TELECOM RED FLAGS CASE
Hugh Grove & Tom Cook, University of Denver
Jon Goodwin, Barra Partners, LLC
This case offers several major teaching objectives for student learning opportunities: (1) To understand complex issues for ratio analysis concerning the detection of earnings manipulation and financial reporting problems, (2) To understand why (and why not) such ratios can be useful as red flags in specific situations, like identifying the three manipulators, out of the nine telecom companies, (3) To appreciate the importance of non-financial red flags in predicting earnings manipulation and financial reporting problems. This case is intended for senior level and graduate courses in finance and financial accounting. The case topics focus upon ratio analysis as red flags for earnings manipulation and financial reporting problems. Related topics include earnings management techniques and both financial and non-financial red flags as leading indicators for financial fraud detection. The case should be positioned near the middle of such courses after earnings management and ratio strategies have been covered.
The students are placed in the role of the recently hired Managing Director of Research for a small investment-banking firm. This Research Director was given the task to establish red flag procedures for detecting earnings manipulation and financial reporting problems, using the telecom industry case with its three high profile, problem companies, Qwest, Global Crossing, and WorldCom. These procedures included the use of “irrational” ratios, updated from prior earnings manipulation research, and various profitability ratios. The ratio analysis was performed on nine major telecom companies: the three problem companies and six other major telecom companies. To challenge the students and enhance their judgmental and analytic skills, they must try to identify the three problem companies out of all nine companies whose specific financial data are provided anonymously in the case.
The Research Director was also given the task of identifying leading non-financial red flags from company-related events that occurred well before the public reporting of earnings manipulation and financial reporting problems. Qwest was chosen to demonstrate this approach since it had so much publicity from numerous investigations and lawsuits. In summary, both financial and non-financial red flags were identified as leading indicators of earnings manipulation and financial reporting problems. The Research Director has continued to create a set of red flag procedures that are fundamental to the core research competency of his new employer.
This case was prepared by Hugh Grove and Tom Cook, University of Denver, and Jon Goodwin, Barra Partners, LLC, and is intended to be used for class discussion rather that to illustrate either effective or ineffective handling of the situation.
Presented to and accepted by the North American Case Research (NACRA) for its annual meeting, November 2003, Tampa, Florida. All rights reserved to the authors and NACRA. © 2003 by Hugh Grove, Tom Cook and Jon Goodwin.