WorldComs Aggressive Acquisitions Result in Audit Failure

AUDIT FAILURE OF WORLDCOM
Group 1

Background
• WorldCom, first named LDDS (Long Distance Discount Services), grew largely by aggressively acquiring other telecommunications companies in 1990s.
• For a time, it was the United State's second largest long distance phone company (after AT&T).

Background
However, the year 2002 comes…
• In March, the SEC began to investigate WorldCom as it reported large profit while AT&T reported loss.
• In May, Arthur Anderson was replaced by KPMG as the audit of WorldCom.

Background
• In June, a small team of internal auditors at WorldCom unearthed .

8 billion in fraud and made known of the company’s audit committee and board of directors. Then, Sullivan, the CFO was fired; Arthur Andersen withdrew its audit opinion for 2001; and SEC launched an investigation into these matters.
• In July, WorldCom filed for bankruptcy protection, in the largest such filing in United States history at the time.

Background
The fraud was accomplished primarily in two ways:
• Underreporting ‘line costs’ (interconnection expenses with other telecommunication companies) by capitalizing these costs on the balance sheet rather than properly expensing them.

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• Inflating revenues with bogus accounting entries from "corporate unallocated revenue accounts".

Analysis
Reasons for the fraud:
1. Internal control defects
2. Economic motivation
3. External Audit failure

1.Internal control defects
• Weak internal audit:
a. It didn’t cover financial
statement auditing;
b. It were not independent as
internal auditors was responsible
for CFO;
c. Its advices were not valued even
though reported drawbacks.

1.Internal control defects
• Management override: Corporate headquarters asked subsidiaries to adjust accounts directly, providing no documentation or authorization signatures.

• Poor incentives: Financial incentive program made managers eager to make profit as managers’ bonus was based on financial performance.

2.Economic motivation
• Ebbers, the CEO, who owned a large number of WorldCom stocks, came under increasing pressure from banks to cover margin calls on his WorldCom stock that was used to finance his other businesses.
• WorldCom needed to keep high price of stock to attract acquisition.

2.Economic motivation
However, the actual situation was as follows:
• Telecommunications industry entered a downturn.
• And WorldCom’s aggressive growth strategy suffered a serious setback when it was forced to abandon its proposed merger with Sprint.
• Thus, WorldCom’s stock was declining.

3.External audit failure
GAAS
• General standard：
The examination should be performed and the report prepared by a person or persons having adequate technical training and proficiency in auditing, with due care and with an objective state of mind.

3.External audit failure
• Examination standard: (ii) The auditor should obtain an understanding of the entity and its environment, including internal control, sufficient to identify and assess the risks of material misstatement of the financial statements whether due to fraud or error, and sufficient to design and perform further audit procedures.

3.External audit failure
(iii) The audit should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion. But, the audit done by Arthur Anderson went against the rules.

(a) Independence

Arthur Andersen service charged in WorldCom：$168,000,000

(a) Independence
The specific examples of independence violation:
• Arthur Andersen offered WorldCom consulting, auditing and other services all together. And as the above picture shows, earnings from auditing is only one-fourth of the total profits Arthur Anderson got from WorldCom.
• WorldCom is the biggest client Arthur Andersen had in Mississippi, and they have been in partnership for about 10 years.

(a) Independence
In all, the threats of independence came in the following three patterns:
• Self-interest threat
• Advocacy threat
• Familiarity threat

(b) Due care
• Arthur Anderson completely relied on management assertion even when the motivation of fraud( details stated above) had been found in WorldCom.

(c) Competence
•

•

Arthur Anderson lacked competence of auditing in WorldCom for its lack of assurance in WorldCom’s internal control and the relative accounting procedures, leading to unsuccessful audit.
For instance, in 2002, WorldCom capitalized line costs while in previous years it expensed these costs.

(d) Evidence
•

•

Dependence on management assertion and lack of awareness of WorldCom’s internal control and accounting procedure made Arthur Anderson ignored some signals and unable to indicate some obvious fraud. For example, Arthur Anderson didn’t try to obtain direct evidence to prove the adjusting entry that $3.8 billion line costs were capitalized as PPE, which didn't appear in budget.

Solution
• Enhance audit ethic education as well as improve supervising system.
• A new and enhanced standard, Sarbanes-Oxley Act, has been enacted. Make sure the act will be executed well.

Sarbanes–Oxley Act
• also known as the 'Public Company Accounting Reform and Investor Protection Act' (in the Senate) and 'Corporate and Auditing Accountability and Responsibility Act' (in the House) and commonly called Sarbanes–Oxley, Sarbox or SOX, is a United States federal law enacted on July 30, 2002, which set new or enhanced standards for all U.S. public company boards, management and public accounting firms.

Sarbanes–Oxley Act
• Sarbanes–Oxley contains 11 titles that describe specific mandates and requirements
for financial reporting.
• Among them, title 1 to 3 focus on the independence of external audit.

1. Public Company Accounting
Oversight Board (PCAOB)
• Title I provides independent oversight of public accounting firms providing audit services ("auditors"). It also creates a central oversight board tasked with registering auditors, defining the specific processes and procedures for compliance audits, inspecting and policing conduct and quality control, and enforcing compliance with the specific mandates of SOX.

2. Auditor Independence
• Title II establishes standards for external auditor independence, to limit conflicts of interest. It also addresses new auditor approval requirements, audit partner rotation, and auditor reporting requirements. It restricts auditing companies from providing non-audit services (e.g., consulting) for the same clients.

3. Corporate Responsibility
• Title III defines the interaction of external auditors and corporate audit committees, and specifies the responsibility of corporate officers for the accuracy and validity of corporate financial reports. It enumerates specific limits on the behaviors of corporate officers and describes specific forfeitures of benefits and civil penalties for non-compliance.

Sarbanes–Oxley Act
• Title 4,8,9,11 Focus on the fraud avoidance for
companies.

4. Enhanced Financial Disclosures
• Title IV describes enhanced reporting requirements for financial transactions, including off-balance-sheet transactions, proforma figures and stock transactions of corporate officers. It requires internal controls for assuring the accuracy of financial reports and disclosures, and mandates both audits and reports on those controls. It also requires timely reporting of material changes in financial condition and specific enhanced reviews by the SEC or its agents of corporate reports.

8. Corporate and Criminal Fraud
Accountability
• Title VIII is also referred to as the “Corporate and Criminal Fraud Accountability Act of 2002”.
It describes specific criminal penalties for manipulation, destruction or alteration of financial records or other interference with investigations, while providing certain protections for whistle-blowers.

9. White Collar Crime Penalty
Enhancement
• Title IX is also called the “White Collar Crime
Penalty Enhancement Act of 2002.” This section increases the criminal penalties associated with white-collar crimes and conspiracies. It recommends stronger sentencing guidelines and specifically adds failure to certify corporate financial reports as a criminal offense.

11. Corporate Fraud Accountability
• Title XI recommends a name for this title as “Corporate Fraud Accountability Act of 2002”. It identifies corporate fraud and records tampering as criminal offenses and joins those offenses to specific penalties. It also revises sentencing guidelines and strengthens their penalties. This enables the SEC the resort to temporarily freeze transactions or payments that have been deemed "large" or "unusual".

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