WorldCom, a telecom giant, perpetrated an $11 billion fraud from 1999 to Q1 2002 by capitalizing operating expenses (e.g., line lease costs) as fixed assets, inflating profits. The scheme, led by CEO Bernie Ebbers and CFO Scott Sullivan, was uncovered by internal auditors Cynthia Cooper, Gene Morse, and Glyn Smith.
Cooper’s team identified $2 billion in questionable entries, confirmed by interviews with Controller David Myers and others. The audit committee fired Sullivan, and WorldCom announced $3.8 billion in inflated profits, leading to bankruptcy in July 2002. Cooper was named a 2002 Time Magazine Person of the Year.
The case highlights senior management’s role in FSF, driven by pressure to meet Wall Street expectations. Detection relied on internal audits, whistleblower persistence, and data analysis.
Consequences included prison sentences (Ebbers: 25 years; Sullivan: 5 years) and significant financial and reputational losses.
FSF involves manipulating financial reports to mislead stakeholders, often driven by pressure on senior management to show strong earnings. It is the costliest form of occupational fraud, causing reputational damage, bankruptcy, and market losses.
The chapter focuses on who commits FSF, why, and how, alongside detection and deterrence strategies.
The chapter is organized into five modules, each with specific learning objectives:
Module 1: Introduction to FSF (Who, Why, How)
Module 2: Accounting principles and their relation to fraud
Module 3: Five major FSF methods
Module 4: Detection techniques
Module 5: Deterrence and the human factor
Senior Management: CEOs (72%) and CFOs (65%) are most involved, per a 2010 COSO study, due to their control over financial reporting.
Mid/Lower-Level Employees: Falsify unit-level data to hide poor performance or boost bonuses.
Organized Criminals: Use FSF for fraudulent loans or pump-and-dump schemes.
Overstate Performance: To meet analyst expectations, comply with loan covenants, secure financing, or support stock prices for mergers or personal wealth.
Understate Performance: To defer earnings, take a “big bath” write-off, reduce expectations, or lower business value (e.g., for divorce settlements).
Pressures include maintaining status, achieving performance bonuses, or meeting external criteria.
Playing the Accounting System: Manipulating assumptions (e.g., depreciation, bad debt allowances) or timing of entries.
Beating the Accounting System: Recording fictitious sales, fabricating inventory/receivables, or using disguised journal entries.
Going Outside the Accounting System: Producing fake financial statements, often with forged documents or no accounting system support.
Public company FSF often uses timing differences to bypass strong controls, involves larger fraud teams, and results in bigger frauds due to risk-reward dynamics. Private company frauds are less studied but significant.
GAAP, set by the FASB, guides financial reporting through assumptions (economic entity, going concern, monetary unit, periodicity), principles (historical cost, revenue recognition, matching, full disclosure), and constraints (cost-benefit, materiality, industry practice, conservatism).
Qualitative characteristics include relevance, reliability, comparability, and consistency, all vulnerable to manipulation.
Economic Entity: Special-purpose entities (e.g., Enron) can hide liabilities.
Going Concern: Concealing terminal conditions inflates value.
Monetary Unit: Foreign currency transactions invite exchange rate fraud.
Periodicity: Short periods increase manipulation risks.
Historical Cost: Shifting to fair value increases subjectivity, enabling overvaluation.
Revenue Recognition: Premature or fictitious revenue boosts income.
Matching: Manipulating cutoffs shifts expenses/revenues across periods.
Disclosure: Omitting material events (e.g., lawsuits) hides risks.
Materiality: Aggregating small misstatements can become material.
Conservatism: Overstating assets or understating liabilities violates this principle.
Management is responsible for financial statements, with the board and senior management setting the “tone at the top.” A strong ethical culture reduces fraud risk, while a corrupt tone enables it.
Fictitious Revenues: Recording fake sales (e.g., to nonexistent customers) or premature revenue recognition (e.g., channel stuffing, conditional sales).
Timing Differences: Shifting revenues/expenses across periods (e.g., early revenue booking, delayed expense recording).
Concealed Liabilities/Expenses: Omitting liabilities (e.g., payroll, warranties) to inflate profits.
Improper Asset Valuations: Overvaluing inventory, receivables, or fixed assets (e.g., WorldCom’s capitalized expenses).
Improper Disclosures: Omitting related-party transactions, accounting changes, or material risks.
Schemes overstate income (most common) or understate it, using the three methods from Module 1. They exploit GAAP subjectivity and management’s control.
Impacts include inflated stock prices, loan approvals, or hidden distress, as seen in the Crazy Eddie case (inventory inflation, fake sales).
Readers learn to identify these schemes and their red flags, applying knowledge to case scenarios.
Horizontal Analysis: Compares financial data across periods to identify unusual trends (e.g., revenue spikes without cash flow support).
Vertical Analysis: Examines financial statement items as percentages of a base (e.g., gross margin anomalies).
Ratio Analysis: Key ratios (e.g., current, quick, receivables turnover, inventory turnover, debt-to-equity, profit margin, ROA, ROE) reveal manipulation (e.g., inflated receivables turnover from fictitious sales).
Dupont Expression: Dissects ROE/ROA into leverage, asset turnover, and profit margin, highlighting inconsistencies.
Cash Flow Analysis: Discrepancies between net income and operating cash flows (e.g., high accruals) signal fraud, as seen in research by Dechow, Beneish, and Rosner.
Nonfinancial Metrics (NFMs): Comparing financial data to NFMs (e.g., employee count, store locations) detects inconsistencies (e.g., revenue growth exceeding NFM growth).
Sudden ratio changes (e.g., declining current ratio from embezzlement), high accruals, or mismatches between financials and NFMs.
External auditor skepticism, whistleblower tips, and forensic specialist involvement enhance detection.
Readers apply detection techniques to discern fraud-related anomalies from normal variations, using case scenarios.
Traditional controls are ineffective, as executives (89% of cases involve CEO/CFO) can override them. The fraud triangle (pressure, opportunity, rationalization) guides deterrence.
Reduce Pressures: Effective board oversight, realistic goals, fair compensation, and managing external expectations (e.g., analyst forecasts).
Reduce Opportunities: Accurate records, physical security, segregation of duties, strong supervision, and uniform accounting procedures.
Reduce Rationalizations: Promote integrity, clear policies, regular training, confidential reporting (e.g., hotlines), and ethical leadership.
Executive ego, pressure to maintain status, or perceived justifications (e.g., “temporary” distress) drive fraud. A strong “tone at the top” and “mood in the middle” deter misconduct.
The Coated Sales case illustrates how management’s lavish lifestyle and loan manipulation fueled a $55 million fraud, detected through receivables analysis.
Readers adapt antifraud methodologies to conditions ripe for FSF, understanding perpetrator motivations for effective deterrence.