The Rise And Fall Of Worldcom
In 1996, WorldCom, a broadcast communications organization, entered the market with a substantial global presence. By 1998, WorldCom was a telecommunications organization that could supply any business with telecom administrations. In 1999, an unsuccessful endeavour to secure Sprint conveyed to WorldCom executives that mergers were no longer a feasible method for development. Between 1999 and 2002, under the direction of Scott Sullivan (CFO), David Myers (Controller) and Buford “Buddy” Yates (Director for General Accounting), WorldCom overstated their pre-tax income by over $7 billion. This lead to the company having to write down $82 billion of assets. During this period, WorldCom used two types of earnings management to achieve their targeted expense-to-revenue ratio of 42%. The two earnings management approaches used were accrual releases and expense capitalisation. Accrual releases are generally utilised when an expense paid is lower than anticipated and the company can release a portion of the accrual. The excess amount will be seen in the income statement under the reduction of line expenses. WorldCom between 1999 and 2000 used this technique. During this time, Sullivan directed staff to release accruals that he believed were too high in comparison to expected future cash payments. Between 1999 and 200, WorldCom released $3. 3 billion worth of accruals. However, the release of accruals during this seven-quarter period resulted in several units having lower accruals then expected future payments. Expense capitalisation occurs when a cost is treated as capital expenditure (capitalized) rather than found in the income statement (expensed). Expense capitalization was adopted by WorldCom between 2001 and 2002 after there were very few accruals left for the company to release.
After the first quarter of 2001, Sullivan directed the staff to treat costs as capital expenditure instead of as operating costs. He instructed Myers and Yates to have $771 million worth of non-revenue-generating line expenses to be capitalized into an asset account. On April 27, 2001, a 10-Q quarterly report was generated with the US SEC. This report included $4. 1 billion in line costs and capital expenditure, $544 million of which were capitalized line costs. This resulted in a 42% expense-to-revenue ratio rather than the 50% ratio which would have been achieved had they not reclassified and released accruals. In October 2000 Betty Vinson (40), a senior manager in the General Accounting department, was instructed to release $28 million of line accruals by Yates. After a lower than expected first quarter for 2001, Vinson was once again instructed to release accruals. Although Vinson was reluctant to create these entries, she was pressured due to her dependence on her job. Vinson’s income at WorldCom was higher than her husband’s even before her promotion to director and subsequent raise at the beginning of 2002. Additionally, WorldCom paid for her family’s insurance benefits and it would have been difficult to find another job which would provide such benefits. The pressures of having to generate false entries for the second time in April 2001 resulted in Vinson suffering multiple physical effects such as lack of sleep and loss of weight as well as having her withdraw from work. Prior to the earnings management scheme, Vinson’s dedication to the company was unparalleled with her voluntarily working extra hours, working at home and even on vacation. Cynthia Cooper (38) was a veteran of WorldCom having worked there for 9 years. She was the head of the 24-member internal audit department. Cooper had grown up at WorldCom’s headquarters, Clinton, Mississippi. Her accounting teacher in high school was also one of the senior auditors at the company. Therefore, it is assumed at she has a great attachment to the company. ShCooper was role in this earnings management scheme was between 2001 and 2002 when the company used the expense capitalization method. During her routine audit in August 2001, it was unveiled that there was a misalignment of capital expenditure amounts between departments. In March 2002 Cooper was made aware of a $400 million transfer from the wireless business unit’s accrual for future expected cash to generate more company earnings. She questioned this to the WorldCom’s audit committee she received backlash from Sullivan in the form of verbal abuse. Subsequently, Cooper worked with Gene Morse, a senior manager of Internal audit who transferred after being threatened by Yates in 1999, to conduct a financial audit of WorldCom to uncover the incriminating actions of the company.
This ultimately led to fraudulent actions of WorldCom to be publicized. Earnings management “occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead stakeholders about the underlying economic performance of the company or otherwise to influence contractual outcomes that depend on reported accounting numbers. ” (Healy and Wahlen, 1999) In earnings management, managers can subjectively time business activities or the reporting of those activities to maximise the value of the firm or provide additional opportunities. Fraudulent reporting is "intentional or reckless conduct, whether, by act or omission, that results in materially misleading financial statements. " (Rocco, 1998). The Fraud Triangle is comprised of three features which are pressure, opportunity and rationalisation. Pressure is the pressure to act, the pressure may come from top management, owners or other external sources. The opportunity for fraudulent reporting must exist and it is generally a temporary situation. For example, this can be through a lack of business ethics or changes in the market. Finally, rationalisation is the incentives of the individual or group of individuals committing the unethical act. From above, it is understood that the most critical factor in distinguishing between earnings management and fraudulent reporting would be the compliance with management and their standards. Due to this, I believe that WorldCom has crossed the line from earnings management into fraudulent reporting. Under the Fraud Triangle, all three requirements must be fulfilled for there to be a fraud claim. The first characteristic, pressure, is evident throughout the entire case with staff being subject to threats and verbal abuse from top management. For instance, when David Schneeman, acting CFO of UUNET, refused to release accruals, Myers sent him a threatening email. The second requirement of opportunity is evident in the failure of the company to maintain its target expense-to-revenue ratio of 42% due to revenue and pricing pressures along with high line costs. The final requirement of rationalisation is evidenced through Sullivan’s admission after he pleaded guilty to federal fraud and conspiracy. He stated that “[he] took these actions…in a misguided effort to preserve the company to allow it to withstand what [he] believed were temporary financial difficulties. ” (Kaplan and Kiron, 2007)
Therefore, with all three requirements of pressure, opportunity and rationalisation satisfied, it can be concluded that the actions taken were fraudulent reporting and not earnings management. WorldCom’s actions were able to go undetected due to multiple reasons, the main two being a lack of corporate culture and the negligence of an external auditor. Additional factors allowing the actions to be undiscovered include a lack of internal control, the failure of corporate governance and omissions of material by management. WorldCom also decided to omit and restrict information to both their external and internal auditors meaning that WorldCom’s lack of good corporate culture contributed to the failure of WorldCom’s governance system, therefore, the actions of managers were not detected for three to four years. A good corporate culture is essential as it is a reflection of business’ goals, values, and principles. The lack of corporate culture at WorldCom is evident through the lack of integration of offices in different locations. WorldCom also did not have any written policies as well as a lack of internal effort to have a code of conduct created. The Effect of Organisational Culture and Ethical Orientation on Accountants’ Ethical Judgements concluded that the organisational ethical culture is indirectly related to the ethical judgments of individuals. The lack of corporate culture, in this case, was found to have originated from a general disintegration of departments but as well as the carelessness from WorldCom’s CEO, Bernard J. (Bernie) Ebbers. Under the conclusions from the case, the lack of ethical judgements of top management flowed through to the managers, therefore, having staff member comply with these illegal actions.
The appropriate course of action for WorldCom to overcome this would be to build their corporate culture, starting with having a written code of conduct followed by the integration of departments across all locations. WorldCom’s independent external auditor, Arthur Anderson, was proved to be negligent. This in conjunction with WorldCom’s restriction of the information shared with their external auditor resulted in their actions going undetected. Anderson was blindsided by his view of his relationship with WorldCom to be long-term and how highly he valued WorldCom as a client that he did not question the abnormal performance results WorldCom was producing during a period of severe decline in the telecommunications industry. Anderson’s risk management software also deemed WorldCom to be highly susceptible to commit fraud due to the volatility of the industry, the company’s active mergers and reliance on stock prices. Anderson’s lack of action to upgrade WorldCom from a “moderate-risk” to a “maximum risk” company resulted in the capitalisation of line costs and accrual releases to go undetected.
Additionally, WorldCom was also withholding information from Anderson to the extent that a separate monthly revenue statement was generated for Anderson specifically. Despite apparent inconsistencies, Anderson still failed to alert the audit committee of restrictions on his ability to access information or personnel. A report commissioned by the Committee of Sponsoring Organisations (COSO) in 1999, investigated the effectiveness of audit tools for fraud detection. The study concluded that auditors who can easily disembed information and can tolerate ambiguous situations can identify misstatements due to fraud. It also outlines that auditors must not be complacent that they fail to recognise indicators of fraudulent reporting when it is encountered. In relation to this case, however, Anderson's negligence brought about the absence of the discovery of inconsistencies between the reports provided. Had he not been careless, the fraudulent activities of WorldCom would have been recognized before.
Therefore, the appropriate system which should have been in place would be for Anderson to take the correct action when prompted to do so, for example upgrading the risk of the company or questioning how WorldCom was able to maintain stable ratios in a declining market. As per the case, if the external auditor is sufficiently competent, the information given by the company would have no effect on their ability to identify fraud indicators. WorldCom’s fall as a company can be attributed to their lack of controls in place for the fraud they committed to be detected earlier. Their lack of corporate culture, negligence of external auditor and their omissions of information to the auditors were what ultimately allowed for their actions to remain unidentified.
