Running head: CASE ANALYSIS OF THE ACCOUNTING FRAUD AT WORLDCOM

Case Analysis of the Accounting Fraud at WorldCom

Angela Crossley

Troy University

October 27, 2008

History

The origin of WorldCom can be traced back to 1983. The CEO, Bernard J. Ebbers, of WorldCom had very interesting beginnings. He invested in Long Distance Discount Services (LLDS) with eight other investors, and believed that the telecommunications industry was a very good business venture. In the beginning the lack of technical experience of the LLDS proved to be detrimental by creating a great deal of debt. The company enlisted Bernard J. Ebbers to create a sound and solid business. Ebbers proved himself to the company and others in the industry that he was a force to be reckoned with and turned the business profitable in less than a year’s time. Ebbers did not have a degree in business from any elite school. He had a very humble beginning with cost cutting at the forefront and a desire to make change within the industry. In 1995, the company publicly became known as WorldCom. By 1998, Ebbers and his Chief Financial Officer, Scott Sullivan, who was the brains behind the MCI merger, received accolades and were recognized by analysts as industry torch bearers. As the years progressed and the company grew larger, problems began to arise. The problems that WorldCom encountered could not have been predicted by any of the stockholders. In 1999, WorldCom tried to attain Sprint, but the merger was terminated, which led to the beginning of the end for WorldCom. On July 21, 2002, WorldCom Group filed bankruptcy, which was due to deliberately overstating tax income.

The Culture

WorldCom’s company culture was extremely oppressive. The advent of expanding the company led to pitfalls that management did not address. WorldCom acquired different companies and continued to manage the companies that they obtained as separate entities. The disconnection of the departments within the company impeded the performance and governance of the WorldCom. Ebbers’ attitude towards corporate governance spearheaded the less than favorable climate of the company. Upper management only wanted to dictate the employees. The employees did not have any way of reporting grievances. The chain of command only flowed downward. Employees did not feel at liberty to disclose inadequacies within the company, because the lack of the code of conduct that Ebbers felt was a waste of resources to pursue. If Ebbers had fostered a culture where employees at all levels followed a chain of command when reporting issues, several problems could have been alleviated or at least Ebbers would have had knowledge of all of the inadequacies of the firm. Sullivan, CFO, took advantage of the lack of a direct chain of command and ran the business how he wanted to do so. Upper management used intimidation and scare tactics to gain what they wanted from employees. The threats and language that Buddy Yates, director of WorldCom General Accounting, used when speaking to the Gene Morse, senior manager at WorldCom’s internet division, was not professional neither ethical. Threats should have been reported and dealt with accordingly.

Employees that were loyal and did what they told, especially the ones that worked in accounting, finance, and investment departments received compensation for their duties. Compensation to those employees in those

departments equated to “hush mouth” money. Ebbers and Sullivan were both aware of the downward turn the company was taking and wanted to make sure to keep the employees that were privileged to the financial information, was kept happy. Often time’s people will keep quiet for the right price.

The Beginning of the End

The external environment that WorldCom faced during 1999-2001 was grim. The telecommunications industry had taken a nosedive. The competition was fierce and the demand for telecommunications declined. Sullivan, CFO, apparently felt that desperate times called for desperate measures. Sullivan and his staff used accounting strategies to realize targeted performance for the company. Executives were pressured by the numbers. The pressures of Wall Street were an increasing concern of executives. The executives wanted to make sure that stock prices were not affected by the companies’ unspoken hardships. Top level executives did everything in their power to “snow” everyone that had some type of interest in the company.

Betty Vinson and Troy Normand from the general accounting department were enlisted to make transfers by their boss Yates. They were opposed to following the orders of top-level management, but eventually they conceded to the pressures. Like “good” employees, they did what they were told. Yates told his employees that the orders were given by Myers and Sullivan. Sullivan insured them that nothing was wrong and he would take full responsibility for their actions. Interestingly enough, Ebbers “heard” about the accountants’ apprehension and reportedly told Myers not to put the accountants in that position. This is another example of the breakdown of communication within the company. This led me to believe that Ebbers was not all knowing of the financial woes of WorldCom. Sullivan called many of the shots that led the company into its detriment. Ebbers should have tightened his grip on the company and conducted his own investigations about the numbers. Ebbers should have insisted on his approval before any major business decisions were made. Ebbers had the title of CEO, but Sullivan was the financial brains behind the company. Ebbers admitted to not knowing about the numbers, and relied heavily on Sullivan to make important financial decisions about the business.

Betty Vinson was a victim. She had a reputation of following orders as directed. Upper-level management used Betty’s weakness to their advantage. Betty was the bread winner of her family and needed her job and did not want to be insubordinate and lose her job by not complying. Betty Vinson was caught in a very difficult situation as many of the employees at WorldCom that needed their jobs to support their families.

Smoothing earnings is not an illegal act; it levels out peaks and valleys from normal earnings. Fraudulent financial reporting is an aggressive act taken by executives within a company to intentionally conceal financial information about the company and to deceive others about the wealth of the company. (http://www.investopedia.com/ask/answers/191.asp) WorldCom committed fraudulent activities. Now, Ebbers is serving time in prison for delegating the responsibility of being the CEO to the CFO.

The internal auditors of WorldCom reported to CFO. The internal auditor should have reported to the CEO and the audit committee. In 2001, Cynthia Cooper headed the internal audit department. Gene Morse, at that time, worked for the audit department. Cynthia Cooper and Gene Morse was a matched made for the demise of the WorldCom. Although a few years had passed, Gene Morse, surely, did not forger about the threats that were made to him by Yates. Morse wanted justice and wanted the executives to be exposed for who they really were. Morse coupled with Cooper’s inquisitive nature and a desire to accurately report financial information went through extreme measures to get to the root of WorldCom’s finances.

External auditors serve a vital role in our economy. They ensure that companies are employing good business practices and disclosing accurate records to shareholders. External auditors are the hub of our economy. Arthur Andersen was WorldCom’s independent external from 1990 to 2002. Initially, he and his team audited WorldCom the conventional way, up until the massive expansion of the company. With the increased mergers, Andersen adopted what he thought was a more efficient way to audit the company. He focused his audits primarily on analytic reviews and risk assessment. There was a checks and balances system. Andersen trusted the company to supply him with accurate financial records. Andersen may have been suspicious about the records. But, he really did not want to find out too much because the success of the company was important to him too. Andersen should not have been WorldCom’s auditor because there were conflicts of interests. Andersen violated the competence, integrity, and credibility ethical practices. He lacked competence because he did not provide accurate information about the results of the risk management software, which indicated that WorldCom was a maximum-risk client. Despite Andersen’s findings, his audit reports continued to depict WorldCom as moderate-risk client. Andersen had a special interest in the company. He even reduced his fees for auditing the company. He lacked integrity by doing so, and felt compelled to keep the corporate conglomerate afloat by not doing thorough investigations. Surely, Andersen was receiving massive amounts of money for auditing the company and not to mention the notoriety he received for being associated with the company. He did not really want to risk his social standing to be a corporate whistleblower. He could have asked more questions and probed a little more, but he wanted the company to thrive. The high-level executives went to extreme measures to ensure that Andersen received records that were not accurate. They prepared special reports for him, which was out right blatant fraud at the executive level. Andersen lacked creditability because he did not disclose to the audit committee about his restrictive access to financial records. Andersen did not actively adjust the numbers, but he was a major part of the problem that led to company’s downfall. He should have been unbiased and reported the findings to the audit committee. He did not act professionally and should have received prison time and should have had to pay restitution because he did not uphold ethical standards. He put many peoples livelihood at risk by simply not doing the job he was hired to do.

Conclusions

Ebbers should have received prison time for his involvement and being the CEO of the company. Ebbers’ unethical behavior trickled down to all of his subordinates. He violated practically all of the professional ethics. Although he was the not the CFO, he should have established an environment where he had oversight of all of the important financial business decisions. His defense of not being a numbers man was not sufficient. He is paying dearly for the lack of not knowing the numbers and trusting his CFO, which in turn, sold him out.

Ebbers’ approach to business was too broad. He acquired too many businesses when he could not control the one that should have been the most lucrative. He was irresponsible for using WorldCom to back his other personal business ventures. Although Ebbers may not have known of all of Sullivan’s poor business decisions, he made plenty of poor decisions himself, in which he was responsible. Ebbers knew exactly what he was doing when he decided to own his many businesses, and that too affected WorldCom.

Sullivan’s sentence was not just. He should have received more time in prison because he orchestrated a great deal of the financial transfers. He acted alone on several occasions, but was not held as accountable for his efforts in the collapse of the company.

Ultimately, the crisis could have been averted by establishing professional standards for managers and employees alike. When there are effective measures implemented to ward off unethical behaviors, employees at all levels are less likely to engage in behaviors that are not becoming of their profession. There should have been

professional development at every level of the company to ensure that all employees knew how and to whom to report activities that could be less than favorable to the company, its reputation, management, and employees.

References

Accounting Fraud at WorldCom. Retrieved October 21, 2008 from Harvard Business Online Website: https://harvardbusinessonline.hbsp.harvard.edu/b01/en/courseplanning/student/student_course_detail.jhtml?courseId=c23431

Horngren, T. C., Sundem, L. G., Stratton, O. W., Burgstahler, D., & Schatzberg, J. (2008). Introduction to Management Accounting Chapters 1-17 (14th ed.).

What is earnings management? Retrieved October 25, 2008, from Investopedia Website: http://www.investopedia.com/ask/answers/191.asp

Abstract:

The case discusses the accounting frauds committed by the leading US telecommunications giant, WorldCom during the 1990s that led to its eventual bankruptcy. The case provides a detailed description of the growth of WorldCom over the years through its policy of mergers and

acquisitions. The case explains the nature of the US telecommunications market, highlighting the circumstances that put immense pressure on companies to project a healthy financial position at all times. The case provides an insight into the ways by which WorldCom manipulated its financial statements. The case also describes the events that led the company to file for reorganization under Chapter 11 of the U.S. Bankruptcy Court in 2002.

The role of the company's top management in the scandal has also been discussed. Finally, the case explores the initiatives being taken by the company to change its management structure, improve its performance and restore investor confidence.

Worldcom 2002: Yet Another Corporate Scam

On June 26, 2002, the US-based telecommunications major WorldCom received unprecedented media coverage all over the world. Not for good reasons though. The company had earned the dubious distinction of being involved in the largest accounting scandal ever to hit the US corporate history. WorldCom had reportedly misrepresented its financial statements to an extent of around $ 4 billion.

The company admitted that it had resorted to fraudulent accounting practices for five quarters (four quarters of 2001 and the first quarter of 2002). Soon after, WorldCom terminated the services of some of its top executives including Scott Sullivan (Sullivan), the Chief Financial Officer and David Myers, the Senior Vice President and Controller. 

The company's auditors held Sullivan responsible for the accounting mess and Sullivan was soon arrested on charges of fraud and misrepresentation. Adding fuel to the fire was the fact that Arthur Anderson was WorldCom's auditor while the inappropriate accounting was taking place.2

However, Arthur Andersen tried to wash its hands off the crisis stating that it was not aware of the accounting discrepancies. They accused Sullivan for withholding crucial information about book-keeping practices followed at WorldCom.

With the sudden appearance of a $ 4 billion hole in its balance sheet, WorldCom was in an acute financial crisis. A severe cash crunch forced the company to layoff 17000 workers, which constituted 20% of its global workforce.

Eventually, the financial crisis forced WorldCom to file for reorganization under chapter 113  of the Bankruptcy Code in July 2002., In August 2002, WorldCom shocked company observers and stakeholders yet again by reporting an additional improper reporting in its financial statements. This time around, the amount involved was $ 3.3 billion, carried out by manipulating the EBITDA4 during 1999-2001, and the first quarter of 2002. By late 2002, the extent of misappropriation by WorldCom was estimated to be well over $ 9 billion...

From being one of the world's most valuable companies (valued over $ 100 billion at its peak), WorldCom came to be known as one of the biggest instances of the 'fraud wave' sweeping the global corporate world since the late 1990s. The company's downfall from WorldCom to 'WorldCon' is a story of a corporate feeding its greed through financial and accounting manipulations.