World Com and Accounting Ethics
World Com and Accounting Ethics
Current business and regulatory environments are more conducive to ethical behavior due to many new laws that have been put into effect in recent years. For many companies, especially small ones, the checks and balances are not put into place as well as they should be. With new laws in effect and more and more accountants paying attention to their clients’ accounts, ethical behavior is on the rise although it will take a long time to recover from the scandals that rocked the world beginning with Waste Management in 1998 and following with Enron, WorldCom, Tyco, HealthSouth, Freddie Mac, AIG, Lehman Brothers, Bernie Madoff and Saytam in 2009. For 10 years unethical behavior and choices almost brought our country to its knees and even now many people are losing their homes and their jobs because the economy has still not fully recovered.
In 1983 in a small coffee shop in Hattiesburg, MS, the business concept that would become WorldCom was born. The company was to become one of the largest telecommunications companies that would one day rival AT&T.
WorldCom began as a small long distance telephone company and through an aggressive acquisition strategy, evolved in the second-largest long distance telephone company in the United States and one of the largest companies handling worldwide Internet data traffic. WorldCom achieved its position through a large number of acquisitions and between 1991 and 1997, WorldCom spent almost $60 billion in the acquisition of many of these companies and accumulated $41 billion in debt.
With each acquisition, WorldCom’s stock continued to rise as the company became more noticeable, rising from pennies per share to over $60 per share in 1997. As the company grew people sat up and took notice and Wall Street investment banks as well as analysts and brokers began making buy recommendations to investors worldwide.
All of this would have ended well if WorldCom had obviously played by the rules but alas, that was not the case. As with any acquisition, let alone 65 of them in six years, management at the top level requires considerable attention to make the merging of the two companies run smoothly. Secondly, the accounting of the financial aspects of each merging company must be accomplished through the application of generally accepted accounting practices (GAAP).
WorldCom’s merger with MCI was the beginning of the end. Bernie Ebbers (CEO) paid little attention to the details of the operations and many things began deteriorating, mainly customer service. Customers were told they were not customers, computer systems conflicted with each other and billing systems were not coordinated – a recipe for disaster. Although WorldCom had an immense talent for buying competitors, it was not up to the task of merging them.
WorldCom also used their own interpretation of accounting rules when preparing financial statements. “In an effort to make it appear that profits were increasing, WorldCom would write down in one quarter millions of dollars in assets it acquired while, at the same time, it “included in this charge against earnings the cost of company expenses expected in the future. The result was bigger losses in the current quarter but smaller ones in future quarters, so that its profit picture would seem to be improving.” (Moberg)
WorldCom managers also made their own assumptions regarding accounts receivables which if the money customers owe the company. They chose to ignore the accounts receivables because this allowed for a lower assumption of non-collectable bills which in turn required a smaller reserve fund. The end result allows for higher earnings.
All of these practices could continue as long as WorldCom continued to acquire additional companies, using those companies as their “merry-go-round” to utilize poor accounting practices. Not only poor practices but unethical. In 2000, the merry-go-round stopped when the government refused to allow WorldCom to merge with Sprint. Another accounting practice that that was uncovered was the allowance of the board of directors to authorize loans to senior executives. Mr. Ebbers received a $341 million loan authorized by the board of directors which is the largest amount any publicly traded company has lent to one of its officers in recent memory. This brings concerns about conflict of interest and breach of fiduciary duty but nevertheless WorldCom was not the only company allowing this practice. And on top of that the loan interest rate was as low as 2% which was not much of a return for the company that loaned him that large of an amount.
WorldCom’s unethical accounting practices were found by Cynthia Cooper who worked as an internal auditor for WorldCom. Cynthia and her team became suspicious of a number of peculiar financial transactions and began their own private investigation. What they found were multiple entries that were misallocated and unauthorized to the tune of $4 billion dollars in capital expenditures. It appeared the company was trying to represent operating costs as capital expenditures in order to make the company look more profitable. By allowing these kinds of practices and attempting to have others following the same kind of unethical behavior, moral and trust were at an all time low within the company.
Beginning in 2002 everything began to unravel. The SEC began an investigation on the company and WorldCom was trying to avoid filing for bankruptcy. Within months they laid off more than 17,000 employees, almost 20 percent of their workforce. By the time it was all said and done, 30,000 employees lost their jobs and investors lost over $180 billion dollars.
WorldCom improperly booked $3.8 billion as capital expenditures which improved cash flow and profit over a 5 quarter period. This disguised the actual net loss for 2001 and the first quarter of 2002. It is possible that the accounting irregularities go back to 2000. In simple terms WorldCom did not account for expenses when it incurred them, but hid the expenses by pushing them into the future, giving the appearance of spending less and therefore making more money. This apparent profitability pleased investors who pushed the stock up to a high of $64.51 in June 1999. When WorldCom was stopped from acquiring Sprint they had to find a way to hide their large expenses so that the price of the stock would not go down. They did this by treating $7 billion of line costs as capital expenditures.
These line costs were basically rental fees paid to other phone companies to use their phone lines. Up until 2001 these fees (expenses) had always been properly expensed in previous years but when WorldCom placed them in the capitalization category the expense was delayed to future periods which in turn boosted current-period profits. The accounting guideline that made this decision fraudulent was materiality. Materiality refers to the impact of an item’s size on a company’s financial operations. Materiality states that if an item would not make a difference in decision-making, the company does not have to follow GAAP in reporting the item. In this case, $7 billion dollars in expenses makes a huge difference so GAAP guideline should have been followed. Consequently profits for 2001 and 2002 were overstated greatly.
This ethical breach could have been avoided long before it became a huge problem basically by maintaining the accounting system from the very beginning. Because WorldCom was more interested in acquiring companies than in merging them properly, accounting systems from various companies did not work together well. After a time and more and more acquisitions it became a huge mess and nobody really had any idea what was right and what was wrong. Senior management used that disorganization to conceal their fraudulent activities. This large of a fraud should have been easily detected by doing a routing comparison of the actual physical assets with a list of the physical assets shown in the accounting records.
Following the scandal of WorldCom which closely followed the Waste Management Scandal in 1998 and the Enron scandal in 2001, Congress passed the Sarbanes-Oxley Act, introducing the most sweeping set of new business regulations since the 1930s.
University/College: University of Chicago
Type of paper: Thesis/Dissertation Chapter
Date: 20 October 2016
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