Cendant Accounting Fraud and the Principal-Agent Problem

The Role of Accounting in Capital Allocation

Accounting is the language of business. It allows shareholders, creditors, stakeholders, and management to gauge the overall performance of a business enterprise. Through financial evaluation, potential investors and creditors can better assess the economic realities facing a company. This allows society to make better-informed decisions as they relate to capital distribution. Well-run companies that earn high returns on capital often attract a greater share of society's financial capital. Likewise, businesses or industries that do not earn a high enough return to compensate investors for the risks they are taking do not obtain large amounts of capital.

The technology industry, for example, earns high returns on capital and can therefore attract large inflows of investor capital. The airline industry, however, earns abysmal rates of return and consequently has a hard time raising capital. Accounting forms the basis of this decision-making on the part of shareholders, creditors, and stakeholders. Without truthful accounting that reflects economic reality, many errors can be made (Cellan-Jones, 2005).

The Principal-Agent Problem at Cendant

When reflecting on the Cendant case, management did not fairly or adequately represent the true economic performance of the business. Instead, they misled shareholders into believing the firm was doing better than it actually was. As the case illustrates, this stemmed from a misalignment between management and shareholder interests. Due to this principal-agent problem, Cendant's management did not perform admirably with respect to shareholders.

Specific Accounting Fraud Techniques Used

The first dimension of this principal-agent problem involves incentives. Management simply wanted to meet Wall Street expectations at the expense of shareholders. They were more concerned with satisfying those expectations and therefore engaged in very aggressive accounting practices. For example, Cendant used revenue recognition manipulation to inflate earnings. Examining company filings, it becomes apparent that Cendant failed to amortize solicitation costs from sales over the same period in which it reported revenue from memberships.

Management, in order to make the company appear to have steady and consistent earnings growth, would transfer money from the deferred revenue account and apply it directly to revenue. Cendant also committed egregious accounting fraud by making fictitious bookkeeping entries. These entries included understating membership cancellations and moving cancellation reserves directly into revenue. All of these techniques misled investors into believing the company was growing steadily and consistently. In reality, the economic performance of the company was deteriorating. Management did not uphold its obligations to shareholders, as it was not forthright about the true underlying performance of the business. Instead, the company attempted to perpetuate accounting chicanery to sustain a deception that would inevitably unravel.

References

Cellan-Jones, Rory (November 2, 2005). "The end of an epic." BBC News (BBC).

Emshwiller, John and Rebecca Smith. 24 Days: How Two Wall Street Journal Reporters Uncovered the Lies that Destroyed Faith in Corporate America. HarperInformation, 2003. ISBN 0-06-052073-6.