Table of ContentsIntroductionAccounting FraudCreative AccountingFinancial StatementsThe Case Study: WorldComDrivers of Accounting FraudAccounting Fraud StrategiesPreventive MeasuresEstablishing a Sound Internal Accounting FrameworkSelection of Credible Independent AuditorsAssessment incentives given to the leaders of a company's management team to motivate performanceKnow your employeesConclusionWorldCom was a large telecommunications company in the United States that enjoyed an almost meteoric rise during the 1990s, but then struggled early on of the 2000s, especially 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 director of a listed company and you have been asked to prepare a report to present at the next board meeting; discuss in detail the particular factors that motivate financial statement preparers to engage in accounting fraud, as well as the safeguards available to prevent accounting fraud. Say no to plagiarism. Get a tailor-made essay on “Why Violent Video Games Should Not Be Banned”? Get an original essayIntroductionThe purpose of this article is to introduce 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 financial statement preparers to commit accounting fraud as well as measures that can be used to minimize exposure to the risk of accounting fraud. It is important that readers familiarize themselves with a number of terms relating to accounting fraud and in the following section key terms will be defined for this purpose. Accounting Fraud Accounting fraud is called a scenario in which the owners or managers of a company deliberately misrepresent financial data. data in such a way as to present a false record of a company's financial condition. The goal of accounting fraud is to hide material omissions that are not flagged by financial audits and most often results in harm to creditors, investors and potentially employees. Creative AccountingAccording to Investopedia, creative accounting is a classification of accounting procedures, practices, and activities that comply with mandatory accounting laws and regulations while conflicting with the objectives that the standards seek to achieve. These practices exploit loopholes in accounting standards to falsely present a superior financial and corporate image of the company for which the financial reports are prepared. Although creative accounting practices are legal, the results of such activities may result in material alteration of a business entity's financial information and users of that information may be induced to make erroneous decisions.Financial StatementsFinancial statements are reports prepared by an entity and are a formal representation of the financial activities and financial condition of that entity. Relevant financial information is presented in a structured and easy-to-understand manner to enable users such as management, government, creditors, lenders and the public to make appropriate decisions regarding the entity. The Case Study: WorldComWorldCom was an American telecommunications company originating from Clinton, Mississippi, United States, the result of amerger between WorldCom and MCI Communications. The company was the second largest long distance telecommunications company and was publicly traded and traded on the New York Stock Exchange. In 2002, a team of internal auditors revealed a $3 accounting fraud. 8 billion, which triggered a series of events, including an investigation by the United States Securities and Exchange Commission (SEC) in June 2002. The investigation revealed that the company had inflated assets of approximately $11 billion and the company filed for bankruptcy on July 21, 2002. Motivators of Accounting Fraud In this section, the article explores the factors that motivate financial statement preparers to engage in accounting fraud: Periods of high economic performance: an economy The boom is a period characterized by economic expansion and is generally a peak phase of the economic cycle. Economic activity increases in the areas of gross domestic product, productivity and income. Business sales increase, which drives up profits. This period is generally accompanied by a bull market in stocks and a bear market in bonds. During this period, managers may take advantage of the bull market to drive up the price of a publicly traded company's stock by falsifying financial reports. Existing and potential investors are easily fooled into expecting good news from an economic performance of this nature. In the 1990s, WorldCom relied on its stock price as a source of capital to finance its acquisitions, and the success of its strategy depended largely on the steady rise in its stock price. The dotcom bubble of the late 1990s was an opportunity for CEO Benard Ebbers and WorldCom's management team to position the company's stock as a high-quality buy for the bull market. the companies they control and therefore seek personal financial gain from their actions. Falsifying financial reports will in these cases become a means to an end, as exceptional financial performance will result in an increase in the value of their shares which they can then pass on to potential buyers. Bernard Ebbers owned shares of WorldCom and devoted his energy to building and protecting the value of his shares. Therefore, a gain or decline in the value of WorldCom's stock had a direct impact on its finances, which incentivized the CEO to commit fraudulent acts. force the value of the company's shares. High Performance Pressure: Management may engage in accounting fraud due to pressure from investors and other stakeholders to exhibit exceptional financial performance, even during difficult economic times. High performance targets and expected performance trends may lead management to use aggressive accounting methods to present required performance results. This was no different for WorldCom as the company presented itself as a high-growth company and, given that revenue growth was a critical part of WorldCom's initial success, deteriorating market conditions across the industry telecommunications in 2000 and 2001, WorldCom under pressure to perform resorted to accounting fraud in order to continue posting impressive revenue growth figures. Promises of double-digit growth on Wall Street translated into pressure within WorldCom to achieve those results. Dishonesty and lack of ethics on the part of managers: managers who are naturallydishonest and unethical people are more likely to engage in accounting fraud with little or no respect. as for the consequences of their actions, they are motivated by personal gain and nothing else. WorldCom's management team demonstrated the same characters by knowingly driving the company into bankruptcy while hiding information about poor financial performance from investors, regulators, lenders and even company staff. The financial director, Sullivan, ordered the creation of false accounting entries to make it appear that the company had achieved its target performance. Additionally, members of various accounting teams who knew or suspected fraud was occurring failed to report the matter to regulators as required by ethics, while some attempts by accountants to report cases were unsuccessful. been repressed by supervisors. High debt levels: Highly indebted companies may engage in financial statement fraud to ensure that their lenders and creditors are not suspicious of the company's ability to pay its obligations. 14 financial institutions were part of WorldCom's list of creditors with a debt value of $45 billion. Poor financial performance of the company would diminish its financial credibility and automatically trigger efforts by its creditors to recover their funds and a concomitant decline in the value of the company's shares due to loss of investor confidence. Focus on accounting rules rather than principles; Managers may seek to exploit accounting rules to conceal financial wrongdoing rather than properly presenting a company's books. WorldCom used a strategy called “Close the Gap.” » For much of 2001, the company's business operations and revenue accounting groups tracked the difference between projected and target revenues and kept a tally of accounting "opportunities" that could be exploited to close this income gap. They would then identify, measure and account for the amount necessary to achieve the Company's external growth projections. They would account for these amounts based on GAAP standards. Lack of auditor independence: Managers may have close relationships with a company's auditors, which may affect the objectivity of their financial audits, as auditors are likely to conceal management's poor financial practices in order to earn. favor in the form of long-term consulting contracts as well as secret rewards. In the case of WorldCom, Arthur Andersen LLP was an independent auditor hired to audit the company's financial reports. However, the auditor was found to have colluded with management to influence the accounting fraud. The auditor was subsequently fired by the board of directors following the discovery of the fraud. Weak accounting and audit structures; Companies that lack strong structures and procedures to guard against accounting misconduct unknowingly expose themselves to possible accounting fraud because unethical management teams can exploit this loophole. The lack of good whistleblower policies makes it difficult for company staff to report accounting fraud to regulators, particularly for publicly traded companies, as fraud cases are reported to the accounting team. very management which could have colluded to commit fraud. WorldCom's accountants repeatedly attempted toreport accounting misconduct within the company, but were suppressed by their supervisors involved. This gave the management team much needed time to execute the fraud for over 4 years. Accounting Fraud Strategies To mitigate accounting fraud risks presented by the motivators explored in the previous section. Business leaders should explore the methods used by management to conceal accounting fraud in order to implement appropriate preventive and corrective measures. Below are some of the tricks financial statement preparers use to hide accounting fraud. Overvaluation of company assets; Financial management teams may omit information associated with costs such as asset depreciation or inventory items that are considered obsolete and worthless in order to increase the book value of the asset. WorldCom management capitalized its long distance line expenses on its balance sheet and consequently inflated its net revenues, giving its investors a false picture of the company's financial performance. This expense was significant given that interconnection expenses accounted for approximately 50% ($3.8 billion) of the company's revenue. Understatement of company expenses: The manager can understate the expenses of a company by withholding the expenses incurred by the company in a single period and reporting them in the next accounting period so as to distort the balance sheet for the accounting period for which they report. Over a four-year period (1999-2002), WorldCom reported accruals for line expenses in 1999 and 2000, after which no significant accruals were reported, even though it was the largest line item. the company's largest expense. Understatement of liabilities: Accountants can misrepresent the true value of a company's liabilities by reducing their book value. WorldCom management reduced the carrying value of its line costs by releasing accruals that had been established for other purposes. The reduction in these costs was inappropriate because these accruals, to the extent that they were deemed to exceed requirements, were not charged to the relevant expenditure when such excess arose. Overestimation of company revenue: Managers may overstate a company's revenue using sales figures. This is usually done either by recording false sales in the account books or by recording a sale in the financial records before the revenue from the sale is actually earned. One such manipulation is WorldCom's "close the gap" strategy of fraudulently accounting for the gap between actual and targeted revenues as unallocated corporate revenues in the month ending the quarter. . Misapplication of GAAP Rules: Management teams that have become familiar with all FASB and GAAP rules and regulations may intentionally exploit loopholes to commit financial statement fraud. In the case of WorldCom, management used general accrual accounts to accumulate excess accruals from other accounts and then released the accruals to offset expenses for which they may not have been established at the time. origin as well as to replenish underfunded regularizations in order to increase declared income. .Preventive MeasuresThis section of the write-up focuses on some of the measures that can be taken by the board of directors of a company to manage accounting fraud and its activities.