WorldCom scandal

The WorldCom scandal was a major accounting scandal that came to light in the summer of 2002 at WorldCom, the USA's second largest long-distance telephone company at the time. From 1999 to 2002, senior executives at WorldCom led by founder and CEO Bernard Ebbers orchestrated a scheme to inflate earnings in order to maintain WorldCom's stock price.[1] The fraud was uncovered in June 2002 when the company's internal audit unit, led by vice president Cynthia Cooper, discovered over $3.8 billion of fraudulent balance sheet entries. Eventually, WorldCom was forced to admit that it had overstated its assets by over $11 billion. At the time, it was the largest accounting fraud in American history.

Background

In December 2000, WorldCom financial analyst Kim Emigh was told to allocate labor for capital projects in WorldCom's network systems division as an expense rather than book it as a capital project. By Emigh's estimate, the order would have affected at least $35 million in capital spending. Believing that he was being asked to commit tax fraud, Emigh pressed his concerns up the chain of command, notifying an assistant to WorldCom chief operating officer Ron Beaumont. Within 24 hours, it was decided not to implement the directive. However, Emigh was reprimanded by his immediate superiors, and subsequently laid off in March 2001.[2]

Emigh, who was from the MCI half of the 1997 WorldCom/MCI merger, later told Fort Worth Weekly in May 2002 that he had expressed concerns about MCI's spending habits for years. He believed that things had been reined in somewhat after WorldCom took over, but he was still unnerved by vendors billing WorldCom for exorbitant amounts.[2] The Fort Worth Weekly article was eventually read by Glyn Smith, an internal audit manager at WorldCom headquarters in Clinton, Mississippi. After examining it, he suggested to his boss, Cooper, that she should start that year's scheduled capital expenditure audit a few months early. Cooper agreed, and the audit began in late May.[3]:220–221

Prepaid capacity

During a meeting with the auditors, corporate finance director Sanjeev Sethi explained that differing amounts in two capital spending expenditures related to "prepaid capacity." No one in the room had ever heard that term before. When pressed for an explanation, Sethi said that he did not know what the term meant, even though his division approved capital spending requests. He referred the auditors to corporate controller David Myers.[3]:223–225 Suspicious, Cooper asked Mark Abide, head of property accounting, about the term. Abide was not familiar with it either, even though he had made several entries about prepaid capacity in WorldCom's computerized accounting system.[3]:225

Cooper and Smith asked senior associate Eugene Morse, one of the "techies" on the internal audit team, to peruse the accounting system for any references to prepaid capacity. Morse was eventually able to find one and trace it through the system. However, the amounts were bouncing between accounts in an unusual manner, resulting in a large round amount moving from WorldCom's income statement to its balance sheet. Cooper asked Morse to see if there was another prepaid capacity entry that moved around in similar fashion.[3]:225–227 Morse went to work, but pulled so much data that he frequently clogged up the accounting servers. Eventually, he and the rest of the team began working at night. Finally, on June 10, Morse found more entries about "prepaid capacity"; large amounts had been transferred from the income statement to the balance sheet from the third quarter of 2001 to the first quarter of 2002.[3]:231–233

Suspicions mount

Soon afterward, chief financial officer Scott Sullivan, Cooper's immediate supervisor, called Cooper in for a meeting about audit projects, and asked the internal audit team to walk him through recently completed audits. When Smith's turn came, Cooper asked about the prepaid capacity entries. Sullivan claimed that it referred to costs related to SONET rings and lines that were either not being used at all or were seeing low usage. He claimed those costs were being capitalized because the costs associated with line leases were fixed even as revenue dropped. He planned to take a restructuring charge in the second quarter of 2002, after which WorldCom would allocate these costs between restructuring charges and expenses. He asked Cooper to postpone the capital-expenditure audit until the third quarter, heightening Cooper's suspicions.[3]:233–237

That night, Cooper and Smith called Max Bobbitt, a WorldCom board member and the chairman of the Audit Committee, to discuss their concerns. Bobbitt was concerned enough to tell Cooper to discuss the matter with Farrell Malone of KPMG, WorldCom's external auditor.[3]:237–238 KPMG had inherited the WorldCom account when it bought Arthur Andersen's Jackson practice in the wake of Andersen's indictment for its role in the accounting scandal at Enron.[3]:229 By this time, the internal audit team had found 28 prepaid capacity entries dating back to the second quarter of 2001. By their calculations, if not for those entries, WorldCom's $130 million profit in the first quarter of 2002 would have become a $395 million loss. Despite this, Bobbitt thought it was premature to discuss the matter with the Audit Committee at that point. He did, however, discuss the matter with Sullivan, and assured Cooper that he would have support for those entries by the following Monday.[3]:240–241

Fraud revealed

Cooper decided not to wait to discuss the matter with Sullivan. She decided to ask the accountants who made those entries to provide support for them herself. Beforehand, she asked Kenny Avery, who had been Andersen's lead partner on the WorldCom account before KPMG took over, if he knew about prepaid capacity. Avery had never heard of the term, and knew of nothing in Generally Accepted Accounting Principles that allowed for capitalizing line costs. Andersen, it turned out, had never tested WorldCom's capital expenditures for it.[3]

Cooper and Smith then questioned Betty Vinson, the accounting director who made the entries. To their surprise, Vinson admitted she had made the entries without knowing what they were for or seeing support for them. She had done so at the direction of Myers and general accounting director Buford Yates. When Cooper and Smith spoke with Yates, he admitted that he did not know what prepaid capacity was. Yates also claimed that accountants reporting to him booked entries at Myers' direction.[3]:243–245

Finally, the internal auditors spoke with Myers. He admitted that there was no support for the entries. In fact, they had been booked "based on what we thought the margins should be," and there were no accounting standards that supported them. He admitted that the entries should have never been made, but it was difficult to stop once they started. Although he was uncomfortable with the entries, he never thought that he would have to explain them to regulators.[3]:246–247 The following day, Farrell met with Sullivan and Myers, and concluded that their rationale for the entries made sense "from a business perspective, but not an accounting perspective." In response, Sullivan, Myers, Yates and Abide scrambled to find amounts that were capitalized when they should have been expensed in hopes of offsetting the prepaid capacity entries. They believed that the only other alternative was an earnings restatement.[3]

Bobbitt finally called an Audit Committee meeting for June 20. By this time, Cooper's team had discovered over $3 billion in questionable transfers from line cost expense accounts to assets from 2001 to 2002. At the meeting, Farrell stated that there was nothing in GAAP that would allow those entries. Sullivan claimed that WorldCom had invested in expanding the telecom network from 1999 onward, but the anticipated expansion in customer usage never occurred. He argued that the entries were justified on the basis of the matching principle, which allowed costs to be booked as expenses so they align with any future benefit accrued from an asset. He also contended that since capital assets were worth less than what the books said they should be, he reiterated his proposal for a restructuring charge, or an "impairment charge," as he called it, for the second quarter of 2002. He claimed that Myers could provide support for the entries. The committee gave him until the following Monday to get support.[3]:256–258

Over the weekend, Cooper and her team discovered several more suspicious "prepaid capacity" entries. All told, the internal audit unit had discovered a total of 49 prepaid capacity entries detailing $3.8 billion in transfers spread out across all of 2001 and the first quarter of 2002. Several of them were keyed in on explicit directions from Sullivan and Myers under the line "SS entry." While some of the suspicious entries were made by directors and managers, others were made by lower-level accountants who didn't understand the seriousness of what they were doing.[3]:258–259 While meeting with another accounting director, Troy Normand, they learned about more potentially illicit accounting. According to Normand, management had drawn down the company's cost reserves in portions of 2000 and 2001 to artificially reduce expenses.[3]:261

At the same time, the Audit Committee asked KPMG to conduct its own review. KPMG discovered that Sullivan had moved system costs across a number of property accounts, allowing them to be booked as capital expenditures. The expenses were spread out so they weren't initially obvious. When KPMG asked Andersen's former WorldCom engagement team about the entries, the Andersen accountants said they would have never approved of the entries had they known about them. Sullivan was asked to present a written explanation for his actions by Monday.[4]

At an Audit Committee meeting that Monday, Sullivan presented a white paper explaining his reasoning. The Audit Committee and KPMG were not persuaded. They concluded that the amounts were transferred with the sole purpose of meeting Wall Street targets, and the only acceptable remedy was to restate corporate earnings for all of 2001 and the first quarter of 2002. Andersen withdrew its audit opinion for 2001, and the board demanded Sullivan and Myers' resignations.[3]:262–264

SEC begins investigation

On June 25, after the amount of the illicit entries was confirmed, the board accepted Myers' resignation and fired Sullivan when he refused to resign. On the same day, WorldCom executives briefed the SEC, revealing that it would have to restate its earnings for the next five quarters.[4][3]:265 Later that day, WorldCom publicly admitted that it had overstated its cash flow by over $3.8 billion over the previous five quarters. The disclosure came at a particularly bad time for WorldCom. Even before the scandal broke, its credit had been reduced to junk status, and its stock had lost over 94 percent of its value. It had been facing a separate SEC investigation into its accounting that had started earlier in the year, and was laboring under $30 billion in debt. Amid rumors of bankruptcy, WorldCom said it would lay off 17,000 employees.[5]

The federal government had already begun an informal inquiry earlier in June, when Vinson, Yates, and Normand secretly met with SEC and Justice Department officials.[3]:261 The SEC filed civil fraud charges against WorldCom on June 26, speculating that WorldCom had engaged in a concerted effort to manipulate its earnings in order to meet Wall Street targets and support its stock price. Additionally, it claimed that the scheme had been "directed and approved by senior management"–thus hinting that executives higher up on the org chart than Sullivan and Myers had known about the scheme.[6]

Trial

Aftermath
gollark: Done.
gollark: Fine. I'll have GTech™ counterprove it in 2022.
gollark: I proved it wasn't some time ago, however.
gollark: Although they all have annoying tradeoffs, so the best approach is probably just to destroy all quantum computers?
gollark: Some of the post-quantum approaches seem at least vaguely related to number theory.

References
  1. "Worldcom, Inc. 2002 Form 10-K Annual Report". U.S. Securities and Exchange Commission.
  2. Gale Reaves (May 16, 2002). "Accounting for Anguish". Fort Worth Weekly.
  3. Cooper, Cynthia (April 15, 2009). Extraordinary Circumstances: The Journey of a Corporate Whistleblower. Hoboken, New Jersey: John Wiley & Sons. ISBN 978-0-470-12429-1.
  4. Kurt Eichenwald; Simon Romero (June 27, 2002). "The Latest Corporate Scandal Is Sudden, Vast and Simple". The New York Times.
  5. Simon Romero; Alex Berenson (June 26, 2002). "WorldCom Says It Hid Expenses, Inflating Cash Flow $3.8 Billion". The New York Times.
  6. Simon Romero (June 27, 2002). "WorldCom Facing Charges Of Fraud, Inquiries Expand". The New York Times.
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