One can only imagine the high expectations of investors when the board of directors of CUC International, Inc. and HFS, Inc. 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 profit growth of the newly formed entity, Cendant. \({ }^{1}\)

Henry R. Silverman, chairman and chief executive officer (CEO) of HFS, noted at the time of the merger agreement that:

This transaction creates a world-class consumer services company with extraordinary revenue and profit growth potential. By combining HFS's brands and our consumer reach of more than 100 million customers annually with CUC's direct marketing expertise, powerful club membership delivery system, and 68 million memberships worldwide, we will create tremendous opportunities that are not available to either company on its own. In so doing, we have the combined potential for exceptional earnings and shareholder value creation for two companies that have already established excellent records in this regard. Walter Forbes and his management team have created one of the most innovative and successful companies in the history of the services industry. We are confident that by combining our operating, financial and management strengths, we will create one of the foremost consumer and business services companies in the world. (Form \(8-\mathrm{K}, \mathrm{CUC}\) International, Inc., May 27, 1997).

Walter A. Forbes, chairman and CEO of CUC, expressed similar views:

Together, we will benefit from this unique franchise: providing value-added services to consumers and businesses while substantially enhancing growth opportunities. With similar business models, both companies have pursued two sides of the same high growth businesses, to compete in a global, information-intensive and increasingly competitive economy. The combined company will have increased purchasing power and other advantages associated with greater scale. (Form 8-K, CUC International, Inc., May 27, 1997) 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. Cendant, a global service provider, was positioned to provide superior growth and value opportunities for its owners. As Henry Silverman noted when the merger was finalized:

Cendant arrives at the global market place as the world's premier consumer and business services company, with strong growth prospects. (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 and Touche was slated to be the successor auditor for the newly formed company. Cendant's \(8-\mathrm{K}\) filing with the Securities and Exchange Commission announcing the selection of Deloitte \& Touche as the successor auditor noted that during the past two years there were no material disagreements between the company and Ernst \& Young 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 facilitates 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 include: 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 assists in employee relocation, provides homebuyers with mortgages, and franchises real estate brokerage offices. Franchise systems operated by Cendant in this business segment include: Century 21, Caldwell Banker, and ERA. The origination, sale, and service of residential mortgage loans are handled by the company through Cendant Mortgage Corporation.

The alliance marketing segment provides an array of value-driven products and services through more than 20 membership clubs and client relationships. Cendant's alliance marketing activities are conducted through subsidiaries such as FISI Madison Financial Corporation, Benefits Consultants, Inc., and Entertainment Publications, Inc. Individual membership programs include 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 licenses the owners and operators of independent businesses to use the Company's brand names. Cendant does not own or operate these businesses. Rather, the company provides its franchisee customers with services designed to increase their revenue and profitability.

ANNOUNCEMENT OF FRAUD
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 management of Cendant were that CUC's 1997 earnings would need to be reduced by approximately \(\$ 100\) to \(\$ 115\) 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, with the accounting records of all major CUC business units affected. 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 \(\$ 31\) million, \(\$ 87\) million, and \$176 million for the first three quarters of 1995, 1996, and 1997.
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:
- Irregular 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.
- False 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.
- Delayed 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 as well as bank rejection 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 FRAUD
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 detect the fraud?
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:
Walter Forbes and Kirk Shelton because of their positions, had responsibility to create an environment in which it was clear to all employees at all levels that inaccurate financial reporting would not be tolerated. The fact that there is evidence that many of the senior accounting and financial personnel participated in irregular activities and that personnel at many of the business units acquiesced in practices which they believed were questionable suggests that an appropriate environment to ensure accurate financial reporting did not exist. (Form 8-K, Cendant Corporation, August 8, 1998)
Cosmo Corigliano, CFO of CUC, in court testimony regarding the fraud noted:
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's, CUC 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. \({ }^{3}\)
Finally, Cendant's audit committee also noted in its report of the fraud investigation that:
Senior management failed to have in place appropriate controls and procedures that might have enabled them to detect the irregularities in the absence of actual knowledge of those irregularities. (Form 8K, Cendant Corporation, August 8, 1998)
Information obtained during the fraud investigation suggests that Cosmo Corigliano, CFO of CUC, directed or was aware of several of the irregular 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 activities noted. All told, more than twenty CUC employees were identified as participating in the fraud.
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 the 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? Two alleged leaders in the fraud, Cosmo Corigliano and Anne Pember, along with two other financial managers of CUC, were previously employed by Ernst \& Young. 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 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, \(\mathrm{COO}\) 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 is trying 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 was made public as of the writing of this case, however, Ernst \& Young settled 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 .
Walter Forbes and Kirk Shelton were subsequently indicted on federal conspiracy and fraud charges and are awaiting trial in New Jersey. Cosmo Corigliano, Anne Pember, and Casper Sabatino pleaded guilty to federal conspiracy and fraud charges and now face potential prison sentences of five years and fines in the millions of dollars.

REQUIREMENTS
1. Professional 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 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 internal control component 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 with CUC's control environment?
3. 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 been used to detect misstatement.
4. 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?