Integrated Case Studies

Accounting Fraud at WorldCom Introduction WorldCom, now known as MCI Inc., was founded in 1983 as LDDS (Long Distance Discount Service). The telecommunications company experienced rapid growth in the 1990s primarily due to several large acquisitions. The company became WorldCom Inc. in 1995 following the purchase of Williams Telecommunications Group Inc. for $2.5 billion. In 1998, WorldCom completed its largest corporate merger to date, purchasing MCI Communications Inc. for $40 billion. Also in 1998 were the mergers with Brooks Fiber Properties Inc. and CompuServe Corp. WorldCom and Sprint Corp. agreed to merge in 1999. However, in 2002 the merge was blocked by regulators in both the U.S. and Europe out of fears the company was becoming too large (FOX News Network, 2005). The companys growth-through acquisition strategy was stunted by this but the 65 acquisitions that had already taken place made the company very competitive. Besides, WorldCom executives realized that large scale mergers were no longer a viable means of expanding the business. At the height of the companys success, WorldComs stock was trading above $64 per share. Yet, the companys steady growth and profits came to a halt when fraudulent financial reporting was eventually uncovered.

Substantive Issues Raised The failed merger signified the beginning of the end for WorldCom. As long-distance rates and revenue declined the accumulation of debt has placed a strain on the financial health of the company, threatening WorldComs ability to meet key-performance indicators and earnings projections. Analysts and observers within the Telecom industry typically focus on the line cost expenditure-to-revenue (E/R) ratio as a critical performance indicator. WorldCom management touted a lower E/R ratio (42 percent) than their competitors and consistently struggled to maintain that level during the fraud years. To meet analysts expectations, management manipulated financial information to increase the appearance of revenue growth, cost reduction, and overall profit. The end result was the largest corporate fraud in U.S. history at $11 billion (J. & Steve, 2006).

Integrated Case Studies

WorldCom management utilized various techniques to mask their financial condition, but four in particular drove the major material misstatements: (1) categorizing operating expenses as capital expenditures, (2) reclassifying the value of acquired MCI assets as goodwill, (3) including future expenses in write-downs of acquired assets, and (4) manipulating bad debt reserve calculations. The cumulative impact of the four techniques resulted in enhanced perceptions of financial position and viability by reducing the key E/R ratio and boosting overall net income from operations (J. & Steve, 2006). For the summary of effect see Table 1.

(Source: Journal of Emerging Technologies in Accounting)

Integrated Case Studies

Analysis 1. What appears to be the ethical issue involved in this case? Companies are in business to make money, yet can a moral and ethical company compete in the 21st century? According to Mendonca (2001), ethical behaviour is that which is "morally good and morally right, as opposed to legally or procedurally right" (Mendona & W., 2001). What is morally good and right; however, is subjective and may differ based on cultural, economic, or religious upbringing and traditions (Hosmer, 2003).

The SEC Report (2003) on WorldCom identified fraudulent behaviour in three main areas: the unauthorized movement of line costs to capital resulting in decreased expenses, the improper release of accruals reducing current expenses, and questionable revenue entries producing an increase to earnings. While these three areas highlight the seriousness of the activities, the SEC Report (2003) indicated numerous other questionable activities by members of the executive team and the board of directors. Figure 1 depicts an organizational chart indicating many of the senior executives identified in the SEC Report (2003). It is uncertain if any of the WorldCom executives followed any of the ethical theories however, it is clear that they did not follow Mendonca's (2001) definition of ethical behaviour by doing what was morally good and morally right (Mendona & W., 2001).

Scharff (2005) posited that much of WorldCom's unethical behaviours may have been caused by groupthink. Groupthink is caused when concurrence seeking becomes paramount in team decision-making. Janis (1982) defined groupthink is a "mode of thinking that people engage hi when they are deeply involved in a cohesive in-group, when the members' strivings for unanimity override their motivation to realistically appraise alternative courses of action" The characteristics of groupthink include a feeling of invulnerability, ability to rationalize events and decisions, moral superiority within the group, group pressure on dissenters, use of stereotypes, self-censorship within the group, and unanimity (Janis, 1972). While groupthink may have contributed to the number of people involved in the unethical behaviours as well as the length of time over which WorldCom's fraud occurred, groupthink does not resolve the ethical concerns with the senior level executives or the board of directors responsible for creating the culture which led to these events. WorldCom has been just one of many companies caught in ethical quandaries and predicaments over the past few years. It appears that while some
3

Integrated Case Studies

companies and their executives have maintained a strong focus on ethical behaviour regardless of economic conditions, others have not (Janis, Groupthink: psychological studies of policy decisions and fiascoes. , 1982).

Hosmer (2003) identified an ethical dilemma in business as one where the economic and financial performance of the business has conflict with the organization's social obligations. He theorized that moral issues are best identified by researching four main components. These elements include who will gain benefit, who will be harmed, whose rights will be upheld, and will anyone's rights be infringed upon or wronged. By this definition it is clear that Ebbers and Sullivan faced a serious ethical dilemma. The guiding principles include building trust and credibility, respect for individuals, creating a culture of open and honest communications, setting the tone at the top, avoiding conflicts of interest, reporting accurately, and promoting substance over form, being loyal and doing the right thing. Now the executive's challenge is to make ethics and values stand out from a business landscape that is laden with messages about beating the competition and achieving quarterly goals and profits" (Hosmer, 2003).

The answer seems to lie partly in a culture emanating from corporate headquarters that emphasized making the numbers above all else; kept financial information hidden from those who needed to know; blindly trusted senior officers even in the face of evidence that they were acting improperly; discouraged dissent; and left few, if any, outlets through which employees believed they could safely raise their objections. Following this line of argument, a management theory built on a lack of trust would lead to untrustworthy behaviours.

2. The key factors for the collapse of WorldCom in the view of Corporate Governance? There are some key factors which has given a strong impact to WorldComs collapse. One of the factor which affects this situation is the Senior Executives were encouraged to lie, cheat and even manipulating the records by giving higher profits margin. The next factor is that the Executives were mostly interested of achieving rewards for their own but however by ignoring the benefits of each stakeholders. Another factor is that the Board members of WorldCom were mostly given rewards but then it consists of friends who have been backing up WorldCom. These friends have never raised any sorts of questions to any doubtful and even unclear information (Aleem, 2010).
4

Integrated Case Studies

Besides that, the following factors which affects the collapse in this corporate scandal is that the Non-Executive Directors were also enormously satisfied with very much rewards and they have worked individually. Another factor is that the audit team was bribed to help WorldCom in producing clean audit report. Also, the factor involved is that the illegal profits were formed and it was exposed that all the policies and rules applied from the top were for the benefit of the shareholders and company; hence this was known to be ethical. The last factor is the cost of the heavy machinery acquired in a specific period was not spread by the company in the upcoming financial years (Aleem, 2010).

3. Who was mainly responsible for the downfall of WorldCom? Practically almost everyone who has involved in this unhealthy activity was responsible for the downfall of WorldCom as states by the Chinese proverbs you cant clap with one hand. The main people responsible for the downfall of WorldCom are definitely the Board of Directors where they have been a part of the cheat and fraudulent. Besides that, the second people who are responsible for the downfall of the company are the NonExecutives Directors where they were actually involved with the Board of Directors in the unhealthy activities.

Other than that, the third people who are responsible for the downfall is the internal audit team where they were easily bribed by the Board and Management to show the company audit report clean (Aleem, 2010). The fourth is that the firm was likewise able to manipulate its financial statements in accounting for its acquisitions. For instance, after getting MCI, WorldCom reduced the book value of some MCI assets by several billion dollars and increased the value of good will by the same amount. This allowed WorldCom to charge a minor amount each year against earnings by spreading greater expenses over decades rather than years.

Integrated Case Studies

4. In general, how does the role of Internal Auditing differ from the role of Independent (or External) Auditing? What is the role of Internal Auditing in a wellrun corporation? When performed by internal auditors, what is a financial audit versus an operating audit? Do you think WorldCom's Internal Audit Department was functioning as it should have been? Explain. Internal auditing is designed to add value and improve an organisation's operations. It helps an organisation accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes. Major roles and responsibilities of internal audit function is to report risk management issues and internal controls deficiencies directly to the audit committee and provides recommendations for improving the organisation's operations, in terms of both efficient and effective performance (Deloitte, 2014).

Other than that, an internal auditor will have to evaluate the organisation's readiness in case of business interruption, regulatory compliance program with consultation from legal counsel, information security associated with risk exposures, maintains open communication with management and the audit committee and engages in continuous education and staff development as well (Deloitte, 2014).

Unlike independent or external auditors, their purpose is to provide investors and creditors with confidence in the securities markets by protecting them from fraudulent financial reporting. The role of independent auditors is not only to find material misstatements and possibly fraud, but ultimately to provide a reasonable assurance that the financial statements are a fair representation of the companys financial position. Due to time and money constraints, it is impossible for every transaction and document of a company to be audited. Therefore, the auditors must take samples and assume that the audit evidence collected is representative of all of the companys financial data (Kennedy, 2012).

Auditors must be independent in order to minimize bias involved in the engagement. If an auditor has a financial stake in the client, they are more likely to make audit decisions that benefit themselves rather than the various stakeholders. There are also several independence rules involving family members working for audit clients, as this could also lead to bias during an audit. There are very strict rules about independence, and upon
6

Integrated Case Studies

receiving certification as a Certified Public Accountant, all auditors are expected to adhere to the requirements of the profession. Without independent auditors, fraud could actually occur at the hands of the auditors in order to benefit them or close family members financially (Kennedy, 2012).

Financial audit is carried out with the intention of obtaining an independent opinion of true and fair view on financial statements, while operational audit is carried out to check whether the operations of the organization are being carried out effectively and efficiently. In general, financial audit is carried out by external auditors, while operational audit is carried out by internal auditors. Professionals who are performing financial audit are external auditors that are not controlled by the management while auditors performing operational audit are employees of the entity and hence controlled by the management.

As an analyst, I think that WorldCom's Internal Audit Department has been functioning as it should have been. This can be seen where in August 2001; Cynthia Cooper started a routine operational audit on WorldComs capital expenditures but was restricted on her scope of inquiries by Sullivan, CFO of WorldCom. Besides that, based on some of the accounting entries her team and she had identified, and also on the odd reactions she was getting from some of the finance executives have changed her suspicions from curiosity to discomfort (Katz & Homer, 2008).

For example, when she showed the evidence to the external audit partner (Arthur Anderson) asking for explanation, he wasnt initially concerned and refused to tell her by saying that he took orders only from Sullivan. So, she brought the issue to WorldComs audit committee but was told by Sullivan to stay away from the wireless business unit. In fact, the audit committee actually gave Sullivan the weekend to write a white paper supporting his position (Katz & Homer, 2008).

But as her suspicions grew, her team and she began working at night and behind closed doors because they didnt want to be detected. They were running so many queries of the accounting system that they were starting to crash it. With the help of a senior manager in WorldComs IT department, Morse was able to access the companys computerized journal entries. Even though her action might cause her to lose her job but due to her role

Integrated Case Studies

and responsibility as an internal auditor, she did not gave up and continue to find out the truth (Katz & Homer, 2008).

5. Sarbanes-Oxley Act of 2002 The Sarbanes-Oxley Act of 2002 (often shortened to SOX) is legislation enacted in response to the accounting scandals in the early 2000s. Scandals such as Enron, Tyco, and WorldCom have shook investor confidence in financial statements and required an overhaul of regulatory standards to protect shareholders and the general public from accounting errors and fraudulent practices in the enterprise. The act is administered by the Securities Exchange Commission (SEC), which sets deadlines for compliance and publishes rules on requirements. Sarbanes-Oxley is not a set of business practices and does not specify how a business should store records; rather, it defines which records are to be stored and for how long. It provides information, and identifies resources, to help ensure successful audit, and management (Rouse, 2007).

By June 2002, WorldCom dropped a bombshell by disclosing a $3.8 billion accounting fraud of its own, sowing panic among investors. The company then filed for bankruptcy protection, wiping out its shareholders and the public demanded for immediate action. After the accounting fraud caused by Enron, Tyco and WorldCom, SEC had decided to let Sarbanes-Oxley Act go into effect immediately (Farrell, 2008).

6. What do you learn from these examples? Being a Business Individual, it allows a person to adapt much information from these two corporate scandals. It even allows an individual to recognize the importance of Corporate Governance in the current business world. However, from these situations of the two corporate scandals, what we can learn is that the business should be able to implement those policies and rules which for almost every stockholders of the company are favourable. In this process, nothing should go wrong in implementing the right policies and rules (Aleem, 2010).

Furthermore, presenting the fair and fine accounts may be an easy task looking it at one glance but it may not be as easy to manage after being showed. Other than that, the Internal Audit Team should work with honour by keeping proper check on the company

Integrated Case Studies

records and while implementing the policies and rules, the focus should be on the stakeholders benefits rather than on personal benefits (Aleem, 2010).

Moreover, when implement a rule and policy; it must have an ethical and legal purpose. The shareholder must have the comprehensive right to vote for the director so that the shareholders can use their right in choosing the most suitable entities for the executive personals. Lastly, the rights of individuality should be with Board of Directors. The management should work under the board following their rules and policies, not on their own (Aleem, 2010).

7. Recommendations being a Business Consultant in order to stand the company in the market again. As a business consultant, there are several steps that should be considered in order to bring World Com back into the market again. For instance, proper voting rights should be given to the shareholders of the company as these shareholders will be the one to decide the Board and also choosing the most suitable personals executives. Furthermore, a company code of conduct which should be made and obeyed strictly by the staffs in order to prevent the company from any future frauds and cheats. Another step which should be considered is choosing a new audit team to conduct the audit work. It is a must that the auditor must be independent in which getting involved in unhealthy activity is totally prohibited and not forgetting auditor should be very alert on checking the accounts from the time to time basis (Aleem, 2010).

In addition, the actual plants and stock will be physically visited by the audit team and any type of mismatching of actual things will be reported clearly and where the records shown by only paper will not be encouraged. If the executive is trying to fraud again, interim audit will be carrying out their job to protect the company. All the information will be disclosed transparently and nothing will be hidden to stakeholders. Also, the Government Best Practice will be tailed to regain the customers trust on the company (Aleem, 2010).

Integrated Case Studies

Moreover, every Annual General Meeting will decide the board members, their legal and principle obligations for the following year. The fact is clear and must be accepted that once a company collapses, it is very hard for itself to regain its previous goodwill and status. They may have a slight possibility that the company will recover to its previous status but surely it will take few years to achieve it. A business consultant should take into account all the situation regarding the market so that he will make the best choice he can (Aleem, 2010).

10

Integrated Case Studies

Bibliography
Aleem, M. (2010). Corporate Scandals of Enron and WorldCom. Deloitte. (2014). Internal audit roles and responsibilities. Retrieved February 18, 2014, from http://www.deloitte.com Farrell, G. (2008, February 15). WorldCom's whistle-blower tells her story. Retrieved February 19, 2014, from http://abcnews.go.com FOX News Network. (2005, March 15). MCI-WorldCom Timeline, 1983-Present. Retrieved February 17, 2014, from http://www.foxnews.com Hosmer. (2003). Ethics of Management. McGraw-Hill School Education Group. J. , R. J., & Steve, G. S. (2006). Learning from WorldCom: Implications for Fraud Detection through Continuous Assurance. Journal of emerging technologies in accounting, 3, 61-80. Janis. (1972). Victims of groupthink: a psychological study of foreign-policy decisions and fiascoes. Boston: Houghton, Mifflin. Janis. (1982). Groupthink: psychological studies of policy decisions and fiascoes. . Boston: Houghton Mifflin. Katz, D., & Homer, J. (2008, February 1). WorldCom Whistle-blower Cynthia Cooper. Retrieved February 19, 2014, from http://ww2.cfo.com Kennedy, K. (2012). An Analysis of Fraud: Causes, Prevention, and Notable Cases. Mendona, D., & W., A. W. (2001). Impacts of the 2001 World Trade Center Attack on New York City Critical Infrastructures. Journal of Infrastructure Systems, 268. Rouse, M. (2007, September). Sarbanes-Oxley Act (SOX). Retrieved February 19, 2014, from http://searchcio.techtarget.com

11