Case Study of WorldCom
The WorldCom fraud was the largest in U.S. history, surpassing even that of Enron. Beginning modestly during mid-year 1999 and continuing at an accelerated pace through May 2002, the company—under the direction of Bernie Ebbers, the CEO; Scott Sullivan, the CFO; David Myers, the controller; and Buford Yates, the director of accounting—“cooked the books” to the tune of about $11 billion of misstated earnings. Investors collectively lost $30 billion as a result of the fraud.
The fraud was accomplished primarily in two ways:
- Booking “line costs” for interconnectivity with other telecommunications companies as capital expenditures rather than operating expenses.
- Inflating revenues with bogus accounting entries from “corporate unallocated revenue accounts.”
During 2002, Cynthia Cooper, the vice president of internal auditing, responded to a tip about improper accounting by having her team do an exhaustive hunt for the improperly recorded line costs that were also known as “prepaid capacity.” That name was designed to mask the true nature of the costs and treat them as capitalizable costs rather than as operating expenses. The team worked tirelessly, often at night and secretly, to investigate and reveal $3.8 billion worth of fraud.
Soon thereafter, Cooper notified the company’s audit committee and board of directors of the fraud. The initial response was not to take action, but to look for explanations from Sullivan. Over time, Cooper realized that she needed to be persistent and not give in to pressure that Sullivan was putting on her to back off. Cooper even approached KPMG, the auditors that had replaced Arthur Andersen, to support her in the matter. Ultimately, Sullivan was dismissed, Myers resigned, Andersen withdrew its audit opinion for 2001, and the Securities and Exchange Commission (SEC) began an investigation into the fraud on June 26, 2002.
In an interview with David Katz and Julia Homer for CFO Magazine on February 1, 2008, Cynthia Cooper was asked about her whistleblower role in the WorldCom fraud. When asked when she first suspected something was amiss, Cooper said: “It was a process. My feelings changed from curiosity to discomfort to suspicion based on some of the accounting entries my team and I had identified, and also on the odd reactions I was getting from some of the finance executives.”1
When asked whether there was anything about the culture of WorldCom that contributed to the scandal, Cooper laid blame on Bernie Ebbers for his risk-taking approach that led to loading up the company with $40 billion in debt to fund one acquisition after another. He followed the same reckless strategy with his own investments, taking out loans and using his WorldCom stock as collateral. Cooper believed that Ebbers’s personal decisions then affected his business decisions; he ultimately saw his net worth disappear, and he was left owing WorldCom some $400 million for loans approved by the board. Ebbers was sentenced to 25 years in jail for his offenses.
Betty Vinson, the company’s former director of corporate reporting, was one of five former WorldCom executives who pleaded guilty to fraud. At the trial of Ebbers, Vinson said she was told to make improper accounting entries because Ebbers did not want to disappoint Wall Street. “I felt like if I didn’t make the entries, I wouldn’t be working there,” Vinson testified. She said that she even drafted a resignation letter in 2000, but ultimately she stayed with the company. It was clear she felt uneasy with the accounting at WorldCom.
Vinson said that she took her concerns to Sullivan, who told her that Ebbers did not want to lower Wall Street expectations. Asked how she chose which accounts to alter, Vinson testified, “I just really pulled some out of the air. I used some spreadsheets.”2
Her lawyer urged the judge to sentence Vinson to probation, citing the pressure placed on her by Ebbers and Sullivan. “She expressed her concern about what she was being directed to do to upper management, and to Sullivan and Ebbers, who assured her and lulled her into believing that all was well,” he said. In the end, Vinson was sentenced to five months in prison and five months of house arrest.
Answer the following questions:
- What is the difference between accrual earnings and cash earnings? In addition to the effect on accrual earnings of capitalizing the line costs, how might the treatment mask the true nature of operating cash flows?
- Identify the stakeholders in the WorldCom case and how their interests were affected by the financial fraud.
- Use ethical reasoning to compare the actions of Cynthia Cooper in the WorldCom case to those of Sherron Watkins in the Enron case, discussed earlier in this chapter.
There is a major difference between accrual earnings and cash earnings. Accrual earnings are considered as incomes and other earned revenues during a financial period, but not received until the next of future financial period. On the other hand, cash earnings are considered as the residual profit of a company after subtracting the cash expenses from the case revenues. The calculation of deriving cash earnings does not include any non-cash expenses like depreciation and amortization. It implies that cash is received instantly in case of cash earnings when cash is receivable in case of accrual earnings (Hui, Nelson & Yeung, 2016).
The management of WorldCom was involved in the misstatement of operating expenses and earnings for masking their actual operating performance through unlawfully moving certain costs that had to be expensed to capital costs. Due to the overstatement of net income and amortization expenses, operating cash flow was overstated that misled the stakeholders into thinking that there were higher total assets, higher net income and higher profitability when they were misplacing billions of dollars in actual.
The affected stakeholders in WorldCom case are as follows:
Investors – WorldCom’s illicit accounting treatment to book operating expenses as capitalized costs disobeyed principles of GAAP resulting incorrect disclosure of the entity’s financial position. This misled and defrauded the investors resulting $30 billion loss to them (Elam, Madrigal & Jackson, 2014).
Employees and Stockholders – Due to the bankruptcy filing of WorldCom, almost 30,000 employees of the company lost their jobs along with compensations and stock benefits.
Creditors and Suppliers – Because of the bankruptcy of WorldCom, it failed in paying the debts to the creditors and suppliers due to huge loss in net income.
Higher Management Employees – the CEO of WorldCom, Bernard Ebbers was sentenced to 25 years in prison due to his involvement in WorldCom fraud. Due to performing $11 million accounting fraud in WorldCom, Scott Sullivan was sentenced to 5 years in prison. Accounting fraud of $3.8 million was uncovered by Cynthia Cooper while secretly working with the auditors and her team; and she left the company later (Elam, Madrigal & Jackson, 2014).
Cynthia Cooper and the team of internal auditors utilized scepticism and objectivity while considering the prepaid capacity costs. They refused to accept casual answers while requesting for additional support and documentation. This action of Cynthia Copper has resemblance with the four component model of morality of Rest where the components are moral sensitivity, moral judgment, moral motivation and moral character (Werhane, 2015). The auditors were able to understand the dilemma and were determined to solve the issue.
In case of Enron, Watkins was aware of the falsification of financial information within the company and decided not to go beyond Ken Lay for taking her concerns to the higher authority. In spite of the knowledge about the financial wrongdoing, she took very little step to resolve the issue since she was concerned about her own interest instead of collective interest. It was a highly unethical job from Watkins (Mintz & Morris, 2017).
Elam, D., Madrigal, M., & Jackson, M. (2014). Olympus Imaging Fraud Scandal: A Case Study. American Journal of Business Education, 7(4), 325-332.
Hui, K. W., Nelson, K. K., & Yeung, P. E. (2016). On the persistence and pricing of industry-wide and firm-specific earnings, cash flows, and accruals. Journal of Accounting and Economics, 61(1), 185-202.
Mintz, S. M., & Morris, R. E. (2017). Ethical obligations and decision making in accounting: Text and cases (4th Ed.). Retrieved from https://www.vitalsource.com
Werhane, P. H. (2015). Moral imagination. Wiley Encyclopedia of Management, 1-2.
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