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The Worldcom scandal was one of the most shocking and widespread frauds in the United States of America to rock the wall street. It was not just the biggest accounting scandal but also one of the biggest bankruptcy stories. Worldcom was one of the biggest telecommunications company which was a long distance phone service provider. At first it started as a very small company named Long Distance Discount Services (LDDS) and gradually became one of the biggest telecommunication company of the United States of America. There were total 85,000 employees and the company had branches in almost 65 countries. Bernie Ebbers was the CEO of the company who was first appointed as an early investor and then he became the CEO. Gradually the company grew from a small business to a $30 billion revenue earning company and the company acquired six other telecommunications company within a decade. On June 25th , 2002 it was revealed that the company has been involved in fraudulent activities. After the investigation was done it was revealed that a total of $11 billion misstatements was there.
First started as a small company named Long Distance Discount Services in 1983, it merged with Advantage Companies Inc and became Worldcom Inc, and Bernard Ebbers was appointed as the CEO of the Company. Gradually Worldcom emerged as a significant player in the telecommunications market by successfully acquiring 65 other companies spending almost $60 billion between 1991 and 1997, and at the same time also accumulating $41 billion in debt.
During the period of Internet boom Worldcom’s stock rose to $60 a share and ‘Wall Street investment banks, analysts and brokers began to mark Worldcom’s value and made “strong buy recommendations” to investors.’ During the 1990’s Worldcom became the ‘second-largest long distance phone company in the US’ mainly due to the successful acquisition strategy.
Because of the acquisitions the market price of the shares increased and due to which the company gained greater financing from banks for further acquisitions. In the year 1998 Worldcom and MCI announced its merger and this was one of the greatest mergers. After this merger the company came to the second position after AT&T in the telecommunications market.
From 1999 to early 2002, CEO of the company, Bernard Ebbers along with the help of senior management used fraudulent and illegal accounting methods to mislead and defraud investors and other directors. The fraudulent accounting method that they used were majorly two in number: ‘The reduction of reported line costs’ and the ‘exaggeration of reported revenue’ . These methods were used to ignore the generally accepted accounting principles (GAAP) along with not informing the users of the financial statements of the changes and alterations made to the previously used accounting practices. This was done to reduce their E/R ratio, which was used as the performance indicator of telecommunications companies.
The gradual failure of Worldcom started by the disruption of the acquisition cycle, when the planned acquisition of Sprint Corporation in 1999-2000 did not work out because of pressures from the US Department of Justice and the European Union over concerns of it creating a monopoly. Because of this Worldcom lost its main growth strategy and had to change to some other growth strategy. Either they had to mix all the previous acquisitions of the company into one entity or business, which they had failed to do and this was the beiginning of the downfall of Worldcom.
The CEO in July 2002 filed for Chapter 11 bankruptcy after disclosing about the frauds and illegal accounting methods used to increase revenue and reduce expenses. By the end of 2003, it was estimated after the investigation that the company’s total assets had been increased by around $11 billion.
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ANALYSIS OF THE CASE:
The tactics used for the scandal by the senior management were that they used to manipulate the accounts of the company so that they can achieve the market expectations on growth so that the financial reports of the company looks healthy and appealing. This was achieved by using basic fraudulent methods of accounting such as changing financial estimates, early revenue recognition, modifying account receivables etc. Also the accounting department of the company underreported the line costs and also the company inflated the revenue by $1 billion. What the company exactly did was as follows:
- Revenue – they basically reduced the money held in reserve by $2.8 billion and showed this money in the revenue line of the company’s financial statements. Also in the year 2000 they showed their operating expenses as long-term investments. By doing all this they could show their losses as profits. In the year 2001 the financial statements of the company showed a profit of $1.38 billion by employing these fraudulent methods. This helped the company to show that its assets are more valuable.
- Line Costs – controlling the line costs was one of the biggest thing for the company and Ebbers promised to reduce expenses of line costs and therefore the accruals were adjusted on a regular basis to improve the company’s overall margins and profits, showing the high growth rate now expected by the market. Worldcom’s finance chief, Sullivan later told to the court that he falsified and manipulated the financial statements of the company and in particular ordered the General Accounting department to reduce Wireless’ Division’s expenses by US$150 million.
- MCI Acquisition – The acquisition of MCI by Worldcom enabled into manipulate its books as it could now apply its illegal methods to all the new assets and expenses of MCI. Therefore they started manipulating and reducing the book value of some MCI assets and at the same time also increasing the value of goodwill by the same balancing amount. This gave greater chance to them for achieving their targets as smaller amounts of expenses were shown against earnings by spreading the charges over decades rather than the year it was incurred. ‘This resulted in Worldcom’s ability to cut annual expenses and losses, and show all MCI revenues and boost profits from the acquisition.
- By using all these tactics they could easily show their losses as profits and they manipulated the accounts and financial statements which helped them to hide the line costs and with all these they showed that the company has a healthy financial position.
All these illegal activities were possible because the company had an environment where fraud activities were easily accomplished and illegal targets were achieved. For this reason, the internal audit function, which was designed to supervise and hold employees accountable for their activities, was suppressed and controlled by a few senior members of the company in an attempt to prohibit their exposure to the sensitive information. This was mainly done by senior management keeping the internal audit department understaffed, generally under qualified and they also kept them busy with other projects as well so that they can retain information from them.
The culture of Worldcom was another problem that was among the biggest causes of its failure, being evident in all aspects of the company, but mostly passed down the ranks from top management starting with Ebbers. Downfall of the firm was because of the absence of accountability from some of the top management. Ebbers tried to argue in his defence that he wasn’t involved in the detailed aspects of the firm and hence he did not know and was not involved in the fraud, however he had the authority and forced others to comply. These were some of the greatest reasons of the scandal.
As the environment of the company was such that the top level management could easily do illegal activities the company by manipulating and altering the accounts and financial statements, by misstating the revenue and by altering the line costs managed to show their losses as profits and after the successful acquisition of MCI this became even easier. Also the aggressive acquisition strategy also helped the company in conducting the fraud. Through all those acquired companies they easily manipulated their accounts, revenue etc.
Also the main reasons of the failure of Worldcom are as follows:
- The corporate culture of the company was extremely autocratic style of management.
- The employees of the company lacked courage to inform about the fraudulent activities of the company.
- The controls of the company’s financial system were extremely deficient.
- The audit committee and the board of directors did not have proper understanding of the company and its activities.
- The audits conducted by the independent auditors were not proper and inadequate.
- Line costs are the costs that Worldcom paid other companies for using their networks for their customers which included access fees and transport charges also. These costs are expenses and instead of showing them as expenses, they opted to hold off on paying these costs in order to show that Worldcom was earning more than it really was. 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.
- 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.
Effects of case on corporate governance structure:
The Worldcom scandal could have discredited US GAAP standard proving that the fraud could only have occurred due to deficient accounting principles. However, there was a broad consensus that the Worldcom scandal was the result of a failure of corporate governance. After the downfall of Enron, the Securities and Exchange Commission had not yet come up with any new laws. However, after the senior management of Worldcom was charged with fraud, the Congress felt the need to come up with some new legislative actions. Thus, a new US federal law, the Sarbanes-Oxley Act came into force in 2002. It is now applicable to any company registered with the SEC and it mainly specifies duties concerning the issues of corporate governance, legal compliance and disclosure of information.
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The most important section of the Sarbanes-Oxley Act is section 404 which requires the implementation and periodic evaluation of an internal auditing system of the company and it has became the main reason behind the increased compliance costs.
After the scandal the following Corporate Governance Principles were proposed:
- 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.
The fraud of Worldcom became public in June 25, 2002. Several measures were taken to bring the confidence of the public upon the company. The board of directors were changed, new independent auditor was hired use of stock options were abolished, new ethical program was implemented etc. Also as many as seventeen thousand employees were let go. The biggest effect was on the investors of the company. After this scandal the Congress quickly passed the Sarbanes Oxley Act on 30th July, 2002. This was done to strengthen the principles of corporate governance so that these kind of corporate frauds could be prevented.
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Author: Vaishanavi Krupakaran
Editor: Kanishka Vaish, Senior Editor, LexLife India.