Case 4 WorldCom Answer

Case 4: ACCOUNTING FRAUD AT WORLDCOM CASE 4 SUGGESTED ASSIGNMENT QUESTIONS (Individual Assignment) Due: 21 November 2013

1. What are the pressures that lead executives and managers to “cook the books”? The main pressures were coming from the economic recession and the aftermath of dot-com bubble collapse which then causes the industry conditions began to deteriorate in 2000. The competition among existing company and the new entrants were becoming more heightened; the company became overcapacity and the demand for telecommunication services reduced significantly. And the pressure to maintain a 42% of expense-to-revenue ratio (E/R ratio) had also becoming one of the forces that lead the executives and the manager to cook the books in order to make it looked good at the public’s eyes. From the perspective of the executives, the main pressure would be to ensure that the investor or the shareholder to keep on trusting the company and continue to keep their investment or inject more investment into the company. This is so much important as the shareholders’ trust greatly depending on the company performance. When the performance indicator shown not a good result, the shareholder will most probably take off their investment and this will impacted the company’s stock price. Besides that, the executives were also surrounded by their self-interest. Having a good position, good title in the company with a good salary, had made them comfortable with current situation. If they choose to reveal the actual company performance, then it is just like digging for their own grave. They would lose everything that they had. Therefore, they prefer to ‘cook the books’ or to cover the real performance by doing some improper accounting practices. For example, in the first quarter of 2000, WorldCom was having revenue, pricing and its highly committed line costs pressures that making it hard to maintain an E/R ration of 42%. This was then lead to Ebbers’s emotional speech to the senior staff about how he and the other director will lose everything if the company did not show good performance. From the perspective of the managers, the employee benefits that they had receive was all because of the great company’s performance. If the company did not improve, then many of them will be fired or loss their job as a way of saving the company’s cost. And due to preventing this thing from happened, the employee had no other choice other than to obey the senior management’s command of cooking the books, or to not engage with the fraud by quitting the job. For example, Betty Vinson, who was previously a manager in the

international accounting division, was having a dilemma after she done her first fraud of releasing an $ 828million of line accruals. She was wondering whether she was at the right action or not. However, after being compromise by the director, David Myers, she and her colleague, Troy Normand feel at ease and decided to do the transfer. But at last, the same things happen and they keep on releasing accruals and capitalizing expense. Troy Normand at last decided to resign while Vinson was rethinking her plan of resigning as the family was at that time depending at her and it’s hard to find a company that give good employee benefits like WorldCom. Thus, she decided to keep working in the company and do whatever being told by the top management. It was clearly shown that sometimes the pressures came from the surrounding and forced one to commit fraud in order to survive. 2. What is the boundary between earnings smoothing or earnings management and fraudulent reporting? The earnings management or earnings smoothing is about the use of accounting techniques to show produce financial reports that may shows an overly positive picture of a company’s business activities and financial position which is considered to be normal for the company. It is deemed as not an illegal act but if the earnings management gone to be abusive (material and intentional misrepresentation), then the action became illegal and the SEC may issue fines. Basically, income smoothing is the reduction of the variance in periodic profit over time to the extent allowed by accounting and management principles. Usually, by smoothing the earnings, the net income fluctuations from one period to the next will be less. Companies practice this because of the investor that prefers to get premium paid (dividend) for stocks that are stable in their earnings. The earnings smoothing can be about changing the accounting methods, recognizing one-time items, or deferring expenses or accelerating revenues to bring about desired short-term earnings result. The main reasons managers doing income smoothing are to maximize company’s wealth, reducing the perceived riskiness of the firm, enhancing company’s value, meeting debt covenants, reducing tax and political costs and enhancing the reliability of financial forecasts. On the other hand, fraudulent reporting is about the deliberate action of issuing misleading financial statements in an effort to avoid negative impacts on the financial stability of a business. And the most important, it is an illegal act as the action was intentional to hide and misreport the actual company’s financial figures and information to the public. As from the case, we can see so clear that the management were not doing income smoothing, instead, they are making fraudulent reporting. The top management such as Scott Sullivan and David Myers were forcing the subordinates to cooks the book in order to show a positive and maintained performance.

For example, they had released a total of $ 3.3billions throughout year 1999 until 2000. Then, instead of recognizing the unused excess network capacity as expense, it capitalizes it and recognized as asset. Besides that, Sullivan intentionally asking Cynthia Cooper to delay the capital expenditure audit until the next quarter as he need the time to prepare for the fictitious transactions. In order to conceal the truth, the top management told the employees on what they can and can’t share with the outsiders especially with the auditor Arthur Andersen. Moreover, Sullivan manipulated the information related to capital expenditures and line costs presented to the board by showing a steady decrease as the board were expecting some cuts on the capital expenditure. However, the actual capital expenditure incurred was far lower than reported. This means, WorldCom were capitalizing the expense as assets more than it should. Furthermore, the board meeting was handled by Ebbers instead of the chairman of the board, Mr. Bert Roberts, which simplifies the process of committing fraud among the top management and hid it properly from the board and the auditor. 3. Why were the actions taken by WorldCom managers not detected earlier? What processes or systems should be in place to prevent or detect quickly the types of actions that occurred in WorldCom? Firstly, the main reason would be from the WorldCom’s corporate culture itself. The corporate culture did not encourage employees to come forward and voice out their opinions, instead, they were ‘taught’ to simply listened to the superiors and do what they were told. There were no official written policies or code of conduct. Because of this culture, employees felt that they did not have an independent outlet for expressing concerns about company policies or behavior. Whereas, the ‘good’ employee will be favored by the top management and receive promotion or get more employee benefits. This was what happened to Betty Vinson, the loyal manager at the international accounting division that willing to do anything she was told, and voluntarily worked over time and even while at home or on vacation. Due to the pressures given from the top management, she was forced to carry out the fraud. She was one of the big roles in releasing the accruals and capitalizing unnecessary capital expenditures. Besides that, the culture that created by Ebbers was setting the legal function aside from the management, causing it to be less influential and becoming totally useless. The head department was tabulated all over the countries. For example, the department of human resources was in Florida, while the legal department was in Washington, D.C. This far away departments and having different types of management style creating an environment that was not synchronized and it was hard to communicate each other. In addition, due to the environment that was totally controlled by the top executives’ management, the internal audit function becoming useless and several employees don’t even

knew their existence. The internal audit reported directly to CFO Scott Sullivan for most purposes and they were not allowed to speaking the truth to the external auditor. Secondly, the next reason would be the distant relation of the board of directors. The board composition was made up of 50% non-executive directors and it included experts in law, finance and the telecommunication services. However, to some extent, the board was just like a puppet of the executives. They got power but they didn’t /can’t use it. Even the board meetings were presided by Ebbers. The same goes with the audit committee and the compensation committee. This was then leading the investigative committee to conclude that the board played far too small a role in the life, direction and culture of the company; the Audit Committee did not engage to the extent necessary to understand and to address the financial issues presented by WorldCom; and the Compensation Committee dispensed extraordinarily generous rewards without adequate attention to the incentives they created and presided enormous loans to Ebbers. Third and lastly, was the auditor; Arthur Andersen. The Andersen, as the external auditor had carried out various type of audit on WorldCom, starting from the old-fashioned way until a more sophisticated and efficient audit procedures. In 1999 to 2000, the risk management software program carried by Andersen had rated WorldCom as a ‘high-risk’ of committing fraud client. However, Andersen did not modify its approach and despite of that, it continued to audit WorldCom as a ‘moderate-risk’ client. The processes or systems that should be in place in order to prevent or detect quickly the types of actions that occurred in WorldCom would be as following. First, the corporate culture should encourage whistle-blowing or in other words, encourage employees to stand up and voice out their opinions regarding any matters that they felt important. A transparent and forthright corporate culture should be implemented. The corporate culture should encourage and expect ethical conduct, and exemplified by the Company’s Code of Ethics which had been signed by the senior management in order to show their commitment towards implementing it. The culture should also make the legal function influential by giving them space to help in decision making process and in the management of the company. Second, a formalized and well-documented accounting policies and procedures should also be carried out including setting up a robust internal control in the process of reporting the financial data. As we can see in the case, due to there is lack of controls, the superiors can easily pact with the employees in committing fraud or threat the employees to do the fraud. This control will actually prevent fraud or alliances among the superiors and the subordinate in misrepresenting the actual data to the public.

Third, there should be open and luminous dealings with the external auditor, which will reflect the critical role they played. External auditor played a significant role in helping companies making a right decision. However, if the auditor is not allow or prevented to know the real condition of the company, or were not disclosed enough, were provide with the wrong information, then the auditor’s roles will diminished as they will analyze it and get the inaccurate result. Nonetheless, still it will be the auditor fault if they had knew that the client is a high-risk of committing fraud but it still insisted to carry on the audit without reporting it to related authorities. 4. Were the external auditors and board of directors blameworthy in this case? Why or why not? Yes, they should be blame. The board of directors who should actually monitor the executives, helping in the direction of the company; instead was just like leaving everything to the management itself to do whatever they feel right. None of the outside directors had regular communications with the top management or with other employee outside of board or committee meetings and prior to April 2002, they were never met by themselves to discuss matter related with WorldCom. They were taking everything easy, did not do anything except attending the board meeting which was presided and decided by Ebbers, and as a return, get the dividend annually. This shows how distant they were from the management of the company. As the board of directors, they had significant role in driving the company performance towards better and higher, not to just waiting for the returns. On the other side, the external auditors should also blame. As an external auditor, they should be independent and unbiased in their decision. Just because WorldCom was its ‘flagship’ and its most ‘highly coveted’ client, didn’t means that Arthur Andersen should cover for them. Instead of recognizing WorldCom as highly fraud committed client, they change it to only moderate risk client. This shows how bias they are in order to please the customer. Even though, they were restricted in gaining access to the company information, still they manage to perform audit that shown the clue of fraud committing. Its can be clearly seen that the auditor was a part of the fraud as they rated WorldCom as fair and it was actually release information that the company was in a good condition. 5. Betty Vinson: victim or villain? Should criminal fraud charges have been brought to her? How should employees react when ordered by their employer to do something they do not believe in or feel uncomfortable doing? As from my opinion, Betty Vinson is actually a victim of the situation. For someone who was in a difficult situation like her, for sure they would also do the same. However, it was not an

excuse of doing fraud. Vinson was a loyal employees and she cooks the book on behalf of the superior, the CFO Scott Sullivan and the director David Myers. Something to note that, Vinson was actually known from the beginning that the things she was asked to do was something wrong. However, she and Troy Normand were later persuaded with the words from Myers, and at last they were swallowed by his words. Being convinced that it will be the first and the last, Vinson and Normand make the release of accruals. Nonetheless, things did not end up. There had always the second, the third time and more, until the total releases of accruals was summed up to be around $ 3.3 billion. She had once decided to resign but because of the interdependence of family financial sources lies on her shoulder, so she did not quit her job and keep obeying her superiors’ commands. For the things that she had done, of course criminal fraud charges should be put on her no matter what excuses it is. Nevertheless, she had pleaded guilty for conspiring in committing fraud together with the others and she was released on a bond secured by $ 25,000 of equity in her home instead of carrying the sentence of 15 years in prison. I think this is best enough for her and the experience should be a lesson for her in the rest lifetime to not ever commit fraud again. Absolutely when one employee was asked to does something uncomfortable or something wrong, they should directly reject it. However, things were not as easy as we think. When employee rejects an employer request, then there should be a consequence, whether they will be fired or they would be discriminate than other ‘loyal’ colleague. Everything was actually depending on one’s principles and determination. If the employees really hold to ethical values and he/she always believe in God, believe that God will give a better return if she do the right things, then they should just not do it. If it was hard to quit job as it is harder to get a better job, then they need to gather up some courage and report it to higher superiors or report to other professional body, which in other word means, be a whistle-blower for the company.