Running head: Review of Accounting Ethics

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Review of Accounting Ethics Cynthia Harley Dr. Julie Hamm Acc 557 5/1/2014

Review of Accounting Ethics The WorldCom Scandal Vikalpa: The Journal For Decision Makers provides us with the following excerpt from WorldCom’s 2002 press release: CLINTON, Miss., June 25, 2002 –- WorldCom Inc. (Nasdaq: WCOM, MCIT) today announced that it intends to restate its financial statements for 2001 and the first quarter of 2002. As a result of an internal audit of the company’s capital expenditure accounting, it was determined that certain transfers from line cost expenses to capital accounts during this period were not made in accordance

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with the generally accepted accounting principles (GAAP). The amount of these transfers was $3.055 billion for 2001 and $797 million for the first quarter of 2002. Without these transfers, the company’s reported EBITDA would be reduced to $6.339 billion for 2001 and $1.368 billion for the first quarter of 2002, and the company would have reported a net loss for 2001 and for the first quarter of 2002 (Pandey & Verma, 2004, p. 113). This information came at a time where the company had reached an all time high in the industry, second only to AT&T. The company originally started out as a small provider of long distance telephone service in Mississippi under the name LDDS and later changed its name to WorldCom. During the 1990’s the company took on an aggressive acquisition strategy acquiring the likes of MCI Communications, UUNET, CompuServe, and America Online’s data network. With these acquisitions, WorldCom became a leader in the telecommunications industry due to its vast infrastructure. The company now had global reach in more than 65 countries and even ranked as a Fortune 500 company. The company’s success was proliferated by the dot com bubble. When the dot com bubble burst in 2000, it affected many of WorldCom’s largest customers; in fact the telecommunications industry as a whole took a severe hit as companies were no longer generating sufficient revenues to cover expenses. Leadership was then faced with an apparent ethical dilemma.

Review of Accounting Ethics Up until this point, Chief Executive Officer Bernard Ebbers had greatly benefited from

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the rise of WorldCom. His wealth increased significantly due to the increasing price of his shares of stock in WorldCom. Ebbers led a culture, where what the boss says goes no questions asked. The culture became very individualistic under his reign and all decisions were made by Ebbers and his close confidants Scott Sullivan, Chief Financial Officer, and David Myers, the Controller. Sullivan had created a culture where it was against the rules to question the plans and decisions of those in charge. When unethical decisions were made to cover up losses anyone that even thought about breaching the subject was shut down. Eventually, one person succeeded in unveiling the truth about the falsities and it led to the resignation of Ebbers and Myers and the dismissal of Sullivan and thirty other individuals in the company that were in close contact with that business department after investigation from the Securities Exchange Commission. This investigation came after the company filed for bankruptcy and was obligated to pay $750 million to the SEC in cash and stock in the new MCI which would be given as reparations to aggrieved investors and $2.25 billion in civil penalties (Accounting Today, 2006, p.20).

The Accounting Violation 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, and (4) manipulating bad debt reserve calculations (Kuhn & Sutton, 2006, p.63). We will address each of these techniques in detail and their effect on the business operation. The categorization of operating expenses as long term capital expenditures violated Generally Accepted Accounting Principles (GAAP) because it did not recognize expenses in the time

Review of Accounting Ethics period in which they occurred. The misrepresentation of these expenses inflated net income and assumed profit due to deferment of expense costs. A similar type of “expense deferment” was

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created after the numerous acquisitions of other companies by WorldCom. Instead of classifying the acquired assets solely as assets on the books they increased the value of goodwill by a balancing amount. This deferred expenses because under GAAP goodwill is amortized over a span of 40 years, in turn yet again overstating net income. Another acquisition related strategy was the misrepresentation of asset value. This created the idea that expenses were decreasing because the value of asset depreciation was decreasing in dollar amount. Again, this allowed for the perception of higher net income from operations. Lastly, WorldCom employed a strategy that altered an account that should have been classified as an expense on the financial statements. When a company allows for customers to make purchases on credit it can be expected that all of this money may not be recouped and therefore this amount is stated as a related expense. The amount was estimated to be less therefore decreasing the amount to be written off as a bad debt expense. This accordingly overstates assets and ultimately net profit. Unethical procedures such as the aforementioned, ultimately led to the bankruptcy of WorldCom on July 21, 2002. After investigation it was uncovered that the fraudulent activity totaled $11 billion dollars. It was the largest corporate fraud in United States history.

Detection and Management Failure & Preventive Measures Breaches such as the WorldCom scandal could have easily been avoided with a system of checks and balances. CEO Ebbers should have held his subordinates accountable for their actions. Sullivan, the CFO at the time, was the mastermind behind the entire fraudulent decision making scheme. I believe had there been some type of auditing committee in place from the very start of the organization the entire breach could have been avoided. People are less likely to

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make a poor decision if they know they will have to be held accountable for their actions and that there will be major consequences resulting possibly in termination. These consequences have to be followed through on by upper management or even then the result would be pointless. In the beginning, there was no system of internal control within the organization until Cynthia Cooper expressed the need for internal auditing controls in 1994 and later became Vice President of the department in 2000 (Anderson, 2013, p. 51). She convinced Ebbers that an auditing committee would save WorldCom money by increasing efficiency and eliminating wastes. In March 2002, the team uncovered $400 million dollars had been moved to falsify the income statement and she did not let it rest her diligence and determination led to the exposure of Sullivan’s fraudulent practices. Had this internal committee been around from the inception of the company in 1983 it would have greatly decreased the likelihood of such fraudulent practices. Also, another way to prevent unethical behaviors would have been to create a transparent corporate culture. The no questions asked environment created by Ebbers allowed room for such activity. If it would have been acceptable to question decisions then it would have given someone an opportunity to address the fraudulent practices. All organizations should have an open door policy that allows everyone’s voices to be heard. Had controls been in place from day one it could have prevented an $11 billion dollar scandal.

Current Climate of Corporate Ethical Behavior In the era during the WorldCom Scandal, there were not many measures in place to help aid in the prevention of unethical decisions by corporations at the judicial level. After a number of accounting ethical breaches the government implemented the Sarbanes-Oxley Act. This act was implemented and rushed to pass after WorldCom filed for bankruptcy. The act widely known as SOX aimed to create more transparency in financial reporting and to restore investor

Review of Accounting Ethics confidence in the United States financial markets (Nicholls & Willits, 2014, p.38). SOX placed restrictions on the amount of nonaudit services that a CPA may provide to its clients. It also

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created a regulating body PCAOB to more closely regulate the profession and its standards in the auditing profession. It required the creation of internal controls within an organization, as well. Executives are required to certify financial statements, attorneys are required to report fraud, and whistleblowers are protected under SOX also. With the implementation of SOX many organizations were not financially capable of financing the proper internal controls needed to be in compliance with the new law and therefore either went private or refrained from listing. The act succeeded in improving the quality of financial reporting. I do believe that the climate of corporate ethical behavior has shifted in a positive direction since the days of widespread unethical accounting breaches during the times of the WorldCom scandal. Would I go as far as to say that the Sarbanes-Oxley act eliminated all unethical acts? No, but I would stand by the notion that it has made the current business and regulatory environment more conducive to ethical behavior. This can be seen and realized in the fact that similar laws of its kind were enacted in many other countries subsequently.

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References Anderson, M. O. (2013). WorldCom's Betty Vinson and Cynthia Cooper: A Tale of Two Professionals. Strategic Finance, 95(7), 48-51. Kuhn Jr., J., & Sutton, S. G. (2006). Learning from WorldCom: Implications for Fraud Detection through Continuous Assurance. Journal Of Emerging Technologies In Accounting, 361-80. Nicholls, C., & Willits, S. D. (2014). Is the Sarbanes-Oxley Act Working?. CPA Journal, 84(4), 38-43. Pandey, S. C., & Verma, P. (2004). WorldCom Inc. Vikalpa: The Journal For Decision Makers, 29(4), 113-126. WorldCom investors set to receive initial payout. (2006). Accounting Today, 20(21), 20. Retrieved from: Business Source Complete, EBSCOhost www.webcpa.com