Fraud Triangle and Fraud Scale - Bernie Ebbers and Scott Sullivan during the WorldCom Saga - Assignment Example

FОRЕNSIСS: WORLDCOM SAGA Name University COURSE TUTOR DATE FОRЕNSIСS: WORLDCOM SAGA Q1. Fraud Triangle and Fraud Scale to do a critical analysis of Bernie Ebbers’ and Scott Sullivian during the WorldCom saga The fraud triangle gives an insight to what must be in existence in order for fraud to take place. The three factors that must exist are rationalization, pressure, and opportunity. Rationalization is from the individual committing the fraud; the individual is under pressure to do so; and he/she must have the opportunity to commit the fraud. The three factors represent the fraud triangle and were first developed by Dr. Donald Cressey during his study of criminology with special focus on the behavior of fraudsters (Beresford, Katzenback, and Rogers, 2003). It is observed that pressure id the factor forcing the individual into an act of fraud. In most cases, individuals are pressurized to commit fraud by such financial aspects as failure to pay bills, gambling, desire for expensive items, and addiction to drugs. In the course of fraud prevention, the most essential factor of consideration is opportunity. There can be significant reduction of fraud one the opportunities for acts of fraud are eliminated. This has the implication that the prevention of fraud ends up being cheaper for organizations than the late-stage detection of the same, considering the little chance of recovering the costs that will already have been incurred. Internal controls, therefore, come into play with the factor of opportunity (Beresford, Katzenback, and Rogers, 2003). High creation and implementation of internal control is associated with low opportunities for employees to commit fraud. Ideally, companies ought to have effective and essential internal controls in order to gain maximum benefits. Internal controls are inclusive of information technology controls, supervision, and segregation of duties. On the other hand, rationalization entails excuses for the acceptability of fraud acts in a number of circumstances. There could be a strong rationalization, for instance a case of ransom in which an individual might lose his/her life without a medical emergency or the money needed for treatment. There are other examples of rationalization which include the perception that everyone is doing it; one deserves it for his/her hard work; the act of fraud being for a good cause; or the promise of paying it back (Beresford, Katzenback, and Rogers, 2003). The fraud scale was developed by Albrecht and is inclusive of a number of components. Firstly, the fraud scale is inclusive of situational pressures, personal integrity, and perceived opportunity. The fraud scale is also inclusive of alcohol or drug problems; living beyond an individual’s means; and high personal debt. The third component of the fraud scale entails personal integrity, situational pressures, and criminal record (Birnbaum et al 2001). The case of WorldCom was revealed via an internal audit in the year 2002. This audit revealed that the company has a number of transfers that were not in line with generally accepted accounting principles. In the course of 2001, alongside the first quarter of 2002, there was improper accounting for approximately $3.8 billion in company’s expenses. Ideally, cash flows of $797 million (2002 first quarter) and $3.055 billion (2001) had to be taken off the books; this erased all the profits reported by the company in that period (Birnbaum et al 2001). A critical analysis reveals pressure as the most influential element of the fraud triangle in the WorldCom case. The company’s top management had personal incentives towards fraudulently reporting financial statements so as to inflate the company’s financial position. The top management at that time was inclusive of Bernie Ebbers as the CEO and Scott Sullivan as the CFO (Birnbaum et al 2001). They had the motivation of making the company appear successful, thus recording income that would not have been realized if the actual losses made by the company had been recorded. According to the 2000 Filing Proxy Statement of WorldCom, the executive compensation plans of the company were characteristic of three elements: long-term incentive compensation, base salary, and annual incentive compensation. The committee played the role of setting the base salary on an annual basis on grounds of pay levels of executives in comparable organizations and the responsibility levels of the executives. The principal components in the determination of the amount of annual incentive compensation were inclusive of the company’s financial performance with respect to the overall economic and overall industry. This has the implication that in the absence of strong financial performance the company’s top executives would not receive handsome amounts of personal compensation. For instance, in the year 1999, CEO Bernie Ebbers and CFO Scott Sullivan received bonuses worth $7.5 million and $2.76 million respectively (Bobhit, 2002). This is, indeed, an extremely strong motivation for the two executives to commit fraud. On the other hand, the commit held the perception that long-term incentive compensation in form of stock options was an ideal means by which executive compensation could be made dependent upon shareholder value increases. According to the stock option plans of the company, there are means via which executive officers have the capability of building an investment in common stock-in doing so, the economic interest of the executive officers end up being aligned with shareholders’ interests. With respect to their long-term compensation, the fraud would have an immense deal benefit to the CEO and the CFO as there would be an increase in the company’s stock price as a result of increase in profits. This has the implication of an increase in wealth of the two top executives thus the potential of selling their shares in the course of the periods of manipulation of earnings (Bosley, 2001). There was also definite opportunity for the fraud considering that in involved top management and accounting personnel. These two top executives definitely had the capability of overriding the existing internal controls so as to commit the fraud. In the course of perpetrating the fraud, the two executives, perhaps, used the rationalization that it was a one-time incident that they would be able to make up for in the future. Such components of fraud scale as perceived opportunity and personal integrity played a significant part in the fraud. The two top executives had the perception that this was a great opportunity to hurt the investor while benefiting themselves, with no adverse effects on the organizations. In addition, it was an issue of personal integrity considering that the fraud was perpetrated by two individuals who were top executives of the company (Charan, Useem and Harrington, 2002). Question 2 If WorldCom was operating in Australia, a journal entry would be termed as an internal transaction of accounting with an objective of making an attachment or a transfer. Ideally, a journal entry ought to show two aspects of a transaction, which are ‘credit’ and ‘debit’, alongside indicating the ledger accounts due for charging. Accounting reporting standards require that debit components’ total value be match the credit component’s total value. A journal entry is inclusive of an explanation that is meaningful and ought to be substantiated via the use of relevant supportive documentation. It is reported that Angela Walter and Dan Renfroe made journal entries worth $771 million and $150 million, respectively, in the absence of substantive supporting documentation (Coope, 2002). In the year 2001, Sullivan gave a direction to General Accounting to make a reduction of the expenses for line costs of the Wireless division in $150 million, in attempts to reduce line costs. Delores DiCicco was called by a General Accounting employee to reduce the line costs, but to her surprise, the journal entry did not have supporting documentation. Instead, DiCicco was instructed by Sullivan to go ahead with the journal entry since she would, at the long run, find $150 million in savings-this was said to be from WorldCom’s disputed billings (Coope, 2002). However, DiCicco insisted that the journal entry would not be made until the savings were found. As a result, a subordinate staff of Vinson, Daniel Renfroe, made the requested journal entry in General Accounting. Wireless accounting was surprised if the entry made by Renfroe had impact on one of the state tax returns of the company. Upon the reception of an email of this question, from a Wireless employee, Renfroe forwarded the email to Vinson, his superior, who in turn forwarded it to her superior by the name Yates. Yates made a response in writing to Walter Nagel, a Tax Counsel of WorldCom, instead of giving a direct response to Wireless Accounting (Coope, 2002). According to standard accounting principles these entries can be termed as ‘false accounting’ considering that they did not have documented support to substantiate them. Ideally, standards of accounting reporting bring up journal entries with the objective of effecting internal adjustments and transfers between different accounts within the ledger. In the event of transferring items from one company’s cost center to another, journal entry acts the appropriate processing method. Journal entries are also brought up to action several accounting adjustments such as period-end accruals, multi-charge transactions, adjustments to liability and asset accounts, and the approved reversal of ledger postings. There ought to be an immense deal of care in the generation of journal input to make sure that the resultant postings do not result to the ledger’s distorted view. Ideally, postings ought not to contravene international accounting standards. The practice of making unsubstantiated journal entries can have diverse effects on the company as noted with WorldCom. In the late 2000 and early 2001, the actual line cost E/R ratio of WorldCom was significantly pushed up by the slow growth of revenue and excess ‘off-net’ capacity. This was an alarming development to senior management Sullivan, Ebbers, and Beaumont that pressurized several groups bearing responsibility for the company’s network to make reduction of line costs (Dick, 2002). As a result, Sullivan and Myers asked senior line cost executives to come up with a plan that would smash down the line cost E/R ratio to match the 41% rate of the first quarter of 2000. At the moment, WorldCom had the option of the capitalization of excess capacity costs that did not generate revenue. This consideration came about as a result of a suggestion by Tony Miner who had been hired in the General Accounting with the role of analyzing line costs and keeping track of any fluctuations. The General Accounting thus prepared a monthly Line Cost to Revenue report matching revenues to line costs for WorldCom’s international and domestic operations, internet unit, foreign operating companies, alongside other businesses. As it was in the case of WorldCom, ‘false accounting’ mostly results from malice top executives (Dick, 2002). Ideally, the subordinate staff members with the responsibility of making the affected journal entries bow to pressure from their superiors thus making entries that are not substantiated by supporting documentation (Sullivan, 2001). Eventually, this practice leads to fraud as some actions have to be taken to make up for the wrong entries. It can thus be argued that, there is a close relationship between wrong journal entries and fraud, with pressure being the contributing factor. Rationalization also plays a key role in the practice of making journal entries that cannot be substantiated. As it is illustrated by the case of WorldCom, Sullivan had advocated for the wrong journal entries claiming that they savings from the company’s billings would make up for that. This indicates that flawed accounting reporting has often resulted from perception of executives that there would be means of making up for any-shortcomings (Dick, 2002). Companies ought to ensure zero-tolerance to lack of adherence to the international accounting reporting. This is the only effective way to ensure that unsupported journal entries are not made hence no ‘false accounting’. It is also an ideal way via which acts of fraud in companies can be prevented. Question 3 A i) Horizontal and vertical analysis of the 2000 and 2001 financial statements Horizontal analysis has focus on changes and trends in financial statement items over a specified period of time (Haddad, 2002). Therefore, horizontal analysis helps users of the financial statements notice the relative changes through the given time, and identify troubling and positive trends. In this form of analysis, one ought to select a base year and thus convert the dollar amount of the subsequent years to percentage of the dollar amount of the base year. 1999 2000 2001 Revenue 35908 100% 39090 108.86% 35179 97.98% Operating Expenses 28080 100% 30937 110.17% 31655 112.73% Net Income 4013 100% 4153 103.48% 1501 37.40% The horizontal analysis of WorldCom’s financial reports of 2000 and 2001 can make use of 1999 as the base year. This is because it is believed that the fraud being investigated took place in the year 2000. There is significant improvement of items in the financial statements between the year 1999 and 2000 (Mehta, 2001). However, a drop is recorded between 2000 and 2001. The most interesting thing is that the margin of the drop in net income is extremely sharp between 2000 and 2001 as compared to the drop in other items over the same period of time. For instance, from 2000 to 2001, revenue dropped from 100% 97.98%, where else, there was a sharp drop in net income (100% to 37.40%) over the same period of time. It is also worth noting the high rates of operating expenses in the financial reports (Mehta, 2001). In the vertical analysis of the financial reports of WorldCom, the various item of a single financial report tend to exhibit similar trend. For example, if for the year 1999 revenue is found to increase, the net income for the same year is also found to increase with a close margin. There is, however, a strange trend in the year 2001, where by, net income exhibits a change of over 60% margin; the other items are only changing with a margin of less than 10%. ii) Beneish ratios DSIR= days’ sales in receivables 2001/days’ sales in receivables 2000 (Myers, 2001) = (35179/39090)*100=89.99% GMI=Gross margin 2001/Gross margin 2000 (3514/8153)*100=43.1% AQI= asset quality 2001/asset quality 2000 Asset quality 2001 non-current assets/total assets = (55900/103914)*100=53.79% Asset quality for 2000= (51725/98,903)*100=52.30% Therefore: AQI=53.79/52.30 =102.84% SGI=sales 2001/sales 2000= (35179/39090)*100=89.99% DEPI=rate of depreciation 2001/rate of depreciation 2000 (Myers, 2001) (9852/7204)*100 =136.75% SGAI=SGA expenses 2001/SGA expenses 2000 (11046/10597)=104.2% LVGI= (total debt: total asset 2001)/ (total debt: total asset2000) Y2001= (43890/103914)*100=42.2% Y2000= (40104/98903)*100=40.54% 42.2/40.54=104.09% TATA= (total accruals: total assets 2001)/ (total accruals: total assets 2000) Y2001=1416/103914=1.36% Y2000=761/98903=0.7% =1.36/0.7=1.94% iii) Eight Variables weighted together M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI – 0.172*SGAI + 4.679*TATA – 0.327*LVGI (Reaves, 2002) =M = -4.84 + 0.92*(89.99%) + 0.528*(43.1%) + 0.404*(102.84%) + 0.892*(89.99%) + 0.115*(136.75%) – 0.172*(104.2%) + 4.679*(1.94%) – 0.327*(104.09%) =-4.84+0.83+0.227+0.415+0.802+0.1572-0.1788+0.0907-0.340 =-2.8369 The five-variable version: M = -6.065 + 0.823*DSRI + 0.906*GMI + 0.593*AQI + 0.717*SGI + 0.107*DEPI M = -6.065 + 0.823*89.99% + 0.906*43.1% + 0.593*102.4% + 0.717*89.99% + 0.107*136.75% -6.065+0.740+0.3895+0.6072+0.6452+0.1455 =-3.6 B Analysis using Figures provided by the SEC 1999 2000 2001 Revenue 19736 100% 22755 115.2% 21348 108.1% Operating Expenses 15105 100% 17714 117.27% 18299 121.14% Net Income 2294 100% 2533 110.4% 1407 61.33%S There is significant change in the trend of various items of the financial statement between the values attached by the company and the values provided by SEC. For instance, it is evident that the exact values of operating expenses are not given in the attached financial statements thus a likelihood of manipulation. The exact value of net income is also significantly different between the two sets of reports, especially for the year 2002. Disparities are not only in the comparative figures of consecutive years but also down the items of reports of individual years. This explains why the top management of the company was accused of manipulation in order to try and cover the fraud. Beneish ratios DSIR= days’ sales in receivables 2001/days’ sales in receivables 2000 = (21348/22755)*100=93.81% GMI=Gross margin 2001/Gross margin 2000 (3049/5041)*100=60.48% AQI= asset quality 2001/asset quality 2000 Asset quality 2001 non-current assets/total assets = (46930/91901)*100=51.06% Asset quality for 2000= (42624/85893)*100=49.62% Therefore: AQI=51.06/49.62 =102.9% SGI=sales 2001/sales 2000= (21348/22755)*100=93.81% DEPI=rate of depreciation 2001/rate of depreciation 2000 (8170/5972)*100 =136.80% SGAI=SGA expenses 2001/SGA expenses 2000 (6058/5689)=106.48% LVGI= (total debt: total asset 2001)/ (total debt: total asset2000) Y2001= (34190/91901)*100=37.20% Y2000= (29557/85893)*100=34.31% 37.20/34.31=108.42%% TATA= (total accruals: total assets 2001)/ (total accruals: total assets 2000) Y2001=1409/91901=1.6% Y2000=720/85893=0.8% =1.6/0.8=2% iii) Eight Variables weighted together M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI – 0.172*SGAI + 4.679*TATA – 0.327*LVGI (Sidgmore, 2002) =M = -4.84 + 0.92*(93.81%) + 0.528*(60.48%) + 0.404*(102.9%) + 0.892*(93.81%) + 0.115*(136.80%) – 0.172*(106.48%) + 4.679*(2%) – 0.327*(108.42%) =-4.84+0.9193+0.3193+0.4157+0.8367+0.1573-0.1830+0.0936-0.3544 =-2.6355 The five-variable version: M = -6.065 + 0.823*DSRI + 0.906*GMI + 0.593*AQI + 0.717*SGI + 0.107*DEPI M = -6.065 + 0.92*(93.81%) + 0.528*(60.48%) + 0.404*(102.9%) + 0.892*(93.81%) + 0.115*(136.80%) -6.065+0.9193+0.3193+0.4157+0.8367+0.1573 =-3.4167 The M-scores obtained when using the values provided by SEC are greater than the values obtained when using the attached figures. The less negative the figure, the more manipulative the company. Therefore, there is evidence that WorldCom had given manipulated figures in its financial report in order to give a face of highly performing company. This was a strategy used by the top executives who had taken part in the fraud of the year 2000. References Beresford, D., N. Katzenback, and C. Rogers, Jr. 2003. Report of investigation by the Special investigative Committee of the Board of Directors of WorldCom Inc. March 31. Available at: http://news. findlaw.com/ hdocs/docs/worldcom/bdspcomm60903rpt.pdf. Birnbaum, J., E. Brown, T. Carvell, G. Colvin, J. Creswell, J. Farley, J. Fox, M. Gunter, J. Guyon, D. Kirkpatrick, B. McLean, S. Mehta, S. Neumeier, D. Roth, N. Schwartz, A. Taylor III, and A. Wheat. 2001. People to watch 2001. Fortune (January 8): 12-17. Bobhit, M. 2002. Minutes of the regular meeting of the audit committee of the board of directors of WorldCom, Inc. March 6. Available at: http://ncws.findlaw.com/hdocs/docs/worldcorn!worldcom030602bdmin.pdf. Bosley, T. 2001. Email message to David Myers, copied to Louis Prestwood. March 6. Available at: http:// news.findlaw.com/hdocs/docs/worldcom/worldcom030602bdmin.pdf Charan, R., J. Useem, and A. Harrington. 2002. Why companies fail. Fortune (Asia) (May 27): 36--45. Cooper, C. 2002. WorldCom internal audit correspondence. June 24, !0:30AM. Available at: http:// news.findlaw.comlhdocs/docs/worldcom/worldcom062402intaud.pdf. Dick, M. 2002. Andersen presentation, report to the Audit Committee, year ended December 31, 200 l. February 6. Available at: http://news.findlaw.com/hdocs/docs/worldcorn/70802mdtst.pdf. Haddad, C. 2002. How Ebbers kept the board in his pocket. Business Week (October 14): 138 140. Mehta, S. N. 2001. Can Bernie bounce back? Fortune (Asia) (January 22): 84-89. Myers, D. 200I. Email message to Tom Bosley, copied to Scott Sullivan. March 5. Available at: http:// news.findlaw.com/hdocs/docs/worldcom/worldcom030602bdmin.pdf. Reaves, G. 2002. Accounting for anguish. Fort Worth Weekly Online (May 16). Roberts, B. 2002. Wrong numbers: The accounting problems at WorldCom. Testimony before the House Committee on Financial Services. July 8. Sidgmore, 1. 2002. Wrong numbers: The accounting problems at WorldCom. Testimony before the House Committee on Financial Services. July 8. Available at: http://news.findlaw.com/hdocs/docs/worldcom/ 070802jstst.pdf. Sullivan, S. 200 l. Email message to David Myers. March 6. Available at: http://news.findlaw.com/hdocs/docs/worldcom/sullivan03060 Iemai1.pdf. Read More