The accounting fraud at Worldcom was participated by the company's CFO, Scott Sullivan, the external auditor Arthur Andersen, and the company's board of directors. This case study looks at the fraud scenario and why the top management of the company failed to avoid it. It also looks into how the company can avoid the future happening of the same problem.
Robert S. Kaplan and David Kiron
Harvard Business Review (104071-PDF-ENG)
April 29, 2004
Case questions answered:
- What are the pressures that lead executives and managers to “cook the books” at WorldCom?
- What is the boundary between earnings smoothing or earnings management and fraudulent reporting?
- Why were the actions taken by WorldCom managers not detected earlier? What processes or systems should be in place to prevent or detect quickly the types of actions that occurred in WorldCom? Discuss mainly the failures in WorldCom’s (1) leadership & culture, (2) internal controls, and (3) internal audit to detect the fraud earlier.
- Were the external auditors and board of directors blameworthy in this case? Why or why not?
- Is Betty Vinson a 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 uncomfortable doing?
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Accounting Fraud at WorldCom Case Answers
1. What are the pressures that lead executives and managers to “cook the books” at WorldCom?
The main strategy of WorldCom was achieving growth through acquisitions. The company managed to perform 60 acquisitions and, in 1999, tried to merge with one of its biggest competitors: Sprint. However, such mergers would discourage competition in the industry of telecommunication. Thus, it was terminated by the U.S. Department of Justice.
Because of the termination, WorldCom’s strategy wasn’t applicable anymore to achieve the growth they desired. In addition, the company’s determination toward growth and revenue was so great that they failed to understand that the growth they desired was accompanied by the necessity to maintain being successful. This was the starting point of the fraudulent activities.
WorldCom’s goal was to become the most valuable stock on Wall Street, which intensified the pressure of the executives to satisfy the criteria of Wall Street’s analysts and to realize that revenue growth was necessary.
Managers and executives pressured to maintain a low E/R ratio (approximately 42%) were obligated to use whatever measure necessary to satisfy the requests of the top management.
In addition, because of the increased competition in 2000 and the reduced demand, the conditions of the telecommunications industry worsened. As a result, Worldcom was obligated to lower its prices like the other competitors, which eventually increased the pressure on maintaining the low ratio since it was almost impossible to have high revenues in conditions where all other telecommunication companies were suffering.
Ebbers was perceived as a great and honest figure in the business world, where many investors were guided by him regarding investment decisions. Thus, he felt the pressure to carry on and be that kind of figure to the public and investors.
Both Ebbers and Sullivan were living an expensive life buying mansions and yachts, so the greed to have more and the fear of losing their money created emotional pressure on them.
The pressure implemented on the executives and managers was deeply interconnected to the corporate culture. The absence of a code of ethics and the fact that employees did not have full access to information can very well imply that they were not aware of the consequences of their actions (i.e., registering existing customers as new). We will explain more in detail the corporate culture of WorldCom in question nr.3.
Another pressure the employees faced was the absence of a channel where they could express all their complaints and worries regarding the actions and approach of the company.
Even employees who expressed their discomfort and attempted to resign failed to do so because of the need to financially support themselves and their families. The pressure to cook the books was also enhanced by the personal statement that Ebbers did, by imposing somehow fear to the senior staff that if they didn’t do what he was requesting, the company and them included would lose everything, so frightened they would lose their job, managers were pressured to do anything to improve the performance of the company.
2. What is the boundary between earnings smoothing or earnings management and fraudulent reporting?
According to ‘Commentary on earnings management (Schipper, 1989)’, earnings management is a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain.
In other words, it is to adjust financial and production decision-making within the scope of financial accounting standards and to adjust reported profits through accounting estimation or selection of accounting methods.
Another concept of earnings management, earnings smoothing, also called income smoothing, is to adjust the reported earnings to be close to the target earnings to prevent them from fluctuating significantly between accounting periods.
For example, when the achieved profit exceeds the target profit, an adjustment is made to reduce the actual profit closer to the target profit in order to adjust the profit target for the next year.
Earnings management increases the range of earnings fluctuations, but earnings smoothing is implemented to reduce the range of earnings fluctuations. If the range of profit fluctuations increases, it becomes difficult for investors who invest by analyzing the company’s financial statement to predict investment profit and make rational decisions.
As the investor’s investment potential decreases, the company’s future market expectations also become uncertain. In addition, if the profit is too low, the manager may be questioned for managerial responsibility, and if the profit is too high, the market expectation increases and the burden on future performance increases, so the company wants to keep the profit at a certain level.
On the other hand, ‘fraudulent reporting’ refers to earnings management that violates GAAP and IFRS. It is the act of intentionally issuing financial statements that have been fabricated to not negatively affect a company’s financial stability.
In the first place, the motives of companies that earnings management are linked to the company’s profits or stock prices, which are the rewards of the executive. Therefore, management often wants to adjust the profits to maximize their benefits and rewards.
As a method of adjusting profits legally, the management can increase net profit by discounting prices to temporarily increase sales, reducing poor performance R&D expenses, adjusting advertising expenses, etc., and disposing of securities.
However, ‘fraudulent reporting’ adjusts profits by manipulating financial statements rather than adjusting profits in a legitimate way to maintain the executive’s private interests or stock price stability for attracting excessive investment. This is illegal because it deliberately misinforms investors and the public.
The difference between ‘earning management’ and ‘fraudulent reporting’ can be very subtle. In practice, it is difficult to distinguish between earnings management and fraudulent reporting because it is unclear which appropriate adjustment is acceptable based on accounting standards.
However, in this case, it can be seen that the executives are fraudulent reporting rather than earnings management or earnings soothing because WorldCom’s executives, Scott Sullivan and David Myers, were forcing their subordinates to cook the books to show investors and the public their positive performance.
First, Scott Sullivan and David Myers released $3.3 billion worth of accruals in one year from 1999 to 2000. In addition, the unused network capacity stopped recognizing as an expense, and a non-revenue generating line expense of $771 million was capitalized into an asset account.
In addition, Sullivan intentionally asked Cynthia Cooper to defer the capital expenditure audit until the next quarter, while management specified to employees what they could and could not share with auditor Arthur Andersen.
Also, WorldCom amended the…
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