WORLDCOM: In 1998, the telecommunications industry began to slowdown and WorldComs stock was declining. CEO came underincreasing pressure from banks to cover margin calls on hisWorldCom. Beginning in 1999 and continuing through May2002, WorldCom used shady accounting methods to mask itsdeclining financial condition by falsely professing financialgrowth and profitability to increase the price of WorldComsstock.
HOW THIS HAPPEN The fraud was accomplished in two main ways. First,WorldComs accounting department underreportedline costs (expenses with other telecommunicationcompanies) by capitalizing these costs on the balancesheet rather than properly expensing them. Second,the company inflated revenues with bogus accountingentries from corporate unallocated revenue accounts.
How the Fraud took place NET INCOME xxx (Huge Increase) Revenues xxx COGS xxx (no change) (no change) CFO’s directions affected the income statement:Fees companies phone Computer expenses: networks: xxx xxx (Huge Decrease) (Huge Decrease)
Overstating Asset Frauds (WorldCom) Overstatement of current assets(marketable securities) Overstating pension assets Capitalizing as assets amounts that should be expensed Failing to record depreciation/amortization expense Overstating assets through mergers and acquisitions Overstating inventory and receivables
HOW WAS DISCOVER The first discovery of illegal activity was by WorldComsown internal audit department who uncovered $3.8 b. ofthe fraud in June 2002. The companys audit committeeand board of directors were notified of the fraud.The Securities and Exchange Commission (SEC)launched an investigation. By the end of 2003, it wasestimated that the companys total assets had beeninflated by around $11 billion.
Largest Bankruptcy FilingsCompany Assets (Billions) When Filed1. WorldCom $103.9 July 20022. Enron $63.4 Dec. 20013. Conseco $61.4 Dec. 20024. Texaco $35.9 April 19875. Financial Corp of America $33.9 Sept. 19886. Global Crossing $30.2 Jan. 20027. PG&E $29.8 April 20018. UAL $25.2 Dec. 20029. Adelphia $21.5 June 200210. MCorp $20.2 March 1989
CONSOLIDATING BALANCE SHEET (10K SEC) (IN MILLIONS) AT DECEMBER 31, 2000 WORLDCOM MCI GROUP ELIMINATIONS WORLDCOMCurrent assets...................................... $ 9,068 $ 2,312 $(1,625) $ 9,755Property and equipment, net......................... 35,177 2,246 -- 37,423Goodwill and other intangibles...................... 36,685 9,909 -- 46,594Other assets........................................ 4,963 168 -- 5,131Total assets...................................... $85,893 $14,635 $(1,625) $98,903Current liabilities................................. $14,213 $ 5,085 $(1,625) $17,673Long-term debt...................................... 11,696 6,000 -- 17,696 Noncurrent liabilities.............................. 3,648 1,087 -- 4,735 Minority interests.................................. 2,592 -- -- 2,592 Company redeemable preferred securities...... 798 -- -- 798Shareholders investment............................ 52,946 2,463 -- 55,409Total liabilities and shareholders investment.... $85,893 $14,635 $(1,625) $98,903 ======= ======= ======= ======= $ 9,755 / 17,673=(7,918) WORKING CAPITAL OR .55 CURRENT RATIOTHE HIGHER THIS RATIO THE BETTER TO MEET THEIR CURRENT OBLIGATIONS.
WorldCom Statement of Cash flowCash flows from operating activities: 2000 2001Net income Operating Activities $4,153 $1,501Originally Reported Revised as of April 15, 2004 2000 2001 2002 N Net loss $ -48,909 -15,597 -9,173
HOW ENDEDOn July 21, 2002, WorldCom filed for Chapter 11bankruptcy protection, the largest such filing in UnitedStates history. The company emerged from Chapter 11bankruptcy in 2004 becoming MCI. On March 15, 2005Bernard Ebbers (CEO) was found guilty of all charges andconvicted on fraud, conspiracy and filing false documentswith regulators. He was sentenced to 25 years in prison. I don’t belief this happen to me .
What do these dates have in common? December 2, 2001 Enron declares bankruptcy July 19, 2002 MCI WorldCom declares bankruptcy August 31, 2002 Arthur Anderson agrees to stop auditing public companies
How did this happen?Corporate Issues Audit Firm Issues Earnings pressure Dependency on consulting fees Lack of mandated disclosure Assumed good intent of their of company reporting model client Minimal oversight into Inability to continuously monitor corporate business practices a company’s internal controls No documented or enforced Unable to identify violations of internal controls internal controls
How Did Government Respond?Sarbanes – Oxley Act
Sarbanes – Oxley Act Highlights Section 103: Your auditor (and therefore, you should) maintain all audit related records, including electronic ones, for seven years. Section 201: Firms that audit your company’s books can no longer provide you with IT related services. Section 301: You must provide systems or procedures that allow employees to communicate effectively with the audit committee.
Sarbanes – Oxley Act Highlights (continued) Section 302: Your CEO and CFO must sign statements verifying the completeness and accuracy of financial reports. Sections 404 CEO’s, CFO’s and outside auditors must attest to the effectiveness and accuracy of financial reports. Section 409: Companies must report material changes in their financial conditions “on a rapid and current basis.” The act calls it “real-time” disclosure but is unclear on what it means.
Sarbanes–Oxley Act Sarbanes–Oxley Law Behavior ConsequenceAny CEO or CFO who “recklessly” violates his Fine of up to $1,000,000 and/or up to 10 yearsor her certification of the company’s financial imprisonment.statements. Fine of up to $5 million and/or up to 20 yearsIf “willfully” violates. imprisonment.Any person who “corruptly” alters, destroys,conceals, etc., any records or documents with Fine and/or up to 20 years imprisonment.the intent of impairing the integrity of the recordor document or use in an official proceeding.
The 3 Cs of Sarbanes-Oxley CEO’s, CFO’s and CIO’sThe jobs of the CEO, CFO & CIO got tougher onJuly 30, 2002 -- the day the Sarbanes-Oxley Actwas signed. The legislation requires significantchanges to financial practices and corporategovernance, and touches all corporate areas --including technology. For the first time ever, theCFO and CEO can look a CIO in the eye and say,Guess what, youre on the hook with us.
Benefits of the New Oxley Act 1. Increased confidence of CEO/CFO in meeting requirements 2. Improved coordination of Company Management Team 3. Improved and clarified Corporate Governance process 4. Systematized process for early identification of business risks/ whistle blowing issues/incident management 5. Systematized approach to dealing with change (i.e., transactions, personnel, accounting principles, internal controls and operating procedures) 6. Increased operational effectiveness
The Enron Scandal The Enron scandal was a corporate scandal involving the American energy Enron Corporation, the worlds leading energy company and the accounting, auditing, and consultancy firm Arthur Andersen. On October 16, 2001, in the first major public sign of trouble, Enron announces a huge third- quarter loss of $618 million.
The Enron Scandal On October 22, 2001, the Securities and Exchange Commission (SEC) begins an inquiry into Enron’s accounting practices. On December 2, 2001, Enron files for bankruptcy, the largest bankruptcy in US history up to that time
Consequences Thousands of employees lost their jobs and even their life savings in 401(k) plans tied to the energy companys stock. Disastrous falling down on the whole stock market during the following months, especially in the financial service industry. Arthur Andersen, which at the time was one of the five largest accounting firms in the world, was dissolved.
How this happen The company used shortcomings of Rule-Based US GAAP , special purpose entities, and poor financial reporting to hide billions in debt from failed deals and projects. Enrons audit committee failed to follow up on high-risk accounting issues Andersen was pressured by the company to ignore accounting practices.
How this happen….Continued 1993-2001: Enron senior management used. Complex and foggy accounting schemes to reduce Enron’s tax payments; to inflate Enron’s income and profits; to inflate Enron’s stock price and credit rating; to hide losses in off-balance-sheet subsidiaries; to engineer off-balance-sheet schemes to direct money to themselves, friends, and family; to fraudulently misrepresent Enron’s financial condition in public reports.
Profit to Enron from all this? $10 million in guarantee fee + fee based on loan balance to JEDI. A total of $25.7 million revenues from this source. Increase in price of Enron stock held by JEDI. Enron recognized $126 million in the first quarter of 2000 from this. But everything began to fall apart when Enron’s share price started to drop in Fall 2000.
Generally Accepted Accounting Principles prior to 2002. Auditing companies often consult for the companies they audit (conflict of interest). Audit company partners often later accept jobs from their client companies. Companies often retain the same auditing company for long periods of time. Auditing companies have been allowed to police themselves. Appointment of auditor company is in theory by shareholders but in practice by senior management