WORLDCOM ACCOUNTING FRAUD - Essay Example

? WORLDCOM ACCOUNTING FRAUD WorldCom is a telecommunication giant in the US telecommunication industry. Faced with the slowdown in the telecommunication industry, WorldCom began to realize a decline in their stocks. This placed the company management under pressure to improve their financial performance in the highly competitive industry. WorldCom is a company that realized growth through evaluated mergers and acquisition that enabled it recorded immense growth and control in the telecommunication industry (Clikeman, 2009). After attaining a peak in the telecom boom, WorldCom Inc. was rated at $ 180 billion. Thereafter, the company company’s credit ratings declined and they started facing job cuts. Consequently, the share prices declined from $64 to $2.65. This decline in the stock prices caused a shock in the financial market and this negatively affected the telecommunication sector and shares of the other sectors of the economy. Banks intensified pressure on the then CEO, Benard Ebbers to restore margin calls on his WorldCom stock utilized in other endeavors (Markham, 2006). Because of the slow down turn, the company profitability was hardly hit in 2000 forcing the company to rescind its earlier decision to merge with Sprit. How the fraud was committed Considering the consolidated income of the company from 1997 to 2001, WorldCom realized a decline in the operating margin in 1988. In the year 2001, the operating margin was -5.51% compared to the previous year where the company realized a profit margin of 13.78% (Clikeman, 2009). Owing to this decline in performance, the management engaged in manipulation of the financial statements to conceal the performance that could result in the share prices. Investors are interested in the financial performance of a company and any loses can force investors withdraw their investment and cause companies to collapse. The manipulation of the financial statements was successful in the year 1999 and 2000 where a profit margin of 21.96% and 20.85% was reported. In 2001, it was impossible to hide the falsified statements to reflect better financial performance (Kaplan & Kiron, n.d.). In this year, the manipulated company profits declined from 20.85% in 2010 to 9.98%, a decline of more than 50%. This year saw the WorldCom split into MCI WorldCom Inc and WorldCom Inc that continued to sell voice and data to corporations. The question on the stability of WorldCom aggravated the situation in 2002 and saw investors start believing that WorldCom had off-balance sheet finances apart from the increasing debt that deteriorated the company’s status (Kaplan & Kiron, n.d.). Efforts by the CEO to explain that the whole industry was experiencing acute problems were ignored. The CEO asserted that competitors were going out of operation because of the hard economic times since the revenues declined sharply. The growth in the mobile phone usage further threw the telecom sector in many problems. WorldCom was compelled to restate the financial performance that revealed losses in the year 1999 to 2001. In the restatement, the capitalized line costs were reversed and the costs that were manipulated to show small amounts were corrected. Since the line costs account for about 40-45%, its manipulation had to result in material financial influences (Kaplan & Kiron, n.d.). For instance, the manipulatedincome statement showed a profit of $1407 million instead of a loss of $1648million, which is an accounting fraud. The violation of the generally accepted accounting standards by capitalizing expenses resulted in creation of worthless assets. This has been considered the largest accounting fraud that was straightforward and that should have been detected by simple audit procedures. In the year 2001, the CEO persuaded the board of directors to offer him a loan and guarantees summing to more than $400 million to cover the pressure from the banks. His request was however rejected by the board that was later ousted as the CEO of the company. The company CFO, Suvellian then took control with assistance from David Meyer who was the controller and Buford Yates who was the director of general accounting. The three tried to mask the deteriorating financial situation by contravening the accounting requirements. Moreover, they provided false forecasts that were relied upon by the stakeholders as an improvement on the profitability and a mitigation of the plummeting stock prices. These illegal actions were first discovered in June 2002 by the internal audit department. The audit committee and board of directors received the notification and later fired Sullivan while Myer resigned. The security exchange commission launched an investigation into the fraud and by 2003, it was estimated that the assets had been inflated by about $11 billion. WorldCom thereafter filed a bankruptcy protection in July 2002 to protect the owners from further losses. From the unfolding, it came out that the company debt was around $5.7 billion. Legal theories that were violated by WorldCom management The code of conduct and other accounting regulations places on them a liability to parties who rely on their work. The main legal theory that the act has for accountants is that of negligence. Negligence is a tort that is committed by a party and affects the position of other parties whom he owes a duty of care. For there to be negligence, there must be proved a duty of care that must be breached for the action to suffice. Accountants’ role is that which is critical as it affects the decision made by various parties contracting with the company. For instance the investors, both potential and existing investors, depend on accountants report. The reports made by accountants, is also used by unknown third parties. The accountants therefore have the legal obligation to consider their liability on other parties who rely on their work whether known or unknown parties. In the case of WorldCom Inc., the company accountants violated their legal liability when they manipulated the financial statements to mask the actual financial position of the company. They therefore breached the duty of care. By breaching this duty, the users incurred financial losses that could be determined and measured in monetary terms. The prerequisite of negligence was therefore met making the actions qualify for negligence. Similarly, the auditors’ actions were also negligent. Anderson by failing to develop audit procedures that could uncover the fraudulent actions of WorldCom accountants makes them negligent. They failed to consider that there report would be depended on by third parties and owners of the company. Besides, the board of directors failed to carry out their role of supervising the management to ensure that the company was well managed. They were therefore negligent of failing to carry out their legal mandate and this led to losses to users of the financial statements. Negligence is an important legal liability that accountants should avoid losses that might arise to the investors and cause panic in the financial market. Secondly, the company management violated the requirements of accounting standards board by altering the financial statements hence defrauding the investors and third parties. The international accounting standards and the SEC regulations require the management to provide financial statements that give a true and fair view of the company’s financial performance (Corporate scandals, 2007). By inflating the financial statements to mask the financial crisis that was looming, the company CEO together with the accountants who engaged in the preparation of the financial statement committed fraud that is actionable in a court of law. The shareholders, creditors and other stakeholders who recorded financial losses have the legal ability to sue the company management for fraud that led to their financial losses. Additionally, a company is not expected to give a loan or any financial assistance to the managers so long as the loan transition is not ordinarily a business course. Giving a loan of $400 million to the CEO was a breach to the legal requirement (Matulich & Currie, 2009). Through this loan, the management covered the losses that it had incurred to help make the financial statement have a better picture. This deprived the users of the financial statement the ability to make informed decisions as losses were hidden. Insider dealing as a legal requirement was also commited. The security exchange act requires company insiders who have some access to internal information not to use this information at the disadvantage of external parties. Company management, employees, directors, and other parties who contract with the business are considered insiders because they have information that is not available to the public. In the case of WorldCom, Ebber who was the former immediate CEO had information about the declining financial information (Matulich & Currie, 2009). Because of this, the company’s stock were bound to fall and cause losses to the investors and other outsiders. Ebber, being privy to the information started selling his stock to get cash to repay personal debts. This action would make the owners incur more losses than normal losses Moreover, the auditors of WorldCom also violated the legal requirements in making their report. Auditors in executing their mandate are required to give an opinion on the financial statement. They therefore have the risk of giving a wrong opinion to the users of the financial statements. In this case, the auditors of WorldCom failed to detect the fraud and violation of accounting standards that guides the preparation of the financial statements (Markham, 2006). In as much as the management can fraudulently conceal its illegal actions, auditors are expected to adopt procedures that can reveal the extent of fraud and misstatement. The loss that was incurred by WorldCom was enormous and a standard audit procedure ought to have disclosed the nature and magnitude of the losses. Those who relied on the auditors’ report and incurred losses had their rights violated and can institute legal proceedings against the auditors. To begin with, substantive audit procedures could have discovered the wrong entries made to the financial statements. WorldCom accounting fraud is considered to be much open and involved cooperation and collusion of many parties. Andersen claim that their assignment was that on standards is insufficient defense that should not be relied on. Later on when it became public that the financial statements were falsified, Andersen gave a disclaimer statement to their previous report in as much as it was already untimely. The WorldCom accountants’ understatements of costs made the financial statements look lucrative in the eyes of its users while this was not the situation. The auditors ought to have detected the violation of the accounting principles that prohibits the understatement or overstatement of expenses. Secondly, the preparers of the financial statements capitalized the costs that were supposed to be expensed. By capitalizing these costs, the balance sheet figures were inflated hence winning the reliance of the investors and creditors of the company (Scharff, n.d.). From the balance sheet, the financial strength and base of the company is weighed. High balance sheet figures will mean better ability to repay debts and expand. This violation to the accounting requirement could have been detected and reported if the necessary procedures could have been put into position. In addition, the board of directors violated their legal mandate of providing supervisory roles to the management. BOD has the mandate of ensuring checks and champions for the interests of the owners’ and external parties who are not involved in the day-to-day operations of the business. By failing to closely monitor the management and their performance, they gave loopholes that were used by the CEO and CFO in orchestrating fraud. Consequences to various parties To begin with, the fraud resulted to the firing and resignation of the top company management. The company CEO after being discovered to have engaged in fraudulent actions was fired by the board of directors thereby losing his job (Scharff, n.d.). Furthermore, the court proceedings resulted in the conviction of the CEO. The employees of the company were also affected by the scandal. After the scandal, 17000 workers were laid from work due to the reduction in the scale of operation (Scharff, n.d.). Creditors of WorldCom were also destabilized by the shock in the financial performance of the business. Creditors are the external parties who give loans and advances to the business in return on interests and repayment of the loan amount. By not being involved in the management process, they wholly depend on the financial statements that are prepared by the management and audited by external accounting firms. This implies that the creditors relied on the publicly availed financial statements. The understatement of costs and capitalization of expenses that improved the financial outlook of the company made the creditors lose incur losses after the bankruptcy proceedings. Besides, the investors also lost the value of their investments in the company. After the accounting fraud, the prices of the stocks significantly declined from over $60 to less than a dollar. This thereby caused the investors top record huge losses on their money. Returns on shareholders investments is either from increasing share prices or dividends paid by the company. Significant decline in the share price therefore cause losses to the company. In addition, the financial sector was also hit by the scandal. The performance of the financial sector depends on the stability of the individual stocks. A shock in the stocks of one firm in the market can cause contagion in the financial sector and send the whole market into disarray. Because of the scandal, the share prices in the telecom and telecommunication sector together with those of other sectors were adversely affected. Business ethics is intended to direct business persons conduct their activities by adhering to the code of conduct and in facilitating the confidence of the public on the services and products that are provided by the business. The accounting profession recognizes the fundamental need to remain ethical to its stakeholders. This justifies why accounting organization provide its members with ethical guidelines. Accounting ethics encompasses creative accounting; insider dealings, misstated financial statements, securities fraud, and executive compensation. For WorldCom, the management committed various unethical practices. This included the misleading financial statements that were published and relied upon by the stakeholders. The CEO further engaged in insider transaction in which he disposed a significant proportion of the shareholding to shield him from the losses. Insider transactions are those that are done by the employees of the organization or those individuals privy to information that is not in the public domain. They therefore use such information for their own gain and results to lose to outsiders. Ethical problems faced many corporations. The management also enhanced creative accounting. Creative accounting is the misrepresentation of the income statement and assets of organizations and has been a major accounting scandal (Torre, 2009). This practice violated the accountant’s ethical requirements and resulted to losses to other parties including the employees. Ethics was also breached when Ebbers sold the stock to repay his personal loans after resigning from the position of the CEO. This propelled the board of directors to extend him a loan that would help meet his financial requirement and make him stop selling his stock. The selling of the stock at a time when the company stocks were declining significantly further led to the plummeting of the company’s stock. At the time when the stock prices are falling, an insider like Ebber ought to have acted in the interest of all the investors to salvage the company from further losses. The BOD also violated the ethical requirement of protecting the interest of the shareholders. By accepting to extend loan to the former CEO who was the chief pioneer of the scandal, the directors fueled the loss to the owners and creditors. Instead of offering the loan to Mr.Ebber, the directors should have instituted legal proceedings against him. The number of accounting scandals that occurred in the late 1990s and early 2000 was because of the failure of the management and accountants to operate within the required accounting standard and legislations. There was also breach of ethical requirement by those granted the opportunity to oversee the daily operation of the company. SEC should therefore increase their supervision and closely monitor the operation of the public companies to reduce the cases of accounting fraud and to ensure stability in the financial markets. Laxity or failure to reduce the number of accounting fraud could impair investments because investors would dispose their investments and hence reduce capital availability. In conclusion, accounting fraud at WorldCom Inc made investors incur colossal losses that could have been avoided if the auditors could have executed their mandate in accordance with the accounting requirements. Organizations should try to make matters of ethics part of their culture to further reduce the losses that might arise to innocent third parties. SEC investigations should be able to uncover cases of fraud and take the legal actions on corporations, which fail to abide by the legal requirements. References Clikeman, P. M. (2009). Called to Account: Fourteen Financial Frauds that Shaped the American Accounting Profession. New York: Routledge. Corporate scandals. (2007). sl.: CBS Broadcasting, Inc.. Kaplan, R. S., & Kiron, D. (n.d.). Accounting Fraud at WorldCom - Harvard Business Review . Harvard Business Review Case Studies, Articles, Books . Retrieved April 16, 2012, from http://hbr.org/product/accounting-fraud-at-worldcom/an/104071-PDF-ENG Markham, J. W. (2006). A financial History of Modern U.S. Corporate Scandals: From Enron to Reform. Armonk, N.Y.: M.E. Sharpe. Matulich, S., & Currie, D. M. (2009). Handbook of Frauds, Scams, and Swindles: Failures of Ethics in Leadership. Boca Raton, FLA: CRC Press. Scharff, M. (n.d.). Understanding WorldCom's Accounting Fraud: Did Groupthink Play a Role? | Journal of Leadership & Organizational Studies | Find Articles. Find Articles | News Articles, Magazine Back Issues & Reference Articles on All Topics. Retrieved April 16, 2012, from http://findarticles.com/p/articles/mi_m0NXD/is_3_11/ai_n25109094/ Torre, I. d. (2009). Creative accounting exposed. Basingstoke: Palgrave Macmillan. Top of Form Bottom of Form Read More