11/8/2011

FSA

ASSIGNMENT 5: ACCOUNTING FRAUD AT WORLDCOM

Ganesh Krishnan | Section C | 2010PGP111

Page 1 of 7

1) What are the pressures that lead executives and managers to cook the books? After the rapid evolution of the telecommunication industry in the 1990s, WorldCom shifted its strategy to focus on building revenues and acquiring capacity sufficient to handle expected growth. Their biggest goal was to be the No. 1 stock on Wall Street rather than capturing the market share. As a result, their Expense-to-Revenue (E/R) Ratio was their measurement for their main objective (increase revenues and become the No. 1 stock on Wall Street). Due to heightened competition, overcapacity and the reduced demand for telecommunication services at the onset of the economic recession and the aftermath of the dot-com bubble collapse, the telecommunication industry conditions began to deteriorate. Prices were falling and WorldCom had no option but to cut their prices as well. This action placed severe pressure on WorldComs most important measurement, the E/R ratio. The E/R ratio was being affected due to revenue and pricing pressures while the committed line cost was still the same. 2) Is there a boundary between earnings management and fraudulent reporting? If so, what is it? Earnings Management is recognized as attempts by management to influence or manipulate reported earnings by using specific accounting methods (or changing methods), recognizing one-time non-recurring items, deferring or accelerating expense or revenue transactions, or using other methods designed to influence short-term earnings (Akers). We do not see any boundaries between earnings management and fraudulent reporting. Both actions will prevent the seeker-of-information (investors, Government etc) from receiving consistent and non-tampered-with results. To use an analogy, murdering someone with a knife (earning management) or a gun (fraudulent reporting) does not add any substantial difference to the final situation; at the end of the day you have committed a murder. Both earnings management and fraudulent reporting will alter either existing data or the way the existing data is portrayed. 3.1) Why were the actions taken by WorldCom managers not detected earlier? The fraudulent actions taken by WorldCom managers were not detected earlier because of WorldComs organizational structure and distant relations with both WorldComs external auditor and Board of Directors. First, WorldComs departments were spread out across the country (The finance department in Mississippi, the network operations headquarters in Texas, human relations in Florida, and legal department in D.C.) made it difficult for the different departments to fully coordinate and realize what was occurring in each department. Furthermore, each department had its own rules and management style, making the entire WorldCom operations uncoordinated. This organizational setup would make it easier for accounting fraud not to be detected by different departments. Second, WorldCom, headed by CEO Bernie Ebbers, encouraged a corporate culture that employees should not question their superiors, but simply do what they were told. Thus, when financial times were difficult, subordinate employees were ordered to maintain World Coms 42% Expense to Revenue ratio, and accounting managers were ordered to release accruals that were too high. The managers had incentives to do so in order to continue receiving high compensation and to avoid personal criticisms or threats that were commonplace to employees who did not obey orders. In later years, starting in 2001, staff members were ordered to treat costs of excess network capacity as capital expenditures, instead of operating costs.

Third, Ebbers and Sullivan granted compensation and bonuses beyond the companys approved salary rate, creating an incentive for employees to go along with the fraud even if they detected it. The staff in the accounting department especially had personal ties to WorldCom, which made them go along with the fraudulent practices for many years. For example, Cynthia Cooper, head of the internal audit department, grew up in the same town as WorldComs accounting headquarters and had personal relationships with family members of senior employees. Thus, Cooper had the incentive to go along with accounting fraud to continue making a large salary and to not ruin personal relationships. Arthur Anderson, the outside auditor, also had many incentives that prevented the auditing company from reporting WorldComs suspicious actions. Anderson considered WorldCom its most highly coveted and flagship client, and wanted to maintain a long term relationship with WorldCom. With these goals in mind, Anderson ignored WorldComs many denials for pertinent financial information and meetings and continued to audit WorldCom at a moderaterisk level, instead of a maximum risk level which Andersons risk management software program rated WorldCom as. Finally, the board of directors had too little connection with WorldCom to even realize fraudulent practices were occurring. Over 50% of the Board of Directors were nonexecutive members of WorldCom, and had little contact with any WorldCom managers besides board meetings, which occurred four to six times a year. Thus, the board members were fooled by the fraudulent packets of information about WorldComs financial health that Ebbers prepared before each board meeting. 3.2) What processes or systems should be in place to prevent or detect quickly the types of actions that occurred in WorldCom? Several systems should have been in place to both prevent and detect the types of actions that occurred in WorldCom. First, the corporate culture should not be one of intimidation where lower level employees must obey managers blindly. Rather, the culture should be one where the why behind all practices is explained and where lower level employees have the right to speak up if they detect something unusual. There should also be a department/ means of communication with the Board of Directors where lower and middle level employees can voice their thoughts if they suspect fraudulent practices. These measures would prevent employees from going along without questioning practices that seem fraudulent. Second, WorldCom should not focus on just one performance indicator, the E/R ratio. Just focusing on one indicator gives managers incentive to do whatever they can to reach the target ratio. By having several performance indicators, managers would have a harder time using fraudulent practices to maintain all indicators, and the multiple indicators would give a better, overall view of the companys health. Most importantly, the external audit system should work correctly to ensure that no fraudulent practices occur. Several times a year the external auditor should audit the old fashioned way by testing thousands of random individual transactions, giving the auditor a better chance of catching fraud, instead of just testing the same summaries each quarter. The external auditor should also not permit clients like WorldCom to deny turning over important financial information or deny meetings or phone conversations; if a client continues to deny financial information or meetings, the external auditor should report the company to the SEC for closer investigation. Lastly, the board of directors should more directly interact with the company to oversee all operations and make sure everything is running smoothly and legally. The board should

personally check out the accountant department financial statements at random to see the true financial situation, instead of just accepting financial packets created by the CEO. The Board of Directors should also be in closer contact with different managers and lower level staff members to get a better picture of true operations, not the picture painted by the CEO. 4) Were the external auditors and board of directors blameworthy in this case? Why or why not? External Auditors: Although the Securities and Exchange Commission ultimately decided Arthur Anderson and his external auditing team were not liable for their auditing practices at WorldCom, we believe Anderson deserves a portion of the blame due to his inability to effectively respond to numerous red flags. As a result of WorldCom's rapid expansion over the 1990's through numerous mergers and acquisitions, Anderson was forced to move away from the tedious auditing methods of checking thousands of transactions and towards a broader, more efficient system based on analytic reviews and risk assessments. Consequently, Anderson and his team assumed that all information reported from General Accounting was valid, looking for errors due to miscalculations or inaccurate records rather than deliberate misrepresentation. In 1999, Anderson's risk software analysis rated WorldCom as a maximum risk company for committing fraud. Ignoring this fact and continuing to audit WorldCom as a moderate risk client is the first of many questionable actions executed by Anderson. Furthermore, while conducting his auditing, Anderson was repeatedly refused access to the general ledger and restricted from talking with key executives in charge of the line-cost accruals. If granted access, Anderson would have easily uncovered the false accrual releases and expense capitalizations. Despite this blatant noncooperation, Anderson still rated WorldCom's compliance with requests for information as fair. In Anderson's defense, quarterly reports were doctored specifically for him, which removed key information and classified the misrepresentations under total revenues. Yet, in March 2002, a transfer of $400 million approved by Anderson from future cash payments to bolster company earnings, came to the attention of Cooper. When Cooper confronted one of Anderson's staff, she was blown off and refused an explanation. Each of these cases show Anderson's inability to react to clear red flags and in some cases even suggest an involvement in the fraudulent actions themselves. We believe that due to the fact that World Com was Anderson's flagship and most highly coveted client, he intentionally allowed the company the necessary freedom to commit this fraud. Although the scope of the fraud was likely not known by Anderson, by complying with Sullivan's requests and accepting his restrictions, he ensured the continued business of his largest client. Ultimately, if Anderson and his staff were competent at their jobs, they would have seen the numerous indications of wrongdoing and uncovered the fraud. In the end they allowed the monetary incentive of keeping their largest client to cloud their judgment and create an atmosphere where fraud could persist. Board of Directors: The WorldCom board of directors consisted mainly of former owners and directors of companies acquired by WorldCom. The extent of the boards involvement with WorldCom was limited to regularly scheduled meetings four to six times per year. These meetings included short presentations from various company executives as well as an overview of key company

operations. During CFO Sullivan's 30 minute presentation, he spoke largely in generalities, devoting only one slide to line-cost expenditures. In addition, Sullivan falsified financial data related to capital expenditures and line costs, showing cuts to be much smaller than actual figures. Due to WorldCom's corporate structure, the board's role was highly limited and segregated from the actual operations of the company. They were given figures that looked plausible, and assumed all data coming from Sullivan to be accurate. As a result of this detached role, and convincing cover-ups, it is very unlikely the board had any knowledge of WorldCom's wrongdoings. With that in mind, in November 2000, a loan was approved from WorldCom to Ebbers to the sum of $50 million before the majority of the board of directors even knew about it. (Emerson) Thus, providing another example of WorldCom's poorly implemented corporate structure. Forced to report these loans on quarterly reports, the board approved these actions, eventually allowing Ebbers to receive loans of $408 million to cover personal debts, with no collateral but company stock. After the approval of these loans, the board did little to nothing to oversee Ebbers use of the funds, some of which were directly used to pay his companies' operating expenses and many of which were invested into illiquid assets such as a sports team and a ranch. The board of directors compliance with these loans not only represents actions antithetical to shareholder interests, but also a large failure of corporate governance. We believe the board of directors is not entirely blameworthy for the fraudulent actions carried out by Ebbers and Sullivan, due to extensive cover-ups and a general lack of involvement. But as members of the board they should be held partly responsible for the companies wrongdoings. One of the primary responsibilities of the board of directors is to protect the shareholders' assets and ensure they receive a decent return on their investment (Kennon). As such, it is their role to do everything in their power to prevent or take preventative measures to counteract cases of fraud just like this. In addition, their approval of Ebbers personal loans to the amount of $408 million and then their inability to monitor Ebbers expenditures is both contradictory to shareholder interests, as well as a failure to protect the shareholders' assets. Although the board is not directly to blame for the fraud, their actions represent a failure to uphold their responsibilities as board members. 5.1) Betty Vinson: victim or villain? Betty Vinson started out as a middle level accountant for WorldCom in 1996. She quickly rose through the ranks due to a reputation for hard work and an employee who would do anything you told her. In October 2000, Vinson's boss Yates told her that the CFO Sullivan requested a release of $828 million of line accruals into the income statement. Vinson was shocked by her boss's proposal, fully understanding that it was not good accounting practice. Yet after some debate and assurance it would not happen again, Vinson approved the transfer. Troubled by her actions, Vinson planned to resign later that year. Yet after a meeting with CFO Sullivan, Vinson was reassured and she was doing nothing illegal, and Sullivan would take full responsibility for her actions. Furthermore, as the primary source of income and insurance benefits for her family, with no alternative employment opportunities, Vinson decided to continue her duties with WorldCom. Despite Sullivan's reassurances, Vinson was continually asked to make similar accrual releases each quarter. In April 2001, Sullivan, even more desperate to bolster revenues, asked Vinson to transfer $771 million out of line costs to capital expenditures, an action even less defensible in Vinson's eyes. Nonetheless, she continued to comply with the requests because of pressures from superiors, no other employment opportunities and was even given a promotion and raise. It was not until one full year later that Vinson had enough and made a pact to cease all fraudulent entries.

Although originally brought in as a witness in the case against WorldCom, when prosecution was transferred to Manhattan, it became clear she would be indicted on charges of securities fraud. All in all she served five months in jail and five additional months under house arrest for her involvement. Yet the question remains, was she a victim, following orders from superiors, or a villain who had the opportunity to blow the whistle yet failed to do so for her own selfish reasons? In Vinson's defense, and as mentioned in some of the previous answers, Ebbers created an environment at WorldCom where subordinates were to not question their superiors, but simply do what they were told. Often a failure to comply was met with hostility and even threats; such is the case with Gene Morse, senior manager of UUNET. In 1999, Buddy Yates director of General Accounting once yelled at Morse, If you show those damn numbers to the f****ing auditors, I'll throw you out the window. When approached in October of 2000 to execute the first of many questionable transfers, Vinson was merely following the orders of her superiors, straight from the CFO. It is fair to assume that in WorldCom's corporate environment, a failure to comply would likely have been met with similar threats or the loss of her job. Acknowledging the wrongdoings in her actions, Vinson's plan to resign shows her strong disapproval with the accounting entries and only after reassurance from Sullivan that she was doing nothing illegal, did she continue. After it became apparent these transfers were not just a one-time occurrence, it is likely that she only continued due to a feeling of entrapment. David Schertler, a lawyer who now represents Mr. Yates, says that his client was put in an "untenable" position by his bosses. "I think that Vinson, Normand and Yates are all low-level players in this who wound up being the victims of unscrupulous higher managers. (Pulliam) On the other hand, Vinson's continuous execution of the transfers over the course of nearly two years raises serious questions about her defense. Even though Vinson carried out the requests with strong reluctance, she carried them out with full knowledge of the fact it was bad accounting from the start. Additionally, when she was asked to release line-costs to capital expenditures, an act even less defensible in her eyes, she continued to do so. She claims to have considered resigning on numerous occasions but didn't so because she had no alternative employment opportunities, but, in reality, she had nearly two years to look for a new job. Secondly, even if she couldn't blow the whistle to Sullivan or Ebbers themselves, as a high level manager, she would have been well aware of Cynthia Cooper's position as Director of Internal Auditing, and could have reached out to her for help. While it is understood that she was put under pressure from superiors, and following orders, James Comey, the U.S. attorney prosecuting Vinson's case holds that just following orders is not an excuse for breaking the law (Pulliam). Furthermore, in some cases, it was up to Vinson to decide which capital expense accounts she transferred the line-costs into. Which is suggestive of the fact that she was not just following orders but actually involved in the formulation of the fraud. Based on the facts presented, we believe Vinson is somewhat of a victimized villain. As the nature of her job, she was put in a very difficult position by her superiors, but over the two years she knowingly broke the law, resulting in the loss of billions of shareholder dollars and tens of thousands of jobs. Her role in the scheme was instrumental to its short-lived success and it can be argued that she engineered some of the specifics herself. It is unlikely she realized the eventual full ramifications of her actions, the first time she was asked to make the transfers, but her continued compliance and inability to expose the fraud is why we do not consider her a victim. 5.2) Should criminal fraud charges have been brought against her? While it is true that Vinson was under high pressure, had worked for six years in an environment that demanded blind obedience, and might have had a personal tendency to follow

orders (she is described as a loyal employee who would do anything you told her), this still does not excuse her from knowingly and continuously producing fall transfer entries for WorldCom. The position she was placed in and the choices she made are described in detail in the answer to question 5.1. For these reasons (and taking into account that even Vinson herself admitted right away that she had done wrong), we think that Vinson justly received criminal fraud charges. 5.3) How should employees react when ordered by their employer to do something they feel uncomfortable doing? We believe that employees should react immediately when ordered by their employer to do something they feel uncomfortable doing. An independent outlet for expressing concern about company policies or behavior should be available to employees at all levels, and the corporate environment should be one that embraces and encourages healthy criticism by its employees. More importantly, a company must have a solid internal controls system, corporate governance, and individually responsible and ethical employees. A culture in which a unified corporate code of conduct is adhered to, and an attitude that is conveyed from the executive level down that ethics in business is a non-negotiable, is necessary for employees to be able to speak up when they are put in a questionable position.