Worldcom Scandal

Background

From riches to rugs

Ethical Principles Violated (Including Accounting and Auditing Principles)

 close personal relationships between company executives and the vendors to whom
they awarded contracts and contractors who were paid exorbitant rates
 threatened him with termination. – Budget Analyst
  cost-cutting measures some managers requested were frequently improper. 
 not paying vendors timely.
 misclassify costs in the accounting books.
 by shifting labor expenses from one category to another
 artificially boost its bottom line to show a profit, rather than a loss
 cooking the books -Under the made-up term “prepaid capacity,” company accountants
were instructed to book certain costs, such as the leases of network lines, as capital
expenses, instead of as operating expenses. Capital expenses are for assets and can
be spread out over a period of years, while operating expenses must be recognized in
full when they occur.  this change resulted in fiscal reports that showed a healthy,
profitable company; in truth, WorldCom was careening towards bankruptcy.
 company had overstated assets by a staggering $11 billion(SEC investigation)
 the SEC charged WorldCom with civil fraud and reached a $2.25 billion settlement.
Several executives and the CEO were indicted on charges of securities fraud,
conspiracy, and filing false documents with regulators.
 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. 
 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.
 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.
 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.
 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.
 other reserves were also manipulated to manage earnings. The reserves, which were
often set aside by WorldCom to cover foreseeable costs and losses, were inflated to
create ‘hefty slush funds’  that could be used to increase profits.
  The internal controls meant to help supervise were controlled by the directors so proved
useless as information could be changed, stopped or edited.
  internal audit function, designed to supervise and hold employees accountable, was
suppressed by a few senior members in an attempt to limit their exposure to the
sensitive information. This was achieved by senior management keeping the internal
audit department understaffed, generally under qualified and busy with other projects as
well as retaining information from them.

Recommendations

  the internal audit function, designed to supervise and hold employees accountable, was
suppressed by a few senior members in an attempt to limit their exposure to the
sensitive information

 The first solution was that the auditors should have relooked at the
financial statements of the company from an ethical standpoint instead of
ignoring expenses of the company[8].
 In order to avoid scandals like Worldcom the company should establish
the culture of legal compliance.
 Cross- internal audit should be there within department instead of formal
auditing.
 Employees should highlight the issues of the internal audit team.
 Also there should be whistle blowing with third party audits.
 Establishing a culture of legal compliance and integrity in the company.
 Development of the company’s strategic plans and there should also be
evaluation of the risk inherent in those plans.
 The audit committee and the board should produce financial statements
that presents the actual financial condition of the company.
 The companies should engage an independent auditing firm for auditing
the financial statement given by the management and should make sure
that those are in accordance with GAAP
 

Key Takeaways

 Due to personal interests, weak internal controls and poor management, corrupt business
practices took hold, driving leaders to make irrational business decisions and alienating
customers and employees.
 Unveiling the corrupt practices within WorldCom's management style and mentality, corporate
strategy, and customer/employee relations all lead to the downfall of the company.
 WorldCom remains the biggest accounting scandal in U.S. history as well as one of the largest
bankruptcies and serves as one of the basis of other entities to formulate internal controls,
make auditors to be vigilant in auditing companies, push the regulating bodies to strengthen the
policies and create strict regulations (SOX Act).
 As a result of the scandal, former CEO Bernard Ebbers was sentenced to 25 years in prison, and
former CFO Scott Sullivan was sentenced to five years. This shows that committing frauds are
punishable by the law and destroys the image of the company and most especially those
responsible with corrupt practices within that company.
 Cooking the books, manipulating the records and threatening the employees will not conceal
the frauds committed.
 Every company should have proper and effective policies and internal controls to avoid business
issues and be strict in enforcing the proper ethical conducts to prevent fraudulent acts to
happen.
 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.

Case Study: WorldCom Accounting Scandal - MBA Knowledge Base (mbaknol.com)

Fraudulent Accounting and the Downfall of WorldCom - Audit & Advisory Services | University of South
Carolina (sc.edu)

WORLDCOM SCANDAL AND ITS IMPACT On CORPORATE AFFAIRS – Lexlife India (wordpress.com)

WORLDCOM SCANDAL AND ITS IMPACT On CORPORATE AFFAIRS – Lexlife India (wordpress.com)