The Earnings Management Issue of WorldCom Case Study Report

Topics: Fraud, Corporate governance, Board of directors Pages: 6 (2077 words) Published: May 9, 2014
WorldCom, the telecommunications giant, once was the largest telecommunications company in the world, with more than $30 billion annual revenue, $104 billion in assets and more than 20 million customers. John Sidgmore (2002), Ebbers’ successor after the scandal, said “WorldCom is a key component of our nation’s economy and communications infrastructure.” However, the giant collapsed in 2002. 1. The Main Issue: Earnings Management

1.1 Definition of Earnings Management
A commonly acknowledged definition of earning management by Healy and Wahlen (1999) demonstrates that managers implement personal judgement in financial reporting and transactions to manipulate financial reports for misleading some investors about a company’s financial performance or influencing contractual outcomes that reply on the numbers. Based on several researches, Lawrence (2009) concludes that earnings management generally involves some level of deceptions, and its accounting manipulations usually motivated by negative behaviours such as opportunistic maximization and avoiding debt covenant violations. Nevertheless, others argue it is unreasonable for managers to manage short-term earnings which will be adjusted in future, and it is a way of releasing blocked inside information (Healy and Wahlen, 1999) and so on. 1.2 Incentives for Earnings Management: Two Main Incentives

1.2.1 The Incentive of Earnings Management for Personal Compensation Plan Daniel and Thomas (2006) states that if CEOs’ potential total compensation is more closely related to the price of stock and option holdings, the firms are more inclined to manipulate reported earnings. In the WorldCom case, in 2002, the CEO, Ebbers personally held 27 million shares of the company; he even borrowed some money to buy WorldCom’s shares (The Wall Street Journal, 2002). Hence, Ebbers had high level of motivation to manipulate reported earnings to inflate share price for personal benefits. 1.2.2 To Meet Expectation of Analysts and Industry Observers Secondly, Burgstahler and Eames (1998) indicate that firms manage earnings for meeting analysts’ forecasts, especially to manipulate earnings upward to avoid falling to meet analysts’ expectation. Failing to meet the expectation would lead to a plunge of the company’s stock value (Skinner and Sloan, 2002). As for the WorldCom case, the E/R ratio, the most important performance indicator, was closely observed by industry, which put significant pressure on WorldCom’s senior managers.

1.3 Manipulation of Earnings and Pressures for Senior Managers 1.3.1 Two Accounting Manipulation Methods
Releasing Accruals. From 1999 to 2000, CFO Sullivan and Controller Mayor forced employees of sub business units to release accruals of line cost which they claimed was too high relative to future cash payments. And the left accruals were below the amount of cash the company have to pay in future. Overall, in-between 1999 and 2000, $3.3 billion worth of accruals were released. Capitalizing expense. At the beginning of 2001, there were so few accruals left to release that Sullivan had to start a new method - treating line costs as capital expenditure rather than operation cost. This action totally violated accounting rules, because the expenditure had been consumed already and there were no future benefits at all. As a result, in April of 2001, $544 million of line costs was capitalized. 1.3.2 Pressures to Senior Managers

There were several issues that were compelling the senior management. Firstly, the most direct pressure to senior managers was from the CEO. Ebbers personally owned large amount of shares of WorldCom and therefore he wanted to lift share price zealously. After industry environment began to deteriorate, as a CEO, he pushed the senior managers aggressively for promoting company’s performance which could also boost its share price. Secondly, senior management was very keen to sustain the 42% E/R ratio, any rise in the E/R would result in...

References: Corporate Governance Principles and Recommendations with 2010 Amendments, 2010, Asxgroup, Viewed 10 October 2013,
Panel on Audit Effectiveness, 2000, Report and Recommendations, Panel on Audit Effectiveness, Viewed 10 October 2013,
Sidgmore, J, 2002, Wrong numbers: The Accounting Problems at WorldCom, Testimony Before the House Committee on Financial Services, Viewed 10 October 2013,
Amanda R, 2008, Q&A: Whistle-Blower Cynthia Cooper, Time, Viewed 10 October 2013,,8599,1709695,00.html.
The Wall Street Journal, 2002, Former WorldCom CEO Built An Empire on Mountain of Debt, Viewed 10 October 2013,
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