Fraud committed by WorldCom

WorldCom filed for bankruptcy in 2002, after having admitted to committing an accounting fraud worth $3.8 billion. The company had inflated its profits by this amount in an attempt to distort the company's falling stock price. This fraud was committed largely to help CEO Bernard Ebbers cover margin calls on options he had on his shares of the company. After having borrowed from the company to cover these calls, Ebbers needed to reverse the long-term decline in the company's stock (BBC, 2002).

How the Fraud was Committed

According to the SEC's Report of Investigation into the matter, the fraud was committed two different ways. The first was through the reduction of reported line costs. In Q4 2001 and Q1 2002, the company transferred $3.852 billion in line cost expenses to asset accounts. The company also announced line cost accounting irregularities, bringing the total fraud online costs to over $7 billion. The line costs refer to the costs of carrying calls on the phone lines and formed the largest expense for the company. Transferring such costs to assets is essentially a statement that the cost did not occur (that is to say, an asset did not need to be liquidated to meet this cost). The net effect is to understate costs, overstate profits and overstate assets.

The second point of fraud was exaggeration of revenues. This fraud was direct in nature -- the company simply invented revenue entries to bridge the gap between actual revenue and target revenue. The transactions were entirely fictitious. The transactions were typically allocated to "Corporate unallocated" accounts, which were distinct from the accounts of operating divisions. The Operations and Revenue Accounting groups were involved in the fraud, in addition to Ebbers and CFO Scott Sullivan.

How They Were Caught

The company was already raising flags because it had maintained strong revenue growth in the face of a declining telecommunications industry in 2000 and 2001, but the fraud was ultimately detected and revealed by employees inside the company. Internal auditors discovered large transactions that they were unable to account for. The auditors searched through the company's records and uncovered the initial $3.8 billion in fraudulent accounting entries. There were simply no matching records for some of the entries. The auditors overcame roadblocks thrown up by external auditor Arthur Andersen.

The initial red flag came when a division head visited the internal audit department to complain about having a $400 million rainy day fund taken away by the CFO and recorded as profit. This would have caused the division head to take a loss in the next quarter. The $400 fund was set aside in accordance with accounting rules to cover revenue shortfalls that were expected, as was the case. Taking the $400 million away not only increased the book value of the firm but it also reflected on the firm's revenues (Pulliam & Solomon, 2002).

The actions of the internal auditors had come around the same time as the SEC had launched its own investigation into the company's accounting practices. The regulators had suspected something was wrong with the financial statements, but could not find evidence in the regulatory filings, so had requested further information from the company. Ultimately, the SEC uncovered the rest of the fraud, and used the information provided by the internal auditing team.

Prevention

There were three main factors contributing to the fraud. The first was the motivation on the part of Ebbers and Sullivan. The second was the complicity of employees within WorldCom's accounting department. The third was the complicity of the external auditor, Arthur Andersen. In order to prevent such frauds from occurring, these different factors should be addressed. With respect tot Ebbers and Sullivan, two problems occurred that should be prevented in future.

The first is the heavy emphasis on option-laden compensation. This created an incentive for Ebbers to manipulate the company's stock, as his options were under water. A greater emphasis on hard salary and bonuses would partially address this problem, or an emphasis on performance-based compensation that takes long-run performance into account would be more useful. In addition, too much control was held by too few. For instance, the internal auditor was informed by the external auditor that he only answered to Sullivan. This concentration of power enabled the abuse. In order to prevent a re-occurrence of fraud, power should be more evenly distributed.

Only a few of the employees within the accounting department were willing to stand against the fraud. Most employees turned a blind eye to the behavior of Sullivan and Ebbers, and this allowed the fraud to not only take place but to continue over a period of months. The corporate culture allowed for this to take place -- ethical behavior was not given a high enough status in the corporate culture. Therefore, the culture needs to be changed in order to restore emphasis on ethical behavior.

The third problem was the complicity of Arthur Andersen, the external auditor. That Arthur Andersen no longer exists, combined with the provisions of Sarbanes-Oxley, in large part addresses the issue of external governance. In addition, the board of directors should include mainly external staff and there should be an accounting professional or two on the audit or finance committee in order that the quarterly reports receive due scrutiny. This will allow help to discourage unethical behavior on the part of the executives, knowing that the directors will spot the fraud.