February 16th, 1999 Draft

A Pathological Probe of
A Pool of Pervasive Perversion


Abraham J. Briloff, Ph.D., CPA
Emanuel Saxe Distinugished Professor Emeritus

Baruch College, New York.
 On August 28, 1998, Arthur Andersen & Co. (“AA”) rendered its “Report to the Audit Committee of the Board of Directors of Cendant Corporation” reporting on its forensic audit of CUC International, Inc., in the wake of disclosures in mid-April that accounting irregularities had been discovered at CUC (which merged in December 1997, with HFS to form Cendant).  That report was introduced as follows:

Throughout the Restatement Period [1995-1997] numerous accounting irregularities and improper accounting practices occurred which had the effect of inflating revenues or decreasing expenses.  The irregularities were pervasive.
The information that has been obtained indicates that the purpose of many of the irregularities was at least to conform CUC’s publicly-reported results to Wall Street’s earnings expectations.  During 1995-1997, operating income was improperly inflated by an aggregate of approximately $500 million before taxes, which represents one-third of the total operating income reported by CUC.

 There then followed a nexus of irregularities determined by AA as CUC’s “Certified Independent Forensic Auditor” (“CIFA”) including those relating to:

This probe will respond to the following queries: The “What” and the “Whys” are inextricably intertwined.  I shall, nonetheless, endeavor to proceed with this analysis in some logical sequence.

Note:  While the accounting perversions detailed by the report also involved the years 1995 and 1996, as well as earlier years, this discourse will concentrate principally on the nefarious activities of 1997.  This is because that was the year of the greatest excesses – both in kind and amount; but probably more importantly that was the year when CUC and HFS were racing towards the consummation of their merger.

 The two areas which should have informed auditors possessed of but a modicum of olfactory sensitivity that they were in the stygian swamp were those relating to the two reserves, Mergers, and Membership Cancellations.

Each of those sectors was clearly and overtly readily identifiable and capable of the most circumspect analysis and audit.  Each was created for a special identifiable objective so that its utilization was capable of being tracked most circumspectly.   The probe by auditors with the requisite healthy professional skepticism would have alerted them that the Cendant accountings for its 1997 year were, at the least, suspect.  This, in turn, would have led them inexorably to their client’s quarter to quarter fakery.

That Ernst & Young (“E&Y”) were not thus led leads to the inference that they preferred not to be thus led.
It was that phenomenon which induced a stream of consciousness taking me back 30 years, to the National Student Marketing (“NSM”) cause celebre.  There, as history relates, NSM was racing towards its merger with Interstate National on Halloween, 1969.  The auditors realized that all was not well with NSM’s accountings; nonetheless, they found themselves unwilling to or incapable of applying the brakes to stop their client from highballing towards disaster.

Even though that book-cooking involved but $1 million, the accounting disaster was followed by criminal indictments and convictions.

Alas!  As Santayana regularly reminds us, those who do not read history are destined to repeat its mistakes.
 Before considering the irregularities relating to the two reserves, it is necessary that we consider the so-called quarter-to-quarter topside adjustments.  This is because the reserve irregularities were required to provide the cover-up for the quarterly perversities described below.

Topside Adjustments to Quarterly Results

At each of the first three fiscal quarters since 1995, CUC inflated its operating income by increasing revenues and/or decreasing expenses of its largest business unit, the Comp-U-Card division in Trumbull, Connecticut, without any valid basis.

So-called “topside” entries were made by accounting personnel at corporate headquarters to increase accounts receivable and revenues, or to decrease accounts payable and expenses, even though (as these personnel acknowledged) there was no actual receivable supporting the entry giving rise to the revenues, and no actual reduction of a payable obligation to justify the reduced expense.  The topside entries were not recorded on any general ledger, thereby creating a discrepancy between the adjusted figures and those reflected on the company’s actual books and records.

The amount of these quarterly adjustments increased from $31 million pretax income in 1995 to $87 million in 1996 to $176 million in 1997.

The amount of the income adjustments at each quarter closely mirrored the amount needed to bring CUC’s results into line with Wall Street earnings expectations . . .

The inflated earnings results were then publicly reported . . .

In addition  to adjusting the company’s income at each quarter to meet Wall Street expectations, CUC also made quarterly unsupported topside adjustments to its balance sheet, particularly to show a greater cash balance than the company actually had on its books.  These adjustments were generally made in conjunction with the earnings adjustments described above.
Unsupported Topside Adjustments Made During 1997

The cumulative impact of the 1997 quarterly adjustments was to increase reported pretax income by $176 million for the nine months ended October 31, 1997.

 These adjustments were effected by inflating the revenues artificially by $47.4, $57.6, and $44.0 millions for the quarters ended April, July, and October, 1997 respectively; the expenses were reduced artificially by $14.7, $3.3, and $9 millions for the respective quarters – leading to the unwarranted increase to the 9-month bottom line of the aforementioned $176 million.
As noted the  above adjustments essentially brought CUC’s net income per share into line with Wall Street analysts’ expectations.

 This leads us to the irregularities relating to the Utilization of Merger Reserves.

As a result of the quarterly topside adjustments to earnings, there was a substantial gap between what was reported to the public and what was recorded on the company’s books.  To help close this gap, CUC made various year-end adjustments to its books to increase revenues or decrease expenses.  In 1997 these largely took the form of reversals of previously established merger and restructuring reserves into income, by decreasing the reserves and correspondingly increasing income (again either by increasing revenues or decreasing expenses) through numerous unsupported journal entries.  In what the information obtained shows to have been a carefully planned exercise, unsupported journal entries to reduce reserves and increase income were made after year-end and backdated to prior months; merger reserves were transferred via intercompany accounts from corporate headquarters to various subsidiaries and then reversed into income; and reserves were transferred from one subsidiary to another before being taken into income.  Approximately $115 million of merger reserves were improperly reversed into income at year-end 1997 in these and other fashions.

 In January, 1998 CUC effected a series of inappropriate reversals from Merger Reserves to income amounting to $115 million.

Of the $115 million in total merger reserve reversals, about $108 million were taken into revenue or other income accounts and only about $7 million were credited against expenses.  This ratio is consistent with the fact that the quarterly 1997 topside adjustments, in overwhelming part, increased revenues as opposed to reducing expenses.

Based upon the information available, the reversal of the reserves to increase revenues and decrease certain expenses, and the transfer of such reserves to subsidiaries as described above, was (1) not consistent with the expressed purpose of the reserves; (2) not supported by adequate (or any) documentation; and (3) not understandable in terms of accepted accounting practices.  In particular, it is difficult to envision any scenario whereby a merger reserve could be appropriately reversed into revenues, as occurred with most of the above reversals.

CUC also improperly utilized merger reserves by writing off assets as impaired against reserves when the assets were not in fact impaired or where such impairment was unrelated and not coincident to any merger.

The Establishment of the Cendant Merger Reserve

Principally in connection with the merger with HFS, CUC charged approximately $556.4 million to operations as merger, integration, restructuring and litigation charges during the year ended December 31, 1997.  Such costs were presumed to be related to ($ millions):

Transactions  costs                                        $180.6
Impairment charges                                         133.9
Business terminations                                        89.9
Facility related costs                                         59.5
Provision for certain litigation matters                75.0
Other                                                               17.5
  Total                                                          $556.4

According to a footnote in CMS (nee CUC’s) 1997 financial statements, these costs were intended to reflect:

The Cendant Merger Reserve, at least, was not established willy-nilly to the contrary, according to the CIFA report:
 As part of its audit of Cendant Membership Services’ (“CMS”) (N’ee Comucand) December 31, 1997 financial statements, E&Y performed auditing work in connection with the establishment of the $556 million CUC portion of the Cendant reserve.  E&Y has stated that much of the support for the various component costs in the merger reserve was received from Corigliano and Pember.  Included in E&Y's workpapers is a document titled "Cendant Merger and Related Costs and Other Unusual Charges Memorandum" which E&Y has stated was provided to it by Pember (the "Cendant Reserve Memorandum").  The memorandum contains a written explanation for the inclusion of most of the cost that comprised the CUC portion of the Cendant reserve.  E&Y's workpapers contained other documents supplied to them by Pember and others relevant to the establishment of the CUC portion of the Cendant reserve.

On February 2, 1998, representatives of E&Y and D&T met.  During this meeting E&Y discussed with D&T the component costs of the CUC portion of the merger reseve and provided the company's justifications for those costs.  Certain members of former HFS management also met with E&Y, Corigliano and Pember to discuss the Cendant reserve. Members of former CUC and HFS management also met from time to time to discuss the components of the Cendant reserve.
 Nature, Use and Abuse of the Membership Cancellation Reserve:

 Turning next to the irregularities concerning the Membership Cancellation Reserve, according to the AA report:  “CUC also made inappropriate use of its membership cancellation reserve by periodically reversing that reserve into income without support, and by recording other entries which obscured the manner in which the reserve was used.  These practices resulted in the membership cancellation reserve being substantially understated.

Establishment of the Membership Reserve

At the time Comp-U-Card records revenue to the general ledger it establishes a reserve, and reduces revenue, for the estimated number of members and related membership fees that will cancel during the membership periods (“cancels”).  Such reserves (hereafter the “Membership Reserve”) are based upon historical trends for each program.

“Rejects in Transit”

After the trial period, if applicable, members are billed through the banks, which charge the member’s credit card.  Any credit card charge that is rejected is charged by CUC against the Membership Reserve.  The entry is to debit (reduce) the reserve and credit (reduce) cash.  In the meantime, new revenues will have been recorded for other new joins, and new reserves established for those revenues, so that the reserve will constantly fluctuate up and down depending on the level of new joins as well as rejects and cancels.

Until the reject is posted to Comp-U-Card’s general ledger (i.e., while the reject is “in transit”), there will be a difference between what appears on the company’s books and what the bank statements show.  The difference would typically appear as a reconciling item on the bank cash reconciliations (at month end) that the Comp-U-Card accounting personnel in Trumbull prepared each month.

As any accountancy 101 student knows, basic accounting procedures would indicate that reconciling items in a bank reconciliation (such as rejects in transit) should be journalized and recorded in the general ledger each month as they are reported by the bank.  Nonetheless, at some point prior to 1995, CUC developed a practice whereby it would not write off any rejects to the Membership Reserve for the last three months of each fiscal year.  Instead, the company would “hold” three months of rejects at year-end and book them in the first quarter of the next fiscal year.

Comp-U-Card’s membership cancellation reserve – the provision for potential membership cancellations and credit card rejections – was substantially understated as of January, 1995.  Despite this, from time to time during the 1995-1997 span that cancellation reserve was improperly reduced, and income increased, through unsupported and backdated journal entries.
To obscure the understatement of the cancellation reserve, and the improper reversals of that reserve into income, CUC engaged in various other irregular accounting practices.  These included the delayed recording of credit card rejects and the creation of fictitious accounts receivable.

The positive income statement impact of these practices on the company’s reported income actually declined from $48 million pretax in 1995 to $19 million in 1996 and $12 million in 1997.  That is because the majority of the income statement benefit from the understatement of the cancellation reserve occurred at some undetermined point prior to 1995 when rejects were initially not written off to the reserve or adequately reserved for.  The precise reasons for the historical understatement of the cancellation reserve could not be determined.

The “Smoking Gun”:

In early November, 1997, in contemplation of an early audit sign-off due to the CUC/HFS merger, E&Y was scheduled to test cash as of September 30, 1997, three months earlier than normal.  This determination on E&Y’s part to test cash three months earlier than usual precipitated a crisis for Stephen P. Speaks, CUC’s vice president and controller for Comp-U-Card.  Thus, the 3-card marital game regularly played as of the end of the fiscal year had to be three months earlier.  The Rejects/Cancellations for the months of July through September aggregating $112 million had already been booked because the end-of-year manipulations were not then anticipated; the booking of that $112 million produced a negative balance in the reserve of $70-80 millions.  And now we return to the CIFA report:  Before the E&Y testing took place, Speaks decided that Comp-U-Card would “un-book” the rejects that had been booked in the normal course in July, August and September 1997.  He directed a series of entries to be recorded that had the following effect:

Dr. Cash                           $111,800,000
Cr. Membership Reserve  $111,800,000

Following this “un-booking” of the rejects for July, August, and September, Comp-U-Card accounting personnel then went back, at Speaks’ direction, and changed the bank reconciliations for those months to show the amounts as “rejects will post.”
Speaks said that he decided around this time that rather than hold three months of rejects at year-end December, 1997 (as the practice had been historically) Comp-U-Card would begin to record rejects on a constant three-month lag.  Thus, the rejects for July would be booked in October; August rejects would be booked in November; and September rejects in December.  Meanwhile, October rejects would be held for three months and booked in January; November rejects would be booked in February and December rejects in March.  Under this new practice, the effect would be the same since CUC would still have three months’ worth of unbooked rejects at year-end.

The effect of “un-booking” the rejects from July through September was to increase both cash and the Membership Reserve as of September 30, 1997, thereby accomplishing as of that date what traditionally had been accomplished by holding the rejects at year-end.  This also meant that the bank reconciliations as of September 30 would show large reconciling items for “rejects in transit,” representing the unbooked rejects for July, August and September.  For example, the September 30 bank reconciliation for just one account showed unposted rejects totaling more than $30 million for the months of July through September.  However, Speaks said that E&Y was accustomed to seeing these reconciling items when it audited cash at prior year-ends.  Indeed, the following notation appears in E&Y’s workpapers for the cash confirmation it performed at September 30, 1997:

It should be noted that significant reconciling activity stemmed from July 1997 and forward, due to the fact CUC records rejects 3 months in arrears, as is Company policy.

 Speaks recalled that one of the E&Y auditors noticed the rejects in transit and questioned Speaks about it during E&Y’s September 30 audit of cash.  He told her that the company’s policy was to hold those rejects for three months before booking them, and that this had always been the policy.  He said he had no other conversations with anyone from E&Y on the topic.
 Marc Rabinowitz, the E&Y partner in charge of the January 1997 & December 1997 year-end audits (who initialed the workpaper quoted above), said he recalled learning at some point that CUC held rejects for a short period of time and that they would “cleanse themselves out” over a short period of time.

 As of December 31, 1997, the balance on CUC’s books for the Membership Cancellation Reserve stood at $37 million.  The CIFA determined that on the basis of the bank statements there were unbooked cancellations amounting to $158 million to be offset by $32 million of “rebills” – as a consequence the CUC’s cash balance was inflated by $126 million, with a corresponding overstatement of the Reserve.  If that $126 million were charged against the Reserve, there would then be a negative balance of $89 million.

According to the AA analysis a cancellation reserve of $115 million was required as of year-end 1997; this meant that $204 million was required to be added to the reserve, and charged to the income account, i.e., the amount which would transmute the $89 million negative to a $115 million positive (of that $204 million AA determined that $119 million related to years prior to 1995, leaving $85 million to be charged to the 1995-1997 span.)

 I congratulate AA for their ability to couch their commentary so objectively and dispassionately.  I could not avoid setting forth my views stridently and with intense indignation.

 What did the E&Y auditors presume to be their professional responsibility?

 Putting aside their awesome professional credentials and reducing the matter to the absurd:

 Assume that you are reconciling your cash balance with that shown by the bank statements and you find that the bank has charged (debited) your account with a $30 service charge.  You would, of course, be constrained to subtract that $30 from your cash balance.  Why not the $30 million identified in that bank statement as of September 30, 1997 referred to by the report?  Why not the $158 million which would have been readily identifiable as debits as of December 31, 1997?

 The fact that the perversity had prevailed for many years serves to exacerbate the condition, and intensifies my indignation.
 Thus, as of January 31,1995, the auditors have noted that the unbooked Rejects /Cancels amounted to $44 million, whereas the reserve on January 31, 1995 stood at  $33 million, hence, a deficit as of that date of $11 million.  In fact, the reserve as of January 31, 1995 should have been more than $100 million.  A year later, the reserve stood at $37 million, the unbooked Rejects/Cancels amounted to $84 million which would have produced a negative balance of $47 million. ---  Again, the balance required as of that date exceeded $100 million.

 As of January 31, 1997, the reserve balance on the books stood at $29 million, Rejects/Cancels were $123 million, which if they were booked, would have produced a deficit of $94 million, whereas an actual reserve of $97 million was required as of that date.  So that the reserve was almost $200 million below that required.

 The auditors were undoubtedly confronted with reconciling items representing amounts charged on the bank statements for the Rejects/Cancels amounting to $44, $84, and $123 millions as they audited CUC’s cash as of the fiscal years ended 1995, 1996 & 1997, respectively.

On April 14, 1998 Speaks brought CUC’s “rejects in transit” practice to the attention of Scott Forbes, Cendant’s senior vice president - finance (Principal Accounting Officer); on the following day Cendant reported that it had discovered potential accounting irregularities in certain former CUC International, Inc. business units and that it expected to restate annual and quarterly net income and earnings per share for 1997 and might restate certain other previous periods related to the former CUC businesses.

 Why was the accounting fraud not discovered before 1998?

I believe that the answer to the question is attributable, at least in part to some relationships noted by the CIFA report, thus:
The arch villains who were there identified were: Cosmo Corigliano, Chief Financial Officer of CUC since early 1995, and prior thereto Corporate Controller of the Comp-U-Card division, directed the unsupported topside adjustments to increase quarterly income and knew about or directly participated in certain of the other activities discussed in this Report; and Anne Pember, the Controller of CUC (and formerly Corporate Controller of the Comp-U-Card division), who reported directly to Corigliano, gave the directions that resulted in the improper reversal of a substantial amount of merger reserves into income and the recording of other improper entries within Ideon.

Whence came Corigliano and Pember?  Again, according to the Report:

E&Y was CUC’s independent public accountant, E&Y was first retained prior to the time CUC went public in 1983 and subsequently conducted each of the company’s annual audits.  E&Y also conducted reviews of CUC’s quarterly financial statements.  Several of CUC’s employees responsible for accounting and financial matters had previously worked at E&Y including Corigliano, Kearney, Pember and Sattler.  [emphasis supplied]

 It may be noteworthy that the CUC audit was conducted by E&Y from its Stamford, Connecticut office.  Thus, how important was CUC to the economics and pecking order of that office?

 According to a Stanford University study Cendant has the dubious distinction of being the subject of more securities litigation than any other corporation during 1998.  It may well be that some of those actions will disclose all of the involvements by E&Y during 1997, the critical period of the CUC-HFS negotiations, especially those involving E&Y’s Mergers & Acquisitions sector.

 A priori!  I submit that the evidence developed on discovery will demonstrate that E&Y’s merger and acquisitions activities impaired the firm’s objectivity when it turned to the December, 1997, audit, possibly also the January 31, 1997, fiscal year-end audit.

 The response to the Quo Vadis?  Query can be stated most expeditiously and categorically, to wit:

 All CPAs who presume to provide services as the independent auditors of publicly-owned enterprises should be presumed to have the qualifications requisite to services as Certfied Independent Forensic Auditors and thereupon to be presumed to serve as such.  This is precisely the role which is presumed of the presumptively independent CPAs – the public deserves and requires nothing less.  Beyond that, I challenge Arthur Andersen & Co. with the responsibility of:
 Filling a complaint against Ernst & Young with the American Institute of Certified Public Accountants Professional Conduct Division – for E&Y’s failure to comply with professional standards; a corresponding complaint should be filed with the AICPA’s Public Oversight Board.

 Arthur Andersen & Co. should also be constrained to cooperate with the Securities & Exchange Commission, the Independent Standards Board, and the Congress of the United States in any investigation they might undertake regarding the role and responsibility of independent auditors into Y2k and beyond.
 An Ironic and Sardonic Coda

During October, 1998, it was disclosed that “Chain Saw” Albert J. Dunlap’s extraordinary earnings accomplishments at Sunbeam Corp. were attributable more to some “heavy lifting” in the accounting department than with his restructuring capabilities.  Thus, from a Barron’s article dated October 26:

 Sunbeam’s long-awaited restatement of financial results under deposed chairman Albert J. Dunlap was disclosed last week after four months’ work by two accounting firms.  It cuts the home-appliance company’s reported 1997 profit by nearly two-thirds, to $38.3 million or 44 cents a share, from the previously reported $109.4 million or $1.25.

 The restatement also boosts this year’s first-quarter loss to $54.1 million or 63 cents a diluted share from the earlier $44.6 million or 52 cents.

 And then, from a December 1 Wall Street Journal article:
  Delray Beach, Fla – Sunbeam Corp. dismissed Arthur Andersen LLP as its independent auditor and named Deloitte & Touche LLP to audit 1998 results.

 The struggling appliance maker recently restated its financial results for 1996, 1997 and the first quarter of 1998 – periods during which Albert J. Dunlap presided as chairman and Arthur Andersen served as independent auditor.

  Industry observers said the move could pave the way for Sunbeam to file suit against the New York Accounting firm, alleging auditing deficiencies.

 And so the “White Knight” in the Cendant saga became the “Black Knight” in the Sunbeam drama.