Accounting is the language of business. It allows shareholders, creditors and stakeholders and management gauge the overall performance of the business enterprise. Through the results of this financial evaluation, potential investor or creditors can better assess the economic realities facing the company. This allows for society to make better informed decisions as it relates to capital distribution. Well run companies that earn high returns on capital, often garner of higher share of societies financial capital. Likewise those business or industries that don’t 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 a high returns on capital and can therefore earn large inflows of investor capital. The airline industry however, earns abysmal rates of return and can therefore have a hard time raising capital. Accounting forms the basis of this decision making on the part of shareholders, creditors and stakeholders. Without truthful accounting the reflects economic reality, many error can be made (Cellan-Jones, 2005)
When reflecting on the Cendant case, management didn’t fairly and adequately represent the true economic performance of the business. Instead, they mislead shareholder into believing the firm was doing better than it actually was. This, as the case illustrates, is due to misalignment between management and shareholder interests. Due to this principle-agent problem, Cendant management did not perform admirably with respect to shareholders.
The first aspect of this principle-agent problem is due to incentives. Management simply wanted to meet Wall-Street expectations at the expense of shareholders. They were more concerned with meeting those expectations and therefore engaged in very aggressive accounting. For example, Cendant use revenue recognition shenanigans to inflate earnings. Looking at company filings, it becomes apparent that Cendant was failing to amortize solicitation costs from sales over the same period in which it reported its revenue from memberships. Management, in order to make the company appear to have steady and consistent earnings growth, would pull money from the deferred revenue account and applied it to revenue. Cendant also committed egregious accounting fraud by making fictitious bookkeeping entries. These entries included, understating membership cancellations, and reserving cancellation reserves directly into revenue. All of these techniques mislead investors into believing the company was growing steadily and consistently. In reality however, the economic performance of the company was deteriorating. Management did not uphold its obligations to shareholders as it was not forthright with the real economic performance of the business. Instead, the company attempted to perform accounting chicanery to continue a hoax that would undoubtedly end at some point.
Management has an obligation to shareholders to be forthright with the true underlying performance of their business. Shareholders are owners of the business after all. They employ and pay management to run their respective operations as a viable going concern. If aspects of the business are not correct, management should share these insights with shareholders so that the appropriate decisions can be made. By misleading investors however, management cost shareholders billions of dollars. They also undermined the integrity in the entire financial system as a whole (Emshwiller, 2003). This reverberates, not only to Cendant by to all publically traded companies. Finally, the company after the fraud broke was forced to lay off many unsuspecting workers who depended on for a work. Due to managements, selfishness, nearly all stakeholders suffered.
References
1) Cellan-Jones, Rory (November 2, 2005). “The end of an epic.” BBC News (BBC).
2) Emshwiller, John and Rebecca Smith, 24 Days: How Two Wall Street Journal Reporters Uncovered the Lies that Destroyed Faith in Corporate America or Infectious Greed, HarperInformation, 2003, ISBN 0-06-052073-6
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