Accounting Fraud at WorldCom: Earnings Management and Governance Failure

ACCT3102 Individual Case Study Assignment ‘Accounting Fraud at WorldCom
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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.
Answer 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
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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
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