April 15, 1998- During the process of merging HFS Incorporated and CUC International forming the new entity Cendant (NYSE: CD), accounting personnel for the new entity discovered potential "accounting irregularities in certain former CUC business units." These accounting problems were discovered in the course of transferring accounting data for the individual companies and the preparation for reporting first quarter 1998 results for Cendant. At the time, accounting irregularities were expected to reduce 1997 reported net income by about $100 million of its reported $872 million.

Cendant executives, in an effort to minimize the damage, noted that the accounting problems were from former CUC businesses and that Cendant still expected to meet and exceed Wall Street 1998 forecasts. This had little impact on the containing the damage, Cendant shares fell almost 50% (see image below).

The action plan developed by Cendant's Audit Committee from the board of directors was designed to reestablish credibility with the newly organized firm. They hired Willkie Farr & Gallagher as special legal counsel to monitor all proceedings and access the process. Arthur Andersen was attained to perform the comprehensive audit and forensic accounting. Finally, all accounting, financing, budgeting, and control functions were reallocated to former HFS staff members.

The company, anticipating restatements, acknowledged that "previously issued financial statements and auditors' reports should not be relied upon."

July 14, 1998- Driven by market speculation on Monday that accounting issued would be greater than expected, shares of Cendant fell 18%. This was odd in that the company had not released any news and Arthur Andersen had not completed its comprehensive audit. However, on Tuesday, Cendant pre-released the results of the audit acknowledging that accounting errors and irregularities were greater than anticipated. In fact, the charges to net income would be almost double the initial estimate of $100 million. Cendant also released details about the accounting issues.

Irregular charges against merger reserves. Operating results at CUC were artificially boosted by the recording of fictitious revenues through inappropriately reversing restructuring charge liabilities and recording it as revenues.

False coding of services sold to customers. Significant revenues were recorded from long-term membership agreements but were immediately recognized as normal revenues form operations. This false recording of revenues generated higher levels of current revenues and income for CUC.

Delayed recognition of cancellation of memberships and "charge backs." A charge-back is a rejection of a credit card purchase by the issuing bank. In addition to overstating revenues by not immediately recording charge backs, it caused CUC cash and working capital accounts to be overstated.

Recording of fictitious revenues. Many accounts receivable entries made in 1997 were fabricated, had no customers, and no associated sale of services. This practice was traced back as far as 1995.

In addition to the accounting irregularities that were the target of the audit, an additional charge will be imposed based on accounting errors overturned by the audit. These accounting errors include inappropriate useful lives for certain intangible assets, delayed recognition of insurance claims, and other policies that did not conform to GAAP.

All of these problems with the CUC acquisition have destroyed almost two-thirds of Cendant market capitalization. Cendant CFO, Michael Monaco, was quoted "The length, breadth, and depth of the investigation ordered by our Board [Cendant] and management have proven its worth by uncovering additional systemic irregularities beyond those initially discovered and immediately disclosed by Cendant management. We believe our thoroughness will benefit shareholders and help restore confidence in the company's prospects and financial results." The graph of Cendant's performance over the last year relative to the S&P 500 indicates that investor confidence is still lacking and that that consolidation of HFS and CUC has destroyed a large amount of shareholder value.

FinanceProfessor.com

Cendant Accounting Irregularities