Business Ethics-Worldcom Scandal

Shiva Kumar.SPGDM-15

Contents

Topic Page No

Introduction 2

Summary 3

Key Players Involved in Scam 5-7

Company Culture 8-9

Corporate Governance 10-14

How Fraud Happened ? 15-22

Discovery-Whistler Blower 23

Audit Committee 24-27

Effect of Scam 28-29

SOX Act 30-31

Impact of the Fraud 32

Proposed US Governance Principle 33-34

Q & A 35-37

After Scandal 38-40

Lessons Learned and Reference 41

Introduction

WorldCom was a provider of long distance phone services to businesses and residents. It started

as a small company known as Long Distance Discount Services (“LDDS”) that grew to become the third

largest telecommunications company in the United States due to the management of Chief Executive

Officer Bernie Ebbers. It consisted of an employee base of 85,000 workers at its peak with a presence in

more than 65 countries. LDDS started in 1983. In 1985, Ebbers was recruited as an early investor of the

company and became its CEO. It went public four years later. Ebbers helped grow the small investment

into a $30 billion revenue producing company characterized by sixty acquisitions of other telecomm

businesses in less than a decade. On June 25, 2002, the company revealed that it had been involved in

fraudulent reporting of its numbers by stating a $3 billion profit when in fact it was a half-a-billion dollar

loss. After an investigation was conducted, a total of $11 billion in misstatements was revealed.

3/41

Summary

On June 25, 2002, WorldCom announced that it intended to restate its financial

statements for 2001 and the first quarter of 2002. It stated that it had determined that certain

transfers totaling $3.852 billion during that period from “line cost” expenses (costs of

transmitting calls) to asset accounts were not made in accordance with generally accepted

accounting principles (“GAAP”).

Less than one month later, WorldCom and substantially all of its active U.S.

subsidiaries filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy

Code. WorldCom subsequently announced that it had discovered an additional $3.831 billion in

improperly reported earnings before taxes for 1999, 2000, 2001 and first quarter 2002. It has

also written off approximately $80 billion of the stated book value of the assets on the4/41

Cont.,Company’s balance sheet at the time the fraud was announced.On June 26, 2002, the

United States Securities and Exchange Commission filed a lawsuit captioned Securities and

Exchange Commission v. WorldCom, Inc., No. 02-CV-4963 (JSR).

On July 3, the Honorable Jed S. Rakoff, of the United States District Court for the Southern District

of New York, appointed Richard C. Breeden, former Chairman of the SEC, as Corporate

Monitor, with the consent of WorldCom. This Committee was established by the Board of Directors

On July 21, 2002. The Board directed to conduct a full and independent investigation

of the accounting irregularities that gave rise to the announced intention to restate, and such

other matters as we concluded should be considered, without any limitations. The members of the

Committee were new to the Board of WorldCom at that time.

5/41

Key Players Involved in WorldCom Scandal

1. Bernard Ebbers-Chief Executive Officer in the company.

2. Scott Sullivan-The chief financial officer and secretary of WorldCom. 

3. David Myers-The controller and senior vice president of WorldCom.

4. Cynthia Cooper-Chief Internal Auditor of WorldCom.

5. Buford Buddy Yates – He was the former director of accounting at WorldCom. 

6. Betty Vinson – She was the former director of corporate accounting at WorldCom.

7. Arthur Anderson LLP – Kenneth M. Avery and Melvin Dick were the primary

auditors representing their firm in the WorldCom scandal. 

6/41

Who was mainly responsible for the downfall of WorldCom?

I. Board of Directors: As they were involved in fraudulent and cheat.

II.  Non-Executive Directors: As they were involved with Board of Directors in

unhealthy activities.

III.  Internal Audit Team: As they were bribed by Board and Management to show

their audit report clean.

7/41

People Who were Affected ?

Share holders.

Management.

Employees.

Creditors.

Customers.

Govt.

8/41

Company Culture- Top Management’s Managing Style

The growth through acquisitions “strategy” at WorldCom was enforced and reinforced

by top management. The consistent pressures from top management created an aggressive and

competitive culture that did not contain any communication of the need for honesty or

truthfulness or ethics within the company.There was a large focus on revenues, rather than on

profit margins and the lack of integration of accounting systems allowed WorldCom employees to

move existing customer accounts from one accounting system to another. The lack of a code of

ethics at WorldCom shows that no training on awareness of fraud or ethics was conducted.

Therefore, it is very possible that when the employees reported existing customers as new ones,

they were not aware of the obdurate consequences that may occur.

9/41

Cont.,

The lack of an ethical code and an outlet for concerns was the concept of

employee compensation with stock options. Employees at WorldCom received a lower

salary than their counterparts at competitors such as AT&T and Sprint. Most of the

information was not fully available to employees, furthering this secrecy. Even some who

had the need to know the information such as the internal auditors, were able to view

only some of the journal entries in the income statement and the balance sheet but never

the entire documents. Ebbers created an individualistic culture where loyalty to a person

was more important than loyalty to the company. This created an environment where the

boss was not to be questioned. 10/41

Corporate Governance- Board of Directors

The Board was inactive and met only about four times a year, not enough for a company

growing at the rate that it was. In addition, the directors were only given a small cash fee as

compensation, thus an appreciation of stock was the only form of compensation available. The

directors also depended on company growth and stock appreciation for compensation, as did the

employees and management. Due to the Board’s lack of active participation, there was a lack of

awareness about WorldCom’s matters. Management aided that lack of awareness by presenting the

directors with very limited information about the company and its acquisitions. The discussions did

not involve the Board at all and at other times no documents were even presented concerning the

terms of the transactions

11/41

Toxic Culture of Senior Management Team

Believed that their actions were not “really” illegal.

Unrealistic financial targets and inability to meet them.

Recording of a/c entries without any evidence.

Company was capitalizing its line costs. Line costs were operatingexpenses but

WorldCom classified as capital expenditure.

In 2000 and 2001, WorldCom claimed pre tax revenue of 7.6 and 2.4Bn $ respectively.

Later discovered as loss of 49.9 and14.5 Bn $ forthe respective years.

Reserve accounts were manipulated to increase figures.

Two versions of accounts the actual version and the Final version for investors.12/41

What are the key factors for the collapse in the view of Corporate Governance?

The following key factors resulted the company to a collapse:

i)Senior Executives were encouraged to lie, cheat and manipulate records by providing

them high margin of profits.

ii)Executives were interested in their personal reward structure ignoring the stakeholders’

benefits.

iii)Board members were mostly highly rewarded and consist of the friends, who did not

raise questions on any doubtful and ambiguous records.

iv)Non-Executive Directors were also highly rewarded and they worked independently.

v)Audit Team was bribed, so that the team will produce a clean audit report.13/41

Cont.,

vi)Illegal profits were generated and it was shown that all the policies and rules

implemented from the top were for the benefit of the company and shareholders, and

hence, were ethical.

vii)The cost of heavy machinery purchased in a particular period was not spread by the

company in the next coming financial years.

15/41

Loans to Ebbers

Ebbers had made several purchases for which he had acquired loans and used his WorldCom

stock as collateral. The price of WorldCom stock fell, Ebbers was required by the banks to fill in the

margins 12 between the value of his loans and the fallen value of his stocks.Instead of selling his stock,

which he thought would further cause a decline in stock price on Wall Street, Ebbers requested the

Board to approve personal loans to fill in the margins. Ebbers took advantage of the lack of

independence of the board members who were loyal to him such as Stiles Kellett, chairman of the

Compensation Committee, and Max Bobbitt, chairman of the audit committee. Not only did the two

allow the loans to grow to more than $400 million, but also when the Board found out about these

loans, they failed to take any action and allowed the loans to carry on.

15/41

How Fraud Happened ?

The fraud was characterized mainly by the improper reduction of line costs and false adjustments to

report revenue growth.

The Misstatement of Line Costs

Releasing Accruals

Capitalizing Line Costs

Revenue

16/41

The Misstatement of Line Costs

Line costs are the costs associated with carrying a voice phone call or data

transmission from the call’s origin to its destination. If a WorldCom customer made a call

from New York City to London, the call would first go through the local phone company’s

line in New York City, then through WorldCom’s long distance, and finally through the local

phone company in London. WorldCom would have to pay both the local companies in New

York City and London for use of the phone lines,these costs are considered line costs. Not

only were line costs WorldCom’s biggest expense but were also approximately half of

WorldCom’s total expenses. Especially after the collapse of the dot com bubble in early

2000, cost savings became extremely important, so important that line cost meetings were

the only meetings with regular attendance by top management.

17/41

Cont.,

WorldCom’s top management strived to achieve a low line cost to revenue ratio because

a lower ratio meant better performance whereas a higher ratio meant poorer performance. To

report better performance and growth, Sullivan implemented two improper accounting methods to

reduce the amount of line costs, release of accruals from 1999-2000 followed by the capitalization

of line costs in 2001 through early 2002.

18/41

Releasing Accruals

The end of each month, during the fraud period at WorldCom, was characterized by the

estimation of costs that were associated with using the phone lines of other companies. The actual

bill for the services was usually not received for several months. This meant that some entries

made to the payables could be 27 overestimated or underestimated. In the case that the liability

was overestimated, when the actual bill was received there would be a surplus of liabilities that

when released would result in a reduction of the line costs.

Accounts Payable 1,000,000

Cash Paid to Suppliers 900,000

Line Cost Expense “release” 100,00019/41

Cont.,

WorldCom adjusted its accrual in three ways:

Some accruals were released without even confirming if any accruals existed in the first

place.

Second, if WorldCom had accruals on its balance sheet it would not release them for the

proper period and instead keep them as “rainy day” funds for future uses.

Lastly, some of the accruals released were not even established for line costs, thereby

violating GAAP by using one expense type to offset.

20/41

Capitalizing Line Costs

The 4% utilization of the fiber optic cables meant that WorldCom was still

paying for the leases on the cables even though it was generating no revenue on them.

According to Morse 29 WorldCom had leased the lines in a 2-5 year agreement that could

not be canceled. However, the costs associated with the lines were causing the line cost

E/R ratio to increase. Thus, when no more accruals could be released, Sullivan turned to

capitalize these costs, another violation of GAAP.

By the time the fraud was discovered, Sullivan had managed to improperly

reduce the line costs by approximately $3.883 billion.Capitalizing the expenses resulted

in shifting the items from the income statement onto the balance sheet, allowing the

overstatement of income as well as the overstatement of assets. 21/41

RevenueA process called “closing the gap” was utilized to achieve the falsified

growth. First, Ebbers and other top management received the “MonRev” report that

provided a picture of the company‟s revenue for a given period. The report was

available exclusively to top management and its access was closely guarded. At the

end of each quarter, top management would meet to close the gap that existed between

the actual revenue number and the expected number. Usually the journal entries

involved large round numbers, in millions or even tens of millions of dollars, and were

booked to an account called Corporate Unallocated revenue account. In reality, this

account had no relation to the operating revenues of WorldCom. A total of

approximately $958 million in revenue was improperly recorded by WorldCom during

Q1 1999 – Q1 2002.22/41

Cont.,What is interesting about the inflated earnings is that WorldCom was able to acquire a lower cost

of capital in terms of borrowing because the banks assumed WorldCom could cover its loans. The

reduction in cost of capital was one of the reasons WorldCom was able to make the multiple

acquisitions, paying for the acquisitions with its own inflated stock. From December 1996 to July

2001, WorldCom spent a total of $65 billion in acquisitions. If the Sprint acquisition had been

approved, it would have spent a total of $195 billion

23/41

Discovery-Whistle Blower

When Cooper, the Vice President of the Internal Audit, questioned about capital

expenditures audit resulted in a large variance due to entries to an account called prepaid capacity.

no one appeared to give a answer. When she asked Sullivan about it, he explained they were line

costs that had been capitalized and told her to delay the audit until the third quarter of

2002.Cooper did not consider his request and continued with the audit. She asked Gene Morse, a

Manager in the Internal Audit department to look into the entries. Morse states it did not take him

long to find the journal entries, especially because they were large round-dollar entries even

though his access to the full view of both the balance sheet and income statement was limited.

24/41

Cont.,

On June 17, 2002, Cooper and Glyn Smith, another internal auditor in the

department, went to Betty Vinson in the General Accounting department to further inquire

about the prepaid capacity entries. She informed them that she had indeed made those journal

entries but only upon the request of top management. They next went to Buddy Yates,

Director of General Accounting, who directed them to Controller David Myers who

confessed to the fact that he indeed did not have any support for the journal entries and that

once top management had started making those entries it was difficult to stop making

them.June 25, 2002 marked the public release of the fraud.

25/41

Audit Committee

An Audit Committee was established to conduct relations with Arthur Andersen, the external

auditor. In WorldCom’s case, the lack of independence and awareness of the Board as a whole

trickled down to the audit committee. The committee’s chairman, Max Bobbitt, was very loyal to

Ebbers. Hence, the members of the committee, including Bobbitt, were either unaware or had

known about the fraudulent misstatements for the years 1999, 2000, and 2001 and choose to ignore

it.

26/41

Internal Audit

WorldCom’s Audit Committee failed to meet with the Internal Auditors of the company, who

had the duty to provide the Audit Committee with an independent and objective view on how

to improve and add value to WorldCom’s operations.

The internal auditors were provided with limited access to the income statements and balance

sheets with only a partial picture of the company’s financial situation that prohibited them

from properly assessing the finances of the company

The Internal Audit department is intended to be independent and report directly to the Audit

Committee to avoid the influence of top management. This form of relationship was lacking

at WorldCom.

27/41

External Auditors

The external auditor, Arthur Andersen, was the one responsible for providing an

independent opinion of the financial situation at WorldCom for investors and

creditors. The auditing firm also failed to carry out its duties properly.

Arthur Andersen’s failed to detect the fraud was due in part to negligence and in

part to the tight control top management kept over information.

Andersen failed to bring this problem to the attention of the Audit Committee

28/41

Effects on Internal EnvironmentAfter the fraud was announced to the public on June 25, 2002, new measures were taken quickly to

reform WorldCom and restore the public’s confidence in the company. The entire Board of Directors was

replaced with a new Board to guarantee independence and objectivity about management’s decision.

While more than four hundred new finance and accounting personnel were hired, 17,000 of the existing

85,000 employees at WorldCom were let go. A new independent auditor was 40 brought in to re-audit the

financial statements for the fraudulent period. The overstated assets were evaluated for impairment and

the goodwill from the previous acquisitions was written down. The use of stock options was also

abolished and restricted stock with full expensing value of equity grants was implemented A new ethics

program was implemented with training programs for employees to educate them on the manner of their

responsibility at the company and on the accounting issues that may signal an irregularity.

29/41

Effects on External Environment

The largest effect on the external environment was on the investors of WorldCom. The New

York State Common Retirement Fund is the second largest public pension fund in the U.S. It

invested the assets of the New York state and local employees retirement system and of the New

York State and Local Police and Fire retirement system. The pension fund lost over $300 million

of its investments in WorldCom.

30/41

Sarbanes & Oxley Act WorldCom’s failure in June 2002, Congress quickly passed the Sarbanes & Oxley Act about a month later

on July 30, 2002 .The purpose of the act is to protect the investors by improving the accuracy and

reliability of the disclosures made by the publicly traded companies.

Section 301 that gives Audit Committees more responsibility to strengthen the committee’s role. Not only

does the act advise the committee to oversee the auditor’s work, but also requires the members of the

committee to be independent to ensure conflicts of interest do not arise. Additionally, the external auditors

are required to report directly to the Audit Committee and not top management to ensure independence

and objectivity.

Lastly, Section 404 of the Act requires the SEC to assess the internal controls of financial reporting giving

the company responsibility to strengthen the controls and exclude the requirement of having the external

auditors assess management’s process of assessing the internal control system.31/41

The Response of President and ParliamentPresident Bush called for tough new legislation to restore faith in American business.

Mr.Bush said those guilty of corporate fraud should be sent to jail for the sake of US

capitalism. He argued that people guilty of such abuses should be prevented from holding

high-level business positions again.

SOX: Sarbanes-Oxley act 2002, was precipitated by Enron, Arthur Andersen, Tyco,

Global Crossing and WorldCom. WorldCom was seen as the last straw in driving through

legislation.

32/41

Impact of the Fraud

Shareholders: $180B of shareholder value lost (based on peak stock price)

Debt & Preferred Stock holders: $37.5B of debt and preferred stock holder value lost

Company: $750M settlement paid to SEC

Employees: 57,000 employees lost jobs

Board of Directors: 12 Directors agreed to pay (out of pocket) a total of $25M to settle

securities class action case

33/41

Proposed US Corporate Governance Principles

Select a chief executive officer and to oversee the CEO and senior management in the competent and

ethical operation.

Establish a culture of legal compliance and integrity.

Develop and implement the corporation’s strategic plans, and to identify, evaluate and manage the

risks inherent in the corporation’s strategy.

Oversight of the audit committee and the board, to produce financial statements that fairly present the

financial condition and results of operations of the corporation.

Engage an independent accounting firm to audit the financial statements prepared by management and

issue an opinion that those statements are fairly stated in accordance with Generally Accepted

Accounting Principles.34/41

Cont.,

Through its corporate governance committee, to play a leadership role in shaping the

corporate governance of the corporation and the composition and leadership of the

board.

Compensation committee, to adopt and oversee the implementation of compensation

policies, establish goals for performance-based compensation, and determine the

compensation of the CEO and senior management.

Deal with its employees, customers, suppliers and other constituencies in a fair and

equitable manner

35/41

What are something's that world com executives could have done to prevent the accounting scandal ?

The main problem is not following the accounting principles . They should have followed the

following principle:

Courage should have been developed by the employees and should not feel insecure to highlight

the issue to the internal audit team . Whistle blowing with third party audits.

Executives should have changed the autocratic culture during a small mistake or data fudging

activities

Accounting executives should do cross –internal audit among the employees within the same

department , instead of a formal audit

36/41

How could corporate ethics have played a part in this failure ? How could they help to bring a new and successful world com

Corporate culture is the main reason for this failure. World com has followed an autocratic culture ,

it means a top down approach. It made all employees to accept the fraud and every one were given

targets to run over that

Corporate ethics should be adopted as follows to bring a successful company

Bottom Up Approach

-Specific and analytic approach

-Executives set directions and define mission

-Tangible and lasting results

37/41

Participative Management – pressure should be made to realize to employees through town hall meeting and by being a transparent management in all policies

Improve Employee self ethics by frequently posting Fraud case studies a knowledge in email

Strong Confidentiality in whistle blowing policies

38/41

After Scandal

The company emerged from Chapter 11 bankruptcy during 2004 with about $5.7 billion in debt

and $6 billion in cash.

On February 14, 2005, Verizon Communications agreed to acquire MCI for $7.6 billion.

On December 2005, the Microsoft announced that MCI will join it by providing Windows Live

Messenger customers "Voice Over Internet Protocol" (VoIP) service.

This was MCI's last new product called "MCI Web Calling".

39/41

Lessons Learned-Ethical Values Violated

Unethical Work Culture.

Pressurising employees to manipulate accounts.

No productive outlet for employee dissent.

Employees who played along were rewarded; others were threatened.

Fudged up the accounts mislead the various stakeholders.

40/41

Reference

https://www.academia.edu/8313717/Case_Study_WorldComs_Corporate_Governance_Failure

http://etd.fcla.edu/CF/CFH0003811/Ashraf_Javiriyah_201105_BSBA.pdf

https://www.academia.edu/6572763/WorldCom_Case_Study

https://www.wsws.org/en/articles/2002/07/mark-j02.html

41/41