WorldCom Accounting Scandal - Report Example

WorldCom Accounting Scandal Order No.212928 March 2008 WorldCom Accounting Scandal WorldCom’s $3.8 billion accounting scandal is one development in Corporate America in recent times that shocked everyone, from employees to small investors to even President George Bush. WorldCom is Americas second-largest long-distance phone company. Market scandals; many times have been the result of "sleight of hand". Accounting scandals according to Wikipedia mainly "involve complex methods for misusing or misdirecting funds, overstating revenues, understating expenses .........." (Wikipedia). WorldComs downfall is a story of greed, a story of a corporate resorting to financial and accounting manipulations to satisfy this greed. (ICMR) WorldCom began as tiny company in the 1980s and soon grew to become the second largest long distance phone company in the world. It grew as a result of more than 60 acquisitions in the past 15 years Its takeover of long-distance provider, MCI, in 1997 became one of the major success stories of the 1990s This rapid growth stopped suddenly when regulators stopped WorldComs proposed merger with Sprint. From 1999 to 2002 the company indulged in fraudulent methods to cover its financial conditions to support the price of its stocks. The following paragraph from Wall Street Journal (2002) article elaborates: By 2000, WorldCom had started to rely on aggressive accounting to blur the true picture of its badly sagging business. A vicious price war in the long distance market had ravaged profit margins in the consumer and business divisions. Mr. Sullivan [WorldCom’s former chief financial officer] had tried to respond by moving around reserves [for bad debt], according to his indictment. But by 2001 it wasn’t enough to keep the company afloat. And so Mr. Sullivan began instructing Mr. Myers [senior vice president and controller] to take line costs, fees paid to lease portions of other companies telephone networks, out of operating expense accounts where they belonged and tuck them into capital accounts, according to Mr. Sullivan’s indictment. In short WorldCom had used illegal accounting practices to cover $3.8 billion dollars expenses it had incurred under capital expenses thereby falsely inflating profits. This inflated the price the companys stock and justified high salaries being given to executives. Shortly after the scandal became public, the company announced that it would lay off 17,000 employees. In 2002 WorldCom announced bankrupcy and also announced that it had manipulated its reserve accounts. The WorldCom scandal according to Investopedia, is considered as one of the worst corporate crimes in history. (Investopedia) Several former executives were involved in the fraud.  The company founder and former CEO Bernard Webbers was sentenced to 25 years in prison, and former CFO Scott Sullivan received a five-year jail sentence. Arthur Anderson was WorldComs auditor while the inappropriate accounting was taking place. WorldCom, in its official statement said that accounting irregularities came to light during a routine audit. But according to the Wall Street Journals online edition, the firms internal auditor, Cynthia Cooper, met with resistance from WorldComs former chief financial officer, Scott Sullivan, when she confronted him with evidence of questionable accounting procedures. She then went to the head of WorldComs audit committee, who delayed taking action on her findings. (Guardian Unlimited, 2002) It can be said that it was pure greed and the way the accounting system rewards corporate managers that ultimately led to the mess WorldCom ended up in.(Mohan Babu) The accounting scandal at WorldCom was largely due to the managers trying to dress up its results by not deducting proper costs from the companys revenues. As a Business Week (2002) article tries to explain it: “During 2001 and the first quarter of 2002, the company counted as capital investments $3.8 billion that it spent on everyday expenses. This makes a difference because capital investments are treated differently from other expenses for accounting purposes. Capital spending is money used to buy long-lasting assets, like fibre-optic cables or switches that direct telephone calls, so the cost is spread out over several years. For example, if WorldCom spent $10 million on switches it expected to last 10 years, it would book a $1 million expense for 10 years. In contrast, if it spent $10 million on office space, it has to count all of that expense in the period in which it occurred. The company says the expenses that were counted as capital expenditure involve “line costs”, which is the fee that WorldCom pays to other telecom players for the right to access their networks.” WorldComs directors were silent in the boardroom while the books were being cooked up. Rather than face a jury and explain their silence or rather lapses, the directors decided to pay one-fifth of their aggregate net worth to cover up the matter. They did so only because Mr.Hevesi, comptroller of New York State and trustee of its Common Retirement Fund insisted. "I felt personally that this would be unfair and not a deterrent for future failures on the part of directors if they werent held personally liable," he said. "The notion that companies can commit fraud and that the directors can ignore that and not meet their obligations as fiduciaries and be covered by insurance is just wrong." A strong culture of secrecy saw management repeatedly conceal financial data from its board and auditors. The management also encouraged a culture that completely prohibited scrutiny and detailed questioning. This culture laid the foundation for a large number of misdeeds "WorldCom appears to have represented the polar opposite of model corporate governance practices during the relevant period," wrote Richard Thornburgh (2003) WorldCom Bankruptcy Examiner, in his report said "Its culture was dominated by a strong chief executive officer, who was given virtually unfettered discretion to commit vast amounts of shareholder resources and determine corporate direction without even the slightest scrutiny or meaningful deliberation or analysis by senior management or the board of directors." The key players in WorldComs accounting fraud were CFO Scott Sullivan, the General Accounting and Internal Audit departments, external auditor Arthur Andersen, and the board of directors. The business strategy of WorldComs CEO, Bernie Ebbers was the driving factor behind this scandal. Ebbers main focus was on achieving high growth through acquisitions. He wanted to utilize the stocks of WorldCom for this. There was a need to show an increase in income and revenue. To achieve this he resorted to financial gimmickry. The deception led to complications and the downturn in the telecommuncations industry added to the problems. A double-digit growth for WorldCom.was expected as it had achieved so much in a relatively short period. To satisfy these expectations, Ebbers had to fudge his companys books. Another major factor was Ebbers desire to amass and protect his personal finances. For this he had to show a continuous growth of net worth to avoid margin calls on the stocks he had pledged to secure loans. Names of several key players were thrown up when SEC started the investigation into the accounting fraud at WorldCom . The following high-ranking WorldCom executives and other employees were implicated Bernard Ebbers, a former CEO of WorldCom Scott Sullivan, a former CFO of WorldCom was indicted on charges of conspiracy, securities fraud and of making false statements to the SEC. David Myers, a former controller of WorldCom was charged with securities fraud, conspiracy, and false statements to the SEC. Buford Yates Jr., a former director of general accounting, pleaded guilty to charges of conspiracy and securities fraud Betty Vinson, a former director of management reporting, pleaded guilty to charges of conspiracy to commit securities fraud. Troy Normand, director of legal entity accounting, pleaded guilty to securities fraud and conspiracy charges. The board of directors failed in their half-hearted efforts to scrutinize the billion-dollar acquisitions spree undertaken by the company. For instance, the Board approved the purchase of Brooks Fiber, listening to just a 30-minute oral presentation and without going into details or the background. The Report of Investigation by the Special Investigative Committee of the Board Of Directors of WorldCom (2003) revealed evidence of the culture of secrecy prevalent in the company. There was evidence that staff were threatened when they questioned the discrepancies in the accounting. E-mails discovered by the Special Investigative Committee reveal Lucy Woods, who was previously the head of WorldComs UK operations claim that she was instructed by the management not to discuss certain numbers with Arthur Anderson, WorldComs UK auditors. In e-mail to the management, Woods mentions "getting through the meeting" with Andersen without showing them certain detailed figures and "pretending ignorance" on capital expenditure and asset impairment. A reply from CFO Scott Sullivan, said, "Thanks Lucy! Great job!" (Report) The investigations of the WorldCom fraud outline the governance practices that were followed during the tenure of former WorldCom CEO Bernard J. Ebbers. It has been found that the board of directors time and again conceded power over the direction of the Company to Ebbers. As CEO, Ebbers was allowed complete reign over the affairs of the Company. The compensation practices of WorldCom also came under scrutiny. The company gave lavish compensation that was not rational in any way. One instance of "Compensation abuse" at WorldCom is the sanction of more than $400 million as loan from shareholders to Ebbers. The loan was a questionable action by a board that was supposed to represent shareholders but seemed to be more interested in finding ways to enrich Ebbers. Also huge amounts of stock options were given to Ebbers, Beaumont, Sullivan, and others totaling millions of dollars. The board granted permission to Ebbers to pay $238 million to favored executives and employees “retention” grants without any supervision. This was in fact a kind of slush fund. Ebbers was allowed to run the Company as if he were running a private family business. Ebbers soon became an unrestrained force. The Compensation Committee of the board certainly did not act as watchdog against dangerous incentives or excessive payments as it was supposed to be doing. It was this executive compensation decisions more than anything else that laid the foundations for the fraud and this also truly represented the worst demonstration of WorldCom’s governance failures. But the strange thing is that WorldCom gave the impression that it was following most of the governance standards of that time. In fact in many areas WorldCom went beyond the accepted practices of good governance. This shows that good governance is not simply following the recommended “best practices,” but that it is very much dependent on the actions or rather inaction and attitudes of the people who govern.. It can be said that 80% of WorldCom’s directors during Ebbers tenure could be considered independent. However these “independents” had been with Ebbers for a long period and the personal wealth some had amassed was due to his actions. Therefore these called “independent” directors were independent in appearance only. This emphasizes the need for more realistic standards to decide who were independent and who had to be disqualified. WorldComs superficial compliance with “best practices” extended to the proportion of outside directors on the board. The NYSE requires only 50% of the board to be independent and for all appearances WorldCom exceeded this requirement. WorldCom was among the few U.S. companies that had the roles of Chairman and CEO separated. A few of WorldCom experienced directors would not have tolerated accounting malpractices if they were fully informed. The outside auditors did not warn these Directors of trouble, and the Audit Committee did not do sufficient work considering the size and complex nature of operations of the Company. On the other hand the board did not conduct its own systemic risk analyses. Since the fraud was deliberate with insiders in the Company perpetuating it and the internal controls were weak and ineffectual, the outside directors could not detect the fraud. To some extent the board might have been misled by the fact that the stock price was rising and hence all was well. WorldCom had a very weak compliance structure when compared to its very competitive business culture. The CEO in this case did all he could to undermine the authority of the legal department. There was no formal and separate office for Ethics and the Company never instilled in its values like truthfulness or transparency nor did it live by them. The Special Committee Report and Thornburgh have specifically mentioned that the weakness of the companys legal department was one of the reasons for the accounting and governance abuses that happened. It was the failure of Board of Directors to recognize and to deal effectively with “culture of greed” within the corporation’s top management and the failure of responsible persons within the company to fulfill their obligations to shareholders that was responsible for the scandal. Another factor that led to a complete breakdown of corporate governance was a lack of transparency between senior management and the Company’s board of directors. The checks and balances that are made to prevent irregularities failed to operate. As someone rightly said “The checks didn’t balance and the balances didn’t check!” It was, in short, a classic case of “cooking the books” (Thornburgh, 2005) Had the Board of Directors stepped in the initial period when WorldCom had just begun to manipulate , the fraud would not have reached such a magnitude. Although the Report clearly puts a great deal of the blame on Ebbers saying, "... The fraud was the consequence of the way WorldComs Chief Executive Officer, Bernard J. Ebbers, ran the Company ... he was the source of the culture, as well as much of the pressure, that gave birth to this fraud," the Board of Directors certainly shares this blame. As the Report states, "... The setting in which it occurred was marked by a serious corporate governance failure ..." The board and the executives should have been more alert and always on the lookout for wrongdoers. For instance, it is surprising that the fact that operational expenses were charged as capital spending was not noticed till the time of the crash. World Corn had been involved in 17 mergers between 1994 and 1998. This should have created suspicion in the Audit Committee or the auditors and the Board should have scrutinized the financial statement at that time. When the company cuts jobs on a large scale it should have prompted stakeholders to be alert and monitor the going-on and not allowed it to reach a crisis situation. Had the above-mentioned precautions and actions taken place, probably WorldCom would not have committed the fraud. In his report, former SEC chairman Richard Breeden (2003) has made not one or two but 78 recommendations to change corporate governance at WorldCom. To sum up had the following policies been followed : A corporate culture where ethics is expected and encouraged,an independent Board of Directors and Committees that is active, advice of lawyers when sought is respected, well formulated and documented policies wherein employees are allowed to report abuse of policies or misconduct, WorldCom would not have failed. After the scandal many questions have been asked: How did a loss of such magnitude take place? Were there no checks and balances? What were the watchdogs doing? Were the regulators sleeping? But the question that has been constantly asked is: Where was the government when Scott Sullivan at WorldCom was manipulating operating expenses as capital expenses? It is obvious that it was not watching. By deregulating the energy, cable, and other industries the Government had withdrawn from its responsibility. Regulatory agencies like the SEC were under funded Fed Chairman Greenspan (2002) has now been quoted as saying that his view had always been that government regulation of accounting was "unnecessary and indeed most inappropriate. I was wrong." Another reason for the governments negligence is that regulatory agencies are inundated with work and do not have adequate resources. SEC has to review the financial records of 17,000 public companies, thousands of mutual funds, brokerage firms and look out for corporate and market misdeeds and manipulations. To do all this the SEC has only about 100 lawyers The scandal has brought the SEC into the limelight and the role of regulators has been questioned.. Some think that the SEC’s reputation as the most powerful watchdog has been compromised. It has been criticized for its lack of independence and its inability to push through regulatory changes that would have helped to prevent the scandal. As Jabu Kuzwayo (2003) Assistant General Manager, Bank Supervision Department, South African Reserve Bank says "On the face of it, there is nothing to suggest that WorldCom’s corporate governance structures were lacking in form. A clear lesson here is that “corporate governance” is not a list of procedures.... Rather, it is the old principle of substance over form. It is a state of mind." According to Virginia Kleist the WorldCom debacle will make organizations stronger and they will not manipulate the balance sheet as readily as before. "We will see lower corporate salaries and perks at the higher management levels of organizations, a focus on long-term earnings over short-term profit goals, and a general clean up in the ranks of high level management structures and the associated boards of directors. WorldCom will end up creating some good over the long run." In conclusion it can be said that corporate governance is all about ethics. The words of Wharton legal studies professor Thomas W. Dunfee (2005) are very apt. ”In many of the classic [corporate scandal] cases, it’s clear that managers didn’t see their actions in the context of ethics,” he says. Transparency in business is very important feels Dunfee. “I like to tell them, ‘If you are writing a memo, imagine that you are cc’ing the Department of Justice.’” References 1. Business Week article retrieved from http://www.businessweek.com/magazine/content/02_27/b3790022.htm 2. Babu Mohan, WorldCom scandal: Lessons for corporate America Retrieved from http://www.itpeopleindia.com/20020722/abroad1.shtml 3. Breeden Richard, Corporate Monitor, http://fl1.findlaw.com/news.findlaw.com/hdocs/docs/worldcom/corpgov82603rpt.pdf 4. Dunfee Thomas, Corporate Fraud on Trial: What Have We Learned? Published: March 30, 2005 in Knowledge@Wharton knowledge.wharton.upenn.edu/createpdf.cfm?articleid=1131 5. Guardian Limited (2002) Retrieved from http://www.buzzle.com/editorials/7-3-2002-21702.asp 6. Greenspan Alan, Quote retrieved from http://query.nytimes.com/gst/fullpage.html?res=9C00E2DF1239F934A25754C0A9649C8B63 7. Hevesi, comptroller of New York State and trustee of its Common Retirement Fund, Quote retrieved from http://www.globalpolicy.org/socecon/crisis/corporate/2005/0109snooze.htm 8. ICMR Retrieved from http://www.icmrindia.org/casestudies/catalogue/Finance/FINC022.htm 9. Investopedia Retrieved from http://www.investopedia.com/terms/w/worldcom.asp 10. Kuzwayo Jabu (2003), Quote retrieved from http://www.reservebank.co.za/internet/Publication.nsf/LADV/9CC88CA6D414106142256D24004D1B7D/$File/Annexure_D2.pdf 11. Kleist Virginia, Quote retrieved from http://www.be.wvu.edu/bl_online/news/badnews.htm 12. Thornburgh Dick, “A Crisis in Corporate Governance? The WorldCom Experience” Retrieved from www.klgates.com/.../Presentation/PublicationAttachment/ee2da30a-9843-4264-b182-f06d9d381051/Corp_Gov.pdf 13. Thornburgh Richard, Bankruptcy Examiner, Statement Retrieved from http://judiciary.senate.gov/testimony.cfm?id=846&wit_id=2440 14. Thornburgh, 2005, Quote retrieved from http://doverfunds.com/tlone.php 15. The Report of Investigation by the Special Investigative Committee of the Board Of Directors of WorldCom Retrieved from http://www.theregister.co.uk/2003/06/11/reports_slam_worldcom_corporate_culture/ 16. Wall Street Journal (2002) Retrieved from http://www.newaccountantusa.com/newsFeat/wealthManagement/sheely_worldcom.pdf 17. Wikipedia: http://en.wikipedia.org/wiki/Accounting_scandals Read More