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Financial Shenanigans
By Howard Schilit The McGraw-Hill Companies, Inc.
Copyright © 2002Howard Schilit
All rights reserved.
ISBN: 978-0-07-142339-7
Excerpt
CHAPTER 1
You Can Fool Some of the People All of the Time
Mention the word whopper to hamburger lovers and many of them will think of the fast-food giant Burger King. Chapter 1 of this book contains something that is a bit less filling and produces considerably more heartburn—a four-part whopper of financial shenanigans.
The Whopper, Part I: Cendant/CUC
The Cendant/CUC story begins in the mid-1980s, when the company was called CUC. (Cendant was created in late 1997 with the merger of CUC and HFS.) CUC's business was pretty simple and straightforward: It sold various types of club memberships to consumers. Its accounting, however, was anything but straightforward.
For more than twelve years, until the exposure of the scheme in 1998, CUC's senior and middle management used a variety of clever means to inflate the company's operating income. The fraud only came to light several months after CUC's merger with HFS and the birth of Cendant. (Since the fraud occurred at CUC before the merger, we will refer to the company as Cendant/CUC.) The chronology of events involving Cendent/CUC is outlined in Table 1-1.
Investigators auditing the records found that more than $500 million of bogus operating income had been recorded during the fiscal years ending January 1996, January 1997, and December 1997. Of that amount, more than half—approximately $260 million—had been added to the income of the fiscal year ending December 1997.
The Scheme
In the earlier years, management had manipulated profits by using an arbitrary system to determine when to recognize membership sales revenue. Management had also inflated profits by failing to properly account for member cancellations and the related liabilities.
As time went on, however, Cendant/CUC became increasingly dependent on acquisitions and mergers to sustain the scheme. Purchase and merger reserves were intentionally overstated when they were established, and the inflated amounts were later released to boost operating income. When it suited management's purposes, assets were written off against these overstated reserves.
In short, each year senior management would review the opportunities for inflating the company's income that were available and would determine how much would be needed from each of these sources that year. The result was an annual "cheat sheet" that assured senior management that that year's results were under control.
Giving Wall Street What It Wanted
Each fiscal quarter, the reported results just matched the consensus quarterly expectations of Wall Street analysts. The reported operating income was what had been expected, and each major expense bore approximately the same percentage relationship to sales as in the prior quarter. These changes were directed by management through a deliberate, top-down process of "reverse engineering," virtually independent of what had actually transpired.
Revenue Recognition Tricks
The Comp-U-Card division of Cendant/CUC marketed a number of membership products, with payment terms ranging from twelve to thirty-six months. In many periods, the company failed to amortize solicitation costs from sales over the same period in which it recorded the revenue; it recorded the revenue early and the expenses later. It also had to account for cancellations to sustain the image to investors of steady, predictable growth. Thus, for any given quarter, management would determine the amount of revenue needed and transfer that amount from deferred revenue. Cendant/CUC made fictitious bookkeeping entries, intentionally understating membership cancellation reserves, and occasionally reversing the cancellation reserves or commissions payable directly into revenue or operating expense.
By the mid-1990s, however, opportunities related to membership sales could no longer sustain the scheme. The company's growth requirements forced Cendant/CUC management to look increasingly to another area of opportunity: merger and purchase reserves.
Manipulating Merger and Purchase Reserves: Turning Unusual Charges into an Ordinary Income Source
By far the largest (in dollar terms) part of Cendant/CUC's games came from merger and acquisition charges and the reversal of these amounts into operating income in later periods.
The company became increasingly acquisitive and engaged in larger and larger deals. Larger mergers provided the opportunity for larger merger reserves, and these large reserves could keep the scheme going for years. In 1996, Cendant/CUC made several acquisitions and established a large merger reserve, and management envisioned that reserve as inflating earnings for years to come. There was just one problem: Cendant/CUC's business was already reeling, and management needed to deplete the reserves much more quickly than it had planned. By 1997, Cendant/CUC was desperate for a major combination, and that desperation led management to renew a previously aborted merger discussion with HFS. By May of that year, those discussions had resulted in the Cendant merger agreement and the possibility of a merger reserve large enough to keep the scheme alive.
Writing Off Assets against the Cendant Merger Reserve
Another category of reserve-related opportunities was created in connection with the Cendant merger and the December 1997 closing. Immediately prior to the merger, managers implemented a scheme in which impaired assets held by Cendant/CUC were not written off at that time. Then, in connection with the December 1997 year-end close, the managers arranged for millions of dollars of Cendant/CUC's assets to be written off against the reserve of the newly formed company. Overall, the write-off of assets against the December 1997 reserve, and the concomitant failure to recognize certain asset impairments in the proper years, artificially inflated income by $6 million for the fiscal year ended January 1996, by $12 million for the fiscal year ended January 1997, and by $29 million for the fiscal year ended December 1997.
When the Fraud Broke
On April 16, 1998, just months after the December 1997 merger (and a mere two weeks after the first certified 10-K [see page 48] filing of the newly formed Cendant), the company disclosed the accounting irregularities. The stock price dropped from $35.63 to $19.06. On July 14, there was more bad news: The accounting irregularities were more extensive than had been anticipated, and the company would have to restate the previous three years. The stock took another hit, closing on July 16 at $14.63. It finally bottomed out at $9.00 in the fall of 1998. (See Fig. 1-1.)
The Charges and Financial Settlements
Before the Enron debacle, Cendant/CUC had been called the biggest accounting fraud ever, with investors having lost a combined $19 billion. Were the scoundrels behind this massive thirteen-year fraud ever brought to justice?
In June 2000, three senior officials pleaded guilty: Cosmo Corigliano, former chief financial officer; Anne Pember, former controller; and Casper Sabatino, former accountant. In his testimony, Mr. Corigliano disclosed something incredible: The fraud had been going on since 1983, the year he joined the company and it went public.
In September 2000, the SEC announced the completion of its investigation, charging three individuals with fraud. In February 2001, a federal grand jury in Newark, New Jersey, indicted the three on fraud charges. If convicted, they could spend ten years in prison.
The company also faced massive litig
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Excerpted from Financial Shenanigans by Howard Schilit. Copyright © 2002 by Howard Schilit. Excerpted by permission of The McGraw-Hill Companies, Inc..
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