Question

Cendant was formed on December 18, 1997, via the merger of CUC Inter-

national and HFS, Inc. The company owns the rights to franchises and

brands including Avis, Century 21 Real Estate, Coldwell Banker, Days Inn, Howard Johnson, and

Ramada. The consolidated entity got off to a bad start when it was revealed that CUC International

executives had been committing "widespread and systemic" accounting fraud with intent

to deceive investors. When the company announced that it had discovered "potential accounting

irregularities" the stock dropped from $36 to $19 per share. Eventually the stock would fall to as

low as $6 per share as the company struggled to convince investors about management's integrity.

According to the company's own investigation, CUC executives had inflated earnings by

over $650 million over a three-year period using several tactics, including (1) failing to timely

record returned credit card purchases and membership cancellations, (2) improperly capitalizing

and amortizing expenses related to attracting new members, and (3) recording fictitious sales.

a. For each of three fraudulent tactics employed by CUC, identify an analysis technique that could have identified

the accounting improprieties.

b. Both the investors and the management of HFS had relied on audited financial statements in making decisions

regarding CUC International. What do you believe was the external auditor's culpability in not detecting these

fraudulent practices?

Answer 1

a.

1. Failing to timely record returned credit card purchases and membership cancellations: An account receivable analysis technique could have identified the accounting improprieties. Continuous growth in receivables or unexplained bad debts written off could have been examined. Ratios that compare cash collection with accounts receivable also identify fraudulent practices.

2. Improperly capitalizing and amortizing expenses related to attracting new members: It is difficult to identify. It is important to understand the growth in intangible assets and their deferred charges and their reasonableness. Unusual increase should be considered as a dangerous sign.

3. Recording fictious sales: One aspect to identify fictious sales is comparison of sales with account receivables. Increasing sales do not lead to slower account receivable turnover. Increase in account receivable turnover should be monitored as it can be a result of fictious sales.

b. Auditor's Responsibilities as per SA 240, relating to fraud in auditing financial statements are:

• Obtain reasonable assurance that financial statements are free from material misstatements.
• Maintain professional skepticism throughout the audit.
• Knowing that risk of non-detection of management fraud is greater than non-detection of employee fraud.
• Must be aware that risk of non-detection of fraudulent misstatement is greater than non-detection of misstatement due to error.

Management has the primary responsibility for the detection and prevention of fraud and not the auditor. If the external auditors have fulfilled all their responsibilities, then they are not primarily responsible for fraud. If the auditors have not fulfilled their responsibilities properly, they will be responsible for not detecting these fraudulent practices.