WorldCom Accounting

Scandal
BSA 3-5
“YOU CANNOT HAVE IT ALL”
Bernard John "Bernie" Ebbers Scott Sullivan
(CEO) CFO
Cynthia Cooper
Introduction

 WorldCom was a provider of long distance phone

services to businesses and residents.

 It started as a small company known as Long Distance

Discount Services (“LDDS”) that grew to become the
third largest telecommunications company in the United
States due to the management of Chief Executive
Officer (“CEO”) Bernie Ebbers.
CAUSES

 The executive and strategic decisions at WorldCom

were characterized by rapid growth through acquisitions
 They did not contain any realistic strategic plans
(Thornburgh, 2003).
 Once WorldCom acquired the new companies, it failed
to properly integrate the systems and policies that not
only led to very high levels of overhead in proportion to
the revenues but also to an extremely weak internal
control environment (Breeden, 2003).
 The MCI merger caused WorldCom to take on a huge
debt load.
 The beginning of WorldCom's fall came with its attempt
to merge with the second largest telecommunication
company at the time: Sprint (WorldCom being the third
largest).
 The plan was terminated by the U.S. Department of
Justice due to the lack of anti-competitiveness it would
create within the telecommunications industry.
 The management at WorldCom was so determined to
grow that it not only failed to create a competitive
strategy, but also did not see that with growth comes
“the need to maintain” to prosper.
 In the end, that lack of strategy prevented it from
effectively planning and determining a position to
acquire that prosperity.
Company Culture
Top Management’s Managing Style

 One employee stated that WorldCom was never a

happy place to work, even when the company was
doing well, the employees were forced to work 10, 12, or
even 15 hour a day but it balanced out with the higher
compensation. However, when the stock dropped, the
employees were still required to work the long hours
even when compensation was all but gone.
 There was a large focus on revenues, rather than on
profit margins and the lack of integration of accounting
systems allowed WorldCom employees to move existing
customer accounts from one accounting system to
Due to the multiple acquisitions, WorldCom's
business units were spread across the eastern
United States. Hence, if an employee working at
headquarters in Clinton, Mississippi was facing a
problem, he/she would have to contact the
Human Resources department in either New
York, N.Y. or Boca Raton, Florida.
1,148.7 Miles (17-hour drive)
730.8 Miles (11-hour drive)
 According to Chalmers, a lawyer who dealt with many
WorldCom employee cases after the fraud, the gap
between the competitors‟ compensation and
WorldCom employee compensation was filled through
stock options which further enforced management's
ideology of focus on revenues.
 The higher the revenues, the better the company
appeared to Wall Street which in turn led to a higher
stock price and higher compensation for both
employees and management. However, when
WorldCom fell, so did the stock price, leaving its
employees with worthless stock options.
Corporate Governance Board of
Directors
 The mix of the Board and the close ties to Ebbers led to
the Board's lack of awareness on WorldCom's issues. The
Board was inactive and met only about four times a
year, not enough for a company growing at the rate
that it was.
 In addition, the directors were only given a small cash
fee as compensation, thus an appreciation of stock was
the only form of compensation available.
 They had a large amount of influence on the approval
or disapproval of company decisions. Their approvals of
the acquisitions allowed WorldCom's growth to an
increase that led to a higher stock price and a large
amount of compensation.
Loans to Ebbers
 Ebbers had made several purchases for which he had
acquired loans and used his WorldCom stock as collateral.
The purchases were quite extravagant and included the
largest ranch in Canada, a yacht construction firm and yard,
a marina, motels, a hockey team, and even a yacht Ebbers
named “Acquasition.”
 To ease the process, Ebbers took advantage of the lack of
independence of the board members who were loyal to him
such as Stiles Kellett, chairman of the Compensation
Committee, and Max Bobbitt, chairman of the audit
committee.
 Not only did the two allow the loans to grow to more than
$400 million, but also when the Board found out about these
loans, they failed to take any action and allowed the loans to
carry on.
Compensation Committee
 One main reason Ebbers's loans were approved was the
Compensation Committee. The Committee approved
the loans to Ebbers without confirming with the Board
and asked for the Board's approval after the loans had
already been paid out (Beresford, Katzenbach, &
Rogers, 2003).
 The Committee was the only one at WorldCom that met
regularly: seven to seventeen times per year during the
fraud period of 1999-2001.
 The approval of Ebbers’s loans does not qualify as an
action in the company's best interests, but only in the
best interests of Ebbers and the board members who
were loyal to him.
Auditing: to detect or to neglect
(Audit Committee)
 An Audit Committee consists of a selected number of Board
members who are to meet from time to time with the company‟s
auditing firm and discuss the progress of the audit, the findings, and
resolve any conflicts that may occur between management and
the firm (Louwers, Ramsay, Sinason, & Strawser, 2008).
 However, in WorldCom‟s case, the lack of independence and
awareness of the Board as a whole trickled down to the audit
committee. The committee‟s chairman, Max Bobbitt, was very loyal
to Ebbers.
 Hence, the members of the committee, including Bobbitt, were
either unaware or had known about the fraudulent misstatements
for the years 1999, 2000, and 2001 and choose to ignore it.
FRAUD TRIANGLE
 FRAUD
was accomplished in two main
ways:

Inflated Revenues
Capitalization of by accounting
revenue entries that does
expenditure not adhere to
GAAP
 How Was Fraud Uncovered?
 On May 21, 2002, a WorldCom employee sent a featured article to
an internal auditor, indicating that the issues raised in the article
might warrant investigation
 Article was from the May 16 edition of Fort Worth Weekly Online and
was based upon interviews with a former WorldCom employee who
was allegedly fired for whistle blowing.
 WorldCom’s Internal Audit Department began an investigation
concerning the capitalization of line costs.
 $2.5 billion in line costs that had been capitalized.
 On June 25, 2002, the Board determined that WorldCom would
restate its financial statements for 2001 and the first quarter of 2002.
 KPMG would reaudit the Company’s financial statements for 2001
 It decided to terminate Mr. Sullivan without severance and to accept
the resignation of Mr. Myers without severance.
The Misstatement of Line Costs

 According to Beresford, Katzenbach, & Rogers (2003), line costs are

the costs associated with carrying a voice phone call or data
transmission from the calls origin to its destination.
 If a WorldCom customer made a call from New York City to
London, the call would first go through the local phone company's
line in New York City, then through WorldCom's long distance, and
finally through the local phone company in London. WorldCom
would have to pay both the local companies in New York City and
London for use of the phone lines; these costs are considered line
costs.
 WorldCom's top management strived to achieve a low line cost to
revenue ratio (“line cost E/R ratio”).
Accounting Fraud 1: Improperly Releasing
Reserves Held Against Operating Expenses (1999 -
2000)
 WorldCom has set reserves to pay anticipated bills, reflecting
estimates of (unpaid) costs associated with the used of lines and
other facilities of outside vendors

 In the third quarter of 2000, WorldCom starts to manipulate true line

cost expenses by releasing reserves (reduced 3Q line costs by $828
million, and 4Q line costs by $407 million).
How WorldCom manipulated the process of adjusting reserves
 First , in some cases accruals were released without any
apparent analysis of whether the Company actually had an
excess accrual in the account. Thus, reported line costs were
reduced (and pre-tax income increased) without any proper
basis.
 Second , even when WorldCom had excess accruals, the
Company often did not release them in the period in which they
were identified. Instead, certain line cost accruals were kept as
rainy day funds and released to improve reported results when
managers felt this was needed.

 In 1999 and 2000, WorldCom reduced its reported line costs by

approximately $3.8 billion through this fraud.
Accounting Fraud #2: Recharacterizing Certain
Expenses as Capital Assets (2001 – 2002)
 Line Costs: Fees WorldCom paid, under long-term contracts, to
third-party telecommunication carriers for the right to access their
network in order to service their customers.
 WorldCom’s largest operating expense and typically reached 50% of revenue.
 By booking line costs as capital assets instead of as an operating
expense, WorldCom.
1. reduced their operating expenses (and increased pre-tax income)
2. increased the value of their capital assets (and total assets)
3. increased the value of the company’s net worth
 In April 2001, WorldCom starts making false general ledger entries
which transfer a significant portion of line cost expenses to a variety
of capital asset accounts. Violates GAAP.
 In 2001 and 2002, WorldCom improperly capitalized $3.5 billion of
line costs.
 False Statements

WorldCom's False Statements in Filings With SEC

Form Filed Reported Line Reported Income Actual Line Actual Income
With the Cost Expenses (before Taxes Cost Expenses (before Taxes
Commission and Minority and Minority
Interests) Interests)
10-Q, 3rd Q. 2000 $3.867 billion $1.736 billion $4.695 billion $908 million
10-K, 2000 $15.462 billion $7.568 billion $16.70 billion $6.33 billion
10-Q, 1st Q. 2001 $4.108 billion $988 million $4.879 billion $217 million
10-Q, 2nd Q. 2001 $3.73 billion $159 million $4.290 billion -$401 million
10-Q, 3rd Q. 2001 $3.745 billion $845 million $4.488 billion $102 million
10-K, 2001 $14.739 billion $2.393 billion $17.754 billion -$622 million
10-Q, 1st Q. 2002 $3.479 billion $240 million $4.297 billion -$578 million
Source: SECURITIES AND EXCHANGE COMMISSION v. WORLDCOM, INC., Civ No. 02-CV-4963 (JSR)
 Net Income

1000
800
600
400
200
0
-200
-400
-600
-800
1st Qtr
2nd Qtr 3rd Qtr
2001 4th Qtr
2001 2001 1st Qtr
2001 Reported income
2002
Actual income
 Effects of fraud

 WorldCom/MCI has acknowledged that it committed more fraud

than it original reported, raising the estimate from $3.8 billion (June
25, 2002) to $7.2 billion (August 9, 2002) to $9 billion (September 19,
2002).
 WorldCom/MCI overpaid taxes and sought to recover $300 million in
federal tax payments that it made to cover up its fraudulent activity.
 Misrepresented cash position to analysts as “solid” while facing cash
crunch. Made loan to Ebbers constituting 30% of WorldCom’s cash.
 WorldCom continued to issue securities using fraudulent and
materially false financial statements and information.
 American investors in WorldCom/MCI lost an estimated $176B in
value in WorldCom stock, laid off 25,000 employees and caused
another 73,000 job losses in the industry.
Sarbanes-Oxley Act (SOX)

 Sections 302-306 of the act require management to

certify that the financial statements are fairly presented.
Hence if any misstatement occurs, management is
responsible (The Laws).

 At his trial Ebbers said that he was unaware of the

fraudulent activities and relied on the accounting
department for all financial matters because he did not
understand the financial statements (Beresford,
Katzenbach, & Rogers, 2003). SOX does not allow that to
be an excuse anymore.
 Moreover, SOX requires that when a restatement due to a
fraudulent activity is discovered in the company, all bonuses and
other incentive-based compensation have to be forfeited.
Therefore, the millions in compensation acquired by both Ebbers
and Sullivan would have to be returned if the act existed previously.

 Lastly, SOX forbids top management to obtain loans from the

company. Consider how different the outcome might have been if
WorldCom's board of directors had denied Ebbers's $400 million in
loans. Lack of easy money may have prevented his extravagant
lifestyle that pressured him to commit the fraud.
References

 http://www.ecommercetimes.com/story/45542.html
 http://money.cnn.com/gallery/news/2015/10/14/biggest-corporate-
scandals/2.html
 http://www.fraud-magazine.com/article.aspx?id=210
 http://faculty.som.yale.edu/shyamsunder/FinancialFraud/WorldCom%20-
%20A%20Bunch%20of%20Dirty%20Fraudsters.ppt
 http://answers.google.com/answers/threadview?id=524376
 https://www.thebalance.com/worldcom-s-magic-trick-356121
 http://www.slu.edu/departments/accounting/keithleyj/Spring%202008/614/
PPSlides/WorldCom%20(A)%20-%20student%20team%20No.%201.ppt
 http://etd.fcla.edu/CF/CFH0003811/Ashraf_Javiriyah_201105_BSBA.pdf
 Group 2 Members:
BSA 3-5

 Amandy, Karl  Marcelo, Louise Dianne

 Ermac, Daizyrie  Onia, Anne Kristine
 Espiritu, Harold
 Pelayo, Jennifer
 Garlitos, Michelle
 Perez, Rosemarie
 Japlos, Angela Nicole
 Pergis, Rossel
 Javier, Louise Lloyd
 Perlas, Abegail Joy
 Leecon, Prince
 Macabago, Joralyn  Pornillos, Robert
 Maclang, Jhoan Joy  Quibral, Joana Dennise

Prof. Maria Luisa U. Oliveros