WorldCom as an Example of Creative Accounting and

Subsequent Regulations of the Accounting Industry

By: Lisa E. Tarras

A thesis submitted in partial fulfillment of the requirements of the

University Honors Program

University of South Florida

21 November 2003

Thesis Advisor: Dr. Gerald Lander

University Honors College University of South Florida Saint Petersburg, Florida

CERTIFICATE OF APPROVAL

Honors Thesis

This is to certify that the Honors Thesis of

Lisa E. Tarras

Has been approved by the thesis committee on November 21 , 2003

as a satisfactory thesis requirement for the University Honors Program

Thesis Committee:

Thesis Advisor r, Ph.D., CPA, CFE, CCEA

Committee Member - oS-03

Table of Contents

Page

Introduction ..... . ... .... .. ... ..... . ... . .. ... ....... ...... ......... .................... .. .. 1

Chapter One - History of WorldCom ... ... .... .. ...... . .. .. ........ ... ........... .. 3

Chapter Two- Audit ofWorldCom .. .. .... .. .... . ................... ..... .. ... . .... 13

Chapter Three - Sarbanes-Oxley Act. .. .. . .. .. ...... ...... ..... ... .......... ..... 20

Conclusion .... ...... ............. . .. .. .. ... .... .. ... .. . ................ ... .... .. .... .. .. 29

Works Cited ... ......... ... ... .... ... .... .... ......... ... ....... ... ... ....... . .... .... . .. 31

iii

"'--- -

Tarras, 1

The public has long viewed corporate America as ruthless pillagers in the name

of profits. Today corporations are blamed for everything from eliminating mom

and pop stores and the family farm to draining the environment in the process.

Yet somehow no one, congressmen or minimum wage workers alike, were

concerned enough to address this brewing epidemic. In the bull market of the

1990's, no one cared what corporations had to do to create profits, as long as

those profits, and subsequent dividends and stock options financed their

retirement funds. However, the corporate environment is much different today.

Very public corporate scandals from companies such as Enron, Tyco and

WorldCom have changed the very definition of corporate responsibility itself. For

each new and old accounting scam, Americans and the world learned a new and

renewed way to cook the books in order to inflate profits. The WorldCom ordeal

was probably the most shocking of all the accounting scandals. On June 25,

2002 the corporation announced that they had misclassified expenses and

overstated their earnings by an astonishing $3.2 billion. It was later determined

that the misstatements where actually as high as $9 billion. As the situation

escalated, the company went on to file for the largest corporate bankruptcy in

history. The American public demanded action. How were companies

circumnavigating existing audit safeguards that were supposed to prevent these

things from happening? It became obvious to the public that new laws and

restrictions would have to be put into place to prevent this from happening again.

Tarras, 2

The WorldCom bankruptcy along with other highly publicized accounting frauds

led the U.S. House and Senate to pass a law commonly refereed to as the

sarbanes-Oxley Act. Is has been described as, "the most far-reaching changes

congress has imposed on the business world since FOR's New Deal," (Miller) by

the Journal of Accountancy. It is these issues that this thesis will focus on. First

we will first review the history of World Com. From its humble beginnings in

Clinton, MS to the multi-national conglomerate at its peak. Second, the key

employees that were involved in the fraud will be examined and how they

avoided regulations that should have stopped the creative accounting. Third, a

short overview of how both internal and external auditing should have stopped

the fraud will be reviewed. Fourth, the interworkings of an audit will show what

steps were avoided that allowed the false financial statements were released.

Finally, the major changes made as a result of the Sarbanes-Oxley Act will be

reviewed and applied to the WorldCom case. What new laws could have made a

difference in WorldCom's situation, or would the fraud have occurred anyway as

a result of the business atmosphere and increased pressure to constantly

increase earnings? The details in this particular case of creative accounting will

be examined closely.

Tarras, 3

HISTORY OF WORLDCOM

The story of World Com oddly enough begins with a breakup of another big

communications company, AT&T. In 1983, in part to reduce AT&T's monopoly,

the federal government mandated that AT&T lease some of their long-distance

phone lines to local companies, who could then resell the line's carrying capacity

at a great profit (Padgett, 56). It was that same year that Bernie Ebbers became

an investor in LDDS, Long Distance Discount Services. The company began

operations on January 14, 1984, after purchasing telephone switching equipment

and working capital. In the first year, LDDS could handle 40 long distance calls

at once and was $1.5 million in debt (Jeter, 26). It soon became obvious that the

company needed to take a new direction. It was then that they turned to one of

their investors for help.

Bernie Ebbers was a businessman, but certainly knew nothing about

telecommunications when he took control of the company in April of 1985 (Jeter,

29). Ebbers was a small town boy from Edmonton, Alberta, the second of five

children (Jeter, 3). He attended college at Mississippi College to play basketball

and liked the state so much he ended up staying. It was in Mississippi where

Bernie Ebbers bought his first business, the Sands Hotel in Columbia (Jeter, 12).

It was Bernie's success with cost cutting that brought him to the forefront of

LDDS. With the company losing money, they needed someone who could

organize the business and get it back on its feet. Bernie Ebbers was the man to

Tarras, 4

do that for them. Immediately upon taking control of the company, Bernie began

buying up other companies. With several small companies merged into one,

LDDS could create economies of scale. From 1985 to 1994 LDDS acquired

about half a dozen other communications companies (Associated Press).

Purchases of companies like Prime Telecommunication and TeleMarketing

Investments allowed LDDS to expand into the Midwest, Southwest and West.

Yet these acquisitions were relatively simple. The companies could easily merge

their billing and accounting systems. However, once the acquisitions became

larger, it became more difficult to integrate their accounting systems as well as

their switches and networks (Jeter, 49). It was in 1992 that LDDS contracted its

billing systems out to a service company called Electronic Data Systems (Girard).

Along with expanding the variety of their services, LDDS had a massive

expansion of their markets. LDDS was not only serving the southeastern United

States, but all over the world. As a better marketing strategy, the company

changed its name to WorldCom (Jeter, 56).

The image of a smoothly run company is not shared by all. A former travel

department manager claims that every department played by their own rules. In

1995, he claims there were no written company wide policies (Jeter, 57). By the

end of 1996, WorldCom ranked 309 in the fortune 500 with over half a million

customers and approximately 15,000 employees worldwide (Jeter, 71). In that

same year, WorldCom purchased MFS Communications for $12 billion, which

Tarras, 5

had purchased UUNet Technologies only months before (Eichenwald). This

made WorldCom the largest internet provider.

It was in the years following that WorldCom made some of its largest purchases.

The purchase of companies like MFS Communications is a good example of how

worldCom's acquisitions helped to drive its growth. When another company is

acquired with mostly stock a write down of assets to book value is necessary.

Not only would World Com write down the physical assets, but they would include

expected future costs in this write down, which ballooned to billions of dollars at

times. This resulted in larger losses in the current quarter, but much greater

earnings in future quarters. Once this is done with several companies, this gave

the image of larger profits when in reality World Com itself was barely growing

and at times even losing money (Eichenwald). Once an increase in earnings

was shown on the books, the stock was more attractive, which would allow

WorldCom to purchase another company and the cycle would continue. All told,

WorldCom made over sixty acquisitions in two decades (Backover). Bernie

Ebbers had a growth through acquisition approach to management, which is how

he got the nickname "Telecom Cowboy" (Foust). However, Ebbers got caught up

in the adventure of taking over another company and never followed through long

enough to efficiently integrate the companies. Another problem may have been

that Ebbers had too much control and no coherent strategy to determine which

companies should have been purchased and at what prices. Since he had no

background in the telecommunications industry, and not much formal business

Tarras, 6

training either, he did not know a lot about details concerning business strategy

or long term management of a company and therefore did not concern himself

with those matters. Former employees say Bernie Ebbers, "focused on things

that were easy to understand" (Backover). Ebbers cut cell phone allotments and

reduced the number of water coolers in offices, but he never took the time to

condense and streamline the over 50 billing systems the company operated at

one time (Backover). With so many systems, customers were constantly double

billed, leading to overestimates in accounts receivable. "By 1999, WorldCom had

accumulated more than $600 million in uncollectable receivables on its books"

(Jeter, 153).

Bernie Ebbers' right hand man through most of the acquisitions was Scott

Sullivan. A graduate of the University of New York, Sullivan learned of mergers

thought his auditing of General Electric while working at KPMG. Sullivan first met

Ebbers while he was CFO of Advanced Telecommunications Corp. , which was

purchased by WorldCom in 1992. Sullivan quickly advanced in the company and

was CFO by 1994 (Foust). He has often been described as the only one who

fully understood the company's books (Jeter, 166). According to Business Week

Sullivan was the one calling the shots behind the scenes. Ebbers always told

Sullivan to "see if the numbers work" before any acquisition was made (Hadded).

It has been reported that the two often lunched together (Backover).

Tarras, 7

The largest successful merger completed by WorldCom was that of it and MCI in

1997. MCI Communications Corporations was already entertaining a bid from

British Communications for $19 billion when Bernie Ebbers offered $30 billion in

worldCom stock for the company, and the deal was done (Eichenwald).

However, according to insiders the two companies failed to fully unite.

WorldCom tended to focus on smaller business customers, generally those

under $20,000 a month, while MCI had multi-million dollar contracts on a

complex billing system that the company built itself (Girard). A stark contrast to

WorldCom who had started contracting out its billing systems in 1992 to a service

company called Electronic Data Systems (EDS). After the merger, MCI and

WorldCom continued on two systems, operated by EDS, and as a result the

same client who purchased multiple data and voice services could get separate

bills, in addition to the nine other billing systems left over from previous

acquisitions (Girard). There were also many turf battles, as is expected when

two companies of that caliber merge. This took a toll on the company's progress.

The major difference seemed to be in the companies philosophies according to

Kate Lee, a former manager. She stated that, "MCI was much more open and

willing to take chances, to let people propose an idea and move forward with it, . .

-but at WorldCom, it was not that was not that way, if an idea didn't come down

from the top or one of the favored people, it didn't happen" (Jeter, 98).

WorldCom also had different ideas on how to book the purchase of MCI.

World Com devalued their hard assets by about $3.4 million at the same time

increasing goodwill by the same amount. This allowed the assets to be

Tarras, 8

depreciated over 40 years instead of the four years they should have been

expensed off, while still recognizing all of MCI's current revenue (Eichenwald).

once the acquisition of MCI was completed, Ebbers created a business plan of

keeping the two entities separate and using WorldCom to head all the internet

part of business, while MCI focused on long-distance (Knight). This however,

never materialized. The companies were still traded separately on the Nasdaq

Stock Market, but the business aspect was never divided. In fact, it seems that

MCI was used to shift expenses from WorldCom's books over to MCI's. This

was accomplished by transferring overhead costs such as sales and

administrative expenses to MCI books. These costs should be allocated once it

is determined which division benefited from the overhead costs. Internally, MCI

calculated that its sales and administrative costs were reduced by $415 million in

2001, but World Com allocated them an additional $457 million (Stern). This

difference of over $950 million is yet to be explained by WorldCom executives.

The acquisition of MCI was not the last merger for WorldCom. In 1998

WorldCom successfully acquired Fiber Properties and CompuServe (Associated

Press) concreting their position as the largest internet provider. Bernie was still

more interested in expanding the telephone branch of World Com and made his

largest move yet. On October 5, 1999, Sprint and WorldCom announced their

$129 billion merger (Haddad). This deal was not to be, and may have

accelerated WorldCom's decline. Despite heavy lobbying, in June 2000 the

Justice Department determined that the merger would be a threat to long

Tarras, 9

distance competition (Eichenwald). This was a major blow for World Com, who

up to this point has survived on acquiring other companies.

In the heyday of WorldCom, the stock price soared to over $60 per share and

actually peaked in June of 1999 at $64.50 (Associated Press). With the stock

price so high it was very easy for Bernie Ebbers to get personal as well as

business loans for various projects and use his stock in WorldCom as collateral.

And he did to the tune of almost $1 billion in outstanding debt. This created a

problem for the board of directors when the stock value started to fall and Ebbers

would have been forced to sell huge blocks of his stocks to cover the loans. The

company claimed a fallout of World Com stock would have ensued if the CEO of

the company began to sell off his stock. As a result the company agreed to loan

Bernie over $400 million at a generous rate of 2 .15% (Padgett).

The Creative Accounting

WorldCom was always on the forefront of accounting numbers in such a way as

to benefit their books, beginning with the write down of hard assets, while

simultaneously increasing goodwill of MCI. Another interesting accounting trick

of WorldCom is the capitc:llization, and not expensing, of developing in-house

software, according to a footnote in the 2000 annual report (Haddad).

Tarras, 10

The real problems started towards the end of 2000 when internet traffic had

slowed, and WorldCom was not billing as much, but it was still required to pay for

the lines the information traveled on because they did not own the lines, they

were leased. It was at that time that Sullivan first classified about $225 million in

revenue, from fees and equipment sales, as cost reductions. Technically not

violating any accounting standards, but certainly bending them (Jeter, 132). But

as the year went on the situation went from bad to worst. The whole telecom

industry was in a slump and the economy was not getting any better.

WorldCom's debt was rising while revenue from wholesale and consumer

markets was falling (Eichenwald). Another problem was that WorldCom had no

streamline direction or even operating standards. Even after shifting millions in

overhead expenses to its subsidiaries, WorldCom was still in the red. And with

stock analysis estimates much higher than reality, the stock price was sure to fall

even farther. WorldCom simply did not have the earnings to meet those

estimates. Apparently, WorldCom had a corporate environment that emphasized

meeting analysts expectations more than creating accurate reports (Jeter, 194).

So Scott Sullivan, along with then controller David Myers, simply maneuvered the

books so they would report gains instead of losses. They took one of

WorldCom's largest expenses, line costs, and capitalized it. Line costs are what

WorldCom pays to lease the physical lines it moves data on. It is a current

expense and should be fully charged in the current period. Capitalizing these

costs draws out the expense over as many as 40 years. This trick allowed

Tarras, 11

worldCom to turn a $662 million loss into a $2.4 billion profit in 2001 (Ripley).

This continued into the first quarter of 2002.

And most of us know the rest of the story. WorldCom's stock continued to

decline as the SEC announced it was performing an overall investigation of

WorldCom's accounting practices in the March of 2002 (Backover). Not long

afterward, Bernie Ebbers resigns as CEO claiming he planed for focus more on

his personal investments. But, the stock continues to fall, below $1 for the first

time on June 24, 2002. Finally, the bomb hits, on June 25, 2002, the company

announces it has inflated earning by $3.8 billion in the previous 5 quarters. And

former controller David Myers has resigned, while Scott Sullivan was fired as

CFO of the company. Less than a month later WorldCom files for Chapter 11

bankruptcy as it tries to restructure and recover from the largest bankruptcy and

fraud America had seen to date. Later revelations would reveal the fraud could

be actually be as high as $11 billion.

Today, as WorldCom is preparing to emerge from Chapter 11 bankruptcy, many

changes are in the works. Not only are they changing their name to MCI, but

also their headquarters from Clinton, Mississippi to Ashburn, Virginia (Powell).

But, there is a vast change in the accounting system in the company. There has

been a dramatic increase in internal controls with more money dedicated to the

internal audit department. As a result of the bankruptcy the company is

preparing to write down the value of its assets by $80 million (Morgenson). This

Tarras, 12

write down of goodwill is so massive, largely in part to WorldCom paying top

dollar for the companies they acquired during their rapid growth of the 1990's.

However, a little less than half of the write down due to the overvaluing of

physical assets. The value of their hard assets was at $44.8 billion and is now

valued at $10 billion (Morgenson).

The questions remain as to how a CEO was allowed to run a company so

recklessly and no one questioned his practices. What procedures, both internally

and externally were in place and were not followed. And maybe even more

importantly, what procedures have been created, in part, as a result of the

WorldCom scandal, to prevent this from happening again. We will examine

these issues in the following chapters.

Tarras, 13

THE AUDIT OF WORLDCOM

There are several reasons the incorrect financial statements of World Com were

made public. In this section we will first review how a proper audit should be

planned and executed as well as what safeguards are already in place that

should have prevented the financial statement release and how they were

avoided. It is obvious the independent auditor did not follow proper procedures

to reveal the blatant financial fraud, which is one of the auditor's responsibilities.

However, it is also true that management did not make fair representations about

the financials to the auditors. This could be a valid argument for Arthur

Anderson, ·except for the fact that auditors are required to ask and be made

available to all types of financial documents relating to the financial statements.

This includes how the numbers for line costs were derived, if this is not made

available to the auditors, it is considered a scope limitation, and should have

resulted in a qualified opinion of the scope paragraph as well as the opinion

paragraph because the limitation would have been client imposed.

A good audit begins with the proper planning. An auditor should take a fresh

look at the company every year and evaluate new risks both to the company

directly and to the company's business environment as a whole. This was

probably not the case at WorldCom. Even after they changed auditors from

Arthur Anderson, who had been their auditor since 1989, to KPMG the same

auditors continued to come and go (Jeter, 166). When the same auditor works

Tarras, 14

on the same client for such an extended period of time, relationships as well as

trust, is built. In this type of environment some potential issues or red flags may

be over looked because of the trust and familiarity of the audit. The long-term

relationship with clients also effects the auditor skepticism of the client. The

auditor must always maintain professional skepticism. This does not mean the

auditor should assume dishonesty, but at the very least consider the possibility of

dishonesty by management at all times. Never believe that anything

management says until you have proven it on your own or verified it with outside

sources. It is imperative that client business risk as well as inherent risk be

assessed every year. Client business risk is the danger that the client fails to

achieve its objective. This should have been high in WorldCom's case, because

they were not meeting their financial goals. Inherent risk is the risk any account

balance is misstated before considering internal controls (Arens). The risks that

are higher that particular year and the accounts that they affect, should obviously

be tested on a more in depth basis than other accounts which are less risky.

This analytical procedure helps guide the auditor in what specific audit

procedures to perform. New pressures in a declining industry is usually a

concern for the auditors, which is applicable to the World Com case. The

telecommunication industry was in decline when the questionable accounting

took place, and the independent auditors, Arthur Anderson, should have taken

note of this and paid special attention to accuracy of the financial statements and

conformity to Generally Accepted Accounting Principals, which is one of the

auditing standards of reporting (Arens, 32).

Tarras, 15

Every audit should follow the Generally Accepted Auditing Standards (GAAS) at

all times. Generally Accepted Auditing Standards are composed of a three part

system involving general qualifications and conduct, fieldwork performance of the

audit, and reporting results. Each of those categories contain subcategories

outlined below.

General Qualifications and Conduct

Adequate auditor training and proficiency

Independence in mental attitude

Due professional care

Field work performance of the audit

Proper planning and supervision

Sufficient understanding of internal control

Sufficient competent evidence

Reporting Results

Whether statements were prepared in accordance with GAAP

Circumstances where GAAP non consistently followed

Adequacy of information disclosures

Expression of opinion on financial statements (Arens, 33)

Just from looking at this list, it is obvious that Arthur Anderson was not following

GAAS. They clearly did not maintain an independent mental attitude or due

Tarras, 16

professional care, otherwise they would have uncovered the accounting fraud

while gathering audit evidence, which is a requirement of proper fieldwork.

During an audit, the auditor gathers evidence to ensure the financial statements

are properly stated. Evidence gathering involves tests of controls, as well as test

of transactions. Sufficient evidence is necessary in order to test management's

assertions about the financial statements. The auditor then uses substantive

tests to prove the assertions. The American Institute of Certified Public

Accountants has developed as set of core assertions that management declares

when the give the financial statements to the auditor, whether they actually say

so or not. These assertions include existence or occurrence, completeness,

rights and obligations, valuation or allocation, and presentation and disclosure

(AU §326.26). The traditional audit approach involves first testing internal

controls to reveal weak points upon which to focus, but continuing to examine all

accounts, on a test basis, for overall accuracy. This was not the case for Arthur

Anderson, who use a risk based approach. They only tested those accounts

where they saw weak internal control (Hilzenrath). However, this was not the

only factor in Arthur Anderson misreporting on WorldCom. The management of

WorldCom refused to give Anderson auditors access to computerized versions of

their general ledger, which would have immediately revealed the accounting

fraud. Anderson's mistake was not reporting this lack of scope to the audit

committee, as well as continuing to issue a clean opinion without properly

verifying its accuracy (Hilzenrath).

Tarras, 17

Audit Committee

This is just one reason that makes it essential that every publicly held company

has an independent audit committee. The audit committee are not employees of

the company and serve as the direct link from the external auditor to the

management of company. The external auditor is not supposed to discuss

questionable matters with the CEO, CFO or controller of a company. The audit

committee serves as a representative of the shareholders who have a stake in

the company. This allows the auditor to effectively voice concerns to an

unbiased party. The audit committee should be dedicated to a fair and proper

representation of the financial statements. This was not the case at WorldCom.

According to reports, the audit committee was, "devoted strikingly little time to

their role, meeting as little as three to five hours per year" (Hilzenrath). With so

little devotion, it is not surprising that the most blatant and largest bankruptcy in

American history was not caught by the audit committee.

Internal Auditors

The internal auditors are not usually a part of the external audit. The main

purpose of internal auditing is to ensure all procedures within the company are

up to company standards. The internal auditor often performs compliance

auditing with in the company, and very rarely tests the accuracy of the financial

statements. However, it was the internal auditors at World Com who helped to

Tarras, 18

uncover the fraudulent accounting. Cynthia Cooper was the head of the internal

audit department at WorldCom when she heard from a wireless division that

$400 million had been removed from their reserve account in order to increase

their profits. Ms. Cooper decided to look into the matter further. Reportedly

Arthur Anderson told her, "matter-of-factly that it was not a problem" (Ripley).

CFO Scott Sullivan also warned Cooper to mind her own business. But, on the

cusp of the En ron scandal with Arthur Anderson, Cooper was skeptical about

how accurate the financial statements were. The discouragement of

management only prompted Cooper to look into the matter further. She decided

to begin the cumbersome and time consuming task of redoing Arthur Anderson's

work and auditing the financials. However, she was more cautious this time.

Cynthia, along with her internal audit staff began working late into the night to

keep their project secret. One of the staff even bought a CD burner so they

could copy the information, worried that it might be destroyed before they could

finish (Ripley). What they found was a large hole in the books where expenses

were reclassified as capital expenditures.

It has been shown that the fraudulent accounting by WorldCom may have been

the direct result of a few aggressive executives, it was the lack of responsibility

by many that ultimately allowed the false financials to be released. Not only did

the auditors fail to do their job correctly according to Generally Accepted Auditing

Standards, but also the audit committee was not as involved as they could have

been. The combination of these factors along with the corporate climate of

Tarras, 19

executive elite who ran the company with a no-questions-asked policy, created

the catalysis that resulted in the largest bankruptcy in history. With such

collusion, how can the government ensure the public that their investments are

protected? The next portion of this paper will discuss the new laws and affects of

the Sarbanes-Oxley Act of 2002 which tries to answer that very question.

Tarras, 20

THE SARBANES-OXLEY ACT

on July 30, 2002 President Bush signed into law what is commonly known as the

sarbanes-Oxley Act. The act was a reaction to the seemingly ramped corporate

fraud that was occurring, which until that point President Bush had described as

a few bad apples. The act was sponsored by Sen. Paul Sarbanes of Maryland

and Rep. Michael Oxley (Richards). And thus was named the Sarbanes-Oxley

Act of 2002, which is hailed as the most far reaching affects on business since

the New Deal (Miller). While some of the changes are better tracking or

enhancements of current laws, others sections are brand new. The law is a

comprehensive 66 page document that outlines the changes in the regulation

and roles of all individuals in business with regards to accounting records. The

Jaw addresses such issues as the creation of the Public Company Accounting

Oversight Board, white-collar penalties, corporate tax returns, work paper

retention, and conflicts of interest as well as protection of the whistleblowers who

reveal the fraud. Some of the new rules reflect the unofficial standards in the

industry. The major advantage of the Sarbanes-Oxley Act is that it does allow for

better monitoring within the accounting industry. The Public Company

Accounting Oversight Board (PCAOB), once it is estabilished, will register public

accounting firms, conduct inspections and ensure their compliance with the

Sarbanes-Oxley Act (Tillman). This is a drastic change from the relatively simple

peer reviews of the past. The PCAOB will now examine on an annual basis

those firms who perform more than one hundred audits of public companies, and

Tarras, 21

once every three years for all the other accounting firms who perform audits on

public company (Miller). This is one example of how the new law not only affects

the auditing of publicly held corporations, but the accounting firms themselves

are also drastically affected by the Sarbanes-Oxley Act.

It is obviously too cumbersome to discuss all the topics that Sarbanes-Oxley

addresses in this format; however, this portion of the paper will go over in detail

the changes that were made that may have resulting in a different outcome in the

WorldCom case. Such issues include the role of audit committees, corporate

responsibility, certain conflict of interests, and auditor independence issues will

be addressed as well as new penalties for the crimes that were committed by

upper management at WorldCom.

Audit Committees

A particular aspect of the accounting world that was altered was audit

committees. Like WorldCom, most publicly traded companies have an audit

committee. However, often the audit committee fails to fully grasp the effects of

accounting changes or the ramifications of the accounting policies that the

company performs. The audit committee also has the difficult job of ensuring

that the auditor has all the resources necessary to properly perform the audit.

One of the main changes resulting from Sarbanes-Oxley is that companies are

now required to disclose whether they have "financial expert" on their audit

r I l (

Tarras, 22

committee (Karmal). This however, does not requires the company to have an

audit committee at all , only that they disclose that they do or do not contain a

financial expert. Often the board of directors fulfill the duties of the audit

committee.

These were not the only effects Sarbanes-Oxley had on audit committees. The

audit committee, or board of directors, must now establish procedures regarding

complaints about auditing and accounting matters. Including receiving and

resolving these matters with external consultants, if necessary. In order to

facilitate this Sarbanes-Oxley also requires that the audit committee have the

authority to engage independent advisors and have the proper resources to do

so. Finally, all of the audit committee members must be independent of the

company. According to Sarbanes-Oxley this means they may not, "accept any

consulting, advisor or other compensatory fee from the issuer or . . . be an

affiliated person of the issuer or any subsidiary thereof' (Sarbanes-Oxley Act,

section 301.3.8).

The audit committee of World Com was certainly not independent. They were

made up of several former executives of companies WorldCom had acquired

over the years. Had the audit committee been more independent and only

received their information from the external auditor, the scandal could have been

prevented. At WorldCom, the audit committee was often misled by management

and the auditors (Hilzenrath). Both internal and external auditors were required I

I

Tarras, 23

to go through upper management before approaching the audit committee. With

these blocks in place it is no wonder the audit committee never received the

proper information.

Management Sign Off

As part of the Sarbanes-Oxley Act there are new responsibilities for executives of

public corporations. These rules apply mainly to the CEO and CFO of

corporations who now have to sign off on the financial statements. When

management signs off on the financial statements, they are not only verifying that

internal controls are working properly, but they also maintaining that they have

not mislead auditors. Sarbanes-Oxley now requires the CEO of a company to

verify that all the information contained in the financial statements is true and

accurate to their knowledge and that it properly represents the financial position

of the company (Hockeimer). If the management signs off on the financial

statements and it is determined that they had knowledge about fraud, there are

now severe implications regarding the punishment of management. In an effort

to delegate responsibility of the information contained in the financial statements

to management, Sarbanes-Oxley requires that all publicly traded companies,

"establishing and maintaining internal controls" (Sarbanes-Oxley Act, section

302.a.4.A). When management signs and verifies the financial statements, they

are also verifying that the internal control structure is working properly.

I I

l

I I ( ( I

Tarras, 24

This new standard could have made a dramatic difference in the WorldCom

case. Had the internal auditors been given free reign they may have caught the

fraudulent accounting much sooner, or management would not have been

inclined to misrepresent the financials had they known the internal audit

department would be checking their numbers. Since the release of the

fraudulent financial statements and the subsequent bankruptcy of WorldCom, the

company has now committed to doubling the size of their internal audit staff,

where Cynthia Cooper works, to fifty. The chain of command has changed too,

the internal auditors now report to the audit committee rather than the CFO or

CEO.

Conflict of Interests

One of the main overall issues that Sarbanes-Oxley attempts to identify and

·correct is conflicts of interest. These issues include auditor, audit committee

independence, as well as management conflicts. The most applicable to

WorldCom being the section relating to personal loans to executives. The

specific section states, "It shall be unlawful for any issuer, directly or indirectly,

including through any subsidiary, to extend or maintain credit, to arrange for the

extension of credit, or to renew an extension of credit, in the form of a personal

loan to or for any director or executive officer of that issuer" (Sarbanes-Oxley Act,

section 402.a.1).

f

f

Tarras, 25

Had this been in effects earlier, it would have been detrimental for WorldCom.

The company made over $400 million in personal loans to Bernie Ebbers as

mentioned earlier (Padgett). There is no telling what may have occurred if

Bernie Ebbers was not granted personal loans from WorldCom. The

misstatement of expenses may not have occurred at all. The pressure to inflate

earnings might have been somewhat diminished. There was no avoiding the

falling stock price. If Bernie sold off chunks of his stock the price would fall, but

probably not as far as it did when the fraudulent accounting was revealed. It is

plausible, however that World Com could have avoided bankruptcy. If nothing

else, had those personal loans been made public the stock rating would have

dropped and the public might have avoided loosing millions of dollars in the

company.

Auditor Independence

The enactment of Sarbanes-Oxley has significantly altered the role of auditors.

In the past, as auditors found flaws in the accounting of business, the same firm

could offer to also provide accounting work for the company, among a plethora of

other services. This created a conflict of interest. In essence the auditor was

verifying their own work. The Sarbanes-Oxley Act completely prohibits auditors

from providing such services as bookkeeping, "financial information systems

design and implementation," outsourcing of internal audits, and any financial

advisory roles (Sarbanes-Oxley Act, section 201 ). In all there were a total of nine

I

I I

Tarras, 26

services, previously allowed to be performed by auditors, which now out righted

banned by the Securities and Exchange Commission (Richards). This does not

mean all services are banned. However, any non-audit services the auditing firm

wants to perform, must first be approved by the audit committee (Reason).

Services were not the only thing limited by Sarbanes-Oxley. There are now

limitations on the number of years coordinating partners or senior managers as

well as reviewing partners can work on the same audits. A so called "cooling off'

period after five years is required (Benman). This allows for a fresh view of the

risks and controls in place by another set of eyes. The idea is that engaging

/ another person to deal with the client will give the audit firm a fresh perspective

I of the client. Originally, the law suggested that the whole audit staff be rotated,

however, it was decided that this was too cumbersome for the auditor.

Punishment for Misrepresentation

To ensure that management is sincere in verifying the financial statement severe

penalties have been put in place. If it is determined that the CFO or CEO had a

knowing violation, meaning the knew the financial statements were materially

inaccurate and signed off on them anyway, the punishment is a $1 million fine

and up to 10 years in prison. If the executive is determined to have a willful

violation, implying that they participated or facilitated the misrepresentation of the

I I

Tarras, 27

financial statements, then the fine is increased to $5 million and imprisonment for

up to 20 years (Hockeimer).

In September of 2003, both Bernie Ebbers and Scott Sullivan were arraigned on

charges of fraud. Scott Sullivan is currently being prosecuted by the federal

government for securities and bank fraud. His trial is not scheduled to begin until

February of 2004 (Hoberock). Sullivan's lawyers are arguing that since all of

Sullivan's alleged crimes occurred before a new white collar punishments were

enforced in late 2001 , he should not be prosecuted under the new laws. Under

the old statues the maximum penalty his can receive is 12 % years in prison. If it

is determined that he can be prosecuted under the new white collar laws then

Scott Sullivan can receive up to double that amount of time. Bernie Ebbers on

the other hand is vehemently denying that he had any idea the fraud was

occurring. A tough idea to swallow since it has been reported by several

employees that neither Bernie nor Scott made a decision without first consulting

the other (Hadded). Before Sarbanes-Oxley the CEO was never required to sign

off on the financials and therefore is technically not responsible for them.

Currently, Bernie Ebbers is be prosecuted in Oklahoma, of all places, who got

tired of waiting for the federal government act. He is being charged with 15

counts of fraud and was let out on bond (CNBC). It is indisputable that the

punishments would be much more severe had Sarbanes-Oxley been enacted

earlier.

Tarras, 28

Other Affects

With all the new requirement of Sarbanes-Oxley there is a hefty price tag that

comes along with it. More money is needed to finance the audit committee,

companies are implementing new controls which often mean new software as

well as testing of the controls by an independent firm. As well as a tremendous

amount of consultants are being called in to make sure public traded companies

are fully in compliance with all the Sarbanes-Oxley requirements. With all the

added expense of adhering to the new laws more and more companies are going

private. Since the passage of Sarbanes-Oxley it is estimated that the number of

public firms reversing and going private has increased 22% (Benman). This is

just one example of the massive effect a law like this has. The Sarbanes-Oxley

Act affects all public companies as well as the CPA's that audit them. It is too

soon to tell how the act will affect the accounting industry in the long run, or how

effective it will be.

J

Tarras, 29

CONCLUSION

So the question remains, would the Sarbanes-Oxley Act have made a difference

in the World Com case if it was implemented sooner? To answer this it is

necessary to consider not only the corporate culture at WorldCom, but also the

economic pressure at the time. In 2001, when the line costs were reclassified,

the economy was moving into a recession. Their was intense pressure on

companies to keep pace with the earnings that were the norm in the late 1990's.

However, WorldCom was simply not making those kind of returns. They were

forced to create the kind of returns the market was expecting with fraudulent

accounting. But, when the history of World Com is examined it was not just in the

2000's when the fraud occurred. Almost since the corporation's inception, there

was little emphasis on a well-structured company. Executives never successfully

combined billing systems between MCI and WorldCom after the merger, and

almost no attention was paid to many of the details concerning the sixty mergers

that took place. The bigger issues were tackled, but never down to the very last

detail, the company always had another merger to worry about. The corporate

culture at WorldCom also included using aggressive accounting tactics to

increase its bottom line, such as devaluing an acquired company's hard assets in

order to increase goodwill and inflate earnings. It is these sort of issues that

should have been caught by the external auditor or at the very least been made

known to the audit committee. If that had been the case the audit committee

Tarras, 30

could have consulted an external accountant to get a second opinion on how the

accounting for mergers and acquisitions were handled.

In every aspect of the Sarbanes-Oxley Act that was examined, a significant

difference could have been made in the WorldCom case. Had auditor rotation

be implemented earlier, Arthur Anderson, who performed the annual audits might

have been able to better assess the risks, and perform a more comprehensive

audit. The most significant change of all is that it would be much easier to

punished the guilty had the Sarbanes-Oxley gone into effect sooner. Bernie

Ebbers as well as Scott Sullivan would have been required to sign off on the

financial statements regarding their accuracy and assuring that no fraud had

been committed, making their prosecution much easier. As it stands, the

punishment is minimal for all of the losses their misstated financial statements

caused . There is no doubt, had more sever rules been in effect, frauds such as

the one that occurred at World Com may have been prevented. With laws such

as Sarbanes-Oxley in effect, the public can be assured that fraud of the

magnitude that occurred at WorldCom will not happen again.

Tarras, 31

Works Cited

American Institute of Certified Public Accountants. Professional Standards. New

York: 1 June 2003.

Arens, Alvin, Randal Elder and Mark Beasley. Auditing and Assurance Services

gth ed. Prentice Hall: NJ, 2003.

Associated Press. "Timeline of the history of WorldCom." 20 May 2003.

Backover, Andrew and Michelle Kessler. "Internal Rifts Threaten WorldCom."

USA Today 27 Aug. 2002, final ed.: 1 B.

Backover, Andrew and Jayne O'Donnell. "Ebbers' high-risk act came crashing

down on him." USA Today 12 Dec. 2002, final ed.: 1B.

Benman, Keith. "Experts Discuss Impact of Law Designed to Keep Corporate

Accounting Honest." The Times 4 Aug. 2003, final ed.: 1 B.

Business Center. CNBC. "Former WorldCom CEO goes to court to face the first

criminal charges against him." Reporter, Scott Cohen. CNBC, Inc. 3 Sept.

2003.

Eichenwald, Kirt and Simon Romero. "For WorldCom, Acquisitions were behind

its rise and fall. " New York Times 8 Aug. 2002, late ed.: A1.

Girard, Kim. "Inside WorldCom's Billing Blunders." Baseline Magazine 14 Mar.

2002

Haddad, Charles and Steve Rosenbush. "Woe is WorldCom." Business Week 6

May 2002: 86+

Foust, Dean and Charles Haddad. "WorldCom's Sorry Legacy." Business Week

8 July 2002: 38+

Tarras, 32

Hilzenrath, DavidS. 'The company's directors were all too often a passive rubber

stamp for management and especially Mr. Ebbers." Washington Post 16

June 2003: E1.

Hoberock, Barbara. "WorldCom Prelim Hearing Set." Tulsa World 7 Nov. 2003:

Bus. A15.

Hockeimer Jr., Henry E. "Conducting Internal Investigations in Today's

Environment." The Legallntelligencer 17 March 2003: pg 5-7

Jeter, Lynne W. Disconnected: Deceit and Betrayal at WorldCom John Wiley &

Sons, Inc. : New Jersey, 2003.

Karmel, Roberta. "Federalization of the Law Regarding Audit Committees." New

York Law Journal v. 729, 20 Feb. 2003: 3.

Knight, Jerry. "Tracking the Trouble Caused by WorldCom's Bernie Ebbers."

Washington Post 18 March 2002: E1 .

Miller, Richard and Dave Pashkoff. "Regulations under the Sarbanes-Oxley Act:

what auditors/audit committees need to know and do to apply." Journal of

Accountancy Oct. 2002, 33-34

Mitchell, Lawrence. Corporate Irresponsibility Yale Univeristy Press. London:

2001 .

Morgenson, Gretchen. "The lesions ofWorldCom keep coming." The New York

Times 19 March 2003: Finance pg 12.

Padgett, Tim. "The Rise and Fall of Bernie Ebbers." Time 13 May 2002: 56+

Powell, Barbara. "WorldCom files reorganization plan that sheds debt, moves

headquarters. " Associated Press 14 April 2003

Tarras, 33

Reason, Tim. "The SEC put much of the Sarbanes-Oxley Act into effect by

passing a slew of new rules." CFO Magazine March 2003

Richards, Meg. "One year later: Landmark legislation ripples through corporate

America." Associated Press 24 July 2003

Ripley, Amanda. "The Night Detective." Newsweek 22 Dec. 2002:

Sarbanes-Oxley Act of 2002. H.R. 3763. 31 July 2002.

Stern, Christopher. "WorldCom Shifted Billions in Expenses to MCI Books"

Washington Post 5 April 2003: E1.

Tillman, Bob. "Who's Afraid of Sarbanes-Oxley?" Information Management

Journal Nov.-Dec. 2002: 16+