‘Accounting Fraud at WorldCom’
1. (a) Earnings Management is the accounting process of deliberately manipulating a company’s financial report to match or make a target. The procedure can also be considered income smoothing. The idea behind this is to even out the years profit and loss to show consistent fluid movement of sales rather than have periods of spiked sales or losses. This is achieved by adding or removing cash from reserve accounts, also known “cookie jar accounts”.
There are many reasons why managers would manipulate their own accounts. Some self-motivated and others motivated towards the shareholders and investors. A study done by Healy (1984) revealed that more managers would be motivated to manipulate net income once they have hit their minimum net income in order to maximise their own contractual bonus. Healy chose a sample of 94 firms with bonus compensation plans and analysed their figures over a period of 50 years. He empirically proved that the firms whose net income reported in between their minimum and capped net income (the maximum bonus that the manager may receive) had all reported positive average accruals. The accruals increased reported net income which in turn increased the manager’s bonus. Inversely, the firms that have bonus compensation plans but reported net incomes below the minimum income level or above their maximum cap showed negative average accruals. This reduced the company’s net income and allowed them to keep cash in reserves to utilize when they could maximise their bonus.
Another reason why managers chose to alter their reported earnings is to convey information to investors as shown in a study by Freidlan (1994). For example, if a company that has never been entered into the public securities market won’t have an established market price. So a company may likely manipulate their earnings to gain an increased short term net income so that investors can see a favourable reported net income and therefore they may bid up the initial market value of the firm.
WorldCom managed their earnings in two main ways. The first was by “releasing” accruals. The idea of this for WorldCom was to reduce the expected bill of line costs therefore lowering their potential liabilities with the excess being reflected in the overall net income of the company. It was Scott Sullivan, the CFO of WorldCom who first ordered staff to “release” the accruals, telling staff that they were too high for future cash payments.
The second way in which WorldCom managed their earnings was by capitalising the line costs. The idea of this was that WorldCom had an excess in network capacity, from lowered line rental sales and from provisions for future possibilities. Sullivan’s idea was that this excess could be considered as Capital Expenditure rather than Operating Costs. What this meant was that the expense of hiring their own non-revenue generating lines to prevent contractual violations (and in turn high termination fees) would be removed from the expense account and be placed into an asset account which he considered as “Construction in Progress”.
The main motivation for Sullivan’s actions was to maintain their 42% E/R ratio. In the face of a struggling economy, Sullivan wanted to show that WorldCom could still maintain their 42% E/R ratio to prevent their stock prices from dropping and maintain their market share.
I believe that there is a very fine line between earnings management and fraudulent reporting. The line is so fine that sometimes the edges get blurred and it becomes hard to distinguish what is fraudulent and what are creative accounting practices being put into place. However, this does give managers an excuse to rearrange their figures to fit their ratios. The most important aspect to factor into determining what is fraudulent and what is not is adequate disclosure. The SEC has outlined disclosure requirements in MD&A