Insight on WorldCom Scandal

Table of Contents

ABSTRACT 2 The importance of accounting conceptual framework 3 Historical Background 5 The Scandal – what happened 6 PENALTIES 7 How the scandal relates to accounting theory 8 RELATION TO POSITIVE ACCOUNTING THEORY 9 Conservatism Principle 9 Lack of Reliability 10 Lack of Relevance 11 Financial Misstatement 11 Conclusion 12 Bibliography 14

Insight on WorldCom Scandal
ABSTRACT
The scope of this paper deals with the WorldCom accounting scandal of the early 2000’s as it relates to elements of accounting theory. The discussion will cover the key reasons that contributed to the collapse of WorldCom. Specifically, this paper will look at: Executive compensation, Earnings Management, and Information Asymmetry. The authors will present arguments that clearly show how each of these three sub-topics played a pivotal role in the scandal. The reader will also see how these reasons are often inter-related, and often overlap each other, the enormity of which caused the company to fall like a stack of dominoes. In particular, information asymmetry was allowed to flourish as the WorldCom executives lavished themselves with huge compensation, all the while keeping the board of directors and investors out of the loop. A poor corporate government structure existed as the board was filled with inept and ineffective individuals who were powerless to stop the pilfering of profits. The end result of these actions can be seen in how the former employees of WorldCom have been victimized the hardest, in terms of their pensions being gutted, as a result of corporate greed.
Agency theory will be used to explain how this failure occurred in terms of information asymmetry, specifically moral hazard, and adverse selection in the relationships between the principal (WorldCom Controller and C.F.O) and agents namely, investors and WorldCom employees.
In conclusion, a summary of the various arguments as well as outlining several important lessons that can be learned, so as to avoid future scandals like WorldCom from reoccurring.
The importance of accounting conceptual framework Before we head into the details of the WorldCom scandal, we should understand the role of accounting conceptual framework in preventing such scandals from reoccurring again. An accounting conceptual framework can be defined as: “a coherent system of inter-related objectives and fundamentals that should lead to consistent standards that prescribe the nature, function and limits of financial accounting and financial statements”(Scott,2012) The main reasons for developing an agreed conceptual framework are that it provides: * A framework for setting accounting standards; * A basis for resolving accounting disputes; * Fundamental principles which then do not have to be repeated in accounting standards.
This conceptual framework is a recent concept. Before setting up the conceptual framework, many accounting standard setters have historically operated without having a conceptual framework. As a result, accounting standards often are disorganized in nature and mainly a response to the issues or scandals. In early 2000, some companies such as, Nortel Networks, Hollinger international in Canada, Enron and WorldCom in the U.S., and Parmalat in Italy faced corporate reporting scandals. Many schemes were uncovered that falsely increased earnings or hide a company's true financial position. Therefore, there were financial lawsuits, fines, and criminal convictions. Investors started to lose confidence in financial reporting and lose their investment. To restore the investor confidence in US public markets, the Sarbanes-Oxley Act was passed by the US congress and sign into law by the president on July 30, 2002.A number of change happened in the financial reporting system to help investors regain confidence in corporate reporting. Investors and creditors rely on the financial statements to make decisions. The lack of an agreed conceptual framework also increases the risk that standards are inconsistent with each other and that there is no overall objective for the preparation of financial statements. The framework can assist users in interpreting information contained within financial statements as it provides an understanding of the principles on which they are prepared. The Framework specifies the qualities that make financial information useful such as, understandability, relevance, reliability and comparability. It also defines the basic elements of financial statements such as, assets, liabilities, equity, income, expenses etc. and discusses the criteria for recognizing and measuring them. According to Amernic& Leon (1984) “judgments based on an objective, internally consistent and generally accepted conceptual framework would provide more useful information to financial statement users than judgment based on subjective factors, which are more difficult to interpret and apply”. Without a conceptual framework, professional accounting judgments are based on personal experiences and biases. Conceptual framework should enhance comparability among companies' financial statements, to solve practical problems and to increase understanding and confidence in International financial reporting systems.

Historical Background Now that we have a good understanding of conceptual framework and its role in setting accounting standard in an attempt to minimize accounting scandals, let us look into the scandals of WorldCom, which pushed for an even stronger conceptual framework.
WorldCom began as a Long Distance Discount Services Inc. (LDDS) during 1983, based in Hattiesburg, Mississippi. In 1985 LDDS appointed Bernard Ebbers (born 1941) to be its CEO. The company became traded publicly as a corporation during 1989 as a result of a merger with Advantage Companies Inc. The company name was changed to LDDS WorldCom during 1995. The company grew rapidly during the 1990s. Among the companies that were bought or merged with WorldCom were Advanced Communications Corp. (1992), Metromedia Communication Corp. (1993), Resurgens Communications Group(1993), IDB Communications Group, Inc (1994), Williams Technology Group, Inc. (1995), and MFS Communications Company (1996), and MCI during 1998
On November 4, 1997, WorldCom and MCI Communications announced their US$37 billion merger to form MCI WorldCom, making it the largest corporate merger of US history.
WorldCom marketed itself as a high-growth company, and revenue growth was clearly a critical component of WorldCom’s early success. In the 1990’s, WorldCom was often cited as a top “growth stock.” Analysts marveled at WorldCom‘s ability to “outgrow an industry that was outgrowing the overall economy,” and Ebbers repeatedly trumpeted the Company‘s impressive record on revenue growth during his quarterly conference calls with analysts. As Ebbers stated in 1998, “[WorldCom’s] industry leading and accelerating revenue growth, combined with a demonstrated track record of margin expansion, are cause for optimism as we continue our relentless pursuit of increasing shareholder value.” This growth was both critical to WorldCom‘s stock market valuation, and to its ability to use its stock as currency for compensation and expansion.
WorldCom traded on NASDAQ under the symbol WCOM before the collapse. At the peak of its performance the stock price traded over $65 per share making it one of the largest companies in terms of market capitalization.
The Scandal – what happened The key players who were involved in the WorldCom scandal were Ebbers the (CEO), Sullivan the (CFO) and Myers the (Contoller). The WorldCom fraud was accomplished in two main ways. First, the accounting department under reported line costs (i.e. interconnection expenses with other telecommunication companies) by capitalizing these costs on the balance sheet rather than properly expensing them. Second, the company inflated revenues with bogus accounting entries from 'corporate unallocated revenue accounts'.
The first discovery of possible illegal activity was by WorldCom's own internal audit department who uncovered approximately $3.8 billion of the fraud in June 2002. The company's audit committee and board of directors were notified of the fraud and acted swiftly: Sullivan was fired, Myers resigned, and the Securities and Exchange Commission (SEC) launched an investigation. By the end of 2003, it was estimated that the company's total assets had been inflated by around $11 billion.
On July 21, 2002, WorldCom filed for Chapter 11 bankruptcy protection, the largest such filing in United States history. The company emerged from Chapter 11 bankruptcy in 2004 with about $5.7 billion in debt. At last count, WorldCom has yet to pay its creditors, many of whom have waited years for the money owed.
PENALTIES
On March 15, 2005 Bernard Ebbers was found guilty of all charges and convicted on fraud, conspiracy and filing false documents with regulators. He was sentenced to 25 years in prison. Other former WorldCom officials charged with criminal penalties in relation to the company's financial misstatements include former CFO Scott Sullivan (entered a guilty plea on March 2, 2004 to one count each of securities fraud, conspiracy to commit securities fraud, and filing false statements), former controller David Myers (pleaded guilty to securities fraud, conspiracy to commit securities fraud, and filing false statements on September 27, 2002), former accounting director Buford Yates (pleaded guilty to conspiracy and fraud charges on October 7, 2002), and former accounting managers Betty Vinson and Troy Normand (both pleading guilty to conspiracy and securities fraud on October 10, 2002) (MCI, 2006). Ebbers reported to prison on September 26, 2006 to begin serving his sentence.
In summary, WorldCom’s collapse reflected not only a financial fraud but also a significant failure of corporate governance. The Board of Directors played far too small role in the life, direction and culture of the Company. The Audit Committee did not engage to the extent necessary to understand and address the financial issues presented by this large and extremely complex business. Its members were not in a position to exercise critical judgment on accounting and reporting issues, or on the non-traditional audit strategy of their outside auditor. The Compensation Committee dispensed extraordinarily generous rewards without adequate attention to the incentives they created, and presided over enormous loans to Ebbers that were unethical to shareholder interests and unjustifiable.
How the scandal relates to accounting theory An accounting scandal arises with the disclosure of financial misdeeds by trusted executives of corporations. Such misdeeds typically involve complex methods for overstating revenues, understating expenses, overstating the value of corporate assets or underreporting the existence of liabilities. The WorldCom scandal reignited the debate over the relative merits of US GAAP, which takes a "rules-based" approach to accounting, versus International Accounting Standards, which takes a "principles-based" approach. The Financial Accounting Standards Board (FASB) announced that it intends to introduce more principles-based standards. The WorldCom scandal case provides sufficient detail to allow for a full discussion of the pressures that lead executives and managers to "cook the books," There was a failure in the company`s internal control systemsand the role played by the auditors. There was weak governance processes performed by external auditors and the board of directors. There was pressure from the higher management to the middle managers who just followed orders that they knew were wrong and unethical.

RELATION TO POSITIVE ACCOUNTING THEORY The effect of corporate performance on disclosure level could be positive, negative, or constant (Lang and Landholm, 1993). The positive relationship is based on assumption that the company will disclose more when it has good or extraordinary performance. This relationship is supported with adverse selection theory which predicts that with certain disclosure cost, high-performed companies will give disclosure while companies below the expectation will not disclose. But WorldCom disclosed voluntarily by the firms in order to expand revenue. It supported negative correlation between performance and disclosure level. Disclosure was also hypothesized that it could reduce expenses cost through the reduction of information gathering cost by investors. This cost reduction could enhance the amount of investors willing to invest on the company.
Conservatism Principle WorldCom ignored the principle of Conservatism which states that, if a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. WorldCom management chose to ignore the credit department’s list of customers who had not paid their bills and were unlikely to do so. The receivables were not written off as uncollectible. In this area, managerial assumptions played two important roles in receivables accounting. They contributed to the amount of funds reserved to cover the bad debts. The lower the assumption of non-collectable bills, the smaller the reserve fund required. The result is higher earnings reflected on the financial statements.
Lack of Reliability Analysts and observers within the Telecom industry typically focus on the line cost expenditure-to-revenue (E / R) ratio as a critical performance indicator. WorldCom management touted a lower E / R ratio (42 percent) than their competitors and consistently struggled to maintain that level during the fraud years (Kaplan and Kiron 2004). To meet analysts’ expectations, management manipulated financial information to increase the appearance of revenue growth, cost reduction, and overall profit. The end result was the largest corporate fraud in U.S. history at $11 billion. WorldCom management utilized various techniques to mask their financial condition, but four in particular drove the major material misstatements: 1. Categorizing operating expenses as capital expenditures 2. Reclassifying the value of acquired MCI assets as goodwill 3. Including future expenses in write-downs of acquired assets 4. Manipulating bad debt reserve calculations.
The cumulative impact of the four techniques resulted in enhanced perceptions of financial position and viability by reducing the key E / R ratio and boosting overall net income from operations. WorldCom began classifying operating expenses as long-term capital investments in 2000. Generally accepted accounting principles (GAAP) dictate that operating expenses must be immediately recognized in the period incurred, unlike capital expenditures, which may be capitalized as assets and depreciated over their useful life. Deferment of these costs artificially inflated reported net income and misled financial statement users. The payments to lease phone network lines from other companies (i.e., allowing access to their networks) are commonly referred to as ‘‘line costs’’ and represent the numerator in the E / R ratio. The fraudulent capital expenditures resulted from manual reclassification of existing operating expense account balances and inappropriate recording of future line-cost transactions.
Lack of Relevance Accounting has been perceived as a medium to provide useful information for economic decision making. However, a number of accounting and business scandals occurred around the world have attracted criticism on accounting. WorldCom was reported scandals and bankruptcy in the world. This case implies that WorldCom had failed to supply accurate information to their investors, and to provide appropriate disclosures of any transactions that would impact their financial position and operating results. The accounting scandal had induced a crisis of confidence in financial reporting practice and effectiveness of corporate governance mechanisms (Bartley 2002; Browning 2002; O’Connell, et al. 2005). In addition, the relevance of accounting regulations in WorldCom accounting scandals had been almost destroyed.
Financial Misstatement WorldCom used a liberal interpretation of accounting rules when preparing financial statements. In an effort to make it appear that profits were increasing, WorldCom would write down one quarter millions of dollars in assets it acquired while, at the same time, it "included in this charge against earnings the cost of company expenses expected in the future. The result was bigger losses in the current quarter but smaller ones in future quarters, so that its profit picture would seem to be improving. WorldCom reduced the book value of some assets by several billion dollars; the company increased the value of "good will," that is, intangible assets-a brand name. This enabled WorldCom each year to charge a smaller amount against earnings by spreading these large expenses over decades rather than years. The net result was WorldCom's ability to cut annual expenses, and boost profits from the acquisition. WorldCom managers believed that users could be fooled by managing earnings.Nevertheless, the financial misstatement led to bankruptcy announcement, 17,000 workers got the push, and the company’s shares dropped from over $60 to less than a dollar.
Conclusion

The world has seen many financial scandals due to misstatement in the financial statements. WorldCom fraud was one of the biggest accounting scandals in the US history. There were many parties involved in WorldCom fraud, such as company management, board of directors, internal audit committee, and external auditor, ArtherAndedrsen, all were liable for this fraud. The WorldCom company management did not follow all GAAP procedures in recognizing revenue and classification of expenses. There were many problems existed in WorldCom operation such as lack of a competitive strategy, weak internal audit committee performance, an aggressive culture that demanded high returns, and the failure to look out for what was best for the stock holder as well as the stakeholders of the company. Also, the competitive culture at WorldCom was followed by loyalty to management with no regards to ethics, honesty, or integrity. The Board of Directors served as an internal control that was a failure on its own part. The Board started to look out for bias rather than fulfill its duty to protect the stake holders. In addition, the collapse of the Internet and Telecomm bubbles led to a continuous decline in the company’s stock price. As a consequence, the company declared bankruptcy and shareholder lost their investment and confidence to invest in the capital market and they could not trust and rely on auditor’s opinion in the financial statements. This scandal is another example that proves that even with the availability of accounting standards and a well-defined accounting conceptual framework, there is high reliance on the moral and ethical behavior of management of the company as well as the audit firm to provide true financial reporting of the company’s performance that can be relied on by the users to make important financial decisions.

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