Case Study:

WorldCom Accounting Scandal

Founded initially as a small company named Long Distance Discount Services in 1983, it
merged with Advantage Companies Inc. to eventually become WorldCom Inc., naming its CEO
as Bernard Ebbers. WorldCom achieved its position as a significant player in the
telecommunications industry through the successful completion of 65 acquisitions spending
almost $60 billion between 1991 and 1997, whilst also accumulating $41 billion in debt. During
the Internet boom WorldCom’s stock rose from pennies per share to over $60 a share  as ‘Wall
Street investment banks, analysts and brokers began to discover WorldCom’s value and made
“strong buy recommendations” to investors.’  During the 1990’s WorldCom evolved into the
‘second-largest long distance phone company in the US’  mainly due to its aggressive acquisition
strategy.

A cycle became apparent in the marketplace  where an acquisition was seen as a positive
move by the analysts leading to higher stock prices of WorldCom. Consequently this allowed
WorldCom to gain greater financing and backing for further acquisitions repeating the cycle.
One of the most significant and largest acquisitions was that of MCI Communications Inc. in
1998, becoming the largest merger in US history at that time. British Telecommunications were
also in the running for the takeover of MCI Communications making a $19 billion bid,
when Bernard Ebbers the CEO of WorldCom decided to place a counter bid 1.8 times higher
than that of what BT had placed, at $35 billion. Evidently this takeover was agreed and the
merger between the two brought MCI WorldCom into second position behind that of AT&T in
the telecommunications market.

However, from 1999 to early 2002, CEO of the company, Bernard Ebbers along with
other senior management used fraudulent and improper accounting methods to mislead investors
and other directors. Their fraudulent accounting method had mainly two approaches: ‘The
reduction of reported line costs’ and the ‘exaggeration of reported revenue’  . These practices
were to ignore the generally accepted accounting principles (GAAP) in addition to not informing
the users of the financial statements of the changes to the previously used accounting practices.
This was done to reduce their E/R ratio, the main key performance indicator used to measure the
performance of telecommunications companies. It is the relationship between their main
expenses; line costs (the rental of telephone lines) to its revenues and the lower figures
consequently produced more recommendations by analysts increasing stock prices.

The eventual failure of WorldCom was caused by the disruption of the cycle, as
discussed before, when the planned acquisition of Sprint Corporation in 1999-2000 was stopped
by pressures from the US Department of Justice  and the  European Union  over concerns of it
creating a monopoly.  As a result WorldCom lost its main growth strategy and left Bernard
Ebbers few options to enhance the business further. Either they had to consolidate all the
previous acquisitions into one efficient business, which they had failed to do so far, as they had
only concentrated on the takeovers or to find other creative ways to sustain and increase the
share price.

The CEO chose the latter and in July 2002 WorldCom filed for Chapter 11 bankruptcy
after disclosures were made about the improper accounting methods used to inflate revenue’s
and reduce expenses. By the end of 2003, it was estimated that the company’s total assets had
been inflated by around $11 billion.
 The Fraud The members of senior management were engaged in a continuing series of
improper accounting manipulations to try and achieve market expectations on growth, making
the financial reports more appealing. This was achieved through basic fraudulent methods,
including changes to financial estimates, early revenue recognition, erroneously capitalisation of
the long term assets, as well as alteration of the reserves in order to improve the earnings picture.

WorldCom’s managers modified their assumptions on accounts receivables, by adjusting

the amount of uncollectible bills owed to the company and as a result increased the total amount
of accounts receivable. Managerial assumptions played two important roles here; firstly they
determine the amount of funds reserved to cover bad debts, as the lower the perceived need of
non-collectable bills, the smaller the reserve required. This resulted in manipulation of the
reserves, reducing them when needed to increase earnings. Secondly, when selling receivables to
third parties the assumptions are used to identify the quantity available for sale, which
WorldCom utilized.  This manipulation was easily achieved as many of the WorldCom’s
customers were small, start-up telecommunication businesses with little data and history of
repayment likelihood, leaving a large degree of judgement from management to set these figures.

Line cost accruals were exploited in a similar way to that of the bad debt reserves, due to
the judgement needed in deciding upon figures. Line cost accruals estimates are extremely
difficult to make with precision, being best practice to adjust them frequently. This, of course,
provides further opportunities for falsification. With the importance of line costs to the
company’s bottom line and with Ebbers promise to reduce expenses; the accruals were adjusted
on a regular basis to improve the company’s overall margins, maintaining the high growth rate
now expected by the market. WorldCom’s finance chief, Sullivan later admitted to the court that
he falsified financial statements of the company and in particular ordered the General
Accounting department to reduce Wireless’ Division’s expenses by US$150 million.

In fact, during the second quarter of 2000, the total accounts receivables at WorldCom
Inc. rose 12.6% to US$926 million, but the allowance only increased by US$443 million, or
3.5%, leading to higher earnings of $69 million.
 The large acquisition of MCI gave WorldCom another opportunity to fiddle its books as
it could now apply its dubious methods to all the new assets and expenses of MCI. Therefore
they started reducing the book value of some MCI assets whilst also increasing the value of
goodwill by the same balancing amount. This gave greater flexibility for achieving their targets
as smaller amounts of expenses were taken against earnings by spreading the charges over
decades rather than the year it was incurred. ‘The net result was WorldCom’s ability to cut
annual expenses, acknowledge all MCI revenues and boost profits from the acquisition.’

Next, there was the existence of a ‘Corporate Unallocated Revenue Account’, which
included entries of corporate level adjustments. This was to assist Ebbers in adjusting the
performance of WorldCom by profit smoothing, such that the predicted 15 percent year on year
growth could be achieved. The access to the “Corporate Unallocated Schedule”, which was an
attachment to the Monthly Revenue Schedule, was only available to the senior management.
This schedule included the journal entries to the revenue account that erroneously increased the
revenue of the company.

According to US GAAP Code 605, the account of such sort is fictitious, as it does not
satisfy the criteria, and thus could not be treated as a legal form of revenue. The management,
knowing this fact, restricted the number of people who had access to the monthly revenue, so
that the fraud in revenue recognition would not be discovered. In addition to that, WorldCom
tended to recognise the revenue, which was yet to be received from long term contracts, even
before the actual service was provided.  This, of course, was another violation of the US GAAP.

Furthermore, in a bid to reduce line costs, WorldCom capitalised the excess capacity
expenses that were not generating revenue. The reason given was that these lines are costs which
should have been incurred after the related benefits were generated. Although this arrangement
does not oppose the classification of asset in FASB Concept Statement No 6, ‘Assets are
probable future economic benefits obtained or controlled by a particular entity as a result of past
transactions or events,’  there was no proper business or accounting rationale for these
procedures.   The latter include journal entries of $798 million and $560 million, made to
capitalise ‘line costs’ during 2001.
 Indeed, according to FRS 16, costs that are related to day to day servicing, or wear and
tear repairs of Property Plant and Equipment (PPE) would be expensed, unless the PPE is
enhanced as a result of the expenditure. Consequently, we can see that WorldCom has wrongly
classified its expenses as an asset account despite the PPE not being enhanced at any state. This
would lead to the reduction of expenses, increment in total assets, and ultimate increase in profits
as well as a stronger balance sheet.

failure to consolidate the firms was also assisted by his remuneration package being to
myopic only focussing on quick profits as opposed to measurement over a period of years
focussing on sustainable growth. Subsequently this focussed his attention on increasing share
prices now as he received large amounts of his remuneration in shares, and an increase in share
price increased his wealth, in the short run anyway.

Infectious greed was apparent among the investors and market, expecting and demanding
maintained high returns. Ebbers owning many shares in WorldCom may have also been
overtaken by this, however as a CEO he must also promote and act in the best interests of the
company and this is where he failed his fiduciary duty to all shareholders and stakeholders. This
meant the continuance of the fast growth acquisition strategy which was detrimental to the
company’s long term success.

(American Telephone & Telegraph) had been laying off tens of thousands in the late 90’s
as it was trying to match WorldCom’s phantom profits  which eventually led to its acquisition by
Baby Bell SBC Communications in December 2005.

Legislative Consequences

The WorldCom scandal could potentially have discredited US GAAP standard setting
provoking the assumption that the fraud could only have occurred due to deficient accounting
principles. However, there is a broad consensus that the WorldCom disaster was rather a failure
of corporate governance.  Following the downfall of Enron, the Securities and Exchange
Commission had not yet enacted any new laws. However, after the senior management of
WorldCom was charged with fraud, the Congress was pushed to answer the critics through
legislative actions. Thus, a new US federal law, the Sarbanes-Oxley Act (SOX) emerged in 2002.
It now applies to any company registered with the SEC and contains eleven sections  that specify
duties concerning the issues of corporate governance, compliance and disclosure.

In answer to the fact that at WorldCom, members of the senior management have been
involved in the fraud, CEOs and CFOs can now be directly and individually be held responsible
for the accuracy of financial statements.  Moreover, it is no longer allowed to give credit to their
directors or officers as WorldCom did to Ebbers. Concerning the relationship to the auditing
company it includes guidelines stipulating that audit firms cannot provide any additional services
that may compromise their independence and auditors can not in any way be involved in
management decisions. Moreover, a new auditor rotation system that requires audit partners to
change every five years and audit firms every seven years respectively has been imposed.

The most notorious section of the SOX is section 404 which requires the implementation
and periodic evaluation of an internal auditing system and it has became the main contributor to
the increased compliance costs. Since its introduction, companies have spent millions of dollars
to comply with the new law which has increased accountability but, as critics say, also
suppresses innovation.  It can also be seen to be unfair and a overburden to the smaller listed
companies as the similar priced compliance costs take a greater share off their revenues, leading
a lot many institutions delisting and some even listing elsewhere, such as the UK where a lighter
hand on governance has been implemented.

In Europe, the reactions to the WorldCom accounting scandal of the U.S. included the
implementation of the mandatory ‘Annual Corporate Governance Statement’. The Company Act
2006 has replaced the Memorandum and Articles of Association with a single document
followed by the attempt to shorten the time limit on information delivery for small companies
from ten to seven months after the financial year end.  Alteration of the statement of duties of
directors also took place together with the Operating & Financial Review being introduced for
large firms.   All of these changes were to try and bring shareholders and other stakeholders
closer to their investments to supervise them more closely