AVOIDING INVESTMENTS IN FRAUDULENT COMPANIES:
THE WORLDCOM FRAUD

Introduction

The purpose of this report is to investigate and discuss the accounting fraud that occurred at WorldCom in order to recommend improved strategies to Berkshire Hathaway’s management for avoiding investments in companies with fraudulent financials. Accounting fraud is a crime committed by high level employees at an organization to manipulate the organization’s financial statements and intentionally disguise company performance. The fraud is committed without the knowledge of owners (shareholders and investors) to benefit the individuals perpetrating or committing the fraud and results in a negative impact on the owners.

This report will give a brief background on WorldCom and the telecommunications industry, and then discuss the details of the WorldCom accounting fraud in order to provide relevant recommendations to Berkshire Hathaway, Inc. for mitigating future losses due to investing in fraudulent companies. We expect management to become more knowledgeable regarding high fraud risk investments and therefore make better informed investment decisions. Recommendations to Berkshire Hathaway include improving current risk assessment procedures and enhancing investment policies.

WorldCom and the Telecommunications Industry

WorldCom was the leader of the telecommunications industry during the 1990’s; in 2000, WorldCom was the 25th largest company in the world (Anderson, 2013, p. 48). The telecommunications industry has grown exponentially over the past decades and is regulated by the Federal Communications Commission (FCC). As a result of the 1934 Telecommunications Act, the FCC was established as an independent agency of the U.S. government and is responsible for regulating fair practice among the diverse communications industries (Economides, 2005, p. 54). The opportunity for WorldCom to compete in the long-distance communications industry arose as a result of the breakup of AT&T’s monopoly in the 1980’s; at one point market share was 90%. In 1984, AT&T was broken down and opportunity for competition gave rise to companies such as Sprint, MCI, and eventually WorldCom; the new competition led to the complete deregulation of long-distance telecommunications in 1995 (p.49). From January 1996 to March 2001, the industry grew 36% (Carbone, 2006, p. 27). Currently, the industry is even more complicated with all the advancements in technology and the switch to digital information, so although there is still regulation in some areas, there is a great deal of services in telecommunications that remain deregulated (Economides, 2005, p. 54).

WorldCom originated in Clinton, Mississippi as a reseller of long-distance services in the early 1980’s after the deregulation of the telephone industry under the name of Long Distance Discount Company (LDDC). Bernie Ebbers was named CEO in 1985 and took LDDC public with the acquisition of Advantage Cos. in 1989. In 1995, LDDC became known as WorldCom, and started trading under the ticker symbol WCOM. In June of 1999, WorldCom shares were trading at $61.99 a share. WorldCom acquired over 60 firms in the late 1990’s and handled 50% of U.S. internet traffic, as well as 50% of emails worldwide. Their largest purchase was of MCI for $37 billion in 1997. By the turn of the century, growth had significantly decreased due to overexpansion in the industry; however, from 1998 to 2001, WorldCom was the second largest long-distance operator in the U.S and had over 20 million customers (O’Reilly, 2005).

The WorldCom Fraud

The massive fraud conducted by CFO, Scott Sullivan and CEO, Bernie Ebbers was revealed on June 25, 2002. WorldCom increased revenues by transferring money from their reserve accounts; the reserves were liabilities representing estimated costs expected to be paid in order to use equipment controlled by outside parties. In addition, Sullivan directed staff members to misclassify operating expenses as long-term investments, inflating assets and net income at the same time. From the second quarter of 1999 through the first quarter of 2002, WorldCom fraudulently reduced its line costs by over $7 billion. From the second quarter in 2001 through the first quarter of 2002, WorldCom improperly capitalized line expenses as long-term assets in the amount of over $2 billion. After all investigations were concluded, over $11 billion worth of accounting fraud had been discovered (Beresford, Katzenbach, Rogers, 2003, p. 9) (WorldCom, 1999-2002, Financial Information).

Table 1. Amount of WorldCom Misstated Expenses 1999-2002 | Year | Reported Expenses According to WorldCom's Records | Actual Expenses According to Security and Exchange Commission | Difference (Amount of Improper Expense Recognition) | Improper Expense Recognition Percentage | 1999 | $24,878 | $24,145 | $733 | 2.95% | 2000 | $26,059 | $22,513 | $3,546 | 13.61% | 2001 | $25,785 | $22,545 | $3,240 | 12.57% | 2002 | $9,179 | $8,406 | $773 | 8.42% | *All dollar figures are in millions.**Expenses include: Line Costs, Selling, General and Administrative Expenses, and Other. | Sources: Beresford, D., Katzenbach, N., & Rogers, Jr., C.B. (2003)WorldCom, Financial Information (1999-2002) |

Due to the overexpansion of the telecommunication industry, in September 2000, WorldCom was $828 million short of Wall Street’s earnings target. Betty Vinson, Director of Management Reporting was instructed by management to cover the shortcoming with reserve accounts for line costs that had been set aside for estimated potential losses. Scott Sullivan, the CFO, ordered Vinson and the Director of General Accounting, Buford Yates, to find reasons for the reserve reduction to conceal the real reason of meeting Wall Street’s targets. Although Yates did not agree, he went along with it since Sullivan claimed it would be a one-time adjustment. Both Yates and Vinson considered resigning due to Sullivan’s requests (Anderson, 2013, p. 49).

In April, right before Quarter 1 earnings release, Sullivan ran out of reserves to cover the remaining $771 million target deficit. He made the switch from the reserve reduction method to the misclassify expense method of fraud. Both Vinson and her co-worker expressed feelings of being cornered into committing what they knew to be fraudulent reporting. Vinson told her workers that she was going to find another job, but first she recorded an entry to transfer $771 million of operating expenses to a capitalized long-term asset account and backdated it to February; the entries were made every quarter for a year (Anderson, 2013, p. 50).

In 2002, the US Securities and Exchange Commission (SEC) was informed by WorldCom’s internal audit team of possible irregularities. For the years last years prior to discovery, David Myers (the Controller) and Sanjeev Sethi (the Director of Financial Planning), both continued capitalizing business expenses they knew should have been expensed. The Vice President of Internal Audit, Cynthia Cooper, had been pressuring the men to explain the entries during an internal audit of capital expenditures in May 2002. She eventually notified the audit partner of KPMG, Farrell Malone, of the issue, as well as the audit committee. Once the SEC prompted their investigation, Myers and Sanjeev confessed to the entries and Sullivan tried to stretch the rules of Generally Accepted Accounting Principles (GAAP) while explaining the entries to the audit committee (Beresford, Katzenbach, Rogers, 2003, p. 124).

Sullivan knew he was in trouble when both their former auditor Arthur Andersen and their new auditor KPMG did not recognize the entries to be GAAP. He was cooperative with law enforcement and was a key witness in the conviction of CEO Bernie Ebbers. For Sullivan’s cooperation, he received a reduced sentence of five years in prison; In July 2005, Bernie Ebbers received a 25 year sentence (Young, Sarcey, Koppel, 2005).

Fraud Risk and the Culture of WorldCom

One of the distinctive traits of the culture at WorldCom provided pressures for the fraud to occur and for the fraud to take place for so long: Bernie Ebber’s attitude towards making the numbers. It is evident that Ebbers was concerned with little else than making the analysts targets and preventing the company from showing financial hardships. Scott Sullivan, although influenced by Ebbers mindset, was also known by employees to pressure that certain information be kept secret from auditors and lower level account managers (Beresford, Katzenbach, Rogers, 2003, p. 18).

When WorldCom executives started the fraud, they were able to rationalize their actions as making up for a business deal gone wrong and then continued to rationalize their fraudulent reporting. Before the fraud began, WorldCom’s unsuccessful bid for Sprint Communications began a decrease in stock prices and executives began the fraud to prevent the company from declining (Morton, 2005, p. FP1). WorldCom executives were able to rationalize the fraud in the years to come based on the company culture and tone that had been created over previous few years. After the fraud had begun, the executives were able to justify their actions based on the existence of their past fraudulent activities.

The managements overall position in the company gave them the opportunities and authority to maintain the fraud. WorldCom executives were doing everything they could to conceal the fraud and they were very clear regarding any consequences of prying. In July 2001, the Controller, David Myers, ordered a computer system security employee to deny access to Internal Audit (Beresford, Katzenbach, Rogers, 2003, p. 18). Sullivan, like Ebbers, developed a reputation for threatening and censoring employees at WorldCom whom were being asked about the fraudulent entries. The tone at the top at WorldCom and the management’s ability to override internal controls were key factors contributing to the fraud.

Although separation of duties allows for a reduction in fraud risk because it is less likely everyone will want to participate, both Ebbers and Sullivan were easily able to manipulate managers and other executives to adhere to their agenda of fraud. Inefficient internal controls allow the opportunity for management to override or bypass them resulting in a passive attitude of employees below. WorldCom did have a policy in place for employees who felt cornered ethically on the job, but only two complaints were ever filed and both resulted in no action against anybody. Most employees claimed they feared they would lose their job if they ever pushed a concern too far with management. The lack of internal controls and management’s position of power provided the needed opportunities for the fraud to take place at WorldCom (Beresford, Katzenbach, Rogers, 2003, p. 18).

In addition to the suppressed attitude of lower level employees, management had the opportunity to bypass internal controls, as well as design them to their benefit. When employees in the Internal Audit department were asked about the process, some did not even know internal audits were going on. Most of them claimed they conduct mostly operational audits to assess operational efficiency. Moreover, the person of whom Internal Audit reports to was Scott Sullivan, CFO. Not only was Sullivan intimidating the very department that was responsible for assuring shareholders that he was doing his job, he also was in charge of the kind of internal audit; naturally Sullivan opted to require operational audits as opposed to Cynthia Cooper’s CapEx audit (Beresford, Katzenbach, Rogers, 2003, p. 23).

The WorldCom culture helped to foster an environment that was susceptible to fraud. Although there were many reasons why WorldCom’s fraud was able to take place, the presence of all three elements of the fraud triangle provided WorldCom executives with the ability to commit the deceitful acts. As a result of the executive’s actions, the fraud ended up negatively impacting large groups of individuals.

The Effects of Fraud

WorldCom’s $11 billion dollar fraud influenced not only the WorldCom executives, but also the surrounding community. Investors in WorldCom were able to recover less than half of their investments in the many years following the fraud. Bondholders accounted for $13.3 billion in losses and are only expected to recover $5 billion after all of the settlements are complete (only 37% recovered). WorldCom shareholders are only expected to recover 2% of their total estimated losses. Even though some of the investors are expected to get back part of their investments, they often have to wait years to receive their payments from settlement disputes (Crawford, 2005).

The community where WorldCom operated suffered massive losses. Ebbers and Sullivan were both actively involved in their surrounding community and Ebbers even taught Sunday school at a local church. Their presence and known donations to the community led to unease about the origin of donations received (Morton, 2005, p. FP1). In addition, the fraud led to the loss of tens of thousands of jobs for employees of the company, impacting the families of all individuals (Hevesi, 2005). The state of Oklahoma suffered a $64 million loss in pension funds that would end up negatively impacting individuals all over the state (Mecoy, 2003). Frauds have the ability to produce significant negative impacts on countless individuals and groups.

Although there were many negative impacts of the WorldCom fraud, the fraud had some overwhelming positive impacts on investing in the future by helping to form two provisions in the Sarbanes-Oxley Act against actions similar to WorldCom. First, WorldCom executives were large stockholders in the company and Sarbanes-Oxley limits the percentage of shares that executives are allowed to hold. Additionally, Section 404 of Sarbanes-Oxley addressed the weaknesses that existed in WorldCom’s internal controls and requires an assessment of a company’s internal controls to be performed by an external auditor. Sarbanes-Oxley regulations would have prevented the large ownership of shares by WorldCom executives and corrected the inadequate internal control environment at WorldCom (Norris, 2005, p. 1). The presence of fraudulent companies should encourage investment companies should perform more extensive due diligence practices to protect themselves from investing in organizations with possible fraudulent activities.

Recommendations

Berkshire Hathaway needs to have successful investment activities in order to remain successful. Investing successfully involves investing in organizations that are able to provide us with a return on our investments and are generating profits from honest business practices. WorldCom’s business environment and culture fostered unethical business practices and led to the continuation of the accounting fraud for 4 years. Before accepting a new investee, Berkshire Hathaway should apply the following practices to assess the ethical reliability of a company and avoid investing in fraudulent organizations with environments similar to WorldCom.

First, Berkshire Hathaway should look at a potential investee’s auditor to determine if the auditor has adequate qualifications and has a reputation for following auditing procedures for performing the audit. Arthur Anderson was the auditor of WorldCom during the time of the fraud and their lack of investigation while performing the audit led to the auditors overlooking the fraud (Beresford, Katzenbach, Rogers, 2003, p. 229). Although it is not possible to determine the extent of an audit by looking at the auditing company, Berkshire Hathaway should try to ensure that a large prospective investee companies are audited by a large firm with a strong reputation. If an investee is audited by a small auditing company that may not have the experience or resources to perform the audit, it could be a sign that the organization has hired an under-qualified auditor to have the fraud go undetected.

Second, large accounting frauds are often the cause of top management of a corporation, making it important to determine the management’s cooperation to work with Berkshire Hathaway during the risk assessment. During WorldCom’s audit, the management was not cooperative with the auditors and often maintaining control of documentation that Anderson required to complete their audit. It was also evident that WorldCom management was altering documents to conceal information from the auditors (Beresford, Katzenbach, Rogers, 2003, p. 24). Berkshire Hathaway should take note on interactions with investee management to ensure that the management is not interfering with the risk assessment process. An investee’s management may be susceptible to perform fraudulent activities if they avoid any interview questions or refuse to provide requested information.

After assessing management’s cooperation, Berkshire Hathaway should interview investee’s employees regarding the structure of the organization and task delegation. It is important to determine if the organization has proper segregation of duties for activities that could affect the financial representation of the organization. As was the case in WorldCom, the CEO and CFO both had the ability to perform all levels of activities, bypass any existing controls, and complete their transactions without review by an additional individual. Segregation of duties ensures that a single individual does not handle all parts of the accounting and disbursement system and decreasing the chance of fraudulent reporting taking place (Wells, 2005, p. 82). The failure to segregate duties, create a system of checks and balances, and maintain strong internal controls could create an environment vulnerable to fraud.

Groupthink is a mentality among individuals where members of a group perform whatever action is asked of them without questioning or opposing unethical actions. Berkshire Hathaway should analyze the mentalities of a few individual workers at prospective investee companies for groupthink characteristics of becoming unwilling to speak up against the group or showing a high amount of loyalty to the organization. When groupthink is present in a business environment, the characteristics result in a business environment that not only environment fraud, but also maintains it (Scharff, 2005, p. 109). Berkshire Hathaway should ensure that groupthink is not present at investee organizations before making an investment decision.

Implementation of these recommendations could be time consuming and costly to Berkshire Hathaway. The additional training and planning that would be needed to perform these additional risk assessments could lead to a higher cost associated with acquiring new organizations to invest. The reduced risk of loss from investing in a suspect fraud company will outweigh the initial implementation costs associated with the additional procedures. These increased risk assessments could significantly decrease the change of Berkshire Hathaway recovering only 37% of their investments after the discovery of a fraud.
Conclusion

The WorldCom accounting fraud case is one example of a type of fraud that can take place at a company and the effect that the fraud has on the organization, employees, and investors. Berkshire Hathaway success is dependent on the ability to make profitable investment decisions with honest organizations by incorporating aggressive due diligence practices. Incorporating due diligence practices such as analyzing auditor qualifications, observing investee’s cooperation, examining investee internal controls and work segregation, and monitoring for groupthink will help Berkshire Hathaway to avoid investing in suspect organizations. These procedures will create a powerful system to help protect Berkshire Hathaway from fraudulent organizations. Berkshire Hathaway’s management should investigate the costs and benefits associated with implementing the increased risk assessment processes to determine if they can be successfully incorporated into company procedures.

References

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