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I have been hired by the SEC as fraud prevention and detection expert to help create training for SEC employees on the lessons we learned from several financial statement frauds. Financial statement fraud occurs when an employee or a member of an organization intentionally misrepresent their financial condition to create a false impression of their financial strengths to lure more investors. In this paper, I want to discuss two major organizations, which are Enron and WorldCom Scandals.
The Enron scandal is that the most vital company collapse within the US since the failure of the many savings and loan banks throughout the1980s. In October 2001, Enron an American energy company based in Houston, Texas filed for bankruptcy. This scandal demonstrates the requirement for important reforms in accounting and corporate governance within the United States, in addition as for an in-depth verify the moral quality of the culture of business usually and of business corporations within the United States. The tone at the top, especially Arthur Anderson, the external auditor and a consultant to Enron played a huge role in this collapse. The lack of attention that was shown by board members, executives at Enron about their misleading off the books financial entities, and the lack of truthfulness by management about the health of the company and it’s business operation was also a cause for this scandal. CEO -Jeffrey Skilling and CFO-Andrew Fastow changed the business strategy and corporate culture of Enron to make it more profitable. The senior executives believed Enron had to be the best at everything and that they had to protect their reputations and their compensation as the most successful executives in the U.S. When some of their business and trading ventures began to perform poorly, they tried to cover up their own failures. To hide the failures from the board of directors they pressured Anderson to ignore the issue with the financial reporting.
WorldCom was once the second-largest telecommunication company in the U.S. WorldCom filed for bankruptcy in 2002 due to a massive accounting scandal. WorldCom executives knowingly misrepresented the company’s accounting numbers, inflating the company’s assets by around $12.8 billion dollars. The WorldCom scandal is considered as one of the worst corporate crimes in history, and several former executives involved in the fraud were held responsible for their involvement. Cynthia Cooper formerly served as the Vice President of Internal Audit at WorldCom and her team were the first people who uncovered this major fraud. The tone at the top, the former CEO of WorldCom Bernie Ebbers played a huge role was by capitalizing inflated revenues with fake accounting entries, conspiracy and filing false documents with regulators and was sentenced to 25 years. The next person to blame was the former CFO of WorldCom; Scott Sullivan received a five-year jail sentence after pleading guilty and testifying against Ebbers. Also, David Myers, former director of General Accounting of WorldCom was sentenced to one year in prison after the fraud incident. Management style consistent with the pressure that created an aggressive and competitive culture that did not contain any communication or ethics in the company culture. Employees were focused on revenues, rather than on profit margins. Lack of integration of accounting system allowed WorldCom employees to move exciting customers accounts from one accounting system to another. Employees had no training or awareness of this fraud or ethics and they were not aware of the consequences that may occur. Overall the culture was toxic and they made themselves believe that their actions were not really illegal, if it profiting the business.
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The causes of financial statement fraud for both companies were due to pressure from the upper management and to protect the company’s reputation. With Enron, the upper management wanted the Board of directors and investors to think that the company is going to be innovative and profitable. Even after the businesses were failing they had their external auditor to fake the numbers. Andersen should have never been their external auditor since he had a conflict of interest. Part of the auditor’s role is to look into the company internal controls to see how much they can rely on the company’s information based on how strong the controls in place are. Enron clearly had very big weaknesses in its internal controls, and Andersen completed disregarded this step. Andersen itself is also supposed to have strong internal controls, and evidence revealed in the aftermath showed that it did not. This was revealed when the national auditor’s committee wanted Enron to make certain changes but there were no controls in place to change. With WorldCom, they were going through a recession at this point. Due to several low demands and high competition in the telecommunication industry the prices start to fall. WorldCom, CEO Ebbers forced the managers to improve the revenue condition to remain in the business to attract more investors. The internal problem with WorldCom was its lack of competitive strategy, weak internal controls, an aggressive culture that demanded high returns, and the failure to look out for what was best for the stockholder as well as the stakeholder of the company. The competitive culture at WorldCom was characterized by loyalty to management with no regards to ethics, honesty, or integrity. Both companies had no policy on fraud prevention or detection in place to control these situations.
The main key factors resulted in both companies to a collapse: Senior Executives were encouraged to lie, cheat and manipulate records by providing them the high margin of profits. Executives were interested in their personal reward structure ignoring the stakeholders’ benefits. Board members were mostly highly rewarded and consist of the friends, who did not raise questions on any doubtful and ambiguous records. Non-Executive Directors were also highly rewarded and they worked independently. The audit team was bribed to produce a clean audit report. Illegal profits were generated and it was shown that all the policies and rules implemented from the top were for the benefit of the company and shareholders, and hence, were ethical.
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Enron and WorldCom need to strengthen their oversight by eliminating inaccurate financial practices that would result in a misleading financial statement. Practice ongoing compensation plans and payments rather than the extreme executive compensation plans for employees and management team. Enron should not have hired outside auditors to become a part of the consulting team. Both companies need to strengthen their independence by having the board and directors to be free of material financial ties to the company. Also having the audit committee to oversee the financial statement and accounting practices and also giving them the authorization to fire and hire outside auditors. To prevent future fraud for both companies, they should follow these six steps: know your employees, make employees aware of the reporting system, implement internal controls, monitor vacation balances, hire external auditors, and have a culture that creates positive work environment. The management team has huge responsibilities to implement this prevention and detection to avoid fraud.
With both companies, management could have adopted better accounting practices to avoid this fraud. Unfortunately in this case management believes that the function of a corporation is to reward upper management, rather than to maximize the profit of the company’s shareholder. Independent auditors made much more money from consulting than they did from the audit. There were pressure and opportunity from upper management for them to make more money if they would work with them to misrepresent the financial statement. There are a couple of ways to management can prevent future fraudulent activity. First, it is important to hire honest people and train them in fraud awareness and to present a code of conduct or ethics that is not only stated on a piece of paper but is truly respected and followed by other employees including top management. Second, a positive work environment must be created. Third employees must b provided with assistance programs. Implementing a code of ethics and having employees read and sign it periodically can reinforce ethical conduct as well emphasize that it is important to the company.
After this scandal SEC passed the law to protect the investors by improving the accuracy and reliability of the disclosures made by publicly traded companies. Section 301, gives audit committees more independence and responsibilities to strengthen the role to advise and oversee the auditors work and ensure the conflict of interest would not occur. Also, the external auditors are required to report directly to the audit committee and not the top management to ensure independence. Section 404 of the act directly impacts the auditing practices and to improve the quality of financial reporting. The goal for the Sarbanes and Oxley Act of 2002 is to increase the confidence in investors and to ensure proper reporting system. The Act was able to implement actionable structures that could reduce the numerous fraudulent activities that have been reported in the past. This act also protects external auditors to work independently and not to rely on the work of internal auditors.
In conclusion, most of these fraudulent activities come from companies where there is no structure. Employees might not be aware of the laws and regulation that is being set forth by the government. In the case of Enron and WorldCom, they had a corrupt environment, which leads the shareholders to lose billions of dollars. However at the end of the day, there are still other ways in which companies can deceive others, and the Act does not cover everything that could take place. In corporate American, the trust is slowly building back up again after these scandals as well as the recession in 2008. It’s a work in process and most companies could takeaway lessons from these scandals and to avoid them in the future.
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