QUESTION: Clearly and distinctly identify the internal and external controls at Worldcom and how they functioned. Comment particularly whether each internal or external control was effective in protecting the company against human errors or mis-behavior. Then comment carefully on the extent to which the failure/success of the company ultimately depended on the failure/success of each control. Indicate which internal controls contributed the most to the companys failure/success.

1 Lecture note A theory is just a way of thinking about something. A context. Shareholders are owners because it's their money invested. Shareholder is the Principal Employees are the agents. These two parties DO NOT ALWAYS have the same interest Everyone is expected to maximize their own welfare. Sometimes the agent may behave against the interest of the shareholder. Today we want to try to understand why does accounting fraud occurs. What makes fraud possible? Discretion in accounting makes it possible for a company to sustain fraud for a while. WorldCom is a Telecom company - primarily long distance. Very large - 104B in assets 60,000 employees Telecom became deregulated. to create a competitive market. Telecom companies are trying to get customers to subscribe with them for local and long- distance service. Industry was VERY competitive. If there is nothing unique about you, then you are going face competition. This meant not a lot of pricing power. Consequences: rocked the stock market. The world's biggest accounting auditor was forced into bankruptcy. Primary growth strategy: acquistions to capture market share. How did they pay for these acquisitions: primarily by using World Com shares. To have buying power, you need your stock price to be very highly valued in the market. So, company had a strong interest in keeping its stock price high. This primarily occurs when you are outright refusing to apply accounting rules correctly OR are applying the wrong rules deliberately to achieve some accounting objective. 1. Bernie Ebbers (CEO) Very competent 2. Scott Sullivan (CFO) Harvard MBA Wall street whiz Highly experienced and competent finance wise Were these guys smart? 3. Betty Vinson - accountant who helped make a lot of fraudulent entries in the books. 4. Cynthia Cooper incharge of the internal audit and discovered the fraud. Shareholders => Board of Directors => CEOs and Mgmt Then how could they fail to see that the fraud is not sustainable? Why do the fraud? Are they derelict? Not doing their job properly or they are complicit. The E/R ratio = Line Cost Expenses/Revenues We want this to be LOW. | Yes 2 Line costs were lease payments that World Com made to AT&T who owned the physical lines. This was the major cost for a telecom company. Accrual Releases What the heck is an accrual release? Through the year End of Year WC estimating Don't get the bill line cost expenses from AT&T until that are incurring. the end of the year. Book an expense of Receive a bill for only $80. $100.00 Reverse $ 20 of the expense. This reversal is called an accrual release. The fraud was that World Com started reversing expenses too soon. To pad their income. Why does World Com need to pad their income through fraud? Is it possible that their income without fraud would not have sustained a high stock price? Why is the income without the fraud not sufficient? - too much competition - no control over price -start losing your margins Expense capitalization means you start calling expenses assets. The impact is to reduce reported expenses and increase income. Leadership = upper management and their behavior Culture = the way things are done in an organization Leadership at WC: Very authoritative - my way or no way. Military style relationship. Strongarming/coercion-imposed employees Strong leaders are focused on driving an agenda. Blind loyalty required Decisive leader Primary motivation of CEO? #1 stock on wall street - feedback not encouraged - don't question leadership. - fall in line or else, lose your bonus, or lose your job, or get transferred. - bodge podge of many companies from different places many different cultures - nothing homogenous. - CEO kept lawyers far away. Could this cause fraud by itself? Probably not. Because you need motivation, and you need other controls fail. What are internal controls ? - are mechanisms put in place by a company to ensure that catastrophic failures don't occur The reason you need them is that it's not possible for a large and dispersed organization to watch everybody. 3 Int controls at World Com - virtually non-existent - did not exist because leadership did not want it Two big internal controls 1) Separation of duties - checks and balances - everything seems to go through the CFO ii) employee code of conduct - it is very important to establish rules of conduct it establishes culture - there is no code of conduct at WC because the CEO doesn't want to be subjected it iii) whistleblowing mechanism - anonymous hotline - does not exist iv) is the internal audit function indpendent? - reported directly to CFO. - very limited in their authority over what they could review. - locked out of access to accounting systems. These are all weaknesses in internal controls at WorldCom. They make it easy for the fraud to proceed or remain undetected but by itself it's not going to cause fraud. - restricted the scope of the investigation because it was directed by the CFO. - if they went the right direct, they would have eventually caught it. Arthur Andersen was the premiere accounting auditor on the planet. External auditor was very very competent and experienced. WC did block a lot of access for AA to its accounting books. The auditor is a monitor. AA was very deeply involved with WC in a consulting capacity. AA has a conflict of interest and is reluctant to do an exhaustive audit of WC. Essentially looked the other way. Audit committees are made of members of the board. To interact with the external auditor to ensure that the financial reporting is accurate. BOD not taking a keen interest or questioning either management or the external auditor about the financial reporting of the company. Fraud had already occurred so may not have prevented it. Could have shortened its duration. Strong, well-functioning internal audit department or an independent and competent external auditor can deter fraud. - it is desirable to have directors who are independent of management. - some members had prior business relations with the CEO. - possibly made them compliant and less questioning of the CEO. 1 Lecture note A theory is just a way of thinking about something. A context. Shareholders are owners because it's their money invested. Shareholder is the Principal Employees are the agents. These two parties DO NOT ALWAYS have the same interest Everyone is expected to maximize their own welfare. Sometimes the agent may behave against the interest of the shareholder. Today we want to try to understand why does accounting fraud occurs. What makes fraud possible? Discretion in accounting makes it possible for a company to sustain fraud for a while. WorldCom is a Telecom company - primarily long distance. Very large - 104B in assets 60,000 employees Telecom became deregulated. to create a competitive market. Telecom companies are trying to get customers to subscribe with them for local and long- distance service. Industry was VERY competitive. If there is nothing unique about you, then you are going face competition. This meant not a lot of pricing power. Consequences: rocked the stock market. The world's biggest accounting auditor was forced into bankruptcy. Primary growth strategy: acquistions to capture market share. How did they pay for these acquisitions: primarily by using World Com shares. To have buying power, you need your stock price to be very highly valued in the market. So, company had a strong interest in keeping its stock price high. This primarily occurs when you are outright refusing to apply accounting rules correctly OR are applying the wrong rules deliberately to achieve some accounting objective. 1. Bernie Ebbers (CEO) Very competent 2. Scott Sullivan (CFO) Harvard MBA Wall street whiz Highly experienced and competent finance wise Were these guys smart? 3. Betty Vinson - accountant who helped make a lot of fraudulent entries in the books. 4. Cynthia Cooper incharge of the internal audit and discovered the fraud. Shareholders => Board of Directors => CEOs and Mgmt Then how could they fail to see that the fraud is not sustainable? Why do the fraud? Are they derelict? Not doing their job properly or they are complicit. The E/R ratio = Line Cost Expenses/Revenues We want this to be LOW. | Yes 2 Line costs were lease payments that World Com made to AT&T who owned the physical lines. This was the major cost for a telecom company. Accrual Releases What the heck is an accrual release? Through the year End of Year WC estimating Don't get the bill line cost expenses from AT&T until that are incurring. the end of the year. Book an expense of Receive a bill for only $80. $100.00 Reverse $ 20 of the expense. This reversal is called an accrual release. The fraud was that World Com started reversing expenses too soon. To pad their income. Why does World Com need to pad their income through fraud? Is it possible that their income without fraud would not have sustained a high stock price? Why is the income without the fraud not sufficient? - too much competition - no control over price -start losing your margins Expense capitalization means you start calling expenses assets. The impact is to reduce reported expenses and increase income. Leadership = upper management and their behavior Culture = the way things are done in an organization Leadership at WC: Very authoritative - my way or no way. Military style relationship. Strongarming/coercion-imposed employees Strong leaders are focused on driving an agenda. Blind loyalty required Decisive leader Primary motivation of CEO? #1 stock on wall street - feedback not encouraged - don't question leadership. - fall in line or else, lose your bonus, or lose your job, or get transferred. - bodge podge of many companies from different places many different cultures - nothing homogenous. - CEO kept lawyers far away. Could this cause fraud by itself? Probably not. Because you need motivation, and you need other controls fail. What are internal controls ? - are mechanisms put in place by a company to ensure that catastrophic failures don't occur The reason you need them is that it's not possible for a large and dispersed organization to watch everybody. 3 Int controls at World Com - virtually non-existent - did not exist because leadership did not want it Two big internal controls 1) Separation of duties - checks and balances - everything seems to go through the CFO ii) employee code of conduct - it is very important to establish rules of conduct it establishes culture - there is no code of conduct at WC because the CEO doesn't want to be subjected it iii) whistleblowing mechanism - anonymous hotline - does not exist iv) is the internal audit function indpendent? - reported directly to CFO. - very limited in their authority over what they could review. - locked out of access to accounting systems. These are all weaknesses in internal controls at WorldCom. They make it easy for the fraud to proceed or remain undetected but by itself it's not going to cause fraud. - restricted the scope of the investigation because it was directed by the CFO. - if they went the right direct, they would have eventually caught it. Arthur Andersen was the premiere accounting auditor on the planet. External auditor was very very competent and experienced. WC did block a lot of access for AA to its accounting books. The auditor is a monitor. AA was very deeply involved with WC in a consulting capacity. AA has a conflict of interest and is reluctant to do an exhaustive audit of WC. Essentially looked the other way. Audit committees are made of members of the board. To interact with the external auditor to ensure that the financial reporting is accurate. BOD not taking a keen interest or questioning either management or the external auditor about the financial reporting of the company. Fraud had already occurred so may not have prevented it. Could have shortened its duration. Strong, well-functioning internal audit department or an independent and competent external auditor can deter fraud. - it is desirable to have directors who are independent of management. - some members had prior business relations with the CEO. - possibly made them compliant and less questioning of the CEO