Question 1
(a) Earnings management
Earnings are major role in financial report and have great impacts on the prospect of a company. Therefore, managing the earnings will become the main issue. Healy and Wahlen (1999) stated that Earnings management (EM) occurs when manager use their discretion to alter accounting numbers in financial reporting, with the intention of mislead some stakeholder about business performance and affect contractual outcomes. In addition, EM will happened in any part of the external disclosure process with intention to achieve some private gain (Xu et al, 2007).
In recent studies, researchers have examined some different incentives for EM, which include meet capital market expectations and contracting motivation (Healy & Wahlen, 1999). The incentive of meet capital market expectation is created by external investors and financial analysts, they widespread use of accounting information to help value stock of a company. If the growth firm cannot meet the analysts’ expectations it may suffer large negative price reactions (Skinner and Sloan, 2002). Inversely, if the firm report growth continuously in annual earnings, it may get a premium price than other firms (Barth et al, 1999). Thus, in order to avoid reporting earnings lower than analysts’ expectations, the manager will manipulate the earnings. For the contracting motivation, it is created because the accounting data are usually used to regulate and monitor contracts between the firm and its stakeholders, as well as the management compensation (Healy & Wahlen, 1999).Therefore, in order to improve job security, bonus awards, and mitigate the potential violation of debt covenants, managers will manage earnings (Healy & Wahlen ,1999).
(b) Earnings management in WorldCom
The case indicated that WorldCom in the rapid expansion of the 1990 mainly aimed to build revenue and achieving capacity sufficient to handle expected growth (Kaplan& Kiron, 2007). The Chief Executive Officer (CEO) encouraged staff to bring as much as revenue in the door, regardless the long-term costs of a project exceeds short-term gains. However, due to reduced demand for telecommunication service, increased competition, and the aftermath of the dot-com bubble collapse, the company struggled for maintained its target revenue and price. In order to achieve its targeted performance, the Chief Financial Officer (CFO) and his staff decided to use two accounting tactics which were accrual releases and expense capitalisation. The company used to accrual the expense to a liability account for the future payment first, and then reduce liability accrual when the company paid the bills by cash. However, due to the high relative future cash payment, the CFO told staff to release accruals. As a result, WorldCom released $3.3 billion worth of accruals between 1999 and 2000, and many business units were left with lower accruals than the actual amount they would have to pay when bills arrived. In addition, because the revenue continuously decrease and release accruals no longer available to achieve the targeted in the early 2001, the CFO and his staff came out another solution which was capitalised the non-revenue-generating line expense into asset account, and then reversed part amount to make it accrual release from ocean-cable liability. Furthermore, WorldCom released a fake report on April 2001 indicated that it has 9.8billion revenue with the usual E/R ratio, which greater than its line cost and without the reclassification and accrual release.
(c) EM and fraudulent reporting
The financial fraud is well defined by the regulators as deliberate misstatement or omission of accounting data and material facts, in order to misleading the reader and influence on their judgments and decisions base on available information (Dechow & Skinner, 2000). According to accounting literature, EM and fraudulent financial reporting are defined as subsets of earning manipulation, both to achieve target
