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Business Ethics-Worldcom Scandal
Shiva Kumar.S
PGDM-15
Contents
Topic Page No
Introduction 2
Summary 3
Key Players Involved in Scam 5-7
Company Culture 8-9
Corporate Governance ...
Introduction
WorldCom was a provider of long distance phone services to businesses and residents. It started
as a small co...
Summary
On June 25, 2002, WorldCom announced that it intended to restate its financial
statements for 2001 and the first q...
Cont.,
Company’s balance sheet at the time the fraud was announced.On June 26, 2002, the
United States Securities and Exch...
Key Players Involved in WorldCom Scandal
1. Bernard Ebbers-Chief Executive Officer in the company.
2. Scott Sullivan-The c...
Who was mainly responsible for the downfall of
WorldCom?
I. Board of Directors: As they were involved in fraudulent and ch...
People Who were Affected ?
 Share holders.
 Management.
 Employees.
 Creditors.
 Customers.
 Govt.
8/41
Company Culture- Top Management’s Managing Style
The growth through acquisitions “strategy” at WorldCom was enforced and r...
Cont.,
The lack of an ethical code and an outlet for concerns was the concept of
employee compensation with stock options....
Corporate Governance- Board of Directors
The Board was inactive and met only about four times a year, not enough for a com...
Toxic Culture of Senior Management Team
 Believed that their actions were not “really” illegal.
 Unrealistic financial t...
What are the key factors for the collapse in the
view of Corporate Governance?
The following key factors resulted the comp...
Cont.,
vi)Illegal profits were generated and it was shown that all the policies and rules
implemented from the top were fo...
Loans to Ebbers
Ebbers had made several purchases for which he had acquired loans and used his WorldCom
stock as collatera...
How Fraud Happened ?
The fraud was characterized mainly by the improper reduction of line costs and false adjustments to
r...
The Misstatement of Line Costs
Line costs are the costs associated with carrying a voice phone call or data
transmission f...
Cont.,
WorldCom’s top management strived to achieve a low line cost to revenue ratio because
a lower ratio meant better pe...
Releasing Accruals
The end of each month, during the fraud period at WorldCom, was characterized by the
estimation of cost...
Cont.,
WorldCom adjusted its accrual in three ways:
 Some accruals were released without even confirming if any accruals ...
Capitalizing Line Costs
The 4% utilization of the fiber optic cables meant that WorldCom was still paying
for the leases o...
Revenue
A process called “closing the gap” was utilized to achieve the falsified
growth. First, Ebbers and other top manag...
Cont.,
What is interesting about the inflated earnings is that WorldCom was able to acquire a lower cost
of capital in ter...
Discovery-Whistle Blower
When Cooper, the Vice President of the Internal Audit, questioned about capital
expenditures audi...
Cont.,
On June 17, 2002, Cooper and Glyn Smith, another internal auditor in the
department, went to Betty Vinson in the Ge...
Audit Committee
An Audit Committee was established to conduct relations with Arthur Andersen, the external
auditor. In Wor...
Internal Audit
 WorldCom’s Audit Committee failed to meet with the Internal Auditors of the company, who
had the duty to ...
External Auditors
 The external auditor, Arthur Andersen, was the one responsible for providing an
independent opinion of...
Effects on Internal Environment
After the fraud was announced to the public on June 25, 2002, new measures were taken quic...
Effects on External Environment
The largest effect on the external environment was on the investors of WorldCom. The New Y...
Sarbanes & Oxley Act
 WorldCom’s failure in June 2002, Congress quickly passed the Sarbanes & Oxley Act about a month lat...
The Response of President and Parliament
President Bush called for tough new legislation to restore faith in American busi...
Impact of the Fraud
 Shareholders: $180B of shareholder value lost (based on peak stock price)
 Debt & Preferred Stock h...
Proposed US Corporate Governance Principles
 Select a chief executive officer and to oversee the CEO and senior managemen...
Cont.,
 Through its corporate governance committee, to play a leadership role in shaping the
corporate governance of the ...
What are something's that world com executives could
have done to prevent the accounting scandal ?
The main problem is not...
How could corporate ethics have played a part in this failure ?
How could they help to bring a new and successful world co...
Participative Management – pressure should be made to realize to employees through
town hall meeting and by being a transp...
After Scandal
 The company emerged from Chapter 11 bankruptcy during 2004 with about $5.7 billion in debt and
$6 billion ...
Lessons Learned-Ethical Values Violated
 Unethical Work Culture.
 Pressurising employees to manipulate accounts.
 No pr...
Reference
https://www.academia.edu/8313717/Case_Study_WorldComs_Corporate_Governance_Failure
http://etd.fcla.edu/CF/CFH000...
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Worldcom Scandal

  1. 1. Business Ethics-Worldcom Scandal Shiva Kumar.S PGDM-15
  2. 2. Contents Topic Page No Introduction 2 Summary 3 Key Players Involved in Scam 5-7 Company Culture 8-9 Corporate Governance 10-14 How Fraud Happened ? 15-22 Discovery-Whistler Blower 23 Audit Committee 24-27 Effect of Scam 28-29 SOX Act 30-31 Impact of the Fraud 32 Proposed US Governance Principle 33-34 Q & A 35-37 After Scandal 38-40 Lessons Learned and Reference 41
  3. 3. Introduction 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 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 telecomm businesses in less than a decade. 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. 3/41
  4. 4. Summary On June 25, 2002, WorldCom announced that it intended to restate its financial statements for 2001 and the first quarter of 2002. It stated that it had determined that certain transfers totaling $3.852 billion during that period from “line cost” expenses (costs of transmitting calls) to asset accounts were not made in accordance with generally accepted accounting principles (“GAAP”). Less than one month later, WorldCom and substantially all of its active U.S. subsidiaries filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code. WorldCom subsequently announced that it had discovered an additional $3.831 billion in improperly reported earnings before taxes for 1999, 2000, 2001 and first quarter 2002. It has also written off approximately $80 billion of the stated book value of the assets on the 4/41
  5. 5. Cont., Company’s balance sheet at the time the fraud was announced.On June 26, 2002, the United States Securities and Exchange Commission filed a lawsuit captioned Securities and Exchange Commission v. WorldCom, Inc., No. 02-CV-4963 (JSR). On July 3, the Honorable Jed S. Rakoff, of the United States District Court for the Southern District of New York, appointed Richard C. Breeden, former Chairman of the SEC, as Corporate Monitor, with the consent of WorldCom. This Committee was established by the Board of Directors On July 21, 2002. The Board directed to conduct a full and independent investigation of the accounting irregularities that gave rise to the announced intention to restate, and such other matters as we concluded should be considered, without any limitations. The members of the Committee were new to the Board of WorldCom at that time. 5/41
  6. 6. Key Players Involved in WorldCom Scandal 1. Bernard Ebbers-Chief Executive Officer in the company. 2. Scott Sullivan-The chief financial officer and secretary of WorldCom. 3. David Myers-The controller and senior vice president of WorldCom. 4. Cynthia Cooper-Chief Internal Auditor of WorldCom. 5. Buford Buddy Yates – He was the former director of accounting at WorldCom. 6. Betty Vinson – She was the former director of corporate accounting at WorldCom. 7. Arthur Anderson LLP – Kenneth M. Avery and Melvin Dick were the primary auditors representing their firm in the WorldCom scandal. 6/41
  7. 7. Who was mainly responsible for the downfall of WorldCom? I. Board of Directors: As they were involved in fraudulent and cheat. II. Non-Executive Directors: As they were involved with Board of Directors in unhealthy activities. III. Internal Audit Team: As they were bribed by Board and Management to show their audit report clean. 7/41
  8. 8. People Who were Affected ?  Share holders.  Management.  Employees.  Creditors.  Customers.  Govt. 8/41
  9. 9. Company Culture- Top Management’s Managing Style 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.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. 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. 9/41
  10. 10. Cont., The lack of an ethical code and an outlet for concerns was the concept of employee compensation with stock options. Employees at WorldCom received a lower salary than their counterparts at competitors such as AT&T and Sprint. Most of the information was not fully available to employees, furthering this secrecy. Even some who had the need to know the information such as the internal auditors, were able to view only some of the journal entries in the income statement and the balance sheet but never the entire documents. Ebbers created an individualistic culture where loyalty to a person was more important than loyalty to the company. This created an environment where the boss was not to be questioned. 10/41
  11. 11. Corporate Governance- Board of Directors 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. Due to the Board’s lack of active participation, there was a lack of awareness about WorldCom’s matters. Management aided that lack of awareness by presenting the directors with very limited information about the company and its acquisitions. The discussions did not involve the Board at all and at other times no documents were even presented concerning the terms of the transactions 11/41
  12. 12. Toxic Culture of Senior Management Team  Believed that their actions were not “really” illegal.  Unrealistic financial targets and inability to meet them.  Recording of a/c entries without any evidence.  Company was capitalizing its line costs. Line costs were operatingexpenses but WorldCom classified as capital expenditure.  In 2000 and 2001, WorldCom claimed pre tax revenue of 7.6 and 2.4Bn $ respectively. Later discovered as loss of 49.9 and14.5 Bn $ forthe respective years.  Reserve accounts were manipulated to increase figures.  Two versions of accounts the actual version and the Final version for investors. 12/41
  13. 13. What are the key factors for the collapse in the view of Corporate Governance? The following key factors resulted the company to a collapse: i)Senior Executives were encouraged to lie, cheat and manipulate records by providing them high margin of profits. ii)Executives were interested in their personal reward structure ignoring the stakeholders’ benefits. iii)Board members were mostly highly rewarded and consist of the friends, who did not raise questions on any doubtful and ambiguous records. iv)Non-Executive Directors were also highly rewarded and they worked independently. v)Audit Team was bribed, so that the team will produce a clean audit report. 13/41
  14. 14. Cont., vi)Illegal profits were generated and it was shown that all the policies and rules implemented from the top were for the benefit of the company and shareholders, and hence, were ethical. vii)The cost of heavy machinery purchased in a particular period was not spread by the company in the next coming financial years. 15/41
  15. 15. Loans to Ebbers Ebbers had made several purchases for which he had acquired loans and used his WorldCom stock as collateral. The price of WorldCom stock fell, Ebbers was required by the banks to fill in the margins 12 between the value of his loans and the fallen value of his stocks.Instead of selling his stock, which he thought would further cause a decline in stock price on Wall Street, Ebbers requested the Board to approve personal loans to fill in the margins. Ebbers took advantage of the lack of independence of the board members who were loyal to him such as Stiles Kellett, chairman of the Compensation Committee, and Max Bobbitt, chairman of the audit committee. Not only did the two allow the loans to grow to more than $400 million, but also when the Board found out about these loans, they failed to take any action and allowed the loans to carry on. 15/41
  16. 16. How Fraud Happened ? The fraud was characterized mainly by the improper reduction of line costs and false adjustments to report revenue growth.  The Misstatement of Line Costs  Releasing Accruals  Capitalizing Line Costs  Revenue 16/41
  17. 17. The Misstatement of Line Costs Line costs are the costs associated with carrying a voice phone call or data transmission from the call’s origin to its destination. If a WorldCom customer made a call from New York City to London, the call would first go through the local phone company’s line in New York City, then through WorldCom’s long distance, and finally through the local phone company in London. WorldCom would have to pay both the local companies in New York City and London for use of the phone lines,these costs are considered line costs. Not only were line costs WorldCom’s biggest expense but were also approximately half of WorldCom’s total expenses. Especially after the collapse of the dot com bubble in early 2000, cost savings became extremely important, so important that line cost meetings were the only meetings with regular attendance by top management. 17/41
  18. 18. Cont., WorldCom’s top management strived to achieve a low line cost to revenue ratio because a lower ratio meant better performance whereas a higher ratio meant poorer performance. To report better performance and growth, Sullivan implemented two improper accounting methods to reduce the amount of line costs, release of accruals from 1999-2000 followed by the capitalization of line costs in 2001 through early 2002. 18/41
  19. 19. Releasing Accruals The end of each month, during the fraud period at WorldCom, was characterized by the estimation of costs that were associated with using the phone lines of other companies. The actual bill for the services was usually not received for several months. This meant that some entries made to the payables could be 27 overestimated or underestimated. In the case that the liability was overestimated, when the actual bill was received there would be a surplus of liabilities that when released would result in a reduction of the line costs. Accounts Payable 1,000,000 Cash Paid to Suppliers 900,000 Line Cost Expense “release” 100,000 19/41
  20. 20. Cont., WorldCom adjusted its accrual in three ways:  Some accruals were released without even confirming if any accruals existed in the first place.  Second, if WorldCom had accruals on its balance sheet it would not release them for the proper period and instead keep them as “rainy day” funds for future uses.  Lastly, some of the accruals released were not even established for line costs, thereby violating GAAP by using one expense type to offset. 20/41
  21. 21. Capitalizing Line Costs The 4% utilization of the fiber optic cables meant that WorldCom was still paying for the leases on the cables even though it was generating no revenue on them. According to Morse 29 WorldCom had leased the lines in a 2-5 year agreement that could not be canceled. However, the costs associated with the lines were causing the line cost E/R ratio to increase. Thus, when no more accruals could be released, Sullivan turned to capitalize these costs, another violation of GAAP. By the time the fraud was discovered, Sullivan had managed to improperly reduce the line costs by approximately $3.883 billion.Capitalizing the expenses resulted in shifting the items from the income statement onto the balance sheet, allowing the overstatement of income as well as the overstatement of assets. 21/41
  22. 22. Revenue A process called “closing the gap” was utilized to achieve the falsified growth. First, Ebbers and other top management received the “MonRev” report that provided a picture of the company‟s revenue for a given period. The report was available exclusively to top management and its access was closely guarded. At the end of each quarter, top management would meet to close the gap that existed between the actual revenue number and the expected number. Usually the journal entries involved large round numbers, in millions or even tens of millions of dollars, and were booked to an account called Corporate Unallocated revenue account. In reality, this account had no relation to the operating revenues of WorldCom. A total of approximately $958 million in revenue was improperly recorded by WorldCom during Q1 1999 – Q1 2002. 22/41
  23. 23. Cont., What is interesting about the inflated earnings is that WorldCom was able to acquire a lower cost of capital in terms of borrowing because the banks assumed WorldCom could cover its loans. The reduction in cost of capital was one of the reasons WorldCom was able to make the multiple acquisitions, paying for the acquisitions with its own inflated stock. From December 1996 to July 2001, WorldCom spent a total of $65 billion in acquisitions. If the Sprint acquisition had been approved, it would have spent a total of $195 billion 23/41
  24. 24. Discovery-Whistle Blower When Cooper, the Vice President of the Internal Audit, questioned about capital expenditures audit resulted in a large variance due to entries to an account called prepaid capacity. no one appeared to give a answer. When she asked Sullivan about it, he explained they were line costs that had been capitalized and told her to delay the audit until the third quarter of 2002.Cooper did not consider his request and continued with the audit. She asked Gene Morse, a Manager in the Internal Audit department to look into the entries. Morse states it did not take him long to find the journal entries, especially because they were large round-dollar entries even though his access to the full view of both the balance sheet and income statement was limited. 24/41
  25. 25. Cont., On June 17, 2002, Cooper and Glyn Smith, another internal auditor in the department, went to Betty Vinson in the General Accounting department to further inquire about the prepaid capacity entries. She informed them that she had indeed made those journal entries but only upon the request of top management. They next went to Buddy Yates, Director of General Accounting, who directed them to Controller David Myers who confessed to the fact that he indeed did not have any support for the journal entries and that once top management had started making those entries it was difficult to stop making them.June 25, 2002 marked the public release of the fraud. 25/41
  26. 26. Audit Committee An Audit Committee was established to conduct relations with Arthur Andersen, the external auditor. 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. 26/41
  27. 27. Internal Audit  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.  The internal auditors were provided with limited access to the income statements and balance sheets with only a partial picture of the company’s financial situation that prohibited them from properly assessing the finances of the company  The Internal Audit department is intended to be independent and report directly to the Audit Committee to avoid the influence of top management. This form of relationship was lacking at WorldCom. 27/41
  28. 28. External Auditors  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.  Arthur Andersen’s failed to detect the fraud was due in part to negligence and in part to the tight control top management kept over information.  Andersen failed to bring this problem to the attention of the Audit Committee 28/41
  29. 29. Effects on Internal Environment After the fraud was announced to the public on June 25, 2002, new measures were taken quickly to reform WorldCom and restore the public’s confidence in the company. The entire Board of Directors was replaced with a new Board to guarantee independence and objectivity about management’s decision. While more than four hundred new finance and accounting personnel were hired, 17,000 of the existing 85,000 employees at WorldCom were let go. A new independent auditor was 40 brought in to re-audit the financial statements for the fraudulent period. The overstated assets were evaluated for impairment and the goodwill from the previous acquisitions was written down. The use of stock options was also abolished and restricted stock with full expensing value of equity grants was implemented A new ethics program was implemented with training programs for employees to educate them on the manner of their responsibility at the company and on the accounting issues that may signal an irregularity. 29/41
  30. 30. Effects on External Environment The largest effect on the external environment was on the investors of WorldCom. The New York State Common Retirement Fund is the second largest public pension fund in the U.S. It invested the assets of the New York state and local employees retirement system and of the New York State and Local Police and Fire retirement system. The pension fund lost over $300 million of its investments in WorldCom. 30/41
  31. 31. Sarbanes & Oxley Act  WorldCom’s failure in June 2002, Congress quickly passed the Sarbanes & Oxley Act about a month later on July 30, 2002 .The purpose of the act is to protect the investors by improving the accuracy and reliability of the disclosures made by the publicly traded companies.  Section 301 that gives Audit Committees more responsibility to strengthen the committee’s role. Not only does the act advise the committee to oversee the auditor’s work, but also requires the members of the committee to be independent to ensure conflicts of interest do not arise. Additionally, the external auditors are required to report directly to the Audit Committee and not top management to ensure independence and objectivity.  Lastly, Section 404 of the Act requires the SEC to assess the internal controls of financial reporting giving the company responsibility to strengthen the controls and exclude the requirement of having the external auditors assess management’s process of assessing the internal control system. 31/41
  32. 32. The Response of President and Parliament President Bush called for tough new legislation to restore faith in American business. Mr.Bush said those guilty of corporate fraud should be sent to jail for the sake of US capitalism. He argued that people guilty of such abuses should be prevented from holding high-level business positions again. SOX: Sarbanes-Oxley act 2002, was precipitated by Enron, Arthur Andersen, Tyco, Global Crossing and WorldCom. WorldCom was seen as the last straw in driving through legislation. 32/41
  33. 33. Impact of the Fraud  Shareholders: $180B of shareholder value lost (based on peak stock price)  Debt & Preferred Stock holders: $37.5B of debt and preferred stock holder value lost  Company: $750M settlement paid to SEC  Employees: 57,000 employees lost jobs  Board of Directors: 12 Directors agreed to pay (out of pocket) a total of $25M to settle securities class action case 33/41
  34. 34. Proposed US Corporate Governance Principles  Select a chief executive officer and to oversee the CEO and senior management in the competent and ethical operation.  Establish a culture of legal compliance and integrity.  Develop and implement the corporation’s strategic plans, and to identify, evaluate and manage the risks inherent in the corporation’s strategy.  Oversight of the audit committee and the board, to produce financial statements that fairly present the financial condition and results of operations of the corporation.  Engage an independent accounting firm to audit the financial statements prepared by management and issue an opinion that those statements are fairly stated in accordance with Generally Accepted Accounting Principles. 34/41
  35. 35. Cont.,  Through its corporate governance committee, to play a leadership role in shaping the corporate governance of the corporation and the composition and leadership of the board.  Compensation committee, to adopt and oversee the implementation of compensation policies, establish goals for performance-based compensation, and determine the compensation of the CEO and senior management.  Deal with its employees, customers, suppliers and other constituencies in a fair and equitable manner 35/41
  36. 36. What are something's that world com executives could have done to prevent the accounting scandal ? The main problem is not following the accounting principles . They should have followed the following principle:  Courage should have been developed by the employees and should not feel insecure to highlight the issue to the internal audit team . Whistle blowing with third party audits.  Executives should have changed the autocratic culture during a small mistake or data fudging activities  Accounting executives should do cross –internal audit among the employees within the same department , instead of a formal audit 36/41
  37. 37. How could corporate ethics have played a part in this failure ? How could they help to bring a new and successful world com Corporate culture is the main reason for this failure. World com has followed an autocratic culture , it means a top down approach. It made all employees to accept the fraud and every one were given targets to run over that Corporate ethics should be adopted as follows to bring a successful company Bottom Up Approach -Specific and analytic approach -Executives set directions and define mission -Tangible and lasting results 37/41
  38. 38. Participative Management – pressure should be made to realize to employees through town hall meeting and by being a transparent management in all policies Improve Employee self ethics by frequently posting Fraud case studies a knowledge in email Strong Confidentiality in whistle blowing policies 38/41
  39. 39. After Scandal  The company emerged from Chapter 11 bankruptcy during 2004 with about $5.7 billion in debt and $6 billion in cash.  On February 14, 2005, Verizon Communications agreed to acquire MCI for $7.6 billion.  On December 2005, the Microsoft announced that MCI will join it by providing Windows Live Messenger customers "Voice Over Internet Protocol" (VoIP) service.  This was MCI's last new product called "MCI Web Calling". 39/41
  40. 40. Lessons Learned-Ethical Values Violated  Unethical Work Culture.  Pressurising employees to manipulate accounts.  No productive outlet for employee dissent.  Employees who played along were rewarded; others were threatened.  Fudged up the accounts mislead the various stakeholders. 40/41
  41. 41. Reference https://www.academia.edu/8313717/Case_Study_WorldComs_Corporate_Governance_Failure http://etd.fcla.edu/CF/CFH0003811/Ashraf_Javiriyah_201105_BSBA.pdf https://www.academia.edu/6572763/WorldCom_Case_Study https://www.wsws.org/en/articles/2002/07/mark-j02.html 41/41

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