Cardillo Travel Systems
The Cardillo Travel Systems case shows the way the management cooked up the books only to be caught later. This essay will attempt to answer some questions on this case.
False Representation to External Auditors: The executives at Cardillo Travel Systems were aware it needed to maintain a minimum of $3 million of stockholder’s equity threshold established by the court outstanding against the organization. (Ritterburg, 2012). This was the reason that shaped their intent to falsify the organization’s books to misrepresent facts before investors and creditors. The issue started with the accountants at Cardillo making an improper adjusting entry to recognize an amount of $203,000 as revenue paid by United Airlines. The payment had a caveat that required the amount would be refundable if its intended objectives were not met within a five-year period, from 1985 to 1990. Considering this, the company’s executives misled the independent auditors, but could not convince them enough to earn a decisive audit opinion. The management intentions to falsify the books and achieve the court’s minimum threshold thus backfired as the external accountants understood that the books contained material misstatements and misrepresentation regarding the payment by United Airlines. This action was in serious violation of the SEC rules regarding fair financial reporting and representations. This violation required criminal penalties under section 13(a) and 15(d) of the SEC code (SEC LAW, 2013).
Failure to Maintain Accurate Financial Records: The responsibility of exercising good governance and internal control over financial reporting lies with the management of the organization. Although Russell Smith acted in a fair and professional manner by refusing to sign the affidavit regarding United Airlines transaction, his refusal to sign off the false affidavit should have signaled the organization’s executives that their anxiety over fulfilling the terms of the court order regarding the threshold of $3 million of stockholder’s equity would put them in a serious situation. Therefore, their failure to plan and preserve a sound policy of internal controls as well as their failure to provide reasonable assurances by posting a deceptive adjusting entry was in violation to the SEC Record Keeping and internal control provisions under section 13(b)(2)(A). Under this section, “corporate organizations must make and keep records and accounts in reasonable details in accordance with Generally Accepted Accounting Principles.” (Securities Exchange Act, 2002).
Failure to file prompt financial reports with the SEC: The first part of this violation occurred when the President and the Chief Operating Officer, Esther Lawrence, of Cardillo Travel Systems published information in the public domain that was misleading regarding the adverse legal settlement. This publication was not only misleading and incomplete, but also not very clear on the fact that the organization had suffered a substantial loss due to this settlement. The later and the worst aspect of this legal violation came when the Company’s Executives’ failed to report in Form 8-K to the SEC the material financial penalties of $685,000 in the law suit settlement case. This failure to report constitutes a legal transgression under Section 13(a) of the Securities and Exchange Act that allows the Commission to undertake an administrative proceeding against an entity that has filed such information late. In addition, the penalty could also involve the further revocation of the organization’s registration, depending on the material circumstances. (SEC – Sarbanes Oxley Act, 2002).
Violating Insider Trading Provisions: The chief executives at Cardillo committed a serious legal violation when they performed a stockholder’s equity transaction by issuing 100,000 shares of the organization stock, primarily to cover up the substantial financial penalties levied by the court. In doing so, the organization violated Section 10b-5 of the Security and Exchange Act which could lead to substantial financial penalties and incarceration. (SEC LAW, 2013).
Entities in violation or compliance of AICPAs code of professional conduct: Russell Smith duly complied with the AICPA’s Professional Conduct Code, although he was fired for doing just that. Smith duly advised the Cardillo Management that their attempt to recognize the United Airlines’ $203,000 transaction differently would enforce a negative effect. In addition, Smith’s refusal to sign off the accounting misrepresentation perpetrated by Cardillo Management was perfectly in line with the AICPA’s Professional Conduct Code, notably Rule 102 which emphasized on honesty and objectivity. Similarly, Helen Shepherd who was the independent auditor also exhibited a good degree of professionalism and was skeptical regarding Cardillo’s Financial Statements. She tried to prevail upon Cardillo’s management that the United Airlines’ $203,000 could not be recorded as a revenue; in doing so, she assumed that they were ignorant of the fact that the accounting entry could not be recognized as Revenue. Likewise, Roger Schlonsky, was similarly skeptical about the Cardillo accounts and he too adhered to the AICPA’s Code of professional conduct by advising the company management that they could record the $203,000 as revenue on a pro rata basis over the contract duration of 5 years. In fact, in doing so he provided the best route for Cardillo to avoid problems with the SEC. Further, he emphatically emphasized to Cardillo management that recording the $203,000 as revenue would raise grave doubts in the minds of the SEC auditors and would amount to material misrepresentation of its financial statements.
On the contrary, William Kaye, Cardillo’s Vice President of Finance, was responsible for adjusting the accounting entry to record the $203,000 as revenue, was in gross violation of both the Generally Accepted Accounting principle as well as the AICPA’s Code of Professional Conduct. While, the external auditor’s observation letter had given him sufficient time to allow him correct the misleading entry, he did not reverse the same. And the same entry was later approved by the Company’s COO and other officers. William Kaye’s action would have been punishable under section 13(b)(2)(A) of the SEC code, for having been duly advised and reporting accounting entries that were fraudulent and misleading, resulting in the possibility of negatively affecting the judgement of its end users.
Analysis of Key Action taken by the External Auditors: Cardillo’s external auditors displayed a very high level of professional skepticism in this case. In practice, Management assumes complete responsibility of its assertions regarding misstatements, frauds in reporting earnings, errors and abuse. In such cases, it becomes the independent auditor’s primary responsibility to comment on the reliability of the statements and provide assurance to the end users. All the external auditors in this matter were greatly focused on working in like with the professional code.
The auditors evaluated the seriousness of the misrepresentation as a significant suspicion, but could do nothing except demand that the management prove that the $203,000 was non-refundable. For instance, Shepherd asked Rognlien, the organization’s CEO on two separate occasions for consent to verify the veracity of his claim, which overrode the formal agreement. Shepherd then correctly reported to the SEC her incongruity with Cardillo in the 8-K statement that was later used by the proceeding auditor. Regarding the audit risk management, Cardillo’s external auditors had complete knowledge of the client, the industry as well as the level of engagement risk. They were also conscious of the weaknesses in Cardillo’s internal control over financial reporting. One should note, in this case, the engagement risk and detection risk are the same, since the external auditors could predict that the organization’s internal control was weak.
Five Components of Internal Control were followed or Not: To find out the reliability of the management’s statement, an external independent auditor must primarily assess a client’s internal control with a view to check if all the five components are fully functional. These are control activities, risk assessment, control environment, Communication & Information, and Monitoring. These components help managements to meet their financial objectives, thus resulting in financial reports that are free from material errors and fully compliant with all applicable laws and regulations. In the case of Cardillo Travel Systems, these components of internal control were not being implemented efficiently. Starting with the management, there was no evidence of a good control environment. The organization’s fiasco of not adequately communicating information on the exact amount and the law suit to the public as well as the SEC was a serious breach of another component. Likewise, the risk assessment of management was also questionable since the management could go to the extent of posting a misleading adjusting entry, and its control activities over financial reporting was also mostly suspicious. One could understand that the entire internal control was not being monitored due to all the above components also being weak.
A very good instance of these weaknesses can be understood when one sees the CEO asking the accountant to sign off on a false affidavit to meet the minimum $3 million requirement. This indicates clearly that the entire control environment was corrupted. One sees yet another instance from the president choosing to publish the consequences of the law suit but failure to disclose the amount of resulting loss that the company incurred in the process. This showed that there was a clear lack of integrity combined with inaccurate information communication.
Whether the auditors have a responsibility to assess the judgement of Cardillo’s decision: When an external auditor performs his professional duties, his decision revolves around the appropriate category, scope and the amount of proof required in order to draw an accurate conclusion about the fair performance of management’s internal control and financial performance. In the case of Cardillo, the auditor needed to gather evidence about his judgement on applying the income earned from United Airlines amounting to $203,000 as income earned or unearned. In most cases, an auditor tries to confirm the receipts of a written response from parties involved in all material transactions that have financial implications on the organization, including, but not limited to, all formal contractual agreements. The audit evidence of confirmation, therefore, is a lawful process the external auditor must complete to check the management decision on suspicious accounting entries, as it happened in Cardillo’s case.
In conclusion, one understands that an external auditor who sticks to the Code of Professional Conduct can prevent a collapse of the corporate order provided he or she does his duty professionally and does not collude with the management.
Reference
SEC (2002): Securities and Exchange Commission; 17 CFR Part 240. Sarbanes-Oxley Act of 2002. Retrieved from www.sec.gov
SEC LAW (2013): SEC LAW: Insider Trading. Retrieved from www.mystockoption.com
SEC. (2002): Recordkeeping and Internal Controls Provisions. Retrieved from www.sec.gov
Ritteberg, J.G.K. (2012): Auditing: A Business Risk Approach With Cases; Byron L. Cardillo Travel Systems, Inc.
