Running Head: WORLDCOM AND ETHICS IN ACCOUNTING 1

WorldCom and Ethics in Accounting
Brian Bartram
Professor Hogan
Strayer University
Accounting 557
11/05/2012

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There have been many corporate and ethical breeches over the years in financial record keeping but it is believed that the current business and regulatory environment is conducive to ethical behavior. Unfortunately, publically traded companies have been prone to the proverb “one bad apple spoils the barrel”. When unethical practices are exposed, of a publically traded company, the effects can be tremendous and affect every individual or entity that is tied to the organization. For ethical principles to apply to companies, it must be shown that they can be considered moral or ethically responsible institutions.
The Securities and Exchange Commission (SEC) is a US regulatory agency that has the authority to establish accounting standards for publically traded companies ("Quickmba financial accounting," 2010). When the SEC was established in 1934 there was no accounting standards issuing body. The SEC has encouraged the private sector to set the standards. In 1939, encouraged by the SEC, the American Institute of Certified Public Accounts (AICPA) formed the Committee on Accounting Procedure (CAP) which dealt with accounting issues as they arose from 1939 to 1959 ("Quickmba financial accounting," 2010). The CAP had limited success because of this approach for they did not develop an overall accounting framework for publically traded companies to work within ("Quickmba financial accounting," 2010). In 1959 the AICPA replaced the CAP with the Accounting Principal Board (APB). The APB was in place until 1973 and its 31 opinions and 4 statements that were issued during this time period lead to the generally accepted accounting principles (GAAP) ("Quickmba financial accounting," 2010). The APB was criticized for its position on several controversial topics and in 1971 the Wheat Committee was formed to evaluate the APB and opposed changes. The findings of the Wheat Committee were to replace the APB with a new standards setting structure. Out of this came the Financial
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Accounting Standards Board (FASB). Different from the APB the FASB was an independent group of people who had severed their ties with their previous employers and private firms. The FASB issues statements of accounting standards which defines the GAAP ("Quickmba financial accounting," 2010). Also, in 1973, to encourage standards and consistency worldwide the International Accounting Standards Committee (IASC) was formed. The IASC was replaced with the International Accounting Standards Board (IASB) in 2001. The accounting standards developed by the IASB are called the International Financial Reporting Standards (IFRS) (Weygandt, Kimmel & Kieso, 2012). The IFRS is a work in progress to harmonize accounting across the world. The purpose of the brief history above is to illustrate that since the early 1930’s there have been standards, guidelines and regulations in place that help standardized how companies report out their financial positions and help keep a company’s and individuals moral compass in check. However, as long as there has been a business community with people to operate it there has been unethical behavior (Kushniroff, 2011). “Accounting partially reflects the moral orders of the world in which it is practiced” (Javeed). Meaning that no matter what guidelines we have as human beings we are still given a choice of deciding between good and bad or right and wrong. The Merriam Webster Dictionary defines ethics “as the discipline dealing with what is good and bad and with moral duty and obligation”. A person or individuals within an organization that have the responsibility of providing input that directly influence a company’s financial statements must have a clear concept of what is right or wrong and by keeping in mind

WORLDCOM AND ETHICS IN ACCOUNTING 3 ethical factors this person or individuals can easily manifest peer pressure. You can put all the regulatory concepts in the world in place but if someone moral compass is amiss there is nothing you can do to stop them. To continue, in recent years there has been a movement to regulate morality and moral judgment to our personal life and create a sterile mechanized business environment (Kushniroff, 2011). This is an impossible task. People are fallible but for the most part our financial systems has a framework of checks and balances and most of the people involved in creating the framework or working within the framework are people with high ethical standards. No amount of regulation will keep ethical breaches from happening.
In 1983 partners that were led by former basketball coach Bernard Ebbers meet and have coffee in Hattiesburg, Mississippi and sketched out an idea for a long distance company. The story goes that the partners sketched this idea on the back of a napkin. The name of the company was called Long Distance Discount Service (LDDS) ("Worldcom news: Questions, 2002”). The University of Southern Mississippi is the first customer (O'Reilly, 2005). In 1989 LDDC goes public by acquiring Advantage Companies and in 1995 LDDC changes its name to WorldCom. Between 1995 and 2001 WorldCom, through acquisitions and mergers, becomes one of the largest global telecommunications companies under direction of their Chief Accounting Officer Scott Sullivan. It was in June of 1999 WorldCom was at its peak. The stock was trading at almost $65 per share; Bernard Ebbers was listed by Forbes as one of the richest men in the US and Michael Jordan provided endorsements. In October 1999, WorldCom attempted to buy out Sprint for $129 billion in stock and debt ("Worldcom news: Questions, 2002”). The Sprint deal was vetoed by the Department of Justice and at the same time WorldCom’s success began to unravel because of the accumulation of debt and expenses, the fall of the stock market and of the fall of the revenue
WORLDCOM AND ETHICS IN ACCOUNTING 4 in the long distance market as technological advancements in communications took place ("Worldcom news: Questions, 2002"). It would not be for another two years before it was realized that WorldCom suffered one of the largest company accounting frauds in history (Beresford, Katzenbach & Rodgers, 2003). WorldCom used unethical accounting methods to mask declining earnings by painting a false picture of financial growth and profitability to keep its stock prices up. The breech in accounting ethics took two principal forms. First there was a reduction of reported line costs (cost of carrying a voice call) and second there was an exaggeration of reported revenue (Beresford, Katzenbach & Rodgers, 2003). The line costs were WorldCom’s largest category of expenses (Richter, 2010). Instead of recognizing the routine operational line costs as expenses incurred Scott Sullivan directed his people to recognize them as long term investments (Richter, 2010). What this did was hold line costs to about 42% of revenues, when they typically exceeded 50%. This enabled WorldCom continued to report double digit revenue growth, when actual growth rates were a lot less (Beresford, Katzenbach & Rodgers, 2003). The line costs are basically monthly fees charged by a third party network or facilities for WorldCom to use its services. These line costs were booked as capital expenditures ("What went wrong," 2002). Capital expenditures are cost incurred that increase the operating efficiency, productive capacity or useful life of a plant asset (Weygandt, Kimmel & Kieso, 2012). They usually are of large expense; occur infrequently and companies generally debit these amounts to the plant asset affected (Weygandt, Kimmel & Kieso, 2012). The transfer of a line cost expense into a capital expenditure is completely fraudulent, not in accordance with generally accepted
WORLDCOM AND ETHICS IN ACCOUNTING 5 accounting principles (GAAP) and could be characterized as embezzlement ("What went wrong," 2002). However, there was no misstatement to cash so it was not cash fraud. It was misrepresenting investing verses operating cash ("What went wrong," 2002). The service charge to lease local lines is a clear expense but if Sullivan viewd this as somehow how correct then it should have been disclosed in a footnote to make it transparent.
The SEC initially reported that that $9 billion in booked transactions were misstated as capitalized investments instead of routine expenses in order to avoid declaring losses (Richter, 2010). In addition to these “irregularities” other manipulations of line costs were discovered. The overall effect was reducing the reported line costs and increasing the pre-tax income by $7 billion (Beresford, Katzenbach & Rodgers, 2003).
As market conditions throughout the telecommunications industry went downhill between 2000 and 2001 WorldCom continued to post impressive revenue growth (Beresford, Katzenbach & Rodgers, 2003). WorldCom had marketed itself to its investors as a high growth company and revenue was clearly a critical component of WorldCom’s early success (Beresford, Katzenbach & Rodgers, 2003). Both Ebbers and Sullivan assured Wall Street that they could continue to sustain the level of growth by successfully managing industry trends that were hurting its competitors (Beresford, Katzenbach & Rodgers, 2003). Since WorldCom basically promised to continue posting double digit growth there was a lot of pressure within WorldCom to achieve these results (Beresford, Katzenbach & Rodgers, 2003). Beginning in 1999 Ebbers and Sullivan would direct WorldCom personnel to make large revenue accounting entries after the close of many quarters in order to report that they had achieved higher revenue growth.
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These entries were also discovered by WorldCom’s internal auditing investigation (Beresford, Katzenbach & Rodgers, 2003). Most of these revenue entries were booked to “Corporate Unallocated” revenue accounts. What this did was boost cash flow and profit. WorldCom’s internal auditors discovered and reported the suspicious accounting entries in 2002 which spurred the SEC’s full investigations. The internal auditors reported their findings to the audit committee and the board of directors. Once the board of directors were informed they acted swiftly by firing Sullivan (Richter, 2010). Arthur Anderson had certified all of WorldCom’s financial statements in accordance with GAAP rules but once notified withdrew its audit opinion for 2001 and the SEC began its investigation (Richter, 2010). In the days that followed WorldCom’s announcement of the SEC investigation WorldCom fires 3,700 or 4.4% of its workforce, the company’s first quarter 2002 profit fell 78% and the biggest three ratings companies dropped their rating to below investment grade (O'Reilly, 2005). WorldCom then filed for Chapter 11 bankruptcy (O'Reilly, 2005). Others that were affected by this fraud were the 20 million WorldCom customers which included large government agencies as well as large manufactures ("Worldcom news: Questions, 2002" )
The large business and government agencies relied heavily on WorldCom’s data networks would be hurt the most. They were usually locked in to lengthy contracts which had large penalties for switching service. While WorldCom is under the Chapter 11 these companies will be forced to choose between the penalties for breaking the contract or let their vital communications network deteriorate ("Worldcom news: Questions, 2002" ).
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This fraud did not include WorldCom’s network, engineering or its technology people. It was caused by a handful of senior management located in its Clinton Mississippi headquarters and implemented by personnel in the accounting departments at various locations (Beresford, Katzenbach & Rodgers, 2003). It was not management that failed by not creating an environment conducive to ethical behavior. It was management! It was a consequence on how Bernard Ebbers ran the company (Beresford, Katzenbach & Rodgers, 2003). Ebbers was the source of the culture and the source of the pressure that gave rise to this fraud. The fraud went on as long as it did because there were others in the WorldCom that lacked the courage to blow the whistle on others in that were in the finance and accounting departments. It went on as long as it did because of inadequate or poor audits done by Arthur Anderson and quite simply WorldCom financial system controls were deficient (Beresford, Katzenbach & Rodgers, 2003). “The setting in which it occurred by a serious corporate government failure” (Beresford, Katzenbach & Rodgers, 2003). Hind sight being 20/20 there are several measures that could have been taken to avoid this fraud. The GAAP are standards that drive reporting economic events (Weygandt, Kimmel & Kieso, 2012). The GAAP also drives transparency and, as mentioned above if, Sullivan disagreed with an accounting practice and choose to book something differently it should have been footnoted. As CFO one would want to evaluate and compare how companies in the same industry and the same sector to see if the allowances for bad debit the same or compare trends in capitalized investments and expenditures ("What went wrong," 2002). As a CFO you would
WORLDCOM AND ETHICS IN ACCOUNTING 8 want to take the measure that your Board of Directors are engaged to an extent that they are very familiar with how your financials are determined verified and explained. In the case of WorldCom the Board of Directors role was too small in the life, direction and the culture of WorldCom (Beresford, Katzenbach & Rodgers 2003). The CFO would also need to establish an audit committee that would be engaged to the extent necessary to understand engage and address the finical issues of a large extremely complex business. The audit committee would be very similar to what WorldCom had established. They would be in charge of overseeing three functions: the Internal Audit department, the external auditors, and management’s financial reporting. The CFO would need to establish procedures that the audit committee would work within and along with the Board of Directors hold this committee accountable for their practices. From 1999-2001 WorldCom’s audit committee met between 3 and 5 times a year and held no special meetings until the accounting irregularities became public (Beresford, Katzenbach & Rodgers 2003). It is very hard to believe that a committee with the responsibility they had at WorldCom only met 3 to 5 times a year.
There are many issues to think about when considering the above measures. First, we need accountability but you have to be realistic that no one could know down to a transactional level all the entries taking place. Therefore you would need to have people you can rely on. If you are named the CFO that is because the CEO believes he can rely on you. This goes down the chain of a well run organization. There needs to be strong external controls where a third party or outside auditor performs at least and annual fiscal audit ("What went wrong," 2002). Lastly, as this paper started ethics is what drives a good financial system. Of course you need guidelines but you also need principals that people can stand behind. There is always going to be the “bad
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apple” and if the “bad apple” feels that the benefits of gambling on a accounting fraud outweigh the potential costs of being caught then there will continue to ethical breeches in accounting.

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References
Beresford, D. R., Katzenbach, N., & Rogers, C.B., N. Securities Exchange Commission , (2003). Report of investigation by the special investigative committee of the board of directors of worldcom inc. (EX-99.1 3). Retrieved from website: http://www.sec.gov/Archives/edgar/data/723527/000093176303001862/dex991.htm
Financial accounting standards board. (n.d.). Retrieved from http://www.fasb.org/facts/
Javeed, A. (n.d.). Are ethics important for public accounts. Retrieved from http://www2.accaglobal.com/pdfs/international/pakistan/2955050
Kushniroff, D. M. (2011). Accounting ethics: Are accounts more inherently to choose immorality over ethical behavior than any other segment of our society.International journal of humanities and social science, 1(Special Issue), 101-110. Retrieved from http://www.ijhssnet.com/journals/Vol_1_No_17_Special_Issue_November_2011/10.pdf
O'Reilly, C. (2005, August 11). From worldcom's origin to sullivan fraud sentence: Timeline. Bloomberg, Retrieved from http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a.OFsbsk_1pQ&refer=us
Quickmba financial accounting standards board. (2010). Retrieved from http://www.quickmba.com/accounting/fin/standards/
Richter, L. (2010, December 10). Unraveling the details of 10 high-profile accounting scandals. Retrieved from http://www.brighthub.com/office/finance/articles/101200.aspx
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References
Weygandt, J. J., Kimmel, P. D., & Kieso, D. D. (2012).Financial accounting. Hoboken: John Wiley & Sons.
What went wrong at worldcom. (2002, July 3).Knowledge@wharton, Retrieved from http://knowledge.wharton.upenn.edu/article.cfm?articleid=587

Worldcom news: Questions, answers and updates. (2002). Retrieved from http://www.worldcomnews.com/worldcomhistory.html