Worldcom Accounting Scandal – Fraudulent Scheme (Case Study)

Founded initially as a small company named Long Distance Discount Services in 1983, it merged with Advantage Companies Inc to eventually become WorldCom Inc, naming its CEO as Bernard Ebbers. WorldCom achieved its position as a significant player in the telecommunications industry through the successful completion of 65 acquisitions spending almost $60 billion between 1991 and 1997, while also accumulating $41 billion in debt. During the Internet boom, WorldCom’s stock rose from pennies per share to over $60 a share as Wall Street investment banks, analysts and brokers began to discover WorldCom’s value and made “strong buy recommendations” to investors. During the 1990’s WorldCom evolved into the second-largest long distance phone company in the US mainly due to its aggressive acquisition strategy.

A cycle became obvious in the marketplace where an acquisition was seen as a positive move by the analysts leading to higher stock prices of WorldCom. As a result, this allowed WorldCom to gain greater financing and backing for further acquisitions in repeating the cycle. One of the most significant and largest acquisitions was that of MCI Communications Inc in 1998, becoming the largest merger in US history at that time. British Telecommunications were also in the running for the takeover of MCI Communications making a $19 billion bid, when Bernard Ebbers the CEO of WorldCom decided to place a counter bid 1.8 times higher than that of what BT had placed at $35 billion. Apparently, this takeover was agreed and the merger between the two; bringing MCI WorldCom into second position behind that of AT&T in the telecommunications market.

However, from 1999 to early 2002, CEO of the company, Bernard Ebbers along with other senior management used fraudulent and improper accounting methods to mislead investors and other directors. Their fraudulent accounting method had mainly two approaches; firstly, ‘The reduction of the reported line costs’ and secondly, the ‘exaggeration of reported revenue’. These practices were to ignore the generally accepted accounting principles (GAAP) in addition to not informing the users of the financial statements of the changes to the previously used accounting practices. And the aim of these illegal practices was to reduce their E/R ratio which was the main key performance indicator used to measure the performance of telecommunications companies. It is the relationship between their main expenses; line costs (the rental of telephone lines) to its revenues, and the lower figures consequently produced the more recommendations offered by analysts to increase stock prices.

How the Fraud Was Discovered

The members of senior management were engaged in a constant series of illegal accounting manipulations to try and achieve market expectations on growth, thus, making the financial reports more appealing. Well, this was achieved through basic fraudulent methods which include changes to financial estimates, early revenue recognition, erroneously capitalization of the long term assets, as well as alteration of the reserves in order to improve the earnings picture.

After tips were sent to the internal audit team and accounting irregularities were spotted in MCI's books, the SEC requested that WorldCom provide more information. At this point, the SEC was suspicious because while WorldCom was making so much profit, AT&T (another telecom giant) was losing money. An internal audit turned up the billions WorldCom had announced as capital expenditures as well as the $500 million in undocumented computer expenses. There was also another $2 billion in questionable entries. WorldCom's audit committee was asked for documents supporting capital expenditures, but they could not produce them. The controller admitted to the internal auditors that they were not adhering to the accounting standards. WorldCom then confessed to inflating its profits by $3.8 billion over the previous five quarters. Finally, a little over a month after the internal audit began, the company filed for bankruptcy.

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