ACCT3102 | Case Study of Accounting Fraud at WorldCom

Introduction

This report is developed mainly for the purpose of identifying and discussing the issues presented in the case study of ‘Accounting Fraud at WorldCom’ that leads to its downfall. In this context, it ahs specially examined its earning’s management practices, governance system and recommend the processes and systems that should be adopted any an entity for overcoming such fraudulent activities.

1.(a)Management of Earnings by Senior Managers at World Com & Pressures responsible for use of such earning managing practices

Worldcom, was an American telecommunication company, recognized by the name of largest accounting scandal that ever occurred within the US. It is attributed to be one of the biggest bankruptcies that have occurred mainly due to use of fraudulent accounting practices related to managing of earnings by the company. Senior managers at Worldcom adopt the use of earning management, an accounting technique that is used by a company for overstating its profitability position during development of the financial statements. The use of such practices enables the senior managers of the company to manipulate the information presented in the financial reports (Kaplan and Kiron, 2007). The main techniques that are adopted by the company’s managers are release of accruals and expenses capitalization for reporting higher profits. These methods are reported to violate the Generally Accepted Accounting Principles (GAAP). The accrual method of accounting requires an entity to allocate the expenses over the entire reporting period for matching the revenues with the cost incurred for its realization. However, Worldcom adopted the use of reporting operating expenses in the property accounts and depicting them under the capital expense accounts. The use of such accounting practices enabled the managers to remove the operating expenses from the income statement and thus reporting higher profits .

The adoption of fraudulent accounting practices by the senior managers of the company has resulted from the pressure they faced from the executives who have directed them to achieve the determined financial results by use of any illegal or unethical means. The executives are facing the pressure to maintain a 42% of expense-to-revenue ratio (E/R) for maintaining capital inflows from the investors (Kaplan and Kiron, 2007). The economic condition prevailing within the market such as economic recession and increasing competition coupled with reduce demand of telecommunication services has caused the pressure on the company’s executives to pressurize the managers for gaining higher profits. The company was facing pricing pressure and also reducing its line costs and thus adopted the use of fraudulent accounting practices to meet the expectations of the stock market. As such, company’s executives have pressurized the employees for promoting its financial growth through building revenues for enhancing its market value (Kennon, 2018).

(b) Boundary between Earnings Management & Fraudulent Reporting

The earnings management can be regarded as the use of accounting techniques by a company for reporting its positive image among its stakeholders. The use of such practices is done mainly by a company in developing the financial reports that intends to develop its improved financial performance among the end-users. The use of such accounting practices is not regarded as illegal if the managers do not use these methods to misinterpret the financial information. The use of earnings management is regarded to be legal by SEC (Securities Exchange Commission) only if it is used by a listed entity only for the purpose of smoothing the earnings and to reduce the income fluctuations from one period over to another. The stabilization of earnings of an entity from one period to another helps in seeking investors attention by reducing the risk related to the returns to be realized (Alleyne and Elson, 2013). This can be carried out by an entity through changing the accounting methods that leads in accelerating the revenues realized for short-term period. The companies through the use of earnings management practices can report is higher market value and improves the reliability of its financial forecast. On the other hand, fraudulent reporting can be regarded as the use of unethical and fraud accounting practices deliberately by business manager to manipulate the financial information for the purpose of misleading the investors through reporting its higher value. It can be stated to be an illegal action that is sued by the business manager’s to conceal the pertinent financial information and disseminating false accounting figures to the end-users (Kaplan and Kiron, 2007).

As such, it can be said that there exist a very fine line between the earnings management and fraudulent reporting that should be taken into consideration by the business managers adopting the use of practices of managing earnings. As depicted in the case study of Worldcom, the senior managers of the company have crossed the line from earnings management to fraudulent reporting. The senior executives of the company have forced the managers to adopt the use of illegal accounting methods for maintaining the company’s positive performance during the times of economic recession. The manager’s increased the net income reported in the financial statements by transferring a part of its current expenses into the capital account. This result in understating the operating expenses and the costs of capital were recognized as an investment. The accounting rules requires the recognizing of operating expenses immediately in the financial statement but the company’s managers instead capitalized it for overstating its pre-tax income (Sidak, 2003).

2.Failure in Worldcom’s Governance System to Detect the Actions by Managers over the Longer Term and Methods for Correcting Such Failures

The main reason for non-detection of the use of unethical accounting practices by the business manager’s at Worldcom earlier was the lack of an effective corporate governance system. The businesses need to establish an effective system of corporate governance that describes the rules, practices and processes to be used by a firm for achieving a balance between its interests with that of its stakeholders. The presence of such governing system is essential within an entity as per the theories of legitimacy and stakeholder’s. The theories have emphasizes on the need for an organization to be legitimate and responsible towards all its stakeholders for ensuring the protection of their varying interests (Kaplan and Kiron, 2007). However, WorldCom has maintained a corporate culture that lacks any governance system of mechanism as there are no official written policies or ethical code of conduct. The senior executives and managers pressurized their subordinates for achieving the desired goals by any means and they were not authorized for expressing their concerns any matter (Yallapragada, 2012). The pressure given by top management is responsible for the accountants involved in developing the financial reports with the use of fraudulent accounting practices such as releasing of accruals and capitalization of irrelevant capital expenditures. In addition to this, it has also been identified in the case study of Worldcom that Board mainly consists of non-executive directors who are appointed on the behalf of the owners and does not have any right or power of their own to interfere in business operations. The presence of ineffective audit and remuneration committee results in un-identification of the corrupt accounting practices that were prevalent in its corporate culture. The extent auditor of the company, Arthur Andersen, failed to identify and report its financial risk to the related authorities besides knowing that its financial results are deliberately manipulated (Sidak, 2003).

In this context, it is recommend to the company’s such as Worldcom to maintain an effective system of processes or system for quick identification of such type of unethical practices within their financial reporting processes. As such, the business companies are required to develop and establish an effective system of corporate governance for developing a culture based on ethical value and principles. The presence of a governing system of rules and regulations would ensure that business managers and employees meet out their roles and responsibilities as per the ethical code of conduct. This will help in promoting transparency and accountability within the business operations. Also, it is required that Board orientation must possess the managers; stake who have a power to interfere within the daily operations of the company (Norwani, 2011). The Board should establish an effective risk management framework within an entity consisting of audit and remuneration committee for maintaining an internal control over its operational processes. This will helps in identifying the operational risks in advance and develop subsequent procedures in advance for mitigating it. In addition to this, an auditor should carry out is roles and responsibilities with utmost care and attention and business are liable to provide them complete materialistic information for ensuring that they have developed error-free financial reports. There is also need for developing more sophisticated and efficient audit procedures to identify and report the materialistic errors for prevention of occurrence of such frauds in the future (Alleyne and Elson, 2013).

Conclusion

It can be stated form the overall discussion held in the report that accounting scandal of WorldCom has occurred mainly due to use of fraudulent accounting practices by senior manager of earnings management. The accounting fraud can be regarded to be occurred due to absence of an effective corporate governance system and ethical code of conduct within the company. Thus, it can be stated on the basis of the report that business corporations should establish sound corporate governance policies and comply with them for carrying out their activities in an ethical manner.

References

Alleyne, B. J. and Elson, R. J. 2013. The impact of federal regulations on identifying, preventing, and eliminating corporate fraud. Journal of Legal, Ethical & Regulatory Issues 16(1), pp. 91-106.

Kaplan, R.S. and Kiron, D. 2007. Accounting Fraud at WorldCom. Harvard Business School.

Kennon, J. 2018. Worldcom's Magic Trick - The Worldcom Scandal Explained. [Online]. Available at: https://www.thebalance.com/worldcom-s-magic-trick-356121 [Accessed on: 3 September 2018].

Norwani, N. 2011. Corporate Governance Failure And Its Impact On Financial Reporting Within Selected Companies. International Journal of Business and Social Science 2(21), pp. 205-213.

Sidak, G. 2003. The failure of good intentions: The WorldCom fraud and the collapse of american telecommunications after deregulation. Yale Journal on Regulation.

Yallapragada, R. 2012. Accounting Fraud, And WhiteCollar Crimes In The United States. Journal of Business Case Studies (JBCS) 8(2), 187- 192