Question

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 (“CEO”) 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 telecom businesses in less than a decade. In 1999, Ebbers was one of the richest Americans with a $1.4 billion net worth. From the outside, WorldCom appeared to be a strong leader of growth. In reality, the appearance was nothing more than a perception. 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.

The executive and strategic decisions at WorldCom were characterized by rapid growth through acquisitions. WorldCom had been involved in mergers with sixty companies. Together, these transactions were valued at more than $70 billion, the largest of which, MCI Communications Corporation (“MCI”), was completed on September 14, 1998, and was valued at $40 billion. WorldCom was motivated by the low interest rates and rising stock prices during the 1990s. From the beginning it committed itself to the high growth strategies that relied on aggressive corporate actions that often involved “creative” accounting practices. Investigation of WorldCom revealed a lack of strategic planning, often depicted by non-existent “proper corporate governance protocols. There was no strategic committee and the decision-makers mainly consisted of Ebbers, Chief Financial Officer (“CFO”) Scott Sullivan (“Sullivan”), and Chief Operations Officer (“COO”) John Sidgmore.

Once WorldCom acquired the new companies, it failed to properly integrate the systems and policies that not only led to very high levels of overhead in proportion to the revenues but also to an extremely weak internal control environment. Due to the fast pace of the acquisitions as well as management’s neglect, the accounting systems at WorldCom were unable to keep up with integration and efficiency. The lack of internal controls allowed manual adjustments to be made in the system without the emergence of any red flags, thereby minimizing any chance of detection.

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. In fact, one former executive reported that the pressure became “unbearable-greater than he had ever experienced in his fourteen years with the Company. One employee stated that WorldCom was never a happy place to work, even when the company was doing well, the employees were forced to work 10, 12, or even 15-hour days but it balanced out with the higher compensation. However, when the stock dropped, the employees were still required to work the long hours even when compensation was all but gone. 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. This allowed the reporting of higher revenues for WorldCom through which employees pocketed extra commissions that amounted to almost $1 million. Efforts were made to establish a corporate Code of Conduct which received Ebbers’s disapproval. He often described the Code as a “colossal waste of time. 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. The employees at WorldCom did not have an outlet to express concerns about company policy and behavior either. Special rewards were given to those employees who showed loyalty to top management while those who did not feel comfortable in the work environment were faced with obstacles in their need to express their concerns

The directors at WorldCom were from different backgrounds. While some had widespread knowledge and experience of business and legal issues, others were appointed due to their connections with Ebbers. The mix of the Board and the close ties to Ebbers led to the Board’s lack of awareness on WorldCom’s issues. 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. They had a large amount of influence on the approval or disapproval of company decisions. Their approvals of the acquisitions allowed WorldCom’s growth to an increase that led to a higher stock price and a large amount of compensation. Directors dependent on this type of “large issuances of equity” not only conveyed an unhealthy practice but also created a conflict of interest where their goal became more focused on the growth of the stock than on what was in the best interests of the company. Another conflict of interest arose for those board members that had strong ties to Ebbers. Their closeness to Ebbers hurt their duty to be independent of the company and its management.

At WorldCom, an Audit Committee was established to conduct relations with Arthur Andersen, the external auditor. An Audit Committee consists of a selected number of Board members who are to meet from time to time with the company’s auditing firm and discuss the progress of the audit, the findings, and resolve any conflicts that may occur between management and the firm. However, 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. The Committee oversaw the $30 billion revenue company when it met for about three to six hours once a year. While the Committee was represented positively, the accounting controls within were “virtually non-existent”. It appears the lack of activity was more of a “going through the motions” as opposed to the Committee sitting down and understanding the policies, the internal controls, and the audit programs that were a necessity to the company’s core structure. Even though Arthur Andersen acknowledged WorldCom as a 15 “maximum risk” client and mentioned to the Committee that WorldCom had “misapplied GAAP (Generally Accepted Accounting Principles) with respect to certain investments,” the committee chose to ignore it and, in the end,, Arthur Andersen gave WorldCom a clean, unqualified opinion. The audit committee’s negligence depicts another weakness in WorldCom’s internal controls. Therefore, it is very important to have members in the committee that fulfill their duties by overseeing the corporation’s internal control structure as well as making sure that the company complies with “laws, regulations, and standards. The members should also periodically meet with the firm’s internal and external auditors to ensure the audit process is efficient and be aware of the company’s operations. The fulfillment of these duties is now a requirement due to Section 301 of the Sarbanes-Oxley Act. 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. Not only were the personnel in the internal audit department not enough for a large company, but they also lacked the proper training and experience to conduct the testing of the company’s controls. In reality, an internal auditor does little work on the financial statements and focuses more on “improving the organization’s operations” rather than conducting the actual operations. External Auditors at WorldCom, it appears there were no checks and balances in auditing. The internal auditors were not sufficiently staffed to work on the internal controls and the audits of the company which prevented them from correctly reporting to the Audit Committee about the operational and financial situation of WorldCom. The Committee itself did not meet on a regular basis either and was unable to properly take action to fix the situation. Yet, 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.

Unfortunately, WorldCom’s internal control environment was inefficient in many ways and therefore allowed Andersen to overlook “serious deficiencies” that existed in the internal environment. If the external auditors had performed their work properly, the fraud could have been discovered long before 2002. Moreover, even though the top management’s control over the information was suspicious, Andersen failed to bring this problem to the attention of the Audit Committee. Unfortunately, the retaining of WorldCom as a client was due to the consulting revenue that it brought in to Arthur Andersen. The auditors spent more time selling those consulting services and less time conducting analytical reviews and testing controls. This situation created a conflict of interest because the auditors would first consult a company about how to increase performance or efficiency and then go back to the same company and independently audit it. Top management at WorldCom was aware of this and made the journal entries in the way they would be tested by Arthur Andersen. In addition, Arthur Andersen may not have overlooked the details purposely but rather the auditors were pressured to have the job completed as soon as they could. It appears that the relationship with WorldCom was more valued than performing appropriate audit work. Andersen’s close relationship with Ebbers, in the end, resulted in a lack of professional skepticism, which is the questioning attitude that the auditor should have when in the field.

Required:

Answer the following questions:

1. What are the circumstances that demand special risk assessment attention in the above case?

2. What are the external factors that lead to the fraud at WorldCom?

3. Were the external auditors guilty? Why or why not?

4. How should employees react to pressures from their employers to do actions they do not believe

       in doing?

Answer 1