What Is Internal Audit? Operational Information

internal controls, the internal audit activity What is internal auditing? provides assurance to management and the Performed by professionals with an in-depth audit committee that internal controls are understanding of the business culture, systems, effective and working as intended. The internal and processes, the internal audit activity provides audit activity is led by the chief audit executive assurance that internal controls in place are (CAE). The CAE delineates the scope of adequate to mitigate the risks, governance activities, authority, and independence for processes are effective and efficient, and internal auditing in a written charter that is organizational goals and objectives are met. approved by the audit committee.

The Institute of Internal Auditors (IIA) has An effective internal audit activity is a valuable developed the globally accepted definition of resource for management and the board or its internal auditing, as follows: equivalent, and the audit committee due to its understanding of the organization and its culture, Internal Auditing is an independent, objective operations, and risk profile. The objectivity, skills, assurance and consulting activity designed to and knowledge of competent internal auditors add value and improve an organization's can significantly add value to an organization's operations. It helps an organization accomplish internal control, risk management, and its objectives by bringing a systematic, governance processes. Similarly an effective disciplined approach to evaluate and improve the internal audit activity can provide assurance to effectiveness of risk management, control, and other stakeholders such as regulators, governance processes. employees, providers of finance, and shareholders. Independence is established by the organizational and reporting structure. Objectivity As the primary body for the internal audit is achieved by an appropriate mind-set. The profession, The IIA maintains the International internal audit activity evaluates risk exposures Standards for the Professional Practice of relating to the organization's governance, Internal Auditing and the profession s Code of operations and information systems, in relation Ethics. IIA members are required to adhere to to: the Standards and Code of Ethics.

. Effectiveness and efficiency of operations. . Reliability and integrity of financial and What is internal audit? operational information. The role of internal audit is to provide . Safeguarding of assets. independent assurance that an organisation’s . Compliance with laws, regulations, and risk management, governance and internal contracts. control processes are operating effectively. Internal auditors deal with issues that are Based on the results of the risk assessment, the fundamentally important to the survival and internal auditors evaluate the adequacy and prosperity of any organisation. Unlike external effectiveness of how risks are identified and auditors, they look beyond financial risks and managed in the above areas. They also assess statements to consider wider issues such as the other aspects such as ethics and values within organisation’s reputation, growth, its impact on the organization, performance management, the environment and the way it treats its communication of risk and control information employees. within the organization in order to facilitate a good governance process. Internal auditors have to be independent people who are willing to stand up and be counted. Their The internal auditors are expected to provide employers value them because they provide an recommendations for improvement in those independent, objective and constructive view. To areas where opportunities or deficiencies are do this, they need a remarkably varied mix of identified. While management is responsible for skills and knowledge. They might be advising the 1 project team running a difficult change programme one day, or investigating a complex more than 36,000 miles. It was also one of the largest overseas fraud the next. independent developers and producers of electricity in

From very early on in their careers, they talk to the world, serving both industrial and emerging executives at the very top of the organisation markets. Enron was also a major supplier of solar and about complex, strategic issues, which is one of the most challenging and rewarding parts of their wind renewable energy worldwide, managed the role. largest portfolio of natural gas-related risk What is the difference between internal and external audit? management contracts in the world, and was one of

the world's biggest independent oil and gas exploration Internal auditors are often confused with external auditors, but there are significant differences companies. In North America, Enron was the largest between the two groups. Internal auditors look at all the risks facing an organisation and what is wholesale marketer of natural gas and electricity. being done to manage these risks. External auditors on the other hand look at financial Enron pioneered innovative trading products, such as accounts. So internal audit’s role is broader and might, for example, include auditing the gas futures and weather futures, significantly reputational risk that a company could be damaged by using cheap labour in foreign modernizing the utilities industry. After a surge of countries. It could also include auditing operational risks such as poor health and safety growth in the early 1990s, the company ran into procedures, or strategic risks such as the board stretching company resources by producing too difficulties. The magnitude of Enron's losses was many products. hidden from stockholders. The company folded after a

failed merger deal with Dynegy Inc. in 2001 brought to

light massive financial finagling. The company had

ranked number seven on the Fortune 500, and its there are 3 types of Audit : failure was the biggest bankruptcy in American history. 1. Internal audit ( first party audit),to ensure implementing, maintaining and improvement of the system audited. Company Origins

2.Customer audit ( second party audit), to evaluate the suppliers performance and compliance for Enron began as Northern Natural Gas Company, standards. organized in Omaha, Nebraska, in 1930 by three other 3.External audit (third party audit), to ensure implementing and documenting according to companies. North American Light & Power Company standards.

and United Light & Railways Company each held a 35

ENRON percent stake in the new enterprise, while Lone Star

Gas Corporation owned the remaining 30 percent. The Before filing for bankruptcy in 2001, Enron Corporation company's founding came just a few months after the was one of the largest integrated natural gas and stock market crash of 1929, an inauspicious time to electricity companies in the world. It marketed natural launch a new venture. Several aspects of the Great gas liquids worldwide and operated one of the largest Depression actually worked in Northern's favor, natural gas transmission systems in the world, totaling however. Consumers initially were not enthusiastic

2 about natural gas as a heating fuel, but its low cost led wells. Another subsidiary, Northern Plains Natural Gas to its acceptance during tough economic times. High Company, was established in 1954 and eventually unemployment brought the new company a ready would bring Canadian gas reserves to the continental supply of cheap labor to build its pipeline system. In United States. addition, the 24-inch steel pipe, which could transport Through its Peoples division, the parent company six times the amount of gas carried by 12-inch cast acquired a natural gas system in Dubuque, Iowa, from iron pipe, had just been developed. Northern grew North Central Public Service Company in 1957. In rapidly in the 1930s, doubling its system capacity 1964, Council Bluffs Gas Company of Iowa was within two years of its incorporation and bringing the acquired and merged into the Peoples division. first natural gas supply to the state of Minnesota. Northern created two more subsidiaries in 1960:

Public Offering in the 1940s Northern Gas Products Company (later Enron Gas

Processing Company), for the purpose of building and The 1940s brought changes in Northern's regulation operating a natural gas extraction plant in Bushton, and ownership. The Federal Power Commission, Kansas; and Northern Propane Gas Company, for retail created as a result of the Natural Gas Act of 1938, sales of propane. Northern Natural Gas Producing regulated the natural gas industry's rates and Company was sold to Mobil Corporation in 1964, but expansion. In 1941, United Light & Railways sold its the parent company continued expanding on other share of Northern to the public, and in 1942 Lone Star fronts. In 1966, it formed Hydrocarbon Transportation Gas distributed its holdings to its stockholders. North Inc. (later Enron Liquids Pipeline Company) to own and American Light & Power would hold on to its stake until operate a pipeline system carrying liquid fuels. 1947, when it sold its shares to underwriters who then Eventually, this system would bring natural gas liquids offered the stock to the public. Northern was listed on from plants in the Midwest and Rocky Mountains to the New York Stock Exchange that year. upper-Midwest markets, with connections for eastern

In 1944, Northern acquired the gas-gathering and markets as well. transmission lines of Argus Natural Gas Company. The Growth through Acquisitions following year, the Argus properties were consolidated into Peoples Natural Gas Company, a subsidiary of Northern made several acquisitions in 1967: Protane

Northern. In 1952, Peoples was dissolved as a Corporation, a distributor of propane gas in the eastern subsidiary, its operations henceforth becoming a United States and the Caribbean; Mineral Industries division of the parent company. Also in 1952, the Inc., a marketer of automobile antifreeze; National company set up another subsidiary, Northern Natural Poly Products Inc.; and Viking Plastics of Minnesota.

Gas Producing Company, to operate its gas leases and Also in 1967, Northern created Northern Petrochemical

Company to manufacture and market industrial and Crouse-Hinds from InterNorth's hostile bid and bought consumer chemical products. The petrochemical Crouse-Hinds in January 1981. The takeover fight company acquired Monsanto Corporation's brought a flurry of lawsuits between InterNorth and polyethylene marketing business in 1969. Cooper. The suits were dropped after the acquisition

was finalized. Northern continued expanding during the 1970s. In

February 1970 it acquired Plateau Natural Gas While InterNorth grew through acquisitions, it also

Company, which became part of the Peoples division. expanded from within. In 1980, it set up Northern

In 1971, it bought Olin Corporation's antifreeze Overthrust Pipeline Company and Northern Trailblazer production and marketing business. It set up UPG Inc. Pipeline Company to participate in the Trailblazer in 1973 to transport and market the fuels produced by pipeline, which ran from southeastern Nebraska to

Northern Gas Products. UPG eventually would handle western Wyoming. Also that year, it created two oil and liquid gas products for other companies as well. exploration and production companies, Nortex Gas &

Oil Company and Consolidex Gas and Oil Limited. The In 1976, Northern formed Northern Arctic Gas latter company was a Canadian operation. In 1981, Company, a partner in the proposed Alaskan arctic gas InterNorth set up Northern Engineering International pipeline, and Northern Liquid Fuels International Ltd., Company to provide professional engineering services. a supply and marketing company. Northern Border In 1982, it formed Northern Intrastate Pipeline Pipeline Company, a partnership of four energy Company and Northern Coal Pipeline Company as well companies with Northern Plains Natural Gas as as InterNorth International Inc. (later Enron managing partner, began construction of the eastern International) to oversee non-U.S. operations. segment of the Alaskan pipeline in 1980. This segment, stretching from Ventura, Iowa, to Monchy, InterNorth significantly expanded its oil and gas

Saskatchewan, was completed in 1982. About that exploration and production activity in 1983 with the time, it became apparent that transporting Alaskan gas purchase of Belco Petroleum Corporation for about to the lower 48 states would be prohibitively $770 million. Belco quadrupled InterNorth's gas expensive. Nevertheless, the pipeline provided an reserves and added greatly to its crude oil reserves. important link between Canadian gas reserves and the Exploration efforts focused on the United States, continental United States. Northern changed its name Canada, and Peru. to InterNorth, Inc. in 1980. That same year, while Other acquisitions of the early 1980s included the fuel attempting to grow through acquisitions, InterNorth trading companies P & O Falco Inc. and P & O Falco became involved in a takeover battle with Cooper Ltd.; their operations joined with UPG--renamed UPG Industries Inc. to acquire Crouse-Hinds Company, a Falco--in 1984 and Chemplex Company, a polyethylene manufacturer of electrical products. Cooper rescued

4 and adhesive manufacturer, also acquired in 1984. Enron's assets there, and Enron began negotiating for

InterNorth had sold Northern Propane Gas in 1983. payment, taking a $218 million charge against

earnings in the meantime. In 1986, Enron's chemical InterNorth made an acquisition of enormous subsidiary was sold for $603 million. Also in 1986, proportions in 1985, when it bid to purchase Houston Enron sold 50 percent of its interest in Citrus Natural Gas Corporation for about $2.26 billion. The Corporation to Sonat Inc. for $360 million but offer was received enthusiastically, and the merger continued to operate Citrus's pipeline system, Florida created the largest gas pipeline system in the United Gas Transmission Company. Citrus originally was part States--about 37,000 miles at the time. Houston of Houston Natural Gas. Natural Gas brought pipelines from the Southeast and

Southwest to join with InterNorth's substantial system In 1987, Enron centralized its gas pipeline operations in the Great Plains area. Valero Energy Corporation of under Enron Gas Pipeline Operating Company. Also

San Antonio, Texas, sued to block the merger. that year, Enron Oil & Gas Company, with

InterNorth had entered into joint ventures with Valero responsibility for exploration and production, was early in 1985 to transport and sell gas to industrial formed out of previous InterNorth and HNG operations, users in Texas and Louisiana. Because these ventures including Nortex Oil & Gas, Belco Petroleum, HNG Oil competed with Houston Natural Gas, InterNorth Company, and Florida Petroleum Company. In 1989, withdrew from them when it agreed to the merger. Enron Corp. sold 16 percent of Enron Oil & Gas's

Valero alleged that InterNorth had breached its common stock to the public for about $200 million. fiduciary obligations, but the Valero lawsuit failed to That year Enron received $162 million from its insurers stop the acquisition. for the Peruvian operations, and it continued to

negotiate with the government for additional Although still officially named InterNorth, the merged compensation. company initially was known as HNG/InterNorth, with dual headquarters in Omaha, Nebraska, and Houston, Enron made significant moves into electrical power, in

Texas. In 1986, the company's name was changed to both independent production and cogeneration

Enron Corp., and headquarters were consolidated in facilities, in the late 1980s. Cogeneration plants

Houston. After some shuffling in top management, produce electricity and thermal energy from one

Kenneth L. Lay, HNG's chairman, emerged as chairman source. It added major cogeneration units in Texas and of the combined company. HNG/InterNorth began New Jersey in 1988; in 1989, it signed a 15-year divesting itself of businesses that did not fit in with its contract to supply natural gas to a cogeneration plant long-term goals. The $400 million in assets sold off in on Long Island. Also in 1989, Enron reached an

1985 included the Peoples division, which sold for $250 agreement with Coastal Corporation that allowed the million. Also in 1985, Peru's government nationalized company to increase the natural gas production from

5 its Big Piney field in Wyoming. Under the accord, industrial and developing nations all over the world:

Coastal agreed to extend a pipeline to the field, since Italy, Turkey, Argentina, China, India, Brazil, the line already going to it could not handle increased Guatemala, Bolivia, Colombia, the Dominican Republic, volume. The same year, Enron and El Paso Natural Gas the Philippines, and others. By 1996, earnings from

Company received regulatory approval for a joint these projects accounted for 25 percent of total venture, Mojave Pipeline Company. The pipeline company earnings before interest and taxes. transports natural gas for use in oil drilling. In the United States, states were given the power to

New Markets in the Early 1990s deregulate gas and electric utilities in 1994, which

meant that residential customers could choose utilities In the early 1990s, Enron appeared to be reaping the in the same way that they chose their phone carriers. benefits of the InterNorth-Houston Natural Gas This looked like an enormous opportunity for Enron. merger. Its revenues, at $16.3 billion in 1985, fell to CEO Lay was fervently in favor of deregulation, less than $10 billion in each of the next four years but believing it would solve problems for consumers and recovered to $13.1 billion in 1990. Low natural gas utilities alike. The company moved into the residential prices had been a major cause of the decline. Enron, electricity market in 1996, when Enron agreed to however, had been able to increase its market share, acquire Portland General, an Oregon utility whose from 14 percent in 1985 to 18 percent in 1990, with transmission lines would give the company access to help from efficiencies that resulted from the integration California's $20-billion market, as well as access to of the two predecessor companies' operations. Enron 650,000 customers in Oregon. In 1997, Enron Energy also showed significant growth in its liquid fuels Services began to supply natural gas to residential business as well as in oil and gas exploration. customers in Toledo, Ohio, and contracted to sell wind

Beginning with the 1990s, Enron's stated philosophy power to Iowa residents. Through a subsidiary, Zond was to "get in early, push to open markets, position Corporation, the company contracted with ourselves to compete, compete hard when the opening MidAmerican Energy Company of Houston to supply comes." This philosophy was translated into two major 112.5 megawatts of wind-generated electricity to sectors: international markets and the newly about 50,000 homes, the largest single purchase deregulated gas and electricity markets in the United contract in the history of wind energy. Zond was to

States. build the facility in northwestern Iowa, using about 150

of its Z-750 kilowatt series wind turbines, the biggest Beginning in 1991, Enron built its first overseas power made in the United States. plant in Teesside, England, which became the largest gas-fired cogeneration plant in the world with 1,875 A Shaky Structure Collapses megawatts. Subsequently, Enron built power plants in 6

In 1995, Enron CEO Kenneth Lay promised investors predicting it would have ten percent of the $300 billion that Enron's profits would rise by 15 percent a year domestic gas and electric retail market within ten over the next five years. Yet the pace of growth was years. Yet in 1999 the company halted its efforts to not uniformly smooth for Enron. By 1997, only seven expand into California and admitted it had been losing states were moving ahead with deregulation of their $100 million a year in its retail push. But Enron had electricity markets. Enron's profit from a national many other ideas for turning a profit. In 1999, it deregulated electricity market was potentially huge, launched an Internet-based commodities trading and the company spent millions on advertising and service, EnronOnline. Enron traded gas and electricity lobbying for the cause. It also hired hundreds of top as well as more exotic futures such as weather. This business school graduates to help the company define gave companies whose business was affected by new markets. The company seemed a potential gold weather, such as home heating companies or golf mine if it could successfully open up the electricity courses, a hedge against the risk of unfavorable market. Meanwhile, some of its earlier projects were weather. Enron also launched Enron Broadband going badly. Its huge deal to build a power plant in Services, a unit that traded capacity in

India, worth $2.8 billion, was held up by embittered telecommunications bandwidth. The company invested local politicians. Other overseas projects also faltered. some $1.3 billion to build a fiber optic network so that

Earnings had grown annually in the early 1990s by more players would be able to buy and sell bandwidth between 16 and 20 percent. The figure shrank to 11 capacity. The company investigated other e-commerce percent for 1995, then to only 1 percent in 1996. In markets as well, such as trading in airport landing the second quarter of 1997, the company took a $550 rights. The company had made natural gas into a million charge, representing losses on the Indian tradeable commodity in the 1980s, and it was looking project and others. to pull off the same trick again in these various other

commodities. Wall Street began to take notice, and The company continued to spend heavily to advertise Enron's stock, which had languished, began to climb and lobby for deregulation. Enron advanced into the again. It rose 55 percent in 1999, and leapt another 87 newly deregulated California electricity market in percent over 2000. 1998, offering consumers discounts for signing up with the company. Enron's president, Jeffrey Skilling, What apparently drew investors to Enron was its aura predicted a revolution in electricity marketing once of getting in on the ground floor of various related deregulation took hold, while admitting that California industries. It seemed to be a new kind of company, not residents initially would not save much money by a blundering old regulation-bound utility but a savvy switching to Enron. The company was bringing in $4 energy trader. Though new ventures such as billion a year from electricity sales in 1998, while broadband trading were not expected to be

7 immediately profitable, Enron supposedly had a sound retirement savings as the stock hit rock bottom. The core business as a gas and electricity wholesaler. In accounting firm Arthur Andersen, which had certified fact, Enron's core business was Enron's bookkeeping, was disgraced, especially as floundering. Newsweek (January 21, 2002) estimated revelations surfaced that it had destroyed potentially that in the late 1990s Enron had lost "about $2 billion incriminating documents. The scandal reached into the on Telecom capacity, $2 billion in water investments, upper echelons of government as well, as Enron had

$2 billion in a Brazilian utility, and $1 billion on a given liberally to many politicians, including President controversial electricity plant in India." An unnamed George W. Bush and Attorney General John Ashcroft.

Enron insider quoted in Business Week (December 17, CEO Kenneth Lay resigned in January 2002, while the

2001) put it this way: "You make enough billion-dollar company faced multiple congressional, criminal, and mistakes, and they add up." Yet investors were not SEC investigations. The company faced liquidation, aware of Enron's troubles. Losses were disguised in with its only valuable asset the network of natural gas elaborate partnerships and joint ventures, keeping pipelines it had started out with in the mid-1980s. them off Enron's books. Enron's duplicitous Principal Subsidiaries: Enron Engineering and bookkeeping kept the stock price high, even as Enron's Construction; Enron International Inc.; Enron top executives began selling off their own holdings. Renewable Energy Corp.; Enron Ventures Corp.; EOG Enron's president Jeffrey Skilling abruptly resigned in Resources Inc.; EOTT Energy Partners LP; Florida Gas August 2001, citing only personal reasons. The Transmission Co.; Houston Pipeline Co.; Transwestern slowdown in technology and Internet stocks brought Pipeline Co.; Enron Wind Corp.; Louisiana Resources Enron's stock down too, and it had fallen almost by Co.; Northern Border Pipeline Co.; Northern Plains half by the third quarter of 2001. At that point the Natural Gas Co.; Northern Transportation & Storage; company announced a loss of $618 million. Shortly Linc Corp.; Azurix Corp.; Enron Capital & Trade thereafter, the company announced that actually it had Resource; Enron Corp. been misstating its earnings since 1997. While the

Securities and Exchange Commission began Chronology investigating irregularities at the company, Enron tried  Key Dates: to sell out to another Houston energy company,  1930: The company is founded as Northern Dynegy. That deal collapsed when the extent of Natural Gas Company in Omaha, Nebraska. Enron's losses became clear. In December 2001, Enron  1947: The company is listed on New York filed for bankruptcy, the largest ever by an American Stock Exchange. company. Enron's collapse stirred tremendous fallout.  1980: The company's name is changed to Its executives had made millions selling off their Enron InterNorth, Inc. shares, while many of its employees lost their

personal net worth as a negative nine-digit  1985: A merger with Houston Natural Gas number.2 No palace in a gated community, no stable of Corp. takes place. racehorses or multi-million dollar yacht to show for the telecommunications giant he created. Only debts and  1986: The company's name changed to Enron; red ink--results some consider inevitable given his

the new company is headquartered in Houston. unflagging enthusiasm and entrepreneurial flair. There is no question that he did some pretty bad stuff, but  1991: Enron begins overseas expansion. he really wasn't like the corporate villains of his day: Andy Fastow of Enron, Dennis Koslowski of Tyco, or  1999: Launches EnronOnline. Gary Winnick of Global Crossing.3  2001: Files for bankruptcy after previously Personally, Bernie is a hard guy not to like. In 1998 when Bernie was in the midst of acquiring the hidden losses come to light. telecommunications firm MCI, Reverend Jesse Jackson, speaking at an all-black college near WorldCom's Additional Details Mississippi headquarters, asked how Ebbers could afford $35 billion for MCI but hadn't donated funds to

 Public Company local black students. Businessman LeRoy Walker Jr., was in the audience at Jackson's speech, and  Incorporated: 1930 as Northern Natural Gas afterwards set him straight. Ebbers had given over $1 million plus loads of information technology to that Company black college. "Bernie Ebbers," Walker reportedly told  Employees: 21,000 Jackson, "is my mentor."4 Rev. Jackson was won over, but who wouldn't be by this erstwhile milkman and bar  Sales: $101 billion (2000) bouncer who serves meals to the homeless at Frank's  NAIC: 211111 Crude Petroleum and Natural Famous Biscuits in downtown Jackson, Mississippi, and wears jeans, cowboy boots, and a funky turquoise Gas Extraction; 22121 Natural Gas Distibution; watch to work. 48621 Pipeline Transportation of Natural Gas; It was 1983 in a coffee shop in Hattiesburg, Mississippi that Mr. Ebbers first helped create the business 221122 Electric Power Distribution; 221119 concept that would become WorldCom. "Who could Other Electric Power Generation. have thought that a small business in itty bitty Mississippi would one day rival AT&T?" asked an editorial in Jackson, Mississippi's Clarion-Ledger newspaper.5 Bernie's fall-and the company's-was abrupt. In June 1999 with WorldCom's shares trading

at $64, he was a billionaire,6 and WorldCom was the

1 darling of the New Economy. By early May of 2002, WorldCom Ebbers resigned his post as CEO, declaring that he was By Dennis Moberg (Santa Clara University) and "1,000 percent convinced in my heart that this is a Edward Romar (University of Massachusetts- temporary thing."7 Two months later, in spite of Boston) Bernie's unflagging optimism, WorldCom declared itself An update for this case is available. the largest bankruptcy in American history.8 2002 saw an unprecedented number of corporate This case describes three major issues in the fall of scandals: Enron, Tyco, Global Crossing. In many ways, WorldCom: the corporate strategy of growth through WorldCom is just another case of failed corporate acquisition, the use of loans to senior executives, and governance, accounting abuses, and outright greed. threats to corporate governance created by But none of these other companies had senior chumminess and lack of arm's-length dealing. The executives as colorful and likable as Bernie Ebbers. A case concludes with a brief description of the hero of Canadian by birth, the 6 foot, 3 inch former basketball the case-whistle blower Cynthia Cooper. coach and Sunday School teacher emerged from the The Growth Through Acquisition Merry-Go-Round collapse of WorldCom not only broke but with a

From its humble beginnings as an obscure long only go up. As the stock value went up, it was easier distance telephone company WorldCom, through the for WorldCom to use stock as the vehicle to continue execution of an aggressive acquisition strategy, to purchase additional companies. The acquisition of evolved into the second-largest long distance MFS Communications and MCI Communications were, telephone company in the United States and one of the perhaps, the most significant in the long list of largest companies handling worldwide Internet data WorldCom acquisitions. With the acquisition of MFS traffic.9 According to the WorldCom Web site, at its Communications and its UUNet unit, "WorldCom high point, the company (s)uddenly had an investment story to offer about the value of combining long distance, local service and  Provided mission-critical communications data communications."14 In late 1997, British services for tens of thousands of businesses Telecommunications Corporation made a $19 billion around the world bid for MCI. Very quickly, Ebbers made a counter offer  Carried more international voice traffic than of $30 billion in WorldCom stock. In addition, Ebbers any other company agreed to assume $5 billion in MCI debt, making the  Carried a significant amount of the world's deal $35 billion or 1.8 times the value of the British Internet traffic Telecom offer. MCI took WorldCom's offer making  Owned and operated a global IP (Internet WorldCom a truly significant global Protocol) backbone that provided connectivity telecommunications company.15 in more than 2,600 cities and in more than 100 All this would be just another story of a successful countries growth strategy if it weren't for one significant  Owned and operated 75 data centers…on five business reality--mergers and acquisitions, especially continents. [Data centers provide hosting and large ones, present significant managerial challenges allocation services to businesses for their in at least two areas. First, management must deal mission-critical business computer with the challenge of integrating new and old 10 applications.] organizations into a single smoothly functioning business. This is a time-consuming process that WorldCom achieved its position as a significant player involves thoughtful planning and considerable senior in the telecommunications industry through the managerial attention if the acquisition process is to successful completion of 65 acquisitions.11 Between increase the value of the firm to both shareholders and 1991 and 1997, WorldCom spent almost $60 billion in stakeholders. With 65 acquisitions in six years and the acquisition of many of these companies and several of them large ones, WorldCom management accumulated $41 billion in debt.12 Two of these had a great deal on their plate. The second challenge acquisitions were particularly significant. The MFS is the requirement to account for the financial aspects Communications acquisition enabled WorldCom to of the acquisition. The complete financial integration of obtain UUNet, a major supplier of Internet services to the acquired company must be accomplished, including business, and MCI Communications gave WorldCom an accounting of assets, debts, good will and a host of one of the largest providers of business and consumer other financially important factors. This must be telephone service. By 1997, WorldCom's stock had accomplished through the application of generally risen from pennies per share to over $60 a accepted accounting practices (GAAP). share.13 Through what appeared to be a prescient and WorldCom's efforts to integrate MCI illustrate several successful business strategy at the height of the areas senior management did not address well. In the Internet boom, WorldCom became a darling of Wall first place, Ebbers appeared to be an indifferent Street. In the heady days of the technology bubble executive who "paid scant attention to the details of Wall Street took notice of WorldCom and its then operations."16; For example, customer service visionary CEO, Bernie Ebbers. This was a company "on deteriorated. One business customer's service was the move," and Wall Street investment banks, analysts discontinued incorrectly, and when the customer and brokers began to discover WorldCom's value and contacted customer service, he was told he was not a make "strong buy recommendations" to investors. customer. Ultimately, the WorldCom representative As this process began to unfold, the analysts' told him that if he was a customer, he had called the recommendations, coupled with the continued rise of wrong office because the office he called only handled the stock market, made WorldCom stock desirable, MCI accounts.17 This poor customer stumbled "across and the market's view of the stock was that it could 10 a problem stemming from WorldCom's acquisition WorldCom managers also tweaked their assumptions binge: For all its talent in buying competitors, the about accounts receivables, the amount of money company was not up to the task of merging them. customers owe the company. For a considerable time Dozens of conflicting computer systems remained, period, management chose to ignore credit department local systems were repetitive and failed to work lists of customers who had not paid their bills and were together properly, and billing systems were not unlikely to do so. In this area, managerial assumptions coordinated."18 play two important roles in receivables accounting. In Poor integration of acquired companies also resulted in the first place, they contribute to the amount of funds numerous organizational problems. Among them were: reserved to cover bad debts. The lower the assumption of non-collectable bills, the smaller the reserve fund  Senior management made little effort to required. The result is higher earnings. Secondly, if a develop a cooperative mindset among the company sells receivables to a third party, which various units of WorldCom. WorldCom did, then the assumptions contribute to the  Inter-unit struggles were allowed to undermine amount or receivables available for sale.21 the development of a unified service delivery So long as there were acquisition targets available, the network. merry-go-round kept turning, and WorldCom could  WorldCom closed three important MCI continue these practices. The stock price was high, and technical service centers that contributed to accounting practices allowed the company to maximize network maintenance only to open twelve the financial advantages of the acquisitions while different centers that, in the words of one minimizing the negative aspects. WorldCom and Wall engineer, were duplicate and inefficient. Street could ignore the consolidation issues because  Competitive local exchange carriers (Clercs) the new acquisitions allowed management to focus on were another managerial nightmare. the behavior so welcome by everyone, the continued WorldCom purchased a large number of these rise in the share price. All this was put in jeopardy to provide local service. According to one when, in 2000, the government refused to allow executive, "(t)he WorldCom model was a vast WorldCom's acquisition of Sprint. The denial stopped wasteland of Clercs, and all capacity was the carousel, put an end to WorldCom's acquisition- expensive and very underutilized…There was without-consolidation strategy and left management a far too much redundancy, and we paid far too stark choice between focusing on creating value from 19 much to get it." the previous acquisitions with the possible loss of share value or trying to find other creative ways to Regarding financial reporting, WorldCom used a liberal sustain and increase the share price. interpretation of accounting rules when preparing In July 2002, WorldCom filed for bankruptcy protection financial statements. In an effort to make it appear after several disclosures regarding accounting that profits were increasing, WorldCom would write irregularities. Among them was the admission of down in one quarter millions of dollars in assets it improperly accounting for operating expenses as acquired while, at the same time, it "included in this capital expenses in violation of generally accepted charge against earnings the cost of company expenses accounting practices (GAAP). WorldCom has admitted expected in the future. The result was bigger losses in to a $9 billion adjustment for the period from 1999 the current quarter but smaller ones in future quarters, thorough the first quarter of 2002. so that its profit picture would seem to be Sweetheart Loans To Senior Executives improving."20 The acquisition of MCI gave WorldCom Bernie Ebbers' passion for his corporate creation another accounting opportunity. While reducing the loaded him up on common stock. Through generous book value of some MCI assets by several billion stock options and purchases, Ebbers' WorldCom dollars, the company increased the value of "good holdings grew and grew, and he typically financed will," that is, intangible assets-a brand name, for these purchases with his existing holdings as collateral. example-by the same amount. This enabled WorldCom This was not a problem until the value of WorldCom each year to charge a smaller amount against earnings stock declined, and Bernie faced margin calls (a by spreading these large expenses over decades rather demand to put up more collateral for outstanding than years. The net result was WorldCom's ability to loans) on some of his purchases. At that point he faced cut annual expenses, acknowledge all MCI revenue and a difficult dilemma. Because his personal assets were boost profits from the acquisition. 11 insufficient to meet the call, he could either sell some prescient criticism, "Auditors and analysts are of his common shares to finance the margin calls or participants in a game of nods and winks."28 It should request a loan from the company to cover the calls. come as no surprise that it was Arthur Andersen that Yet, when the board learned of his problem, it refused endorsed many of the accounting irregularities that to let him sell his shares on the grounds that it would contributed to WorldCom's demise.29Beyond that, depress the stock price and signal a lack of confidence however, were a host of incredibly chummy about WorldCom's future.22 relationships between WorldCom's management and Had he pressed the matter and sold his stock, he Wall Street analysts. would have escaped the bankruptcy financially whole, Since the Glass-Steagall Act was repealed in 1999, but Ebbers honestly thought WorldCom would recover. financial institutions have been free to offer an almost Thus, it was enthusiasm and not greed that trapped limitless range of financial services to their commercial Mr. Ebbers. The executives associated with other and investment clients. Citigroup, the result of the corporate scandals sold at the top. In fact, other merger of Citibank and Travelers Insurance Company, WorldCom executives did much, much better than which owned the investment bank and brokerage firm Ebbers did.23 Bernie borrowed against his stock. That Solomon Smith Barney, was an early beneficiary of course of action makes sense if you believe the stock investment deregulation. Citibank regularly dispensed will go up, but it's the road to ruin if the stock goes cheap loans and lines of credit as a means of attracting down. Unlike the others, he intended to make himself and rewarding corporate clients for highly lucrative rich taking the rest of the shareholders with him. In his work in mergers and acquisitions. Since WorldCom was entire career, Mr. Ebbers sold company shares only so active in that mode, their senior managers were the half a dozen times. Detractors may find him irascible targets of a great deal of influence peddling by their and arrogant, but defenders describe him as a banker, Citibank. For example, Travelers Insurance, a principled man.24 Citigroup unit, lent $134 million to a timber company The policy of boards of directors authorizing loans for Bernie Ebbers was heavily invested in. Eight months senior executives raises eyebrows. The sheer later, WorldCom chose Salomon Smith Barney, magnitude of the loans to Ebbers was breathtaking. Citigroup's brokerage unit, to be the lead underwriter The $341 million loan the board granted Mr. Ebbers is of $5 billion of its bond issue.30 the largest amount any publicly traded company has But the entanglements went both ways. Since the loan lent to one of its officers in recent memory.25 Beyond to Ebbers was collateralized by his equity holdings, that, some question whether such loans are ethical. "A Citigroup had reason to prop up WorldCom stock. And large loan to a senior executive epitomizes concerns no one was better at that than Jack Grubman, about conflict of interest and breach of fiduciary duty," Salomon Smith Barney's telecommunication analyst. said former SEC enforcement official Seth Grubman first met Bernie Ebbers in the early 1990s Taube.26 Nevertheless, 27percent of major publicly when he was heading up the precursor to WorldCom, traded companies had loans outstanding for executive LDDS Communications. The two hit it off socially, and officers in 2000 up from 17percent in 1998 (most Grubman started hyping the company. Investors were commonly for stock purchase but also home buying handsomely rewarded for following Grubman's buy and relocation). Moreover, there is the claim that recommendations until stock reached its high, and executive loans are commonly sweetheart deals Grubman rose financially and by reputation. In involving interest rates that constitute a poor return on fact, Institutional Investing magazine gave Jack a company assets. WorldCom charged Ebbers slightly Number 1 ranking in 1999,31 and Business more than 2percent interest, a rate considerably below Week labeled him "one of the most powerful players on that available to "average" borrowers and also below Wall Street.32 the company's marginal rate of return. Considering The investor community has always been ambivalent such factors, one compensation analyst claims that about the relationship between analysts and the such lending "should not be part of the general pay companies they analyze. As long as analyst scheme of perks for executives…I just think it's the recommendations are correct, close relations have a wrong thing to do."27 positive insider quality, but when their What's a Nod or Wink Among Friends? recommendations turn sour, corruption is suspected. In the autumn of 1998, Securities and Exchange Certainly Grubman did everything he could to tout his Commission Chairman Arthur Levitt Jr. uttered the personal relationship with Bernie Ebbers. He bragged

12 about attending Bernie's wedding in 1999. He attended Smith Barney two weeks later seemed to contradict board meeting at WorldCom's headquarters. Analysts the notion that Grubman's analysis was conflicted: at competing firms were annoyed with this "Mr. Grubman was not alone in his enthusiasm for the chumminess. While the other analysts strained to future prospects of the company. His coverage was glimpse any tidbit of information from the company's based purely on information yielded during his analysis conference call, Grubman would monopolize the and was not based on personal relationships."41 Right. conversation with comments about "dinner last On August 15, 2002, Jack Grubman resigned from night."33 Salomon where he had made as much as $20 It is not known who picked up the tab for such dinners, million/year. His resignation letter read in part, "I but Grubman certainly rewarded executives for their understand the disappointment and anger felt by close relationship with him.34Both Ebbers and investors as a result of [the company's] collapse, I am WorldCom CFO Scott Sullivan were granted privileged nevertheless proud of the work I and the analysts who allocations in IPO (Initial Public Offering) auctions. work with me did."42 On December 19, 2002, Jack While the Securities and Exchange Commission allows Grubman was fined $15 million and was banned from underwriters like Salomon Smith Barney to distribute securities transactions for life by the Securities and their allotment of new securities as they see fit among Exchange Commission for such conflicts of interest. their customers, this sort of favoritism has angered The media vilification that accompanies one's fall from many small investors. Banks defend this practice by power unearthed one interesting detail about contending that providing high-net-worth individuals Grubman's character-he repeated lied about his with favored access to hot IPOs is just good personal background. A graduate of Boston University, business.35 Alternatively, they allege that greasing the Mr. Grubman claimed a degree from MIT. Moreover, he palms of distinguished investors creates a marketing claimed to have grown up in colorful South Boston, "buzz" around an IPO, helping deserving small while his roots were actually in Boston's comparatively companies trying to go public get the market attention bland Oxford Circle neighborhood.43 What makes a they deserve.36 For the record, Mr. Ebbers personally person fib about his personal history is an open made $11 million in trading profits over a four-year question. As it turns out, this is probably the least of period on shares from initial public offerings he Jack Grubman's present worries. New York State received from Salomon Smith Barney.37 In contrast, Controller H. Carl McCall sued Citicorp, Arthur Mr. Sullivan lost $13,000 from IPOs, indicating that Andersen, Jack Grubman, and others for conflict of they were apparently not "sure things."38 interest. According to Mr. McCall, "This is another case There is little question but that friendly relations of corporate coziness costing investors billions of between Grubman and WorldCom helped investors dollars and raising troubling questions about the from 1995 to 1999. Many trusted Grubman's insider integrity of the information investors receive."44 status and followed his rosy recommendations to The Hero of the Case financial success. In a 2000 profile in Business Week, No integrity questions can be raised about Cynthia he seemed to mock the ethical norm against conflict of Cooper whose careful detective work as an internal interest: "What used to be a conflict is now a synergy," auditor at WorldCom exposed some of the accounting he said at the time. "Someone like me…would have irregularities apparently intended to deceive investors. been looked at disdainfully by the buy side 15 years Originally assigned responsibilities in operational ago. Now they know that I'm in the flow of what's auditing, Cynthia and her colleagues grew suspicious 39 going on." Yet, when the stock started cratering later of a number of peculiar financial transactions and went that year, Grubman's enthusiasm for WorldCom outside their assigned responsibilities to investigate. persisted. Indeed, he maintained the highest rating on What they found was a series of clever manipulations WorldCom until March 18, 2002, when he finally raised intended to bury almost $4 billion in misallocated its risk rating. At that time, the stock had fallen almost expenses and phony accounting entries.45 90 percent from its high two years before. A native of Clinton, Mississippi, where WorldCom's Grubman's mea culpa to clients on April 22 read, "In headquarters was located, Ms. Cooper conducted her retrospect the depth and length of the decline in detective work was in secret, often late at night to enterprise spending has been stronger and more avoid suspicion. The thing that first aroused her damaging to WorldCom than we even curiosity came in March 2002 when a senior line 40 anticipated." An official statement from Salomon manager complained to her that her boss, CFO Scott

Sullivan, had usurped a $400 million reserve account acclaimed, and Cynthia Cooper apparently has it. Thus, he had set aside as a hedge against anticipated it was not surprising that on December 21, 2002, revenue losses. That didn't seem kosher, so Cooper Cynthia Cooper was recognized as one of three inquired of WorldCom's accounting firm, Arthur "Persons of the Year" by Time magazine. Andersen. They brushed her off, and Ms. Cooper Questions For Discussion decided to press the matter with the board's audit 1. What are the ethical considerations involved in a committee. That put her in direct conflict with her company's decision to loan executives money to cover boss, Sullivan, who ultimately backed down. The next margin calls on their purchase of shares of company day, however, he warned her to stay out of such stock? matters. 2. When well conceived and executed properly, a Undeterred and emboldened by the knowledge that growth-through-acquisition strategy is an accepted Andersen had been discredited by the Enron case and method to grow a business. What went wrong at that the SEC was investigating WorldCom, Cynthia WorldCom? Is there a need to put in place protections decided to continue her investigation. Along the way, to insure stakeholders benefit from this strategy? If so, she learned of a WorldCom financial analyst who was what form should these protections take? fired a year earlier for failing to go along with 3. What are the ethical pros and cons of a banking firm 46 accounting chicanery. Ultimately, she and her team giving their special clients privileged standing in "hot" uncovered a $2 billion accounting entry for capital IPO auctions? expenditures that had never been authorized. It 4. Jack Grubman apparently lied in his official appeared that the company was attempting to biography at Salomon Smith Barney. Isn't this simply represent operating costs as capital expenditures in part of the necessary role of marketing yourself? Is it order to make the company look more profitable. To useful to distinguish between "lying" and merely gather further evidence, Cynthia's team began an "fudging."? unauthorized search through WorldCom's 5. Cynthia Cooper and her colleagues worried about computerized accounting information system. What their revelations bringing down the company. Her they found was evidence that fraud was being boss, Scott Sullivan, asked her to delay reporting her committed. When Sullivan heard of the ongoing audit, findings for one quarter. She and her team did not he asked Cooper to delay her work until the third know for certain whether this additional time period quarter. She bravely declined. She went to the board's might have given Sullivan time to "save the company" audit committee and in June, Scott Sullivan and two from bankruptcy. Assume that you were a member of others were terminated. What Ms. Cooper had Cooper's team and role-play this decision-making discovered was the largest accounting fraud in U.S. situation. history.47 ARTHUE ANDERSEN As single-minded as Cynthia Cooper appeared during For Andersen, the Enron scandal may only get worse. this entire affair, it was an incredibly trying ordeal. Her A senior Administration official told TIME last week that an indictment of the Big Five accounting firm or some parents and friends noticed that she was under of its executives could be imminent. An adviser to the considerable stress and was losing weight. According company, meanwhile, acknowledged that it was on the brink of serious financial trouble and suggested that an to the Wall Street Journal, she and her colleagues indictment might force it to seek protection under worried "that their findings would be devastating to the bankruptcy laws. This is vehemently denied by company [and] whether their revelations would result Andersen spokesman Charlie Leonard. "You can't [declare bankruptcy] if you're solvent," he says. in layoffs and obsessed about whether they were "Andersen is solvent." jumping to unwarranted conclusions that their colleagues at WorldCom were committing fraud. Plus, Nonetheless, some of Andersen's most prestigious and they feared that they would somehow end up being loyal clients — including pharmaceutical giant Merck, blamed for the mess."48 It is unclear at this writing whether Bernie Ebbers will mortgage agency Freddie Mac and Delta Airlines — are be held responsible for the accounting irregularities canceling contracts. "There's such a drumbeat of that brought down his second in command. Jack departures that it may trigger a flow of clients they Grubman's final legal fate is also unclear. While the ethical quality of enthusiasm and sociability are can't stop," says Richard Ossoff, publisher of Auditor- debatable, the virtue of courage is universally Trak, which follows the accounting industry. "The 'Big

The Sarbanes-Oxley Act is arranged into eleven titles. Four' is a potential outcome." This reality is not lost on As far as compliance is concerned, the most important sections within these are often considered to be 302, Andersen's competitors. A senior employee at Deloitte 401, 404, 409, 802 and 906.

& Touche says his firm is "going after Andersen An over-arching public company accounting board was companies dead-on." also established by the act, which was introduced amidst a host of publicity.

In an effort to reassure clients, Andersen's partners Sarbanes-Oxley Compliance Compliance with the legislation need not be a daunting fired the lead auditor on the Enron account, David task. Like every other regulatory requirement, it should be addressed methodically, via proper analysis Duncan, in January and admitted to Congress later in and study. the month that potentially incriminating documents Also like other regulatory requirements, some sections of the act are more pertinent to compliance than had been shredded. But suspicion that Andersen was others. To assist those seeking to meet the demands not exactly forthright about the level of involvement of of this act, the following pages cover the key Sarbanes-Oxley sections: several executives was stoked by the revelation that  Sarbanes-Oxley Section 302 Nancy Temple, a lawyer with the company, sent a  Sarbanes-Oxley Section 401  Sarbanes-Oxley Section 404 memo reminding employees of Andersen's document-  Sarbanes-Oxley Section 409 retention policies on Oct. 12. The memo, observers  Sarbanes-Oxley Section 802 suspect, was a tacit order to start the shredding.

Miscellaneous And now, to add a new twist to the scandal, plaintiffs' Having studied the above pages, even if you are considering using an external consultant or legal lawyers involved in the deposition of Duncan's former expert, it is well worth taking some basic steps to enhance your position immediately. This not only assistant Shannon Adlong told TIME last week that the demonstrates due diligence, but may well reduce the consultancy costs themselves. shredding of documents actually began on Oct. 13 —

10 days before Andersen admitted it started and a day One area that perhaps falls into the category is security. In many respects security underpins the after Temple's memo. Adlong, who was responsible for requirements of the Sarbanes-Oxley Act. It is therefore important to quickly establish a credible and detailed ordering extra bags for the shredded papers, said so security policy, which can often be done readily via off the shelf packages. much evidence had to be destroyed that 32 "trunks," Finally, perhaps the most important statement on the each the size of a football locker, were hauled off by a entire web site: don't put off until tomorrow what can shredding company. be done today! With other legislation and regulation we have seen far too often organizations leave compliance until the last few days, and subsequently The Sarbanes-Oxley Act suffer adverse consequences.

The Sarbanes-Oxley Act of 2002 is mandatory. ALL organizations, large and small, MUST comply.

This website is intended to assist and guide. It provides information, and identifies resources, to help ensure successful audit, and management. Whether you are entirely new to the Sarbanes-Oxley legislation, or whether you have an established strategy, this portal should hopefully prove to be of substantial value

Introduction The legislation came into force in 2002 and introduced major changes to the regulation of financial practice and corporate governance. Named after Senator Paul Sarbanes and Representative Michael Oxley, who were its main architects, it also set a number of deadlines for compliance.