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C E N D A N T C O R P O R A T I O N EVALUATING RISK OF FINANCIAL STATEMENT FRAUD AND ASSESSING THE CONTROL ENVIRONMENT
A J E N G F E B Y PA L U P I FAV I A N K A S Y F U R R A H M A N PUTRA LUCKY BAGUS SEPTYO N U R B A R I D A I N TA N FA J R I A T I A R A O K TA R I N A

BACKGROUND
Cendant Corporation was created in December 1997 from merger of CUC International, Inc. (CUC) and HFS, Inc. (HFS). At the time of the merger, Cendant had a market capitalization of approximately $29 billion, making it one of the 100 largest U.S. corporations. CUC was audited by Ernst & Young, LLP, HFS was audited by Deloitte & Touche, LLP.

Deloitte & Touche, LLP was selected as the successor auditor for Cendant. LLP noted that there were no material disagreements between the company and Ernst & Young, LLP regarding accounting or auditing matters.

FRAUD
The fraud occurred at CUC prior to its merger with HFS. The CUC fraud was discovered by HFS personnel early in 1998 when they took over accounting responsibilities from CUC personnel. CUC's 1997 earnings were overstated by $100 to $115 million. From period 1995 to 1997, the cumulative overstatement of pretax quarterly earnings was approximately $300 million. CUCs recording fictitious revenues and reducing expenses to meet Wall Street analysts expectations so that inflates CUCs stock prices thereby providing opportunities to use CUC stock to merge or acquire other companies.

FRAUD
CUC's pretax earnings for the first three quarters of 1995, 1996, and 1997 were misstated by $31 million, $87 million, and $176 million, respectively. To cover-up the inflated quarterly earnings at yearend, CUC management : made irregular charges against merger reserves, falsely coded cash receipts from membership programs, delayed recognition of membership cancellations and credit card rejections. After the investigation was completed CUCs year-end 1995, 1996, and 1997 pretax earnings were reduced by $96 million, $159 million, and $ 245 million.

FRAUD
Over twenty CUC employees were identified as participating in the fraud including Cosmo Corigliano, chief financial officer and Anne Pember, controller. Four of CUCs directors were identified as having personal ties with Walter Forbes, chairman and chief executive officer. Four of CUCs financial managers were previously employed by Ernst & Young, LLP including Cosmo Corigliano, chief financial officer and Anne Pember, controller. The audit committee report on the fraud investigation notes that senior management of CUC encouraged employees to conceal certain information from the auditors.

QUESTION & SOLUTION

1 (A) WHAT RESPONSIBILITY DOES AN AUDITOR HAVE TO DETECT MATERIAL MISSTATEMENTS DUE TO ERRORS AND FRAUD?

Answer : Auditors are required to plan and perform audit engagements to provide reasonable assurance that the financial statements are free of material misstatement, whether the result of error or fraud. The distinguishing feature between errors and fraud is whether the misstatement was unintentional or intentional. Errors are unintentional misstatements while frauds are intentional misstatements. The auditor provides reasonable assurance of detecting frauds leading to material misstatements by evaluating the likelihood of fraud and expanding audit tests when there is a higher likelihood of fraud.

1 (B) WHAT TWO MAIN CATEGORIES OF FRAUD AFFECT FINANCIAL REPORTING?

Answer : Fraud misstatements can occur from fraudulent financial reporting or misappropriation of assets. Financial statement misstatements or omissions to intended deceive users are referred to as fraudulent financial reporting. Thefts of entity assets reported in the financial statements are referred to as misappropriation of assets.

1 (C) WHAT TYPES OF FACTORS SHOULD AUDITORS CONSIDER WHEN ASSESSING THE LIKELIHOOD OF MATERIAL MISSTATEMENTS DUE TO FRAUD?

Answer :

Broad risk factors to consider when assessing the likelihood of fraudulent financial reporting include: Managements characteristics and influence over the control environment Industry conditions Operating characteristics and financial stability. Broad risk factors to consider when assessing the likelihood of misappropriation of assets include: Susceptibility of assets to misappropriation Controls over assets SAS 82 provides extensive detail about potential indicators for each of these factors.

[1](d) Which factors existed during the 1995 through 1997 audits of CUC that created an environment conducive for fraud?

..ANSWER :
Factors that existed during the 1995 through 1997 audits of CUC that created an environment conducive to fraud include: The excessive emphasis of CUC management on meeting analyst expectations. The focus of CUC management on maintaining a strong stock price to provide opportunities to use CUC stock to acquire and merge with other companies

[2] Professional standards indicate that an entitys internal controls consist of five interrelated components. (a) What responsibility does an auditor have related to each of these five components?

..ANSWER :
Internal controls consist of five interrelated components including: -the control environment

-risk assessment
-control activities -information and communication -monitoring. In all audits, the auditor must obtain a sufficient understanding of internal controls to identify the types of misstatements that can occur, determine the risk of misstatement, and determine the design of substantive tests.

(b) One component of internal control is the entitys control environment. What factors should an auditor consider when evaluating the control environment?

..ANSWER :
As noted in the professional standards, factors to consider when evaluating the control environment include: -Integrity and ethical values -Commitment to competence Board of directors and audit committee participation -Managements philosophy and operating style -Organizational structure -Assignment of authority and responsibility -Human resource policies and practices

QUESTION #2
What red flags were present during the 1995 through 1997 audits of CUC that may have suggested weaknesses in CUCs control environment?

ANSWER #2 (C )
Lack of appropriate board oversight Lack of integrity and ethical values

QUESTION #3
Several misstatements were identified as a result of the fraud perpetrated by CUC management. (a)For each misstatement identified, indicate one management assertion that was violated. (b)For each misstatement identified, indicate one audit procedure the auditor could have used to detect the misstatement.

ANSWER #3 A
Irregular charges against merger reserves existence of revenues, completeness or valuation of expenses, and valuation of merger reserves. False coding of services sold to customers presentation and disclosure of revenues and presentation and disclosure of deferred revenues.

Delayed recognition of membership cancellations and bank rejection of charges made to members credit card accounts existence or valuation of revenues and existence or valuation of cash.

ANSWER #3 B
Irregular charges against merger reserves scan the journals looking for unusual journal entries or examine the journal entries for the adjustments to the merger reserve account and examine related support for those entries/adjustments.
False coding of services sold to customers examine documents supporting cash receipts to ascertain proper classification of revenue from various programs.

Delayed recognition of membership cancellations and bank rejection of charges made to members credit card accounts test year-end bank reconciliations

QUESTION #4
WHY WOULD A COMPANY WANT TO HIRE A MEMBER OF ITS EXTERNAL AUDIT TEAM?

The auditor is familiar with the company The auditor is perceived as being highly motivated and competent with relevant accounting experience Management has developed a strong working relationship with the auditor as a result of the audit.

IF THE CLIENT HAS HIRED FORMER AUDITORS, HOW MIGHT THIS AFFECT THE INDEPENDENCE OF THE EXISTING EXTERNAL AUDITORS?

There is the possibility that independence can be threatened in both fact and in appearance.
Current auditors may have a close personal friend Current auditors may rely too much on the representations made by their former colleague The potential for successfully hiding an accounting fraud or mismanagement of funds may increase

THANK YOU