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Act 1

Russell Smith knew why he had been summoned to the office of A.
Walter Rognlien, the 74-year-old chairman of the board and chief
executive officer (CEO) of Smith’s employer, Cardillo Travel
Systems, Inc. Just two days earlier, Cardillo’s in-house attorney,
Raymond Riley, had requested that Smith, the company’s controller,
sign an affidavit regarding the nature of a transaction Rognlien
had negotiated with United Airlines. The affidavit 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 specific 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 longtime 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.”

Act 2

In November 1985, Heleni Shepherd, the audit partner supervising
the 1985 audit of Cardillo by Touche Ross, stumbled across
information in the client’s files 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:

DR Receivables-United
Airlines                                             
$203,210

     CR Travel Commissions and
Fees                                                   
       $203,210

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. Shephered’s concern regarding the adjusting entry stemmed
from information she had reviewed in the client’s files that
pertained to the United Airlines agreement. That information
suggested that 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.

Shepherd received the requested confirmation from United
Airlines on December 17, 1986. The confirmation stated that the
disputed amount was refundable through 1990 if certain stipulations
of the contractual agreement between the two parties were not
fulfilled. After receiving the confirmation, Shepherd called
Rognlien and asked him to explain the obvious difference of opinion
between United Airlines and Cardillo regarding the terms of their
agreement. Rognlien told Shepherd that he had a secret arrangement
with the chairman of the board of United Airlines. “Rognlien
claimed that pursuant to this confidential business arrangement,
the $203,210 would never have to be repaid to United. Shepherd
asked Rognlien for permission to contact United’s chairman to
confirm the confidential business arrangement. Rognlien refused. In
fact, as Rognlien knew, no such agreement existed.”

A few days following Shepherd’s conversation with Rognlien, she
advised William Kaye, Cardillo’s vice president of finance, that
the $203,000 amount could not be recognized as revenue until the
contractual agreement with United Airlines expired in 1990. Kaye
refused to make appropriate adjusting entry, explaining that
Lawrence had insisted that the payment from United Airlines be
credited to a revenue account. On December 30, 1985, Rognlien
called Shepherd and told her that he was terminating Cardillo’s
relationship with Touche Ross.

In early February 1986, Cardillo filed a Form 8-K statement with
the Securities and Exchange Commission (SEC) notifying that agency
of the company’s change in auditors. SEC regulations required
Cardillo to disclose in the 8-K statement any disagreements
involving accounting, auditing, or financial reporting issues with
its former auditor. The 8-K, signed by Lawrence, indicated that no
such disagreements preceded Cardillo’s decision to dismiss Touche
Ross. SEC regulation also required Touche Ross to draft a letter
commenting on the existence of any disagreements with Cardillo.
This letter had to be filed as an exhibit to the 8-K statement. In
Touche Ross’s exhibit letter, Shepherd discussed the dispute
involving the United Airlines payment to Cardillo. Shepherd
disclosed that the improper accounting treatement given that
transaction resulted in misrepresented financial statements for
Cardillo for the six months ended June 30, 1985, and the nine
months ended September 30, 1985.

In late February 1986, Raymond Riley, Cardillo’s legal counsel,
wrote Shepherd and insisted that she had misinterpreted the United
Airlines-Cardillo transaction in the Touche Ross exhibit letter
filed with company’s 8-K. Riley also informed Shepherd that
Cardillo would not pay the $17,500 invoice that Touche Ross had
submitted to his company. This invoice was for professional
services Touche Ross had rendered prior to being dismissed by
Rognlien.

Act 3

On January 21, 1986, Cardillo retained KMG Main Hurdman (KMG) to
replace Touche Ross as its independent audit firm. KMG soon
addressed the accounting treatment Cardillo had applied to the
United Airlines payment. When KMG personnel discussed the payment
with Rognlien, he informed them of the alleged secret arrangement
with United Airlines that superseded the written contractual
agreement. According to Rognlien, the secret arrangement precluded
United Airlines from demanding a refund of the $203,000 payment
under any circumstances. KMG refused to accept this explanation.
Roger Shlonsky, the KMG audit partner responsible for the Cardillo
engagement, told Rognlien that the payment would have to be
recognized as revenue on a pro rata basis over the five-year period
of the written contractual agreement with United Airlines.

Cardillo began experiencing severe liquidity problems in early
1986. These problems worsened a few months later when a judge
imposed a $685,000 judgment on Cardillo to resolve a civil suit
filed against the company. Following the judge’s ruling, Raymond
Riley alerted Rognlien and Lawrence that the adverse judgement
qualified as a “material event” and thus had to be reported to the
SEC in a Form 8-K filing. In the memorandum he sent to his
superiors. Riley discussed the serious implications of not
disclosing the settlement to the SEC: “My primary concern by not
releasing such report and information is that the officers and
directors of Cardillo may be subject to violation of rule 10b-5 of
the SEC rules by failing to disclose information that may be
material to potential investor.”

Within ten days of receiving Riley’s memorandum, Rognlien sold
100,000 shares of Cardillo stock in the open market. Two weeks
later, Lawrence issued a press release disclosing for the first
time the adverse legal settlement. However, Lawrence failed to
disclose the amount of the settlement or that Cardillo remained
viable only because Rognlien had invested in the company the
proceeds from the sale of the 100,000 shares of stock.
Additionally, Lawrence’s press release underestimated the firm’s
expected loss for 1985 by approximately 300 percent.

Following Lawrence’s press releases, Roger Shlonsky met with
Rognlien and Lawrence. Shlonsky informed them that the press
release grossly understated Cardillo’s estimated loss for fiscal
1985. Shortly after that meeting, KMG resigned as Cardillo’s
independent audit firm.

Epilogue

In May 1987, the creditors of Cardillo Travel Systems, Inc.,
forced the company into voluntary bankruptcy proceedings. Later
that same year, the SEC concluded a lengthy investigation of the
firm. The SEC found that Rognlien, Lawrence, and Kaye had violated
several provisions of the federal securities laws. These violations
included making false representations to outside auditors, failing
to maintain accurate financial records, and failing to file prompt
financial reports with the SEC. In addition, the federal agency
charged Rognlien with violating the insider trading provisions of
the federal securities laws. As a result of these findings, the SEC
imposed permanent injunctions on each of the three individuals that
prohibited them from engaging in future violations of federal
securities laws. The SEC also attempted to recover from Rognlien
the $237,000 he received from selling the 100,000 shares of
Cardillo stock in April 1986. In January 1989, the two parties
resolved this matter when Rognlien agreed to pay the SEC
$60,000.

Write a four to five (4-5) page paper in which
you:

1. Explain the Securities and Exchange Commission’s
rationale to charge Cardillo executives with each of the following
violations:

a) making false representations to outside
auditors

b) failing to maintain accurate financial
records

c) failing to file prompt financial reports with the
SEC

d) violating the insider trading provisions of the
federal securities laws

2. Determine who was in violation or compliance of the
AICPA’s Code of Professional Conduct in this case study and analyze
the key reasons why they were or were not in compliance. Provide
support for the rationale.

3. Analyze the actions taken by Cardillo’s outside
auditors and evaluate the level of efficiency of the audit risk
management in this case study. Provide support for the
rationale.

4. Determine whether or not the five (5) components of
internal control were being followed. Support the response with at
least two (2) examples.

5. Create an argument for or against whether auditors
have a responsibility to assess the judgment of the decisions made
by Cardillo’s management. Support the argument.

6. Use at least two (2) quality academic resources in
this assignment. Note: Wikipedia and similar type Websites do not
qualify as academic resources.