TEAM 1

ACCOUNTING FRAUD AT
WORLDCOM
WORLDCOM COULD NOT HAVE FAILED AS A RESULT OF THE ACTIONS OF A
LIMITED NUMBER OF INDIVIDUALS. RATHER, THERE WAS A BROAD
BREAKDOWN OF THE SYSTEM OF INTERNAL CONTROLS, CORPORATE
GOVERNANCE AND INDIVIDUAL RESPONSIBILITY, ALL OF WHICH WORKED
TOGETHER TO CREATE A CULTURE IN WHICH FEW PERSONS TOOK
RESPONSIBILITY UNTIL IT WAS TOO LATE.
RICHARD THORNBURGH

• Background

• Corporate Culture

• Expense-to-Revenue (E/R) Ratio

• Accrual Releases

• Expense Capitalization

• General Accounting Department

• Internal Audit

• The Outside Auditor: Arthur Andersen

• The Board of Directors

• The Endgame

• Epilogue
 Tax

Revenue overstated its pre- tax

income by at least $7 billion
more than $30 billion

Effect

Asset
JULY 21, 2002 20 million retail
customers,80 million Social
$104 billion,wrote down about $82 Security beneficiaries
billion

All in all

Employees
filed for bankruptcy
protection under Chapter 11
60000, 17000 -lost jobs of the U.S. Bankruptcy
Code
 BACKGROUND
-organised in 1983 from breakup of AT&T
LDDS started with about $650,000 in capital but soon accumulated $1.5 million in debt since it lacked the technical expertise to
handle the accounts of large companies that had complex switching systems.

By 1998, WorldCom had become a

By the end of 1993, LDDS was In 1996, WorldCom entered the
full-service telecommunications
the fourth-largest long-distance local service market by purchasing
MFS Communications Company,
company, able to supply
carrier in the United States. After a
Inc., for $12.4 billion. virtuallyWorldCom’s integrated
shareholder vote in May 1995, the service packages and its Internet
The $42 billion price represented, at
company officially became known strengths gave it an advantage
the time, the largest takeover in
as WorldCom. over its major competitors, AT&T
U.S. history.
and Sprint.
 In 1999, WorldCom attempted to acquire Sprint, but the
U.S. Justice Department, in July 2000, refused to allow
the merger on terms that were acceptable to the two
companies. The termination of this merger was a
significant event in WorldCom’s history. WorldCom
executives realized that large- scale mergers were no
longer a viable means of expanding the business.a
WorldCom employees noted that after the turndown of
the Sprint merger, “Ebbers appeared to lack a strategic
sense of direction, and the Company began drifting.
 CORPORATE CULTURE
WorldCom’s finance department at the WorldCom’s headquarters for its network
Mississippi corporate headquarters operations, which managed one of the largest
maintained the corporate general ledger, Internet carrier businesses in the world, was
which consolidated information from the based in Texas. The human resources
incompatible legacy accounting systems of department was in Florida, and the legal
more than 60 acquired companies. department in Washington, D.C.

In sum, Ebbers created a culture in Ebbers and Sullivan frequently granted compensation beyond the company’s
which the legal function was less approved salary and bonus guidelines for an employee’s position to reward selected,
influential and less welcome than in a and presumably loyal, employees, especially those in the financial, accounting, and
investor relations departments. The company’s human resources department virtually
healthy corporate environment
never objected to such special awards.
 EXPENSE-TO-REVENUE (E/R)
RATIO
The leases contained punitive termination provisions. Even if capacity were underutilized, WorldCom could
avoid lease payments only by paying hefty termination fees. Thus, if customer traffic failed to meet expectations,
WorldCom would pay for line capacity that it was not using.

Failing telecommunications companies and new entrants were drastically reducing their prices, and WorldCom
was forced to match. The competitive situation put severe pressure on WorldCom’s most important performance
indicator, the E/R ratio (line-cost expenditures to revenues), closely monitored by analysts and industry
observers.WorldCom’s E/R ratio was about 42% in the first quarter of 2000, and the company struggled to
maintain this percentage in subsequent quarters while facing revenue and pricing pressures and its high
committed line costs.
As business operations continued to decline, however, CFO Sullivan decided to use accounting entries to achieve
targeted performance. Sullivan and his staff used two main accounting tactics: accrual releases in 1999 and 2000,
and capitalization of line costs in 2001 and 2002
ACCRUAL
RELEASES

Over a seven-quarter period between 1999

and 2000, WorldCom released $3.3 billion
worth of accruals, most at the direct
Myers reportedly told request of Sullivan or Myers. Several
Schneberger, asking business units were left with accruals for
future cash payments that were well below
him to book the $370
the actual amounts they would have to pay
million adjustment. when bills arrived in the next period.

Throughout 1999 and 2000, In 2000, General Accounting released

Sullivan told staff to release $281 million against line costs from
accruals that he claimed were too accruals in the tax department’s
high relative to future cash accounts, an entry that the tax group did
payments. not learn about until 2001.
 Expense Capitalization

An accounting manager in 2000 had raised this possibility of treating periodic line costs as a capital expenditure but had been
rebuffed by Yates: “David [Myers] and I have reviewed and discussed your logic of capitalizing excess capacity and can find
no support within the current accounting guidelines that would allow for this accounting treatment.

In April 2001, however, Sullivan decided to stop recognizing expenses for unused network capacity.13 He directed Myers and Yates
to order managers in the company’s general accounting department to capitalize $771 million of non-revenue-generating line
expenses into an asset account, “construction in progress.” The accounting managers were subsequently told to reverse $227 million
of the capitalized amount and to make a $227 million accrual release from ocean-cable liability.

WorldCom’s April 26, 2001 press release and subsequent 10-Q quarterly report filed with the U.S. Securities and Exchange Commission
(SEC) reported $4.1 billion of line costs and capital expenditures that included $544 million of capitalized line costs. With $9.8 billion in
reported revenues, WorldCom’s line-cost E/R ratio was announced at 42% rather than the 50% it would have been without the
reclassification and accrual release
 GENERAL ACCOUNTING DEPARTMENT
• In October 2000, Vinson and her colleague Troy Normand (another manager in General Accounting) were called into their boss’s office. Their boss, Yates, told them that

Myers and Sullivan wanted them to release $828 million of line accruals into the income statement.In April 2001, Vinson and Normand were again placed in a difficult

position, except this time the position was, from Vinson’s perspective, even less defensible. Revenues in the quarter were worse than expected, and Sullivan wanted them

to transfer $771 million of line costs into capital expenditures.

• It was her job to distribute the amount across five capital accounts. She felt trapped but eventually

made the entries and backdated them to February 2001.

• Vinson continued to make similar entries throughout 2001 but began losing sleep, withdrawing

from workers, and losing weight. Each time she hoped it would be the last, yet the pressure

continued. In early 2002, she received a raise (to roughly $80,000) and a promotion to director. In

April 2002, Yates, Normand, and Vinson reviewed the first-quarter report, which included $818

million in capitalized line costs. They also learned that achieving Ebbers’s projections would

require making similar entries for the remainder of the year. They made a pact to stop making such

entries.
 INTERNAL
AUDIT
Arthur Andersen, WorldCom’s independent auditors, performed the financial audits to assess the reliability and integrity of the
publicly reported financial information. Andersen reported to the audit committee of the company’s board of directors. In August
2001, Cooper began a routine operational audit of WorldCom’s capital expenditures. Sullivan instructed Myers to restrict the scope of
Cooper’s inquiry: “We are not looking for a comprehensive Capex audit but rather very in depth in certain areas and spending.”
Cooper’s audit revealed that Corporate had capital expenditures of $2.3 billion. By way of comparison, WorldCom’s operations and
technology group, which ran the company’s entire telecommunications network, had capital expenditures of $2.9 billion. Internal
Audit requested an explanation of Corporate’s $2.3 billion worth of projects. Cooper’s team received a revised chart indicating that
Corporate had only
$174 million in expenditures. A footnote reference in this chart indicated that the remainder of the
$2.3 billion included a metro lease buyout, line costs, and some corporate-level accruals.
 In March 2002, the head of the wireless business unit
complained to Cooper about a $400 million accrual in
his business for expected future cash payments and
bad-debt expenses that had been transferred away to
pump up company earnings. Both Sullivan and the
Arthur Andersen team had supported the transfer.
Cooper asked one of the Andersen auditors to explain
the transfer, but he refused, telling her that he took
orders only from Sullivan.
 THE OUTSIDE AUDITOR: ARTHUR ANDERSEN
• Andersen, which had a Mississippi-based team of 10–12 people working full time on WorldCom’s audits, underbilled the
company and justified the lower charges as a continuing investment in its WorldCom relationship.
• For line costs, Andersen assessed the risk that line-cost liabilities might be understated or overstated by testing whether
the domestic telco accounting group received accurate information from the field. It did not perform comparable tests for
the international line-cost group even after WorldCom employees told Andersen’s U.K. audit team about a corporate
reversal of $34 million in line-cost accruals after the first quarter of 2000.s Andersen focused primarily on the risk that
WorldCom revenues would be misstated because of errors or inaccurate records, not by deliberate misrepresentation.
• Andersen rated WorldCom’s compliance with requests for information as “fair,” never informing the audit committee
about any restrictions on its access to information or personnel.
 THE BOARD OF DIRECTORS
Sullivan manipulated the information related to capital expenditures and line costs presented to the board. His presentation of total
capital spending for the quarter included a breakdown on spending for local, data/long haul, Internet, and international operations and
major projects. The board, which was expecting cuts in capital expenditures, received information that reflected a steady decrease.
However, the spending cuts were far greater than they were led to believe. The hundreds of millions of dollars of capitalized line costs
inflated the capital expenditures reported to the board

On April 26, 2002, the nonexecutive directors met by themselves, for the first time, to discuss Ebbers’s delay in providing collateral for
his loans from the company. The directors, dissatisfied with Ebbers’s lack of strategic vision and his diminished reputation on Wall
Street, voted unanimously to ask Ebbers for his resignation. Within three days, the board signed a separation agreement with Ebbers
that included a restructuring of his loans into a five-year note and a promise of a $1.5 million annual payment for life.
 REPORT OF CAPITAL EXPENDITURES TO BOARD VS. ACTUAL CAPITAL
EXPENDITURES (IN MILLIONS)

3Q 4Q 1Q 2Q 3Q 4Q 1Q

As reported to board
2,648 2,418 2,235 2,033 1,786 1,785 1,250

Actual spend, not shown to board

1,691 1,473 1,044 944 462
 THE ENDGAME

June 2002, had discovered $3 billion in questionable expenses,

including $500 million in undocumented computer expenses.On
June 25, 2002, WorldCom announced that its profits had been
inflated by $3.8 billion over the previous five quarters. Nasdaq
immediately halted trading of WorldCom’s stock. Standard &
Poor’s lowered its long-term corporate credit rating on WorldCom
bonds from B+ to CCC-.
EPILOGUE

Arthur Andersen was never held to account for its WorldCom audits.
On June 13, 2002, after a six- week trial and 10 days of deliberations,
jurors convicted Arthur Andersen for obstructing justice for its
destruction of Enron documents while on notice of a federal
investigation. After the verdict, the Securities and Exchange
Commission announced that the accounting firm would cease
practicing before the commission by August 31, 2002.
 7 500

5 000

2 500
SELECTED WORLDCOM
FALSE STATEMENTS TO THE
SECURITIES AND
EXCHANGE COMMISSION
0

-2 500

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THANK
STUDENTS:

Hamroqulova Guloro

Bobonazarova Mohichehra

YOU Rahmonova Nigora

Sharipov Shahzodjon