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We will discuss the accounting frauds committed by WorldCom, the leading US telecommunications giant during the 1990's that led to its eventual bankruptcy. Our report provides a detailed description of the growth of WorldCom over the years through its practice of mergers, acquisitions and an insight into the ways, by which WorldCom manipulated its financial statements.
On June 22, 2002, announcements of a scandal at Worldcom, hit the news. Media coverage was unlike any other in history, being that this was the largest accounting scandal to hit the United States corporate history. At this time it was reported that WorldCom had misrepresented their financial statements in excess of $4 billion dollars.
What factors led to the fraud?
In 1997, WorldCom and MCI completed a US $37 billion merger making it the largest merger in US History. In 1998 the new company MCI WorldCom opened for business. MCI WorldCom announced another merger agreement with Sprint that would have resulted in a $129 billion merger agreement. [i] During this short period of time from 1995 to 1998, WorldCom's growth was fueled by acquisitions and mergers. After the announcement of the merger with Sprint, the US Department of Justice and the European Unions' had concerns of MCI WorldCom creating a monopoly. This merger would have put MCI WorldCom ahead of AT & T. MCI WorldCom and Sprint's board of directors acted to terminate the merger after receiving pressure. [ii] This halt caused a set-back for WorldCom's' aggressive growth strategy, at a time when the telecommunications industry had entered a downturn. Ebbers had used his WorldCom stock to finance some of his other business ventures, as this stock began to decline. Banks were asking Ebbers for additional funds, to cover the margins on his securities accounts. Ebbers, then requested and obtained corporate loans from the WorldCom board of directors in excess of $400 million. The loan was so Ebbers could avoid from otherwise having to sell substantial amounts of his WorldCom stock causing a further downturn in stock prices. [iii]
What specific fraud occurred?
From 1998-2000, WorldCom reduced reserve accounts held to cover liabilities of acquired companies, WorldCom added $2.8 billion to the revenue line from these reserves. CFO told key staff members to make false accounting entries, turning operating expenses into assets, and other financial misstatements on the income statement and balance sheets to a total of $3.85 billion. For example, operating expense to assets, CFO directed to remove computer expenses and fees paid to lease other companies to phone networks (huge decrease of expenses which leads to huge increase of net income).
What was the effect on?
Investors and Creditors
The WorldCom scandal had a range of effects on Investors, Creditors, Company employees, the investment and regulatory markets and the people who perpetrated the fraud. Depending on the amount of accessibility to investment accounts, knowledge of the stock market, and amounts invested varied the effects of financial impact upon each investor.
Some investors experienced small losses while others may have lost everything. In whole WorldCom investors lost nearly $150 billion on WorldCom common stock alone, and tens of billions of dollars more on debt and other securities. Other effects on investors, was mistrust in WorldCom executives due to their deceit and betrayal.
A group of 67 institutional investors opted out of the class action lawsuit. Later this group pursue its own lawsuit filing in which the were able to litigation involving WorldCom's bankruptcy filing, to later recover $651 million from a group of banks and other defendants to compensate the investors for losses on purchases of WorldCom bonds and stocks from 1998 through 2001 [iv] WorldCom listed an estimated 1,000 creditors according to bankruptcy filings, some of these same creditors were named in litigation to compensate investors for their losses on purchases of WorldCom bonds and stocks. After the bankruptcy the previous bondholders were less the 36 cents on the dollars.
On June 28, 2002 Fifty one hundred employees were laid off, severance and benefits were withheld when WorldCom filed bankruptcy. On August 07, 2002 the ex-WorldCom "5100" group was launched. The group was composed of the WorldCom employees with a common goal of seeking full payment of severance and benefits based on the WorldCom Severance Plan. [v] The number "5100" represents the number of employees laid off before WorldCom's bankruptcy.
Individuals who perpetrated the fraud
Former Accountant Betty Vinson was sentenced to five months in prison and five months home detention for her role in WorldCom's accounting scandal. vi (Washington Business Journal - by Jeff Clabaugh ) Buford Yates Jr., a WorldCom accounting director, and David Myers, the former controller, each faced five years of prison but instead received a year and a day. Former accountant Troy Normand received probation. [vi] Mr. Yates Jr., Mrs. Vinson and Troy Normand cooperated with the prosecution in the government's case against former WorldCom chief executive Bernie Embers.
Scott D. Sullivan, the former chief financial officer, who acknowledged his leading role in WorldCom's $11 billion accounting fraud, was sentenced to five years in prison and three years' probation. As a benefit of working with the government, Sullivan sentence was a fifth of what sentencing guidelines suggested. Mr. Sullivan was not fined and would not pay any restitution beyond certain assets that he agreed to turn over. He was sent to a minimum-security prison in Pensacola, Fla., near his home, and received treatment for alcohol abuse. Mr. Sullivan agreed to sell a $10 million house he has been building in Boca Raton, Fla., and gave the proceeds to investors who sued over the fraud. He also surrendered about $200,000 in his 401(k) retirement account
CEO Bernard Ebbers accused of conspiracy, securities fraud, and seven counts of making false statements to the Securities and Exchange Commission, was sentenced to 25 years in prison. Ebbers also agreed to pay as much as $45 million, almost all of his assets, to settle claims by the government, ex-employees and defrauded investors.
In addition to the cash payments to the securities class and the ERISA class, Ebbers required to transfer to the class/MCI trust all of his remaining non-cash assets, including his multimillion-dollar home in Clinton, Miss., a prospective multimillion-dollar income tax refund, and his interests in a number of businesses including a lumber company, several thousand acres of timberland, a major trucking company, a marina, a golf course, a grain elevator company, a rice farm, a hotel and other real estate ventures. [vii]
Ebbers, is serving his sentence as inmate #56022-054 in the Federal Correctional Institution (FCI) in Oakdale. He is scheduled to be released on July 04, 2028. [viii]
Investment and Regulatory Markets
WorldCom's disclosures have wreaked havoc on the financial markets. WorldCom common stock dropped from a Class Period high of approximately $65 per share to pennies, leading to its delisting from the NASDAQ exchange. The impact on WorldCom bonds was also catastrophic. For example, on June 27, 2002, WorldCom 8% Notes, which had a value of $62.25 a few days prior to the announcement, traded at $11, a loss of over 80%. These Notes once traded as high as $106. Some Published estimates place the losses of WorldCom bondholders alone at more than $9 billion. [ix]
A number of regulations were created due to the WorldCom scandal. The most commonly known regulation is the Sarbanes Oxley Act. this act was formed so that the CEO, or any other high ranking official in a company cannot say "I did not know what was going on in the company" Also external auditors should not serve as internal auditors of the same company that the do the external audits for. With the proposal of tougher IPO's (initial public offerings) rules by the National Association of Securities Dealers (NASD), the SEC Voted on Rules to stop IPO trading manipulations.
Some of these abuses such o as "spinning" which is defined as giving hot IPO's to favorable executives, such as that deals between Solomon Smith Barney and top WorldCom executives. Though these alleged abuses are already banned by the NASD, the proposals would apply stronger and more specific procedures, such as disclosing information on who receives the stock. [x]
What was the role of the auditors in the fraud?
There were two very distinctive roles for the auditors in the WorldCom scandal. One role being that of the Whistle-blower played by Cynthia Cooper a former chief audit executive at WorldCom. She blew the whistle on an $11 billion accounting fraud scheme. Since uncovering the scandal, Cooper has been speaking publicly about her role and the role that whistle-blowers play in the business world. Cooper described how she and a few colleagues performed their own secret internal audit of the telecommunications giant beginning in early 2002. They uncovered 50 suspicious entries in WorldCom ledgers that added up to $3.8 billion in assets the company didn't really have.
Beginning in 1999 and continuing through May 2002, the company under Scott Sullivan (CFO), David Myers (Controller) and Buford Yates (Director of General Accounting) used fraudulent accounting methods to mask its declining earnings. She was able to implement the whistle blower steps that were outlined by Trevino & Nelson in their book Managing Business Ethics. When Ms. Cooper confronted Scott Sullivan, he claimed that the financial transfers were appropriate. The companies lease payments were for the purchase of capacity the company intended to use them in the future, making them appear as a capital expense.
Despite all of Mr. Sullivan's efforts to delay her, Ms. Cooper continued her review of the company's books. She demanded him to produce documentation on the purchasing of these capital expenditures, when he failed to produce the needed evidence she report her findings to the board of directors for WorldCom.
"Courage", she said," isn't doing something without fear, but doing something in spite of fear". She also said "as long as there are human beings on Earth, we will continue to see frauds and scandals. Students may have to face similar dilemmas sooner than they might think, Cooper warned.
She continues to say you just need to stick with your morals and stick to your values." Two key accountants who first altered the books wrote their resignation letters but never resigned. Afraid to lose their incomes, one of the accountants said, "It just goes to show how easy it can be to cave under pressure."
In my opinion Cooper helped reestablish some faith in the profession showing that people will take the steps they need to keep the profession honest even when it might affect their own lives. On the other hand, we can see the role that was played by Arthur Anderson, which was one of the big 5 accounting firms at the time. They were the auditors for WorldCom's financial statements during the 15-month period in question. Arthur Andersen would coincidentally become the same firm that audited Enron prior to its bankruptcy.
Officials at the Chicago-based accounting firm said WorldCom's chief financial officer, Scott Sullivan, misled them and that important information had been withheld from the auditors.
The lead External auditor of WorldCom was Melvin Dick, he testified that Andersen carefully reviewed the company's statements and conducted stress tests, computer analysis and other sophisticated reviews that failed to detect the transfers, which occurred during their audit of the financial reports.
"How could anybody overlook a $3.8 billion shell game? In the downfall at WorldCom, accused of hiding operating costs in order to exaggerate its earnings that are as big a puzzle for accountants and auditing experts as it is for lay observers. The sheer amount of money involved, experts said, represents yet another staggering audit failure by the company's longtime accounting firm Arthur Anderson LLP. ''
As an accountant, I am just embarrassed,'' said John J. Fahy, a New Jersey accountant and former prosecutor. ''This should not have been missed. Andersen has to confess to incompetence or complicity".
Arthur Andersen's officials have said repeatedly they were left out of the loop by the WorldCom executives, at the time WorldCom's scandal unraveled. Anderson was convicted of obstruction of justice in the Enron scandal, and facing a barrage of lawsuits, Arthur Anderson was charged with "intend to deceive, manipulate or defraud" investors.
In the WorldCom case Arthur Anderson became so involved with their client that it would turn a blind eye to any fraud, and in the end I think any set of rules alone. Disconnected from the values, which those rules are ultimately meant to reflect is like a body without a soul.
How was the audit firm affected by the fraud?
Generally the Public Companies have two types of auditors: internal auditors and external auditors. Each of the members of the internal audit team for WorldCom was able to find good jobs after the 2002 scandal. Jon Marbry works as a contractor. Ten former WorldCom internal auditors work with Jon Marbry. Glyn Smith, who was senior manager in Internal Audit, accepted an Internal Auditor Director position with Blockbuster in Texas. Gene Morse and Tonia Buchanan who were senior auditors and worked on the capital expenditure audit were able to find jobs in the Jackson area. Dean Taggart is the Vice President of Internal Controls in charge of the Sarbanes Oxley compliance at HealthSouth. Lisa Smith is a Director of Internal Controls with HealthSouth as well. Cynthia Cooper was chief audit executive and she is the person who blew the whistle on what became one of the biggest accounting scandals in the corporate history. Since she left WorldCom she speaks for corporation, professional groups and students about her experience. She also wrote a book called "Extraordinary Circumstances" about her journey with WorldCom. In 2002 the Time magazine named her "Person of the Year "because she " took a huge professional and personal risks to blow the whistle on what went wrong at WorldCom, and in so doing helped remind us what American courage and American values are all about". Also she was nominated in 2004 for the AICPA Hall of Fame and is the first woman to receive this distinction.
The external auditing firms before and after the fraud was Arthur Andersen and KPMG. Prior to May 16, 2002 Andersen LLP was the WorldCom's external auditing firm. Andersen audited the Company's 2001 financial statements and reviewed the Company's first quarter 2002 financial statements. During this period, Andersen's engagement partner on the company's audits was Melvin Dick. Andersen gave an unqualified opinion on the company 2001 financial statements following its audit.
Six years after the collapse of WorldCom Inc., the Securities and Exchange Commission barred two of the Arthur Andersen auditors from practicing before the agency in settlements of claims that they inadequately scrutinized the 2001 earnings as the communications company was defrauding investors. Melvin Dick and Kenneth Avery didn't admit or deny any wrongdoing on their settlements.
One of the external auditors from Arthur Anderson, Kenneth Avery currently serves as Vice President for Monsanto Vegetables covering Japan to Australia and over to India. Arthur Anderson, once the fifth largest US accounting firm, collapsed in 2002.
On May 16th 2002, KPMG LLP was appointed as the Company's external auditing KPMG would later be accused in a report by WorldCom's bankruptcy examiner, Richard Thornburgh, a former U.S. attorney general who is now a lawyer at Kirkpatrick& Lockhart LLP of its flawed tax advice to WorldCom. The report said the company had avoided state taxes by charging subsidiaries more than 12 million dollars in royalties in over 4 years. KPMG assigned Farrell Malone as the engagement partner on this audit.
In 2004 the Accountingweb.com says "The Commonwealth of Massachusetts is claiming that it was denied $89.9 million in tax revenue because of an aggressive KPMG-promoted tax strategy that helped WorldCom cut its state tax obligations by hundreds of millions". KPMG is still in business and Farrell Malone is still with KPMG.
What could have been done to prevent the fraud?
With all the talk about fraud since the big scandals of Enron, WorldCom and Tyco, it would only seem natural for companies to do whatever they can to prevent employee fraud. Yet companies have not radically changed their fraud prevention policies and procedures.Â In my opinion to reduce the fraud in the future and what we should have done to prevent the fraud in the past we definitely first need to spend more time teaching the young generation especially in schools about ethics, moral values and leadership. It is true that the foundation of a character comes from the childhood but teachers, speakers, and leaders could shape the personality of our teenagers setting examples themselves.
Secondly to prevent the fraud, the Security and Exchange Commission needed to come up with new rules and regulations. The Sarbanes-Oxley Act of 2002 also known as the 'Public Company Accounting Reform and commonly called Sarbanes-Oxley or SOX enacted on July 30, 2002. It is named after sponsors U.S. Senator Sarbanes, Paul and U.S. Representative Oxley, Michael. Sarbanes-Oxley contains 11 titles that describe specific mandates and requirements for financial reporting including and some the titles are: Auditor Independence, Corporate Responsibility, Corporate and Criminal Fraud Accountability, White Collar Crime Penalty, Corporate Tax Return, and Corporate Fraud Accountability.
PCAOB is working on establishing a financial-reporting fraud center for collecting information on preventing and detecting fraud. The regulator published a job posting for a director last month.
Thirdly, the SEC and IRS should have come up that time with changes in Internal Revenue Code which was in discordance with the Exchange Commission (SEC) rules. Under IRS rules, a company is not allowed to expense an item until the item has been put in service. On the other hand WorldCom tried to move operating expense of excess capacity in their fiber optic lines, which were not being used, to the future when the fiber optic lines would be put in services. Under SEC guidelines the accounting adjustments are incorrect.
Finally, the Federal Bureau of Investigation (FBI), Department of Justice, U.S. attorney general, and other federal agencies have extensive investigative and prosecuting powers to bring white-collar criminals to justice to protect people from these kinds of financial frauds.
In our opinion, WorldCom's destruction was not only the result of its executive officers, and directors. Shown through a number of court cases, litigations, and congressional hearings companies that rated WorldCom's worth such as investment banks, along with the external Auditors made it possible for WorldCom to commit and conceal the fraud for a period of time.
It had been stated the WorldCom was the largest client for both Arthur Anderson and Solomon Smith Barney. The greed of some U.S. investment and commercial banks helped to take down the world's economy. The said companies benefitted greatly from doing business with WorldCom, this benefit may have contributed to the company's reluctance or incapability of detecting, reporting, or rating the target company honestly. Auditors should only be allowed to Audit a company. No other business with the client company should be allowed, brokerage companies, (Smith Barney) should not be allowed to recommend companies with which they do substantial business with. Conflict of interest and coercion were common factors for all involved.
During the hearing of Betty Vinson Judge Barbara S. Jones of United States District Court in Manhattan said Mrs. Vinson was "among the least culpable members of the conspiracy at WorldCom." Still, "had Ms. Vinson refused to do what she was asked, it's possible this conspiracy might have been nipped in the bud." Sometimes it is a simple act of courage the makes all the difference. Just voicing your concerns, to senior executives, as Mrs. Vinson had stated, was not enough to detour the fraud. Cynthia Cooper has said it best as she believes "where ethics are concerned, you have to obey your conscience and accept the consequences".
Maybe if just one of the six perpetrator, had a similar belief, they would have had the courage to prevent the destructions that were passed on to thousands of investors, employees, and creditors of WorldCom, due to the greed of a handful of individuals.