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WorldCom as an Example of Creative Accounting and
Subsequent Regulations of the Accounting Industry
By: Lisa E. Tarras
A thesis submitted in partial fulfillment of the requirements of the
University Honors Program
University of South Florida
21 November 2003
Thesis Advisor: Dr. Gerald Lander
University Honors College University of South Florida Saint Petersburg, Florida
CERTIFICATE OF APPROVAL
Honors Thesis
This is to certify that the Honors Thesis of
Lisa E. Tarras
Has been approved by the thesis committee on November 21 , 2003
as a satisfactory thesis requirement for the University Honors Program
Thesis Committee:
Thesis Advisor r, Ph.D., CPA, CFE, CCEA
Committee Member - oS-03
Table of Contents
Page
Introduction ..... . ... .... .. ... ..... . ... . .. ... ....... ...... ......... .................... .. .. 1
Chapter One - History of WorldCom ... ... .... .. ...... . .. .. ........ ... ........... .. 3
Chapter Two- Audit ofWorldCom .. .. .... .. .... . ................... ..... .. ... . .... 13
Chapter Three - Sarbanes-Oxley Act. .. .. . .. .. ...... ...... ..... ... .......... ..... 20
Conclusion .... ...... ............. . .. .. .. ... .... .. ... .. . ................ ... .... .. .... .. .. 29
Works Cited ... ......... ... ... .... ... .... .... ......... ... ....... ... ... ....... . .... .... . .. 31
iii
"'--- -
Tarras, 1
The public has long viewed corporate America as ruthless pillagers in the name
of profits. Today corporations are blamed for everything from eliminating mom
and pop stores and the family farm to draining the environment in the process.
Yet somehow no one, congressmen or minimum wage workers alike, were
concerned enough to address this brewing epidemic. In the bull market of the
1990's, no one cared what corporations had to do to create profits, as long as
those profits, and subsequent dividends and stock options financed their
retirement funds. However, the corporate environment is much different today.
Very public corporate scandals from companies such as Enron, Tyco and
WorldCom have changed the very definition of corporate responsibility itself. For
each new and old accounting scam, Americans and the world learned a new and
renewed way to cook the books in order to inflate profits. The WorldCom ordeal
was probably the most shocking of all the accounting scandals. On June 25,
2002 the corporation announced that they had misclassified expenses and
overstated their earnings by an astonishing $3.2 billion. It was later determined
that the misstatements where actually as high as $9 billion. As the situation
escalated, the company went on to file for the largest corporate bankruptcy in
history. The American public demanded action. How were companies
circumnavigating existing audit safeguards that were supposed to prevent these
things from happening? It became obvious to the public that new laws and
restrictions would have to be put into place to prevent this from happening again.
Tarras, 2
The WorldCom bankruptcy along with other highly publicized accounting frauds
led the U.S. House and Senate to pass a law commonly refereed to as the
sarbanes-Oxley Act. Is has been described as, "the most far-reaching changes
congress has imposed on the business world since FOR's New Deal," (Miller) by
the Journal of Accountancy. It is these issues that this thesis will focus on. First
we will first review the history of World Com. From its humble beginnings in
Clinton, MS to the multi-national conglomerate at its peak. Second, the key
employees that were involved in the fraud will be examined and how they
avoided regulations that should have stopped the creative accounting. Third, a
short overview of how both internal and external auditing should have stopped
the fraud will be reviewed. Fourth, the interworkings of an audit will show what
steps were avoided that allowed the false financial statements were released.
Finally, the major changes made as a result of the Sarbanes-Oxley Act will be
reviewed and applied to the WorldCom case. What new laws could have made a
difference in WorldCom's situation, or would the fraud have occurred anyway as
a result of the business atmosphere and increased pressure to constantly
increase earnings? The details in this particular case of creative accounting will
be examined closely.
Tarras, 3
HISTORY OF WORLDCOM
The story of World Com oddly enough begins with a breakup of another big
communications company, AT&T. In 1983, in part to reduce AT&T's monopoly,
the federal government mandated that AT&T lease some of their long-distance
phone lines to local companies, who could then resell the line's carrying capacity
at a great profit (Padgett, 56). It was that same year that Bernie Ebbers became
an investor in LDDS, Long Distance Discount Services. The company began
operations on January 14, 1984, after purchasing telephone switching equipment
and working capital. In the first year, LDDS could handle 40 long distance calls
at once and was $1.5 million in debt (Jeter, 26). It soon became obvious that the
company needed to take a new direction. It was then that they turned to one of
their investors for help.
Bernie Ebbers was a businessman, but certainly knew nothing about
telecommunications when he took control of the company in April of 1985 (Jeter,
29). Ebbers was a small town boy from Edmonton, Alberta, the second of five
children (Jeter, 3). He attended college at Mississippi College to play basketball
and liked the state so much he ended up staying. It was in Mississippi where
Bernie Ebbers bought his first business, the Sands Hotel in Columbia (Jeter, 12).
It was Bernie's success with cost cutting that brought him to the forefront of
LDDS. With the company losing money, they needed someone who could
organize the business and get it back on its feet. Bernie Ebbers was the man to
Tarras, 4
do that for them. Immediately upon taking control of the company, Bernie began
buying up other companies. With several small companies merged into one,
LDDS could create economies of scale. From 1985 to 1994 LDDS acquired
about half a dozen other communications companies (Associated Press).
Purchases of companies like Prime Telecommunication and TeleMarketing
Investments allowed LDDS to expand into the Midwest, Southwest and West.
Yet these acquisitions were relatively simple. The companies could easily merge
their billing and accounting systems. However, once the acquisitions became
larger, it became more difficult to integrate their accounting systems as well as
their switches and networks (Jeter, 49). It was in 1992 that LDDS contracted its
billing systems out to a service company called Electronic Data Systems (Girard).
Along with expanding the variety of their services, LDDS had a massive
expansion of their markets. LDDS was not only serving the southeastern United
States, but all over the world. As a better marketing strategy, the company
changed its name to WorldCom (Jeter, 56).
The image of a smoothly run company is not shared by all. A former travel
department manager claims that every department played by their own rules. In
1995, he claims there were no written company wide policies (Jeter, 57). By the
end of 1996, WorldCom ranked 309 in the fortune 500 with over half a million
customers and approximately 15,000 employees worldwide (Jeter, 71). In that
same year, WorldCom purchased MFS Communications for $12 billion, which
Tarras, 5
had purchased UUNet Technologies only months before (Eichenwald). This
made WorldCom the largest internet provider.
It was in the years following that WorldCom made some of its largest purchases.
The purchase of companies like MFS Communications is a good example of how
worldCom's acquisitions helped to drive its growth. When another company is
acquired with mostly stock a write down of assets to book value is necessary.
Not only would World Com write down the physical assets, but they would include
expected future costs in this write down, which ballooned to billions of dollars at
times. This resulted in larger losses in the current quarter, but much greater
earnings in future quarters. Once this is done with several companies, this gave
the image of larger profits when in reality World Com itself was barely growing
and at times even losing money (Eichenwald). Once an increase in earnings
was shown on the books, the stock was more attractive, which would allow
WorldCom to purchase another company and the cycle would continue. All told,
WorldCom made over sixty acquisitions in two decades (Backover). Bernie
Ebbers had a growth through acquisition approach to management, which is how
he got the nickname "Telecom Cowboy" (Foust). However, Ebbers got caught up
in the adventure of taking over another company and never followed through long
enough to efficiently integrate the companies. Another problem may have been
that Ebbers had too much control and no coherent strategy to determine which
companies should have been purchased and at what prices. Since he had no
background in the telecommunications industry, and not much formal business
Tarras, 6
training either, he did not know a lot about details concerning business strategy
or long term management of a company and therefore did not concern himself
with those matters. Former employees say Bernie Ebbers, "focused on things
that were easy to understand" (Backover). Ebbers cut cell phone allotments and
reduced the number of water coolers in offices, but he never took the time to
condense and streamline the over 50 billing systems the company operated at
one time (Backover). With so many systems, customers were constantly double
billed, leading to overestimates in accounts receivable. "By 1999, WorldCom had
accumulated more than $600 million in uncollectable receivables on its books"
(Jeter, 153).
Bernie Ebbers' right hand man through most of the acquisitions was Scott
Sullivan. A graduate of the University of New York, Sullivan learned of mergers
thought his auditing of General Electric while working at KPMG. Sullivan first met
Ebbers while he was CFO of Advanced Telecommunications Corp. , which was
purchased by WorldCom in 1992. Sullivan quickly advanced in the company and
was CFO by 1994 (Foust). He has often been described as the only one who
fully understood the company's books (Jeter, 166). According to Business Week
Sullivan was the one calling the shots behind the scenes. Ebbers always told
Sullivan to "see if the numbers work" before any acquisition was made (Hadded).
It has been reported that the two often lunched together (Backover).
Tarras, 7
The largest successful merger completed by WorldCom was that of it and MCI in
1997. MCI Communications Corporations was already entertaining a bid from
British Communications for $19 billion when Bernie Ebbers offered $30 billion in
worldCom stock for the company, and the deal was done (Eichenwald).
However, according to insiders the two companies failed to fully unite.
WorldCom tended to focus on smaller business customers, generally those
under $20,000 a month, while MCI had multi-million dollar contracts on a
complex billing system that the company built itself (Girard). A stark contrast to
WorldCom who had started contracting out its billing systems in 1992 to a service
company called Electronic Data Systems (EDS). After the merger, MCI and
WorldCom continued on two systems, operated by EDS, and as a result the
same client who purchased multiple data and voice services could get separate
bills, in addition to the nine other billing systems left over from previous
acquisitions (Girard). There were also many turf battles, as is expected when
two companies of that caliber merge. This took a toll on the company's progress.
The major difference seemed to be in the companies philosophies according to
Kate Lee, a former manager. She stated that, "MCI was much more open and
willing to take chances, to let people propose an idea and move forward with it, . .
-but at WorldCom, it was not that was not that way, if an idea didn't come down
from the top or one of the favored people, it didn't happen" (Jeter, 98).
WorldCom also had different ideas on how to book the purchase of MCI.
World Com devalued their hard assets by about $3.4 million at the same time
increasing goodwill by the same amount. This allowed the assets to be
Tarras, 8
depreciated over 40 years instead of the four years they should have been
expensed off, while still recognizing all of MCI's current revenue (Eichenwald).
once the acquisition of MCI was completed, Ebbers created a business plan of
keeping the two entities separate and using WorldCom to head all the internet
part of business, while MCI focused on long-distance (Knight). This however,
never materialized. The companies were still traded separately on the Nasdaq
Stock Market, but the business aspect was never divided. In fact, it seems that
MCI was used to shift expenses from WorldCom's books over to MCI's. This
was accomplished by transferring overhead costs such as sales and
administrative expenses to MCI books. These costs should be allocated once it
is determined which division benefited from the overhead costs. Internally, MCI
calculated that its sales and administrative costs were reduced by $415 million in
2001, but World Com allocated them an additional $457 million (Stern). This
difference of over $950 million is yet to be explained by WorldCom executives.
The acquisition of MCI was not the last merger for WorldCom. In 1998
WorldCom successfully acquired Fiber Properties and CompuServe (Associated
Press) concreting their position as the largest internet provider. Bernie was still
more interested in expanding the telephone branch of World Com and made his
largest move yet. On October 5, 1999, Sprint and WorldCom announced their
$129 billion merger (Haddad). This deal was not to be, and may have
accelerated WorldCom's decline. Despite heavy lobbying, in June 2000 the
Justice Department determined that the merger would be a threat to long
Tarras, 9
distance competition (Eichenwald). This was a major blow for World Com, who
up to this point has survived on acquiring other companies.
In the heyday of WorldCom, the stock price soared to over $60 per share and
actually peaked in June of 1999 at $64.50 (Associated Press). With the stock
price so high it was very easy for Bernie Ebbers to get personal as well as
business loans for various projects and use his stock in WorldCom as collateral.
And he did to the tune of almost $1 billion in outstanding debt. This created a
problem for the board of directors when the stock value started to fall and Ebbers
would have been forced to sell huge blocks of his stocks to cover the loans. The
company claimed a fallout of World Com stock would have ensued if the CEO of
the company began to sell off his stock. As a result the company agreed to loan
Bernie over $400 million at a generous rate of 2 .15% (Padgett).
The Creative Accounting
WorldCom was always on the forefront of accounting numbers in such a way as
to benefit their books, beginning with the write down of hard assets, while
simultaneously increasing goodwill of MCI. Another interesting accounting trick
of WorldCom is the capitc:llization, and not expensing, of developing in-house
software, according to a footnote in the 2000 annual report (Haddad).
Tarras, 10
The real problems started towards the end of 2000 when internet traffic had
slowed, and WorldCom was not billing as much, but it was still required to pay for
the lines the information traveled on because they did not own the lines, they
were leased. It was at that time that Sullivan first classified about $225 million in
revenue, from fees and equipment sales, as cost reductions. Technically not
violating any accounting standards, but certainly bending them (Jeter, 132). But
as the year went on the situation went from bad to worst. The whole telecom
industry was in a slump and the economy was not getting any better.
WorldCom's debt was rising while revenue from wholesale and consumer
markets was falling (Eichenwald). Another problem was that WorldCom had no
streamline direction or even operating standards. Even after shifting millions in
overhead expenses to its subsidiaries, WorldCom was still in the red. And with
stock analysis estimates much higher than reality, the stock price was sure to fall
even farther. WorldCom simply did not have the earnings to meet those
estimates. Apparently, WorldCom had a corporate environment that emphasized
meeting analysts expectations more than creating accurate reports (Jeter, 194).
So Scott Sullivan, along with then controller David Myers, simply maneuvered the
books so they would report gains instead of losses. They took one of
WorldCom's largest expenses, line costs, and capitalized it. Line costs are what
WorldCom pays to lease the physical lines it moves data on. It is a current
expense and should be fully charged in the current period. Capitalizing these
costs draws out the expense over as many as 40 years. This trick allowed
Tarras, 11
worldCom to turn a $662 million loss into a $2.4 billion profit in 2001 (Ripley).
This continued into the first quarter of 2002.
And most of us know the rest of the story. WorldCom's stock continued to
decline as the SEC announced it was performing an overall investigation of
WorldCom's accounting practices in the March of 2002 (Backover). Not long
afterward, Bernie Ebbers resigns as CEO claiming he planed for focus more on
his personal investments. But, the stock continues to fall, below $1 for the first
time on June 24, 2002. Finally, the bomb hits, on June 25, 2002, the company
announces it has inflated earning by $3.8 billion in the previous 5 quarters. And
former controller David Myers has resigned, while Scott Sullivan was fired as
CFO of the company. Less than a month later WorldCom files for Chapter 11
bankruptcy as it tries to restructure and recover from the largest bankruptcy and
fraud America had seen to date. Later revelations would reveal the fraud could
be actually be as high as $11 billion.
Today, as WorldCom is preparing to emerge from Chapter 11 bankruptcy, many
changes are in the works. Not only are they changing their name to MCI, but
also their headquarters from Clinton, Mississippi to Ashburn, Virginia (Powell).
But, there is a vast change in the accounting system in the company. There has
been a dramatic increase in internal controls with more money dedicated to the
internal audit department. As a result of the bankruptcy the company is
preparing to write down the value of its assets by $80 million (Morgenson). This
Tarras, 12
write down of goodwill is so massive, largely in part to WorldCom paying top
dollar for the companies they acquired during their rapid growth of the 1990's.
However, a little less than half of the write down due to the overvaluing of
physical assets. The value of their hard assets was at $44.8 billion and is now
valued at $10 billion (Morgenson).
The questions remain as to how a CEO was allowed to run a company so
recklessly and no one questioned his practices. What procedures, both internally
and externally were in place and were not followed. And maybe even more
importantly, what procedures have been created, in part, as a result of the
WorldCom scandal, to prevent this from happening again. We will examine
these issues in the following chapters.
Tarras, 13
THE AUDIT OF WORLDCOM
There are several reasons the incorrect financial statements of World Com were
made public. In this section we will first review how a proper audit should be
planned and executed as well as what safeguards are already in place that
should have prevented the financial statement release and how they were
avoided. It is obvious the independent auditor did not follow proper procedures
to reveal the blatant financial fraud, which is one of the auditor's responsibilities.
However, it is also true that management did not make fair representations about
the financials to the auditors. This could be a valid argument for Arthur
Anderson, ·except for the fact that auditors are required to ask and be made
available to all types of financial documents relating to the financial statements.
This includes how the numbers for line costs were derived, if this is not made
available to the auditors, it is considered a scope limitation, and should have
resulted in a qualified opinion of the scope paragraph as well as the opinion
paragraph because the limitation would have been client imposed.
A good audit begins with the proper planning. An auditor should take a fresh
look at the company every year and evaluate new risks both to the company
directly and to the company's business environment as a whole. This was
probably not the case at WorldCom. Even after they changed auditors from
Arthur Anderson, who had been their auditor since 1989, to KPMG the same
auditors continued to come and go (Jeter, 166). When the same auditor works
Tarras, 14
on the same client for such an extended period of time, relationships as well as
trust, is built. In this type of environment some potential issues or red flags may
be over looked because of the trust and familiarity of the audit. The long-term
relationship with clients also effects the auditor skepticism of the client. The
auditor must always maintain professional skepticism. This does not mean the
auditor should assume dishonesty, but at the very least consider the possibility of
dishonesty by management at all times. Never believe that anything
management says until you have proven it on your own or verified it with outside
sources. It is imperative that client business risk as well as inherent risk be
assessed every year. Client business risk is the danger that the client fails to
achieve its objective. This should have been high in WorldCom's case, because
they were not meeting their financial goals. Inherent risk is the risk any account
balance is misstated before considering internal controls (Arens). The risks that
are higher that particular year and the accounts that they affect, should obviously
be tested on a more in depth basis than other accounts which are less risky.
This analytical procedure helps guide the auditor in what specific audit
procedures to perform. New pressures in a declining industry is usually a
concern for the auditors, which is applicable to the World Com case. The
telecommunication industry was in decline when the questionable accounting
took place, and the independent auditors, Arthur Anderson, should have taken
note of this and paid special attention to accuracy of the financial statements and
conformity to Generally Accepted Accounting Principals, which is one of the
auditing standards of reporting (Arens, 32).
Tarras, 15
Every audit should follow the Generally Accepted Auditing Standards (GAAS) at
all times. Generally Accepted Auditing Standards are composed of a three part
system involving general qualifications and conduct, fieldwork performance of the
audit, and reporting results. Each of those categories contain subcategories
outlined below.
General Qualifications and Conduct
Adequate auditor training and proficiency
Independence in mental attitude
Due professional care
Field work performance of the audit
Proper planning and supervision
Sufficient understanding of internal control
Sufficient competent evidence
Reporting Results
Whether statements were prepared in accordance with GAAP
Circumstances where GAAP non consistently followed
Adequacy of information disclosures
Expression of opinion on financial statements (Arens, 33)
Just from looking at this list, it is obvious that Arthur Anderson was not following
GAAS. They clearly did not maintain an independent mental attitude or due
Tarras, 16
professional care, otherwise they would have uncovered the accounting fraud
while gathering audit evidence, which is a requirement of proper fieldwork.
During an audit, the auditor gathers evidence to ensure the financial statements
are properly stated. Evidence gathering involves tests of controls, as well as test
of transactions. Sufficient evidence is necessary in order to test management's
assertions about the financial statements. The auditor then uses substantive
tests to prove the assertions. The American Institute of Certified Public
Accountants has developed as set of core assertions that management declares
when the give the financial statements to the auditor, whether they actually say
so or not. These assertions include existence or occurrence, completeness,
rights and obligations, valuation or allocation, and presentation and disclosure
(AU §326.26). The traditional audit approach involves first testing internal
controls to reveal weak points upon which to focus, but continuing to examine all
accounts, on a test basis, for overall accuracy. This was not the case for Arthur
Anderson, who use a risk based approach. They only tested those accounts
where they saw weak internal control (Hilzenrath). However, this was not the
only factor in Arthur Anderson misreporting on WorldCom. The management of
WorldCom refused to give Anderson auditors access to computerized versions of
their general ledger, which would have immediately revealed the accounting
fraud. Anderson's mistake was not reporting this lack of scope to the audit
committee, as well as continuing to issue a clean opinion without properly
verifying its accuracy (Hilzenrath).
Tarras, 17
Audit Committee
This is just one reason that makes it essential that every publicly held company
has an independent audit committee. The audit committee are not employees of
the company and serve as the direct link from the external auditor to the
management of company. The external auditor is not supposed to discuss
questionable matters with the CEO, CFO or controller of a company. The audit
committee serves as a representative of the shareholders who have a stake in
the company. This allows the auditor to effectively voice concerns to an
unbiased party. The audit committee should be dedicated to a fair and proper
representation of the financial statements. This was not the case at WorldCom.
According to reports, the audit committee was, "devoted strikingly little time to
their role, meeting as little as three to five hours per year" (Hilzenrath). With so
little devotion, it is not surprising that the most blatant and largest bankruptcy in
American history was not caught by the audit committee.
Internal Auditors
The internal auditors are not usually a part of the external audit. The main
purpose of internal auditing is to ensure all procedures within the company are
up to company standards. The internal auditor often performs compliance
auditing with in the company, and very rarely tests the accuracy of the financial
statements. However, it was the internal auditors at World Com who helped to
Tarras, 18
uncover the fraudulent accounting. Cynthia Cooper was the head of the internal
audit department at WorldCom when she heard from a wireless division that
$400 million had been removed from their reserve account in order to increase
their profits. Ms. Cooper decided to look into the matter further. Reportedly
Arthur Anderson told her, "matter-of-factly that it was not a problem" (Ripley).
CFO Scott Sullivan also warned Cooper to mind her own business. But, on the
cusp of the En ron scandal with Arthur Anderson, Cooper was skeptical about
how accurate the financial statements were. The discouragement of
management only prompted Cooper to look into the matter further. She decided
to begin the cumbersome and time consuming task of redoing Arthur Anderson's
work and auditing the financials. However, she was more cautious this time.
Cynthia, along with her internal audit staff began working late into the night to
keep their project secret. One of the staff even bought a CD burner so they
could copy the information, worried that it might be destroyed before they could
finish (Ripley). What they found was a large hole in the books where expenses
were reclassified as capital expenditures.
It has been shown that the fraudulent accounting by WorldCom may have been
the direct result of a few aggressive executives, it was the lack of responsibility
by many that ultimately allowed the false financials to be released. Not only did
the auditors fail to do their job correctly according to Generally Accepted Auditing
Standards, but also the audit committee was not as involved as they could have
been. The combination of these factors along with the corporate climate of
Tarras, 19
executive elite who ran the company with a no-questions-asked policy, created
the catalysis that resulted in the largest bankruptcy in history. With such
collusion, how can the government ensure the public that their investments are
protected? The next portion of this paper will discuss the new laws and affects of
the Sarbanes-Oxley Act of 2002 which tries to answer that very question.
Tarras, 20
THE SARBANES-OXLEY ACT
on July 30, 2002 President Bush signed into law what is commonly known as the
sarbanes-Oxley Act. The act was a reaction to the seemingly ramped corporate
fraud that was occurring, which until that point President Bush had described as
a few bad apples. The act was sponsored by Sen. Paul Sarbanes of Maryland
and Rep. Michael Oxley (Richards). And thus was named the Sarbanes-Oxley
Act of 2002, which is hailed as the most far reaching affects on business since
the New Deal (Miller). While some of the changes are better tracking or
enhancements of current laws, others sections are brand new. The law is a
comprehensive 66 page document that outlines the changes in the regulation
and roles of all individuals in business with regards to accounting records. The
Jaw addresses such issues as the creation of the Public Company Accounting
Oversight Board, white-collar penalties, corporate tax returns, work paper
retention, and conflicts of interest as well as protection of the whistleblowers who
reveal the fraud. Some of the new rules reflect the unofficial standards in the
industry. The major advantage of the Sarbanes-Oxley Act is that it does allow for
better monitoring within the accounting industry. The Public Company
Accounting Oversight Board (PCAOB), once it is estabilished, will register public
accounting firms, conduct inspections and ensure their compliance with the
Sarbanes-Oxley Act (Tillman). This is a drastic change from the relatively simple
peer reviews of the past. The PCAOB will now examine on an annual basis
those firms who perform more than one hundred audits of public companies, and
Tarras, 21
once every three years for all the other accounting firms who perform audits on
public company (Miller). This is one example of how the new law not only affects
the auditing of publicly held corporations, but the accounting firms themselves
are also drastically affected by the Sarbanes-Oxley Act.
It is obviously too cumbersome to discuss all the topics that Sarbanes-Oxley
addresses in this format; however, this portion of the paper will go over in detail
the changes that were made that may have resulting in a different outcome in the
WorldCom case. Such issues include the role of audit committees, corporate
responsibility, certain conflict of interests, and auditor independence issues will
be addressed as well as new penalties for the crimes that were committed by
upper management at WorldCom.
Audit Committees
A particular aspect of the accounting world that was altered was audit
committees. Like WorldCom, most publicly traded companies have an audit
committee. However, often the audit committee fails to fully grasp the effects of
accounting changes or the ramifications of the accounting policies that the
company performs. The audit committee also has the difficult job of ensuring
that the auditor has all the resources necessary to properly perform the audit.
One of the main changes resulting from Sarbanes-Oxley is that companies are
now required to disclose whether they have "financial expert" on their audit
r I l (
Tarras, 22
committee (Karmal). This however, does not requires the company to have an
audit committee at all , only that they disclose that they do or do not contain a
financial expert. Often the board of directors fulfill the duties of the audit
committee.
These were not the only effects Sarbanes-Oxley had on audit committees. The
audit committee, or board of directors, must now establish procedures regarding
complaints about auditing and accounting matters. Including receiving and
resolving these matters with external consultants, if necessary. In order to
facilitate this Sarbanes-Oxley also requires that the audit committee have the
authority to engage independent advisors and have the proper resources to do
so. Finally, all of the audit committee members must be independent of the
company. According to Sarbanes-Oxley this means they may not, "accept any
consulting, advisor or other compensatory fee from the issuer or . . . be an
affiliated person of the issuer or any subsidiary thereof' (Sarbanes-Oxley Act,
section 301.3.8).
The audit committee of World Com was certainly not independent. They were
made up of several former executives of companies WorldCom had acquired
over the years. Had the audit committee been more independent and only
received their information from the external auditor, the scandal could have been
prevented. At WorldCom, the audit committee was often misled by management
and the auditors (Hilzenrath). Both internal and external auditors were required I
I
Tarras, 23
to go through upper management before approaching the audit committee. With
these blocks in place it is no wonder the audit committee never received the
proper information.
Management Sign Off
As part of the Sarbanes-Oxley Act there are new responsibilities for executives of
public corporations. These rules apply mainly to the CEO and CFO of
corporations who now have to sign off on the financial statements. When
management signs off on the financial statements, they are not only verifying that
internal controls are working properly, but they also maintaining that they have
not mislead auditors. Sarbanes-Oxley now requires the CEO of a company to
verify that all the information contained in the financial statements is true and
accurate to their knowledge and that it properly represents the financial position
of the company (Hockeimer). If the management signs off on the financial
statements and it is determined that they had knowledge about fraud, there are
now severe implications regarding the punishment of management. In an effort
to delegate responsibility of the information contained in the financial statements
to management, Sarbanes-Oxley requires that all publicly traded companies,
"establishing and maintaining internal controls" (Sarbanes-Oxley Act, section
302.a.4.A). When management signs and verifies the financial statements, they
are also verifying that the internal control structure is working properly.
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This new standard could have made a dramatic difference in the WorldCom
case. Had the internal auditors been given free reign they may have caught the
fraudulent accounting much sooner, or management would not have been
inclined to misrepresent the financials had they known the internal audit
department would be checking their numbers. Since the release of the
fraudulent financial statements and the subsequent bankruptcy of WorldCom, the
company has now committed to doubling the size of their internal audit staff,
where Cynthia Cooper works, to fifty. The chain of command has changed too,
the internal auditors now report to the audit committee rather than the CFO or
CEO.
Conflict of Interests
One of the main overall issues that Sarbanes-Oxley attempts to identify and
·correct is conflicts of interest. These issues include auditor, audit committee
independence, as well as management conflicts. The most applicable to
WorldCom being the section relating to personal loans to executives. The
specific section states, "It shall be unlawful for any issuer, directly or indirectly,
including through any subsidiary, to extend or maintain credit, to arrange for the
extension of credit, or to renew an extension of credit, in the form of a personal
loan to or for any director or executive officer of that issuer" (Sarbanes-Oxley Act,
section 402.a.1).
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Had this been in effects earlier, it would have been detrimental for WorldCom.
The company made over $400 million in personal loans to Bernie Ebbers as
mentioned earlier (Padgett). There is no telling what may have occurred if
Bernie Ebbers was not granted personal loans from WorldCom. The
misstatement of expenses may not have occurred at all. The pressure to inflate
earnings might have been somewhat diminished. There was no avoiding the
falling stock price. If Bernie sold off chunks of his stock the price would fall, but
probably not as far as it did when the fraudulent accounting was revealed. It is
plausible, however that World Com could have avoided bankruptcy. If nothing
else, had those personal loans been made public the stock rating would have
dropped and the public might have avoided loosing millions of dollars in the
company.
Auditor Independence
The enactment of Sarbanes-Oxley has significantly altered the role of auditors.
In the past, as auditors found flaws in the accounting of business, the same firm
could offer to also provide accounting work for the company, among a plethora of
other services. This created a conflict of interest. In essence the auditor was
verifying their own work. The Sarbanes-Oxley Act completely prohibits auditors
from providing such services as bookkeeping, "financial information systems
design and implementation," outsourcing of internal audits, and any financial
advisory roles (Sarbanes-Oxley Act, section 201 ). In all there were a total of nine
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services, previously allowed to be performed by auditors, which now out righted
banned by the Securities and Exchange Commission (Richards). This does not
mean all services are banned. However, any non-audit services the auditing firm
wants to perform, must first be approved by the audit committee (Reason).
Services were not the only thing limited by Sarbanes-Oxley. There are now
limitations on the number of years coordinating partners or senior managers as
well as reviewing partners can work on the same audits. A so called "cooling off'
period after five years is required (Benman). This allows for a fresh view of the
risks and controls in place by another set of eyes. The idea is that engaging
/ another person to deal with the client will give the audit firm a fresh perspective
I of the client. Originally, the law suggested that the whole audit staff be rotated,
however, it was decided that this was too cumbersome for the auditor.
Punishment for Misrepresentation
To ensure that management is sincere in verifying the financial statement severe
penalties have been put in place. If it is determined that the CFO or CEO had a
knowing violation, meaning the knew the financial statements were materially
inaccurate and signed off on them anyway, the punishment is a $1 million fine
and up to 10 years in prison. If the executive is determined to have a willful
violation, implying that they participated or facilitated the misrepresentation of the
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financial statements, then the fine is increased to $5 million and imprisonment for
up to 20 years (Hockeimer).
In September of 2003, both Bernie Ebbers and Scott Sullivan were arraigned on
charges of fraud. Scott Sullivan is currently being prosecuted by the federal
government for securities and bank fraud. His trial is not scheduled to begin until
February of 2004 (Hoberock). Sullivan's lawyers are arguing that since all of
Sullivan's alleged crimes occurred before a new white collar punishments were
enforced in late 2001 , he should not be prosecuted under the new laws. Under
the old statues the maximum penalty his can receive is 12 % years in prison. If it
is determined that he can be prosecuted under the new white collar laws then
Scott Sullivan can receive up to double that amount of time. Bernie Ebbers on
the other hand is vehemently denying that he had any idea the fraud was
occurring. A tough idea to swallow since it has been reported by several
employees that neither Bernie nor Scott made a decision without first consulting
the other (Hadded). Before Sarbanes-Oxley the CEO was never required to sign
off on the financials and therefore is technically not responsible for them.
Currently, Bernie Ebbers is be prosecuted in Oklahoma, of all places, who got
tired of waiting for the federal government act. He is being charged with 15
counts of fraud and was let out on bond (CNBC). It is indisputable that the
punishments would be much more severe had Sarbanes-Oxley been enacted
earlier.
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Other Affects
With all the new requirement of Sarbanes-Oxley there is a hefty price tag that
comes along with it. More money is needed to finance the audit committee,
companies are implementing new controls which often mean new software as
well as testing of the controls by an independent firm. As well as a tremendous
amount of consultants are being called in to make sure public traded companies
are fully in compliance with all the Sarbanes-Oxley requirements. With all the
added expense of adhering to the new laws more and more companies are going
private. Since the passage of Sarbanes-Oxley it is estimated that the number of
public firms reversing and going private has increased 22% (Benman). This is
just one example of the massive effect a law like this has. The Sarbanes-Oxley
Act affects all public companies as well as the CPA's that audit them. It is too
soon to tell how the act will affect the accounting industry in the long run, or how
effective it will be.
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CONCLUSION
So the question remains, would the Sarbanes-Oxley Act have made a difference
in the World Com case if it was implemented sooner? To answer this it is
necessary to consider not only the corporate culture at WorldCom, but also the
economic pressure at the time. In 2001, when the line costs were reclassified,
the economy was moving into a recession. Their was intense pressure on
companies to keep pace with the earnings that were the norm in the late 1990's.
However, WorldCom was simply not making those kind of returns. They were
forced to create the kind of returns the market was expecting with fraudulent
accounting. But, when the history of World Com is examined it was not just in the
2000's when the fraud occurred. Almost since the corporation's inception, there
was little emphasis on a well-structured company. Executives never successfully
combined billing systems between MCI and WorldCom after the merger, and
almost no attention was paid to many of the details concerning the sixty mergers
that took place. The bigger issues were tackled, but never down to the very last
detail, the company always had another merger to worry about. The corporate
culture at WorldCom also included using aggressive accounting tactics to
increase its bottom line, such as devaluing an acquired company's hard assets in
order to increase goodwill and inflate earnings. It is these sort of issues that
should have been caught by the external auditor or at the very least been made
known to the audit committee. If that had been the case the audit committee
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could have consulted an external accountant to get a second opinion on how the
accounting for mergers and acquisitions were handled.
In every aspect of the Sarbanes-Oxley Act that was examined, a significant
difference could have been made in the WorldCom case. Had auditor rotation
be implemented earlier, Arthur Anderson, who performed the annual audits might
have been able to better assess the risks, and perform a more comprehensive
audit. The most significant change of all is that it would be much easier to
punished the guilty had the Sarbanes-Oxley gone into effect sooner. Bernie
Ebbers as well as Scott Sullivan would have been required to sign off on the
financial statements regarding their accuracy and assuring that no fraud had
been committed, making their prosecution much easier. As it stands, the
punishment is minimal for all of the losses their misstated financial statements
caused . There is no doubt, had more sever rules been in effect, frauds such as
the one that occurred at World Com may have been prevented. With laws such
as Sarbanes-Oxley in effect, the public can be assured that fraud of the
magnitude that occurred at WorldCom will not happen again.
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