Accounting Fraud at Worldcom - Assignment Example

ACCOUNTING FRAUD AT WORLDCOM Name: Lecturer: Course name: Course code: Date: Executive Summary WorldCom Company was the second largest long distance organization after AT&T before its bankruptcy. Before going public in 1989, the company acquired other companies hence making to grow rapidly. The general performance of telecommunication industry declined in 2000 which in turn led to the decline in stock prices. WorldCom started engaging in financial fraud so as to maintain its stock prices. The chief executive of the WorldCom made the company to issue corporate loans so he could use it to meet his margin calls that the bank wanted (Ayeir, 2011). The company managed to commit financial frauds by capitalizing costs rather than expensing them and also they made the revenues to go up by application of improper entries of accounts. Unluckily, the corporate culture of WorldCom was not in favoring prevention of frauds and also the external auditors as well as the internal auditors did not work in an efficient manner. At the time of fraud discovery, the company had a fraud worth $3.8 billion and it was estimated that the company assets had been inflated to $11 billion. The senior management who were involved was legally liable. QUESTION 1 (a) Explain what is meant by earnings management, and outline two motivations for managers to manage earnings. Earnings management is the manipulation of financial earnings of a company by either direct or applying indirect methods of accounting. There is a high tendency of occurrence earnings management when a company is repeatedly not meeting the expectations of its investors or in financial periods where earnings are volatile. Earnings management is oftentimes regarded materially misleading and thus termed to be a fraudulent activity (Cecilia, 2007). Even though all the changes may be abiding by all the laws and accounting standards, they may take paths that are against the laws and standards were primarily trying to constitute. Earnings management is a strategy applied by the company management to intentionally manipulate the earnings of the company so that earnings figures are in line with the per-determined target. Earnings management is purposively carried out to smooth out income. Offensive earnings management is considered by the Securities and Exchange Commission to be a material and deliberate misrepresentation of earnings results. The 2 competing explications for motivation for earnings management by the management are contracting motivations and capital market motivations. Capital market motivations. Capital market motivations explains that the extensive use of accounting information by shareholders, potential investors and financial analysts for purposes of valuing stock bring into existence incentives for managing executives of a company to manage with the aim of influencing the short term performance of stock. Contracting motivations Contracting motivations emphasizes the application of accounting data to control and regulate the contracts that exist between companies and their owners. Definite and implied executive management rewarding contracts between are applied to rank executive management and owner incentives, and debt agreements are noted to safeguard executive management behavior that might be considered exceptionable by current or potential creditors of the company (Clarke, 2012). Researchers on contracting motivation have recommended that these contracts create incentives for earnings management because of the capability for committee on compensation and costs related to creditors. (b) Describe how senior managers at WorldCom managed earnings. What pressures led senior managers to manage WorldCom’s earnings? Management of earnings at WorldCom took two major forms: line costs reported were reduced, the largest category of WorldCom's expenses; and the reported revenues being exaggerated. The main aim of these manipulations was to keep the reported line costs to an estimate of 42% of revenues (when in fact they exceeded 50%), and to proceed reporting growth in revenue of double digits when the actual growth rates were significantly low. Concerning financial reporting, WorldCom applied a liberal explanation of accounting rules when they were preparing the financial statements. While trying to disguise that the profits were following an upward trend, executive management of WorldCom would publish in a particular quarter assets in millions of dollars it purchased while, concurrently, it added in this charge against profits the cost of expenses of the company that are expected in future (Jamison, 2007). The outcome was huge losses during the current quarter but smaller ones in the coming quarters; this was aimed at making profits to seem to be progressively improving. WorldCom acquired MCI which gave them an opportunity to commit accounting frauds. The company managers reduced the assets' book values of MCI by greater billions of dollars and in turn, the company inflated the value of goodwill, i.e. a brand name which is an intangible asset. This made WorldCom to charge a smaller amount against profits yearly by distributing these huge expenses throughout decades preferably than years. The net outcome was that WorldCom was able to reduce yearly expenses, recognize all revenues from MCI and elevate revenues from acquisition. The senior managers of WorldCom twisted their accounts receivables assumptions, the amount of money that the debtors owe the entity. Over a considerable period of time, the management did not consider the list of debtors who had not paid and were likely to be bad debts from credit department list. The assumptions made by the senior managers had two significant roles in accounting for receivables. In the first instance, the management contributed to the amount of money set aside to cover the bad debts. If the assumption of non-collectable bills is low, the amount of reserve fund required will be smaller. The final outcome is higher amounts of earnings. In the second place, if the company decided to sell receivables to a third party, which in this case WorldCom did, then the presumptions to the available amounts of receivables for sale. The management of WorldCom made other accounting adjustments which were concluded to be inappropriate, that had relatively small impacts on reported profits. First, management of the company reduced three other categories of expenses, that is, general, selling and administrative costs; depreciation and income expenses (Earl, 2007). Secondly, the company used general accrual account to accommodate surplus accruals from other accounts, so as to be released afterward to counterbalance expenses for which they may not have been recognized at first, to refill under-fund accruals, and to record the accounts of assets, this was aimed at increase reported profit. Pressures that led senior managers of WorldCom to manage earnings include; The investors pressurized the management to make the company to grow. Personal reasons such as greed and wanting more made the senior managers to manage earnings. The senior management wanted to attract more investors to enable the growth of the company. The management received pressure from the big shareholders. They wanted to maintain the company name since it was a very respectable company in communications industry. (c) What is the boundary between earnings management and fraudulent reporting? In your opinion, did senior managers at WorldCom cross the line from managing earnings into fraudulent reporting? Earnings management arises when the management applies judgments in financial reports and in organizing transactions of the company to change financial reports to misguide some stockholders on company performance or to influence outcomes of contracts that rely on the reported financial information. Management of earning applies aggressive tactics of accounting to artificially reduce or increase the revenues, earnings per share and/or profits. Management who engage in earnings management look for lose areas in the financial reporting standards that gives them an opportunity to modify figures in order to achieve their objectives or to fulfill financial analysts’ projections. The modifications results to financial reporting frauds when they go beyond acceptable accounting practices. Motivators for management of earnings include the expectations of the market, personal greed for bonuses and to maintain best a position within an industry. Earnings management in WorldCom resulted to fraudulent reporting. The management recognized unsuitable revenues and they also gave inappropriate accruals and estimates of liabilities. QUESTION 2 Why were the actions taken by WorldCom managers not detected for three to four years? What processes or systems should be in place to detect quickly the types of actions that occurred in WorldCom? The actions taken by WorldCom managers were not detected earlier because, when financial staff of the company raised concerns on accounting inconsistencies, executive management often thwarted those concerns through threats. Sometimes, executive managers responded to raised concerns on corporate adjustments with complex and confusing explanations. At some point, they simply turn down to answer questions asked by employees, and frequently referred those asking questions to Sullivan CFO, whom was very difficult to reach (Ayeir, 2011). The blame of failure on Anderson to detect fraud appeared to lie with staff both at WorldCom and Anderson. Certain WorldCom employees maintained firm control over information that Andersen required distorted documents with the evident purpose of concealing from Andersen substance that might be compromised. These issues made WorldCom fraud undetected for a long time. Systems and processes that should be put in place to place to hinder or uncover quickly the types of actions that occurred at WorldCom would be to make internal and external audits at random times, audits should be performed frequently, audit sample taken should be considerably large, introduction of programs for employees that are designed to bring integrity and faithful representation (Ayeir, 2011), the board of directors should be fully engaged to company decisions and steps, because it can lead to prevention or early detection of actions that occurred at WorldCom. QUESTION 3 (a) Compare and contrast the actions taken by Ms Cynthia Cooper (Head of Internal Audit Department at WorldCom), and Ms Betty Vinson (Senior Manager in General Accounting at WorldCom) Betty Vinson and Troy, were managing the department of accounting, they were instructed in October 2000 to remove $828 million of line cost accruals of the statements of, and then they were given instructions to convey $771 million of line cost to capital expenditure because they were affirmed that they were not doing anything illegal or wrong by Mr. Sullivan. It is regarded a stupid error if someone recorded operating expenses to capital expenses because it is one of the most visible in financial accounting. Betty Vinson was acting unethically because she knew what she was supposed to do, that is report the case. Cynthia Cooper was of high morals, integrity and upheld strong ethics in her work. It was her task detects and uncovers frauds as an internal auditor and she did it very well. She faced intimidation by her seniors but she pressed on and revealed the discrepancies in accounting (Jamison, 2007). She was ethical and of high integrity because her careful detective works in the internal audit department revealed some accounting irregularities that were commuted to deceive the investors. (b) If you were placed in the same position as Vinson, how would you handle it? Discuss the alternate courses of action that might be available to you. When situations like Vinson's case at WorldCom occur, where workers are forced into executing tasks that their employers wants them to perform even if it may be uncomfortable or illegal, workers should take it upon themselves to reveal their stand or position on an issue and/or go for other things they would find more happy and comfortable doing. They need to be firm for what they believe in which is doing the right thing. In the case of WorldCom, Vinson should have hired a legal representative or contacted the authorities to advice and assist her come up with the best course of action to take.   Reference List Ayeir, N., 2011. Accounting: General Accepted Financial Accounting Standards. Cengage Learning. Cecilia, D., 2007. Corporate Auditing and Fraud Detection. UNSW Press. p.639. Clarke, E.A., 2012. Accounting: An Introduction to Principles and Practice of Auditing. Cengage Learning. p.12. Earl, C., 2007. The international handbook of financial reporting. Cengage Learning EMEA. p.32. Jamison, R., 2007. Multistate Tax Guide on Auditing Financial Issues. Cengage Learning. Pickett, K.H.S., 2006. Audit Planning: A Risk-Based Approach. Reuvid, J., 2011. Managing Business Risk: A Practical Guide to Protecting Your Business. Vona, L.W., 2011. The Fraud Audit: Responding to the Risk of Fraud in Core Business. Read More