Questionable accounting devices

In the year 1990’s, many companies in U. S. A had cheated their shareholders by resorting to questionable accounting devises as understatement of reserves, irregular revenue recognition, understatement of reserves, recording of fictitious receivables and delaying to record credits. The employment of restructuring reserves fund resulting to several billion dollars was a main notable devise pursued by the companies.

Instead of covering one-time costs connected with takeovers, the reserve fund employed as an instrument for charging ordinary business outlays and losses and acted as a pot which could be immersed into to meet the anticipated earnings results. [Paul 9]. Cendant, a franchiser of hotel chains (Travelodge, Ramada Inn, and Howard Johnson), real estate agencies and car rental agencies, which merged with a company called CUC International whose business was selling memberships in discount shopping clubs.

CUC was later found to have methodically overestimated the revenues to be gained from new members. Cendant Inc witnessed a drastic reduction in its stock price during 1998 due to many factors including failed expansion attempts, accounting scandals and poor market conditions. Cendant scandal related to inflated earnings and improper employment of reserves The Cendant scandal was related to report inflated earnings to SEC and the investing public mainly to manipulate the stock price synthetically.

The modus operandi of the fraud was to fraudulently increase the earnings of Cendant Membership Services Inc [CMS], which in turn fraudulently inflated earnings of Cendant as reported to SEC [Stock Exchange Commission] and the investors, there artificially jacked the price of Cendant stock. By using CUC International, Inc [CUC] stock, the price of which had been synthetically increased, to defray for CUC’s acquisition of other companies.

Further, by employing the artificially jacked price of CUC stock, CUC deceitfully raised earnings reports, and dishonestly manipulated the future earnings estimates of CUC mainly to influence HFS Inc [HFS] and its investors to merge with CUC. Top executives of Cendant whether out of greed or out of extreme anxiety seemingly utilized the accounting fraud to fabricate imaginary revenues or sales figures mainly to jack up the earnings, over a period of years. Due to this over greediness of the top executives, the real losers were the shareholders who lost billions of dollars when Cendant stocks plummeted.

On April 15, 1998, top officials of the Cendant after the close of the market of that day revealed a shocking message through press. Company officials had detected a serious accounting fraud in its main membership-club processes that would compel them to reduce the already reported operating income of 1997 by $ 100 million or more and this would have its impact on Cendant earnings of 1998. The most important issue at hand was the method adopted by the CUC unit in accounting revenues in its club-memberships revenues.

It was detected that excess revenue was reported upfront, while accounting of expenses related with the membership was delayed until future accounting periods. Due to this press announcement, the stock price of Cendant plummeted the following day from that of $ 36 to $ 19. 06 as a whooping 108 million shares were traded on that particular day alone. It is to be noted that the average trading volume of Cendant had been around 4 million shared per day in the ordinary market conditions. The disaster did not stop for the Cendant stock holders.

Again, on July 14, 1998, the company released second outrageous news to the market: So as to cater the Wall Street’s earnings expectation, CUC had accounted nonexistent revenue of $300 million over the past three accounting periods. Silverman, CEO of HFS before merger had been made as president and CEO of the Cendant after the merger announced that “HFS merged with a company wherein its 50 to 60% of its earnings were without any essence. It should be called as a terrible transaction. However, in a layman parlance, it would be known as fraud.

It is perplexing to note that how Ernst & Young LLP, auditors of the CUC had issued unprofessional audit views for the accounting periods concerned. In an effort to defend their stand, Ernst & Young LLP maintained that “Revenue recognition is an intricate matter. Accounting is a fine art. Accounting principles are prone to elucidation. ” ANALYSIS OF CENDANT’S FRAUD: The quarterly , half-yearly and annual financial data released by Cendant , while calculation the operating income , Cendant regularly kept out non-recurring expenses ,including merger costs and frequently excluded the effect of interest charges and taxes .

It is to be noted that operating income is the best indicator of the company performance and investors and analysts mostly reckoned upon this indicator for making investment decisions. Usually, operating income is arrived at after exclusion of effect of on one occasion or extraordinary, events on a company’s revenues, while net income will include the effect of those events. The main charge against Walter A. Forbes and E. Kirk Shelton, the top officials of the Cendant were the following: ? Omitted to state material facts and made untrue statements on the affairs of the Cendant business.

? Committed deceit and fraud on the shareholders of the Cendant and its affiliates and general investing public against to Title 15, USC, Sections 1341 and 1343. ? Wantonly made misleading and false accounting statements and filed with Stock Exchange commission in various forms like 10-k which was contrary to Title 15, U S C ,Section 78 ff [a]. ? Filed false accounting reports matching with the financial prediction made by stock analyst of Wall Street for fear that any underperformance could activate a downfall in the price of Cendant shares.

? Employing merger reserves to hijack operating income. ? Failed to preserve a sufficient membership cancellation reserve to qualify for more favourable accounting treatment. ? Made innumerable fraudulent accounting entries. ? Made false representation that Cendant adhered public accounting policies. ? Created unwarranted merger reserves and utilized such reserves to hijack the reported operating income of Cendant. ? Creating excessive merger reserves against provisions of the GAAP. ? Operating income of CUS was overstated over the period from 1980 to 1995 by millions of United States Dollars.

? Excess reporting of operating income to the tune of $ 10 million in CUC during year 1996. ? Excess reporting of operating income to the tune of $ 23 million in CUC during year 1997. ? Overstating income of Cendant to the tune of $ 110 million during the year 1997. ? Fraudulent treatment of the membership cancellation reserve in Cendant. ? Fraudulently increasing the reported revenues and suppressing the expenses. ? Top officials of Cendant deliberately influenced some standard calculations of membership solicitation cost thereby reducing the expenses.

After the second news flash of reported misstatement of $ 300 million loss, Cendant stock price further dropped to $15. 69, which was a 53 –week low. Due to these unexpected happenings, on July 29, 1998, irate investors throw their mounting pressure on Walter Forbes to resign as the chairman of the Cendant Inc along with the other former associates of the Board of CUC International Inc Despite of this mammoth scandal, Mr. Forbes received $ 47. 5 million as severance pay and Silverman was then elected as the successor of Forbes.

Due to these unforeseen incidents, the stock price of Cendant Inc came down further in August 1998. SEC had commenced its investigation into the Cendant’s accounting policies. On findings from its investigation, SEC further mandated the Cendant with strict requirements which forced the Cendant to lower its estimated earnings for 1998. Further decline of Cendant’s stock price at the fag end of 1998 made Cendant in a precarious situation as it had became evident that Cendant’s intended acquisitions would be hard to complete.

As a result, Cendant was forced to call off its intended acquisitions of Providian Auto & Home Insurance Co and American Bankers Insurance Group, Inc. Further, due to allegations of fraud, there were innumerous lawsuits filed against Cendant. An astonishing fine of $3. 19 billion was paid as settlement by Cendant Corp and accounting firm Ernst & Young, mainly to repay investors who sustained losses due to financial misstatements over a period of three years in 1999. The prime plaintiff’s in this case were the U. S. A’s three largest retirement systems, representing state workers in New York and California.

[Jost 817]. Ernst & Young finally agreed to pay a $ 335 million settlement in a suit brought by shareholders of franchise conglomerate Cendant Inc. The plaintiff’s charged the accounting firm for misstatement of profits by one of the companies that merged to form Cendant in 1997. Ernst & Young blamed that it had been the victim of international conniving fraud by the unscrupulous management. [Jost 820]. Retrieving compensation from an ousted CEO frequently becomes a laborious ordeal. Cendant Corp. has attempted to recover a $47. 6 million severance package from its erstwhile Chairman Walter A.

Forbes for many numbers of years. The New York based travel-services and residential real-estate company attempted to recoup compensation from an ousted CEO often becomes a strenuous ordeal. . Under tremendous pressure from Cendant’s shareholders, Mr. Forbes forced to resign in July 1998. Attempts to recuperate fractions of ex-chief executive officers pay in case if there is any scandal at a later date rarely succeeds. For this lacuna, corporate-governance connoisseurs partly fault directors themselves for the muddle, since it is they who offered a rich reward upon the CEO’s whom they later ousted.

Walter Forbes, the former chairman of Cendant was sentenced for 12 years and 7 months and asked to pay a fine of $3. 3 billion. Forbes was earlier convicted on one count of conspiracy and two counts of false reporting after two previous mistrials for his role in the accounting scandals. [The Evening Standard, January 18, 2007]. As per Wall street journal [August 4, 2005 B2] past Vice Chairman of Cendant namely Kirk Shelton was awarded an sentence of 10 years in prison for his active role in a three billion dollar accounting scandal Shelton was asked to defer full compensation of $3. 28 billion.

It was challenged by Prosecutors that Shelton hijacked profits by $501 million to maneuver Cendant’s stock price. Further, lawyer of Shelton vehemently argued that Shelton did not earn profit from the scheme, however lost millions of dollars. Cendant’s market value dropped $14 billion honestly in a single day, when the fraud was flashed in 1998. During June 2000, the Court endorsed the plan of allocation and settlement in Cendant case. Court observed that the overall recovery of $ 3. 3 billion from all defendants in Cendant case amounted to 38% recovery to class which is far in excess of amount recovered so far.

The Court observed that the settlement was fair enough and the amount recovered in Cendant case was three times higher than the next case reported in securities laws scandal case and about ten times greater than any recovered amount in any class action case related to fraudulent financial accounting reports. Further, the settlement paid by the Ernst & Young was the largest fine amount paid by an accounting firm in the history of America. The court observed that this Action concluded in “exceptional ‘settlements of unusual amount out of the exceptional efforts pursued by highly professional counsel with rational cost to the class.