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.

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 took the telecom industry by storm when it began a frenzy of acquisitions in the 1990s.
The low margins that the industry was accustomed to weren't enough for Bernie Ebbers, CEO of
WorldCom. From 1995 until 2000, WorldCom purchased over sixty other telecom firms. In 1997 it
bought MCI for $37 billion. WorldCom moved into Internet and data communications, handling 50
percent of all United States Internet traffic and 50 percent of all e-mails worldwide. By 2001,
WorldCom owned one-third of all data cables in the United States. In addition, they were the second-
largest long distance carrier in 1998 and 2002.

How the Fraud Happened

So what happened? In 1999, revenue growth slowed and the stock price began falling. WorldCom's
expenses as a percentage of its total revenue increased because the growth rate of its earnings
dropped. This also meant WorldCom's earnings might not meet Wall Street analysts' expectations. In
an effort to increase revenue, WorldCom reduced the amount of money it held in reserve (to cover
liabilities for the companies it had acquired) by $2.8 billion and moved this money into the revenue
line of its financial statements.

That wasn't enough to boost the earnings that Ebbers wanted. In 2000, WorldCom began classifying
operating expenses as long-term capital investments. Hiding these expenses in this way gave them
another $3.85 billion. These newly classified assets were expenses that WorldCom paid to lease phone
network lines from other companies to access their networks. They also added a journal entry for
$500 million in computer expenses, but supporting documents for the expenses were never found.

These changes turned WorldCom's losses into profits to the tune of $1.38 billion in 2001. It also made
WorldCom's assets appear more valuable.

How it Was Discovered

After tips were sent to the internal audit team and accounting irregularities were spotted in MCI's
books, the SEC requested that WorldCom provide more information. The SEC was suspicious because
while WorldCom was making so much profit, AT&T (another telecom giant) was losing money. An
internal audit turned up the billions WorldCom had announced as capital expenditures as well as the
$500 million in undocumented computer expenses. There was also another $2 billion in questionable
entries. WorldCom's audit committee was asked for documents supporting capital expenditures, but
it could not produce them. The controller admitted to the internal auditors that they weren't following
accounting standards. WorldCom then admitted to inflating its profits by $3.8 billion over the previous
five quarters. A little over a month after the internal audit began, WorldCom filed for bankruptcy.

Where Are They Now?

When it emerged from bankruptcy in 2004, WorldCom was renamed MCI. Former CEO Bernie Ebbers
and former CFO Scott Sullivan were charged with fraud and violating securities laws. Ebbers was found
guilty on all counts in March 2005 and sentenced to 25 years in prison, but is free on appeal. Sullivan
pleaded guilty and took the stand against Ebbers in exchange for a more lenient sentence of five years.