Case Study
The top two former officers of CUC International Inc. were accused of directing a massive financial fraud while selling millions of dollars worth of the company's common stock. For the period 1995-1997 alone, pre-tax operating income reported to the public by CUC was inflated by an aggregate amount of over $500 million.
CUC merged with HFS Incorporated on December 17, 1997, to form Cendant Corporation. Upon disclosure of the fraud, the price of Cendant common stock plummeted, causing billions of dollars in losses for investors.
CUC's chairman and chief executive officer directed the fraud from its beginnings in 1985. From at least 1991 on, CUC's president and chief operating officer, joined the chairman in directing the scheme. The following are some of the ways it was done:
1. Personally reviewing and managing schedules listing fraudulent adjustments to be made to CUC's quarterly and annual financial statements. CUC senior management used the adjustments to artificially pump up income and earnings, defrauding investors by creating the illusion of a company that had ever-increasing earnings and making millions for themselves along the way.
2. Undertaking a program of mergers and acquisitions on behalf of CUC in order to generate inflated merger and purchase reserves at CUC. Forbes and Shelton sought out one merger partner (HFS) because they believed the reserves that would be created would be big enough to bury the fraud. To entice the HFS management into the merger, they artificially increased CUC's current-year earnings as well as future earnings projections. Soon after the merger, they explicitly congratulated each other on being masterful "financial engineers" who had been able to nurture the fraud through the years and who had assured their continued success by duping HFS into agree- ing to a merger with CUC
3. Profiting from their own wrongdoing. They sold CUC and Cendant securities at inflated prices while the fraud they directed was underway and undisclosed. These sales brought executives millions of dollars in ill-gotten gains.
The SEC found that Cendant violated many provisions of federal securities laws. In addition to the final judgment against the officers, a class action suit was settled for $2.85 billion, the largest case ever to that date. In addition, the auditor, Ernst & Young, paid Cendant almost $300 million.
Case Study Questions
1. Do you believe that income smoothing is an ethical practice? Are there times when it might be considered ethical and others when it might not be?
2. Income smoothing is just shifting income from one year to another. What is wrong with that?
3. Analyze the management actions from the perspective of these Fraud Triangle.
4. Even though they paid a fine, do you think the auditors met their ethical obligations? Why or why not?
Case Study
The top two former officers of CUC International Inc. were accused of directing a massive financial fraud while selling millions of dollars worth of the company's common stock. For the period 1995-1997 alone, pre-tax operating income reported to the public by CUC was inflated by an aggregate amount of over $500 million.
CUC merged with HFS Incorporated on December 17, 1997, to form Cendant Corporation. Upon disclosure of the fraud, the price of Cendant common stock plummeted, causing billions of dollars in losses for investors.
CUC's chairman and chief executive officer directed the fraud from its beginnings in 1985. From at least 1991 on, CUC's president and chief operating officer, joined the chairman in directing the scheme. The following are some of the ways it was done:
1. Personally reviewing and managing schedules listing fraudulent adjustments to be made to CUC's quarterly and annual financial statements. CUC senior management used the adjustments to artificially pump up income and earnings, defrauding investors by creating the illusion of a company that had ever-increasing earnings and making millions for themselves along the way.
2. Undertaking a program of mergers and acquisitions on behalf of CUC in order to generate inflated merger and purchase reserves at CUC. Forbes and Shelton sought out one merger partner (HFS) because they believed the reserves that would be created would be big enough to bury the fraud. To entice the HFS management into the merger, they artificially increased CUC's current-year earnings as well as future earnings projections. Soon after the merger, they explicitly congratulated each other on being masterful "financial engineers" who had been able to nurture the fraud through the years and who had assured their continued success by duping HFS into agree- ing to a merger with CUC
3. Profiting from their own wrongdoing. They sold CUC and Cendant securities at inflated prices while the fraud they directed was underway and undisclosed. These sales brought executives millions of dollars in ill-gotten gains.
The SEC found that Cendant violated many provisions of federal securities laws. In addition to the final judgment against the officers, a class action suit was settled for $2.85 billion, the largest case ever to that date. In addition, the auditor, Ernst & Young, paid Cendant almost $300 million.
Case Study Questions
1. Do you believe that income smoothing is an ethical practice? Are there times when it might be considered ethical and others when it might not be?
2. Income smoothing is just shifting income from one year to another. What is wrong with that?
3. Analyze the management actions from the perspective of these Fraud Triangle.
4. Even though they paid a fine, do you think the auditors met their ethical obligations? Why or why not?
