Lessons for Auditors and Regulators from the WorldCom Fraud - Essay Example

 Lessons for Auditors and Regulators from the WorldCom Fraud Introduction WorldCom was the second largest listed long-distance phone company, which acquired other telecommunication corporations such as the MCI communications and thus grew aggressively. Later on, WorldCom was faced with corporate fraud where its financial executives undertook to hide certain expenses during the period of 2000 to 2002. The financial executives sought to misrepresent and delay reporting particular expenses to give investors a false growth picture of the company’s stock prices. The fraud was undertaken by representing line costs as capital, rather than expenses and inflating revenue on the financial statements. However, a team of internal auditors later on came to discover the fraudulent representation of financial statements and notified the Company’s board of directors and audit committee, who acted swiftly although the company had already become bankrupt (Albrecht, Albrecht, Albrecht & Zimbelman, 2011, 457). Lessons from WorldCom Fraud Lessons learnt from WorldCom fraud presents a broad range of issues to put into consideration such as, the importance of fraud auditors to have knowledge and an understanding of corporate systems and processes. Lessons have it that routine internal audit processes may not expose fraud, since auditors focus on providing assurance with respect to effective controls, rather than detecting irregularities as `possibilities of fraud. Fraud auditors should actively seek to identify irregularities and anomalies as indicators of fraudulent behaviors among financial executives and general corporate staff, and use the knowledge to undertake further in-depth analysis to root out fraud. Fraud detection in corporate organisations relies on the knowledge and understanding of auditing and detection by officials of the fraud background, fraud schemes, principles, and indicators (Singleton & Singleton, 2010, p.145). WorldCom internal auditors were well conversant with the organisation’s culture and choices of recording the financial statement, which helped them immediately to recognise the $2 billion operating cost recorded as a fixed asset. This came out as a red flag unlike the normal culture of the organisation, more so when an official referred to the expenditure as prepaid capacity. Auditors’ understanding of the normal organisations culture was able to detect the omission of lease line cost in the operating expense account as a fraud (Rezaee & Riley, 2010, p.212). However, new loopholes in financial statements often require auditors to improve and devise new ways of detecting fraud, since past indicators may not be applicable in future fraud cases. Corporate fraud has continuously advanced with the computerisation of operations, and thus requires fraud auditors to be proactive in improving their fraud detection schemes. Corporations need to put in place mechanisms for assessing fraud as an organisation’s risk, and approach the risks using relevant internal audit methodologies. Fraud auditors should also be keen with regard to the presence of indicators of fraud, and design relevant controls and prevention methods of fraud. However, proactive fraud seeking auditing activities may be costly for organisations, though not comparable to extent of loss in case of successful fraud. Cost involved may include knowledge expansion in the area of fraud detection and more so, the use of electronic-detection tools. Internal auditors have the mandate to understand an organisation’s corporate culture, conditions, and choices that may have been used by fraudsters in engaging in financial statement fraud. Such an understanding would go a long way in providing accurate indicators of fraud and possible fraud in future of the organisations in consistency with fraud risk levels that organizations face (Rezaee & Riley, 2010, p.213). Fraudulent individuals may include brokers-dealers, financial advisors, and private investors who seek to mislead clients with respect to inside information, while corporate officials may hide and alter information to deceive shareholders. Such deceptive fraudulent activities may involve accounting fraud where inaccurate books of accounts are kept to intentionally present false information and misrepresentation of information by presenting misleading information about an organisation. On the other hand, shareholder fraud occurs when representatives of a corporation falsify revenue and profitability report, or conceal its debts to mislead stockholders and investors, as in the case of WorldCom. According to Nguyen (2008, p.7), financial statement fraud occurs from intentional mis-statements in financial reporting to mislead users of financial statements with regards to actual situation. Mis-statements may also arise from misappropriation of an organisation’s assets, where misleading records are presented to hide the missing assets that have been misappropriated. Corporate fraud involves securities fraud where investors and security traders are deceived of the actual values involved. Perpetrators of such fraud include analysts, stockbrokers, brokerage firms, private investors, and corporations who act on inside information. Corporate fraud is overseen by Securities and Exchange Commission and National Association of Securities Dealers, which seek to protect investors and traders of securities. Fraud may also include investment fraud where brokerage houses manipulate their markets by offering misleading information to their investors in an effort to manipulate the market. Bodies such as Securities and Exchange Commission set standards for brokerage houses to handle flow of inside information in a manner that is not misleading. Internal auditors should therefore be well conversant with all types of fraud in addition to having a heightened understanding of the organisation’s culture and loopholes for possible fraud. This would enable them to easily identify possible fraud through indicators and irregularities involved. Research has it that executives and employees of corporations can manipulate fraud situation more easily where auditors are not using the red flag checklist and more so, in line with fraud risk levels that face an organisation. Specific red flag indicators in line with fraud risk levels serve well as a continuous assessment checklist to render fraud situations impossible through the lifetime of an organisation (Sutton, 2006, p.65) The Sarbanes-Oxley Act The Sarbanes-Oxley Act is a legislation that was put in place to help restore investor confidence through regulation of companies listed in the financial markets with regards to accuracy and reliability of auditing practices, accounting, and financial reporting. The Act imposed new regulatory obligations on attorneys, analysts, brokerage firms, and the accounting profession in general through certification requirements of financial statements (Ambler, Massaro & Stewart, 2010, p.4). The Sarbanes–Oxley contains eleven aspects that clearly address requirements and specific mandates of corporations with respect to financial reporting. The aspects include the Public Company Accounting Oversight Board, Auditor Independence, Corporate Responsibility, Enhanced Financial Disclosures, Analyst Conflicts of Interest, Commission Resources and Authority, Studies and Reports, White Collar Crime Penalty Enhancement, Corporate and Criminal Fraud Accountability, Corporate Tax Returns and Corporate Fraud Accountability (Ambler, Massaro & Stewart, 2010). The Public Company Accounting Oversight Board provides an independent oversight on auditors and more specifically, public accounting firms. The board also creates a central oversight, tasked with defining specific procedures and processes for audit compliance and audit registration. More so, the board oversees policing conduct, inspection, and quality control alongside compliance enforcement with particular mandates of SOX. Auditor Independence on the other hand establishes external auditor independence standards in order to eliminate conflicts of interest. This aspect addresses approval and reporting requirements, and audit partner rotation for new auditors alongside restricting auditing firms from provision of non-audit services such as consultancy (Garner, McKee & McKee, 2008, p.62). Corporate Responsibility mandates senior executives of corporations to take individual responsibility for completeness and accuracy of their financial reports. This further defines interaction of organisation’s audit committees and external auditors, and specifies corporate staff responsibility for validity and accuracy of an organisation’s financial reports. More so, it outlines specific limits concerning corporate staff behaviors and specific civil penalties and forfeitures of benefits for non-compliance. Enhanced Financial Disclosures describes enhanced financial reporting requirements for corporate staff stock transactions, financial transactions, pro-forma figures and off the balance sheet transactions. It also requires internal controls and mandates both reports and audits on controls to assuring the accuracy of disclosures and financial reports and disclosures, while placing emphasis on timely reporting of particular reviews enhanced by corporate reports agents and material changes in status of finance. Analyst Conflicts of Interest is also an important aspect which includes measures that are designed to assist restore confidence of investors in analyst’s reporting of securities by defining codes of conduct for this particular analysts and requires them to disclose any conflicts of interest that may arise. Commission Resources and Authority defines practices to be used in restoring confidence of investors. The commission also defines authority of Securities and Exchange Commission with respect to censuring professionals from practice by specifying conditions under which professionals may be prevented from practice (Warren & Duchac, p.315). Studies and Reports requires the Securities and Exchange Commission and controller general to perform various researches and reporting concerning the role of agency ratings in security markets operations, the effects of public accounting firms consolidation, enforcement actions and their security violations among other acts of financial conditions and earnings manipulation. Corporate and Criminal Fraud Accountability outlines particular criminal penalties for alteration, manipulation, and destruction of financial records and fraud investigations interference with investigations while providing protections to whistle-blowers. On the other hand, White Collar Crime Penalty Enhancement increases criminal penalties that are associated with collusion and white-collar crimes and recommends heavier penalty guidelines to failures of certify criminal offenses with regards to financial reports. Corporate Tax Returns mandates chief executive officers to sign tax returns of companies while Corporate Fraud Accountability identifies and links record alteration and corporate fraud criminal offenses with relevant penalties. More so, it revises guidelines for sentencing and strengthens relevant penalties while enabling Securities and Exchange Commission to temporarily freeze suspicious transactions that have been deemed unusual (Holt, 2006, p.3-6). The Financial Reporting Council The Financial Reporting Council s the independent regulator of the United Kingdom that is responsible for enhancing and supporting financial reporting and corporate governance at high quality standards to promote investment. The council generally seeks to enhance high standards in corporate governance with the enforcement of the United Kingdom Corporate Governance Code. The council particularly sets standards for actuarial practice and corporate reporting and oversees enforcement of quality auditing and accounting standards. It acts as an oversight to professional accountancy, actuarial profession bodies regulatory activities and operates as an independent disciplinary body in support of public interest concerning accountants, and actuaries conduct. This is in support of the strong connections that are believed to exist between the professionalism of actuaries and accountants and the issues of prudent corporate reporting and corporate governance along with the auditing and actuarial practices (Volosin, 2007, p.7) The Financial Reporting Council of the United Kingdom is an entity that is limited by guarantee and is partly funded by the industry and government. The Secretary of State for Business, Innovation, and Skills appoints its board of directors while its subsidiaries play a vital role in developing and overseeing standards of corporate governance in the United Kingdom. Perfect examples include standards of accounting industry and the United Kingdom Corporate governance code. The Financial Reporting Council also incorporates Accounting Standards Board, Accountancy and Actuarial Discipline Board, Financial Reporting Review Panel, Auditing Practice Board, Professional Oversight Board and Board of Actuarial Standards as its operating bodies. In totality, with all its organs of operations, the council seeks to monitor the corporate governance combined code’s operations and approve any alteration to it alongside providing advice on issues concerning budgets, strategies, and structure (Gray & Manson, 2008, p.114: Gee, 2006, p.16). The Audit Committee The United States Publicly traded corporations audit committees are Board of Directors operating committees that are charged with overseeing disclosures and financial reporting. Audit Committee members are members of the board of directors of an organisation with the Chairperson being selected from among the members of the committee members. Audit committees are a qualification needed for companies in the United States to be listed in the stock exchange to be empowered to acquire expertise and consultancy deemed necessary to satisfactorily oversee financial reporting and disclosures. According to Burke, Guy & Tatum (2008, p. 202), the audit committee concept has its origin from Mckesson & Robbins, Inc which had overstated its accounts receivables and thereafter saw the need to have a committee of non staff members to select external auditors to oversee such matters. Since the enactment of the Sarbanes Oxley Act, the role of audit committees has evolved to encompass complex and diverse functions such as risk management and regulatory compliance oversight with regards to increasing uncertainties. Other key responsibilities include risk intelligence, having co-operative relationship with the independent auditor, the management, and internal auditors alongside overseeing establishment of antifraud programs and appropriate controls. The committee also acts as an oversight to dissemination of financial information and earnings press releases while monitoring code of ethics and putting in place processes for investigating fraud allegations (Braiotta, Gazzaway, Colson, Colson &Ramamoorti, 2010, p.3). The audit committee is also required to report on its operations as a proxy statement component necessary for all public companies. The report serves as key means of communication to investors with regards to critical activities of the committee with regards to overseeing financial reporting. The audit committee report extends beyond the minimum disclosures to communication requirement and takes credit for overall audit performance in a particular publicly listed company. Publicly listed companies are dependent on its investors and stockholders who are subsequently influence by the overall functions and confidence in the audit committee (Spira, 2002, pp.1-8). The audit committee helps in fraud prevention by ensuring anti-fraud programs in internal controls are put in place to enable fraud detection, while constantly encouraging employees to act as whistleblowers and report any irregularities they come across. The audit committee further maintains an open line communication with the management and both external and internal auditors to ensure their responsibilities regarding potential fraud are carried out. More so, employees are better placed to notice possible fraud, and thus, the existence of audit committee provides employees with a system to privately discuss the matter in a bid to prevent fraud. ISA ISA 520 seeks to control the use of analytical procedures by practicing auditing professionals as substantive procedures. It also addresses the responsibility of auditors in undertaking analytical procedures with respect to completing audit tasks and generally assists audit professionals incoming up with overall financial statements conclusion. The processes further address the application of analytical procedures as procedures of assessing existing risks and provides guidance and requirements with respect to the nature, extent, and timing of audit procedure. Substantive analytical procedures may also be inclusive of analytical procedures and guidance with respect to risk assessment response to help in preventing fraud (Collings, 2011, p.174). External auditors also have the mandate of exercising professional skepticism when performing there duties and responsibilities. Auditors should follow the general standards and guidance put in place in performing financial audits and attestation engagements with regards to the generally accepted government auditing standards. Generally, Accepted government standards and ethical principles seek to establish a credibility foundation for the performance of auditors through compliance. General standards emphasize on the independence of professional audit individuals and audit organizations that have the mandate of exercising professional judgment. This is with respect to their work performance in preparing audit reports, auditing firms’ audit staff competence, external peer reviews and audit quality assurance and control. Auditors also need to have reasonable assurance that financial statements are free from material misstatements that may have been the result of fraud or error (Duska, Duska & Ragatz, 2011: Dauber, Qureshi, &Levine, 2009, p.40). Auditing profession should also seek to embrace Computer Assisted Audit Techniques in searching for anomalies in data files and to assist the internal accounting departments to achieve a more detailed analysis of financial statements in preventing fraud. Computer Assisted Audit Techniques also assists to support forensic accountants in extrapolating huge amounts of data for detection of fraud and further analysis. Such advancement comes in handy as large corporations have adopted the extensive use of information technology and thus necessitated information technology audit to curb material misstatement risks according to ISA 315. The dynamics of information technology in corporate operation has increased and developed fraud loopholes into more complex, advanced and ever-changing strategies that necessitates the use of advanced technology fit fraud detection methods such as Computer Assisted Audit Techniques (Moeller, 2009, p. 481: Puttick, Esch, Esch & Kana, 2007, p.492). Recommendations Fraud detection is generally dynamic and divergent since fraud indicators for the past may not be relevant for the present and future risks more so in the technologically dynamic world. Organisations are therefore advised to advance their fraud detection methodologies to embrace technologies such as for Computer Assisted Audit Techniques. It is also important that organisations carry out risk assessment and further training of auditors in IT aspects to enable them keep up with fraud dynamics. Risk assessment seeks to assist and focus attention of an organisations management on the significant risk of fraud facing the organisation. Fraud risk assessment may be systematic and recurring from previous periods while recognising the fact that the risks can involve a variety of levels of staff and management across the organisations functions in its entirety. Conclusion Fraud detection in its entirety relies on achievement of effective fraud risk assessment after which corrective measures are taken. Risk assessment needs to include specific schemes of fraud that could be used against the organisation. These schemes also need to recognise possible participation of staff and departments within an organisation and the likelihood of the schemes taking place in a particular period. More so, the assessment needs to recognise risks in both the present and future alongside the magnitude of each scheme to the financial status of an organisation. 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