WorldCom Accounting Scandal Analysis


WorldCom (presently known as MCI) which is the U.S’s second-biggest long-distance phone company is considered to have committed the greatest accounting fraud in the annals of the history of the U.S. In the late 1990s, WorldCom is under pressure to maintain its EBITDA or cash flow levels to maintain its share price as the orders for the company declined sharply. This exerted more pressure on executives of WorldCom to engage in fraudulent and unethical activities. The total accounting fraud reported by WorldCom amounted to $ 11 billion. This research essay analyses the WorldCom scandal in a detailed manner and suggests ways and means avoid such frauds in the future.

Corporate environment: the degree to which fraud is allowed to occur, or is discouraged, through corporate policies and practices.

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A written fraud policy or manual of an organization defines what an unacceptable demeanor is and how a fraud investigation will be handled. It reflects the intention of the management to view such frauds very seriously and to deter fraud and formalizes the style in which the company will manage the fraud. A vibrant corporate policy must demonstrate the message that no one has the power to perform illegal acts. The fraud policy incorporates a structure for ethical demeanor by all employees in all scenarios and explains the steps that will be initiated to address fraud by individuals both outside and inside of the company. The fraud policy must spell out the procedures that have to be followed when probably fraudulent activities are faced.

It should have the following:

  • A statement of the company’s goal to punish those individuals who commit fraud.
  • The policy should demonstrate who is accountable for detection, deterrence, and investigation of fraud.
  • Procedures and guidelines for handling suspected frauds.
  • Procedures for reporting and unleashing the outcomes of fraud investigations. (Corderre13).

WorldCom accounting scandal demonstrated that efficient controls were not in place to prevent fraudulent transactions.

The degree to which each of the following types of fraud has occurred:

  • Improper asset valuation: This involves indulging in fictitious inflation of asset values or other improper valuations normally to augment the strength and appearance of financial statements. This is perused by inflating accounts receivables, inventory, and revenue and misreporting of fixed assets. Improper valuation of assets happens when assets are valued at either greater or less than their net realizable value or cost. If assets are overvalued or undervalued, it will result in understatement or overstatement of net worth and income. For instance, if a company’s accounts receivable or inventory is overstated, its net income, working capital, and net worth will also be overstated. (Montgomery & Majeski, p346).
  • Fictitious revenues: This is one of the common mechanisms employed to manipulate financial statements and can assume varied forms.

Improper disclosures within financial statements by posting fictitious revenues comprise more than fifty percent of all the financial statement frauds reported. By the misapplication of accounting methods, revenues can be manipulated. For instance, premature recording of a sale can be made before the earning process is completed. Fictitious revenues not only boost the sales but also inflate the net worth and bottom line.

The common fictitious revenue scam is being indulged as per the following schemes:

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  • Dumping of inventory with the regular dealers at the year-end where goods will be finally returned to the warehouse.
  • Channel stuffing
  • Fabrication of documents
  • Not adhering to mandatory accounting standards
  • Disguised side deals
  • Contracts backdated, which facilitates to cancel the sale later. (Montgomery & Majeski, p345).

WorldCom engaged in inappropriate discharge of accruals, which resulted in deflation of current year overheads and inflated revenues. WorldCom also reported inflated operating earnings by posting objectionable revenue entries and involved disclosure omissions.

Skimming

This is also known as front end fraud. Under this category, funds are misappropriated even before a recording entry is made. Since the money is stolen in advance, it is very difficult to detect this fraud. This type of fraud is common in business where cash is predominantly accepted like restaurants, bars, gas stations, vending machines, retail stores and home modernization contracting jobs. Skimming is common in casinos in Las Vegas as the owner himself indulged in skimming mainly to conceal income to avoid taxes.

Skimming falls into three categories namely receivable schemes (Unconcealed schemes, lapping schemes and write-off schemes), sales schemes (understated sales, unrecorded sales) and refund schemes. According to a survey, about 28% of all cash frauds constitute skimming. (Singleton, Bologna & Lindquist, p120).

Understatement of liabilities

One another accounting fraud techniques include the understatement of liabilities or failure to record liabilities. Both income statement and balance sheet will be erroneous if there is a concealment of liabilities. General mechanism involved in omitting of liabilities fraudulently will be as follows:

  • Purchases of inventory
  • Lawsuit settlement
  • Related party transactions
  • When cash is received, a liability is reported as revenue.
  • Omitting to record contingencies (Montgomery & Majeski, p348).

Timing differences

The accuracy of the financial statements can be corroborated if the financial transactions are recorded within the proper period. This is known as “matching principle.” This implies that matching of revenues of a period with that of expenses of that particular period. An improper matching of revenues and expenses would arise if matching principle is not followed. This is also known popularly as “improper cutoff.” No doubt, timing difference would end in a material misrepresentation of the financial statements.

Some of the instances of timing differences are:

  • To record future revenues prematurely in the current accounting period
  • Failure to account current years expenses or costs
  • Postponing a current expense or costs to a future period (Montgomery & Majeski, p347).

Bribery

Bribery can be illustrated as the giving, offering, soliciting or receiving anything of worth manipulating a business decision or an official act. Bribery is an acknowledged way of conduction a business in many nations. Bribes have been linked with the ouster of many managers, government officials, legislators and even governments. According to one survey, about $80billion is being expended by way of bribery or some other form of kickbacks each year. Many Honda American executives were convicted of taking bribes from local auto dealers in 1990’s.Lobbying is the accepted form of bribery where industries in USA are spending billions of dollars to legislate law favoring their industry. (Singleton, Bologna & Lindquist, p112).

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Illegal gratuities

Though, it is analogues to bribery, but it is differing from bribery as there is no intention to manipulate a business decision. In this type, an expensive gift, a free vacation and so on can be offered mainly to influence in a business deal or a negotiation and however, the gift is made after the deal is over. For instance, a pharmaceutical company may offer gratuities to doctors who prescribe their medicine. (Singleton, Bologna & Lindquist, p113).

  • The responsibility of the Board of Directors in preventing, identifying, and correcting fraud-related problems.

Duties of Board of directors include establishing strong internal controls to protect shareholder’s interest and company’s assets which include detection and prevention of frauds, which are based on 1) establishing proper control environment 2) instituting vibrant and effective internal control measures 3) appreciating vibrant ethical standards and establishing appropriate code of conduct and to see that audit committee functions in an independent manner and to report to the board about the company’s internal control systems. (Gray and Manson 672).

  • The responsibility of the internal auditors in preventing, identifying, and correcting fraud-related problems. The degree to which conflicts of interest influenced the frauds.

It is the responsibility of management to frame and maintain effective control standards at a reasonable cost. Internal auditors have a duty to exercise due professional care. Internal auditors should have adequate awareness about fraud to recognize the indicators that fraud may have been occurred, be attentive to opportunities that could encourage fraud , assess the requirement for extra investigation and to inform the proper authorities either to audit committee or to the Board if CEO does not take any actions of such fraud.

  • The degree to which collusion among employees, managers, or others influenced the frauds.

The company should discourage collusion between the vendors or customers and employees and clearly demonstrate to the customers and vendors that company is dead against fraud. To prevent collusion between employees, managers and top executives, company should appoint a fraud prevention officer or vigilance officer and whistle blowing should be encouraged and should be properly rewarded. (Albrecht et al 109).

WorldCom fraud reveals that management was exceptionally optimistic and assumed unusual risks including fraud. WorldCom accounting department supported by management had rather resorted to some novel technology or an escape route in GAAP (Generally Accepted Accounting Principles) to commit this mammoth accounting fraud.

  • The degree to which the Company’s external auditors and investment bankers were complicit in each of the frauds.

External auditors should avoid any surface of conflict of interest with their customers and should be careful not to become business partners. In case, if the external auditor finds any fraud, then they should qualify their audit report and should submit to the Board. If the board does not act within some couple of days, then should resign, which will compel the company to file form 8K to the SEC as regards to resignation of the external auditor.

In WorldCom, External auditors Anderson failed to report their serious findings to the Audit Committee.

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In Enron scandal, investment banker Merrill Lynch was fined for their involvement. There is evidence that investment bankers knew that Enron’s financial statements were misleading but still knowingly permitted investors to rely on it. In Enron scandal, Merrill Lynch was charged by SEC that it abetted and aided the fraud. (Marnet 243).

  • The degree to which the Sarbanes-Oxley Act should reduce the risk of fraud for the subject company.

To address sinking individual and institutional investor confidence mainly aggravated due to accounting restatements and business failures, SOX was enacted in July 2002 by Congress. One of the main aims of the SOX is to deter corporate frauds by imposing heavy fines and penalties for frauds and other infringements. Further, The United States Sentencing Commission was directed by Sarbanes –Oxley Act to impose stricter sentencing guidelines for some white-collar crimes. The Sarbanes –Oxley Act increased the maximum prison sentences for certain crimes like “attempt or conspiracy.” These concerted efforts by SOX will no doubt would reduce the risk of fraud in any company in the future.

As per SEC Report of 2003, WorldCom management made numerous countervailing accounting entries so as to achieve the aggressive revenue budgets set out by both financial community and by the company. Wherever there was variance between actual revenues and budgeted revenues, management passed numerous accounting entries, mainly to cover up the gap so that targeted financial were achieved.

  • Specific recommendations to reduce the potential for future fraud, in the areas in which it occurred. Address all levels of management and oversight bodies, as appropriate. Also address the corporate environment.

Some of the fraud prevention and detection strategies are as follows:

  • To review and enhance internal control strategies.
  • To increase the focus of top management teams by setting a tone at the top.
  • To offer training courses in fraud prevention and detection.
  • To establish a corporate code of conduct
  • To perform a reference checks on new employees.
  • To provide training in ethics to employees.
  • To carryout periodical fraud vulnerability reviews.
  • To encourage whistle blowing and rewarding.
  • To engage the services of forensic accountants for the prevention and detection of fraud. (Rezaee 12).

WorldCom management failed to visualize and introduce efficient reporting and honest auditing and the investors and public were indeed lost billions of dollars due to their intentional fraud. (Zekany 101)

WorldCom is now been rechristened as MCI. The present management is in the effort to resurrect the company both financially as well as ethically. Now, all the employee at MCI (erstwhile WorldCom) is compulsorily have to undergo ethical training. For avoiding scandals and frauds at the corporate level, MCI is training its employees of all categories in building credibility and belief, fostering a culture of frank and open communications at all levels, to peruse accurate reporting, being loyal to the management and executing the right thing.

As a part of settlement with the SEC (Stock Exchange Commission), WorldCom paid $ 750 million as fines. CEO of WorldCom, Ebbers faced a charge with a fine of $ 8.25 million and an imprisonment of 85 years in jail. No doubt, these deterrent fines and imprisonment will prevent many more WorldCom to happen in the future.

Works Cited

Albrechit Steve, Albrecht Conan, Albrecht Chad & Mark Zimelman. Fraud Examination. London: Cengage Learning, 2009.

Coderre, David. Computer Aided Fraud Prevention and Detection. New York: John Wiley and Sons, 2009.

Gray Lain & Manson Stuart. The Audit Process: Principles, Practice and Cases. London: Cengage Learning, 2007.

Marnet, Oliver. Behavior and Rationality in Corporate Governance. New York: Routledge, 2008.

Montgomery, Reginald J & Majeski, William J. Corporate Investigations. New York: Lawyers & Judges Publishing Company, 2005.

Rezaee, Zabihollah. Financial Statement Fraud: Prevention and Detection. New York: John Wiley and Sons, 2002.

Singleton Tommie, Singleton Aaron, Bologna Jack & Lindquist, Robert J. Fraud Auditing and Forensic Accounting. New York: John Wiley & Sons, 2006.

Zekany, Kay E., Lucas W. Braun, and Zachary T. Warder. “Behind Closed Doors at WorldCom: 2001.” Issues in Accounting Education 19.1 (2004): 101+.

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