Case Study: WorldCom Accounting Scandal

Founded initially as a small company named Long Distance Discount Services in 1983, it merged with Advantage Companies Inc to eventually become WorldCom Inc, naming its CEO as Bernard Ebbers.WorldCom achieved its position as a significant player in the telecommunications industry through the successful completion of 65 acquisitions spending almost $60 billion between 1991 and 1997, whilst also accumulating $41 billion in debt. During the Internet boom WorldCom’s stock rose from pennies per share to over $60 a share as ‘Wall Street investment banks, analysts and brokers began to discover WorldCom’s value and made “strong buy recommendations” to investors.’ During the 1990’s WorldCom evolved into the ‘second-largest long distance phone company in the US’ mainly due to its aggressive acquisition strategy.

A cycle became apparent in the marketplace where an acquisition was seen as a positive move by the analysts leading to higher stock prices of WorldCom. Consequently this allowed WorldCom to gain greater financing and backing for further acquisitions repeating the cycle. One of the most significant and largest acquisitions was that of MCI Communications Inc in 1998, becoming the largest merger in US history at that time. British Telecommunications were also in the running for the takeover of MCI Communications making a $19 billion bid, when Bernard Ebbers the CEO of WorldCom decided to place a counter bid 1.8 times higher than that of what BT had placed, at $35 billion. Evidently this takeover was agreed and the merger between the two brought MCI WorldCom into second position behind that of AT&T in the telecommunications market.

WorldCom Accounting Scandal

However, from 1999 to early 2002, CEO of the company, Bernard Ebbers along with other senior management used fraudulent and improper accounting methods to mislead investors and other directors. Their fraudulent accounting method had mainly two approaches: ‘The reduction of reported line costs’ and the ‘exaggeration of reported revenue’ . These practices were to ignore the generally accepted accounting principles (GAAP) in addition to not informing the users of the financial statements of the changes to the previously used accounting practices. This was done to reduce their E/R ratio, the main key performance indicator used to measure the performance of telecommunications companies. It is the relationship between their main expenses; line costs (the rental of telephone lines) to its revenues and the lower figures consequently produced more recommendations by analysts increasing stock prices.

The eventual failure of WorldCom was caused by the disruption of the cycle, as discussed before, when the planned acquisition of Sprint Corporation in 1999-2000 was stopped by pressures from the US Department of Justice and the European Union over concerns of it creating a monopoly. As a result WorldCom lost its main growth strategy and left Bernard Ebbers few options to enhance the business further. Either they had to consolidate all the previous acquisitions into one efficient business, which they had failed to do so far, as they had only concentrated on the takeovers or to find other creative ways to sustain and increase the share price.

The CEO chose the latter and in July 2002 WorldCom filed for Chapter 11 bankruptcy after disclosures were made about the improper accounting methods used to inflate revenue’s and reduce expenses. By the end of 2003, it was estimated that the company’s total assets had been inflated by around $11 billion.

The Fraud

The members of senior management were engaged in a continuing series of improper accounting manipulations to try and achieve market expectations on growth, making the financial reports more appealing. This was achieved through basic fraudulent methods, including changes to financial estimates, early revenue recognition, erroneously capitalisation of the long term assets, as well as alteration of the reserves in order to improve the earnings picture.

WorldCom’s managers modified their assumptions on accounts receivables, by adjusting the amount of uncollectible bills owed to the company and as a result increased the total amount of accounts receivable. Managerial assumptions played two important roles here; firstly they determine the amount of funds reserved to cover bad debts, as the lower the perceived need of non-collectable bills, the smaller the reserve required. This resulted in manipulation of the reserves, reducing them when needed to increase earnings. Secondly, when selling receivables to third parties the assumptions are used to identify the quantity available for sale, which WorldCom utilized. This manipulation was easily achieved as many of the WorldCom’s customers were small, start-up telecommunication businesses with little data and history of repayment likelihood, leaving a large degree of judgement from management to set these figures.

Line cost accruals were exploited in a similar way to that of the bad debt reserves, due to the judgement needed in deciding upon figures. Line cost accruals estimates are extremely difficult to make with precision, being best practice to adjust them frequently. This, of course, provides further opportunities for falsification. With the importance of line costs to the company’s bottom line and with Ebbers promise to reduce expenses; the accruals were adjusted on a regular basis to improve the company’s overall margins, maintaining the high growth rate now expected by the market. WorldCom’s finance chief, Sullivan later admitted to the court that he falsified financial statements of the company and in particular ordered the General Accounting department to reduce Wireless’ Division’s expenses by US$150 million.

In fact, during the second quarter of 2000, the total accounts receivables at WorldCom Inc rose 12.6% to US$926 million, but the allowance only increased by US$443 million, or 3.5%, leading to higher earnings of $69 million.

The large acquisition of MCI gave WorldCom another opportunity to fiddle its books as it could now apply its dubious methods to all the new assets and expenses of MCI. Therefore they started reducing the book value of some MCI assets whilst also increasing the value of goodwill by the same balancing amount. This gave greater flexibility for achieving their targets as smaller amounts of expenses were taken against earnings by spreading the charges over decades rather than the year it was incurred. ‘The net result was WorldCom’s ability to cut annual expenses, acknowledge all MCI revenues and boost profits from the acquisition.’

Next, there was the existence of a ‘Corporate Unallocated Revenue Account’, which included entries of corporate level adjustments. This was to assist Ebbers in adjusting the performance of WorldCom by profit smoothing, such that the predicted 15 percent year on year growth could be achieved. The access to the “Corporate Unallocated Schedule”, which was an attachment to the Monthly Revenue Schedule, was only available to the senior management. This schedule included the journal entries to the revenue account that erroneously increased the revenue of the company.

According to US GAAP Code 605, the account of such sort is fictitious, as it does not satisfy the criteria, and thus could not be treated as a legal form of revenue. The management, knowing this fact, restricted the number of people who had access to the monthly revenue, so that the fraud in revenue recognition would not be discovered. In addition to that, WorldCom tended to recognise the revenue, which was yet to be received from long term contracts, even before the actual service was provided. This, of course, was another violation of the US GAAP.

Furthermore, in a bid to reduce line costs, WorldCom capitalised the excess capacity expenses that were not generating revenue. The reason given was that these lines are costs which should have been incurred after the related benefits were generated. Although this arrangement does not oppose the classification of asset in FASB Concept Statement No 6, ‘Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events,’ there was no proper business or accounting rationale for these procedures.  The latter include journal entries of $798 million and $560 million, made to capitalise ‘line costs’ during 2001.

Indeed, according to FRS 16, costs that are related to day to day servicing, or wear and tear repairs of Property Plant and Equipment (PPE) would be expensed, unless the PPE is enhanced as a result of the expenditure. Consequently, we can see that WorldCom has wrongly classified its expenses as an asset account despite the PPE not being enhanced at any state. This would lead to the reduction of expenses, increment in total assets, and ultimate increase in profits as well as a stronger balance sheet.

Lastly, other reserves were also manipulated to manage earnings. The reserves, which were often set aside by WorldCom to cover foreseeable costs and losses, were inflated to create ‘hefty slush funds’ that could be used to increase profits.

Auditing Issues

Actions of the company’s management yielded an environment where fraud activities were easily accomplished. For this reason, the internal audit function, designed to supervise and hold employees accountable, was suppressed by a few senior members in an attempt to limit their exposure to the sensitive information. This was achieved by senior management keeping the internal audit department understaffed, generally under qualified and busy with other projects as well as retaining information from them. They also hampered efforts from internal auditors to find information once they became wary of the accounting processes used. The effort to delve into the financials was brought by Cynthia Cooper the Vice President of internal audit who did eventually help uncover the truth by gathering information after-hours to avoid suspicion and supervision by her repressive bosses. Cynthia questioned external auditors Arthur Anderson over some of the methods and they refused to respond initially eventually stating that they had approved the methods and that she should leave it at that. The internal controls meant to help supervise were controlled by the directors so proved useless as information could be changed, stopped or edited.

Arthur Andersen’s involvement being the Auditors of WorldCom would have been to find the irregularities in the company’s accounts. The level of complexity of the fraud found in WorldCom were more of judgement as opposed to those complex issues raised through Enron (who Arthur Anderson also audited), yet they were still missed. However following their failure at Enron, WorldCom switched to KPMG as their auditing firm. The resulting implication for Arthur Andersen is that it lost Public trust and was implicated in the frauds of both Enron and WorldCom due to not fulfilling their duties.

Corporate Governance and Accountability Issues

WorldCom’s failure was down to a multitude of underlying issues and shortcomings. Firstly, one might have to blame the system of the market for their method of assessing the value of a company solely on its share value. This created situations where a company could behave in an unsolicited manner. The pressure of achieving targets led to the company creatively constructing some of its financials to meet expectations laid down by the market, which might have been over-optimistic.

The aggressive acquisition strategy used by Ebbers was brought through from his previous ventures where he found himself adept at raising money, mainly due to his likeable personality. The appointment of a CEO that had little knowledge and no background in the phone technology market led to Ebbers doing what he knew; raising funds and this was used on these acquisitions. However in his quests he failed to consolidate these companies into one efficient business leaving only one route to improve stock values; more acquisitions. The failure to consolidate the firms was also assisted by his remuneration package being to myopic only focussing on quick profits as opposed to measurement over a period of years focussing on sustainable growth. Subsequently this focussed his attention on increasing share prices now as he received large amounts of his remuneration in shares, and an increase in share price increased his wealth, in the short run anyway.

Infectious greed was apparent among the investors and market, expecting and demanding maintained high returns. Ebbers owning many shares in WorldCom may have also been overtaken by this, however as a CEO he must also promote and act in the best interests of the company and this is where he failed his fiduciary duty to all shareholders and stakeholders. This meant the continuance of the fast growth acquisition strategy which was detrimental to the company’s long term success.

The culture of WorldCom was another problem that was among the underlying causes of its downfall, being apparent in all aspects of the company, but mostly passed down the ranks from top management starting with Ebbers. A downfall of the firm was the absence of accountability from some of the top management. Ebbers tried to argue in his defence that he was a hands-off director who wasn’t involved in the detailed aspects of the firm and hence not involved in the fraud, however he had the authority and forced others to comply. There was no direct accountability on him to align his and the firm’s objectives of providing true and fair accounts, as there were little repercussions for his actions. He was able to gamble with other people’s money whilst either increasing his value of shares and remuneration when successful or having a severance payment if the company starts failing.

This culture also enticed dubious business transactions with the appointment of Salomon Smith Barney being among many. Smith Barney became and remained WorldCom’s investment banker only after allocating the executives large amounts of shares in a planned IPO’s, which could be construed as a bribe.

The audit committee and the rest of the board not only failed to oppose Ebbers and his CFO, Scott Sullivan, but even financed Ebbers and others with large loans. Consequently, Ebbers was allowed to continue with other pursuits setting up and running other companies utilising loans from WorldCom. The latter, of course, has created several conflicts of interest and independence issues, as well as allowing the attention of the CEO to divert from his core responsibilities.

Effects of Fraud

Effects on WorldCom

The bankruptcy case of WorldCom was considered to be unprecedented in terms of its scale until the breakdown of Lehman Brothers in 2008. While the debtors of WorldCom were protected from some losses, WorldCom’s shareholders received nothing. Within days, the stock of not so long ago major player in the telecommunication industry fell well under $1. By the same token, 17,000 WorldCom employees lost their jobs together with insurance and pensions, which have collapsed along with the share price. Three years after the fraud was revealed, Bernard Ebbers, who had already left the company’s CEO position, was found guilty and sentenced to 25 years of prison for the charges of fraud, conspiracy and filing false documents. On April 2004 WorldCom emerged from Chapter 11 under the name of MCI with Michael Capellas as new CEO and CFO Robert Blakely. Supported by 200 employees of the company’s external auditor KPMG and an additional 600 people workforce from Deloitte & Touch they then had the task of settling the company’s remaining debt of $35 billion. Eventually, in February 2005, MCI ceased to exist as an independent company when it was bought by Verizon Communications for $8.4 billion.

WorldCom’s fraudulent activities gradually took its toll on the entire U.S. telecommunications industry. Equipment manufacturers such as Lucent Technologies, Nortell Networks, and Corning which have initially been benefitting from WorldCom’s fictitious profitability and projections ultimately suffered with depressed stock prices and were forced to lay off work forces, too. WorldCom’s then larger rival, the telecommunication company AT&T (American Telephone & Telegraph) had been laying off tens of thousands in the late 90’s as it was trying to match WorldCom’s phantom profits which eventually led to its acquisition by Baby Bell SBC Communications in December 2005.

Legislative Consequences

The WorldCom scandal could potentially have discredited US GAAP standard setting provoking the assumption that the fraud could only have occurred due to deficient accounting principles. However, there is a broad consensus that the WorldCom disaster was rather a failure of corporate governance. Following the downfall of Enron, the Securities and Exchange Commission had not yet enacted any new laws. However, after the senior management of WorldCom was charged with fraud, the Congress was pushed to answer the critics through legislative actions. Thus, a new US federal law, the Sarbanes-Oxley Act (SOX) emerged in 2002. It now applies to any company registered with the SEC and contains eleven sections that specify duties concerning the issues of corporate governance, compliance and disclosure.

In answer to the fact that at Worldcom, members of the senior management have been involved in the fraud, CEOs and CFOs can now be directly and individually be held responsible for the accuracy of financial statements. Moreover, it is no longer allowed to give credit to their directors or officers as WorldCom did to Ebbers. Concerning the relationship to the auditing company it includes guidelines stipulating that audit firms cannot provide any additional services that may compromise their independence and auditors can not in any way be involved in management decisions. Moreover, a new auditor rotation system that requires audit partners to change every five years and audit firms every seven years respectively has been imposed.

The most notorious section of the SOX is section 404 which requires the implementation and periodic evaluation of an internal auditing system and it has became the main contributor to the increased compliance costs. Since its introduction, companies have spent millions of dollars to comply with the new law which has increased accountability but, as critics say, also suppresses innovation. It can also be seen to be unfair and a overburden to the smaller listed companies as the similar priced compliance costs take a greater share off their revenues, leading a lot many institutions delisting and some even listing elsewhere, such as the UK where a lighter hand on governance has been implemented.

In Europe, the reactions to the Worldcom accounting scandal of the U.S. included the implementation of the mandatory ‘Annual Corporate Governance Statement’. The Company Act 2006 has replaced the Memorandum and Articles of Association with a single document followed by the attempt to shorten the time limit on information delivery for small companies from ten to seven months after the financial year end. Alteration of the statement of duties of directors also took place together with the Operating & Financial Review being introduced for large firms.  All of these changes were to try and bring shareholders and other stakeholders closer to their investments to supervise them more closely.

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