"At this point we wanted to cancel the reservation but we were told by Airbnb that if we did we wouldn’t be able to rent the unit for that week and we will be penalized."
It's too bad you didn't have the policy at hand to read to the Airbnb agent, who never should have told you that. You had every right to cancel the reservation penalty-free when the guest asked you to remove the rugs indicating that her dog might relieve itself indoors.
ESAs and service dogs have to be housebroken. They don't get to have "accidents". That's in the Airbnb rules under that section.
@Lala72