Critical Review: Agency Problems in Accounting Fraud Cases

This report provides a critical review of agency problems in the context of accounting fraud, focusing on the conflicts of interest between shareholders, managers, and directors. It examines two prominent case studies: WorldCom and Enron, detailing how these companies suffered from fraudulent activities due to agency problems. The report highlights the issues of information asymmetry and conflicting objectives, which led to significant financial scandals. Furthermore, it offers recommendations to mitigate agency costs, such as implementing robust internal accounting governance, transparent financial records, incentive compensation, and fostering an ethical workplace culture. The analysis underscores the importance of clear regulations, ethical conduct, and effective monitoring to prevent accounting fraud and protect stakeholder interests. The report concludes that addressing agency problems is crucial for reducing agency costs and promoting a fair and transparent business environment.

Introduction
The assignment provides a critical review on agency problems in the area of
accounting fraud. In the assignment, there will be a brief review at the two case
studies and its implications of conflict between shareholders, managers, directors
and investors. Furthermore, recommendations to avoid the agency costs will be
mentioned in the last part of the assignment.
Agency Problem
The agency problem is a conflict of interest that happens between the agent and the
principals. The owner of the company, also called principals, is unable to perform
day-to-day management. Agents are hired to represent and make decisions on
behalf of the company. Agency problems arise due to the different aims and
objectives between the agent and the principle, coupled with uncertainty and
information asymmetry. (Hayes, 2021)
Conflicts
In theory, the goal of the manager is to maximise the wealth of the company.
However in practice, the managers are more concerned about maximising their own
wealth and benefits. So it is faltering that managers would work their best to promote
the value of the company. There is also a possibility that the manager may tend to
play safe at an acceptable level instead of trying his/her best to maximise the value.
Thus, the impact of the rise in agency problems is affecting the performance and
leads to a decrease in corporate value and fails to meet investors’ expectations and
cause them to lose money.

WorldCom
One of the famous examples of accounting fraud is WorldCom. WorldCom was
founded as a small company named Long Distance Discount Services (LDDS) in
1983 and soon merged with Advantage Companies Inc to become WorldCom Inc.
Under the CEO Bernard Ebbers’s management, WorldCom has rapidly grown and
successfully become the second-largest telecommunications company in the US,
and was downfall to bankruptcy in 2002.
Later, WorldCom accumulated almost $40 billion in debt and spent almost $61 billion
on acquisitions. (Center, 2003) In late 1997, Ebbers offered to merge with MCI at the
amount of $30 billion and $5 billion in additional in MCI debt. Due to the
inconsiderate decisions made, Ebbers and the managers repeatedly counterfeit the
financial statement to prove to the public and investors that WorldCom is creating
profit. The scandal was uncovered by the head of the internal audit department,
Cynthia Cooper in 2002. (Carozza, 2008) Eventually, WorldCom declared bankruptcy
because of understatement and improper capitalization of operating expenses and
the overstatement of revenue.
Agency Problem Between Shareholders and Directors
First agency problems can be brought up in the WorldCom case. In the business
company, agents are required to protect the interests expected by the principal and
closely monitor the company’s performance to maximise the value of the company.
Agents represent directors and principals represent shareholders. Agents failed to do
the necessary checks and monitoring the company’s activities, thus it leads to the
business failure. As the result of over trusting Ebbers, agents failed to implement the
required legal framework within WorldCom and ignored the interests of principals.
Agency Problem Between Directors and Managers

The second agency problem in the WorldCom case occurs between the directors
and Ebbers who was voted in by the board of directors. Ebbers prioritised
maximising his own welfare instead of the company’s value. (Case Study: WorldCom
Accounting Scandal, 2021) During this time, he is trying to increase his ownFirm
well-being by using his positions, authorities, and the trust from the directors.
Enron
Another famous example of accounting fraud is Enron who was named the most
innovative company by Fortune Magazine for 6 years from 1996 to 2001. Enron was
a very successful company and it seems a great company to invest in. However, the
company used improper accounting methods to make Enron look more productive
and profitable while it is already just a shell company.
The managers used fraudulent accounting methods to adjust the numbers on paper
to hide the debts and mark the revenue higher for a few years. Enron fell to a stage
where the share prices dropped from $90 to a few cents per share and the truth was
finally discovered in late 2001. Several Enron executives were charged with financial
violations, and followed by the accounting firm Arthur Andersen also convinced to
justice. (Nigam, 2022)
Agency Problem Between Managers and Shareholders
The agency problem found in Enron is there was a significant amount of information
asymmetry between the managers and shareholders. (Corporate Finance Institute,
2021) Both executives CEO Skilling and CFO Fastow were using their authority to
convert the company’s value to their own incentives. Skilling implemented the
accounting method of mark to market accounting to build assets and convinced the
investors that Enron is earning profit while it is already in a loss situation. Fastow
was hired to conceal the deficit of Enron by creating a special purpose vehicle which

acts as a risk monitor. (Hayes, 2021) The bogus accounting statement and
manipulation of the stock price have successfully driven Enron from heaven to hell.

Recommendations to Avoid Agency Cost
Agency cost is a type of internal expenses that includes the hiring cost to take on a
task, along with the cost of managing the principal-agent relationship and resolves a
variety of priorities. The harder the task is, the higher the agency cost involved.
Agency Cost in WorldCom Case
The accounting fraud in WorldCom is avoidable if both managers and directors do
their duties as executives. To avoid agency costs in the WorldCom case, a
professional internal accounting governance should be implemented in order to have
a stricker audit in the financial statement. Instead of hiring an external auditor, the
company should keep their financial records transparent, routinely audit by an
internal auditor and review by the directors. In addition, the financial manager has
the right to report directly to the national audit office if he/she discovers any improper
transaction records and no legal liability is required.
Agency Cost in Enron Case
The conflict found between Enron’s shareholders and managers causes agency
costs. The solution to the mentioned conflict is to implement incentive compensation
like stock ownership, which can be included as a value added performance bonus to
the managers. The plan should align the manager’s interest with shareholders as
much as possible in order to make managers act like them. On top of the basic
bonus that managers receive, incentives will be given based on their long-term
performance in the company. This method not only helps them to stay longer in the
company, but it also provides equity in the workplace.

Conclusion
There are several parties who are responsible for the accounting fraud that
happened in WorldCom and Enron. From the senior management to managers, they
should be fair and raise up the enquiry whenever they have found suspicious
behaviours in the company. Rules and regulations should be more clear and
consistent to form a culture that every employee and even company owner carry out
an ethical workplace. Applying the proper system to reduce the agency problem
would hence reduce agency cost.

References
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Case Study: WorldCom Accounting Scandal (2021) MBA Knowledge Base.
Center, M., 2003. WorldCom. [Online]
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https://www.scu.edu/ethics/focus-areas/business-ethics/resources/worldcom/
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Chen, J., 2022. Agency Problem. [Online]
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Corporate Finance Institute, 2021. Enron Scandal. [Online]
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https://corporatefinanceinstitute.com/resources/knowledge/other/enron-scandal/
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Hayes, A., 2021. Special Purpose Vehicle (SPV). [Online]
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Hayes, A., 2021. The Agency Problem: Two Infamous Examples. [Online]
Available at:
https://www.investopedia.com/ask/answers/041315/what-are-some-famous-scandals
-demonstrate-agency-problem.asp
[Accessed 22 May 2022].
Nigam, R., 2022. Enron Scandal. [Online]
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