Table of Content

Content

Page

Introduction

Question 1

2-3

Question 2

4-5

Question 3

6-7

Question 4

8-9

Recommendation

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Introduction

WorldCom, a multi-billion dollars telecommunication company was established in 1983. It

shocked the world by declaring bankruptcy at 21st July 2001 and became the largest bankruptcy
filing in United State history. It was the second largest telecommunication company in US. Due
to its rapid growth, the company had also high level of debts to continue their operation.
Collapsing of WorldCom had affects many sectors. Not only their employees, retailers,
government and even bankers were affected.
They started their business which provides long distance telecommunication services under the
name Long Distance Discount Services' (LDDS). It was high profitable since beginning of the
operation. In 1985, Bernie Ebbers had become the companys CEO. LDDS had changed its name
to WorldCom in 1995. During the 1990s, the company had a lot of successful acquisition and
merging. This leads the company to growth.
During the late 1999, Worldcoms performance began to drop due to high competition, over
capacity and lesser demand for telecommunication services due to recession and also the dotcom bubble collapse. Other than that, reduction of price in WorldCom was also cause by falling
telecommunication companies and new entrants and this caused them to make fraud. The
WorldComs CFO, Scott Sullivan starts the process of misdirecting as capital expenditure what
should have been normal expenses, thus turning losses into profit, creating a camouflage that the
business is acting well.
People started to feel curious when the companys stock price plunged at June 2002 and
investigation was carried out. On June 25, WorldCom admits that they had did fraud by
overstated its profits by $3.8 billion which was the largest fraud in history. After several
investigation, the total discovered amount from improper accounting procedures increased to $9
billion and lead WorldCom to file bankruptcy in July. The CEO, CFO and controller were
responsible for the fraud.

1. What are the pressures that lead executives and managers to "cook the books?"
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During 1990s, WorldComs revenue growth had been reduced and the stock price began to fall.
The percentage of expenses over income raised due to the growth rate of the earnings dropped
which meant WorldCom cannot meet the Wall Street analysts expectations. These situations
cause the managers to cook the books.
To lead to the revenue growth of company, Ebbers pressured his employees by asking to be the
number one stock in Wall Street. He demand his staffs to focus on making profits and gaining
adequate capacity to handle expected growth even if the long-term cost exceeds the short-term
profit. A companys market value is measured by the revenue growth. Executives and managers
are stressed to show the increase in revenue due to Ebbers demand. This causes them to start
cooking the books.
In order to meet the expected increase in customer demand, WorldCom entered into long-term
fixed rate leases for network capacity. They can only avoid lease payments by paying hefty
termination fees. WorldCom would pay for unused line capacity if the customer could not meet
the expectation. The telecommunication began to fall apart due to the high competition with low
demand from the customer at the onset of the economic recession and the result of the dot-com
bubble collapse.
As there are new company began to enter to the market, the decreasing in the price forced
WorldCom to match with them. Thus, this had become an obstacle for WorldCom to increase the
revenue. On the other hand, WorldCom was struggling in maintain the same level of earning per
revenue ratio but on the same time closely monitored by analysts and industry observers. They
also faced pricing pressures and its high committed line costs.
Furthermore, investors may not be interested with WorldCom anymore. Ebbers, the CEO treated
the senior managers by saying that they will lose everything. He stressed the managers by giving
them an emotional speech on how all the directors would lose everything if the finance
performance of the company did not improve. This causes the managers to do whatever to boost
the revenues to remain their positions.
Consequently, Sullivan decided to entries to achieve targeted performance. He found out the only
way which is he and his two staff used main accounting tactics that accrual releases and
capitalization of line costs to manipulating with the figures in order to show that company is in a

better position. Pressures within the industry such as meeting market expectation, economy
recession and intense competition has caused executives and managers to cook the books.

2. What is the boundary between earnings smoothing/earnings management and

fraudulent reporting?
Earnings is defined as the profits of a organization. In order to determine the attractiveness of a
specific stock, the analysts and potential investors will took a look to earnings. Companies that
have good earnings prospects normally will have higher share prices than those with poor
earnings prospects. Therefore, the ability of a company to generate profit in future plays a key in
determining the stock price.
Earnings management is the creative used of various accounting techniques by the management
of a organization in order to deliberately manipulate the reported earnings. These types of
practices also known as earnings smoothing, where the companies will try to keep the figures to
match their pre-determined target by artificially increase or decrease the figures from cookie
jar accounts, reserve accounts.
Fraud is known as an act of criminal deception or an unlawful conduct. Fraudulent reporting is
defined as an intentional act of management to issue materially misleading financial statements.
This happen when the management intent to deceive the users of financial statement in order to
avoid negative opinions of the companies financial stability.
Both earnings management and fraudulent reporting will lead to misrepresentation of reported
earnings performance. However, earnings management does it by following the laws and
accounting standards, while fraudulent reporting leads the presentational infidelity and
unfaithfulness by violating corporate laws or accounting standards. Differ from fraudulent
reporting, earnings management will not create fictitious figures. Rather than being made up, it
creatively smoothed the reported earnings across accounting periods.
Earnings management is not considered as fraud. In accounting, the use of fictitious transactions
or any of those which prohibited by Generally Accepted Accounting Principles (GAAP) are
considered as fraud. Earnings management is within legitimate constraints and GAAP, but is a
type of accounting manipulation. As in WorldCom case, the management utilized earnings
management for their self-benefits, instead of the shareholders benefits. On the other hand,
fraudulent reporting is illegal and may lead to loss in public confidence.

The best way to differentiate between fraudulent and legitimate action is by understanding the
motives behind an action and the management intent. This may help us to determine whether the
action was accidental or deliberate. Differ from earnings management, fraudulent reporting
consists of the intention of management to deceive the users of financial statement.

3. Were the external auditors and board of directors blameworthy in this case? Why or
why not?
External Auditor
WoldCom external auditor, Arthur Andersen has failed to carry out its responsibilities. External
auditors are considered as a watchdog and they are supposed to act on behalf of the company
benefits. There are a few factors that Arthur Andersen has failed to act as an external auditor.
One of it is lack of professional skepticism. Proffesional skepticism is an attitude that the auditor
must possess while doing collecting audit evidence. They must be skeptical and have a
questioning mind. As in the case, a mistake that Andersens did was it limited its testing of
account balances by relying on WorldComs perceived strong internal control environment.
Unfortunately, WorldComs internal control environment was inefficient which allowed
Andersen to overlook serious shortages that existed in the internal control environment.
Moreover, Arthur Anderson can be said as lack of independence as they earn more profits than
other audit services. Anderson spent most of the time by selling consulting services rather than
conducting an audit. These actions shows that Anderson is having conflict of interest as they
wants a long term relationship with WorldCom. Myers found out that Anderson might not be
ignoring the details purposely but they were forced to complete the tasks as soon as they could. It
seems that the relationship with WorldCom was more valued than doing proper audit work.
Professional skepticism in audit cannot be overemphasized. Professional judgment by the auditor
can brings a high quality audit. Furthermore, a mindset that includes professional skepticism
throughout the planning performance of the audit. In conclusion, Arthur Anderson is
blameworthy for this case.
Board of directors
The board members was inactive and they never really met outside of the meeting. Meetings are
only held four times a year. It was not sufficient to discuss company matter. Over the years, as
the company is expanding, Ebbers still maintain the format of the meeting. The outside directors
were only given a set of documents prior meeting. The board did not have much influence on the
approval or disapproval of company operation decision. WorldCom expansion led to a higher
stock price thus it causes a large amount of compensation towards the directors. It creates a
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conflict of interest between the directors as their goals become more focused on the stock growth
rather than focusing on the shareholders interest. Close ties between Ebbers and its board
members also affects the independent of the management.
There was a lack of awareness about WorldComs matter due to the boards lack of inactive
participation. Directors will receive information about issue that going to be discuss in a week
before the meeting. This gives the directors an inadequate time to identify problem and
highlighting it to the board as WorldCom becomes complex due to the acquisition expansion.
Besides, directors also unable to question the top management as they have little or no clue about
the company culture and activities.
In a nut shell, board of directors are responsible to take an active role in overseeing the company
management. The directors should have a say in approving the companys strategy, review its
financial statements, and evaluate company policy from time to time. They should always
interact with the external and internal auditors. In this case, WorldCom board of directors is
blameworthy.

4. Why were the actions taken by WorldCom managers are not detected earlier? What
process or systems should be in place to prevent or detect quickly the types of actions that
occurred in WorldCom?
The accounting fraud in WorldCom is initiated by both internal and external factors.
Internal factors
i.

Top management

The accounting fraud is made by the top management itself. Bernie Ebbers (CEO), Scott Sullivan
(CFO) and its controller are involved in the swindle. Top management is the core of the company
operations. They are the main people running the company by making vital decisions for
company growth. However, the top management of WorldCom uses their influence and power
for their own interest.
ii.

Corporate culture

The expansion of WorldCom by acquisition has created jumble of people and cultures. Each
department had its own rules and management styles. There were no written policies and which
shows that the operation is flawed and triggered fraud to happen. The company also encouraged
a systemic attitude where the employees are told what to do without questioning their
supervisors. Any employees which criticize their supervisors action will face great
consequences.
iii.

Lack of communication

There are no relationships between the employees to supervisors, within departments, internal
and external auditors and board of directors. The company senior lawyers are not included in the
company inner circle. Its CEO has created a culture in which the legal function is less significant
and unwelcomed. The company also provides limited information to its directors. None of their
outside directors had regular interactions with WorldCom top management or employees. The
outside directors also never met by themselves. The internal and external auditors are often being
blocked of company information and the employees received a strict order of what information
could and could not be shared.

iv.

Employees mindset and awareness

The employees are trained in a way to follow their supervisors instructions without any
question. It created an environment where the employees are terrified to challenge their
supervisors or report anything suspicious. Therefore most of the employees have low awareness
of fraud and mostly keep it to themselves. In addition, there are no proper channels for the
employees to express any doubts as they have to report to Sullivan, the company CFO. Even if
the employees know there are frauds happening among the top management, they do not know
how to handle it.
v.

Manipulation of information

The Board and Audit Committee were given a mixed of false and credible information. For
instance, the company is not being completely truthful with its auditors, Arthur Andersen. Rather
than withholding the information, WorldCom also altered documents. The monthly revenue is
being altered by omitting several items in the report. In addition, Sullivan also manipulated the
information to the board. Directors only received information of what they need them to know
only.
External factors
The external auditors play an important role in the company. They act as a watchdog and
expresses opinion of the financial report. The external auditors are the one investors rely to as
they are expected to express a true and fair opinion of the company. WorldCom external auditor
is Arthur Andersen. An auditor must uphold principles such as integrity, competency,
independence and objectivity. However, thats not the case in WorldCom. Arthur Andersen
values WorldCom as its crown jewel as the audit firm received quite a percentage of revenue
from WorldCom itself. Therefore, Arthur Andersen fails to maintain the principles above.
Anderson audit focused primarily on the risk of errors and inaccurate records instead of
deliberate misrepresentation. There were signs and symptoms of fraud present but they continued
to issue unqualified audit report for years.

Recommendations
The company should have a proper platform for the employees to raise their concerns or doubts.
They may implement a whistle blowing policy in the company and encourage the employees to
take an active role in inspecting any irregularities. The whistle blowing policy while help the
management team to detect any flaws and strategize actions that needs to be implemented.
Whistle blowers identity should be kept private to retain their safety. Rewards can be given
accordingly depending on the truthful of the information to encourage whistle blowing.
The company should enhance its communication within the company. A healthy corporate
environment consists of good communication between the audit committee, internal and external
auditor, the board of directors and employees. This allows them to exchange information
effectively. All parties must be able to express their opinions without third party interference.
Outside directors must be included in the loop so they could question the managements decision
rather than agreeing to everything being made by the management.
A good internal system must be in place that able to detect or prevent any wrongdoings that
occurred in WorldCom. They should hire a new team that is free from bias to enhance the code
of corporate governance which monitors actions, policies and decisions of the company. This
enhances the level of transparency and efficiency of the company performance. A good internal
control will lower the risk of misrepresentation and fraud from happening.
The company may request proactive audit to be performed frequently. A quarterly or half yearly
audit can be considered as a preventive measure. Proactive audit is used to minimize the risk of
fraud from happening as it can detect fraud at early stage. The audit committee should annually
review its auditors. They must ensure that the company auditors are independent and its opinions
are not bias. If the auditor is no longer fit for the position, the audit committee should replace and
appoint another auditor. The company may consider replacing Arthur Andersen with other
auditors as he has audited the company for many years which creates familiarity threat.
As a conclusion, the fraud happened in WorldCom undetected is because the top management are
the one responsible for the fraud. The top management was acting in collusion with the auditor to
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cover the act of fraud. The weak company culture and poor management were also part of the
contributing factors.

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