Earnings management practices

Case Study
Hospitality Franchise Systems (HFS) was founded in 1991 by Henry Silverman, a business executive and private equity investor. The business model of HFS was to acquire and manage a number of hotel and rental car franchises. Among HFS’ purchases were brands such as Ramada, Howard Johnson’s, Avis Rent a Car, as well as Days Inn, which HFS was able to buy for $290 million (almost half what HFS ultimately sold it for). The company went public in 1992, and by the late 1990s, HFS was one of the fasting growing companies on Wall Street with its stock price increasing from $4 per share to $77 per share by 1998.
In 1998, HFS merged with CUC International, a direct marketing company that operated Shoppers Advantage and Travelers Advantage. The $14 billion merger of HFS and CUC resulted in the formation of Cendant Corporation. However, just months after the merger, Cendant uncovered massive accounting improprieties at CUC which resulted in one of the largest financial scandals in U.S. corporate history. Cendant disclosed that for three years prior to the merger, CUC had fraudulently overstated its income by over $500 million.
Investigators found that over $500 million in nonexistent company income had been reported at CUC from 1995 – 1997. Membership sales revenue had been over-reported and canceled memberships under-reported, allowing for the company’s earnings to be manipulated at will. In reality, CUC was in deep financial trouble with little cash and even their manipulated books were insufficient to cover all of the company’s losses. Thus, CUC turned to the merger with HFS as a way bolster the failing company’s assets, boost their income, and inflate their stock price.
Ultimately, the financial fraud was uncovered and the Securities and Exchange Commission (SEC) brought charges against several members of the CUC staff including the company president and CEO. Both the CUC president and CEO were sentenced to more than 10 years in prison and ordered to pay Cendant $3.275 billion in restitution.
Cendant never fully recovered from the major accounting scandal and ultimately split into four major different companies. Today, these split company’s still represent major brands in the hospitality industry such as Realogy, Wyndham Worldwide, and Avis Budget Group.
To read more about the financial scandal, access this link: https://money.cnn.com/1998/08/27/companies/cendant_folo/

Questions:

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1.    Discuss your key take-aways (one or two) from the Cendant case. Possible topics include: the corporate culture, the financial statement implications of the fraud, earnings management pressures, or consequences of financial fraud.

2.    Who are the various parties involved in identifying and monitoring a publicly traded company to help prevent earnings management? What regulations or laws are in place to ensure people and companies are held accountable for earnings management?

3.    In what ways can companies engage in earnings management? Be specific in your discussion. What does a company gain from engaging in earnings management?

4.    Discuss your perspective about earnings management. Is it always inappropriate for companies to engage in earnings management practices?

5.    Searching the business press, find an example of a company who engaged in earnings management. What was the impact on the company or its key employees?

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