Russell Smith knew why he had been summoned to the office of A. Walter Rognlien, the 74-year-old chairman of the board and chief executive officer of Smith's employer, Cardillo Travel Systems, Inc. \({ }^{1}\) Just two days earlier, Cardillo's in-house attorney, Raymond Riley, had requested that Smith, the company's controller, sign an affidavit regarding the nature of a transaction Rognlien had negotiated with United Airlines. The affidavit stated that the transaction involved a \(\$ 203,000\) payment by United Airlines to Cardillo but failed to disclose why the payment was being made or for what specific purpose the funds would be used. The affidavit included a statement indicating that Cardillo's stockholders' equity exceeded \(\$ 3\) million, a statement that Smith knew to be incorrect. Smith also knew that Cardillo was involved in a lawsuit and that a court injunction issued in the case required the company to maintain stockholders' equity of at least \(\$ 3\) million. Because of the blatant misrepresentation in the affidavit concerning Cardillo's stockholders' equity and a sense of uneasiness regarding United Airlines' payment to Cardillo, Smith had refused to sign the affidavit.

When Smith stepped into Rognlien's office on that day in May 1985, he found not only Rognlien but also Riley and two other Cardillo executives. One of the other executives was Esther Lawrence, the firm's energetic 44-year-old president and chief operating officer and Rognlien's wife and confidante. Lawrence, a longtime employee, assumed control of Cardillo's day-to-day operations in 1984. Rognlien's two sons by a previous marriage left the company in the early 1980s following a power struggle with Lawrence and their father.

As Smith sat waiting for the meeting to begin, his apprehension mounted. Although Cardillo had a long and proud history, in recent years the company had begun experiencing serious financial problems. Founded in 1935 and purchased in 1956 by Rognlien, Cardillo ranked as the fourth-largest company in the travel agency industry and was the first to be listed on a national stock exchange. Cardillo's annual revenues had steadily increased after Rognlien acquired the company, approaching \(\$ 100\) million by 1984 . Unfortunately, the company's operating expenses had increased more rapidly. Between 1982 and 1984, Cardillo posted collective losses of nearly \(\$ 1.5\) million. These poor operating results were largely due to an aggressive franchising strategy implemented by Rognlien. In 1984 alone that strategy more than doubled the number of travel agency franchises operated by Cardillo.

Shortly after the meeting began, the overbearing and volatile Rognlien demanded that Smith sign the affidavit. When Smith steadfastly refused, Rognlien showed him the first page of an unsigned agreement between United Airlines and Cardillo. Rognlien then explained that the \(\$ 203,000\) payment was intended to cover expenses incurred by Cardillo in changing from American Airlines' Sabre computer reservation system to United Airlines' Apollo system. Although the payment was intended to reimburse Cardillo for those expenses and was refundable to United Airlines if not spent, Rognlien wanted Smith to record the payment immediately as revenue.

Not surprisingly, Rognlien's suggested treatment of the United Airlines payment would allow Cardillo to meet the \(\$ 3\) million minimum stockholders' equity threshold established by the court order outstanding against the company. Without hesitation, Smith informed Rognlien that recognizing the United Airlines payment as revenue would be improper. At that point, "Rognlien told Smith that he was incompetent and unprofessional because he refused to book the United payment as income. Rognlien further told Smith that Cardillo did not need a controller like Smith who would not do what was expected of him."

Aст 2

In November 1985, Helen Shepherd, the audit partner supervising the 1985 audit of Cardillo by Touche Ross, stumbled across information in the client's files regarding the agreement Rognlien negotiated with United Airlines earlier that year. When Shepherd asked her subordinates about this agreement, one of them told her of a \(\$ 203,000\) adjusting entry Cardillo recorded in late June, an entry apparently linked to the United Airlines-Cardillo agreement. The entry, which Esther Lawrence approved, follows:

Shepherd's subordinates had discovered the adjusting entry during their second-quarter review of Cardillo's 10-Q statement. When asked, Lawrence had told the auditors the entry involved commissions earned by Cardillo from United Airlines during the second quarter. The auditors had accepted Lawrence's explanation without attempting to corroborate it with other audit evidence.
After discussing the adjusting entry with her subordinates, Shepherd questioned Lawrence. Lawrence insisted that the adjusting entry had been properly recorded. Shepherd then requested that Lawrence ask United Airlines to provide Touche Ross with a confirmation verifying the key stipulations of the agreement with Cardillo. Shepherd's concern regarding the adjusting entry stemmed from information she had reviewed in the client's files that pertained to the United Airlines agreement. That information suggested the United Airlines payment to Cardillo was refundable under certain conditions and thus not recognizable immediately as revenue.
Shortly after the meeting between Shepherd and Lawrence, Walter Rognlien contacted the audit partner. Like Lawrence, Rognlien maintained that the \(\$ 203,000\) amount had been properly recorded as commission revenue during the second quarter. Rognlien also told Shepherd that the disputed amount, which United Airlines paid to Cardillo during the third quarter of 1985, was not refundable to United Airlines under any circumstances. After some prodding by Shepherd, Rognlien agreed to allow her to request a confirmation from United Airlines concerning certain features of the agreement.
On December 17, 1985, Shepherd received the requested confirmation from United Airlines. The confirmation stated that the disputed amount was refundable through 1990 if certain stipulations of the contractual agreement between the two parties were not fulfilled. \({ }^{2}\) After receiving the confirmation, Shepherd called Rognlien and asked him to explain the obvious difference of opinion between United Airlines and Cardillo regarding the terms of their agreement. Rognlien told Shepherd that he had a secret arrangement with the chairman of the board of United Airlines. "Rognlien claimed that pursuant to this confidential business arrangement, the \(\$ 203,210\) would never have to be repaid to United. Shepherd asked Rognlien for permission to contact United's chairman to confirm the confidential business arrangement. Rognlien refused. In fact, as Rognlien knew, no such agreement existed."
A few days following Shepherd's conversation with Rognlien, she advised William Kaye, Cardillo's vice-president of finance, that the \(\$ 203,000\) amount could not be recognized as revenue until the contractual agreement with United Airlines expired in 1990. Kaye refused to make the appropriate adjusting entry, explaining that Lawrence had insisted that the payment from United Airlines be credited to a revenue account. On December 30, 1985, Rognlien called Shepherd and told her that he was terminating Cardillo's relationship with Touche Ross.
In early February 1986, Cardillo filed an 8-K statement with the Securities and Exchange Commission (SEC) notifying that agency of the company's change in auditors. SEC regulations required Cardillo to disclose in the \(8-\mathrm{K}\) statement any disagreements involving technical accounting, auditing, or financial reporting issues with its former auditor. The \(8-\mathrm{K}\), signed by Lawrence, indicated that no such disagreements preceded Cardillo's decision to dismiss Touche Ross. SEC regulations also required Touche Ross to draft a letter commenting on the existence of any disagreements with Cardillo. This letter had to be filed as an exhibit to the \(8-\mathrm{K}\) statement. In Touche Ross's exhibit letter, Shepherd discussed the dispute involving the United Airlines payment to Cardillo. Shepherd disclosed that the improper accounting treatment given that transaction resulted in misrepresented financial statements for Cardillo for the six months ended June 30, 1985, and the nine months ended September 30, 1985.
In late February 1986, Raymond Riley, Cardillo's legal counsel, wrote Shepherd and insisted that she had misinterpreted the United Airlines-Cardillo transaction in the Touche Ross exhibit letter filed with the company's 8-K. Riley also informed Shepherd that Cardillo would not pay the \(\$ 17,500\) invoice that Touche Ross had submitted to his company. This invoice was for professional services Touche Ross had rendered prior to being dismissed by Rognlien..........

QUESTIONS
1. Identify the accountants in this case who faced ethical dilemmas. Also identify the parties who would be potentially affected by the outcome of each of these dilemmas. What responsibility did the accountant in each case owe to these parties? Did the accountants fulfill these responsibilities?
2. Describe the procedures an auditor should perform during a review of a client's quarterly financial statements. In your opinion, did the Touche Ross auditors who discovered the \(\$ 203,000\) adjusting entry during their 1985 second-quarter review take all appropriate steps to corroborate that entry? Should the auditors have immediately informed the audit partner, Helen Shepherd, of the entry?
3. In reviewing the United Airlines-Cardillo agreement, Shepherd collected evidence that supported the \(\$ 203,000\) adjusting entry as booked and evidence that suggested the entry was recorded improperly. Identify each of these items of evidence. What characteristics of audit evidence do the profession's technical standards suggest auditors should consider? Analyze the audit evidence that Shepherd collected regarding the disputed entry in terms of these characteristics.
4. What are the principal objectives of the SEC's rules that require \(8-\mathrm{K}\) statements to be filed when public companies change auditors? Did Shepherd violate the client confidentiality rule when she discussed the United Airlines-Cardillo transaction in the exhibit letter she filed with Cardillo's \(8-\mathrm{K}\) auditor change statement? In your opinion, did Shepherd have a responsibility to disclose to Cardillo executives the information she intended to include in the exhibit letter?
5. Do the profession's technical standards explicitly require auditors to evaluate the integrity of a prospective client's key executives? Identify the specific measures auditors can use to assess the integrity of a prospective client's executives.

Transcribed Image Text:

Dr Receivables-United Airlines Cr Travel Commissions and Fees $203,210 $203,210