The Financial Number Game: The Enron and Worldcom Story

Creative accounting is the measurement and presentation of the accounts using the flexibility within the rules of standard accounting practices, so that they serve the interests of preparers (Mulford, 2002). Fraudulent accounting , in contrast,  deliberately steps outside of the regulatory framework in order to deceive financial users. (Singleton et al. 2006)  The main features of creating accounting are increasing assets by aggressive capitalization and extended amortization policies , inflating revenues by recognizing premature or fictitious revenue, decreasing liabilities by off-balance sheet financing , decreasing expenses by tax evasion and provision accounting and maximizing operating cash flow. (Jones, 2011).Fraudulent and Creative accounting can be driven by multiple factors for simplicity these drivers may be categorized into three circumstances; pressure, rationalization and opportunity

The Enron and WorldCom story was a story not just of the failure of the accounting firm, but also the traditional gatekeepers: the board, the audit committee, the lawyers, the investment bankers, the rating agencies. (Levitt, 2002). A key feature used by both companies was to be particularly optimistic in their revenue recognition approaches in order to inflate profits. Enron's approach in inflating profits were by recording fictitious sales through use of merchant-model rather than "agent-model" in booking trades and by employing mark-to-market accounting , where current revenues were based on estimates of present value of net future cash flow for volatile contracts (Lambert ,2006). Worldcom's approach for inflating profits were to recognize fictious revenue through corporate unallocated revenue accounts and capitalize long-distance line cost expenses as prepaid capacity.

Enron also inflated revenues through round-trip trading, this is essentially done by transferring an asset to another company through sales while buying back the same asset for about the same price and recognizing the trade as revenue (Bond, 2000). Enron achieved this through establishing special purpose entities  such as JEDI, Chewco and Whitewing these entities were also used to hide debt through off-balance sheet financing, this was also a common approach for other energy and telecommunications company such as AOL, CMS Energy and Duke Energy(Forbes, 2002)

Both companies where pressured by declining profits due to the downturn of the economic climate after the dot-com bubble, huge focus on meeting analyst estimates and unrealistic internal earnings targets from , the CEOs, Bernie Ebbers and Jeffrey Skilling. An SEC Investigation found handwritten notes in Worldcom premises that calculated the difference between “act[ual]” or “MonRev” results and “target” or “need[ed]” numbers, and identified the entries necessary to make up that (SEC,2002).

The opportunity for fraudulent accounting was fostered by the company culture in both firms and the relationship with Arthur Andersen. An auditor upholds principles such as independence, objectivity, integrity and competency , due diligence and professional skepticism.  However, most the principles mentioned above weren’t observed by Arthur Anderson. There were obvious signs of cooking the books in both companies, however, the auditors failed to detect any fraud and issued unqualified audit report for years. The company culture of both Enron and Worldcom were shaped by rewarding high-risk taking, unquestionable compliance with seniority,  subpar emphasis on professional ethics and arbitrary rank-and yank approaches to hiring and firing employees.

Several methods could be adopted to mitigate fraud and the losses as a result of fraud. These primarily includes proper corporate governance, auditor independence and persecution. Some significant measures for corporate governance include confidential hotlines, fraud awareness training, management reviews and data mining. Studies show that 51% of fraud were detected by tips from confidential hotlines. Fraud awareness trainings are particularly effective in establishing the company code of conduct and a suitable company culture. Management reviews are used to assess internal controls , frequency of control override and establish the right tone at the top. Data mining is an effective forensic accounting tool that helps in the early detection of fraud . It includes using trend analysis in susceptible accounts such as accounts payable, latent semantic analysis and address geocoding.

While external auditors have been proven to be rather inefficient in detecting fraud , steps need to be taken to establish standards for external auditor independence and limit conflicts of interest. The Sarbanex-Oxley act , that was introduced after the crackdown of Enron and Worldcom, addresses new auditor approval requirements, audit partner rotation, and auditor reporting requirements. It also restricts auditing companies from providing non-audit services (e.g., consulting) for the same clients (Roebuck,2012).

Finally, the legal process in mitigating financial statement manipulation needs to be strengthened. The benefits of gambling on accounting fraud appear to outweigh the potential costs of being caught for committing this fraud. Fines are deemed by the unscrupulous as a price worth paying in return for much lucrative gains from share price manipulation and fraudulent reporting. (Leng, 2006) This suggests that current U.S. civil and criminal penalties for committing accounting fraud are not strong enough to deter this type of behavior (Wharton, 2002)