Worldcom Fraud Case Analysis

Accounting Fraud at WorldCom 1. What are the pressures that lead executives and managers to “cook the books”? Some of the pressures that led executives and managers to “cook the books” stems directly from the leadership of CEO Bernard Ebbers and CFO Scott Sullivan. Because of WorldCom’s growth through acquisitions focused on building revenue, its goal was to increase revenue by any means necessary. This encouragement from upper management to do whatever it takes pressured executives and managers to “cook the books” so to keep up with revenue demands. When industry conditions began to deteriorate and CFO Sullivan found their revenue decreasing, he put pressure on the accounting team into accrual releases and expense capitalization to achieve the targeted performance of positive revenue growth. 2. What is the boundary between earnings smoothing or earnings management and fraudulent reporting? Fraudulent financial reporting exists when there is material false statement, intent to deceive, and there is damage to the victim who relied on the falsified statement. Fraudulent financial reporting always violates the GAAP. Earnings management, on the other hand, does not violate GAAP. Although both fraudulent reporting and earnings management are actions to achieve targeted earnings level, earnings management is still considered within the scope of GAAP. 3. Why were the actions taken by WorldCom managers not detected earlier? What process or systems should be in place to prevent or detect quickly the types of actions that occurred in WorldCom? The actions taken by WorldCom managers were not detected earlier because senior management obstructed those who were raising questions about WorldCom’s accounting discrepancies through intimidation. It also didn’t help that the Board of Director’s connection with the company was rather minimal. At other times, senior management responded to questions about corporate adjustments with elusive or confusing explanations. At times, senior management simply refused to answer employee questions. The blame for Andersen’s failure to detect the fraud appears to lie with personnel both at Andersen and WorldCom. Certain WorldCom personnel maintained tight control over information that Andersen needed altered documents with the apparent purpose of concealing from Andersen items that might have raised questions. 4. Were the external auditors and board of directors blameworthy in this case? Why or why not? Both the external auditors and board of directors are blameworthy. The external auditors did not properly exercise audit procedures when reviewing WorldCom. They trusted WorldCom and as a result did not investigate any further. The board of directors did not play a significant enough role. Other than attending meetings, which were short and brief and did not matter much, they did not address the concerns employees had regarding the operations of the company. The board of directors wasn’t even aware of the fraudulent financial reporting.

5. Betty Vinson: Victim or Villain? Should criminal fraud charges have been brought against her? How should employees react when ordered by their employer to do something they do not believe in or feel comfortable doing? The criminal charges of one count of securities fraud and one count of conspiracy to commit securities fraud were both justifiably brought against her. Although she felt trapped by her superiors and the lack of comparable work elsewhere, she knew that she was doing was against GAAP guidelines. She had every opportunity to resign, but continued to improperly account for the line costs. When situations like these occur, where employees are almost bullied into doing what their employer wants them to do even though it may be wrong, employees need to take it upon themselves to make known their position or stance on an issue that they find more appropriate. In the case of WorldCom, Vinson should have contacted the authorities or hired a legal representative to help her decide the best course of action. 6. What went wrong with the financial reporting of WorldCom? The primary objective of financial reporting is to provide useful information. However, WorldCom did not made any attempt to provide useful financial information to present and potential equity investors, lenders, and other creditors. The senior managers subverted these objectives by focusing on revenue growth, to increase the company’s market value. WorldCom encouraged their managers to spend whatever was necessary to bring revenue to the door. Therefore, CFO Sullivan and others subverted the objectives of providing useful information to external users by using accounting entries to achieve targeted performance. In regards to accrual releases, the accounting treatment reduced expenses causing net income to be higher than it was in reality. Reducing the liability accrual by the amount of the cash payment increased its net income. Additionally, because of a failure to record expenses, reported retained earnings are higher than they should have been. Consequently, shareholder’s equity will be reported higher than it should be. Because capital expenditures appear as assets on the company’s balance sheet, and when put in service, are depreciated gradually over time. By capitalizing operating expenses, this allowed WorldCom to improperly shift these expenditures from its income statement to its balance sheet, increasing current income and postponing the time when these costs would offset revenue. 7. What could be done to prevent similar occurrences in the future? Processes or systems that should be in place to prevent or detect quickly the types of actions that occurred at WorldCom would be to randomize internal and external audits, perform audits more often, take a larger audit sample, create employee programs designed to create faithful representation and integrity, and more involvement from the Board of Directors could have all contributed to preventing or detecting more quickly the actions that occurred at WorldCom. Companies should implement other channels of communication other than just employee reporting to management. This is to allow employees within the company an opportunity to blow the whistle without fear in case they notice any major financial irregularities within a company. However, the WorldCom fraud occurrence could have been prevented if the company had good internal controls to prevent the higher-ups to order changes in accounts just to allow the company

to report phony profits. For example, the auditor cannot be part of a client’s internal control as this will impair the auditor’s independence.

AICPA Case 96-07 Part 1 1. What is the authoritative literature that Reggie Lewis should be reviewed in judging whether MiniScribe’s revenue recognition practices were consistent with GAAP? Based on your review of the literature, do you agree with Reggie or his superior? Reggie Lewis should review section 605 of the Accounting Standards Codification concerning everything surrounding revenue recognition. ASC 605-25-1 states that, “The recognition of revenue of an entity during a period involves consideration of the following two factors, being realized or realizable and being earned.” In terms of revenue realization, FASB Concepts Statement No. 5 states that, “revenue is realized when products, merchandise or other assets are exchanged for cash or claims to cash.” In MiniScribe’s case, by booking sales when goods are shipped to the warehouses rather than when they were shipped to customers to increase sales, they were not following the Accounting Standards Codifications guidelines of reporting revenues when earned. Based on these documents Reggie, and not his superior, is right to question the practices of MiniScribe in their effort to increase sales. 2. Assume you are in Reggie’s position. What would you do in the above situation? Explain in detail the rationale that supports your decision. As a part of your explanation, include a discussion of the major stakeholders of the company who would be affected by your decision. Reggie is in an extremely tough position. While his superior’s main goals are to increase sales, Reggie should realize as a worker in the company that the goal should be to increase sales ethically and by the rules. Although it might not be what his superiors want, Reggie should tell them about their faulty practices in reporting revenue. Although his boss may see this as a lack of enthusiasm to increase sales on Reggie’s part, if his boss is an ethical business person, he will realize that Reggie is only trying to help the company. If Reggie does not say anything, the company will continue their unethical practices and while they may continue to see sales increases in the couple years, in the long run not accounting by the rules will end up hurting them in the future if they end up being labeled as an unethical business. If Reggie were to bring up the faulty accounting practices to his superiors and actions were taken to correct the situation, many of the owners will be greatly affected. The presidents or owners will realize that the new CEO’s efforts to raise sales are not as effective as they may seem. If the company were to decide to revalue their revenue to correctly follow the Accounting Standards Codification, their revenue will likely take a big hit in their sales revenues but in the long run it will be better for the company as the company continues to grow. Part 2 1. What were the possible courses of action for Reggie Lewis? Assume you are in Reggie’s position, which course of action would you take? Reggie has a couple of possible courses of action. Reggie can ignore all the faulty practices he’s witnessed so far and continue with his job, with the added benefit of possibly

moving up the corporate ladder as the company continues to see improved sales; or, he can report the faulty practices to an auditor and potentially see his company go bankrupt because of all the false sales that had been recorded. In reporting the faulty practices to accounting authorities Reggie could be labeled as disloyal to the company and potentially lose his job. If I was Reggie, the course of action I would take is the ethical route. I would report the people involved to the authorities. With faulty practices only the higher up business people such as owners or the CEO stand to benefit the most and in the future, the common consumer as well as the everyday investor will have to bear the burden that the buildup of faulty revenue information. 2. As an employee-accountant, was Reggie legally or professionally obligated to blow the whistle about what was happening at MiniScribe? Did Reggie have an ethical obligation to blow the whistle? As an employee-accountant, Reggie should see himself as professionally obligated to blow the whistle about MiniScribe. Reggie is ethically obligated to blow the whistle as a business professional, although his company won’t think he is obligated to blow the whistle on them. If Reggie considers himself a “professional,” he should not hesitate in the decision to blow the whistle on his company. Part 3 1. Considering the catastrophic consequences of the financial fraud committed by MiniScribe executives, do you wish to change any of your decisions made in Part 1 and/or Part 2? Although the company ends up having to file for bankruptcy, I still wouldn’t change any of the decisions I made in Part 1 and/or Part 2. All the decisions from Part 1 and Part 2 are based on ethical values. If I were to change my answers, it would mean to ignore all the questionable and fraudulent actions WorldCom is doing in order to move up in the company. However, there is always the possibility of another whistleblower resulting in the same consequence for the company. 2. Discuss the relationship between professional ethics and professional advancement, and more generally, discuss the relationship between business ethics and business success. Professional ethics are professionally accepted standards of personal and business standards to help guide members in performing their job functions according to sound and consistent ethical principles. The relationship between ethics and advancement is whether people are willing to break their ethical values in order to climb the corporate ladder. For example, Reggie could have broken his professional ethical practices by not telling anyone the faulty practices to further advance his career. The same relationship can be said about business ethics and business success. Businesses would ignore business ethics to manipulate their financial statements to have an inflated net income, which as a result, would end up having a higher stock price.