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Income smoothing can be ethical or unethical depending on the situation. Income smoothing is keeping revenue consistent over periods of time by using accounting practices to move money across different years. An ethical example of income smoothing could move revenue to the following year if the following year is predicted to be down. If a company were to smooth their income with the intention of hiding the actual state of the company to the public and investors, then it would be considered unethical. The motivation behind the income smoothing performed by Cendant was to make profit. CFO Cosmo Corigiliano profited after selling inflated stock of the company. Walter A.Frobes, former chair of the board of directors, and E.Kirk Shelton, former vice chair also profited from selling off inflated stock. The income smoothing done by Cendant was not done with the intention of preparing for a bad year, it was done with the unethical intention of lying to investors and making profit off the lie.
The pressure was to inflate operating income to meet the financial results anticipated by Wall Street analysts consistently.
EY auditors’ overreliance on the management representation letters provided, thus performing little substantive testing.
EY auditors’ failure to recognize the client’s establishment and use of the Cendant reserve did not conform with GAAP.Examples: Contradictory and inconsistent schedules pertaining to the reserves were provided to EY by the client. EY did not gain sufficient adequate analyses, documentation or support for changes.
By meeting the earnings projections through income smoothing, CUC wanted to portray a smooth and steady increase of earnings year after year. This would attract potential investors.
Most of the officers involved in this fraud profited individually, by selling CUC and/or Cendant securities at inflated prices.
Trust is essential when it comes to forming professionalism between auditors and clients. In Cendant Corporation Case, we can see a glimpse of the fraudulent activities of CUC, the direct marketing business that was once deceitful during the merger with HFS Inc. As the case stated that Cendant Corporation was created from CUC and HFS Inc, Cendant Corporation’s internal investigations disclosed that the CUC managers take most of Cendant’s managerial roles. It revealed that they had been engaged in false earning statements for up to three years, aiming for the merger with HFS Inc. to coincide with analysts’ estimates. CUC leaders’ culture or bad habits are transferred to Cendant Corporation, and it becomes a culture for them to modify accounting practices and make them more presentable in the eyes of the public and shareholders. Unfortunately, mergers saw opportunities for fraudulent activities and to pour their greed and pride. The Cendant Corporation hierarchies, once holding CUC managerial roles, began to implement various adjustments in the income statement and balance sheet. Low-level managers started to adopt the process as usual. They wouldn’t see the problem doing those fraudulent activities because it became their culture that had developed for years. The trust between auditors and Cendant Corporation broke down due to the authority’s misinfluence, and the Cendant Corporation’s accountants couldn’t see the wrongdoing due to the misinfluence of their managers. Suppose the accountant itself could detect the fraudulent activities at work; however, end up providing all those false statements to the auditors for years and years. In that case, no auditors could trust Cendant Corporation, and in unfortunate circumstances, Cendant Corporation got involved in unethical accounting procedures to run the company..
Auditors should be expected to discover fraud at a reasonable assurance level. This means exercising due professional care and maintaining professional skepticism when conducting the audit.
For example, due care in this case would involve requesting for documentation and support for changes made in the schedules related to the Cendant reserves.
When due care is practiced, auditors can detect most errors, fraud or illegal acts.
There are situations where auditors will not be able to discover fraud, despite exercising a high level of due care, because clients tried their best to hide any suspicious activity from the auditors.
In this case, there were multiple red flags that EY auditors did not catch, such as unsupported, post-closing entries, keeping rejects and cancellations off the books, and inconsistent schedules with the Cendant reserves.
CUC and Cendant misled the EY auditors into believing that the financial statements were legitimate.