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