WorldCom Accounting Scandal

Introduction

WorldCom was the provider of long distance phone services to residents and businesses. The company started its operations in 1983 as a small provider of the long distance telephone services. In 1989, it became a public traded company. WorldCom tools the telecom industry by storm when it starts a series of acquisitions of other telecommunication firms including MCI communication. From its acquisitions, it became the second largest long distance telephone company after AT&T. in 1997, WorldCom and MCI merged forming MCI WorldCom, which made it the largest corporate merger in the US history. In a span of six years, WorldCom completed 65 acquisitions. Later, WorldCom moved to internet and data communication where it handled 50% of all the US Internet traffic and 50% of all e-mails across the world. From outside, WorldCom appeared as being a strong leader of growth; however, in reality, that appearance was just a perception (Rogers et al. 2003). During the period of the company’s success, its stocks were trading above $64 per share; however, the steady growth of the company came to a stop when fraudulent financial reporting was uncovered.

On June 25, 2002, WorldCom claimed that it was involved in fraudulent reporting of its numbers through stating a $3 billion profit when it was half a billion dollar loss. After conducting an investigation, it was revealed $11 billion in misstatements. In this research paper, I will identify the key players involved in the crime including the victims and perpetrators. The paper will also explain the type of crime committed, discuss the legal process used in prosecuting the crime, and analyze any regulations or the social controls implemented to avoid future crimes of such nature.

People involved in the crime

Perpetrators

There were several people involved in the WorldCom scandal. Based on the investigation, the accounting maneuver was discovered by Cynthia Cooper, the internal auditor in the company. The executives at the company perpetrated the accounting fraud that resulted in the largest bankruptcy in history (Pandey & Verma 2004). The principal players in the WorldCom fraud included Scott Sullivan, Bernard Ebbers, Arthur Anderson, the General Accounting and Internal Audit Departments, David Myers, Betty Vinson, Troy Normand, and Buford Yates Jr. Ebbers was the CEO of the company who conspired to file false documents with the regulators. Sullivan was the CFO of WorldCom and was indicted on the charges of security fraud, conspiracy, and false statements to SEC (Rogers et al. 2003). Myers was the controller of WorldCom and charged with security fraud, conspiracy, and the false statements to SEC. Buford Yates was director of general accounting and pleaded guilty to charges of security fraud and conspiracy. Normand was the director of legal entity accounting who pleaded guilty to security fraud and conspiracy charges. Vinson was the director of management reporting and pleaded guilty to the charges of conspiracy to commit security fraud.

Author Anderson was the external auditor. In the midst of the fraud revelation, Anderson released a statement claiming it acted according to the professional standards and declared that the internal audit report could not be relied on given the accounting manipulations (Sack & Rakoff 2005). In this case, Anderson worked in collusion with Sullivan, Myers, and Yates in increasing the price of the WorldCom’s stock through falsely inflating the profitability. Ebber and Sullivan were the main perpetrators; the fraud was implemented by and under the direction of the CFO Sullivan. As the business operation fell further short of the targets announced by Ebber, Sullivan would direct the making of accounting entries that did not have a basis in the GAAP so as to create a false appearance that the company has achieved the targets. In doing this, Sullivan was helped by Myers who directed the making of entries he knew were not supported. With all the activities happening, Ebbers was aware of all the practices by Sullivan and Myers for inflating the reported revenues (Rogers et al. 2003).

The fraud was not only confined to the executives at WorldCom. However, others at the company knew or even suspected that the senior financial management was engaging in improper accounting. It included people in the General Accounting group located in Clinton, Mississippi corporate headquarters and people in financial reporting and accounting groups. Employees in the groups suggested, made, or even knew of the entries that were not supported and even prepared reports that were false (Pandey & Verma 2004). Irrespective of their awareness, the employees did not raise any objections that the accounting was wrong, and they just followed directions.

Victims

There are a large number of people who got whacked by WorldCom fraud. From the incident, thousands of employees lost jobs and medical insurance and also 401(k) accounts that were heavily invested in the company stock. Three days following the reports of fraud, 17,000 general employees at WorldCom were fired. The move was expected to save the company $900 million yearly (Rogers et al. 2003).  The company shareholder’s also lost billions including many pension funds. Other victims included investors in the company who believed that they would never receive their money bank after the bankruptcy. The New York State Common Retirement Fund was an investor of WorldCom and a victim of the fraud. The pension fund invested assets of the New York state and the local employee's retirement system and also the New York State and Local Police and Fire Retirement system (Pandey & Verma 2004). They lost over $300 million of its investment in WorldCom. HGK Asset Management also purchased about $130 million of debt securities offered by WorldCom on behalf of its union-sponsored pension and lost all of it.

Type of crime committed

WorldCom accounting fraud is an example of white collar crime. A white collar crime is one committed in a business setting for financial gain. Perpetrators of this crime are usually corporations or individuals that appear above reproach and crimes tend to be non-violent in nature. WorldCom committed the crime of misrepresentation of the financial statements. It is also referred to cooking the books that tend to occur when the financial statements are internally misstated so as to make the company’s financial position to look better than what it is. The misrepresentation involves decreasing reported expenses or increasing the reported revenues. It might also involve the misrepresentation of the balance sheet accounts so as to make the ratios look favorable.

The crime WorldCom committed was fabricating their financial statements through turning the loss into profit. There are sometimes when it is debatable if certain expenditure should be treated as a capital item or an operating expense. In the case of WorldCom, they took the operating expenses and pretended that they were capital expenses in the attempt of trying to convince the investors and the lenders that the company was making a profit when in reality, it was losing money.

The incidents leading to the fraud can be traced back in 1990. In the 1990s, Ebber borrowed over $1 billion for personal purposes from various banks and pledged his WorldCom stocks as collateral. When the company stock price started declining in early 21st century, Ebber lenders started pressurizing him to sell the stock so as to raise cash to support his loans. Fearing that the sale would result in further drop in the company’s share price, the Board of Directors in the company decided to authorize loans to Ebber so as to pay off his debts. Between 2000 and 2002, the company gave Ebber loans to the extent of $408 million. In 1998, the operating margin that does indicate how well the profitability of the company is decreased.

As a result, WorldCom used accounting manipulation so as to try to improve the margin that could provide impressive earnings for WorldCom. In this case, WorldCom reduced reserve accounts held to cover the liabilities of the acquired companies by $2.8 billion and then moved the money into the revenue line of financial statements (Rogers et al. 2003).

The move by the company was not enough for boosting the earnings that Ebber wanted. Thus, in 2000, the company started classifying the operating expenses as long-term capital investments. By hiding the expenses in this way, they were able to have $3.85 billion (Sack & Rakoff 2005). The company reported about $3.8 billion as capital assets on the balance sheet instead of line cost expenses on the income statement; thus, allowing the firm to spread the cost over several years resulting in an overstatement of the net income and the cash flows. The newly classified assets were the expenses that the company paid to lease phone network lines from other companies so as to access their network. The company also added a journal entry for $500 million in the computer expenses and the supporting documents for the expenses were not available. Because of the changes made, it turned the losses into profits to $1.38 billion in 2001 and made the company’s assets appear more valuable.

So as to increase the stock price, the accounting department at the company underreported the line cost, which is the interconnection expense with other telecommunication companies. In 2000, WorldCom had a loss of $649 million, but through using the accounting fraud, they did record a profit 2608 million (Rogers et al. 2003). The company reported them as capital investment in the balance sheet instead of properly expensing them so as to show they are spending less and making more money. A certain amount of the current expenses was transferred to the capital account where WorldCom boosted its net income and its assets from 1999 to 2001. That means that WorldCom kept the off balance sheet through capitalizing on the line cost rather than expressing the expenses immediate; hence, avoiding the loss of billions of dollars. If WorldCom reported the transactions correctly, they would have recorded a net loss. The personal loans that include $341 million loans to Ebbers were the largest personal loan to date made by a public firm to its CEO.

The element of the fraud that was most influential in the WorldCom scandal was motivation. WorldCom top management had personal financial incentives of fraudulently reporting financial statements so as to inflate the company’s financial position (Rogers et al. 2003). The management did have the motivation of making the company look successful and record income that could not have happened if the true losses were recorded. WorldCom’s filing Proxy Statement stated that the executives’ compensation plan has three elements including the base salary, long-term incentive compensation, and annual incentive compensation.  The annual incentive compensation was determined on the financial performance of the company. Therefore, without showing profits and strong financial performance, the top executives would not be receiving the large amounts of personal compensation. The company’s compensation plan was a strong motivation for them committing the fraud.

Legal process

In the WorldCom scandal, the authorities involved followed the proper legal, process in prosecuting the crime. The process of prosecuting the crime started with the investigation. After tips had been sent to the internal audit team and accounting irregularities seen in MCI’s book, SEC requested that WorldCom provides information. SEC together with the Justice Department started investigating WorldCom. SEC started its investigation in June 2002 and in July 2002, WorldCom filed for bankruptcy protection (Sack & Rakoff 2005). Thus, SEC obtained the court order that barred the company from destroying the financial records, limited payments to the past and current executives, and also requiring an independent monitoring of the company. The investigation was a private inquiry.

They requested and received voluntary production of documents from most people at WorldCom and also received files collected and the materials prepared by WorldCom and its counsel. The advisors also obtained access to the company’s computer system and reviewed the company’s general ledger, the supporting papers, and other accounting documents. The counsel and accounting advisors reviewed about two million pages of documents, collected about 1.2 million email messages with more than 400,000 attachments, and used the search techniques so as to identify those of relevance to the investigation.

The council did interview about thirteen former WorldCom directors that include all members of the Audit and Compensation Committee from 2000 to 2002 (Sidak, 2003). With the help of accounting advisors, the counsel also managed to interview 122 current and former employees of WorldCom.

From the investigation, SEC found sufficient information to press charges against the parties involved. SEC alleged that from 2000 to 2001, WorldCom capitalized and deferred costs rather than expensing and recognizing them, which was a violation of generally accepted accounting principles. As a result of that, the company’s revenue was overstated by about $3.8 billion. The complaints by SEC alleged that WorldCom falsely portrayed itself as being a profitable business in 2001 and the first quarter of 2002 through reporting earnings that it did not have. The actions by the company were intended to mislead the investors and also manipulate the company’s earnings so as to keep them in line with the estimates by the Wall Street analysts. WorldCom was charged with violating various antifraud and reporting provisions of federal securities laws. They include the section 10(b) and 13(a) of Security Exchange Act of 1934 and Exchange Act Rules 10b-5, 12b-20, and 13a-13 (Warder et al. 2004).

From the investigation conducted, the counsel found nothing that would indicate that the audit commit and the board were aware of the improper accounting entries. There was no evidence that the improper release of accruals, improper revenues items, capitalization of line costs, or miscellaneous items was brought to the attention of the board or the audit committee by either Andersen or employees. SEC also ensured that it gathered sufficient witnesses to testify against WorldCom CEO (Warder et al. 2004). After building a case against Ebbers, the federal government charges the CEO for helping orchestrate the largest accounting fraud in the US history. The CEO was charged with security fraud, making the false filing to regulators, and conspiracy to commit securities fraud.

The prosecution followed the appropriate process. There was hearing, trial, and sentencing. During the hearing, the witnesses were given the chance to provide their evidence in court. The United States Attorney for the Southern District of New York charged the former WorldCom financial officers with the conspiracy of committing security fraud, making false statements to SEC quarterly and annual filings, and security fraud (Sidak, 2003). In the charges, the government claimed that the defendants falsified entries in the company’s accounting records. For the criminal charges filed against Sullivan by the US attorney’s office, the CFO pled guilty. He consented to an anti-fraud injunction that permanently barred him from serving as an officer and the director of a public company and permanently suspending his from practicing as an accountant before SEC. Sullivan was sentenced to five years in prison.

In the case of Bernard Ebbers, he was found guilty. The federal jury convicted Ebbers on all the nine counts that he helped in masterminding the $11 billion accounting fraud at WorldCom (Warder et al. 2004). Ebber was charged with one count of securities fraud, one count of conspiracy, and seven counts of filing false statements with the Securities regulators. Ebber claimed that his management style was one of a coach and heavy on delegation; however, the jury found that he knew everything that was happening in the company (Sack & Rakoff 2005).

Following the verdict, Ebber’s attorney claimed that there would be an appeal and noted that the government refusal to immunize three major witnesses did deprive the defense testimony at the trial. The argument that the attorney provided did not work well. In this regards, the court concluded that it is up to prosecutors to decide who they will prosecute and who they will not (Strawser, 2008). If the witness decides to take the fifth, and not testify, then he can do so even if it means another defendant has deprived his testimony. In July 2005, the federal judge sentenced the former WorldCom CEO to 25 years behind bars without parole (Warder et al. 2004). The lengthy sentence to Ebber was a move in the long-running government effort of holding the business executives accountable for the malfeasance that happens on their watch.

The judge claimed that it was quite clear that Ebber was a leader of the criminal activity as the testimony from the trial showed that Ebber repeatedly misled the employees and investors and also filed false financial information with SEC (Sidak, 2003). Sullivan was also the key government witness at Ebber’s trial, and he was the only witness to link Ebber directly to the fraud.  Based on the ruling by the judge, she claimed that Ebber would have faced 230 years to life in prison. However, she decided to eliminate the five years after considering about 170 letters from neighbors and friends that described Ebber’s good works. 

Regulations or social controls implemented to avoid future crimes

After the WorldCom’s failure in 2002, the Congress passed the Sarbanes & Oxley Act a month later. Li, Pincus, & Rego (2008) claim that the purpose of the Act is to protect investors through improving the reliability and accuracy of disclosures made by publicly traded companies. it is likely that the act was passed as a political response; however, it was something was necessary for economic environment. if this act was passed before the WorldCom scandal, it is probable that the fraud would not have occurred. In the act section, 302-306 require that the management should certify that the financial statements are fairly presented (Maleske, 2012). Therefore, if any misstatements occur, the management is normally responsible. In the WorldCom case, Ebber claimed that he was not aware of the fraudulent activities happening in the company, and he relied on the accounting department for financial matters since he did not understand the financial statements.

Sarbanes & Oxley Act does require that when a restatement because of fraudulent activity is discovered, all the bonuses and other incentive-based compensation be forfeited (Maleske, 2012). Thus, the millions in compensation acquired by Sullivan and Ebber would have to be returned if the act did exist previously. Another requirement as per the act is that it forbids the top management to obtain loans from the company. If the board of directors at WorldCom had denied Ebber the $400 million in loans, there would be a different scenario in the company (Strawser, 2008). The lack of easy money could have prevented the extravagant lifestyle of the CEO that pressured him to commit the fraud. When Sullivan asked Ebber to report on earnings warning to the public, he could have followed the advice and prevented the collapse of a company that he worked for twenty years in building it. SOX do ban the executive perk of corporate loans and allows the SEC to freeze the executive bonuses and any other extraordinary payments (Sack & Rakoff 2005). The rules lead to a broader focus on when the executives pay, and perks are excessive, what policies govern decisions on pay, how consistently pay is set, and golden parachutes.

Sarbanes & Oxley Act (SOX) also help to prevent crimes such as one evident in WorldCom based on section 301 of the Act (Maleske, 2012). The section does give the audit committee more responsibility in strengthening the role of the committee. The act advice the committee to oversee the auditor’s work and also require members of the committee to be independent tin ensuring conflict of interest does not arise. Based on the act, it also requires the external auditors to report directly to the audit committee and not the top management so as to ensure independence and objectivity (Strawser, 2008).

Another factor of great significance with the Act is Section 404 that requires SEC to assess the internal controls of the financial reporting providing the company responsibility of strengthening controls and excluding the requirement of external auditors assess the management process in assessing the internal control system. Katz and Homer (2008) claim that the section does establish the need for effective ethics office and fraud hotline that could make it easier for Cynthia Cooper to report the fraud and maybe another employee would have reported the misstatements in the accounts sooner.

SOX also recognize that the director independence is essential for the board to serve effectively as a check on management. The regulation does allow for the director liability if the board does not exercise the appropriate oversight.  With the implementation of SOX, companies tend to be stronger and subject to oversight from more proactive board members with a greater technical expertise (Maleske, 2012). The need for independence and increased demand has resulted in greater diversity among the people serving on the boards.

With the SOX regulations, it helped to empower SEC. SOX did extend the statute of limitation for SEC to pursue actions and also increased the penalties at their disposal. It also makes it clear what disclosures are required of the public companies; hence, it is easy for the agency to pursue enforcement. The Dodd-Frank Wall Street Reform and the Consumer Protection Act were also introduced so as to improve some of the sections of SOX and introduce new standards and regulations to the financial sector. The act aims at promoting the financial stability of the US through improving transparency and accountability in the financial system.

In the wake of WorldCom and Enron scandal, the Congress created the Public Company Accounting Oversight Board. The implementation of the Board signaled the end of voluntary self-regulation of the auditing profession and beginning of compulsory independent oversight (PCAOB 2004). SOX does charge the board with overseeing the audits of public companies, protecting the investor’s interests, and furthering the interest of the public in the preparation of accurate, informative, and independent audit reports (PCAOB 2004). The board is not part of the government and members, and staff is not the government employees. The primary responsibility of the board includes registering accounting firms, establishing auditing standards, inspecting registered firms, and conducting an investigation and disciplinary proceedings. With the Board, it can call any given partner in any given accounting firm and ask to see all the work papers for the last five engagements.

The accounting firms that do an audit for the public companies should register with the board, and they are subject to annual agency inspections. For the board, as part of reviewing the audit engagement during the inspection, it can look at how the auditors make tough calls on the applications of the accounting principles in the client’s financial statement. Due to their access to the audit work papers, the reviewers are likely to focus on the GAAP issues in greater depth than SEC routine filing reviews.

Conclusion

The WorldCom scandal affected many people. In the case, the Former CEO and CFO were charged with fraud and violating the security laws. Based on the occurrences at WorldCom, it is important that auditors and stakeholders of a company should look for a way of preventing a fraud. After the incident, the government took a major step so as to help prevent such incident from happening and as a result, SOX was put into place. Most of the regulations that are present in SOX are essential in preventing the WorldCom fraud. While the regulations help to ensure that another fraud similar to WorldCom does not occur in the future, it tends not to guarantee that the massive fraud will not happen.

Reference

Beresford, R., Katzenbach, N., & Rogers, J. (2003). Report of investigation by the special investigative committee of the board of directors of WorldCom, Inc

Dodd-Frank Wall Street Reform and Consumer Protection Act, et seq. (2010)

Katz, D., & Homer, J. (2008). On the record: Cynthia Cooper. CFO,

Li, H., Pincus, M., & Rego, S. (2008). Market reactions to events surrounding Sarbanes-Oxley Act of 2002 and earnings management. Journal of Law and Economics, 51

Louwers, T., Sinason, D., & Strawser, J. (2008). Auditing & assurance services. New York, McGraw-Hill Irwin

Maleske, M (2012). Eight ways SOX changed corporate governance. 

Pandey, C., & Verma, P. (2004). WorldCom Inc. Vikalpa, 29(4), 113-126

PCAOB (2004). The PCAOB and Public Companies.

Sack, J & Rakoff, J (2005). Federal Corporate Sentencing. Law Journal Press

Sidak, G. (2003). The failure of good intentions. Yale Journal on Regulation

Zekany, K., Braun, L., & Warder, Z. (2004). Behind closed doors at WorldCom: 2001. Issues in Accounting Education, 19(1), 101-117.

Sherry Roberts is the author of this paper. A senior editor at Melda Research in affordable term papers if you need a similar paper you can place your order for essay writer services.