Something or Rather

ACCT7102 Individual Case Study Assignment:

‘Accounting Fraud at WorldCom’

1. (a)

Earnings Management is the accounting process of deliberately manipulating a company’s financial report to match or make a target. The procedure can also be considered income smoothing. The idea behind this is to even out the years profit and loss to show consistent fluid movement of sales rather than have periods of spiked sales or losses. This is achieved by adding or removing cash from reserve accounts, also known “cookie jar accounts”.

There are many reasons why managers would manipulate their own accounts. Some self-motivated and others motivated towards the shareholders and investors. A study done by Healy (1984) revealed that more managers would be motivated to manipulate net income once they have hit their minimum net income in order to maximise their own contractual bonus. Healy chose a sample of 94 firms with bonus compensation plans and analysed their figures over a period of 50 years. He empirically proved that the firms whose net income reported in between their minimum and capped net income (the maximum bonus that the manager may receive) had all reported positive average accruals. The accruals increased reported net income which in turn increased the manager’s bonus. Inversely, the firms that have bonus compensation plans but reported net incomes below the minimum income level or above their maximum cap showed negative average accruals. This reduced the company’s net income and allowed them to keep cash in reserves to utilize when they could maximise their bonus.

Another reason why managers chose to alter their reported earnings is to convey information to investors as shown in a study by Freidlan (1994). For example, if a company that has never been entered into the public securities market won’t have an established market price. So a company may likely manipulate their earnings to gain an increased short term net income so that investors can see a...