The Concept of Accounting Fraud and The Case Study of Worldcom

WorldCom was a large telecom company in the United States that enjoyed an almost meteoric rise during the 1990s but later ran into trouble in the early 2000s, particularly 2001 was difficult. This case gives future generations of accountants the opportunity to study the largest accounting scandal in history from an internal financial accounting perspective. You have been appointed a board member of a public listed company and have been asked to prepare a report to be presented in the next board meeting; discussing in detail the particular factors that motivate preparers of financial statements to engage in accounting fraud, and safeguards available in preventing accounting fraud.

Introduction

The purpose of this write up is to introduce the readers to the concepts of accounting fraud and the strategies used to commit accounting fraud such as creative accounting. Readers will be presented with the various factors that motivate preparers of financial statements to commit accounting fraud as well as the measures that can be employed to minimise the exposure to the risk of accounting fraud. It is important for readers to get abreast with a number of terms relating to accounting fraud and in the following section, key terms shall be defined for that purpose.

Accounting Fraud

Accounting fraud is referred to as a scenario in which business owners or managers deliberately distort financial data so as to present an untrue record of a company’s financial status. The objective of accounting fraud is to obscure the material omissions from being flagged by financial audits and more often than not results into harm or injury to creditors, investors, and potentially employees.

Creative Accounting

According to Investopedia, creative accounting is a classification of accounting procedures, practices and activities that comply with the mandated accounting laws and regulations whilst conflicting with the objectives the standards set out to accomplish. These practices leverage on the on gaps in the accounting standards to falsely portray a superior financial and corporate image of the company for which the financial reports are being prepared. Although creative accounting practices are legal, the outcomes of such activities can result into a material alteration of financial information of a business entity and the users of this information can be biased into making misguided decisions.

Financial Statements

Financial statements are reports prepared by an entity and are a formal representation of the financial activities and financial position of the said entity. The relevant financial information is presented in a structured easy to comprehend manner to enable users such as management, government, creditors, lenders and the public be able to make appropriate decisions in relation to the entity.

The case study: WorldCom

WorldCom was an American telecommunications company originally from Clinton, Mississippi USA that resulted from a merger between WorldCom and MCI communications. The company was the second largest long distance telecom company and was publically listed and traded on the New York Stock Exchange. In 2002, a team of internal auditors revealed accounting fraud of $3. 8 billion dollars and this triggered a chain of events including an investigation by the US Securities and Exchange Commission (SEC) in June, 2002. The investigation revealed that the company had inflated its assets by about $11 Billion and the company filed for bankruptcy on 21st July, 2002.

Motivators of Accounting Fraud

In this section the write up explores the factors that motivate preparers of financial statements to engage in accounting fraud:

Periods of high economic performance: An economic boom is a period characterised by economic expansion and is usually a peak phase of the business cycle. Economic activity rises in the areas of gross domestic product, productivity and income. Business sales increase, driving up profits. This period is usually accompanied by a bull market in stocks, and a bear market in bonds.

During this period, managers can capitalise on the bull market to elevate the prices of shares in publically listed company by falsifying the financial reports. Existing and potential investors are easily fooled as they expectant of good news during economic performance of that nature. In the 1990s, WorldCom relied on its stock prices as a source of capital to finance acquisitions and the success of the strategy greatly depended on a consistently increasing stock price. The dotcom bubble of the late 90’s served as an opportunity for CEO, Benard Ebbers and the management team of WorldCom to position the company’s stocks as a high-quality buy for the bull market.

Misplaced incentives: Managers may own equity within the very publically listed companies they control and as a result seek to make personal financial gains from their share holdings. Falsification of financial reports will in these cases become a means to an end because exceptional financial performance will culminate into an increase in value of their shareholdings that they can then offload to potential buyers. Bernard Ebbers had stock holdings in WorldCom and directed his energy into building and protecting his equity value and as a result a gain or drop in the share value of WorldCom stocks had a direct impact on his finances this served as an incentive for the CEO to fraudulently force up share value of the company’s stocks.

High pressure to perform: Management may engage in accounting fraud as a result of pressure from investors and other stakeholders to post exceptional financial performance even during tough economic periods. High performance targets and forecasted performance trends can lead management into employing aggressive accounting methods to portray the required performance results. This was no different for WorldCom as the company marketed itself as a high-growth company, and given that revenue growth was a critical component of WorldCom’s early success, the deterioration of market conditions throughout the telecommunications industry in 2000 and 2001, WorldCom under pressure to perform resorted to accounting fraud so as to continue posting impressive revenue growth numbers. The promises of double-digit growth to Wall Street translated into pressure within WorldCom to achieve those results.

Dishonesty and a lack of ethics by managers: Managers that are innately dishonest and lack ethics are more likely to engage in accounting fraud with little or no regard for the consequences of their actions, they are motivated by self-gain and nothing else. The management team at WorldCom exhibited the same characters as they knowingly drove the company into the ground whilst concealing information on the poor financial performance from investors, regulators, lenders and even the company’s very own staff. The CFO, Sullivan directed the making of false accounting entries so as to falsely portray that the company had attained the targeted performance. In addition members of the various accounting teams that knew or suspected that fraud was going on did not report the case to the regulatory bodies as ethically required while for some of the attempts by accounting officers to report cases were supressed by the supervisors.

High debt levels: Companies with high debt liabilities may engage in financial statement fraud so as to ensure their lenders and creditors are not wary of the company’s ability to settle their obligations. 14 financial institutions were part of WorldCom’s list of creditors with a debt value of $ 45. 7 Billion, Poor financial performance at the company would diminish its financial credibility and automatically trigger efforts by its creditors to recover their funds and a coinciding drop in value of the company’s stocks due to loss of investor trust. Focus on accounting rules rather than principles; Managers may look to exploit the accounting rules to conceal financial malpractices rather than correctly portraying a company’s books of account. WorldCom employed a strategy called “Close the Gap. ” Throughout much of 2001, The Company’s Business Operations and Revenue Accounting groups tracked the difference between projected and target revenue and kept a running tally of accounting “opportunities” that could be exploited to bridge that revenue gap. They would then identify, measure and book in the amount needed to hit the Company’s external growth projections. They would book these amounts based on the GAAP standards.

Lack of auditor independence: Managers may have a close relationship with a company’s auditors and this may affect the objectivity of their financial audits as auditors are likely to conceal financial malpractices by management in order to win favour in form of long term consultancy contracts as well as secret pay offs. For the case of WorldCom, Arthur Andersen LLP were an independent auditor hired to audit the company’s financial reports, however, it was discovered that the Auditor colluded with management to affect the accounting fraud. The auditor was later terminated by the board of the directors following the discovery of the Fraud.

Weak accounting and audit structures; Companies that lack sound structures and procedures to guard against accounting malpractice unknowingly expose themselves to possible accounting fraud as unethical management teams can exploit this loophole. Absence of sound whistle-blower policies make it hard for company staff to report accounting fraud to regulators especially for publically listed companies as cases of fraud are reported to the very management team that may have colluded to commit fraud. Accounting officers at WorldCom attempted several times to report the accounting malpractice at the company but were suppressed by their supervisors that were involved. This bought the management team the much needed time to execute the fraud for over 4 years.

Strategies of committing accounting fraud

In order to mitigate the accounting fraud risks presented by the motivating factors explored in the previous section. Company directors must explore the methods employed by management in concealing accounting fraud in order to implement appropriate preventive and remedial measures. Below are some of the antics used by preparers of financial statements to conceal accounting fraud.

The over valuation of company assets; financial management teams can omit information associated with costs such as asset depreciation or items in the inventory that are considered to be obsolete of no value in order to increase the book asset value. WorldCom management capitalised their long distance line expenses on their balanced sheet and as a result inflated their net incomes giving their investors a wrong picture of the company’s financial performance. This expense was material given that interconnection expenses accounted for approximately 50% ($3. 8 Billion) of the company’s revenue.

Understatement of company expenses: Manager can understate a company’s expenses by holding the expenses the business incurred in one period and declaring them in the next accounting period so as to skew the balance sheet in the accounting period for which they are reporting. Over a period of four years (1999-2002), WorldCom declared accruals of line expense in 1999 and 2000 after which no large accruals were reported even thou the item was the company’s largest expense.

Understatement of liabilities: Accounting officers can misrepresent the actual value of the liabilities of a business by reducing their book value. WorldCom’s management reduced the book value of their line costs by releasing accruals that had been established for other purposes. The reduction of these costs was inappropriate because such accruals, to the extent determined to be in excess of requirements were not released against the relevant expense when such excess arose.

Overstatement of company revenues: Managers can over book a company’s revenue figures by use of inflated sales. This is generally accomplished either by entering fake sales in books of accounts or by booking a sale into the financial records before the revenue from the sale is actually earned. The “close the gap” strategy WorldCom to fraudulently book the differential between the actual revenues and targeted revenues as unallocated corporate revenue in the quarter ending month is one such manipulation.

The Misapplication of the GAAP Rules: Management teams that have acquainted themselves with all of the rules and regulations for the FASB and GAAP can exploit the loopholes intentionally so as to commit financial statement fraud. In the case of WorldCom, management used general accrual accounts to accumulate excess accruals from other accounts and later released the accruals to offset expenses for which they may not have been established originally as well as to replenish under-funded accruals so as to increase reported income.

Preventive measures

This section of the write up focuses on some of the steps that can be taken by a company’s board of directors to manage accounting fraud and its associated activities.

Establishment of a sound internal accounting framework

Management teams can establish internal protocols to ensure adherence to the proper application of GGAP rules in the treatment of accounts and preparation of financial reports. This minimises the opportunities available to unethical managers to intentionally manipulate the rules to their advantage. The protocols are to explicitly guide the accounting officers on how to apply the accounting rules in their daily operations and allows for quick identification of deviations. Instituting a reporting framework. According to the 2014 report from the Association of Certified Fraud Examiners (ACFE), over 40% of occupational fraud is detected because of a tip. This could be from employees, creditors, customers and even competitors. It is thus important that companies have frameworks that encourage whistle blowing. Employees that are likely to engage in fraud will be deterred by the knowledge that management has monitoring tools in place and that they can easily be tipped off by anyone that may discover the employee’s fraudulent activity.

Selection of credible independent auditors

It is imperative that the board of directors appoints an auditor with minimal ties to the board as well as the management team of a corporation. This will minimise the likelihood of collusion between the external auditor and the management team of the company in concealing fraudulent activity. The audit team will be able to comfortably execute their duties with objectivity. In the case of WorldCom, it was discovered that the management team had colluded with Arthur Anderson to conceal the fraud being committed by the company. Instituting of internal controls such as an internal compliance team. The board of directors can engage in activities such as segregation of duties as well as enforcement initiatives such as set up a compliance division within a company’s structure. Segregation of duties allows management identify the sources of anomalies quickly as the author of suspicious information can easily be identified. A compliance division enables management enforce the protocols put in place during the company’s day to day operations.

Evaluation of incentives given to a company’s management team to motivate performance

The board has to make careful considerations in the incentive structure offered to its management team, as these incentives can increase the risk of accounting fraud. Offering Chief Executive Officer’s equity in a publically listed company exposes the company to risks such as misdirection of efforts by the CEO’s towards growing the share value as opposed to sustainable growth of the company. Regular financial reporting activities. Management committees can institute periodic financial reports with shorter accounting periods to allow better visibility on the financial position of a company. Monthly financial reports enable management have a better view of the company’s performance and identify anomalies than annual reports as it is hard to identify the source of the anomalies over a larger reporting period.

Comparison of the company’s financial reports with competitors to obtain the relative financial position of the company against its competitors as well as the industry base line.

This enables decision makers to quickly identify elements of exceptional performance as well as fraud indicators. Comparison of WorldCom’s financial statements with those of competitors operating in the same business environment was one of the activities that were engaged in to ascertain the anomalies in the company’s reported financial performance.

Know your employees

Management can set up sound human resource structures to enable them have a proper understanding of their employees this includes their backgrounds, financial situations and their motivating factors. This enables them identify employees that are likely to involve themselves in fraud at the workplace. Employees with great financial constraints are highly susceptible to engaging in fraud as they are desperate to get money and are likely to do anything to obtain it. Instituting proper documentation procedures. Documentation is a very key in the verification of financial reports and management has to ensure that accounting officers comply with the expected documentation procedures. This enables auditing teams verify the financial reports with physical paperwork. Financial records without corresponding documentation are quickly identified and investigated before being cleared as genuine.

Conclusion

Publically listed companies are exposed to an array of risks both external to the organisations as well as internal risks. The majority of these risks being internal, the board of directors of such companies are expected to set up controls to minimise the exposure towards the fraud risks taking into account the various factors that motivate employees and managers into participating in accounting fraud. Despite the majority of the proposed controls being administrative in nature, there is also a need for company directors to encourage ethical behaviour amongst their employees thru non administrative methods.