IndexIntroductionAccounting FraudCreative AccountingFinancial StatementsThe Case Study: WorldComMotivators of Accounting FraudStrategies for committing accounting fraudPreventive measuresEstablishing a robust internal accounting frameworkSelecting credible independent auditorsEvaluating incentives granted to the company 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 later ran into trouble in the early 2000s, particularly 2001 it was difficult. This case offers future generations of accountants the opportunity to study the largest accounting scandal in history from the perspective of internal financial accounting. You have been appointed to the board of directors of a listed company and 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 commit accounting fraud and the safeguards available to prevent accounting fraud. Say no to plagiarism. Get a tailor-made essay on "Why Violent Video Games Shouldn't Be Banned"? Get an Original Essay IntroductionThe 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 introduced to the various factors that motivate financial statement preparers to commit accounting fraud, as well as steps that can be taken to minimize exposure to accounting fraud risk. It is important for readers to keep up to date with a number of terms relating to accounting fraud and the next section will define key terms for this purpose. data in order to present a false documentation of a company's financial situation. The goal of accounting fraud is to hide material omissions so that they are not flagged by financial audits and more often than not result in damage 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 mandatory accounting laws and regulations, while conflicting with the objectives that the standards are intended to achieve. These practices exploit gaps in accounting standards to falsely portray a superior financial and corporate image of the company for which financial reports are prepared. While creative accounting practices are legal, the results of such activities may result in a material alteration of a business entity's financial information, and users of this information may be influenced to make poor decisions. Financial Statements Financial statements are reports prepared by an entity and are a formal representation of the financial activity and financial position of that entity. Relevant financial information is presented in an easy-to-understand structured manner to enable users such as management, government, creditors, financiers and the public to make appropriate decisions in relation to the entity. The Case Study: WorldComWorldCom was an American telecommunications company originating in Clinton, Mississippi, USA, resulting from the merger between WorldCom and MCI Communications. The company was the second largest long-distance telecommunications company and was publicly traded and listed on the New York Stock Exchange. In 2002, a group of internal auditors revealed a $3 accounting fraud. 8 billion dollars and this set off a chain of events betweenincluding an investigation by the United States Securities and Exchange Commission (SEC) in June 2002. The investigation revealed that the company had inflated its assets by approximately $11 billion, and the company filed for bankruptcy on July 21, 2002. Motivators of the 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 Boom is a period characterized by economic expansion and usually represents a peak phase of the economic cycle. Economic activity increases in the areas of gross domestic product, productivity and income. Company 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 exploit the bull market to increase the stock prices of publicly traded companies by falsifying financial reports. Existing and potential investors are easily fooled as they expect good news during such an economic performance. In the 1990s, WorldCom relied on its stock prices as a source of capital to finance acquisitions, and the strategy's success depended largely on a steadily rising 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. Misplaced Incentives: Managers can own shares within publicly traded companies. companies they control and consequently seek to obtain personal financial gain from their stock holdings. The falsification of financial statements will in these cases become a means to an end because exceptional financial results will culminate in an increase in the value of their holdings which they can then pass on to potential buyers. Bernard Ebbers held equity interests in WorldCom and directed his energies into building and protecting the value of his net worth and, as a result, a gain or decline in the share value of WorldCom stock had a direct impact on his finances, this served as an incentive for the CEO to act fraudulently. force the share value of the company's shares. 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 difficult economic times. High performance goals and projected performance trends can lead management to employ aggressive accounting methods to represent required performance results. This was no different for WorldCom as the company presented itself as a high-growth company, and as revenue growth was a key component of WorldCom's early success, deteriorating market conditions across the industry of telecommunications in 2000 and 2001, WorldCom under pressure to resorted to accounting fraud to continue posting impressive revenue growth numbers. Promises of double-digit growth on Wall Street have translated into pressure within WorldCom to achieve those results. Dishonesty and Lack of Ethics on the Part of Managers: Managers who are innately dishonest and unethical are more likely to engage in accounting fraud with little or no consideration. by the consequences of their actions, they are motivated by personal gain and nothing else. WorldCom's management team hasdisplayed the same characteristics when he knowingly drove the company into bankruptcy, while hiding information about poor financial performance from investors, regulators, financiers, and even the company's own staff. CFO Sullivan directed the creation of false accounting records to falsely portray that the company had achieved expected performance. Furthermore, members of various accounting teams who knew or suspected fraud were taking place did not report the case to regulators as ethically required, while some attempts by accountants to report cases were repressed by regulatory authorities. vigilance. High Debt Levels: Companies with high debts may commit financial fraud in order to ensure their lenders and creditors are not wary of the company's ability to meet its obligations. 14 financial institutions were on WorldCom's list of creditors with a debt value of $45.7 billion. A bad financial performance of the company would diminish its financial credibility and automatically trigger efforts by its creditors to recover their funds and a simultaneous fall 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 hide improper financial practices rather than fairly represent a company's books. WorldCom has adopted a strategy called “Close the Gap”. For much of 2001, the Company's Business Operations and Revenue Accounting groups monitored the gap between projected and projected revenues and kept a running tally of accounting "opportunities" that could be exploited to close that revenue gap. They would then identify, measure and account for the amount needed to achieve the Company's external growth projections. They would record these amounts under GAAP standards. Lack of auditor independence: Managers may have a close relationship with a company's auditors and this can affect the objectivity of their financial audits as auditors are likely to hide poor financial practices by management to win. favor in the form of long-term consultancy contracts and secret fees. 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 following the discovery of the fraud. Weak accounting and auditing structures; Companies that do not have strong structures and procedures in place to safeguard against accounting abuse unknowingly expose themselves to possible accounting fraud as unethical management teams can exploit this gap. The absence of robust reporting policies makes it difficult for company personnel to report accounting fraud to regulators, especially for publicly traded companies, as cases of fraud are reported to the very management team that may have colluded to commit fraud. WorldCom accountants attempted several times to report the company's accounting abuses, but were repressed by the supervisors involved. This gave the management team much needed time to run the fraud for over 4 years. Strategies for committing accounting fraud In order to mitigate the risks of accounting fraud presented by the motivating factors explored in the previous section. The administratorsof the company must explore the methods used by management to hide accounting fraud in order to implement appropriate preventive and corrective measures. Below are some of the quirks used by financial statement preparers to hide accounting fraud. Overvaluation of company assets; Financial management teams may omit information associated with costs such as asset depreciation or inventory items considered obsolete and worthless in order to increase the value of accounting assets. WorldCom management capitalized long-distance expenses on its balance sheet and consequently inflated its net income, giving investors the wrong 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 business expenses: The manager can understate a company's expenses by withholding expenses incurred by the company in one period and reporting them in the next accounting period so as to distort the balance sheet in the accounting period for which they are reporting. For a four-year period (1999-2002), WorldCom reported line expense accruals in 1999 and 2000, after which no large accruals were reported even though the item was the company's largest expense. Undervaluation of liabilities: Accountants may misrepresent the actual value of a company's liabilities by reducing their book value. WorldCom management reduced the book value of line costs by releasing accruals established for other purposes. The reduction of these costs was inappropriate because such provisions, to the extent determined in excess of the requirements, were not released against the relevant expenditure when such excess occurred. sales. This is generally accomplished by entering false sales into the books or recording a sale in the financial records before the revenue from the sale is actually earned. WorldCom's "gap closing" strategy of fraudulently accounting for the difference between actual revenues and forecasted revenues as unallocated corporate revenue in the quarter-end month is one such manipulation. Misapplication of GAAP rules: Management teams familiar with all FASB and GAAP rules and regulations can intentionally exploit loopholes to commit financial reporting fraud. In the case of WorldCom, management used general accrual accounts to accumulate excess accruals from other accounts and subsequently released accruals to offset expenses for which they may not have been originally established, as well as to replenish underfunded accruals so as to increase reported income .Preventive measuresThis section of the article focuses on some of the measures that can be taken by a company's board of directors to manage accounting fraud and associated activities.Establishment of a robust internal accounting framework. Management teams can establish internal protocols to ensure compliance with the correct application of GGAP rules in the processing of accounts and the preparation of financial reports. This minimizes the opportunities available to unethical managers to intentionally manipulate the rules to their advantage. The protocols must explicitly guide accountants on how to apply accounting standards in their daily operations and allow for rapid identification of deviations. Establish a reporting framework. According to the Association of Certified Fraud Examiners (ACFE) 2014 report, more than 40% of workplace frauds are detected due to.