WorldCom's $3.8 billion accounting fraud and detection methods

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.

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.

Taken as a whole, the WorldCom fraud illustrates some of the problems with corporate governance at the time. There was little oversight and the cultures of both the company's accounting department and the external auditor were oriented towards profit. As a result, the opportunity for fraud existed and the climate existed that would allow that fraud to take place over the course of months until it was discovered by the internal auditing department.

Conclusion

WorldCom was a successful telecom company, but its directors and managers refused to accept a downturn in business, in large part due to the equity-based nature of their compensation. The internal conditions de-emphasized ethical behavior, and this allowed the fraud to take place. While the fraud was eventually discovered, the company was by that point ruined, so it is imperative to learn lessons from the WorldCom experience that will help to prevent similar frauds in the future.

Works Cited:

BBC. (2002). Disgraced WorldCom faces fraud charge. British Broadcasting Corporation. Retrieved February 9, 2011 from http://news.bbc.co.uk/1/hi/2068865.stm

Pulliam, S. & Solomon, D. (2002). How three unlikely sleuths exposed fraud at WorldCom. Wall Street Journal. Retrieved February 9, 2011 from http://www.happinessonline.org/MoralCode/LiveWithTruth/p23.htm

SEC. (2003). Report of investigation. Securities and Exchange Committee. Retrieved February 9, 2011 from http://www.sec.gov/Archives/edgar/data/723527/000093176303001862/dex991.htm