Earnings manipulation and bankruptcy: WorldCom

Transcription

1 28 may Dhr. Drs. Joost Impink 2 e semester Third version, Bachelor paper Betzabeth Ignacius Earnings manipulation and bankruptcy: WorldCom Abstract In this paper I study to what extent earnings manipulation affect the following bankruptcy indicators; going-concern opinion, Z-score and the Logit scoring model. The WorldCom fraud serves as case study. The results show that the going-concern opinion of WorldCom is affected to the extent that it gives a clean concern instead of a going-concern and the bankruptcy measures to the extent that they still were able to predict bankruptcy for the company even with the earnings manipulation applied. 1

2 Table of contents Abstract 1 Executive summary 3 1 Introduction 5 2 Earnings manipulation (EM) Earnings management Earnings manipulation The role of accruals Motivations for Earnings manipulation 10 3 Going-concern and bankruptcy measures AU Section 341 and SAS 59 (Going-concern opinion) Bankruptcy measures The Z-score The Logit scoring model 16 4 Case study: WorldCom WorldCom fraud method Impact of EM on the going-concern and bankruptcy measures Negative trends Financial problems The Z-score The Logit scoring model 25 5 Conclusion 28 References 30 Tables 32 2

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4 Executive Summary A firm s ability to continue operating is important for its stakeholders. An auditor is required to analyze the firm s going-concern at the end of the annual report. This assessment is called the going-concern opinion. Here the auditor evaluates whether the firm will be able to fulfil its financial obligations within the coming year (AU section 341, p 505). Alongside the going-concern opinion there are also two popular bankruptcy measures that help predict bankruptcy; the Z-score and the Logit scoring model. However, failing firms may have the tendency to manipulate their earnings in their reported statements in order to reflect financial health (Rosner, 2003). Our current research question: To what extent does the earnings manipulation affect the expectation of a bankruptcy via the going concern opinion, the Z-score and the Logit scoring model? It underscores the need to evaluate the success and danger of these manipulations. Earnings manipulation reduces reliability of reporting; hence the paper suggests and tests the following hypothesis: Earnings manipulation will induce the going concern opinion, the Z-score and the Logit scoring model to give an incorrect analysis of the financial condition of a firm. Earnings manipulation is the extreme form of earnings management. It is the event in which managers violate the GAAP and commit an accounting fraud. Earnings manipulation is most likely to happen in companies with a weak governance structure, and likewise, earnings management can be caused by the debt-hypothesis and when the need for external financing is high. AU section 341 describes how auditors should form the going concern opinion. It provides some conditions and events that he must take into account. These are the negative trends, indications of financial problems, internal and external matters. Only the first two of these matters can be affected by earnings manipulation and are therefore relevant for this paper. Alongside the going-concern opinion, this paper also includes two bankruptcy measures; The Z-score and the Logit scoring model. Both measures predict the probability of termination of a firm. A Z-score lower than 1.8 indicates high probability of bankruptcy, while the Logit scoring model provides a percentage as probability of failure. 4

5 In order to answer the research question, I will analyze how the fraud in WorldCom affected its going-concern opinion and its bankruptcy measures. This fraud was the biggest in US history and was accomplished through the releasing of line cost reserves and capitalization of these line cost expenses (Lavey, 2006). In order to analyze the effect of the WorldCom fraud, I have computed and compared the ratios indicating negative trend and/or financial problems on basis of the reported statements and restated statement in 10K form. These statements are provided by the SEC database. I did the same for the measures. The WorldCom fraud affected the going-concern opinion to the extent that they did not raise any concerns. The indicators for both possible negative trends and/or financial difficulties made the company seem financially healthy when in reality it was suffering from huge losses and decreases in their working capital, operating cash flow and equity. The fraud also affected the two bankruptcy measure, but they were still able to predict bankruptcy for the company. The Z-score had in both years a value of less than 1.8 which indicates that the company has a high probability of termination and the Logit scoring model a predicted circa 90% chance for failure. On the other hand, the findings are also consistent with prior findings in the literature. First, the fraud methods used by WorldCom are consistent with the asset and liability distortion mentioned by Palepu, Healy, Bernard and Peek (2007) and the use of accruals by Burgstahler and Dichev (1997). Secondly, the fraud occurred in a firm with weak governance structure and supports in this the findings of Dechow, Sloan and Sweeney (1996). Finally, the results show that WorldCom was significantly dependant of external finance which implies that the need for credit may be a cause for the earnings manipulation in the company. The findings also imply that the earnings manipulation induced the goingconcern opinion conditions to give an clean concern. The negative trends and financial problems did not show any obstacles as for the firm s ability to continue when in reality the company was practically bankrupt. The bankruptcy measures were also affected but were still able to predict bankruptcy for the manipulated statements, which suggest that they are more reliable than the conditions defining in the going-concern opinion. For this reason auditors should include other factors, rather than only the ones required, when doing their assesment. These results do not provide enough evidence to support 5

6 the hypothesis that earnings manipulation induces incorrect analyses of the financial condition of a firm. However these findings are based on only one case study. I suggest further research in order to improve the way to assess a firm s ability to continue. 1 Introduction Auditors are required at the end of the annual report to give an opinion whether the company is financially healthy. They need to assess whether the level of certainty, that it will continue to perform, is sufficient. This assessment is called the going-concern opinion. This opinion is used by various stakeholders to analyze the financial position of a company. The opinion supports investors and lenders in their decision-making; whether to invest in or lend money to the firm. The going-concern opinion should help predict and explain bankruptcy. Chen and Church (1996) find that firms that did receive a going-concern opinion experience less negative returns when announcements surrounding bankruptcy are made than firms that received clean-concern. However, Rosner (2003) finds that failing companies did not show any signal of financial distress based on their reported data. On the other hand, the cash flow component of the earnings of these companies is significantly low in nongoing-concern years indicating earnings manipulation. Non-going concern year is a year when the company is failing or is financially not healthy and is therefore a non-goingconcern. Moreover she finds that that bankrupt firms financial statements are most likely to reflect reversal of earnings overstatement in the years that the company is doing well again. Rosner s findings suggest that earnings manipulation influences the auditor s opinion on the firm s ability to continue. But to what extent does the manipulation of earnings affect this prediction of failure? Besides, the going concern opinion, there are other measures for bankruptcy probability; the most popular measures being the Z-score and the Logit scoring model. Hence, I try to answer the following research question: To what extent does the earnings manipulation affect the expectation of a bankruptcy via the going concern opinion, the Z-score and the Logit scoring model? In other words I analyze how earnings manipulation affects the above mentioned bankruptcy indicators. The fact that earnings manipulation reduces the reliability of financial reporting, leads 6

7 to the following hypothesis: Earnings manipulation will induce the going concern opinion, the Z-score and the Logit scoring model to give incorrect analysis of the financial condition of a company. The purpose of this research is to analyze whether the use of earnings manipulation in failing firms affects the accuracy of bankruptcy indicators. Moreover, the study focuses on the question whether the manipulation of earnings prevents the auditor to deliver a correct opinion and/or prevent the bankruptcy measures to predict failure. This would help auditors and stakeholders, such as investors and lenders, identify the best way to assess the firm s ability to continue even when earnings manipulation is applied. This paper will answer the research question in the following manner; in chapter 2, I explain earnings management and the role of accruals since these are the basis for earnings manipulation, subsequently some reasons why earnings manipulation is applied are provided. Hereafter, in chapter 3, I analyze the rules that establish the formation of the going concern opinion and how the bankruptcy measures, Z-score and Logit scoring model, are computed. This will help identify which factors can be influenced by earnings manipulation and how can they be influenced. Then in chapter 4, the fraud case of WorldCom is introduced, which is the case study in this paper, where I provide how the fraud was committed. Next I study how the earnings manipulation made by the company affected the going-concern opinion and the bankruptcy measures. For this, both reported and restated financial statements in 10K form provided by the database of the Securities and Exchange Commission are analyzed. Finally I conclude with the findings of the case study and the answer to the research question in chapter 5. 2 Earnings manipulation This chapter provides the theoretical framework on earnings manipulation. Firstly, the distinction between earnings management and earnings manipulation needs to be made. Thereafter, the role of accruals and the reasons for managers to apply earnings manipulation are explained. This in order to understand clearly what is meant by earnings manipulation. 2.1 Earnings management Although, the difference between earnings management and earnings manipulation is 7

8 not always recognized in the literature, a distinction needs to be made. It is important to first understand earnings management since earnings manipulation is the extreme form of it. This section starts with an explanation of earnings management and accruals. Accruals are the accounting adjustments that make earnings management possible. Therefore, accruals also form the basis of earnings manipulation. Earnings consist of three components: cash flow, discretionary accruals and nondiscretionary accruals. Non-discretionary accruals are required adjustments from regulatory institutions such as the Financial Accounting Standard Board ( FASB), which must be made to cash flows while discretionary accruals are adjustments chosen by the manager and are not mandatory (Healy, 1985, p.89). Earnings management is not a clearly defined concept. It is described in diverse ways in the literature and even disguised under other names such as 'income smoothing' (Defond and Park, 1997). Bergstresser and Philippon (2006) define earnings management as the use of accruals to either increase or decrease profits. According to them earnings management is possible because; reported income includes cash flows as well as changes in the firm value that are not reflected in current cash flows. While cash flows are relatively easy to measure, computing the change in firm value that is not reflected in current cash flow often involves much discretion. The accrual components of income capture the wedge among firm s cash flow and reported income (p.514). In other words, earnings management occurs because cash flow does not capture changes in the firm s value. Accruals are the decisions that reflect those changes and are usually based on subjective judgment. Another definition is given by Healy and Wahlen (1999); Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers (p.368). Put differently, it is how managers influence financial reporting by managing earnings, giving the stakeholders a differing picture from what reality holds. As seen, multiple definitions can be found in the literature for earnings management, but all of them are ultimately about the same. Earnings management is the event when managers use the flexibility offered by accruals to steer profit in a desired direction. Earnings management has a 8

9 legal and illegal form. Earnings manipulation is the extreme form of earnings management, and fraudulent. Although some uses of earnings management are not prohibited, criticism is still possible This criticism of earnings management has a lot to do with accruals. Earnings management reduces the reliability of reporting and the quality of earnings. The fact that some decisions are subject to the discretion of the managers, reduces the reliability of financial reporting and the findings in Sloan s article (1996) suggest that accruals are less persistent than cash flows. The greater the accrual component compared with the cash flow component, the lower the quality of earnings. However, earnings management can also be applied to give the user more information (Healy and Wahlen, 1999, p. 369). Subrahmanyan (1996) presumes that the use of discretionary accruals improves the information on economic value. He explains that this is due to the reason that accruals are reflected in various performance measures. His research shows a link among the accruals and the stock price, future results and cash flow. The use of earnings management makes it easier to predict future income. Therefore the information about the value of an organization is most likely to improve and thus also the reliability. 2.2 Earnings manipulation Earnings manipulation is also known as fraudulent financial reporting and according to Rosner (2003), both earnings management and manipulation, refer to techniques that managers deliberately employ to achieve a desired level of reported earnings, but differ in the kinds of techniques used or the intensity with which they are employed. While earnings management does not technically violate generally accepted accounting principles, fraud does (p.367). Thus, what differentiates earnings manipulation of earnings management is that it is illegal. Earnings management is when managers make choices regarding accruals according to the generally accepted accounting principles (GAAP) and for earnings manipulation managers choose methods that violate these principles. The use of accruals for earnings manipulation remain thus important, only here they are used in a more extreme and opportunistic way. Hereafter, in 2.3 follows the justification of the existence of accruals. Dechow, Sloan and Sweeney (1996) however, consider earnings manipulation 9

10 both within and outside the bounds of GAAP. They explain that earnings management within GAAP can prevent the potential legal costs of earnings manipulation outside GAAP, so managers are expected to use earnings management in order to cover the outside GAAP violations (pp.3-4). Due to the illegalness of earnings manipulation it is very important that this is discovered as early as possible. There is thus a need for a model that helps detect such offenses. In his search for such a model, Beneish (1999) finds that the probability of earnings manipulation is the highest when there are unusual increases in receivables, deteriorating gross margins, decreasing asset quality, sales growth and increasing accruals (p.4). His findings support the assumption that accounting data are useful when detecting irregularities as for manipulations of earnings and when assessing reliability of those data. He did find a model which variables indicate distortion in financial statements that may have arisen from manipulation. The model consists of eight variables and uses some financial ratios to calculate a score. This score describe the degree to which the earnings have been manipulated. A company with a score of less than implies that it did not manipulate its earnings. But if the score is higher than it is most likely that the company manipulates its earnings. 1 On the other hand discretionary accruals models used to detect earnings management are also useful for detecting earnings manipulation since managers use accruals when applying both. Dechow, Sloan and Sweeney (1995) find that the Jones model is the one that works best in detecting discretionary accruals, because it is the one model that separates discretionary accruals from the non-discretionary accruals the best. Furthermore, according to Dechow, Sloan and Sweeny (1996, p. 5) earnings manipulation is most likely to occur when a firm s board of directors is dominated by management, when the CEO also serves as Chairman of the board or when the CEO is also the firm s founder and if there is neither audit committee nor outside block holder. Also these firms are less likely to have a Big Six auditor. All these characteristics mentioned make the internal governance weak with the consequence that there is less control on the management s actions. This increases the chances for earnings manipulations. Take for example the situation that the CEO is also the firm s founder:

11 he/she will have more to say and more influence on the firm and is less likely to be hold accountable for his/her action to the board of directors. 2.3 The role of accruals Although accruals offer the possibility to use earnings management and manipulation, they play a crucial role in measuring the performance of a firm. They deduct the problem of timing and matching, making earnings more insightful on the results than cash flow. Dechow (1994) examines different circumstances in which the results of organizations can be better reflected by earnings. She uses stock returns as a measure of the firm performance. The findings suggest that the importance of accruals increases as the interval which is measured becomes shorter. The chance that income and expenses are booked in the wrong period becomes bigger with higher cash flow. This risk is reduced through accruals and accounting rules (Dechow, 1994, p.13). The paper also looks at the variation among the required working capital and investment and financial activities. The results show that cash flow does not necessarily give a bad picture of how firms perform; it depends on the magnitude of accruals in that particular firm. This is especially the case in firms where the accrual component is reasonably small and that of the cash flow and earnings is respectably even. But, the larger the fluctuations among the working capital, investment and financial activities, the more cash flow will suffer of timing and matching problems (Dechow, 1994, p.27). 2.4 Motivations for earnings manipulation There are many studies on the possible motives that manager have to manage earnings. Since earnings manipulation is very similar to earnings management, many research for its motivation has included the motivation for earnings management. Dechow, Sloan and Sweeney (1996) examine to which extent earnings manipulation can be explained by extant earnings management motivations. They consider the following motivations; bonus hypothesis, debt hypothesis, external financing and insider equity sales. The bonus hypothesis was first investigated by Healy (1985) where he finds that managers tend to manage earnings to get their bonus; he describes three situations in which managers use accruals. He explains that if it is no longer possible for managers to receive their bonus, they tend to further reduce profits in the expectation that earnings 11

12 will amount more next year. This also happens when the profit has already reached a required maximum and it is most probable that they will receive the bonus, so in this case it is not viable to choose income-increasing accruals. In addition, managers choose to increase profits if it is reasonably possible to reach the maximum in that period. Another paper written by Holtausen, Larcker and Sloan (1995) supports the findings of Healy (1985); that managers indeed use accruals to achieve the bonus, however they do not find that managers manipulate earnings downwards when earnings are below target. But on the other hand Dechow, Sloan and Sweeney (1996), do not find any indication that the bonus hypothesis can be applicable to earnings manipulation. The debt hypothesis is also mentioned by Healy and Wahlen (1999); they recognize regulatory motives for earnings management. Here one must think of debt covenants. Such requirements may give managers the incentive to influence the income statement and balance sheet (p.378). Dechow, Sloan and Sweeney (1996) do find evidence that debt motivation can lead to earnings manipulation especially when lending contracts include special conditions. Lenders are risk averse and demand for that reason conditions to the loan known as debt covenants. In order to meet those requirements and prevent possible defaults managers will use accruals to increase earnings. For the external financing hypothesis, Dechow, Sloan and Sweeney use a measure of a firm s ex ante demand for financing in the first year of manipulation assuming that current assets can be converted in cash and represent the stock of funds available to the firm. Therefore they use the FreeC t - ratio. This ratio estimates for how long the firm can continue to fund its current level of operating and investment activities internally. They predict that when the FreeC t -ratio becomes more negative, the probability for earnings manipulation increases (1996, p.13). Managers manipulate the earnings to show a better performance to external parties when applying for credit. Like the bonus-hypothesis, insider trading is found to be no cause for earnings manipulation. The Security and Exchange Commission (SEC) defines insider trading as any security transaction made when the person behind the trade is aware of nonpublic material information. 2 Such trade includes selling stockholdings at inflated prices

13 Hereby, managers would manage earnings to sell their stock at the highest price possible and so make a reasonable high profit. However, there is no evidence that managers use earnings manipulation for insider trading reasons (Dechow, Sloan and Sweeney, 1995, p.30). Concluding, earnings manipulation occurs when managers choose accruals outside GAAP and commit accounting fraud. The literature also mentions the use of accruals within GAAP which refers to earnings management to help cover the fraud. Earnings manipulation has the tendency to happen in organizations with weak governance structure and like earnings management, earnings manipulation occurs in cases of debt covenants and when external financing is needed. There is no evidence that managers commit fraud to achieve their bonus or insider trading. This implies that managers tend to commit fraud in favor of the company s interest rather than for their personal. 3 Going-concern This chapter will give the rules that establish the formation of the going concern opinion. This will help identify which factors help form this opinion in order to determine later on in this study to what extent these factors can be influenced by earnings manipulation. When assessing the going concern of a firm, the auditor is actually looking for any indications whether the firm will go bankrupt soon. For this reason this paper looks at two popular bankruptcy measures; the Z-score and the Logit scoring model. 3.1 AU Section 341 and SAS No. 59 (Going-concern opinion) AU section 341 Auditors have the responsibility to give a going concern opinion to an entity and/or organization. The going-concern is an indication whether the firm will be able to continue performing in the future. Investors and lenders are examples of stakeholders who use the going-concern opinion when analyzing a firm. For investors it is important that the firm keeps carrying on, due to their expectation of a part of the future earnings 13

14 and on the other hand, lenders need to be sure their money will be restored. AU Section 341 and SAS 59 describe the going-concern opinion and how auditors form their opinion of this. 3 AU Section 341 provides guidance to the auditor in conducting an audit of financial statements in accordance with generally accepted auditing standards (GAAP) with respect to evaluating whether there is substantial doubt about the entity's ability to continue as a going concern (p.505). In other words the moment the auditor assesses whether there is substantial doubt for the firm to go bankrupt. In the case of a high probability of bankruptcy the auditor gives a goingconcern opinion and a clean-opinion when there are no concerns. The auditor is required to use his knowledge and other information such as current events or events that took place before the auditor s report. The auditor should evaluate the going-concern of a firm in the following manner: The auditor considers whether the results of his procedures performed in planning, gathering audit evidence relative to the various audit objectives, and completing the audit identifies conditions and events that, when considered in the aggregate, indicate there could be substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time. It may be necessary to obtain additional information about such conditions and events, as well as the appropriate audit evidence to support information that mitigates the auditor's doubt. (AU section 341, p. 506) The auditor must also follow some procedures that may identify such conditions and events. For example a company that is failing to meet the demands of a debt covenant may indicate financial distress; this can help the auditors recognize obstacles for the continuity of the firm. AU section 341 provides some examples of the conditions and events that may rise substantial doubt about the going-concern, these are; negative trends, other indications of possible financial difficulties, internal and external matters that have occurred (AU 341, p.507). Moreover it explains what is meant by these matters. Negative trends may include working capital deficiencies and operating losses. Restructuring of debt and not meeting statutory capital requirements are indications of possible financial difficulties

15 Internal matters acknowledge labor difficulties or work stoppages. It is thus really about internal factors that may impede the continuity of the firm. External matters are events that hinder the firm to keep doing their operations for a reasonable period of time. Some examples of external matters are loss of an important client or supplier or even insurance issues related to a drought or earthquake. The following subjects are relevant for this study; the negative trends and the indications of financial troubles. The reason for this is that these events may be influenced through earnings manipulation, while the remaining is influenced through other factors rather than by the high use of accruals. How these two subjects can be influenced by the use of accruals will follow in chapter 4. SAS No. 59 Prior to SAS No. 59, SAS No.34 was applicable in determining going concern opinion. SAS No. 59 is an extension of the requirements of SAS No.34 on evaluating the goingconcern of a firm. Holder-Webb and Wilkins (2000) evaluate if the incremental information of SAS No. 59 have allowed investors to analyze firms better. They describe the main differences between SAS No. 34 and SAS No. 59. First, SAS 34 required auditors to evaluate the going concern in a more passive way, while SAS No. 59 expect auditors to research actively what conditions or events may raise substantial doubt on the going concern. Secondly, under SAS 59 auditors must assess a going concern for a reasonable period of time, not to exceed one year beyond the date of audited financial statements (AU 341, SAS No.59). SAS 34 does not state a specific time period to evaluate a going concern. The findings of Holder-Webb and Wilkins shows that SAS No. 59 has improved auditors evaluations of going concern in a more active way. However, Tucker, Matsumura and Subramanyan (2003, pp ) suggest that auditors may face some complication when making their judgment on a firms going concern, these difficulties are the self-fulfilling prophecy and noise in the auditor s forecast. In their paper they describe that self-fulfilling prophecy is when the auditor s public expression of doubt, in itself, hastens a company s end, particularly one whose viability rests on trust and a high stock price. At the other hand they predict that an auditor will express a going concern opinion as the noise, in the forecast about the client s ability to continue, increases. However, if after a clean-concern opinion was 15

16 given, the firm was still unable to continue as a going concern, the auditor cannot be hold amenable for an inaccurate assessment. The above given four conditions and events can also be considered as the factors that help an auditor assess the going concern opinion. These are negative trends, financial difficulties, internal and external matters. We also noted that only the first two are relevant for the case study that will follow later in this paper; since they are the factors which can be directly influenced by earnings management and manipulation. On the other hand, a going concern opinion can be affected by the self-fulfilling prophecy and when the noise in the forecast increases. 3.2 Bankruptcy measures Although bankruptcy measures are not mentioned in the regulations for the going concern opinion, they are essential for the assessment of the firm s ability to continue operating in the future. This paragraph will explain the bankruptcy measures often used to determine the probability of failure in firms. These measures are the Z-score designed by Altman and the Logit scoring model by Ohlson The Z-score In the literature, the going-concern is often related to bankruptcy. Subramanyan and Wild (1996) refer to a going-concern as an entity s probability of termination. The Z-score is a measure often used to measure the probability of bankruptcy and was revised by Altman (1968). Subramanyan and Wild (1996) define the Z-score as a linear, prespecified combination of operating and financial ratios and, hence, there is the possibility that one or more component ratios individually determine results, rather than termination probability per se (p.266). They also use the Altman Z-score in their paper. Altman (1968) computed it as follow: Z i,t = 1.2 X 1,i,t X 2,i,t X 3,i,t X 4,i,t X 5,i,t where X 1,i,t = (current assets current liabilities)/total assets, X 2,i,t = retained earnings / total assets X 3,i,t = earnings before interest and taxes / total assets X 4,i,t = market value of preferred and common equity / book value of total 16

17 liabilities X 5,i,t = sales / total assets The Z-score can be computed for every quarter. The variables X 1,i,t, X 2,i,t, X 4,i,t use current information while the other variables (X 3,i,t, X 5,i,t ) will also use the information of sales and earnings of the prior three quarters at the end of the fourth quarter. So the Z-score measures the termination probability on a continuously base (Subramanyan and Wild, 1996, p.257). Palepu, Healy, Bernard and Peek (2007, p.418) explain that when Z i,t < 1.81, the chance for a public quoted company to go bankrupt is very high. If 1.81 < Z i,t < 2.67, it is less probable for the company to go bankrupt but it still remains in an ambiguous area. A Z i,t higher than 2.67 implies a low probability for bankruptcy. The reason to include the Z-score in this study, besides its popularity, is due to the manageable components of this equation. All the components can be influenced by the decisions of the managers; some of them in part consist of earnings; by simply decreasing or increasing the reported earnings, they will affect the Z-score and the same goes for the other components. This paper will expand upon this in chapter The Logit scoring model The Logit scoring model, alongside the Z-score, also predicts probability of bankruptcy within one year. This model was developed by James Ohlson who did a research on what factors would predict the failure of a firm best. Unlike the Z-score, the Logit model is based on the size of the company, a measure of the financial structure, a measure of performance and a measure of the current liquidity (Ohlson, 1980, p 110) and gives a percentage as probability of failure. According to Ohlson (1980) the major advantage of the Logit scoring model is that there is no need to make assumptions regarding prior probabilities of bankruptcy. He explains that other models that are based on suppositions may lead to invalid or poor approximations, if the assumption is incorrect and the Logit scoring model use real data instead. The probability of bankruptcy using the Logit scoring model is computed as (Ohlson, 1980): Score = 17

18 y = size D D E Where size is measured as the natural logarithm of capitalization, TL is total liabilities, TA is total assets, WC is working capital, CL is current liabilities, CA is current assets, NI is net income and WCO is working capital flow from operations. D1 equals 1 if net income was negative for the last two years and 0 otherwise. D2 equals 1 if total liabilities exceed total assets and 0 otherwise and E is the change in net income divided by total sum of absolute values of current and prior years net incomes. Such as Z-score, this model also contains a manipulative portion namely the net income, total assets and total liabilities. Furthermore, there is an element that makes the Logit model sensible to earnings manipulation made in prior years, see (7). Earnings that have already been manipulated in the last two years will affect the current Logit score model because it also includes the net income in the prior years. This paragraph explained how both bankruptcy measures are computed and gives some indications on why these predictions could be sensible to earnings management and earnings manipulation. 4. Case study: WorldCom As mentioned earlier in the introduction, this paper analyzes how the manipulation of earnings would have an impact on the going-concern opinion and other assessment when predicting bankruptcy. It focuses on negative trends, financial problems and the bankruptcy measures; Z-score and Logit scoring model. This part tests the accuracy of the hypothesis that the use of Earnings manipulation will lead to incorrect bankruptcy fillings. WorldCom will serve as case study. The study focuses on how the earnings manipulation of WorldCom affected its going-concern opinion in 2000 and It shows the opinion that was based on the reported earnings by the company in 10K form of the SEC 4 database and also how it would be based on the restated statements made

19 in Idem goes for the Z-score and the Logit scoring model. But first, we take a look on how the fraud was committed in WorldCom. 4.1 Accounting methods used in WorldCom In 2002, the SEC announced another accounting scandal; After Enron the telecom company WorldCom manipulated earnings. CFO and board member of WorldCom, Scot Sullivan, was held responsible accounting fraud, which also constitutes the largest scandal in U.S. history. 5 Sullivan had increased the reported earnings of the financial statements of 2000, 2001 and first quarter of 2002 that indicated that the company was doing well while in reality this was not the case. The auditor responsible for the financial statements of WorldCom was the once Big 5 accounting firm Arthur Andersen that was also the auditor of Enron. WorldCom made over 60 acquisitions and paid these with the company s shares. This is believed to be the reason that the company committed the fraud; by increasing the company value they were also increasing their share price on the market and had thus more purchasing power. 6 The WorldCom accounting fraud was relatively simple compared to the more complex fraud that the CEO s committed in Enron. Since 1999 the company was facing problems, it borrowed $366 million to cover losses on stocks and the industry itself did not offer more opportunity for higher profit. Another telecom company AT&T was losing money when suddenly WorldCom was making profit. This raised a red flag at the SEC who decided to investigate the accounting policies of the company. They found that WorldCom s reported earnings were increased through the removal of some expenses and capitalization. 7 Lavey (2006) describes two processes through which the company violated the GAAP. First, line costs reserves were released into income, which reduced the line cost expenses reported on the financial statements. Line costs are the fees WorldCom paid to third party for transmitting portions of WorldCom s services such as calls. A

20 manipulation was made because the reserves were not released according to the GAAP, subsequently they did not make any statement or analysis of why these reserves should be released. This is how WorldCom reported a total of $ billion for line costs where in fact its line cost totaled $ billion in that year (Sidak, 2003, p.238). Secondly, CEO and Co-founder of WorldCom, Bernard Ebbers requested the capitalization of hundred of millions of the line cost expenses. A capitalization involves removing expenses of the income statement and converting them into assets on the balance sheet. According to the GAAP these costs must be expensed and not capitalized. In this manner expenses on the income statement are reduced as well as the net expenses, the company inflated its value. On the other hand, the fact that the accounting fraud was so simple leads to the question; why was it not discovered earlier? As noted in 2.2 earnings manipulation is most likely to happen when the firm s governance structure is weak. WorldCom did have a weak internal governance structure; they had a CEO who was also the cofounder of the company and a CFO who was also a Board member. This reduces internal controls on management actions; there is no separation of duties, in such situations one has the opportunity to commit fraud due to the high position as CEO and CFO and also conceal it because he is the co-founder or board member. However, the company had one of the Big 5 as external auditor, namely Arthur Anderson and still the fraud went undetected for two years. How can this be? The literature provides some explanations of why a fraud can go undetected. For start, the auditor does not include the likelihood of GAAP violations through their audit and the future negative consequences that high accruals may have (Bradshaw, Richardson and Sloan, 2001, p.72). And Defond and Subramanyan (1998) find that a client will change his auditor if they do not agree on the appropriate application of the GAAP. However, according to Defond and Subramanyan (1998), the auditor will choose for a more conservative reporting due to the high litigation risks concerning high accruals. They find that auditors are most likely sued when reported earnings are overstated and almost never to be sued when earnings are understated (p.41) Heninger (2001) also examines the relation between high accruals and litigation risk. He finds that auditors face increased litigation risks if they do not detect the use of abnormal 20

21 (discretionary) accruals by managers to manipulate earnings. An internal auditor discovered the fraud in the case of WorldCom. It seems that the then external auditor, Arthur Anderson did not find any red flags in the reported financial statements by WorldCom and was thus not in compliance with the company. However, outsiders do criticize Arthur Anderson. They find it difficult to believe that such simple accounting fraud was not discovered earlier Impact of the EM on the going concern and bankruptcy measures This section discusses how managers in failing firms would use accruals to hide their poor performance and how this would affect the going concern based on the literature. Moreover, it shows how earnings manipulation affects the factors which help form a going-concern opinion and the predictions of failure in WorldCom in the years that the fraud was committed. As noted earlier, the fraudulent statements are compared to the restated statements. This gives an indication on how it works in practice and if it coincides with what is mentioned in the literature Negative trends Firms suffering from negative trends that include severe operating losses or falling short on the working capital, or both, will probably try to mitigate these problems since the auditor looks to such events in order to make his opinion about the continuity of the firm. To cover such losses they can smooth their income. Defond and Park (1997) suggests that managers borrow earnings from the future in an attempt to give stability to the current earnings. If the company currently performs poorly, managers opt to shift earnings from the next period to the current one (p.116). Burgstahler and Dichev (1997) suggest in their research that managers use accruals to avoid losses. They mention the manipulation of working capital accruals. This paper looks at the following negative trends for the case study; recurring operating losses, working capital deficiencies and negative cash flows from operating activities. The results are shown in table 1 and are discussed hereafter. The results show how the accounting fraud committed influenced the factors that state the negative trends. The reported operating income for 2000 and 2001 was significantly 8 bz.accounting27jun27,0, story 21

22 higher than it should be. WorldCom was actually operating with enormous losses; for 2000 they reported an operating income of $8.5 million, when actually they should have reported a loss of $49 million. Thus an opinion made on the basis of the reported earnings would be positive since no negative trends are visible in the operating income. If the actual losses were reported, there would have been immediate concerns about the firm s ability to continue. Moreover, their working capital was much more negative than they reported. Although, it was already negative when they reported it did not raise a red flag because working capitals normally can have some small deficiencies. But the actual working capital in 2000 shows an abnormally high deficiency of $7.7 million; such a deficit could have warned investors and auditors. The cash flow from operating activities was positive even after the financial statements were restated. However, the reported operating cash flow showed an increase in 2001 of $0,328 million when really it decreased in 2002 with almost $1.4 million. The difference of the reported operating cash flow in 2000 and 2001 with the restated cash flow was respectively $3.4 and $5.2 million. But still, this would probably have not raised any concerns on the going concern due the fact that the operating cash flow was positive even after the restatements. On the other hand this method of increasing the cash flow from operations is consistent with what Burgstahler and Dichev (1997) suggest in their paper about using cash flow to avoid decreases in earnings. However, the results show some improvements in the actual situation of those years; in 2001 the operating income is higher than 2000, same goes for the working capital. The operating income improved with $37.6 million in 2001 and $2 million for working capital Financial problems Another situation where it s most probable that earnings manipulation will be used is when a firm is failing to meet the constraints on a loan or debt requirements. Such events may indicate financial distress and influence the continuity capability of the firm. A company in financial troubles will have difficulties obtaining more credit and will experience the tendency to use accruals to manipulate the requirements in their favor. Healy and Wahlen (1999) explain this in their paper; they mention regulation as motivation for earnings management and subdivide it in two categories; Industry 22

23 regulation and Anti-trust and other regulation. Industry such as banking and insurance are usually required to meet some condition for financial health and such regulations often lead to earnings management in the financial reporting intended for the interested parties (p.377). The anti-trust and other regulation is applicable on the situation described above; these are the regulations that are required from public firms in, for example, a debt covenant. An example of requirements may be a ratio of earnings before tax to net interest expense not less than 2 to 1 or a current ratio not less than 1.5 to 1. In these circumstances the managers will try to use income increasing methods such as asset distortions. One way to manipulate an asset in order to increase earnings is by underestimating the value of allowances (Palepu, Healy, Bernard and Peek, 2007, p 146). WorldCom made use of an asset distortion method; recall 4.1. They capitalized the line cost expenses, increasing the total assets and hereby also the retained earnings. WorldCom s financial ratios This part analyses the financial position of WorldCom more in-depth with help of the notes on long term debt of the company for the years 2000 and The paper considers the ratio mentioned in the notes; debt to capital. But since the company does not give any more specifications on the debt covenants and is not obligated to do so, I will also analyze the financial ratio total debt to equity and free cash flow to current liabilities. Such ratios give an indication of the debt position of the firm. If the debt position of the firm is known it may also serve as an indicator of what could have driven WorldCom to commit fraud, since the debt hypothesis of earnings management is also applicable for earnings manipulation (Dechow, Sloan and Sweeney, (1996). The ratios are computed in table 2 and the findings are discussed below. The company reported for 2000 that it was in compliance with all the financial covenants on the credit facilities. These financial covenants were based on the ratio of total debt to total capitalization (assets), calculated on a consolidated basis and on operating covenants. The higher the debt to capital ratio the more the company uses debt instead of its equity and thus the more the cost of debt will weigh on the company which increases the default risk. This ratio was for the reported statements in 2000 and 2000, respectively 24% and 28% and implies that the company used more equity instead of debt for financing, which leads to a lower default risk. But this factor was in reality 44% for 2000 and 87% for 2001, implying that the company was using debt to 23

24 finance its operations. The default risk was thus also presumably high. The actual data would have warned lenders of the high possibility of WorldCom s failure. The other financial ratios were also affected by the earnings manipulation. The net debt to equity was according to the reported statements both between 40% and 50% for 2000 and 2001 which is a reasonable percentage. But the net debt was actually 10 times the equity for 2000 and even negative in 2001 due to negative shareholders equity. This gives an indication that WorldCom could not finance internally and needed external financing. For external financing it is important that the borrowing company is performing well. So the possibility that WorldCom committed fraud due to reasons of external financing cannot be ruled out. Recall external finance as a cause of earnings manipulation (Dechow, Sloan and Sweeney, 1996). However, CEO Ebbers borrowed $250 million for the purchase of WorldCom shares and had thus significantly personal financial interest in high stock prices. This suggests that the bonus hypothesis may still be applicable for earnings manipulation. The free cash flow to current liabilities ratio indicates how well the current liabilities are covered by the cash flow available (cash that remains after all operating expenses). This ratio was in the years, 2000 and 2001 higher than 1, which led to the conclusion that WorldCom was capable of paying its current liabilities with its free cash flow. However, this is based on the manipulated financial statement. The actual ratio was lower than 1, in 2000 the company was able to cover its current liabilities for 80% and in 2001 for 66%, which is still a reasonable percentage and therefore would not be alarming Z-score As noted earlier in 3.2.1, a Z-score value of lower than 1.8 indicates a high probability of termination. The Z-score can be affected by earnings manipulation due to its manipulatable portions. Take the variable X 3,i,t for example, not only does this variable have an earnings component but it also has the highest multiplying factor in the equation; 3.3. Only increasing the earnings will already increase the Z-value and therefore also decrease the chances for bankruptcy predictions. The same holds when decreasing the assets; the value of X 3,i,t will also improve when assets are lower. Again managers can make use of asset underestimations as mentioned in the book of Palepu, Healy, Bernard and Peek (2007, p.157) to reduce the value of the total assets. 24