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'The largest accounting scandal in history'. Telecommunications company WorldCom collapsed after an investigation by the US Securities and Exchange Commission (SEC) for using fraudulent accounting methods to inflate assets and revenues and under report costs. Key personnel involved in the scandal included Chief Executive Bernie Ebbers, Chief Financial Officer, Scott Sullivan, Controller David Myers and Director of General Accounting Buford Yates. Improper review and auditing techniques by long term auditors, Arthur Andersen was also found to have contributed to the company's collapse.
WorldCom company rules for ethical behaviour were breached when Sullivan, Myers and Yates used fraudulent accounting strategies to cover the deteriorating financial situation of WorldCom and improperly account for $3.85 billion of expenses. WorldCom personnel failed to act honestly, in good faith and in the best interest of the company as a whole especially when Ebbers obtained a personal loan of significant value from WorldCom, which was believed to be used for his private investment. Internal auditor, Cooper discovered and reported findings of negligent, fraudulent acts to Max Bobbitt, the chief of the audit commission of WorldCom and assisted in implementing measures to fire Sullivan.
Arthur Andersen gave WorldCom a low audit risk with a subsequently high materiality level and so declared no necessary further action was required. Improper review and auditing techniques were carried out by Arthur Andersen. A major flaw in their approach was that Andersen overlooked the documentation and controls that were exploited by WorldCom's finance personnel. Andersen had a decreased chance in detecting fraud on accounting irregularities due to the flaws in its audit approach. Reasonable care and skill was not exercised and there were flaws in Arthur Andersen's audit approach. WorldCom personnel were not cooperative in providing the information that Andersen needed. They exerted excessive control over Andersen's access to information, as well as the access to the computerized General Ledger, that caused the difficulty for Andersen to perform its duties. Arthur Anderson failed to assess the going concern of WorldCom at the planning stage and overlooked the going concern assumption as WorldCom was a major client and they had fear of losing future relation and audit fees.
On review of the ethics and culture, corporate governance, whistle blowing, materiality, the auditor's, management's and directors roles, aggressive accounting policies used in financial statement, auditor's negligence, contributory negligence and going concern it can be said that both Arthur Andersen and WorldCom personnel were responsible for the collapse of WorldCom. An implementation plan has been devised based on recommendations involving the themes of WorldCom directors' salary and reward being based on the key performance index of company and not on stock market, the elimination of personal loans, director's liability, an anonymous whistle-blowing channel and supervision from regulatory agencies.
This report is a literature review carried out by Chantell Abrahams, Yu Yin Ma & Zixuan Zhang. Valid and reliable information is readily available through online sources. Sources include the Edith Cowan University Library Database which provided articles from journals including the 'Journal of the International Academy for Case Studies' and 'Issues in Accounting Education'. Various websites were also used for data collection as well as the text book 'Auditing & Assurance Services in Australia' by G. Gay & R. Simnett. All sources are listed in the reference page at the end of this report.
The scope of the case study is to determine causes, identify events and responsible parties that contributed to the collapse of WorldCom. The information available ensured that these topics were able to be covered in depth.
The information available was abundant and so a limitation of the study was not exceeding 10 pages for the length of the written report including any Appendices (for data, tables, graphs and diagrams). Please note that the total number of pages of this report is 12 however this includes the ECU Assignment Coversheet and the Reference List.
WorldCom, a telecommunications company, began in 1983 and by 2002 they were operating in more than 65 countries. In 2003, the US Securities and Exchange Commission (SEC) launched an investigation into what became known as 'the largest accounting scandal in history' based on findings uncovered by an internal audit. The collapse of WorldCom became a leading example in unethical behaviour leading to the collapse of a previously successful company. 2001 proved the beginning of tumultuous times for telecommunication companies and it was discovered that WorldCom were using fraudulent accounting methods to inflate assets and revenues and under report costs in order to stay afloat. Key personnel involved in the scandal included Chief Executive Bernie Ebbers, Chief Financial Officer, Scott Sullivan, Controller David Myers and Director of General Accounting Buford Yates. Improper review and auditing techniques by long term auditors, Arthur Andersen was also found to have contributed to the company's collapse.
Key issues addressed in determining the causes, identify events and responsible parties that contributed to the collapse of WorldCom include the ethics and culture of WorldCom, corporate governance, whistle blowing, materiality, the auditor's role in being the most responsible for the crisis, the management's & directors' role in being the most responsible for the crisis, aggressive accounting policies used in financial statement, the auditor's role in fraud, the management and directors' role in fraud, auditor's negligence and contributory negligence and going concern. The findings will be presented and then the implications of these findings are acknowledged. Conclusions, recommendations and the implementation plan are then addressed.
The following is a summary of facts and issues surrounding the collapse of WorldCom:
Ethics and culture
Company rules for ethical behaviour were breached
WorldCom personnel failed to act honestly, in good faith and in the best interest of the company as a whole
Cooper, internal auditor, reported findings of negligent, fraudulent acts
Arthur Andersen gave WorldCom a low audit risk with a subsequently high materiality level and so declared no necessary further action was required
Auditor's role in being the most responsible for the crisis
Improper review and auditing techniques by Arthur Andersen
Management & directors' role in being the most responsible for the crisis
WorldCom withheld information and altered reports
Aggressive accounting policies used in financial statement
Inappropriate accounting procedures used by WorldCom including a reduction of reported line costs and exaggeration of reported revenues
Auditor's role in fraud
Andersen had a limited chance in detecting fraud on accounting irregularities due to the flaws in its audit approach
Management and directors' role in fraud
Accruals and operating costs were manipulated to give the illusion of a more favourable financial position
Reasonable care and skill was not exercised
WorldCom exerted excessive control over Andersen's access to information resulting in contributory negligence
Arthur Anderson failed to assess the going concern of WorldCom at the planning stage
DETAILED FINDINGS & IMPLICATIONS
Ethical rules play an important part in creating an ethical culture and ensure the moral integrity of auditors. According to G. Gay & R. Simnett (2012), five fundamental principles contained in the codes of ethics: Integrity, objectivity, professional competence and due care, confidentiality, and professional behavior. In the case of WorldCom, Sullivan had devised a strategy that improperly accounted for $3.85 billion of expenses. From 1999 to May, 2002, Sullivan accompanied Myers and Buford 'Buddy' Yates, using fraudulent accounting strategies to cover the deteriorating financial situation of WorldCom, fabricating profit to manipulate share price. As senior accountant and auditor, Sullivan and Myers breached the ethic rules for company's interest, even though they would have clearly understood the restriction of the fundamental principles (APES 110). Hence, they failed to act as honestly and with integrity and ethical behaviour. At the same time, Sullivan insisted that line cost could be transferred into assets. It indicated that Sullivan failed to meet the requirements of objectivity and independence. Meanwhile, cheating public for profit gain is seriously against the professional behaviour of an auditor.
According to J, Owen (2003), corporate governance is defined as the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled by corporations. Auditors, coming with management and board of directors consist of 3 different groups in corporate governance. In this case, Ebbers directed Sullivan to assist him to conduct misrepresentation of accounting entries, in order to make up the financial reports for 2000 and 2001 to meet market expectations. However, the real condition of WorldCom was described as heavily indebted and draining revenues. Moreover, Ebbers was trying to obtain a 408 million US dollars personal loan from WorldCom, which was believed to be used for his private investment. It can be seen that Ebbers had failed to act honestly, in good faith and in the best interest of the company as a whole. He also misused his office power to cheat stakeholders, creditors and the public. In the meantime, WorldCom overextended and bought into negligent management strategies which caused the safeguard integrity in financial reporting become invalid. However, Cynthia Cooper, one of WorldCom's internal auditors found the loopholes in the financial report after being required to re-organise an inspection on the capital outlays record. It eventually revealed the huge financial scandal of WorldCom.
Whistle-blowing requires resolution of the conflict between the principles of independence, objectivity, integrity and public interest (G. Gay & R. Simnett , 2012). Also, the decision to blow the whistle is not easy for an auditor. Cooper might have decided to cover the fraud made by Sullivan to keep her position or draw her own benefits. She reported the whole findings to Max Bobbitt, the chief of audit commission of WorldCom instead, and assisted in implementing measures to fire Sullivan. In this case, Copper's honest, independent and objective behaviours represented the importance of whistle-blowing in corporate governance.
Materiality is the information, individually or in aggregate, that if misstated or omitted from a financial report may affect economic decisions of users taken on the basis of the financial report. According to ASA320.10, the auditor needs to determine materiality for the financial report as a whole when establishing the overall audit strategy. The relationship between audit risk and materiality is inverse. WorldCom had an audit risk rating as "low" according to Arthur Andersen, resulting in the materiality level to be high and therefore no further action was required to be taken in the audit procedure.
The auditor's role in being the most responsible for the crisis was revealed when WorldCom exerted unreasonable control over Andersen to limit access to the information (S 310 Right of access the records) and altered documents before submitting them to Andersen. This therefore made it difficult for Andersen to discover accounting irregularities. Reliance on WorldCom's control systems by Andersen was executed without the conduction of sufficient tests. A major flaw in the auditing approach was that Andersen overlooked the documentation and controls that were exploited by WorldCom's finance personnel. According to ASA500, auditors are required to obtain sufficient appropriate evidence to support their audit opinion. WorldCom personnel were not fully co-operative with Arthur Andersen in the course of its audits.
When examining the management's & directors' role in being the most responsible for the crisis, it was discovered that in order to meet the earnings projections, Ebbers directed Sullivan to assist him in creating fraudulent accounting entries resulting in financial reports that met the financial targets set by Ebbers. Overstatement of profit and decreases in costs were the resulting entries. It has been documented that WorldCom would not have collapsed if Arthur Andersen had used proper review and auditing techniques for the detection of fraud. Andersen had approved most of WorldCom's reporting without an in-depth investigation into unusual reporting. Management were trying to hide unusual transactions by not giving access rights to Andersen. Andersen's feedback indicated that there were no significant or unusual transactions or material transactions and management had adequate controls to prevent a material error in the financial statements. Andersen responded that there was no accounting position taken by WorldCom with which Andersen was not comfortable. This comment was made without putting in extra effort on substantive testing of information maintained in financial accounting statements.
Aggressive accounting policies were used in financial statement. WorldCom continually used accounting methods which were not in accordance with Generally Accepted Accounting Principles (GAAP). This was for the purpose of masking its financial decline. To increase the price of WorldCom's stock, personnel would falsely declare financial growth and profitability. There was a transfer of a total of $3.852 billion from 'line cost' expenses to asset accounts.
The following are two keys areas on WorldCom's improper accounting:
Reduction of reported line costs
WorldCom manipulated the process of adjusting accruals by improperly releasing the accruals without any visible analysis on excess accruals and kept the accruals, to release them when necessary to improve the reported result. Capitalization is also one of way that WorldCom had used to reduce reported line cost. They simply avoided recognizing incurred standard operating expenses and postponed them into the future.
Exaggeration of reported revenues
WorldCom made use of the non-recurring items to create a double-digit revenue growth.
Beside the two keys areas, WorldCom had also improperly reduced 3 categories of expenses (Selling, general and administrative cost, depreciation and income taxes). General accruals from other accounts were also accumulated, so as they could be later released to offset expense and write down asset accounts. Myers and Yates assisted Sullivan by giving instructions to Ron Lomenzo (Senior Vice President of Financial Operations) to adjust line cost to move international results closer to budgeted margins. Though there were others in WorldCom who suspected in improper accounting, nobody raised the issue up to Human Resource Department or Internal Audit Committee.
The auditor has a duty to report fraud, irrespective of materiality, to an appropriate level of management when suspicious aroused during the course of normal, careful gathering of evidence. In WorldCom's case, Andersen had limited the chance to detect fraud on accounting irregularities due to the flaws in its audit approach. Therefore, Andersen missed many opportunities to discover the misuse of accruals, capitalization of line costs, and improper recognition of revenues.
Management and the directors' played a role in fraud. In order to meet the high growth expectation from Wall Street, WorldCom's management made an effort to reduce the reserve by $2.8 billion. The money reduced was then moved into the revenue of its financial statement. They manipulated the process of adjusting accruals and capitalizing the operating costs. All these had caused WorldCom to be able to achieve a high revenue growth when in fact it should be substantially lower.
Arthur Andersen were negligent. A professional auditor has a duty to exercise the reasonable care and skill when performing their duties as the auditor's duty of care to a client arises both in contract and in the tort of negligence. If the auditor breaches this duty of care and has been negligent in conducting the audit work or has committed fraud, the auditor will be liable for any loss suffered as a result of the auditor's actions. In WorldCom's case, Arthur Andersen has failed to perform what a professional auditor expected to perform.
First of all, there were flaws in Arthur Andersen's audit approach and therefore, Arthur Andersen failed to detect accounting irregularities and frauds. Arthur Andersen applied the audit approach that concentrated more on identifying risks and assessing whether adequate controls is in place in the company to mitigate those risks, rather than accentuating the traditional substantive testing of information maintained in accounting records and financial statements. If there is failure in identifying a significant risk, or relying on company control without adequately determining by Arthur Andersen, there will be insufficient testing to make detection of fraud which is the consequences of this audit approach. Besides the consequence of the audit approach, it seems that adequate testing were not performed by Arthur Andersen to justify reliance on WorldCom's controls as there were journal entries and accrual reversals without proper support.
Secondly, Arthur Andersen failed to disclose to WorldCom's Audit Committee that they were not receiving full cooperation from WorldCom personnel on critical aspects of the work by controlling tightly over information that Andersen needed and providing modified documents with the apparent purpose of concealing from Andersen items that might have raised questions.
Lastly, Arthur Andersen did not devise sufficient auditing procedure to detect the possibility of fraud as it trusted and relied on senior management of WorldCom. Moreover, Arthur Andersen assumed that there was no cause for heightened scrutiny for the absence of variances in the financial statement and schedules in WorldCom's business environment without verifying with relevant people.
Contributory negligence is a failure by the plaintiff to meet the standard of care required for its own protection where this is a contributing cause, together with the defendant's fault, in bringing about loss. WorldCom personnel were not cooperative in providing the information that Andersen needed. They exerted excessive control over Andersen's access to information, as well as the access to the computerized General Ledger, that caused the difficulty for Andersen to perform its duties.
Moreover, significant documents were altered by certain members of WorldCom's management before providing them to Andersen in order to hamper Andersen's ability to identify problems at the Company.
According to ASA 570.2, going concern assumption is defined as the entity is viewed as continuing in business for the foreseeable future without any intention or necessity to liquidate or otherwise cease its operations. ASA 570.10 requires that auditor must consider the appropriateness of the going concern assumption that underlies the financial report when planning and performing audit procedures and evaluating the results. Arthur Anderson failed to assess the "going concern" of WorldCom at the planning stage and overlook the going concern assumption as WorldCom is the major client and they had fear of losing future relation and audit fees. And hence, Arthur Andersen rendered an unbiased opinion on WorldCom's financial statement.
CONCLUSIONS AND RECOMMENDATIONS
Ethics and culture, corporate governance, whistle blowing, materiality, the auditor's, management's and directors roles, aggressive accounting policies used in financial statement, auditor's negligence, contributory negligence and going concern have all been taken into consideration. It can be concluded that both Arthur Andersen and WorldCom personnel were responsible for the collapse of WorldCom.
Recommendations for Management and Directors of WorldCom
Key performance of the company should be the gauge for directors' salary and reward instead of stock market.
In order to avoid a conflict of interests, no loan should be made to the CEO.
The CEO and CFO should be bounded by contract to be liable for true and fair view on the financial statement.
There should be anonymous whistle-blowing channel to alert WorldCom's Audit Committee of any fraud.
Two methods might be applied to improve corporate governance:
Supervision from regulatory agencies. The FASB (U.S) and ICAA / AICD (Australia) monitor the behaviour of accountants and directors. The SEC (Securities and Exchange Commission) and ASX (Australian Stock Exchange) are responsible for safeguarding a fair and well-organised market.
Whistle-blowing. In Australia, the Corporation Act 2001 requires auditors to inform ASIC of any significant contraventions of the Act discovered in the normal course of their duties and, any other contraventions that cannot be remedied by bringing the matter to the attention of directors.
Recommendations for the Auditor
The auditor needs to be able to accurately identify business risk.
Professional scepticism & judgement needs to be applied rather than relying on the accuracy of the financial reports given by the management.
The heavy reliance on a control-based auditing approach needs to be eliminated and consideration needs to be given to a substantive testing approach.
An appropriate level of auditor independence needs to be considered as Arther Andersen provided other non-audit services such as consulting, resulting in a conflict of interest
The Auditor needs to inform Audit Committees when they face difficulty to the right of access to the general ledgers.
Audit Committee of WorldCom should have been informed by the auditor about WorldCom being rated as a "maximum risk" client.
Analytical procedures, discussions and comparison of various industry players' financial statement should have been applied by Arthur Andersen in order to easily highlight the business risk of the telecommunication industry that is facing a decline in revenue.
Audit procedures applying to WorldCom should be reviewed and adjusted to make sure they are covering areas that are most susceptible to material misstatement (both error and fraud) in more detail. Furthermore, they should not be complacent because of the long-term client relationship.
Arthur Andersen should have evaluated control risk as income can be manipulated in many ways. These included improper revenue recognition, overvalued inventory and other assets, and misclassification of expenses as assets.
Some testing of classification control should have been done by taking a sample of capitalized items or even a subjective sample of unusual items.
They should have realized something was amiss when they were facing restriction to the right of access on WorldCom's financial information. They should have informed the audit committees immediately.
They should have re-assessed the materiality level of WorldCom. If they have rated WorldCom's audit risk as high and materiality level to be low, they will have taken action for more work to be done in the audit procedure.
In order to respond to such unethical behaviours, two methods could be approached:
Enhancing the external assurance and auditing controls. A powerful and responsible external safeguard is essential to avoid any unethical behaviours implemented by internal auditors. In this case, Arthur Andersen, which was firstly taking charge of external audit for WorldCom missed chances to discover the misuse of accruals, capitalization of line costs, and improper recognition of revenues. It indirectly resulted in the rapid collapse of WorldCom.
On the other hand, improving corporate governance strategy is key to stop unethical behaviours as well.
For WorldCom to move forward, a team responsible for corporate governance is to be set up within WorldCom. This team is to be made up of suitably qualified personnel from different departments. Regular education sessions are to be held and feedback is to be openly communicated.
The directors' remuneration is to be based on the key performance index of company and will be established by the board
Policies and procedures are to be documented outlining the following:
No personal loans will be granted
The CEO and CFO are to be bound by contract to be liable for true and fair view on the financial statement.
An open and anonymous whistle-blowing channel will be set up through the corporate governance committee