Success of WorldCom - Case Study Example

INTRODUCTION By all accounts, WorldCom appeared to be a great success story. In 1983 partners led by former basketball coach Bernard Ebbers, sketched out their idea for a long distance company on a napkin in a coffee shop in Hattiesburg, MS. Their company LDDS (Long Distance Discount Service) began providing service as a long distance reseller in 1984. For 15 years it grew quickly through acquisitions and mergers. Bernard Ebbers was named CEO in 1985 and the company went public in Aug. 1989. Its $40 billion merger with MCI in 1998 was the largest in history at the time. The company was a favorite with investors and Wall Street analysts. The stock ran up to a peak of $64.51 in June 1999. At that time CEO Bernard Ebbers was listed by Forbes as one of the richest men in the US. Michael Jordan, the most popular athlete in the world, provided commercial endorsements. In October 1999, WorldCom attempted to purchase Sprint in a stock buyout for $129 billion in stock and debt. The deal was vetoed by the Department of Justice. At the same time, the success began to unravel with the accumulation of debt and expenses, the fall of the stock market, long distance rates and revenue. It would tale 2 years for extent of these problems to become public. WorldComs 2002 has been a horror story with accounting scandals, SEC investigations, the resignation of CEO Bernard Ebbers, possible bankruptcy and a stock that is worth less than a payphone call. FRAUD AT WORLDCOM In June 2002, Securities and Exchange Commission (SEC) lawyers filed civil fraud charges against WorldCom for what would later be estimated at over $9 billion worth of accounting errors. While the current suit wasn’t filed until June 2002, it is apparent that some in the public were aware of illegal practices at WorldCom over a year earlier. A previous lawsuit was filed in June 2001 by several WorldCom shareholders, only to be thrown out. That suit included testimony from a dozen former WorldCom employees, detailing the same problems that would eventually bring about the company’s downfall. WHY WAS THE FRAUD COMMITTED Unlike Enrons scam the theory behind WorldComs scandal is much simpler - treating operating costs as capital expenditure meant that the costs could be depreciated in pieces over time. Hence this meant that expenses incurred in the year would not have such a great impact on its cash flow, but instead push expenses were been pushed into the future. The problem therefore arose because all this was doing was delaying payments in the financial statements, but after all the costs were going to be incurred. Hence the company would have to hope that more revenue was going to be received over the next years and so WorldComs CFO defended his actions by stating that because WorldCom wasnt receiving revenue, he could defer the costs of leasing the lines until they produced revenue. His mistake was that he was doing this in the anticipation that the agreements would start producing revenue later, but he ended up discovering that 15% of these connection agreements were not producing revenue. DESCRIBE THE FRAUD Financial executives at WorldCom exercised various methods of hiding expenses for a period of more than two years between 2000 and 2002. They delayed reporting some expenses and misrepresented others to give investors the appearance of growth during secretly hard times. The accounting fraud at WorldCom involved, among other things, the improper classification of $3.8 billion in ordinary costs as capital expenditures in violation of generally accepted accounting procedures which led to WorldComs overstatement of earnings.  In 2000, Grubman adopted a new accounting model designed to omit the influence of capital expenditures a key element of WorldComs accounting fraud.  This model was initially adopted for WorldCom alone among all of the telecom companies Grubman followed.      SSB and Grubman knew, or by the exercise of proper due diligence should have known, that WorldComs financial condition was deteriorating.  In early 2001, WorldCom badly needed to raise money and approached Citibank, and others about refinancing a $3.75 billion line of credit.  The Citibank loan approval memo, dated March 2001 discussed WorldComs negative cash flows for fiscal 2001, 2002 and 2003.  According to the memo, WorldComs negative free cash flow   essentially how much more it would spend than it took in   was expected to be $1.4 billion in 2002 and 2003.  The proceeds from a planned 2001 $11.8 billion note offering were going to be used to refinance $9 billion in debt, including $3 billion in short-term notes that were issued in 2000 but were coming due in 2001.  Despite internal views about the financial deterioration of WorldCom, Citibank approved the loan.  The March 2001 loan approval memo noted that Susan Mayer, former treasurer of WorldCom, had told Citigroup that if it committed $800 million to the $3.75 billion line of credit for WorldCom, Salomon Smith Barney would be awarded a coveted role as co-manager of the big note deal, earning $20 million in investment banking fees.  (New York Times, 3 Banks Had Early Concern About WorldCom Finances, March 17, 2004) WHY THE FRAUD REMAINED UNDETECTED The audit provided new insights into the nature and the magnitude of the fraud at WorldCom. In fact, the same complexity that made the audit so difficult was one reason the fraud was able to go undetected for so long. As a result of Ebberss acquisition spree, WorldCom had also acquired a slew of accounting systems that were integrated loosely, if at all. By Blakelys reckoning, there were 60 billing platforms and more than 20 accounts-receivable systems. The numbers rolled up from the various operating units to the companys former headquarters in Clinton, Mississippi. There, it was easy for accounting staffers to simply change the numbers. "It was a very low-tech fraud in a sense," says Richard Breeden, a former SEC chairman and MCIs court-appointed corporate monitor. "If [a WorldCom employee] didnt like the figure he got, he just changed it." He says it was not unknown for accountants at headquarters to come to the office and find Post-it notes on their computer monitors telling them to change numbers. Breeden says that in some quarters, imaginary revenue was added to the books using consolidated entries in big, round numbers that "didnt even look real." Breeden also describes a command-and-control structure with a lot of power concentrated at the top. In his report of recommended reforms, he noted that Ebbers ruled with "nearly imperial reign." "The attitude at the company was that orders were to be followed, and it was clear that anybody that didnt would be fired," says Breeden. Along with the big stick came a few carrots. A generous stock-option plan was supplemented by a $238 million "employee-retention program" that was dipped into and doled out at the discretion of Ebbers and Sullivan. "It was basically a slush fund to give out quiet money" says Breeden. Sullivan wrote personal checks for $10,000 to some employees, he says, and gave $10,000 more to their wives. Breeden and Blakely say that the fraud involved fewer than 50 people, mostly those who rolled up the financial statements in Clinton. When managers at operating units saw the consolidated financials, they were surprised how well the rest of the company seemed to be doing when the numbers they reported were so poor. Dennis Beresford, a former chairman of the Financial Accounting Standards Board who now chairs MCIs audit committee, led one of two internal investigations into the fraud. Hes convinced that everyone involved has been removed from the company. Beresford says WorldCom asked about 50 executives in the finance department to leave after the investigation showed they either took part in the accounting fraud or should have known about it. "We had too many people who looked the other way," he says. In March, Sullivan agreed to plead guilty to securities fraud, conspiracy, and giving false statements to regulators. Those crimes could carry a sentence of up to 25 years in prison under federal sentencing guidelines, but Sullivan hopes to get less in exchange for his testimony in the trial against Ebbers that is scheduled to begin in November. Former controller David Myers and accounting executives Betty Vinson and Troy Normand have also pleaded guilty and are cooperating with authorities. Impressive as it was, cleaning up the fraud wasnt enough to restore the confidence of WorldComs customers; Blakely had to make sure that nothing remotely like Sullivans manipulations could ever happen again. In July 2003, WorldComs largest customer, the federal government, had barred it from bidding on federal contracts while it reviewed whether the company should be placed on an "excluded parties" list. "Getting that [ban] lifted was the highest priority," says Blakely. "If the government doesnt want to do business with you, why should anyone else?" The two main concerns identified by the General Services Administration, which administers the list, were controls and ethics. Indeed, KPMG, which succeeded Arthur Andersen as WorldComs auditor, had identified 96 control issues, and a separate assessment by Deloitte zeroed in on several other "high risk" areas. With help from both accounting firms, Blakelys finance team put together a "heat map" that listed high-priority risk areas, and then went about fixing them. The solutions included adding basic checks and balances such as segregation of duties among finance staffers, limited access, and documented policies. The company then implemented a much more stringent, and inclusive, policy for closing the books. "It is impossible to completely eliminate the possibility of fraud," says Blakely. But, he says, the hundreds of added controls will greatly diminish the chances of it reoccurring. MCI was also forced to implement what is likely the most stringent set of corporate-governance practices ever adopted. As part of WorldComs $750 million cash and stock settlement with the SEC, it agreed to accept all the recommendations of the court-appointed monitor. Breedens 150-page report on corporate governance, "Restoring Trust," lists 78 recommendations, includes the separation of the CEO and chairman roles and the required removal of one board member each year to make room for a new director. "Some [of the requirements] go beyond what is reasonable," contends Beresford. "But we have no choice but to accept them." As for ethics training, MCI put the entire company of 50,000 employees through a course designed for it by professors at New York Universitys Stern School of Business. In addition, 90 executives attended a two-day ethics program at the University of Virginias Darden School. Not surprisingly, MCI is trying to keep ethics in the foreground. Large banners proclaiming the companys "guiding principles" festoon the halls of its Ashburn, Virginia, headquarters. They include such mottos as "Everyone should feel comfortable to speak his or her mind" and "Do the right thing." The principles are also printed on the back of employee security badges. All these measures were enough to convince the government that MCI had reformed. Last January, it lifted the debarment just in time for the renewal of a contract worth as much as $400 million. THE ROLE OF INTERNAL AND EXTERNAL AUDITORS WorldCom, the nations second-largest long-distance phone company was also found guilty of accounting fraud. The basis of this fraud was very similar to that of Enron in that it used window-dressing to inflate profit. However WorldComs major sham was that they disguised $3.8 billion in expenses over 15 months. This was carried out in the strategy operated by their Chief Financial Officer, in which operating costs like basic network maintenance and line-costs were booked as capital investments. Unlike Enrons scam the theory behind WorldComs scandal is much simpler - treating operating costs as capital expenditure meant that the costs could be depreciated in pieces over time. Hence this meant that expenses incurred in the year would not have such a great impact on its cash flow, but instead push expenses were been pushed into the future. The problem therefore arose because all this was doing was delaying payments in the financial statements, but after all the costs were going to be incurred. Hence the company would have to hope that more revenue was going to be received over the next years and so WorldComs CFO defended his actions by stating that because WorldCom wasnt receiving revenue, he could defer the costs of leasing the lines until they produced revenue. His mistake was that he was doing this in the anticipation that the agreements would start producing revenue later, but he ended up discovering that 15% of these connection agreements were not producing revenue. Surprisingly WorldComs auditors were also Arthur Andersen LLP, who says that they were never consulted or notified about the line-cost capitalization. However an accounting professor at Columbia Business School in New York went against them in saying that auditors are supposed to look at material expenditures and make sure they are reported properly, this is accounting 101. (WorldCom Accounting debacle) Nevertheless WorldCom was forced to replace Andersen, who were been described as the scandal-plagued Arthur Andersen, with KPMG. Ironically KPMG are currently been sued in respect to the Xerox scandal mentioned below. Though its involvement in the WorldCom scandal is doubted because of its late involvement with this case. COMMENTS AND CONCLUSION The accounting fraud at WorldCom amounted to a decision by its ousted chief financial officer to categorize as long-term investments money paid to local phone companies to complete calls. At the beginning of 2001, Scott Sullivan, who lost his job when the $3.8 billion scandal came to light this week, took that fateful decision after discovering that at least 15% of these connection agreements werent producing revenue, The Wall Street Journal reported Thursday. Sullivan decided to capitalize the so-called "line costs" as long-term investments to be written down over time, hoping the agreements would start producing revenue later, the newspaper reported. WorldCom shook corporate America Tuesday night by announcing it would be forced to restate five quarters of earnings statements to reclassify the expenses as routine costs. The revelation sent its stock down to pennies a share before it was halted by NASDAQ and prompted the Securities and Exchange Commission to file criminal charges against the former highflier. The companys top accountant, Sullivan became a close ally of former WorldCom chief executive Bernard Ebbers in 1992 when Ebbers company acquired Sullivans Advanced Telecommunications Corp. The two shared adjacent offices until Ebbers were ousted by the WorldCom board in April. Read More