2002 WorldCom Scandal - Bernie Ebbers & Scott Sullivan
WorldCom was once one of the world’s largest telecommunications companies and a core dividend-paying stock that many retirees held in their portfolios. But in less than a decade the company became a symbol of accounting fraud and a warning to investors that when something appears to be too good to be true, it probably is.
Founded in 1983, WorldCom’s growth is largely attributed to acquisitions, with one of the largest acquisitions taking place in 1998, where it acquired MCI communications at $40 billion. Under the leadership of the CEO, Bernie Ebbers, the company managed to acquire over sixty telecommunication companies between 1985 to 1995.
WorldCom’s Accounting Shenanigans
WorldCom had employed a variety of accounting tricks to inflate its revenues and cash flow. Between mid-1999 and mid-2002, it was discovered that the company's CEO, Bernie Ebbers, the Chief Financial Officer, Scott Sullivan, the controller of budget, David Myers, and the general accounting director, Buford Buddy, used fraudulent schemes to hide WorldCom Inc.'s deteriorating state and give the impression that the company was doing well.
The primary and the initial, shenanigan at WorldCom involved making numerous acquisitions, and once an acquisition was made, the company wrote off the cost almost immediately. The company then created reserves, which were later converted into revenue whenever it was required. During this time, WorldCom made over sixty acquisitions, the majority of which were directed to the reserves to be released into earnings later.
In 1999, WorldCom grew interested in acquiring Sprint Corporation. This involved a $129 billion merger, making the two companies the world's largest corporation mergers ever. However, the merger was challenged by the US Department of Justice's Antitrust lawyers and regulators, as well as the European Union, who claimed that it may result in the creation of a market monopoly. In July 2000, the merger between WorldCom and Sprint Corporation was terminated by the Boards of Directors of both companies. WorldCom was unable to maintain its reserves as a result of this scenario, as the majority of revenues designated to reserves had been drained as a result of their repeated release into income.
In 2000, WorldCom had to devise a new strategy, as the acquisition-driven approach had failed. At the time the company was facing both the internal pressure of declining stock price and the external pressure from Wall Street to perform by either maintaining or increasing its numbers. As a result, in 2001 WorldCom engaged in a more aggressive and intense approach falsifying approximately $4 billion in earnings on its profit-and-loss statement. This was accomplished by tampering with its financial data, which had an impact on its income statement, balance sheet, 10-K filing, and annual report.
This poor accounting approach was carried out through the activities of WorldCom’s top executives, including Scott Sullivan, the company’s chief financial officer (CFO), who failed to appropriately manage capital expenditures and expenses.
Sullivan distributed billions of dollars in operating expenses across so-called property accounts (a type of capital expense account). This action enabled WorldCom to disguise its declining profitability by classifying expenses as investments, inflating net income and cash flow.
After a whistleblower auditor noticed a suspicious entry in the balance sheet during a mini-departmental audit of normal capital expenditures in mid-2002, a team of internal auditors set out to review the company's financial statement. As a result, it was found that the company overstated profits by roughly $3 billion in 2001 and $797 million in Q1 2002 by capitalizing expenses, reporting a profit of $1.4 billion instead of a net loss.
Only a month after Arthur Andersen was convicted of obstruction of justice for shredding documents relating to its audit of Enron, WorldCom filed for bankruptcy on July 21, 2002. It was later found that Arthur Andersen ignored memos from WorldCom executives warning them that the company was inflating profits by improperly accounting for expenses.
Because of the tremendous loss suffered by investors, the events at WorldCom will go down in history as one of the worst accounting fraud scandals ever. The early 2000s saw an avalanche of corporate fraud charges, scaring away investors who had lost faith in the financial sector. It meant that there was a pressing need to handle the rising number of cases of corporate fraud. To address some of these issues, Congress created and approved the Sarbanes-Oxley Act (SOX) in 2002. This Act meant that corporate executives, auditors, and investors were all held to a higher standard of transparency and accountability.
While a company's stock and profit growth is a desirable thing, large company acquisitions, such as the one at WorldCom, can act as a crucial warning sign for investors.
When free cash flow suddenly decreases, it is an indicator of serious problems and could be a red flag for possible fraud.
The organizational culture at WorldCom was characterized by employees that were loyal to the company's senior executives, regardless of the code of ethics such as honesty and integrity.
The Board of Directors failed yet again. Instead of exercising its responsibility to independence and playing an important role in ensuring accountability and transparency, the Board collaborated with management to hide the fraud.
The WorldCom accounting fraud scandal was one of the largest accounting scandals in the United States. At this time, WorldCom was among the largest long-distance telephone companies, rated second in the stock market. The causes of the WorldCom fraud case, including the consequences, tells the story of the collapse of a giant company, as a result of a financial accounting fraud scheme.
As the WorldCom accounting crisis demonstrates, a company's executives may make or ruin it, and there are many other examples of executive leadership gone wrong. A good leader is more than an eloquent speaker or inspiring motivator – he or she empowers employees to do their jobs effectively and keep the organization going in the right direction.