WorldCom fraud was committed in two main ways

WorldCom’s History

WorldCom was a telecommunication company which was located in Clinton, MS. It had 20 million customers, 80 thousand employees and thousand of clients. During 1983, Murray Waldron and William Rector drafted a business plan offering long distance telephone service. WorldCom was established in Hattiesburg, Mississippi by Bill Fields in 1984 under the name of Long Distance Discount Services (LDDS). Bernard Ebbers was appointed as a CEO in 1985. http://forum.globaltimes.cn/forum/attachment.php?attachmentid=9540&d=1257139436

Over its course of operations, the firm made a series of acquisitions – Advantage Companies Inc., Advanced Telecommunications Corp., Resurgens Communication Group Inc., Metromedia Communications Corp., IDSB Communication Group Inc. and William Telecommunications Group Inc. – which placed it 42nd among Fortune 500 companies. In 1995, LDDS changed its’ name to WorldCom. This was because the management found that the new name was more consistent with the company’s future growth strategy. On 10 November 1997, WorldCom was merged with Microwave Communication Inc (MCI) for $37 billion, which made it the second largest U.S. long distance carrier. The company then ran its business by the name of MCI WorldCom on September 15, 1998. The stock price of WorldCom went up to the peak and because of that; CEO Bernard Ebbers become one of the richest men in the US. The company continued to expand its business by acquiring various companies such as UUNet, CompuServe and America Online’s data network, which put WorldCom among the leading operators of Internet infrastructure.

During 2000, telecommunication industry started to slow down and WorldCom faced job cuts, credit rating downgrades and enquiries as well. This causes a decline in WorldCom stock values from $64 to $2.65. Their revenues have fallen short of expectations, while debt taken on to finance mergers and infrastructure investment remains. As a result, CEO Bernard Ebbers resigned on April 30, 2002. In another specific incident, WorldCom’s board of directors lent $415 million from the company’s coffers to help Ebbers cover some of his personal debts, amounting to more than $800 million, in an attempt to avoid a massive sell of company stock by the CEO which would have further driven down the company stock. Corporate loans of $400 million was provided for financing his other business such as timber and yachting to avoid him from selling his substantial amount of his WorldCom stock. Begins from 1999 to May 2002, WorldCom which is under the direction of Scott Sullivan (CFO), David Myers (Controller) and Buford “Buddy” Yates (Director of General Accounting) had used fraudulent accounting methods to hide its declining financial condition by giving a false picture of financial growth and profitability in order to increase the stock price of WorldCom.

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Discussion of the fact

On June 25, 2002, WorldCom announced that improper accounting method had overstated earnings in 2001 and the first quarter of 2002 by more than $3.8 billion. WorldCom filed for Chapter 11 bankruptcy on July 21, 2002. It was the largest filing in United States history. The company listed $103.8 billion in assets and $41 billion in debt on which it must make payments. WorldCom had to lay-off 17000 workers, about a fifth of the total workforce in an effort to stay in business. According to the investigation, the accounting maneuver was discovered by the internal auditor, Cynthia Cooper in WorldCom. The company’s revenue expenditure had been treated as capital expenditure, causing overstatement of profits by $3.8 billion in the financial results. In lights of these revelations, Arthur Anderson released a statement it had acted in accordance with professional standards at all times and declared that the internal audit report could not be relied upon in the view of accounting manipulations. Arthur Anderson worked in collusion with the Scott Sullivan (CFO), David Myers (Controller) and Buford Yates (Directors of General Accounting) to increase the price of WorldCom’s stock by falsely inflating the profitability. Max Robbit, the audit committee WorldCom’s board of directors, replaced Arthur Anderson with KPMG, the outside auditor to investigate the matter when he received the report.

On March 15, 2005, Bernard Ebbers was charged with criminal penalties on fraud, conspiracy and filing false documents with regulators and was sentenced to 25 years in prison. Other former WorldCom officials were found guilty and charged on committing fraud and company’s financial misstatements included former CFO Scott Sullivan, former Controller David Myers, former accounting director Bufors Yates and former accounting managers Betty Vinson and Troy Normand.

How the fraud

The fraud was committed in two main ways.

Reducing the reserve accounts

Table

The table above showed the before restatement figures and to determine how the accounting manipulations changed the data. The operating margin of WorldCom, which indicates how well the profitability of the company, was sharp decreased in 1998. Therefore, the company used the accounting manipulation in an attempt to improve the margin which could provide impressive earnings for the company. The company inflated its revenues with bogus accounting entries from ‘corporate unallocated revenue accounts’. WorldCom reduced the reserve accounts held to cover the liabilities of acquired companies. WorldCom had added $2.8 billion to the revenue line from these reserves. As a result, the profit margin had increased constantly in 1999 and 2000. However, the accounting manipulation was inadequate for maintaining the earnings by 2001. The operating margin decreased to less than half compared to previous year’s earnings.

Underreporting the expenses

Table

Table 2 summarized the WorldCom’s consolidated financial statement for three years period. In order to increase the stock price, the accounting department of WorldCom underreported ‘line cost’ which is the interconnection expenses with other telecommunication companies. In 2000, the company had a loss of 649 million but by using the account fraud they recorded the profit of 2608 million. It reported them as capital investments on balance sheet rather than properly expensing them to show that they are spending less and making more money. Part of a current expenses was transferred to a capital account. In such a way, WorldCom boosted its net income (as expenses were understated) and its assets (as capitalized costs are treated as investment) from 1999 to 2001. In other words, WorldCom kept off balance sheet by capitalizing the line cost instead of expressing the expenses immediately and thus avoiding the loss of billion dollars.

What drives the perpetrators to commit the fraud?

Organizational strategy

There were several reasons that drive the perpetrators to commit the fraud. The first factor that causes this fraud to happen was the business strategy of Bernard Ebbers, the CEO of WorldCom. In the 1990s, WorldCom was undergoing an impressive growth through it acquisition. However, Bernard Ebbers acquisition strategies come to an end when WorldCom was failed in its proposed merger with Sprint in the early 2000. Ebbers wished to maintain the company’s increasing revenue and income so that the company can show a positive financial picture to its investor. WorldCom’s organizational structure significantly contributed to its failure. WorldCom started expanding its business and grew rapidly from 1991 to 1997. WorldCom had acquired 11 companies in only six years, which made it the leading internet provider in United States. However, it had failed to properly integrate them in the organization as mergers and acquisitions are costly, time consuming and represent significant managerial challenges. This provides the opportunities for the WorldCom executives to perpetrate fraud by falsely misrepresenting the financial statements.

Financial

Another reason that drove the perpetrators to commit this fraud was the desire of Ebbers to protect and maintain his personal financial condition. When he was the CEO’s of WorldCom, he was pledging his own WorldCom’s stock to secure his personal loans to finance his personal business. To avoid margin calls from bank on his own stock, he was facing a lot of pressure to make sure WorldCom was doing well so that the stock price of the company will not go down. Because of this reason, he had resorted to fraudulently present the financial statements to show a continually growing net worth to avoid the margin calls.

Expectations

The downturn in telecommunication industry makes the situation become worse. At that time, the management of WorldCom also needs time to catch up its newly acquired companies. They need to learn the methods on how to run and manage them well. However, Wall Street had expected double-digit growth for WorldCom. Ebbers was under highly pressure to maintain the increasing growth. He also did not have intention to inform Wall Street that WorldCom need time for the consolidation and digestion of its acquisition. In order to meet the high expectation of Wall Street, Ebbers had to falsely report his company’s financial statement. WorldCom’s senior management, however, improperly directed the transfer of line costs to its capital accounts in amounts sufficient to keep WorldCom’s earnings in line with Wall Street’s expectations.

Pressure from top management

There are indications that improper conduct and fraudulent actions were taking place in most levels and parts of the organization. First, the organization’s top management participated in fraudulent activities on a regular basis. For instance, the CEO had submitted falsified SEC reports and pressured other executives to achieve expected financial results by all means, including fraud. Such way contributed the strategic apex acted in such a way as to lead the organization’s middle line to ignore and commit fraudulent behavior, and was propagated down to the operating core in multiple occasions. As certain email communications illustrated, certain employees part of the operating core were well aware of the accounting irregularities and participated in hiding such practices. In addition, the technostructure was at a certain point also taking part in this downward spiral of falsified reports and suspicious accounting practices. Their auditors, Arthur Andersen failed to identify the accounting irregularities and didn’t persist in trying to identify them. Above all, the organization’s Ideology had poor values, ethics, and promoted fraudulent conduct. In one instance, following the attempts of certain employees to establish a corporate Code of Conduct, Ebbers, the CEO, reportedly described this effort as a “colossal waste of time”.

What accounting rules were broken?

The CFO, Scott Sullivan violated the accounting treatment of capital expenditure and the accrual method which was one of the basic principles of accounting. In accrual method, the accounting rules GAAP (Generally Accepted Accounting Principles) states that the expense incurred by a business should be allocated over the entire period that it will benefit the company. This is to match revenues with the cost it takes to generate that revenue. This rule was broken by WorldCom. Scott Sullivan had fraudulently taken billions of dollars in operating expenses and recorded them in the property accounts, which are a type of capital expense accounts. This accounting treatment allowed him to remove the operating expenses from income statement causing huge increases in net income and also a huge increase in asset. By the end of first quarter of 2001, the above tactic cannot be used anymore because there are only a few accruals were left to release. Sullivan started to use a new method which treated the costs of excess network capacity as capital expenditure but not as an operating expense.

Furthermore, WorldCom set up its reserves for making payments for the line costs. However, the bills for these costs were not paid for even several months after recalls has been incurred. According to the Generally Accounting Accepted Principle, the company needs to estimate the expected payment and match expense with its revenue. In other words, these fees must be expensed and may not be capitalized under GAAP. The company could reserve some of the accruals with the extra accounted in the income statement as a reduction in line expense if the bill amount came in lower than expected. In the case of WorldCom, Scott Sullivan had instructed its employee to release accruals that were too high to meet future payments. Several business units left with accruals for future cash payments that in sufficient when the bills need to be settled. In this manner, WorldCom understated its expenses and overstated its earnings, thereby defrauding investors.

How could the fraud go undetected?

How a firm could go got away with these fraudulent accounting practices and not being caught. There are a few reasons as to how could the fraud go undetected. However, the accounting fraud was first discovered by WorldCom internal audit. A small team of internal auditors worked together secretly to investigate and uncovered $3.8 billion of the fraud in June 2002.

The corporate culture

The corporate culture of an organization is crucial for any business because it reflects the values and principles of the organization. It is the founder and the top management of a company that helps creates corporate culture of an organization. The employees at the bottom level will follow the beliefs and values that flow down from the top. Therefore, if the top management in an organization are unethical or believe it is ok to lie to the public and investors in order to make the company appear good, this attitude may work its way into the company. In addition, Worldcom top management advocates teamwork, but not in the good way. The teamwork alleged at Worldcom was like, the employees will follow what they are told to do and be a good team player. The group conspiring together was a main factor in why the fraud went undetected for such a long period of time.

Failure of auditor

When the telecommunications industry began to decline, many people felt WorldCom would go down. However, when they still managed to meet earnings expectations, no one expect fraud because everything appeared to go on smoothly. The auditors of Worldcom never expect the company would use the fraudulent accounting practices that are so ridiculously simple and dumb that they oversee those potential fraudulent misrepresentations. As the auditor Arthur Anderson say, in reality who would think that a chief financial officer or anyone for that matter at the second largest telecommunications company in the world would take almost $4 billion of expenses and book them as assets.

In addition, Arthur Anderson, the external auditor of WorldCom since 1989 has been criticized for its negligence in handling of WorldCom’s accounting policies systems and books. Anderson did not find out the line costs that has been capitalized and also not having designed its audit to detect misclassifications of the large amount. Many observers also think that Anderson should have realized the large and increasing financial loss of WorldCom and pay more attention to its possibility of aggressive accounting practices.

The failure of corporate governance

The failure of corporate governance in WorldCom also causes the fraud to go undetected. The stakeholder group other than top management was poorly served by WorldCom board of directors. WorldCom was terminated by Ebbers and Sullivan. There are no checking and constrains on their actions and easy for them to do. Ebbers was given high control over the affairs of the company without the board of directors exercising any restraint on his action although he did not have enough experience or training that qualified for his position. The employee of WorldCom also do not have any initiative to communicate the fraudulent actions because worry about losing job.

The lack of effective internal control

Another reason why the fraud could go undetected is the lack of effective internal controls in WorldCom. Internal controls are one of the corporate governance that helps to prevent frauds to occur within the company and help with making operations run more smoothly. At WorldCom, there was a lack of effective internal controls. This allowed for many fraudulent activities to be done by those perpetrators without much inspection. The absence of proper checks and balances and segregation of duties made it easier for fraudulent acts to be done with only a few people being aware. The internal control system at WorldCom undoubtedly played a role in allowing for the accounting manipulations to continue for a long period of time.

The intentional alterations and omission of material information by top management

Arthur Anderson, WorldCom’s external auditor had audited WorldCom’s 2001 financial statements and reviewed WorldCom’s books for the first quarter of 2002. Arthur Anderson said that the work it performed for WorldCom was complied with professional and Securities and Exchange Commission standards. Anderson blames the CFO of WorldCom for not telling about the line cost transfers and did not consult with Anderson about the accounting treatment. This means that there are important information about line cost was withheld from Anderson auditors by the chief financial officer of WorldCom. Andersen’s auditors only can limitedly access to the WorldCom’s accounting information. WorldCom tried to altered and omitted information to mislead Andersen.

What could have been done to prevent the fraud?

Reducing the dictatorial powers of the CEO

The power hierarchy in WorldCom should be changed by reducing the dictatorial powers of the CEO. The board of directors should make sure that the CEO has no power to arbitrarily fire any employees that try to report the fraudulent activities directly to them. Boards can make sure that the executives report to both the CEO and the Board. This can prevent CEO from committing fraud to serve his own personal interest. It would also allow the Board’s independent access to financial information of the company so that power abuse can be avoided.

Establish reporting system

The company should have established a reporting system that enables employees, vendors and customers to report any suspected fraud activities. In this case, when Cynthia Cooper, internal auditor of WorldCom discovered the fraud, she reported to the CFO. But, there was no action taken until she reported the case to the audit committee. Many companies are now started to use this method by having a hotline and some other ways for employees to directly report any suspected fraud that they discovered. For example, usually there are people inside the corporation had discovered those bad practices and trying to do something but ultimately failed. By this way, the fraud can be uncovered and solve earlier.

Disclosure of their personal benefit and compensation plans

The CEO and directors should have been required to disclose their personal benefit and compensation plans to the stakeholders. The CFO engaged in the company’s financial misstatements for his own benefits, which leads to the questionable accounting practices in WorldCom. Thus, the disclosure must be complete and clear. This can further ensure that they will act in the best interest of the company and not for their personal benefit. Indirectly, the interest of the shareholders can be protected and fraud can be prevented.