Last week, we concluded our discussion of the Enron accounting scandal. We noted that commercial interest took precedence over allegiance to professional integrity and that the Enron case was the biggest audit failure in American history. As a result of this and other similar scandals occurring around the same time, the United States Government passed the Sarbanes-Oxley (SOX) Act of 2002 to restore the reliability of the public company audit process by, among others, prohibiting auditors from rendering consulting services for the company they are at the same time auditing. The key requirements of SOX are:
● Creation of the Public Company Accounting Oversight Board (PCAOB) to provide for an independent oversight of public accounting firms providing auditing services;
● Additional resources for the Securities and Exchange Commission (SEC) to enable it to effectively discharge its responsibilities;
● Enhanced standards for auditor independence to limit conflicts of interest; new auditor approval requirements; audit partner rotation; auditor reporting requirements; and restrictions on auditing firms in providing non-audit services for the same clients;
● Enhanced corporate social responsibility by providing for: senior executives to take individual responsibility for the accuracy and completeness of corporate financial reports; clarifications on the interactions between external auditors and audit committees; and principal officers to certify and approve the integrity of quarterly financial reports;
● New financial disclosure requirements, especially as regards off-balance sheet transactions and information on stock transactions of corporate officers; and
● Adequate internal controls to be in place as a basis for the preparation of financial statements and for securing the accuracy of financial reporting and disclosures, including certification by the responsible officers, and auditing and reporting on them by the external auditors.
We also noted that SOX-type laws have since been enacted in Japan, Germany, France, Italy, Australia, Israel, India, South Africa and Turkey. Today, we look at the WorldCom accounting scandal which is larger than that of Enron.
Background information on WorldCom
WorldCom began operations in 1983 as a small provider of long distance telephone service. It became a publicly traded company in 1989. During the 1990s, WorldCom began a series of acquisitions of other telecommunications companies, most notably being MCI Communications. As a result, it became the second largest long distance telephone company after AT&T.
In November 1997, WorldCom and MCI merged to form MCI WorldCom, making it the largest corporate merger in US history. In six years, WorldCom completed successfully 65 acquisitions. However, since funds had to be found to finance these mergers and acquisitions, the company rang up debts totalling US$40 billion. It was therefore necessary for WorldCom to maintain an income stream to enable it to maintain its day-to-day operations and to service these debts. Acquisitions, however, were not without its problems for WorldCom, the chief being managerial, especially as regards the integration of the old with the new, each having different systems and procedures, among others.
At the beginning of 2000, WorldCom and other telecommunications companies began to see their revenues decline due largely to the oversupply in telecommunications capacity and over-optimistic projection of internet growth. The economy was also entering recession. This, combined with the forced abandonment of the proposed merger with Sprint Corporation (which would have made MCI WorldCom larger than AT&T) was a serious setback for the company’s aggressive growth strategy. In January 2002, the market value of the company’s common stock was US$150 billion. By July 2002, it plummeted to US$150 million.
In order to maintain its stock price, from mid-1999 onwards, the company used accounting chicanery and other fraudulent methods to disguise its decreasing earnings and to give the impression that the company was growing and was profitable. This effort was led by CEO Bernard Ebbers, Chief Financial Officer Scott Sullivan, Controller David Myers and Director of General Accounting Buford Yates.
Discovery of the scandal
In May 2002, Cynthia Cooper, WorldCom’s internal auditor, and a small team of auditors worked secretly at nights and discovered inappropriate accounting treatment amounting to US$7.6 billion for certain transactions in order to inflate profits and hence the performance of the company. Two main methods were used:
● Charging interconnection expenses with other telecommunications companies as capital expenditure in the balance sheet i.e. treating them as assets instead of operating expenses, thereby under-reporting expenses; and
● Inflating revenues with bogus accounting entries from “corporate unallocated revenue accounts” i.e. inappropriately transferring from reserves to revenue to boost profits.
By the end of 2003, the company had inflated its assets by an estimated US$11 billion.
Sullivan, who was Cooper’s boss, tried his best to dissuade the latter from auditing capital expenditure. She, however, got more suspicious and persevered. Cooper discussed the misclassification of the accounting entries with Sullivan and Myers. She was told to ignore the problem and turn her attention elsewhere, and was even threatened in various ways. Cooper then reported the matter to the Audit Committee which in turn asked the external auditors KPMG to mount an investigation. In May 2002, KPMG had replaced Arthur Andersen who had been the auditors since 1989.
Sullivan failed to provide adequate justification for the accounting treatment and was dismissed on 25 June 2002. Myers resigned the same day. Prior to the announcement of the results of the investigation, WorldCom’s stock price had fallen from as high as US$64.50 in mid-1999 to less than US$2. With the announcement, the price fell to less than US$1.
Earlier, Ebbers had persuaded WordCom’s board to approve a US$400 million loan to assist him with his private investments. This was in the hope that he would not find it necessary to sell a substantial part of his stock in WorldCom, which would have further decreased to value of the company’s stock. The strategy failed, as the stock price continued to decline. In April 2002, Ebbers was forced to resign as CEO and was replaced by John Sidgmore. As in the case of Enron, senior executives held significant amounts of shareholdings in WorldCom. There was therefore every incentive to manipulate the accounts to show higher profits in order to boost the share price. Therein, lies a conflict of interest.
In June 2002, WorldCom announced that it had overstated earnings in 2001 and the first quarter of 2002 by more than US$3.8 billion and that it had manipulated its reserve accounts in recent years in the sum of an additional US$3.8 billion.
Given these revelations, Arthur Andersen withdrew its audit opinion for 2001. However, Andersen’s work as the external auditors was seriously called into question. The auditing firm defended its position by stating that it was not informed of the inappropriate accounting treatment referred to above. However, Andersen had a professional duty to evaluate the internal controls of the organization and to design tests to detect material errors which can result in a misstatement of the financial statements. To this extent, Andersen had failed in its duty.
The SEC began its investigation in June 2002, and in July 2002, WorldCom filed for Chapter 11 bankruptcy protection, the largest at the time. Smarting from the Enron scandal, the SEC obtained a court order barring the company from destroying financial records, limiting payments to current and past executives and requiring an independent monitor for the company.
Aftermath of the scandal
At the end of 2000, some US$642.3 million of retirement funds were held in stocks. After the revelations of fraudulent transactions, the value fell to less than US$18.7 million. In addition, after 25 June announcement, WorldCom stated that it would cut 17,000 out of 85,000 of its workforce. WorldCom emerged from Chapter 11 bankruptcy in 2004 with about US$5.7 billion in debts and as at 2007, its creditors, who had waited several years, were yet to be paid.
In March 2005, Ebbers was convicted of fraud, conspiracy and filing false documents with regulators. He was sentenced to 25 years in prison and had agreed to relinquish his US$40 million Mississippi mansion and other assets to settle a lawsuit brought by investors who had lost billions of dollars in the scandal. Sullivan received five years after he entered a guilty plea in March 2004 and surrendered his US$11 million mansion in Florida. Myers had pleaded guilty in September 2002 and received a one year and one day sentence.
Cooper was named one of Time magazine’s “person of the year” for 2002. She wrote a book about her life and the WorldCom fraud entitled “Extraordinary Circumstances: The Journey of a Corporate Whistleblower”, published in 2008. In an interview in February 2008 with CFO Magazine, Cooper expressed the view that the reporting structure of the internal audit function often presented a conflict of interest in that many chief audit executives still reported to Chief Financial Officers who determined their compensation. She advocated that the reporting relationship, both functionally and administratively, should be to the audit committee, or alternatively functionally to the audit committee and administratively to the CEO. Since then, internal audit has come a long way with many chief audit executives now reporting functionally to audit committees. Cooper had the following advice to give:
I encourage people not to give in to the thinking that fraud won’t happen in their companies. History has a way of repeating itself, and based on human nature there will always be fraud. When there’s increased pressure due to another boom-and-bust in the market, there may well be another rash of frauds. I think we have to do our best not to forget what we’ve been through and hold tight to the positive changes in corporate governance that many people have worked to achieve.
