Auditing Assessment - Assignment Example

Name: Course: Tutor: Institution: City and State: Date: Question 1 Fraud is among the top ethical issues that the business world deals with due to its implication on investment and operational decisions (Zekany et al 2004 p.101). Accounting departments are the lifeblood of frauds due to their access and control of financial documents that reflect the movement of assets within the business. Accountability and transparency rely on the authenticity of financial statements in recording movement of assets as well as their value for which fraud intends to manipulate. In understanding this menace, one must begin with the root of the problem and fraud theories suggest certain approaches to assessing the conceptualization of fraud. The fraud triangle model focuses on the causes of fraud by assessing the factors that lead individuals into committing fraud. The components of the model are perceived opportunity, financial need, and rationalization that work together to influence fraudulent behaviour. The fraud scale also assesses the various prevailing conditions that force individuals into fraudulent behaviors. Similarly, it focuses on the opportunities, individual’s financial situation, and personal integrity. WorldCom is one of the major companies hit by the fraud menace and the analysis of the causes would help in deriving lessons for other corporations in their quest for fraud prevention. WorldCom wrote its success story in the 1990s before facing serious financial crisis in the early 2000s where the top management drove the company to its downfall (Zekany et al 2004 p.101). The company faced fraudulent activities that amounted to approximately $3.8 billion with the CEO and the CFO named as the main perpetrators in these practices. The CEO, Bernie Ebbers, faced an immense amount of pressure due to his business strategy. His main agenda involved achieving impressive growth patterns that earned him a reputation and brought him fame and tremendous respect. He achieved this through numerous acquisitions and mergers that saw the company grow not just locally but globally. During his reign, he orchestrated approximately 75 mergers with top companies and numerous acquisitions, which appeared as an ultimate success to the outside world. His reputation attracted admirers who formed part of his management team as well as the board of directors. The press, investors, and stockholders also admired the brains that created the telecommunications empire within a short period. The analysts were in awe as the company managed to exceed expectations and outperform performance predictions. His personalities were that of risk taking, free spending, and he made an impression of an overzealous businessperson. Maintenance of the stock price placed immense pressure on the management due to its significance in the success story of the company as the currency used to make acquisitions (Zekany et al 2004 p.102). The stock price had to rise continually in value to achieve the strategy of obtaining as many acquisitions and mergers as possible. The largest achievement to this regard was the acquisition made in 1998 of MCI Communications with revenue of over 2.5 times that of WorldCom. However, in 2000, the company had to forego merger arrangements with Sprint over emerging antitrust issues. This further accelerated the pressure to reflect consistent and tremendously rising revenue in its books. The only possible solution to achieve this objective was resulting to financial gimmickry since legitimate measures could not assist to this recourse. This opened the door to a major fraud saga since the financial misstatements need a cover up with more financial misstatements. The end of the dotcom bubble resulted in an industry downturn of the telecommunications industry with major effects on the companies. This occurred at a period where WorldCom had a target of a double-digit growth influence by the major achievements in the previous past. Evidently, the management needed time to adjust to the newly acquired territory through devising sustainability strategies and avoid financial problems (Zekany et al 2004 p.102). Ebbers could not disclose the fact to Wall Street since that meant lowering the company’s reputation and this could translate into a reduced stock price. This also threatened his personal reputation that he had worked tooth and nail to protect. Manipulation of financial statements seemed as the only coping mechanism for the company. The financial status of an individual offers an opportunity for committing fraud as suggested by the fraud triangle and fraud scale model. Evidence of the suggestion emerges in the case of Ebbers who suffered from expensive and unsustainable spending habits. Ebbers borrowed large amounts of loans and used the company’s stock as collateral hence he had to maintain the value they possessed (Zekany et al 2004 p.103). The extravagant expenditure included the purchase of the largest ranch in Canada, motels, a marina, hockey team, yachts, yard, and a yacht construction firm among others. Once the value of the stock began declining, Ebbers had to find finances to cover the loans hence the need to misappropriate the company’s funds. Ironically, the board of directors also extended a personal loan to the CEO to cater for the debt margins instead of demanding financial responsibility for the extravagant lifestyle. Ebbers took advantage of the opportunity to acquire huge loans since most board members pledged loyalty to him. The situation worsened when the board discovered about Ebbers’s financial swindle and refrained from taking action since Ebbers was a friend. Pressure is a major cause of fraud and WorldCom demonstrated this fact through the CFO’s actions. The Pressure mounting in 2001 forced CFO Scott Sullivan to find creative measures to reduce the company’s expenses (Sandbberg, Solomon & Blumenstein 2002p.154). The CFO decided to reduce the line cost expenses that formed the largest part of the company’s expenditure. The general accounting following his directions reduced these costs by$150 million but the wireless division detected the manipulations that they eventually reversed (Zekany et al 2004 p.108). He further ordered the recording of unrelated large value journal entries of rounded figures without supporting documentation. Initially, the accounting team trusted Sullivan and believed in his actions despite the lack of supporting documents for the transactions. Over time, the accounting team began questioning the CFO’s directions and became suspicious of them but failed to report the fraud speculations. The team failed to report their suspicions due to the fear of losing their jobs in the company, which again comes as a form of rationalization. Agency relationship between the management and the shareholders requires that the management team conduct business with the sole purpose of fulfilling the shareholders’ goals. In WorldCom, an agency conflict emerged when the decision-makers forgot their obligation towards the shareholders. Ebbers had found him in a very influential position after his success record of accomplishment in building an empire within a short period. This offered him an excellent opportunity to make use of his power to influence the direction of the company as he saw best fit. The decision makers who consisted of the board members as well as the management team all admired the CEO (Zekany et al 2004 p.101). They placed very high confidence in his actions and failed to question his strategies despite the red flags. Despite their duty towards the shareholders through ensuring the long-term survival of the business, they followed Ebber’s directions to uphold short-term success through financial manipulations. Organizational culture acts as a great determinant of the values and ethics of employees working within the organization. In WorldCom, the top management enforced the strategy of growth through acquisitions, which became the metric of performance measurement (Zekany et al 2004 p.103). This paved way for a competitive and aggressive culture whose main objective involved achievement of financial goals at the expense of organizational relationships. The culture neglected the nurturing of ethics among employees that could uphold honesty, transparency, and accountability. This gave rise to an intense amount of pressure on the employees to deliver the set targets at whatever cost. Management encouraged long working hours with a better compensation scheme despite the performance of the organization. Ideally, poor performance reduces payment rates matched with the same long working hours. The large focus on revenue opened a loophole for the manipulation of the accounting system where the employees reported abnormally large revenues and subsequently pocketed large amounts of commissions of almost $1 million. Ebbers made a personal effort to discourage the establishment of a code of conduct within the organization terming it as a waste of time. Clearly, ethics took a backseat in this company with the direction of the CEO hence fraudulent malpractices dug deeper roots. This offered an enabling environment for the employees to misappropriate funds and manipulate financial statements. Some employees fell victim of the fraud scandal unknowingly as they reported existing markets as new ones due to lack of proper documentation. Others however, received rewards for cooperation with the top management over fraudulent malpractices. Management also made sure the employees maintained their loyalty and kept silence over the evident malpractices through maintaining a complicated communication system within the organization. Employees had to report problems to the human resource department at the headquarters in New York despite their workstation. Personal integrity determines individuals’ level of resistance to influence in conducting malpractices. Sullivan had the reputation of impeccable integrity with a similar leadership to that of Ebbers. The hypocritical reputation led his employees into blindly following his directions to manipulate financial statements. He took advantage of the level of influence he possessed over his employees and manipulated them into committing fraud. The low level of personal integrity drove the employees into fraud and prevented them from reporting suspicious operations of the top management. The high rewards associated with loyalty to the management motivated the silence and for many, this appeared more attractive than losing their well paying jobs. The similarity of both leaderships prepared a breeding ground for dishonest practices further facilitated by the high level of secrecy maintained within the organization. Loyalty emerged as a crucial requirement for the survival of the company to cover up the various malpractices hence only trusted employees could access full documentation of transactions (Zekany et al 2004 p.104). Inactivity of the board of directors also denied them the opportunity to uncover the company’s issues and their personal relationship with Ebbers clouded their judgment. Situational pressures appear as a major cause of fraud in WorldCom due to the need to maintain an attractive corporate image. Ebbers was an accelerator of this pressure through his introduction of a destructive corporate culture that pushed the employees too hard in delivering set financial goals within a short period. Adoption of ambitious and unsustainable business strategies by Ebbers further put pressure on the management as well as the employees in straining to keep up the pace. The pressure to maintain a flawless image to the public transferred to the employees who also felt the need to protect the company as well as their share of stock in it (Zekany et al 2004 p.103). Payment of the employees through stock options forced loyalty from them and the company became their personal responsibility. Question 2 False accounting refers to an action where an individual dishonestly destroys, defaces, falsifies, or conceals any account, document, or record made or required for any accounting purposes. Falsifying accounts therefore occurs when a person intentionally prepares or concurs in the preparation of a deceptive, false, or misleading account or document. It includes manipulation of accounting principles to reflect high level of profitability hence attract investors and maintain existing shareholders. The Generally Accepted Accounting Principles (GAAPs) offer guidelines on the accounting of various components such as incomes, expenses, capital, and liabilities, among others (Sandbberg, Solomon & Blumenstein 2002p.155). Profitability level depends on the amount of income and expenses hence tactful manipulation of the two components would place a business at various profitability platforms. Performance ratios assess the performance of a business, its value, and going concern by using various components of the financial statements. Falsification of these figures may largely mislead the stakeholders and may influence the making of investment decisions in either direction. Alteration of the right components may work in manipulating the public into believing that the company has an excellent record of accomplishment while in reality the company makes huge losses. Supporting documents such as vouchers show evidence of transactions recorded in the financial statements and their absence raises questions of the authenticity of these transactions. Action 1 Line costs accruals release was one of the major accounting malpractices in WorldCom that contributed to its financial crisis. In 2001, WorldCom faced serious financial problems that required immediate attention from the management. Sullivan attempted to cover up these problems by directing the general accounting team to reduce expenses by $150 million (SEC v. WorldCom, Inc. [2002]). There existed no supporting evidence for this transaction as discovered by some employees who raised the issue to no avail. Dan Renfroe and the other employees received clear directions to make this journal entry. DiCicco on the other hand firmly declined to follow the orders until presented with supporting documents of the transaction. Renfroe made this entry, which added to a list of other similar entries made previously by the subordinate of Vinson. Renfroe was in the habit of preparing large, round dollar journal entries upon direction of the CFO. Wireless accounting as expected raised questions concerning the entry and wrote to Renfroe enquiring about its implication on tax returns (Zekany et al 2004 p.109). He consequently forwarded the email to his boss who then forwarded it to his boss indicating the lack of accountability within the accounting team. The top management once again colluded to cover up the issue and manoeuvre their way into tax evasion. In this scenario, Ronfroe’s actions amounted to false accounting due to his prior knowledge of the intentions of this journal entry. The entry’s aim was to misrepresent the wireless line costs to indicate less expense than actually incurred. The adjustment of the accruals occurred without confirmation of the actual existence of these accruals in the books of accounts. In a logical sense, the company would not have released the accruals in the balance sheet but instead maintained them as future backup funds. The use of one expense to offset another violates the GAAP where only an income would offset an expense. Additionally, the expenses used for the offsetting purposes did not belong to the line costs but lacked evidence of their origin. Eliminating accrual expenses reflected less financial liability for the company and high level of income that exceeded expenses. Less expense would translate into higher profitability and elimination of losses hence portraying the performance of the company as promising. There was also an absence of supporting documents for the entry and this knowledge did not stop him from making the entry. Presence of suspicious activity also failed to deter Renfroe from making the entry demonstrating the employee’s high level of ignorance. Deceptive actions and intentions of the employee indicate presence of false accounting in the making of the $150 million journal entry. Action 2 Line costs capitalization was another fraudulent practice involving the accounting department under the management of the CFO. A director in General Accounting, Troy Normand, directed Angela Walter, one of the managers to make an entry to reduce costs by $771 million (Zekany et al 2004 p.112). Walter received a document from Normand indicating the expected adjustments that required recording. The document detailed the amounts, account numbers, and indicated the adjustments ’heading as ‘Prepaid Capacity Costs’. Walter found nothing unusual with these entries due to her habit of making similar entries under Normand’s directions. Normally, she received instructions in a similar manner to make entries worth $500 million to $1 billion, which she followed without evidence of supporting documents for the transactions. Upon making enquiries, she received answers that the entries were only temporary until they figured out where to place them. The $771 million reduction in costs ended up in the construction asset account where further adjustments emerged to increase the capital expenditure for consistency purposes. Capitalization of the line costs aimed at offering misleading information to the public and any other users of the financial statement. It aimed at reducing costs to reflect higher revenue and profits while increasing the capital base thus indicating a continuous growth in the company’s assets. Walter made the entry despite lacking knowledge of the authenticity of the transaction that amounted to the $771 million (SEC v. WorldCom, Inc. [2002]). This demonstrates negligence on her part since she has a duty to prepare financial statements that reflect a true and fair view of the company’s financial position and performance. The intent of the entry therefore qualifies the action as false accounting and Walter played a major role in facilitating the entry. She concurred with the falsification of the accounts to give misleading information on the actual performance of the organization hence she undoubtedly took part in false accounting. Question 3 Vertical analysis involves the calculation of each entry appearing on a financial statement as a percentage of another item in the same statement. For instance, a vertical analysis conducted on a balance sheet represents each item as a percentage of the total assets while the items in the income statement appear as a percentage of total sales. The restated amounts then appear in a common-size balance sheet that enables comparison of the company’s balance sheet to that of other industry players. Current assets: Cash and cash equivalents Accounts receivables Deferred tax asset Other current assets Property and equipment: Transmission equipment Communications equipment Furniture, fixtures and other Construction in progress Accumulated depreciation Goodwill Other assets LIABILITIES AND SHAREHOLDERS' INVESTMENT Current liabilities: Short-term debt Accrued interest Accrued line costs & accounts payable Other current liabilities Long-term Liabilities, Less Current Portion: Long-term debt Deferrable tax liability Other liabilities Minority interest Redeemable debentures of the Company and other redeemable preferred securities Additional paid-in capital Common stock Retained earnings Unrealized holding gain on marketable equity securities Cumulative foreign currency translation adjustment Treasury stock Percentage 761/98903=0.77 6815/98903=6.89 172/98903=0.17 2007/98903=2.03 20288/98903=20.51 8100/98903=8.19 9342/98903=9.45 6897/98903=6.97 (7204)/ 98903=(7.28) 46594/98903=47.11 5131/98903=5.19 7200/98903=7.28 446/98903=0.45 6022/98903=6.09 4005/98903=4.05 17695/98903=17.89 3611/98903=3.65 1124/98903=1.14 2592/98903=2.62 798/98903=0.81 29/98903=0.03 3160/98903=3.20 345/98903=0.35 (817)/98903=(0.83) (185)/98903=(0.19) Percentage 1416/103914=1.36 5308/103914=5.11 251/103914=0.24 2230/103914=2.15 2318/103914=2.23 7878/103914=7.58 11263/103914=10.84 5706/103914=5.49 (9852)/ 103914=(9.48) 50537/103914=48.63 5363/103914=5.16 172/103914=0.17 618/103914=0.59 4844/103914=4.66 3576/103914=3.44 30038/103914=28.91 4066/103914=3.91 576/103914=0.55 101/103914=0.1 1993/103914=1.92 - 4400/103914=4.23 (51)/ 103914=(0.05) (562)/ 103914=(0.54) (185)/ 103914=(0.18) Horizontal analysis involves the analysis of amounts in the financial statement in relation to those of previous years. It analyses the amounts of the current financial period against those of a previous period thus developing a trend. This analysis enables the demonstration of changes in an item in relation to changes in other items. Current assets: Cash and cash equivalents Accounts receivables Deferred tax asset Other current assets Property and equipment: Transmission equipment Communications equipment Furniture, fixtures and other Construction in progress Accumulated depreciation Goodwill Other assets LIABILITIES AND SHAREHOLDERS' INVESTMENT Current liabilities: Short-term debt Accrued interest Accrued line costs & accounts payable Other current liabilities Long-term Liabilities, Less Current Portion: Long-term debt Deferrable tax liability Other liabilities Minority interest Redeemable debentures of the Company and other redeemable preferred securities in capital Common stock Retained earnings Unrealized holding gain on marketable equity securities Cumulative foreign currency translation adjustment Treasury stock Percentage 761/1416=53.74 6815/5308=128.39 172/251=68.53 2007/2230=90 20288/2318=875.24 8100/7878=102.82 9342/11263=82.94 6897/5706=120.87 (7204)/(9852)=73.12 46594/50537=92.20 5131/5363=95.67 7200/172=4186.05 446/618=72.17 6022/4844=124.32 4005/3576=112 17695/30038=58.91 3611/4066=88.81 1124/576=195.14 2592/101=2566.34 798/1993=40.04 29/0=0 3160/4400=71.82 345/(51)=(676.47) (817)/(562)=145.37 (185)/(185)=1 The Beneish ratios involve the calculation of the m-score which is a mathematical model using a combination of eight ratios with the intention of detecting any manipulations of the earnings. These variables emerge from calculations from the financial statements that provide a score to illustrate the degree of manipulation to the figures. The m-score therefore features a combination of eight indices that combine to offer a conclusive report on the earning manipulation. DSRI = Days’ Sales in Receivables Index. This index measures the ratio of days’ sales in receivables in comparison to previous year thus acting as an indicator of possible revenue inflation. DSRI=5308/6815=0.78 GMI = Gross Margin Index. This is the ratio of gross margin in comparison to the previous year. A firm with poorer prospects is more likely to manipulate earnings. GMI=31665/30937=1.02 AQI = Asset Quality Index. The index appears as the ratio of non-current assets to total assets, the ratio of asset quality in comparison to prior year. AQI=44627/103914=0.43 SGI = Sales Growth Index. This measures the ratio of sales in relation to prior year. Sales growth may not indicate manipulation but growth companies may find themselves succumbing to pressure and manipulate them in order to maintain an appearance. SGI=35179/39090=0.9 DEPI = Depreciation Index. It is the measure of the rate of depreciation in relation to prior year. A slower rate of depreciation i.e. when DEPI is greater than 1 may indicate the revision of useful asset life assumptions upwards, and/or adopting a new income friendly depreciation method. DEPI=(9852) /(7204)=1.37 SGAI = Sales, General and Administrative expenses Index. The index measures the ratio of these expenses in relation to the previous period. It assumes that most analysts expectedly interpret an arising disproportionate increase in sales as a negative indicator of the firm’s future. SGAI=2393/7568=0.32 LVGI = Leverage Index. It calculates the ratio of total debt to the total assets in relation to prior year. It captures debt covenants and various incentives for the manipulation of earnings. LVGI=2243/103914=0.02 TATA = Total Accruals to Total Assets. It measures the degree to which managers make accounting choices aimed at altering earnings. It calculates total accruals as the variance in working capital accounts and not cash less depreciation. TATA=446/103914=0.004 M = -4.84 + 0.92*0.78 + 0.528*1.02 + 0.404*0.43 + 0.892*0.9 + 0.115*1.37 – 0.172*0.32 + 4.679*0.02 – 0.327*0.004= -2.41 The five variable m-score: M = -6.065 + 0.823*0.78 + 0.906*1.02 + 0.593*0.43 + 0.717*0.9 + 0.107*1.37= -3.45 Both m-scores indicate a less likelihood of the manipulation of the financial statements since they give a figure less than -0.22. References Sandbberg J, Solomon D, Blumenstein R (2002), Accounting Spot-Check Unearthed A Scandal In Worldcom’s Books. The Wall Street Journal; 153-160 SEC V. Worldcom, Inc.[2002], 02-CV-4963 (JSR), United States District Court Southern District Of New York, http://www.sec.gov/litigation/complaints/comp17829.htm Zekany K E, Braun L W, Zachary T (2004), Behind Closed Doors At Worldcom: 2001. Issues In Accounting Education; 19, 1; 101-115 Read More