THE WORLDCOM SCANDAL

An Accounting Fraud, its Causes, and ultimate Consequences

By

(Name).
Table of content
Introduction …………….………………………………...……………………… 03
Responsible Personnel ………………………..…………………………. 03
Objective ………………………………………………………………… 03
Causes ………………...………………………………………………............... 04
Internal Environment …..…………...…….…...…………………………….. 04
Corporate culture…………………….………………………………….. 04
Control deficiencies ……………………………………………………. 04
Business strategy ….……………………………………………………. 05
Corporate Governance ….………………………………………………. 06
Extensive Debts ………….…………………………………………….. 06
Auditing ..…………………………………………………………………..… 07
Internal Audit ………………………………………………………….... 07
Audit Committee ………………………………………………………... 07
External Audit …………………………………………………………… 08
External Environment ………………………………………………………….. 08
Accounting Tactics ……………………………………………………………….. 08
Releasing Accruals ……………………………………………………….... 08
Capitalization of Line cost ………………………………………………….. 09
Revenue ……………………………………………...……………………… 09
Discovery by Internal Auditors ……………………………………………………. 09
Consequences …………………………………………………………………….... 09
Bibliography ……………………………………………………………………….. 10
Introduction
Long Distance Discount Services (LDDS) was a small telecommunications
company that provides long-distance telephone services to residents of the United
States. By management policies of Chief Executive Officer, this nurtured to become
the third-largest in the U.S. As per the WorldCom website, the company had 85,000
employees and was operating in over sixty countries. At its peak, it provided a
substantial amount of voice traffic and internet traffic than any other company in the
whole world. Long Distance Discount Services was first incorporated in 1983. Later
on, Bernard Ebbers, a Canadian businessman was an early investor of the company
and became Chief Executive Officer in 1985. In 1989 WorldCom was registered as a
public limited company.
Within a decade, WorldCom acquired more than 60 other telecommunication
businesses. There were two significant acquisitions. The acquisition of MSF
Communications aided in the acquisition of UUNET Technologies, which was one of
the largest suppliers of internet services. The MCI acquisition aided the WorldCom to
be one of the largest carriers of business and consumer telephone services. In 1997,
Bernard Ebbers's strategy of growth by aggressive acquisition had risen the
WorldCom’s share price from pennies per share to $60 per share. In those days,
Bernard Ebber had a net worth of more than $1.4 billion, making him one of the
richest persons in the United States.
WorldCom gave the impression to be a very strong leader in market growth.
Its rise in share stock price coupled with analyst recommendations made it desirable
for new investors. But in reality, this was just a perception. The company exposed its
involvement in fraudulent reporting on 25 June 2002. The company officials stated
that there was half a billion-dollar loss instead of $3 billion reported profits in
financial statements. Later on, an investigation was conducted that exposed the
misstatements totaling more than $11 billion. Finally, on 21 July 2002, Worldcom
filed for bankruptcy.
Responsible Personnel:
 Bernard Ebbers, Chief Executive Officer(CEO)
 Scott Sullivan, Chief Financial Officer (CFO)
 David Myers, Director of General Accounting
 Max E. Bobbitt, Chairman of Audit committee
 Cynthia Cooper, Vice President of Internal Audit
Cynthia Cooper and her team were the first ones, whose careful detective work as an
internal auditor exposed the accounting irregularities and uncovered this major fraud
at WorldCom in 2002.
Objective:
To understand the WorldCom scandal, why the fraud happened, and what it
constitutes. It is necessary to understand the internal and external environment of the
company, as well as the details of accounting procedures abridged in The Report of
Investigation, led on WorldCom while the fraud happened. The objective of this paper
about The WorldCom Scandal is to assess the causes of this fraud and its ultimate
consequences. To analyze the Accounting techniques and methods that are used to
perpetrate the fraud and the lessons learned from this scandal.

Causes
Internal Environment:
Corporate Culture:
The tone at the top is the term used to express the attitude and integrity of
higher management in any organization. This is one of the most basic and essential
elements of the organizational internal control environment. If the top management
has a prodigious tone at the top, it has a trickle-down effect on the whole organization.
All employees will have good ethical values and commitment toward honesty,
integrity, and objectivity. In opposite to this, if the top management has poor tone at
the top, the whole organization will disdain the internal control environment.
As per Albrecht (2004), to prevent any fraud, the opportunity to commit fraud
should be minimal or nonexistent. Creating a work culture of “honesty, openness, and
assistance” is the key to fraud prevention. (Albrecht & Albrecht, 2004, p. 61). The
growth acquisition strategy was imposed by the higher management of the company.
This strategy creates a culture of aggression and competition in the whole organization
without taking any account of ethics, integrity, or honesty. In reality, the former
company executive hearsays that the consistent pressure became “unbearable-greater
than he had ever experienced in his fourteen years with the Company” (Zekany,
Braun, & Warder, 2004).
Control deficiencies:
The top management mainly focused on the revenues, instead of profit
margins. The WorldCom accounting systems were not integrated that created an
opportunity for workers to commit fraud. This lack of accounting systems integration
allowed them to move customer accounts from one accounting system to another. This
manipulation created an incentive for employees to get extra commissions that
resulted in reporting higher revenues than actual. These deficiencies showed that no
attention was given to the code of ethics. The blackness expressed that no training on
awareness of fraud or ethics was conducted in WorldCom. It might also be possible
that when workers deliberately reported existing customers as new ones, they were not
aware of the obstinate consequences that may result.
There were no systems or policies for employees to express their concerns
about management behavior or policies. Those who showed loyalty to higher
management were given special rewards. Because of the several acquisitions by
WorldCom, the company was spread across the whole world. Therefore, if employees
working at headquarters in Clinton, was facing any problems, they would have to
contact the H.R department in either New York or Florida. This self-directed structure
of the company complicated matters further and dispirited employees from expressing
their concerns (Katzenbach, Beresford, and Rogers, 2003).

Business strategy:
The multiple acquisitions strategy led to hasty growth. Within a decade,
WorldCom acquired more than 60 telecom companies. All these acquisitions were
valued over the U.S $70 billion and WorldCom accumulated over $41 billion debt.
The largest of these acquisitions was MCI Communications Corporation, which was
finalized at the U.S $40 billion (In re WorldCom, Inc. 2003).
Besides, MCI Communications Corporation mostly served residential
customers that have relatively slower growth rates while WorldCom had historically a
business customer base, a customer base consisting of very high margins and less
turnover. (Katz & Homer, 2008).
The low-interest rates and the rising stock prices motivated WorldCom.
These high evolution tactics that depend on aggressive company actions usually
involved “creative” accounting policies and procedures. Later on, an investigation
conducted by Dick Thornburgh exposed a lack of strategic planning. Just for the
formality, the formal documents were originated, but they only comprised of an
overview of the company‟s financial outlook if WorldCom immobile the aggressive
acquisitions strategy. There were no realistic strategic plans in these documents (Dick
Thornburgh, 2003).
In reality, mergers and acquisitions, especially large ones like MCI
Communications Corporation, put significant managerial challenges for WorldCom.
First and foremost, the management must deal with the challenge of integrating new
and old businesses into sole efficiently functioning companies. This process is
generally time-consuming and also involves considerate planning and senior
managerial attention. With over 65 acquisitions in less than a decade, WorldCom
management had a great deal to manage them, if these acquisitions process are
focused to increase the value of the firm to both shareholders and stakeholders.
The other challenge was the requirement to account for the financial facets
of all these acquisitions. The integration of the newly acquired business must be
completed, including an accounting of assets, liabilities, goodwill, and other financial
factors. This whole process must be accomplished by the application of generally
accepted accounting practices (GAAP).
WorldCom Planned to merge with the second largest telecommunication
company at the time: Sprint (WorldCom being the third-largest at that time). The plan
was terminated by the United States Department of Justice because of the anti-
competitiveness it would create within the telecommunications industry. When there
were no more companies for acquisition, WorldCom’s growth acquisitions strategy
came to a squealing break (Clikeman, 2009).

Corporate Governance:
The board of directors at WorldCom was from several different
backgrounds. While some had widespread knowledge and experience of business and
legal issues, but others were appointed because of their contacts with Barnie Ebbers
(Breeden, 2003). The mix of the Board of directors and their very close bonds to
Barnie Ebbers led them to lack of awareness on WorldCom’s issues. The Board at
WorldCom was very inactive and the members met only about four or five times a
year. Also, there were no policies for compensation based on their performance except
for appreciation of the stock. The director’s approval of the acquisitions enabled
WorldCom’s growth to uprise which led to a higher stock price and a very large
amount of compensation. Their morbid practices created a conflict of interest for
directors. They mainly focused on the growth of the stock than on what was in the
best interests of the company (Breeden, 2003).
There was another conflict of interest for those board members that had
robust close bonds to Barnie Ebbers. These close ties created a threat to their
independence and objectivity. According to Thornburgh (2003), there were
multibillion-dollar transactions that were approved by the Board of Directors with
very limited available information. Most of these transactions were approved with
discussions that lasted less than an hour and some of these discussions did not involve
the Board at all. Also, no risk assessment procedures were performed on WorldCom’s
growth acquisitions. (Thornburgh, 2003).
Extensive Debts:
The board of directors had a policy of authorizing loans for senior executives. The
utter extent of these loans was breathtaking. The board of directors authorized a $341
million loan to Mr. Bernard Ebbers. This was the largest sum that any publicly traded
company has lent to one of its senior executives. This raises a question on the ethical
conduct of board at WorldCom. Furthermore, there is an entitlement that executive
debts are generally sweetheart deals if they include low-interest rates. This might
result in a low return on business financial assets or capital. In this case, the interest
rate was a little more than 2%, very less than the average interest rate. The charged
rate was not even equal to the WorldCom’s marginal rate of return.
Auditing:
Internal Audit:
The Internal Audit department of an organization needs to be independent and
should report to the audit committee irrespective of any influence by top executive
personnel. The internal audit department's responsibilities include the risk
management and efficiency of operations. There was no such thing that existed at
WorldCom. Moreover, the senior executive Bernard Ebbers incorrectly associated the
duties of an internal auditor with an external auditor. In reality, an internal auditor
does little work on the financial statements and focuses more on “improving the
organization’s operations” (Louwers, 2008, p. 629).
No integrity questions can be raised about Cynthia Cooper, the Vice
President of the Internal Audit department, whose cautious detective effort as an
internal auditor at WorldCom uncovered accounting irregularities intended to betray
stakeholders. The board assigned her responsibilities in operational auditing, Cynthia
and her team raised doubtful of several unusual financial transactions. On
investigation, it was found that several manipulations intended to hide almost $4
billion in misallocated expenses. Finally, she exposed a $2 billion accounting entry for
capital expenditures that had never been authorized by the board. According to Gene
Morse, the internal auditors had limited access to the financial statements of the
company. This proscribed them for the proper assessment of the financial situation of
the company. (Gene Morse, 2010).
Audit Committee:
The company board formed an audit committee to conduct relations with the
external auditor, Arthur Anderson. The policy was made that the selected board
members will have a meeting with the audit firm to discuss the progress and findings
of the audit procedure. It aimed to resolve any conflicts that may occur between
management and the firm. (Louwers, Ramsay, and Strawser, 2008).
The unethical behavior and tone at the top had a trickle-down effect on the
whole organization including the audit committee. Max E. Bobbitt, the chairman of
the audit committee, was very loyal to Bernard Ebbers (CEO). As per Breeden (2003),
the audit committee supervised the $30 billion sales revenue of WorldCom when it
met for about three to six hours once a year. (Breeden, 2003).
The audit committee carelessness and negligence portray another internal
control deficiency at WorldCom. The members of the audit committee should oversee
the internal control system to ensure that the organization complies with relevant
“laws, regulations and standards”. (Romney and Steinbart, 2008)
External Audit:
When we oversee the above scenarios, it seems that there were no proper
checks and balances in the auditing process. The internal audit department was not
sufficiently staffed to work on the internal controls and audit process. The operational
and financial situation of the company was not correctly reported to the audit
committee. Still, Arthur Andersen, the external auditor was solely responsible for
providing an independent opinion of the financial statements of WorldCom. The audit
firm seems unsuccessful to carry out its duties effectively.
As per Beresford, Katzenbach, and Rogers (2003), Arthur Andersen’s
inappropriate opinion was due in part to the tight control of the top management over
information and in part to negligence. While testing account balances, Arthur
Andersen relied on the perceived strong internal control environment of WorldCom.
Unluckily, the company’s internal control system was inefficient and enabled
Andersen to overlook “serious deficiencies” that existed in the internal control system
(Beresford, Katzenbach, and Rogers, 2003, p. 223).
External Environment:
The external environment also contributed to this fraud. In 1996, UUNet made
an announcement that internet traffic was doubling every hundred days. The sole
purpose of this statement was to increase the investment for their companies. The
people who believed in this myth made a rapid investment in the telecom sector. The
internet bubble was created and When the bubble burst in early 2000, WorldCom’s
stock share price plunged along with other volatile telecom companies.
During the false growth era of the internet, the United States government
passed the Telecommunications Act of 1996. This act enabled long-distance
companies such as WorldCom to compete in the local market and the local phone
companies to compete in the long-distance market. Hence, it opened the different parts
of the telecommunications industry to ferocious competition and lowered the price of
Telecomm services (Economides, 1998).
In 1995, the WorldCom's share price was in the $20 range. In 1999, WorldCom's
share price rose to more than $90. Later on, when the new millennium started,
WorldCom’s stock faced a continuous decline until it became worthless. WorldCom
got delisted from the Nasdaq market, once the misstatements were made public.
(Thornburgh, 2002).
Accounting Tactics:
Releasing Accruals:
During each month of the fraud period at WorldCom, they estimated the cost
associated with using the phone line of other companies. The actual bill for the
services was normally not received for several months. It implies that some entries
made to the payables or accruals could be overestimated or underestimated. In the
case that the liability was overestimated, when the actual bill was received there
would be a surplus liabilities available that when “released” would result in a
reduction of the line costs. For two years, these inappropriate accruals totaled $3.3
billion(Beresford, Katzenbach, and Rogers, 2003). When accruals started to run out,
Sullivan came up with another strategy, the capitalization of line costs.
Capitalization of Line Costs:
WorldCom leased the fiber optic cables that had just 04% utilization, for a
non-cancellable 2-5 year contract. The costs associated with the lines were increasing.
When no more accruals could be released, Sullivan came up to capitalize these costs,
that was another violation of GAAP. By the time the fraud was exposed, Sullivan had
managed to inappropriately reduce the line costs by almost $3.8 billion.
Revenue:
The WorldCom was depicted as a high growth company by the board. When
market conditions had started to deteriorate by April 2000, Bernard Ebbers stated that
he was still relaxed with revenue growth of 13.5%-15.5%. “Closing the Gap” process
was used to accomplish this falsified growth. A total of almost $958 million in
revenue was inappropriately recorded by WorldCom during 1999-2002 (Beresford,
Katzenbach, and Rogers (2003).
Discovery by Internal Auditors:
The very first suspicion arose in May 2002, when the 2001 capital expenditure
audit resulted in great variances due to entries in an account called “prepaid capacity”.
No one answered the internal auditor’s questions about “Prepaid capacity”. Sullivan
said that these were capitalized line costs and asked Cynthia Cooper to delay the audit
process. She continued the audit and told her team to look into entries.
When they inquired the David Myers, Director of General Accounting, who
confessed that he indeed didn’t have any support for the journal entries. Once the top
management had started making those entries it was difficult to stop making them
(Beresford, Katzenbach, and Rogers (2003). On June 25, 2002, marked the public
release of the fraud.
Consequences:
Once the fraud was announced, new measures were taken to reform WorldCom
and restore public confidence. The first measure was the removal of top management.
Bernard Ebbers resigned earlier in the year due to the overgenerous debts. Sullivan
was fired, and Myers resigned. The entire Board of Directors was replaced with a new
Board of directors to pledge independence and objectivity. With WorldCom’s failure
in June 2002, U.S Congress passed the Sarbanes and Oxley Act “SOX” about a month
later on July 30, 2002. (Smith and Walter, 2006).
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