an independent investigation. Cendant then fired Cosmo Corigliano, former chief financial officer (CFO) of CUC, and dismissed Ernst & Young, LLP, which was serving as the auditor for Cendant's CUC business units. The staff of the Securities and Exchange Commission and the United States Attorney for the District of New Jersey also initiated investigations relating to the accounting fraud. Unfortunately, the bad news did not stop for Cendant. In July 1998, Cendant announced that the fraud was more widespread than initially believed and affected the accounting records of all major CUC business units. Cendant revised its earlier announcement by noting that CUC's 1997, 1996, and 1995 financial statements would all be restated. The total cumulative overstatement of pretax quarterly earnings over the three-year period totaled approximately $300 million. CUC's management allegedly inflated earnings by recording fictitious revenues and reducing expenses to meet Wall Street analysts' earnings expectations. CUC managers simply looked at the analysts' earnings estimates and fictitiously increased revenues and/or reduced expenses to meet those expectations. Meeting analysts' expectations artificially inflated CUC's stock prices thereby providing it with more opportunities to merge or acquire other companies in the future through stock issuances. The pretax operating earnings were inflated by $176 million, $87 million, and $31 million for the first three quarters of 1997, 1996, and 1995, respectively. The misstatements reflected in CUC's quarterly reports filed with the Securities and Exchange Commission were not recorded in the general ledger. However, for year-end reporting purposes, CUC made various year-end adjustments to incorporate the misstatements into the general ledger. Some of the most significant misstatement techniques used by CUC to adjust its general ledger included the following: ƒIrregular charges against merger reserves. In its earlier acquisitions of other companies, CUC would record a one-time expense and establish a reserve (liability) for restructuring costs expected as a result of the merger. CUC would later artificially inflate earnings by fictitiously recording revenues or reducing expenses and reducing the merger reserve (liability) account. The reserve was used as a cushion to offset poor future performance. ƒFalse coding of services sold to customers. CUC would falsely classify amounts received from customers for deferred revenue recognition programs as amounts received from customers for immediate revenue recognition programs. For example, CUC would improperly record amounts received for the Shoppers Advantage program (which required revenues to be recognized over 12 to 15 months) to amounts received from the Creditline program (which allowed revenues to be recognized immediately). This misclassification of purchased benefits allowed CUC to immediately recognize revenues and profits instead of deferring them over the benefit period. ƒDelayed recognition of membership cancellations and bank rejection of charges made to members' credit card accounts. Customers were assessed an annual fee to be a member of the benefit programs, such as Auto Advantage. CUC would delay recognizing customer cancellations of benefit programs and bank rejections of credit card charges to inflate revenues and profits during the current reporting period. The final results of the fraud investigation were announced to the public in August 1998. In the end, pretax annual operating earnings were overstated by $262 million, $122 million, and $127 million for 1997, 1996, and 1995, respectively. All told, more than one-third of CUC's reported earnings during the fraud period were deliberately and fictitiously manufactured. MARKET REACTION TO THE FRUD Prior to the announcement of the fraud, Cendant's stock was trading at a 52-week high of approximately $42 per share. After the second announcement that the fraud was more widespread than initially believed, Cendant's stock dropped to a 52-week low of approximately $16 per share, a 62 percent drop, causing a total market value decline of over $20 billion. The resulting drop in Cendant's stock price squelched the company's planned $3.1 billion cash and stock acquisition of American Bankers Insurance. Additionally, numerous class action lawsuits were filed against the company and the current and former company officers and directors. On March 17, 1999, Cendant © reached an agreement on one class action lawsuit that resulted in a $351 million pretax charge to the 1999 financial statements and on December 7, 1999, Cendant reached an agreement on the principal class action lawsuit that resulted in a $2.83 billion pretax charge to the 1999 financial statements.
ASSIGNING BLAME
Many questions remain in the aftermath of the CUC fraud. How could CUC's senior management and the board of directors not be aware of the fraud? Where was CUC's audit committee? How could Ernst & Young, LLP, not have detected the fraud? Information obtained during the fraud investigation suggests that Cosmo Corigliano, CFO of CUC, directed or was aware of several of the irregular financial reporting activities noted during the investigation. Evidence also suggests that Anne Pember, the controller of CUC, who reported directly to Corigliano, directed individuals to carry out some of the irregular financial reporting activities noted. All told, more than twenty CUC employees were identified as participating in the fraud. Cosmo Corigliano, CFO of CUC, in court testimony regarding the fraud noted:
1 It was ingrained in all of us, ingrained in us by our superiors, over a long period of time, that that was what we did.
2 Casper Sabatino, CUC's accountant, in response to the judge's question on why he went along with the fraud noted: Honestly, your honor, I just thought I was doing my job.
3 Walter Forbes, chairman and CEO of CUC, and Kirk Shelton, chief operating officer (COO) of CUC, denied any involvement or knowledge of the alleged fraud. Cendant's audit committee, which oversaw the fraud investigation, concluded that because of the evidence suggesting that many senior accounting and financial personnel were involved in the irregular financial reporting activities the CEO and COO did not create an environment that encourage and expected accurate financial reporting (Form 8-K, Cendant Corporation, August 28, 1998). Cendant's audit committee also concluded in its report of the fraud investigation that senior management failed to design and implement internal controls and procedures that would have detected the irregular financial reporting activities without knowledge of such activities (Form 8-K, Cendant Corporation, August 28, 1998). Why did CUC's board of directors and audit committee not ferret out the fraud? The board of directors for CUC met several times during the year and reviewed financial reports that contained the fraudulent information. Were the outside directors too cozy with senior management? Four of CUC's directors were noted as having personal ties with Walter Forbes through other joint investments in startup companies.
4 Did Ernst & Young, LLP, exercise the professional skepticism required of an external auditor? Were the auditors inappropriately swayed by CUC employees who were formerly employed by Ernst & Young, LLP? T
wo alleged leaders in the fraud, Cosmo Corigliano and Anne Pember, along with two other financial managers of CUC, were previously employed by Ernst & Young, LLP. Moreover, Cosmo Corigliano was an auditor on the CUC engagement prior to being employed by CUC. The audit committee report on the fraud investigation notes several instances in which Ernst & Young, LLP did not substantiate or question fraudulent transactions. However, the report also shows that the senior management of CUC encouraged subordinates not to show certain information to the auditors. Additionally, the report notes instances in which the auditors accepted incomplete answers from management regarding CUC's financial performance. During the late 1980's and early 1990's, CUC was required to amend its financial statements filed with the Securities and Exchange Commission several times for using aggressive accounting practices, such as capitalizing marketing costs in place of using the standard practice of expensing them as incurred.
5 Why didn't these problems sensitize the auditors to the potential for problems with financial reporting? EPILOGUE Walter Forbes, chairman of the board of Cendant and former chairman and CEO of CUC, and ten other members of Cendant's board of directors formerly associated with CUC tendered their resignations shortly after it was announced that the fraud was more widespread than initially believed. Cendant's board of directors, after reviewing the fraud investigation report, dismissed Kirk Shelton, COO of CUC, for cause, eliminating the company's obligation to fulfill his previously negotiated severance package. Walter Forbes was allowed to receive a severance package totaling $47.5 million since he was not directly linked to the fraud; however, Cendant attempted to recover the severance payment Walter Forbes received. In January 1999, Cendant Corporation filed a lawsuit against Ernst & Young, LLP, for allegedly violating professional standards. No resolution of this lawsuit has been made public. Ernst & Young, LLP did settle the principal shareholder class action lawsuit for $335 million. Additionally, investigations by the Securities and Exchange Commission and the United States Attorney for the District of New Jersey found that CUC and its predecessors were issuing fraudulently prepared financial reports beginning as early as 1985. Two Ernst & Young, LLP partners involved with the audit engagement during the fraud period agreed to suspensions from practice before the SEC with rights to reapply in four years.
6 In January 2005, a federal jury convicted Kirk Shelton on federal conspiracy and fraud charges.
7 Kirk Shelton was sentenced to 10 years in prison and ordered to pay $3.275 billion in restitution to Cendant.
8 The fine covers settlements paid by Cendant for shareholder class action lawsuits and $25 million in legal fees paid by Cendant for Shelton's legal defense. After two mistrials in October 2006, a federal jury convicted Walter A. Forbes on federal conspiracy and false statement charges.
9 Walter Forbes was sentenced to 12 years, seven months in prison and also ordered to pay $3.275 billion in restitution to Cendant.
10 Cosmo Corigliano, Anne Pember, and Casper Sabatino pleaded guilty to federal conspiracy and fraud charges. Cosmo Corigliano was sentenced to 6 months house arrest and 3 years probation while Anne Pember and Casper Sabatino were sentenced to two years probation.
11 These three individuals were given reduced sentences as a result of cooperating with authorities related to the fraud investigation. Cosmo Corigliano agreed to pay civil penalties in excess of $14 million and Anne Pember agreed to pay civil penalties of $100,000.
[1] Professional auditing standards outline the auditor's consideration of material misstatements due to errors and fraud. (a) What responsibility does an auditor have to detect material misstatements due to errors and fraud? (b) What two main categories of fraud affect financial reporting? (c) What types of factors should auditors consider when assessing the likelihood of material misstatements due to fraud? (d) Which factors existed during the 1995 through 1997 audits of CUC that created an environment conducive for fraud?
[2] Professional auditing standards indicate that an entity's internal controls consist of five interrelated components. (a) What responsibility does an auditor have related to each of these five components? (b) One component of internal control is the entity's control environment. What factors should an auditor consider when evaluating the control environment? (c) What red flags were present during the 1995 through 1997 audits of CUC that may have suggested weaknesses in CUC's control environment?
[3] Professional auditing standards recognize there is a possibility that management may override internal controls. (a) Provide an example where management override occurred in the Cendant fraud. (b) What are the required auditor responses to further address the risk of management override of internal controls?
[4] Several misstatements were identified as a result of the fraud perpetrated by CUC management. (a) For each misstatement identified, indicate one management assertion that was violated. (b) For each misstatement identified, indicate one audit procedure the auditor could have used to detect the misstatement.
[5] Some of the members of CUC's financial management team were former auditors for Ernst & Young, LLP. (a) Why would a company want to hire a member of its external audit team? (b) If the client has hired former auditors, how might this affect the independence of the existing external auditors?
[6] What is meant by the term professional judgment, and why is it a particularly important concept to consider in the Cendant case?
[7] What are some examples of judgment traps and tendencies that likely affected the auditor's judgment when auditing CUC's financial statements?