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ACCT3102 External Reporting Issues 2

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  • Course Code: ACCT3102
  • University: The University Of Queensland
  • Country: Australia

Questions:

Case Study: ‘Accounting Fraud at WorldCom’

1.

(a) Describe how senior managers at WorldCom managed earnings. What pressures led senior managers to manage WorldCom’s earnings?

(b) 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? Explain.

2.

Why were the actions taken by WorldCom managers not detected for three to four years? How should WorldCom have set processes or systems to detect quickly those types of actions? (i.e., Explain the failure in WorldCom’s governance system to detect the actions by managers over the longer term and how to correct the failure.)

 

Answers:

1:

Part (a):

Ways through which senior managers at WorldCom managed earnings:

Scott Sullivan, the Chief Financial Officer of WorldCom, has distorted the earnings of the organisation by breaching two primary accounting rules, which include capitalisation and accruals. Moreover, the senior managers had overstated the pre-tax earnings of the organisation by disclosing the accrual balance to the profit and loss statement and by capitalising the operational expenses in the books of accounts (Agrawal and Cooper 2015). According to “Generally Accepted Accounting Principles (GAAP)”, it is necessary for an organisation to adhere to the matching concept between expense and revenue for any accounting year. Between 1999 and 2000, the CFO managed the earnings by manipulating the expense accrual accounting entry, which implies that the accruals are reversed for minimising the expense line in the profit and loss statement. Therefore, the accruals remaining in the books of accounts were much lower compared to the actual payment need for future (Agrawal and Cooper 2017).

During 2001, when only some remaining accruals were left to be disclosed, the senior managers initiated disguising operational costs in the form of capital expenditure for avoiding disclosure of the business losses. According to GAAP, it is necessary to book operating cost totally in the period to which it relates and capital expenditure is to be capitalised and booked in expense section over the period as depreciation. However, Scott Sullivan had ordered the other senior managers working under him to re-categorise the operating cost to capitalisation head for booking the expense head over the timeframe.

 


Pressures that led senior managers to manage WorldCom’s earnings:

The senior managers distorted the earnings of WorldCom, as they were pressurised to maintain the expense-revenue ratio between 40% and 42% range (Ailon 2015). According to the Chief Executive Officer, Bernard Ebbers, the primary goal of the organisation was to be the leading stock in Wall Street. For fulfilling the expectation of the organisation, the senior managers were always under pressure in managing earnings at all cost. In addition, the economic recession, collapse of dot-com and immense competitive rivalry led the senior managers of WorldCom in overstating the profit of the organisation. From the managerial and employee perspective, the employee benefits that they had obtained were due to the extraordinary performance of the organisation. In order to save their jobs and personal benefits, the managers and staffs had blindly followed the decisions of their immediate supervisors.

Part (b):

Boundary between earnings management and fraudulent reporting:

Earnings management could be defined as the accounting technique in the best possible way at the time of formulating the financial statements of the organisation for depicting the positive picture of the business performance. The earnings management takes into consideration legitimate and less than legitimate attempts for smoothing earnings over the accounting year (Giroux 2017). Earnings management are carried out in line with the principles of GAAP. However, at the time organisations provide information, which is material misleading deliberately, it is converted into fraud. The earnings management takes into account variation in accounting methods and policies, deferred expense, one-time cost and accelerating revenue based on short-term. Fraudulent reporting is considered to be illegal and the Securities Exchange Board (SEC) might impose fines on the organisations.

 


Discussion of whether senior managers at WorldCom crossed the line from earnings management to fraudulent reporting:

It is clearly apparent from the WorldCom case that the senior managers were involved in fraudulent reporting by deliberately conducting manipulated entries in the books of accounts for increasing the profit level of the organisation. Scott Sullivan and David Myers, the controller of WorldCom, had compelled their staffs to manipulate the books of accounts by disclosing capitalising and accrual expenses without any form of basis and support. The only motto of the organisation was to maintain the leading position in Wall Street (Hail, Tahoun and Wang 2018).

There are some instances from which it could be found that the senior managers had conducted fraudulent reporting and they are enumerated briefly as follows:

  • Disclosure of $3.3 billion accrual between 1999 and 2000 for maintaining the profit level of the organisation
  • At the start of the year 2001, the senior managers of the organisation had initiated capitalising the unused additional cost of network capacity rather than booking the same in the form of an expense
  • Scott Sullivan had asked Cynthia Cooper, the Director of Internal Audit, to delay the audit for capital expenditure for gaining time in developing fictitious support (Jackson 2015)
 

2:

Reasons for not detecting the actions of WorldCom managers for three to four years:

The primary reason emphasises on unclear and closed corporate culture and the junior members had to abide by the orders of their seniors. Moreover, none of the staffs of WorldCom associated with fraud had unveiled the act because they might lose their jobs. For instance, Betty Wanson, a loyal employee of the organisation, had not complained against fraud by blindly adhering to the orders of her senior supervisor (Markham 2015).

Secondly, Arthur and Andersen, the external auditor of WorldCom, could not identify accounting fraud because of a variety of reasons. The reason is that the auditor could not communicate with some staffs; no access to the computerised financial system and use of substandard approach rather than substantive procedure at the time of analysing the books of accounts (Melé, Rosanas and Fontrodona 2017).

Finally, the development of departments such as HR in Florida along with Legal in Washington had made it complex in establishing synchronisation between departments and staffs. In addition, the department of internal audit had not performed vigilantly, since majority of the decisions were undertaken by senior managers by not seeking permission and accordingly, supportive documents were prepared.

 

Governance failures in WorldCom and processes or systems needed to detect quickly the types of actions that occurred in the organisation:

From a prima facie evidence, it has been identified that the Director Management Reporting, Betty Vinson, was a victim, since she had no other option than following the order of her supervisor during that time. However, she was associated with fraud, since she was fully aware of the malpractices and accounting distortions from the beginning. At the time the senior manager (CFO) of WorldCom asked her to manipulate the books of accounts through profit inflation or accrual reversal, she knew that it was wrong. This is because they violated GAAP; however, she still conducted the manipulation. Even though she refused to carry out the same in the initial stage, she was later convinced to pass the misleading entries in the books of accounts. Thus, Betty Vinson had full knowledge about such fraud from start to end for saving her job. The colleague of Vinson, Troy Normard, the “Director Legal Accounting Reporting”, was engaged in the fraud as well and he left the job immediately. Although Vinson had thought of the same; however, her family was dependent on her job due to which she changed her mind.

Vinson had disclosed the accrual of $3.3 billion over the years from the books so that the profit of the organisation could be inflated based on the order of the immediate seniors. This surely has violated the corporate governance failures due to which criminal charges need to be brought against her. This is because she prioritised her self-interest by ignoring the needs of the shareholders, bankers, lenders and customers (Pamungkas, Ghozali and Achmad 2018).

In order to deal with those governance failures, WorldCom could have used proactive, reactive and automotive systems so that the organisation could be saved from fraud and malpractices. Firstly, there needs to be openness and clarity in corporate culture. Adequate rights need to be provided to the staffs to communicate with any individual in hierarchy and they need to provide correct answers to the questions. In this context, Soltani (2014) cited that the organisation could have whistle blowing policy in place to assist the staffs in raising their voice against any malpractice by not scared of job loss. Moreover, it is necessary to ensure fair dealings with the auditors. The auditors should have been provided with the authority of collecting any data along with accessing its books of accounts. However, as per Sorensen and Miller (2017), the auditors are needed to be independent and they should carry out their obligations with honesty and due diligence for representing the actual financial health of the organisation.

Finally, WorldCom could have ensured the presence of written policies and documents in place in relation to policies, authority as well as decision making power. Thus, according to Wong and Venkatraman (2015), all the employees are required to abide by the norms and regulations at their workplace. However, the principles and moral values of the employees play a significant role, as they need to be more determined in raising their voice against the business malpractices. If the authorised committee does not undertake any action, the employees need to inform the same to the top management and statutory auditor regarding the unethical practices adopted by the managers. Thus, they are required to serve as whistle blowers for protecting the interests of the creditors, bankers, staffs, shareholders, customers and other stakeholders of the organisation.

 

References:

Agrawal, A. and Cooper, T., 2015. Insider trading before accounting scandals. Journal of Corporate Finance, 34, pp.169-190.

Agrawal, A. and Cooper, T., 2017. Corporate governance consequences of accounting scandals: Evidence from top management, CFO and auditor turnover. Quarterly Journal of Finance, 7(01), p.178-197.

Ailon, G., 2015. From superstars to devils: The ethical discourse on managerial figures involved in a corporate scandal. Organization, 22(1), pp.78-99.

Giroux, G., 2017. Accounting Fraud: Maneuvering and Manipulation, Past and Present. Business Expert Press.

Hail, L., Tahoun, A. and Wang, C., 2018. Corporate Scandals and Regulation. Journal of Accounting Research, 56(2), pp.617-671.

Jackson, C.W., 2015. Detecting Accounting Fraud: Analysis and Ethics. Pearson Higher Ed.

Markham, J.W., 2015. A financial history of the United States: From Enron-era scandals to the subprime crisis (2004-2006); From the subprime crisis to the Great Recession (2006-2009). Routledge.

Melé, D., Rosanas, J.M. and Fontrodona, J., 2017. Ethics in finance and accounting: Editorial introduction. Journal of Business Ethics, 140(4), pp.609-613.

Pamungkas, I.D., Ghozali, I. and Achmad, T., 2018. A pilot study of corporate governance and accounting fraud: The fraud diamond model. Journal of Business and Retail Management Research, 12(2), pp.111-125.

Soltani, B., 2014. The anatomy of corporate fraud: A comparative analysis of high profile American and European corporate scandals. Journal of business ethics, 120(2), pp.251-274.

Sorensen, D.P. and Miller, S.E., 2017. Financial accounting scandals and the reform of corporate governance in the United States and in Italy. Corporate Governance: The International Journal of Business in Society, 17(1), pp.77-88.

Wong, S. and Venkatraman, S., 2015. Financial accounting fraud detection using business intelligence. Asian Economic and Financial Review, 5(11), p.1187.

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