Clive Vlieland-Boddy FCA FCCA MBA

1. Accounting Fraud at Worldcom Clive Vlieland-Boddy FCA FCCA MBA

2. WorldCom Group Review: • Summarise your criticisms of the methods of accounting. The policies and the concepts. • Reversal of Provisions • Capitalisation of Expenditures • How do they compare with good accounting practice?

4. Key Issues • What is the Company? • What is the Industry? • What is the decision to be made? • Who is to make the decision?

5. The Company

6. The Industry • Many large players. • Highly competitive. • Difficult to differentiate but R & D important. • Barriers to entry. • Deregulation stimulating competition.

7. What is the decision to be made? • Why did it go bust?

8. Who is to make the decision? • US!

9. History & Background • Formed in 1983 from break-up of ATT as Long Distance Discount Service. (LDDS) • Initial Capital $650k and debt of $1.5m. • Ebbers initial investor and became CEO. • 1996 Bought MFS for $12.5b. • 1997 Bought MCI for $42b. • By 1998 was one of the leading US telecom providers. • 1999 attempted bid for Sprint refused by US justice.

10. Corporate Culture • Fragmented management and control. • Only a few key executives really knew all that was going on. • Difficult for employees to see whole picture. • Ebbers & Sullivan in total control. • Autocratic Management Style.

11. The Problem • The industry was becoming over populated and excessively competitive. • Margins were being eroded. • The key ratio of Line Costs to Revenue were increasing. (E/R) • Sullivan wanted to keep this at 42%!

12. The Solutions…. ?

13. Back to Basic Accounting Debits Credits Assets Liabilities Expenditure Income

14. Solution No 1- Accrual Releases • Companies need to match revenue with expenditure. • Often expenditure may not yet have been paid for but is expected to be in the future. Example. Line rentals tended to be paid at the end of the month or even quarterly in arrears. • Thus reducing these provisions would reduce the charge for expenditure in the Income Statement.

15. Accruals or Matching Concept • An accrual is a provision to match income with expenditure. • If we don’t match income with its expenditure then we understate profits.

16. 1999 and 2000 Several large releases were made from the provisions thereby reducing expenditure. • $370m of international fixed costs. • $281m of tax provisions. • Over the 7 quarters $3.3b was released. • This left virtually no provisions to meet the known expenditure.

17. So where next? OH!!!!.... We have run out of provisions to misuse…

18. Solution No 2 – Expense Capitalisation • Brilliant………. • You will go far…… • You have saved the company?

19. What is Expense Capitalisation? Companies have expenses which they show in their Income Statement. These include say: • Wages and Salaries. • Rents. • Lighting & Heating Costs. These represent expenditures that have been incurred and consumed.

20. But what do we mean by “consumed”? • What if you can say that there is still some value left?

21. The Argument • Line rentals represent an expense for being able to use a cable connection. • It may be that you have to hire such a line say between New York and Los Angeles. It might cost $10m a month, but enable say 1m separate users to access that line at the same time. What if only 100,000 users use it. It is only being used 10%. • What about saying that 90% is investment in the future!

22. Do you agree?

23. Step One • $771m capitalise as the line was underused albeit the rental period had expired. • Then… because the E/R ratio is not 42% reverse out $227m so as to get an exact 42%. • Net capitalisation is $544m of line rentals which have been consumed but were not 100% accessed by customers. But the rental period had expired!

24. Step 2 • The next quarters again showed poor results so to maintain the E/R of 42% capitalise more line rentals. • Initially another $828m, but over 18 months a total of $2.3b. • In reality only $174 of capital expenditure existed.

25. Internal Auditors – Their function • To constantly review the internal controls and ensure that the company minimises risk. • Regularly review accounting entries, assets and liabilities and ensure that recommended good accounting practice is being employed. • Should report to an independent audit committee.

26. Cynthia Cooper • What do you think of her? • Did she do her job well? • Where did she fail? • Was the audit committee really independent?

27. External Auditors – Their duties • Evaluate the internal controls of the business. • Review and probe the integrity of the financial statements. • Express a view as to what extent the financial statements are “true and fair”.

28. Arthur Andersen's? • What do you think were their main failings? • Why did they not question in depth the accounting entries. • Why did they not question the issues that the SEC raised?

29. The Board of Directors • Were they not really highly paid puppets to the whim and fancy of Ebbers and Sullivan. • How would you act differently?

30. Comparison of Accounting See table A

31. Ebbers Loans • $400m to help him with his other activities.

32. Ebbers Resignation Deal! • Restructuring of $400m loans over 5 years. • $1.5m a year salary for life! WOW what a deal!

33. The Final Curtain! • There is only so long that you can play with figures before the truth surfaces and with it the day of reckoning. • Such fraud requires the problem to multiply as continued losses have to be matched by fraudulent accounting entries which get bigger and bigger.

34. Return to Double Entries Debits Credits Assets Liabilities Expenditure Income The books balance if you increase An asset and reduce an expense. Likewise an increase in an asset with an increase in income.

35. Balance Sheet & Income Statement – Optimistic Balance Sheet 31 December 2002 Profit & Loss Year 2003 Balance Sheet 31 December 2003 Liabilities £350,000 Liabilities £350,000 Assets £500,000 Assets £850,000 Revenues £1,000,000 Expenses £650,000 Shareholders Equity £150,000 Shareholders Equity £500,000 Profit £350,000 Profit added to Retained Earnings

36. Accounting Adjustments • Reduce expenditure by $300,000 and increase assets by $300,000.

37. Balance Sheet & Income Statement – Optimistic Balance Sheet 31 December 2002 Profit & Loss Year 2003 Balance Sheet 31 December 2003 Liabilities £350,000 Liabilities £350,000 Assets £500,000 Assets £850,000 Revenues £1,300,000 Expenses £950,000 Shareholders Equity £150,000 Shareholders Equity £500,000 Profit £350,000 Profit added to Retained Earnings

38. Yes the books balance… • But the assets are overstated!

39. Balance Sheet & Income Statement – Optimistic Balance Sheet 31 December 2002 Profit & Loss Year 2003 Balance Sheet 31 December 2003 Liabilities £350,000 Liabilities £350,000 Assets £500,000 Assets £550,000 Revenues £1,000,000 Expenses £950,000 Shareholders Equity £150,000 Shareholders Equity £200,000 Profit £50,000 Profit added to Retained Earnings

40. Accounting Adjustments • Reduce expenditure by $300,000 and increase assets by $300,000.

41. Returning to Worldcom

42. What are your views on? • Andersen’s role? • Betty Vinson? • Cynthia Cooper? • The Audit Committee? • The Board of Directors?

43. What lessons can we learn from this? • Corporate Governance • Accounting Standards • Auditor Independence • Whistle Blowers.

44. Whistleblowers • In 2002, time Magazine had on its front cover, Cynthia Cooper (Worldcom), Sherron Watkins (Enron) and FBI agent Coleen Rowley as they were named women of the year.

45. Video • http://www.youtube.com/watch?v=KQtq77RQRf0&feature=related

46. And Could it Happen Again?