Russell Smith knew why he had been summoned to the offi ce of A. Walter Rognlien, the 74-year-old chairman of the board and chief executive offi cer (CEO) of Smith’s employer, Cardillo Travel Systems, Inc.1 Just two days earlier, Cardillo’s in-house attorney, Raymond Riley, had requested that Smith, the company’s controller, sign an affi davit regarding the nature of a transaction Rognlien had negotiated with United Airlines. The affi davit stated that the transaction involved a \($203,000\) payment by United Airlines to Cardillo but failed to disclose why the payment was being made or for what specifi c purpose the funds would be used. The affidavit included a statement indicating that Cardillo’s stockholders’ equity exceeded \($3\) million, a statement that Smith knew to be incorrect. Smith also knew that Cardillo was involved in a lawsuit and that a court injunction issued in the case required the company to maintain stockholders’ equity of at least \($3\) million. Because of the blatant misrepresentation in the affidavit concerning Cardillo’s stockholders’ equity and a sense of uneasiness regarding United Airlines’ payment to Cardillo, Smith had refused to sign the affidavit. 

When Smith stepped into Rognlien’s office on that day in May 1985, he found not only Rognlien but also Riley and two other Cardillo executives. One of the other executives was Esther Lawrence, the firm’s energetic 44-year-old president and chief operating officer (COO) and Rognlien’s wife and confidante. Lawrence, a long-time employee, had assumed control of Cardillo’s day-to-day operations in 1984. Rognlien’s two sons by a previous marriage had left the company in the early 1980s following a power struggle with Lawrence and their father.

As Smith sat waiting for the meeting to begin, his apprehension mounted. Although Cardillo had a long and proud history, in recent years the company had begun experiencing serious financial problems. Founded in 1935 and purchased in 1956 by Rognlien, Cardillo ranked as the fourth-largest company in the travel agency industry and was the first to be listed on a national stock exchange. Cardillo’s annual revenues had steadily increased after Rognlien acquired the company, approaching \($100\) million by 1984. Unfortunately, the company’s operating expenses had increased more rapidly. Between 1982 and 1984, Cardillo posted collective losses of nearly \($1.5\) million. These poor operating results were largely due to an aggressive franchising strategy implemented by Rognlien. In 1984 alone that strategy more than doubled the number of travel agency franchises operated by Cardillo. 

Shortly after the meeting began, the overbearing and volatile Rognlien demanded that Smith sign the affidavit. When Smith steadfastly refused, Rognlien showed him the first page of an unsigned agreement between United Airlines and Cardillo. Rognlien then explained that the \($203,000\) payment was intended to cover expenses incurred by Cardillo in changing from American Airlines’ Sabre computer reservation system to United Airlines’ Apollo system. Although the payment was intended to reimburse Cardillo for those expenses and was refundable to United Airlines if not spent, Rognlien wanted Smith to record the payment immediately as revenue. Not surprisingly, Rognlien’s suggested treatment of the United Airlines payment would allow Cardillo to meet the \($3\) million minimum stockholders’ equity threshold established by the court order outstanding against the company. Without hesitation, Smith informed Rognlien that recognizing the United Airlines payment as revenue would be improper. At that point, “Rognlien told Smith that he was incompetent and unprofessional because he refused to book the United payment as income. Rognlien further told Smith that Cardillo did not need a controller like Smith who would not do what was expected of him.”

In November 1985, Helen Shepherd, the audit partner supervising the 1985 audit of Cardillo by Touche Ross, stumbled across information in the client’s fi les regarding the agreement Rognlien had negotiated with United Airlines earlier that year. When Shepherd asked her subordinates about this agreement, one of them told her of a \($203,000\) adjusting entry Cardillo had recorded in late June. That entry, which follows, had been approved by Lawrence and was apparently linked to the United Airlines-Cardillo transaction: 

Shepherd’s subordinates had discovered the adjusting entry during their second-quarter review of Cardillo’s Form 10-Q statement. When asked, Lawrence had told the auditors that the entry involved commissions earned by Cardillo from United Airlines during the second quarter. The auditors had accepted Lawrence’s explanation without attempting to corroborate it with other audit evidence. After discussing the adjusting entry with her subordinates, Shepherd questioned Lawrence. Lawrence insisted that the adjusting entry had been properly recorded. Shepherd then requested that Lawrence ask United Airlines to provide Touche Ross with a confirmation verifying the key stipulations of the agreement with Cardillo. Shepherd’s concern regarding the adjusting entry stemmed from information she had reviewed in the client’s fi les that pertained to the United Airlines agreement. That information suggested that the United Airlines payment to Cardillo was refundable under certain conditions and thus not recognizable immediately as revenue.
Shortly after the meeting between Shepherd and Lawrence, Walter Rognlien contacted the audit partner. Like Lawrence, Rognlien maintained that the \($203,000\) amount had been properly recorded as commission revenue during the second quarter. Rognlien also told Shepherd that the disputed amount, which United Airlines paid to Cardillo during the third quarter of 1985, was not refundable to United Airlines under any circumstances. After some prodding by Shepherd, Rognlien agreed to allow her to request a confirmation from United Airlines concerning certain features of the agreement......

Questions 

1. Identify the accountants in this case who faced ethical dilemmas. Also identify the parties who would be potentially affected by the outcome of each of these dilemmas. What responsibility did the accountant in each case owe to these parties? Did the accountants fulfi ll these responsibilities?

2. Describe the procedures an auditor should perform during a review of a client’s quarterly fi nancial statements. In your opinion, did the Touche Ross auditors who discovered the \($203,000\) adjusting entry during their 1985 second-quarter review take all appropriate steps to corroborate that entry? Should the auditors have immediately informed the audit partner, Helen Shepherd, of the entry?

3. In reviewing the United Airlines-Cardillo agreement, Shepherd collected evidence that supported the \($203,000\) adjusting entry as booked and evidence that suggested the entry was recorded improperly. Identify each of these items of evidence. What characteristics of audit evidence do the profession’s technical standards suggest auditors should consider? Analyze the audit evidence that Shepherd collected regarding the disputed entry in terms of those characteristics.

4. What are the principal objectives of the SEC’s rules that require Form 8-K statements to be fi led when public companies change auditors? Did Shepherd violate the client confi dentiality rule when she discussed the United AirlinesCardillo transaction in the exhibit letter she fi led with Cardillo’s 8-K auditor change statement? In your opinion, did Shepherd have a responsibility to disclose to Cardillo executives the information she intended to include in the exhibit letter?

5. Do the profession’s technical standards explicitly require auditors to evaluate the integrity of a prospective client’s key executives? Identify the specifi c measures auditors can use to assess the integrity of a prospective client’s executives.

Transcribed Image Text:

Dr Receivables-United Airlines Cr Travel Commissions and Fees $203,210 $203,210