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Financial accounting case study at WorldCom


Lin Binbin 43161458

Accounting Fraud at WorldCom
1. Earning management
1.1 The definition of earnings management and two motivations
Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either to mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers said by Healy and Whalen (1999). One of the incentives to induce CEOs to manage earning is about stock price concern. In 1999, Barth et al found that firms report continuous growth in annual earnings, other factors keeps unchanged, are priced at a premium relative to other firms. With a similar statement, Skinner and Sloan (2002) show that missing analysts? forecasts have an immediate negative impact on stock price. Another one is about manager themselves? concern about external reputation so as to hit the desired earnings benchmark. Most CFOs feel that their inability to hit the earnings target is seen by the executive labor market as a “managerial failure”. Repeatedly failing to meet earnings benchmarks can inhibit the upward or intra-industry mobility of the CFO or CEO because the manager is seen either as an incompetent executive or a poor forecaster concluded by Farrell and Whidbee (2003); Feng (2004); Francis et al (2004).

1.2 The accounting method to manage earning and senior manager’s pressure
Throughout 1999 and 2000, the manager of WorldCom in order to reduce the amount of line costs, asked accountant to reverse the estimated provision for the unpaid line costs. Under normal situation, this action should be taken when the actual amount need to pay is lower than the amount estimated, then the excess flow into income statement. Therefore, the abnormal transaction entries made WorldCom have a less expense and a higher ratio, but a risky debt. Except of this, in order to maintain the ratio, no more accruals could be released and no revenue flowed in, the company decided to capitalize the non-revenue generating expenses as an assets and make the entry as construction in progress which meant it would generate revenue in the future. Thus, $771 million expenses disappeared which helped the ratio keep favorable. There are two obvious pressures and incentives which induced senior managers to take action like this. First, the reason why WorldCom expanded so quickly is that they emerged their competitors and become the biggest telecommunication company in the world. Therefore senior managers did not want the company collapse under their management and this would ruin their reputation in their future career. Second, the share value in the stock market is an important criteria to judge a company is good running or not. In this way, managers would do whatever they can to keep the value as high as possible, and this also helped them to attract fund helping operating the company. That is the reason why they maintain the expense revenue ration at 42%.

1.3 Earnings management and fraudulent reporting
There are a lot of definitions about earnings management and fraudulent along with different opinion about their differences. However, a new approach has been proposed and one of the researchers, Jones (2011), believed that the only way to differentiate between fraudulent and legitimate action is via understanding the motives behind each. For normal earnings management, every transaction is under the standard requirement; even if some action is beyond this, just to identify the underlying motivation, it would be accidental. On the other side, fraudulent reporting is a deliberate action which break the standard and also relative law.

ACCT7102 Financial Accounting

1 Accounting Fraud at WorldCom

Lin Binbin 43161458
In the case of WorldCom, when the controller Myers ordered his subordinate to release line accruals, Schneeman asked for a reason and there is no explanation. It is obvious that this order is abnormal and no material given to suggest that the release of expense is correct, just an order. Another action did by Sullivan is capitalizing the line expenses which cannot generating further incomes. Just after Sullivan devised this creative solution, Yates and Myers told him there is no support within any current accounting guidelines that would allow for this accounting treatment. Concluded from this two facts, the accounting transactions taken by WorldCom are a deliberate action which the motivation is for private purposes and to cheat public believed that they have a good running of the company. In my opinion, managers at the WorldCom should not have been engaged in accounting entries management. Accounting is a procedure that keep the records of company operating correct and sometimes, if necessary, utilized some different methods to display a favorable results without breaking any laws. However, in the case of WorldCom, the managers were lack of accounting knowledge that once through modification of accounting and receiving a short-term benefits, it will reverse in the future, no mention that in the case, this was actual a fraudulent accounting accrual. Therefore, managers just need give accountants an objective to reach. Afterwards, they would do their best with expertise knowledge and this is a long-run strategy.

2. Processes or systems in WorldCom
2.1 Failure to detect the actions by managers in WorldCom
There are two main reasons can be explained that why the misconduct action by manages failed to be detected for a long time. First, a poor regulatory system and bad corporate culture led to less communication between different departments and there is non-corporative working environment. For instance, in WorldCom, an unhealthy culture was that no one can question their superiors, just simply do what they were told. Also, the Company?s lawyers played a little role of the consultant. Second, a bad corporate governance led to no one in the company can detect and then solve the problem as early as possible. As far as the board of Directors concern, none of the outside directors met senior managers outside the meetings. Moreover, the board of directors not bothered to look into the account of the company, not mention what happened in the company. Apart from this, there are problems inside audit. In one respect of internal audit, there is a limited scope for information and just conducted primarily operational audits. For example, the internal audit group cannot receive a detailed project when they asked for. Except from this, there is no power either, and the internal audit reported directly to CFO for most purposes. In other respect of outside auditor, Arthur Anderson Firm just regarded WorldCom to be its “flagship” client, so that they had too much confidence about WorldCom and at last, they even neglected and overlooked the serious problem in the WorldCom?s accounting ledgers. During the time, they only tested their account balance relying on the WorldCom?s control environment which in fact is not correct.

2.2 An applicable processes or systems
In my opinion, I think the corporate need to rebuild a fresh and freedom culture. The reason is a healthy corporate culture which is so important that can determine how far a company can develop. Ravasi and Schultz (2006) stated that corporate culture is a set of shared mental assumptions that guide interpretation and action in corporate by defining appropriate behavior for various situations. Moreover, the company also need to set up an efficient corporate governance system and it can also help corporate grow healthy and correctly. As Justice Owen (2003) defined “Corporate governance is ?the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations?. It encompasses the mechanisms by which companies, and

ACCT7102 Financial Accounting

2 Accounting Fraud at WorldCom

Lin Binbin 43161458
those in control, are held to account”. In this way, if when one step went wrong, every other department can help detect the misconduct action and then work in a health way.

3. Analyzing difference between two managers
3.1 The actions of Ms. Cooper and Ms. Vinson
Ms. Vinson was a hardworking and loyal employee and she did what her manager wanted her to do, even though she was shocked and reluctant about the entry. Her underling motivation was for her self?s interest that to keep the position so she can pay her family?s insurance and also it was difficult for her to find another job which had the enough salary. Ms. Cooper was a strong-willed leader of internal audit department of WorldCom. Since she found the problem, Ms. Cooper never give up asking for an explanation until she and her internal audit team disclosed their finding with audit committee. The difference between Ms. Cooper and Ms. Vinson was their motivation. For Ms. Cooper?s point of view, as a header of internal audit team, her responsibility was to make sure all the entries was correct and material. Therefore, when she was refused about the explanation, she decided to find out by herself and disclosure it.

3.2 Personal response
If I was Vinson, firstly, I would have to think about the importance and severity of the action my manager want me to do. In the case of WorldCom, if there was no standard supported the entries, I would ask relevant expertise for help whether this action break any law, if the answer was yes, then I need to think about the consequence of the thing when I started to do. Compared with losing my job and salary, it would be the best choice not involve a legal problem. Another choice apart from asking outside expertise, I would ask the manager of internal auditor, Ms. Cooper. The reason was internal audit department have connection with international accounting division, and they need to audit the entries accounting division made. Therefore, if asked them first, in some degree, it can make sure every entries recorded properly and also avoid conflict.

ACCT7102 Financial Accounting

3 Accounting Fraud at WorldCom

Lin Binbin 43161458

References Healy and Whalen. 1999. A review of the earnings management literature and its implications for standard setting. Accounting Horizons p. 368. Barth, M., J. Elliot and M. Finn. 1999. Market rewards associated with patterns of increasing earnings. Journal of Accounting Research 37: 387-413. Skinner, D. J. and Sloan, R. G. 2002. Earnings surprises, growth expectations, and stock returns or don?t let an earnings torpedo sink your portfolio. Review of Accounting Studies 7(2-3): 289-312. Farrell, K. and D. Whidbee. 2003. Impact of firm performance expectations on CEO turnover and replacement decisions. Journal of Accounting & Economics. 36(1-3): 165-196. Jones, M. 2011. Creative accounting, fraud, and international accounting scandals. The Atrium, Southern Gate, Chichester. England. John Wiley and Sons Ltd p. 7. Ravasi, D. and Schultz, M. 2006. Responding to organizational identity threats: Exploring the role of organizational culture. Academy of Management Journal 49(3): 433–458. Justice Owen, HIH Royal Commission. 2003. The Failure of HIH Insurance, Volume 1: A Corporate Collapse and Its Lessons. Commonwealth of Australia p. xxxiii. Justice Owen. 2003. Corporate Governance: Level upon Layer. Speech to 13th Commonwealth Law Conference 2003, Melbourne p. 2.

ACCT7102 Financial Accounting

4 Accounting Fraud at WorldCom


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