Final Paper: Case Study of WorldCom Financial Statement Fraud

Introduction
This paper will discuss the financial statement fraud committed by WorldCom by examining what led up to the fraud, who committed it and why, and the impact it caused on various stakeholders and the economy. WorldCom applied aggressive and undisclosed accounting tactics to provide financial statements that reflected a $10 billion profit for the years 2000 and 2001, rather than the actual combined loss of $73.7 billion that occurred (Romar, 2006). Opportunity, pressure, and rationalization were all present in this severe example of financial statement fraud which had a devastating impact on stakeholders globally.
Basis for Understanding Financial Statement Fraud
Prior to taking a deep dive into this specific example, it is important to first understand what constitutes financial statement fraud. Financial statement fraud can be defined as “deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors” (Wells, 2011, p. 299). Financial statement frauds can be broken down into five distinct categories: fictitious revenues, improper asset valuations, concealed liabilities and expenses, timing differences, and improper disclosures” (Wells, 2011, p. 292).
The History of WorldCom
“WorldCom began in Mississippi as a small provider of long distance telephone services” (Lyke, 2002). However, due to deregulation in the telephone industry as well as aggressive leadership by CEO Bernie Ebbers, the company quickly grew due to many acquisitions and mergers in the 1990’s. This decade was a thrilling time of growth, high expectations, and technological advances. Industries in the telecomm industry were excited by the expectation of high demand for long distance services, internet service, and data transmission services.
In an aggressive growth tactic, WorldCom purchased MCI in 1997 at a high price tag of $37 billion, which was $12.1 billion higher than the next highest offer. WorldCom was expected to use MCI’s strong marketing skills and presence in addition to synergies from shared networks to increase revenue and decrease costs. However, these synergies, for the most part, would not be achieved. The MCI purchase also came with a high amount of debt, including the 20% share payable to British Telecom.
CEO Ebbers relied upon and consistently proclaimed the impressive revenue growth of his company. “He believed that continuing revenue growth was crucial to increasing WorldCom’s stock market value so that the stock could be used as currency for corporate acquisitions. In addition, top executive compensation and bonuses were dependent on achieving a double-digit rate of revenue growth. Corporate performance just had to meet expectations. Miraculously, even when market conditions throughout the telecommunications industry deteriorated, WorldCom continued to post impressive revenue growth numbers” (Zekany, 2004).
The Beginning of the End
The high expectations set for WorldCom by Bernie Ebbers could not be met by sheer will. While the company continued to be aggressive with its technological advances and other capital expenses, the market would need to cooperate in order to achieve the revenue to compensate for such expenses. “Unfortunately, the demand boom expected did not happen and all that resulted was the gross mismatch between supply and demand” (Gollakota, 2004, p.67) Furthermore, WorldCom was denied by the Justice department of the right to merge with wireless carrier Sprint. This left WorldCom without a strong wireless presence, which would turn out to be fastest growing demand segment.
In addition to demand needed to hit revenue targets, WorldCom leadership was also very interested in controlling expenses. The most costly of these expenses was line cost, which attempted to be controlled through “effective utilization of the network, favorable contracts with carriers, and network efficiencies” (Zekany, 2004). This key measure to track this expense by leadership was the line cost E/R ratio. “An increase in the line cost E/R ratio indicates deteriorating performance, either the under-usage of leased capacity or overpayment for leased capacity” (Zekany, 2004). “As economic conditions worsened, the search for cost savings became more intense” (Zekany, 2004). The goal of a line cost E/R ratio of 41 was impossible due not only to increased expenses and reduces revenues, but also because the prior year this goal was met, a reserve was released to offset costs. The economy and excess capacity pushed this ratio to closer to 50 percent. However, leaders Ebbers and Sullivan were determined to produce the results needed to meet their boasting predictions to analysts. They began an aggressive exercise to track projected and budgeted revenue which they called “Close the Gap” (Zekany, 2004).
Pressure Presents Rationalizations: Perpetuation of Fraud
The measures previously taken to cut expenses and increase revenues were not early enough. In second quarter of 2001, Ebbers and Sullivan began applying even more pressure to find ways to meet the line cost E/R ratio goal. As with most cases of financial statement fraud, the pressured employees at WorldCom began exploring “creative” accounting. One such employee presented the idea of capitalizing line costs as prepaid capacity. This shifted line costs from current expenses to capitalized expenses, under the guise that revenues would be generated in future accounting periods from these expenses.
However, the revenue needed to meet offset these expenses was unrealistic. The rationale behind the accounting maneuvers was based “upon the common belief at the time that the Internet and data demand would continue at 8 times annual growth factor the industry was experiencing” (Zekany, 2004). Soon these line costs found new homes in various capitalized expense categories. Sullivan expressed his concern to Ebbers, including the following statement: “we are going to dig ourselves into a huge hole because year to date it’s disguising what is going on in the recurring service side of the business” (Zekany, 2004). Nonetheless, Sullivan included the new capitalized expenses to analysts in future quarterly meetings, notably without drawing attention to the recent accounting changes. In addition to controlling costs, the company needed to boost its revenue stream. CFO Sullivan had sole power over an account called the “Corporate Unallocated” revenue account. This account was separate from all other revenue streams at WorldCom. Mysteriously, the final quarterly numbers in this revenue account were much different than at non-quarter ending months. It is not known at this time the amount, method, or frequency in which Sullivan affected this account.
An additional “creative accounting” tactic was also discovered by pressured employees. WorldCom was under contract with Electronic Data Services Corporation to outsource its network and communication services. “Under the terms of the contract, EDS agreed to minimum commitments for such outsourcing services, including an agreement on penalty payments if EDS failed to meet these required minimums on an annual basis or cumulatively measured at the end of five-year, eight-year, and eleven-year periods. “(Zekany, 2004). WorldCom could potentially recoup some of the costs of this contract in the form of penalties beginning in 2005.
In 2001, the decision was made by WorldCom to begin recognizing this potential revenue in current quarters. Beginning in second quarter, a large “catch-up” entry of $30 million followed by $5 million in subsequent quarters was added as an EDS Ratable accruable entry. Sullivan again responded with concern to this booking entry: “I believe this looks like a contingent asset and cannot be recorded until the final legal settlement.” (Zekany, 2004). Nonetheless, the quarterly results beginning in second quarter of 2001 included these revenue entries, again without disclosure.
The Big Picture
In the end, these accounting exploitations used during the “Close the Gap” program by WorldCom escalated to a point where it was inevitably discovered. By this point, the results were staggering. In mid-year 2002, “WorldCom admitted that the company had classified over $3.8 billion in payments for line costs as capital expenditures rather than current expenses. By transferring part of a current expense to a capital account, WorldCom increased both its net income (since expenses were understated) and its assets (since capitalized costs are treated as an investment)” (Lyke, 2002).
Furthermore, WorldCom later admitted that it had “manipulated its reserve accounts in order to inflate earnings for years 1999, 2000, and 2001. The amounts at issue totaled $3.8 billion, thus doubling the total reported accounting irregularities” (Lyke, 2002). “Consequently, instead of a $10 billion profit for the years 2000 and 2001, WorldCom had a combined loss for the years 2000 through 2002 (the year it declared bankruptcy) of $73.7 billion” (Romar, 2006).
Impacts
The impacts of WorldCom’s financial statement fraud were profound and far-reaching. “The market value of the company’s common stock plunged from about $150 billion in January 2000 to less than $150 million as of July 1, 2002” (Lyke, 2002). It its peak in 1999, WorldCom’s stock price was $64.50. After the announcement, the price per share dropped to mere pennies. This is significant to all shareholders, but perhaps most noticeably so to employees and retirees. Lyke (2002) notes that 37 percent of employees’ retirement funds were in the form of WorldCom stock.
Unable to recover from its financial problems due to both fraud and firm prosperity, WorldCom filed for the largest bankruptcy in U.S. history with $103.8 billion in assets. “In comparison, Enron listed assets of $63.4 billion when it filed for bankruptcy in December, 2001” (Lyke, 2002). Four months prior to filing for bankruptcy, WorldCom announced it would lay-off 17,000 workers.
Most employees were blind-sided by the financial scandal and resulting bankruptcy. Although a few workers had pieced together some of the signs, management did not keep them abreast of any happenings until they received their lay-off notices. More frighteningly, WorldCom “had informed the workers laid-off prior to bankruptcy that the company was under no obligation to pay severance once they filed for bankruptcy” (Pfeifer, 2003). Thankfully, with the assistance of AFL-CIO, “laid-off workers were able to convince the U.S. Bankruptcy Court to grant WorldCom permission to pay full severance and benefits to all laid-off workers” (Pfeifer, 2003).
Other stakeholders impacted include lenders, competitors, customers and suppliers. Many of these were financially impacted not only due to contracts or outstanding debts, but also due to the optimism they had experienced through unrealistic predictions made by WorldCom. For example, Romar (2006) states “telecommunications equipment manufacturers such as Lucent Technologies, Nortell Networks, and Corning, while benefiting initially from WorldCom's groundless predictions, suffered in the end with layoffs and depressed share prices. Perhaps most significant, in December 2005, the venerable AT&T Corporation ceased to exist as an independent company.”
The WorldCom financial fraud announcement occurred at a precarious time in the United States’ economy. McDonald (2002) explains that as a result of scandals such as WorldCom, “investors in Wall Street are fleeing anything that is remotely similar to WorldCom or other troubled sectors, such as energy and utilities. Banks, which lent money to all of these companies, are also under scrutiny by nervous investors.” This reverberated on a global scale. Foreign governments with more regulated capitalistic systems were given more credence than the de-regulated system in the United States. This led, directly or indirectly, to the devaluation of the dollar. Countries reliant on exports to the United States were damaged as a result. Furthermore, foreign investors demanded a premium for US investors due to credit risk.
Legal costs, inevitable after any financial statement fraud, were exceedingly high for WorldCom partners. For example, “Citigroup settled class action litigation for $1.64 billion after-tax brought on behalf of purchasers of WorldCom securities. In like manner, JPMorgan Chase & Co., agreed to pay $2 billion to settle claims by investors that it should have known WorldCom's books were fraudulent when it helped sell $5 billion in company bonds” (Romar, 2006).
Local economies were also impacted by the telecomm giant’s financial scandal and subsequent bankruptcy. At one time employing more than 85,000 employees nationwide, many areas felt the shock to their local economy. The company’s headquarters and much of its workforce was located in Mississippi. As described by local Mississippi resident Stacey Wall (Jeter, 2003) “Our economy in Mississippi and metro Jackson is struggling, but it’s not stagnant and it’s nothing different than what we’re seeing nationwide. I think what’s having much more of an impact on the economy in Mississippi — and I don’t know any way to put statistics on it — is that so many people had so much WorldCom stock, and so many of them rode it down to the ground. That, more than the loss of jobs at WorldCom, has hurt Mississippi’s economy.”
Personal Impacts
“Cynthia Cooper, who spearheaded the uncovering of the fraud, went on to become one of Time Magazine's 2002 Persons of the Year. She also received a number of awards, including the 2003 Accounting Exemplar Award, given to an individual who has made notable contributions to professionalism and ethics in accounting practice or education. At present, she travels extensively, speaking to students and professionals about the importance of strong ethical and moral leadership in business (Nationwide Speakers Bureau, 2004). Even so, ‘after Ebbers and Sullivan left the company ...Cooper was treated less positively than her virtuous acts warranted. In an interview with her on 11 May 2005, she indicated that, for two years following their departure, her salary was frozen, her auditing position authority was circumscribed, and her budget was cut’" (Romar, 2006).
As the company’s CEO and evident ringleader of the fraud, “Ebbers was formally charged with one count of conspiracy to commit securities fraud, one count of securities fraud, and seven counts of fraud related to false filings with the Security and Exchange Commission” (Romar, 2006). He was sentenced to twenty five years in federal prison, which he later appealed. The Supreme Court denied his appeal. He agreed to surrender $40 million in personal fortune to investors. CFO Scott Sullivan, after agreeing to cooperate heavily by providing key witness details, was sentenced to five years in federal prison. He sold some assets to make attempted retribution to investors, although he fell far short. He was not court ordered to pay a fine or restitution. David Myers, WorldCom’s controller, was also lightly sentenced due to cooperation; he received one year and a day in federal prison.

Application of Cressey’s Fraud Triangle: Pressure, Opportunity, Rationalization
Pressure. As discussed previously, the previous growth of WorldCom in a competitive market set a frantic pace for which the company to maintain. Early in its history, the company enjoyed double digit growth, but as more competitors joined the market and demand for certain data transmission services did not meet expectations, this growth was not sustainable. However, CEO Ebbers relied on this history and subsequently created forecasts of prosperity for his own financial success as well as those of the company’s stakeholders. The pressure of the company to meet unrealistic expectations set by leadership forced employees to apply aggressive and questionable accounting practices. This is not to say that the employees were completely innocent; however, these accounting practices applied were not shared as part of the public financial statements. Therefore the deceit of the accounting transgressions falls on the leadership which presented the public statements without full disclosure. Research shows that leadership knew that the forecasts were unreachable and unsustainable as the fraud transpired. The company has a duty to act with the best interests of its shareholders in mind. Nonetheless, companies are often guilty of putting short-term goals ahead of long-term ones. In this case, the leaders sacrificed the long-term success of the company by attempting to achieve unattainable short-term goals. In hindsight, the company should have created more realistic forecasted revenue and cost expectations as well as disclosed any issues it had with meeting current expectations. This would have reduced the tremendous pressure that resulted in the utilization of aggressive and undisclosed accounting tactics.
Opportunity. Opportunity for fraud can be created and distributed by the “tone at the top.” Scharff (2005) states the following: “the SEC Report (2003) found that Ebbers, as the founder of WorldCom, initiated much of the culture and pressure that allowed the fraud to transpire. Supporting this finding, (leadership) created a culture where leaders and managers were not to be doubted or questioned. This may have been a contributing factor in the length of time over which the fraud occurred.” In addition, executive compensation was tied directly to the financial reporting results of WorldCom. This created an opportunity for such executives to achieve positive results through whatever means possible. Furthermore, according to the article by Scharff, a company code of ethics was dismissed and deemed unnecessary by leader Ebbers. Without an ethical code of conduct and unethical leadership, employees may not have known they were committing fraud or felt too threatened or frightened to discontinue or report it. Clearly, the ethical culture of this company deteriorated from the weak ethical nature of top leadership and was further emphasized by the inability and discouragement of employees to question the behaviors of their leadership. Leadership was privy to undisclosed financial information as well as some accounting ledgers. This autocratic leadership style, endorsed by the board of directors, allowed Ebbers, Sullivan, and others to force these aggressive accounting measures to be applied as seen fit. In fact, they encouraged a limited number of employees to exploit accounting through whatever means possible to “close the gap” on their revenue and expense margins. Clearly there was a lack of internal controls present to reduce the opportunity of leaders to apply inappropriate accounting tactics. Even if there were, I’m not sure that this would have stopped the leaders from doing so, given the ethical culture of the organization and lack of intervention by the board of directors.
This opportunity was further perpetuated by a limited internal auditing function as well their external auditing firm Arthur Andersen. Bernie Ebbers’ felt that all employees should add value to the bottom line. Therefore, the internal auditing team “avoided working on financial audits that might overlap with the role of the external auditors on the grounds of cost-savings” (Zekany, 2004). The internal auditing team was kept to a minimum and often assigned special projects that consisted of work other than traditional internal auditing functions. The external auditing firm assigned to WorldCom, Arthur Andersen, has maintained its innocence in the financial statement fraud. While in hindsight this seems implausible, “experts said that it was conceivable that Andersen's auditors at WorldCom could have done their job properly and nonetheless failed to detect the problems with the company's financial reports” (Glater, 2002). Nonetheless, the auditing firm should have taken additional steps in light of high risk factors associated with WorldCom and after the Enron debacle.
Glater’s article (2002) includes some insight into a successful audit, as described by Robert Willens, accounting analyst. He states that each audit should be tailored to each client and mindful of its risk factors. “Such a review would include a comparison of the client's financial data to that of another company in the same industry, to make sure there are no striking discrepancies. It would also include study of the client's data to find internal inconsistencies. Second, auditors should ensure that a client's internal procedures are reliable. For example, auditors should check that a company's internal auditors are effectively monitoring expenses at a particular division. Finally, auditors should examine the documentation backing a sampling of the company's transactions” (Glater, 2002).
In reaction to recent the financial statement frauds, including WorldCom, regulation came in the form of the Sarbanes-Oxley Act of 2002. This Act is intended to improve corporate governance and accountability in regards to its accounting functions. It mandates additional auditing functions, internal controls, independent regulation, and severe penalties for misdeeds. It also assigns personal responsibility to the CEO of a company, regardless of proven connection or knowledge of fraud. This Act has provided some much needed guidance and control over firms’ accounting practices and disclosures, but at a high price tag. Many innocent companies struggle to maintain budgets for the extensive mandates of the Act. However, this Act may have prevented or deterred financial statement fraud such as WorldCom.
Rationalization. The third leg of Cressy’s Fraud Triangle, rationalization, allows an explanation as to why “corrupt individuals tend not to view themselves as corrupt” (Zyglidopoulos, 2009). To understand rationalization in a company with multiple stakeholders, it is important to understand the stakeholder agent theory. The stakeholder agent theory maintains that a corporation as a fiduciary duty to act in the best interests of its stakeholders. Given this theory, it is comprehensible to believe that the leaders of WorldCom used aggressive and undisclosed accounting methods in efforts to preserve the reputation, stock price, and in their minds, longevity of the firm. Rationalization often breeds further rationalization, a key reason for perpetuation of fraud. As rationalization grows, the CEO may begin to move from saving the firm to believing he or she is acting in order to save the economy. In hindsight, the leadership at WorldCom applied rationalizations surrounding short-term strategies and objectives rather than focusing realistically and honestly on long-term goals and sustainability. As previously discussed, WorldCom deployed autocratic leadership methods without an ethical culture in place. Given this “tone at the top” as well as the tremendous pressures placed on employees, it is conceivable that employees rationalized that they needed to take the necessary actions to maintain their positions as well as to maintain the success of company. A strong ethical training program, combined with reporting policies and whistleblower protection, could have been effective in deterring or at least identifying this fraud before it had perpetuated to the inevitable disastrous result.
Conclusion
In conclusion, it is clear to see how pressure, opportunity, and rationalization led to the enormous financial statement fraud committed by WorldCom and its infamous leaders. WorldCom began applying aggressive and undisclosed accounting tactics in a desperate move to provide expected results to shareholders. As common with fraud, these unethical moves escalated until the eventual discovery of the fraud. The result was a catastrophic blow to all shareholders and would result in a change in auditing and accounting practices for future generations.

References

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