Case Study - answer the questions on the bottom, 500 word minimum recieve thumbs up ^^
WorldCom Lights the Fire
WorldCom, Inc., the second largest U.S. telecommunications giant and almost 70 percent larger than Enron in assets, announced on June 25, 2002, that it had overstated its cash flow by $3.8 billion.1 This came as a staggering blow to the credibility of capital markets. It occurred in the middle of the furor caused by:
The Enron bankruptcy on December 2, 2001, and the related Congress and Senate hearings and Fifth Amendment testimony by Enron executives
The depression of the stock markets
The pleas by business leaders and President Bush for restoration of credibility and trust to corporate governance, reporting, and the financial markets
Responsive introduction of governance guidelines by stock exchanges and the Securities and Exchange Commission
Debate by the U.S. Congress and Senate of separate bills to improve governance and accountability
The conviction of Arthur Andersen, auditor of both Enron and WorldCom, for obstruction of justice on June 15, 2002
WorldComâs Accounting Manipulations
WorldComâs accounting manipulations involved very basic, easy-to-spot types of fraud.2 Overstatements of cash flow and income were created because one of WorldComâs major expenses, line costs, or âfees paid to third party telecommunication network providers for the right to access the third parties networks,â3 were accounted for improperly. Essentially, line costs that should have been expensed, thus lowering reporting income, were offset by capital transfers or charged against capital accounts, thus placing their impact on the balance sheet rather than the income statement. In addition, WorldCom created excess reserves or provisions for future expenses, which they later released or reduced, thereby adding to profits. The manipulation of profit through reserves or provisions is known as âcookie jarâ accounting.
The aggregate overstatement of income quickly rose to more than $9 billion4 by September 19, 2002, for the following reasons:
$3.85 billion for improperly capitalized expenses, announced June 25, 20025
$3.83 billion for more improperly capitalized expenses in 1999, 2000, 2001, and the first quarter of 2002, announced on August 8, 20026
$2.0 billion for manipulations of profit through previously established reserves, dating back to 1999
Ultimately, the WorldCom fraud totaled $11 billion.
Key senior personnel involved in the manipulations at WorldCom included:
Bernard J. Ebbers, CEO
Scott D. Sullivan, CFO
Buford Yates Jr., Director of General Accounting
David F. Myers, Controller
Betty L. Vinson, Director of Management Reporting, from January 2002
Troy M. Normand, Director of Legal Entity Accounting, from January 2002
According to SECâs complaint against Vinson and Normand:7
4. WorldCom fraudulently manipulated its financial results in a number of respects, including by improperly reducing its operating expenses in at least two ways. First, WorldCom improperly released certain reserves held against operating expenses. Second, WorldCom improperly recharacterized certain operating costs as capital assets. Neither practice was in conformity with generally accepted accounting principles (âGAAPâ). Neither practice was disclosed to WorldComâs investors, despite the fact that both practices constituted changes from WorldComâs previous accounting practices. Both practices artificially and materially inflated the income WorldCom reported to the public in its financial statements from 1999 through the first quarter of 2002. 5. Many of the improper accounting entries related to WorldComâs expenses for accessing the networks of other telecommunications companies (âline costsâ), which were among WorldComâs major operating expenses. From at least the third quarter of 2000 through the first quarter of 2002, in a scheme directed and approved by senior management, and participated in by VINSON, NORMAND and others, including Yates and Myers, WorldCom concealed the true magnitude of its line costs. By improperly reducing reserves held against line costs, and thenâafter effectively exhausting its reservesâby recharacterizing certain line costs as capital assets, WorldCom falsely portrayed itself as a profitable business when it was not, and concealed the large losses it suffered. WorldComâs fraudulent accounting practices with respect to line costs were designed to and did falsely and fraudulently inflate its income to correspond with estimates by Wall Street analysts and to support the price of WorldComâs common stock and other securities. 6. More specifically, in the third and fourth quarters of 2000, at the direction and with the knowledge of WorldComâs senior management, VINSON, NORMAND and others, by making and causing to be made entries in WorldComâs books which improperly decreased certain reserves to reduce WorldComâs line costs, caused WorldCom to overstate pretax earnings by $828 million and at least $407 million respectively. Then, after WorldCom had drawn down WorldComâs reserves so far that the reserves could not be drawn down further without taking what senior management believed was an unacceptable risk of discovery, VINSON, NORMAND and others, again at the direction and with the knowledge of senior management, made and caused to be made entries in WorldComâs books which improperly capitalized certain line costs for the next five quarters, from the first quarter 2001 through the first quarter 2002. This accounting gimmick resulted in an overstatement of WorldComâs pretax earnings by approximately $3.8 billion for those five quarters.
The motivation and mechanism for these manipulations is evident from the SECâs description of what happened at the end of each quarter, after the draft quarterly statements were reviewed. Steps were taken by top management to hide WorldComâs problems and boost or protect the companyâs stock price in order to profit from stock options, maintain collateral requirements for personal loans, and keep their jobs. These steps were required, in part, to offset the downward pressure on WorldComâs share price caused by U.S. and European regulatorsâ rejection of WorldComâs US $115 billion bid for Sprint Communications.8 Ebbersâ company had been using takeovers rather than organic growth to prop up earnings, and the financial markets began to realize this would be increasingly difficult.
According to the SEC:
27. In or around October 2000, at the direction and with the knowledge of WorldCom senior management, VINSON, NORMAND and others, including Yates and Myers, caused the making of certain improper entries in the companyâs general ledger for the third quarter of 2000. Specifically, after reviewing the consolidated financial statements for the third quarter of 2000, WorldCom senior management determined that WorldCom had failed to meet analystsâ expectations. WorldComâs senior management then instructed Myers, and his subordinates, including Yates, VINSON and NORMAND, to make improper and false entries in WorldComâs general ledger reducing its line cost expense accounts, and reducingâin amounts corresponding to the improper and false line cost expense amountsâvarious reserve accounts. After receiving instructions through Yates, VINSON and NORMAND ensured that these entries were made. There was no documentation supporting these entries, and no proper business rationale for them, and they were not in conformity with GAAP. These entries had the effect of reducing third quarter 2000 line costs by approximately $828 million, thereby increasing WorldComâs publicly reported pretax income by that amount for the third quarter of 2000.9
Manipulations followed the same pattern for the fourth quarter of 2000, but a change was required for the first quarter of 2001 for fear of discovery.
29. In or around April 2001, after reviewing the preliminary consolidated financial statements for the first quarter of 2001, WorldComâs senior management determined that WorldCom had again failed to meet analystsâ expectations. Because WorldComâs senior management determined that the company could not continue to draw down its reserve accounts to offset line costs without taking what they believed to be unacceptable risks of discovery by the companyâs auditors, WorldCom changed its method of fraudulently inflating its income. WorldComâs senior management then instructed Myers, and his subordinates, including Yates, VINSON and NORMAND, to make entries in WorldComâs general ledger for the first quarter of 2001, which fraudulently reclassified line cost expenses to a variety of capital asset accounts without any supporting documentation or proper business rationale and in a manner that did not conform with GAAP. 30. Specifically, in or around April 2001, at the direction and with the knowledge of WorldComâs senior management, defendants VINSON, NORMAND and others, including Yates and Myers, fraudulently reduced first quarter 2001 line cost expenses by approximately $771 million and correspondingly increased capital asset accounts, thereby fraudulently increasing publicly reported pretax income for the first quarter of 2001 by the same amount. In particular, in or about April 2001, NORMAND telephoned WorldComâs Director of Property Accounting (the âDPAâ) and instructed him to adjust the schedules he maintained for certain Property, Plant & Equipment capital expenditure accounts (the âPP&E Roll-Forwardâ) by increasing certain capital accounts for âprepaid capacity.â NORMAND advised the DPA that these entries had been ordered by WorldComâs senior management. Correspondingly, a subordinate of NORMAND made journal entries in WorldComâs general ledger, transferring approximately $771 million from certain line cost expense accounts to certain PP&E capital expenditure accounts.10
In future periods, the increase of certain accounts for âprepaid capacityâ remained the manipulation of choice.
WorldComâs Other Revelations
It should be noted that Ebbers was not an accountantâhe began as a milkman and bouncer, and became a basketball coach and then a Best Western Hotel owner before he entered the Telcom business,11 where his sixty acquisitions and style earned him the nickname âthe Telcom Cowboy.â However, he was ably assisted in these manipulations by Scott Sullivan, his Chief Financial Officer, and David Myers, his Controller. Both Sullivan and Myers had worked for Arthur Andersen before joining WorldCom.
Other spectacular revelations offer a glimpse behind the scenes at WorldCom. The company, which applied for bankruptcy protection in July 21, 2002, also announced that it might write off $50.6 billion in goodwill or other intangible assets when restating for the accounting errors previously noted. Apparently other WorldCom decisions had been faulty.
The revelations were not yet complete. Investigation revealed that Bernard Ebbers, the CEO, had been loaned $408.2 million. He was supposed to use the loans to buy WorldCom stock or for margin calls as the stock price fell. Instead, he used it partly for the purchase of the largest cattle ranch in Canada, construction of a new home, personal expenses of a family member, and loans to family and friends.12
Finally, it is noteworthy that:
At the time of its scandal, WorldCom did not possess a code of ethics. According to WorldComâs Board of Directorâs Investigative Report, the only mention of âethicsâ was contained in a section in WorldComâs Employee Handbook that simply stated that â⦠fraud and dishonesty would not be toleratedâ (WorldCom 2003, p. 289). When a draft version of a formal code was presented to Bernie Ebbers ⦠for his approval before the fraud was discovered in 2001, his response was reportedly that the code of ethics was a â⦠colossal waste of timeâ (WorldCom 2003, 289).13
Why Did They Do it?
According to U.S. Attorney General John Ashcroft:
the alleged Sullivan-Myers scheme was designed to conceal five straight quarterly net losses and create the illusion that the company was profitable.14
In view of Ebbersâ $408.2 million in loans, which were largely to buy or pay margin calls on WorldCom stock and which were secured by WorldCom stock, he would be loathe to see further deterioration of the WorldCom stock price. In short, he could not afford the price decline that would follow from lower WorldCom earnings.
In addition, according to the WorldComâs 2002 Annual Meeting Proxy Statement,15 at December 31, 2001, Ebbers had been allocated exercisable stock options on 8,616,365 shares and Sullivan on 2,811,927. In order to capitalize on the options, Ebbers and Sullivan (and other senior employees) needed the stock price to rise. A rising or at least stable stock price was also essential if WorldCom stock was to be used to acquire more companies.
Finally, if the reported results became losses rather than profits, the tenure of senior management would have been shortened significantly. In that event, the personal loans outstanding would be called and stock option gravy train would stop. In 2000, Ebbers and Sullivan had each received retention bonuses of $10 million so they would stay for two years after September 2000. In 1999, Ebbers received a performance bonus allocation of $11,539,387, but he accepted only $7,500,000 of the award.16
An Expertâs Insights
Former Attorney General Richard Thorn-burgh was appointed by the U.S. Justice Department to investigate the collapse and bankruptcy of WorldCom. In his Report to the U.S. Bankruptcy Court in Manhattan on November 5, 2002, he said:
One person, Bernard Ebbers, appears to have dominated the companyâs growth, as well as the agenda, discussions and decisions of the board of directors, ⦠A picture is clearly emerging of a company that had a number of troubling and serious issues ⦠[relating to] culture, internal controls, management, integrity, disclosure and financial statements. While Mr. Ebbers received more than US $77 million in cash and benefits from the company, shareholders lost in excess of US $140 billion in value.17
The Continuing Saga
The WorldCom saga continues as the companyâs new management try to restore trust it its activities. As part of this effort, the company changed its name to MCI. âOn August 26, 2003, Richard Breeden, the Corporate Monitor appointed by the U.S. District Court for the Southern District of New York, issued a report outlining the steps the Company will take to rebuild itself into a model of strong corporate governance, ethics and integrity ⦠(to) foster MCIâs new company culture of âintegrity in everything we do.ââ18 The company is moving deliberately to reestablish the trust and integrity it requires to compete effectively for resources, capital, and personnel in the future.
The SEC has filed complaints, which are on its website, against the company and its executives. The court has granted the injunctive relief the SEC sought. The executives have been enjoined from further such fraudulent actions, and subsequently banned by the SEC from practicing before it, and some have been banned by the court from acting as officers or directors in the future.
WorldCom, as a company, consented to a judgment:
⦠imposing the full injunctive relief sought by the Commission; ordering an extensive review of the companyâs corporate governance systems, policies, plans, and practices; ordering a review of WorldComâs internal accounting control structure and policies; ordering that WorldCom provide reasonable training and education to certain officers and employees to minimize the possibility of future violations of the federal securities laws; and providing that civil money penalties, if any, will be decided by the Court at a later date.19
Bernie Ebbers and Scott Sullivan were each indicted on nine charges: one count of conspiracy, one count of securities fraud, and seven counts of false regulatory findings.20 Sullivan pleaded guilty on the same day he was indicted and later cooperated with prosecutors and testified against Bernie Ebbers âin the hopes of receiving a lighter sentence.â21
Early in 2002, Ebbers stood up in church to address the congregation saying: âI just want you to know that youâre not going to church with a crook.â22 Ebbers took the stand and argued âthat he didnât know anything about WorldComâs shady accounting, that he left much of the minutiae of running the company to underlings.â23 But after eight days of deliberations, on March 15, 2005, a federal jury in Manhattan didnât buy his âaw shucks,â âhands-off,â or âostrich-in-the-sandâ defense.
The jury believed Sullivan, who told the jury that Ebbers repeatedly told him to ââhit his numbersââa command ⦠to falsify the books to meet Wall Street expectations.â24 They did not buy Ebbersâ âI know what I donât knowâ argument, âespecially after the prosecutor portrayed a man who obsessed over detail and went ballistic over a US $18,000 cost overrun in a US $3-billion budget item while failing to pick up on the bookkeeping claim that telephone line costs often fluctuatedâfraudulentlyâby up to US $900-million a month. At other times, he replaced bottled water with tap water at WorldComâs offices, saying employees would not know the difference.â25
On July 13, 2005, Ebbers was sentenced to twenty-five years in a federal prison.26 Once a billionaire, he also lost his house, property, yacht, and fortune. At 63 years of age, he is appealing his sentence. Sullivanâs reduced sentence was for five years in a federal prison, forfeiture of his house, ill-gotten gains, and a fine.
Investors lost over $180 million in WorldComâs collapse,27 and more in other companies as the confidence in credibility of the financial markets, governance mechanisms and financial statements continued to deteriorate.
Questions
1.
Describe the mechanisms that WorldComâs management used to transfer profit from other time periods to inflate the current period.
2.
Why did Arthur Andersen go along with each of these mechanisms?
3.
How should WorldComâs board of directors have prevented the manipulations that management used?
4.
Bernie Ebbers was not an accountant, so he needed the cooperation of accountants to make his manipulations work. Why did WorldComâs accountants go along?
5.
Why would a board of directors approve giving its Chair and CEO loans of over $408 million?
