Worldcom Financial Statement Fraud

Answer :

Worldcom Financial Statement Fraud

Executive summary:

Although the key points of the Financial statement fraud definitions differ but there is a common thread among all the definitions. The common thread confirms that in the case of FS fraud the information is misrepresented deliberately or the number of disclosures is not sufficient to provide transparency. The focus of this kind of fraud is to mislead the key users like potential investors, stakeholders, and customers. In this context, it is significant that the term fraud can be used in a wider context considering the perspectives of internal controls, external environment, competitive pressure etc. But the intentional wrongdoing majorly affect the public or the economy, therefore, this paper has selected the real example of a well known public company to understand the FS fraud issues. In the case of Worldcom, the catastrophic accounting scandal has disrupted 17,000 jobs and confirming the inflated profit issues in the financial environment. Therefore, the paper has tried to identify the key reasons behind the Worldcom FS fraud with major solutions using the secondary research documents.

Introduction:

According to the definition of FS fraud, the issue can involve financial material falsification, intentional omission or misrepresentation of the transaction, event and accounts, intentional misapplication of financial policies, regulations in terms of measurement, recognition, reporting, and accounting event disclosures, deliberate presentation of inadequate information including accounting principles. As there are many components included in the FS fraud definition, therefore, the paper has selected the real-life example of Worldcom to understand the issue better. The background of the case confirms that it has the huge impact on the confidence of the public in the financial system. After the fraud case is disclosed in the public the governing bodies have made lots of changes in financial and accounting principles to close the hidden gaps. The large-scale fraud determined that the financial risk detection, auditing, and advisory components were of poor standards and the US government passed the  Sarbanes-Oxley legislation understanding the long-term implications of the issue. In this context, it is significant that Enron also has shown this systematically dangerous pattern in the year 2001 when the inflated income issue was ignored by the auditor Andersen. For Worldcom, the risk was more compound because apart from US$4 billion deceptive accounting profit the CFO was involved in the fraud case. Moreover, the former CEO Ebbers was actively involved in the FS fraud deterring the gaps in the corporate governance and internal controls. In this context, it is significant that the CFO has warned the former CEO about the improper adjustments of inflated profit but Ebbers has denied the warnings (Albrecht et al., 2015). However, the overview of the telecom giant Worldcom is highly significant here as it determines the degree of risk quotient in the domestic and international business environment. The telecommunication company has suffered from one of the biggest bankruptcy cases in US history covering the largest accounting fraud issues. According to the report of investigation (2003), the major accounting misstatements involve more than $9 billion worth unsupported accounting entries to publish the desired financial results. Moreover, the disclosures (financial result) prove that the key driving factor of this fraud is the business strategy and corporate governance framework in the company where acquisition strategy aimed the impressive stock value increase in the small amount of time. However, the CEO also has the intention to improve his personal business conditions. So, the BOD structure and power balance are important here. The research has tried to identify the key financial issues with effective solutions considering both internal and external environments in the paper. The problem and objective sections discuss the key probes and goals of this document while literature review provides comprehensive information about the case using the selected articles. Finally, the design and methodology cover the searching criteria and points while the findings gather the key points in the document.

Research Problems:

The research problems refer to the major areas of concerns as well as some conditions which can be improved while doing the research. For the Worldcom case and financial statement fraud research, the research article identification was one major issue as the telecom giant case is almost 15 years old. However, the implications of this case on the governing bodies like AUASB, FRC, PCAOB have made the case study highly visible on the internet and other literature-based environments. The case is also related to corporate governance, financial as well as accounting structures. That means there are huge interconnected sources on the financial fraud issues where specific source identification is very difficult. Again, this kind of research has to deal with the ethical and methodological barriers significantly. This research is no different from the above-mentioned issue. As the interdependent factors of the fraud case sometimes face oversimplification problem, therefore, the result or findings development process was very difficult. Moreover, identifying the directly relevant information was another key problem as the number of research questions was limited. Most of the identified articles either have discussed more than one case studies (Worldcom, Enron, Sunbeam) or the hypotheses are too complicated in terms of multiple and diverse parameters (Woolley, 2016). As an example, some articles have determined the fraud issue with internal control gaps while some identified the policy and legislation issues in the financial environment. Again, bankruptcy and monitoring disruptions of a large company have the direct effect on the market and economy and some articles have discussed the factors moving away from the key questions of this extensive research. Furthermore, the research is completely dependent on the secondary sources that means the clarification points face specificity and quality issues sometimes. The Worldcom case has international implications which are country specific and that means the content analysis has suffered from media control issues. In summary, the key problems while conducting the research are:

• Source identification issues due to a wider context of FS fraud
• Quality and ethical problems while developing the key findings
• Specificity issues in terms of questions of concern

Research Objectives:

The key objective of this research is to identify the reasons behind financial statement fraud and the most effective solutions. However, the term financial statement fraud can be defined with various business, economic, market and financial parameters. Therefore, the research focuses on covering all the perspectives of this fraud issue considering the legal and governing frameworks. But the concern is not only the theory based research as most of the time the theory and hypothesis seem inadequate to answer the research questions. Therefore, the objectives of this research also include a real-life example analysis which has major impacts on the related environments. As a business entity, the telecom giant Worldcom has the influence on the business and economic environments which was confirmed when the auditors' oversight and financial regulations have changed after the bankruptcy case. The SOX act and fraud triangle points are regenerated after the worldwide financial scandal. In the international context, the regulatory responses were reformed after the case. As an example, Australia has introduced the CLERP 9 (ASIC) reforms in the year 2004 while the "culture of silence" term becomes more significant in the middle management levels (F. di Stefano, 2005). So, the objectives of this research are to answer the following questions:

• What is the definition of financial statement fraud?
• How are the FS fraud terms applicable in Worldcom case?
• What are the causes, drivers, consequences and solutions of Worldcom accounting fraud?
• How are financial fraud schemes defined by power, fraud triangle, and classical frau theory?
• How have the regulatory bodies responded to the Worldcom accounting scandal?
• Are the key findings and solutions adequate to deal with new accounting threats?

Literature Review:

Financial background:

In early 2000 the major accounting scandal cases had the huge impact on the business investment structures as the key investors were overwhelmed with the big bankruptcy and misstatement cases of Enron, Worldcom, Tyco, HealthSouth etc. In this context, it is significant that those high profile scandals have opened the hidden disclosures issues in many other domestic companies of USA. Moreover, the investment concerns were directly alerting for the stock market instruments reflecting the stock price declinations, SEC investigations (frequent) as well as different lawsuits from the regulators and investors (Agrawal and Cooper, 2015). The involvement of executives and management has raised the question if the corporate securities were traded before the accounting issue revelation. The example of Enron determines that the Former CEO Skilling held the public information hidden during the fraud case. In the case of Worldcom, the unsupported accounting entries have led the worldwide downturn of the telecommunication business while the stock market was expecting double-digit growth from the company. Apart from the stock market crisis, the court orders on the case confirm that the business environment needed BOD and corporate governance reforms to balance the power of senior management. As an example, the Worldcom report of the investigation published some recommendations like the followings:

• Independent & active BOD and vertical hierarchy
• Corporate culture with an effective code of conduct 
• Well-defined policy in terms of corporate governance, risk management, audit and whistleblower concepts (F. di Stefano, 2005)

Financial fraud and trade issues:

The recommendations determine the need for foolproof internal control where trade activities will be controlled and transparent. In case of earning management, it is significant that CEOs with high equity incentives use the trend of management manipulation to sell more share for inflated profits. This trend was reflected in the Worldcom where the growth cum acquisition strategy was very competitive and the large insider sales have introduced low earning and stock return issue.  Again, the high accrual periods make the management sell more shares than usual using different measures like avoiding the current period based on positive earnings, subsequent periodic stock sales and reporting the earnings with the standard forecast. In this context, the earning investigations confirm that various organizations define the pension plans as more optimistic options to determine the illusion of high ROI boosting the initial public offerings. Moreover, the organizations try earning manipulation measures using SEC enforcement actions to violate the GAAP conditions while ignoring the accounting irregularities (Agrawal and Cooper, 2015). Another way to avoid the accounting transparency is to provide the earning misstatements where the audit gives mixed information about the earning and business transactions. In many restatement cases, it is identified that the senior executives and their restating (Exercise) options directly affect the net income. The insider trading activities and research have identified that firm size in terms of market capitalization determine the number of insiders cum sellers while the stock return volatility as aggressive features. 

Corporate failure factors contributing to financial fraud:

Again, the change in the stock returns depends on the management's share covering the prior stock return performance as well as the book to market decile.  Again, the research and development section of the organizations introduces asymmetric pattern between insiders and outsiders where the LDDS of Worldcom is the significant example. So, the potential stock-price effect signals a negative corporate governance change where the code of best practices is neglected. It is clear that the accounting scandal is directly related to the corporate culture as Worldcom was devalued in terms of good corporate governance. The value management conditions of corporate governance confirm that both legal and financial improvement is required to reach the credible points. Again, the strategic alignment and firm performance are connected where major domains are environment, organization, competency, and strategy (Rezaee & Kedia, 2012). Therefore the ESCO model confirms that market changes, disruptive innovation, global competition rates are environmental influences while static strategy can lead towards competitive advantage issue. In this context, the corporate failure can be divided into two basic categories. The deterministic type aims the external environment where industrial and ecological conditions are important. The Voluntaristic category focuses on the internal business psychology where resource, capabilities, leadership styles and managerial decision making are important. However, the age, size and life cycle of the organization introduce the IO perspective to understand the industry dynamics where the population ecology should be balanced by the behavioral capabilities. So, the improper business strategy identifies six basic factors for the corporate failure and they are:

• Passive, ineffective leadership of BOD
• Aggressive growth strategy/ highly ambitious fundraising policy ignoring credit and over-valued stock issue (Heracleous & Werres, 2016)
• Post-merger integration and comparative performance issue
• Level misalignment in terms of downsized leads, process duplication, wastage of talent pool
• Unproductive culture in terms of strategy and competency issues

Worldcom case study:

It is significant that more or less all the issues were visible in the Worldcom accounting scandal. The strategic decisions of Worldcom have focused on highly ambitious growth in terms of acquisitions and by the year 1998, the company had merging relation with nearly sixty companies. Internally, the high growth strategy was based on low-interest rate and high rate of stock prices in the market. The business investigation has confirmed that the company lacked strategic planning in terms of standard corporate governance protocols. Again, the strategic committee was absent and the major decision-making process was dependent on the CEO Ebbers, CFO, and the COO. Again, the MCI merging has increased the competency issue as it has merged with the huge debt load. Moreover, it has a slower customer growth rate than Worldcom which has made the company strategy unstable for the long term. In the case of company culture, the aggressive and competitive culture lacked the honesty, openness, and assistance which are considered as the keys to fraud prevention (Fox et al, 2016). The revenue focused strategy was ignorant of the profit margin while the lack of integration in the accounting system has helped the employees to do improper jobs (moving customer accounts in different accounting systems). Moreover, the employees have stated that the company had no outlet to express concerns making the working environment unhealthy. In this context, it is true that low fraud environment can be created with healthy workplace components like employee assistance program, open door policies where lack of ethical codes was visible. The employee retention program was poor and the employees used to receive a low salary than the employees in other companies (business rivals). Again, the CEO Ebber has played an active role in the global marketing of LDDS where the business management style was similar to a sole proprietorship management. In terms of corporate governance, the BOD was inactive and the personal financial situation of the CEO was dependent on the Worldcom stocks. The Board's approval on personal loan has increased the margin by $400 million and the audit and compensation committees were vague representers of the major information. In this case, the best interest theory of a company seems compromised indicating the invisible power of the audit committee. From the information of both internal and external auditors, the records on cheque and balances were vague and they had not conducted regular meetings to solve the problem. In the same time, the external environment or market was in the dot-com bubble trouble where the Telecommunication act 1996 increased the fierce competition in the domestic market. Again, the vast investment in the transatlantic cable and Wall Street shares were two major strategic disappointments for the company which confirms the major features of the Worldcom financial fraud. The major features include both the improper line of cost reduction and false revenue growth reports. As the cost estimation during the fraud period was informed by the phone lines, therefore, the company lacked the actual bill of costs. It is significant that the white paper and the research information can describe the fraud issue using the fraud triangle where the three points are pressure, opportunity, and rationalization.

Fraud triangle:

Source: (Ashraf, 2011)

The term pressure is the personal motivation of the fraud where the financial, emotional and lifestyles are important domains. In the case of Worldcom, the management level from the top indicates the intensive financial pressure which confirmed the economic downturn of the company. That means the lack of ethical behavior and communication gaps are major drivers here. The term opportunity is defined as the condition to commit the fraud and the personal gain is the major driver here.  It is clear that the opportunity domain of the fraud triangle indicates the control structure of Worldcom as well as accounting systems and procedures. The unclear corporate culture and passive auditors have given the CEO the opportunity to conduct the fraud actively for his personal gain. The last element of the fraud triangle or rationalization determines a specific justification of the mind of the wrongdoer while performing the actions. That means the Worldcom case had some justification driver too. According to the research, the key wrongdoers of this fraud case had no criminal background which means their first-time offense worked as the justification point here. The market and economic conditions were also indirect contributors as the top managers with their journal entries considered the same as the one-time act. So the fraud control strategies should be aligned with the key consequences in this case. 

Consequences and solutions:

First of all to maintain the public reputation the company has taken active reformation and restoration actions for the internal controls. So, the top management faced the major changes in terms of CEO, CFO and COO removal (resignation and firing). After a new recruitment of president, the internal control made it clear that stock options and the top managers have no personal relations. The BOD was completely replaced while focusing on the independence and objectivity (managerial decisions). The fraud site of Clinton was shut down and new financing and accounting personnel were hired while removing 17,000 roles. In case of misstated assets they were evaluated and documented and the company filed for bankruptcy. Considering the large market capital and infrastructure the controls were reinvented. Moreover, the external environment or the investors like public pension funds lost more than $300million worth of investments and some issues were covered by SEC settlements. The competitors like AT&T and Sprint have suffered the customer confidence issues with the financial statement at the same time. In the regulatory environment, the Worldcom case had huge consequences. The Congress passed the SOX t protect investors with accuracy and reliability in the FS. Although it was a direct political response but it is considered that if the bill was passed before the Worldcom case then many investors might have survived. The section 31 of SOX also introduced more responsibilities for the audit committee while making external auditor reports mandatory for the top management. For public interest and ethics, the PCAOB was constructed as a monitoring body indicating the active role of government to prevent fraudulent activities. The case consequences determine the following solutions to manage and prevent FSF:

• The relevant and strong corporate governance with an ethical, honest and open model
• The awareness of whistleblower policy, transparent terms, documentation, and communication guides
• Ensuring the quality, integrity of FS (Cooper, 2005)
• Introducing frequent training modules and meetings among employees, BOD and auditors to solve major issues
• Introducing anti-fraud education and proactive leadership styles while complementing the management
• Promoting accountability in terms of financial instruments and internal controls
• Introducing active anti-fraud role of the BOD ensuring investors interests, voting module, oversight functions
• Engaging management evaluation and compensation policy
• Considering the independent auditors' feedback while supervising the anti-fraud policies and financial reporting process
• Monitoring the control override and collision risks (Rezaee and Kedia, 2012)
• Introducing the anti-fraud role of internal auditor and management
• Producing reliable FS without misstatement and material issues while implementing the policies and procedures
• Covering “management certification” statement in the annual report especially for public companies (Awolowo et al, 2018)
• Implementing audit planning and proactive approaches to deal with  asset and corruption
• Using the external reports on corporate governance, assessment for comparative controls
• Introducing industry-specific audit standards while using risk-based audit methodologies

Research Design & Methodology:

This research paper has used one of the most common research methods which are popular as the secondary research method. The type of research is exploratory where the approach is mixed covering both qualitative and quantitative research. This research process is selected because the primary data sources are already in existence. Therefore, the research process has to identify the key sources using research questions and keywords. This internet and search engines like Google, Yahoo, Wolfram Alpha as well as scholarly sites like Science Direct, Elsevier, Google scholar are used here to identify valid and up-to-date resources for the 2002 case study. This is a quick and low-cost method where the information sources are already available on the web. Moreover, the primary resources in the web work as the quick and effective guides for this exploratory research considering the categories of internal secondary data and corporation-specific (Worldcom) breakdown structure. Although this mixed research scheme has certain limitations including media control, validity, clarification issues but the main purpose of this secondary research is to gather information in an easy, low-cost and quick way. Moreover, the validity and research questions clarification issues are solved by the selection process where only peer-reviewed scholarly articles and standard business magazines (Economist, Ecommercetimes) are used. The data collection process is diverse here as articles have used theory, interviews, and sampling in the primary sources. As an example, the Fraud scheme article has constructed the dyad reciprocal model combing the fraud triangle, collusion theory while some articles have used G index, Tobin Q and descriptive statistics to gather the results. The sampling size is based on 500-900 restatement data, financial statements, accounting and employee reviews in different articles where some hypothesis based articles have used business students as major survey participants. However, it is significant that this secondary research method has the scope to rule out the irrelevant proposals and articles because the primary data sources are working as the key guideline here.

Research Findings:

The Worldcom case and its features have taught both the market and business entities that financial statement fraud has harsh and longtime implications. As an example, when the CFO was involved in the fraud he had missed pension and retirement issues in the business environment. Moreover, the personal gain terms were reversed quickly after the Worldcom case was published in the public. The horrific event of bankruptcy and business failure had the huge impact on the public and to control the public unrest government responded with the SOX bill. Although the bill was passed to prevent the FSF but the key focus was on the Worldcom gaps and controls. The bill ensures that similar case will not occur in the future but there is no guarantee of a general fraud occurrence in the financial environment. With the organizational study, it is clear that financial regulations may face accounting volatility issues in terms of economic drivers and political issues. Tha means SOX can be protective of FSF but it is not foolproof to deal with all the issues of corporate governance. In this context, the PCAOB can deal with the external environments but compound business characteristics can always introduce loopholes for fraud. However, the fraud case alerts the auditors and the auditors should take extra care of the information collection if the company is involved in a past fraud case. The accounting tactics should consider the three vertices of the fraud triangle where the classical fraud theory is visible. As the financial statement is defined as the performance indicators comparing the firm and investors expectations, therefore, the pressure is always high on the top management and executives. However, the pressure can lead towards the opportunities of fraudulent activities if the corporate culture has standard issues. In the same point, the motivation factor becomes compound with collusion. The co-conspirator theory determines the relationships among power, decision, and recruitment where the reciprocal model indicates the unhealthy corporate culture components ( lack of knowledge, relationships, level of obedience etc). So, the key findings include that FSF is contributed by:

• The poor corporate governance
• The role of auditors
• The role of regulatory bodies and legislation

Conclusion:

The paper has tried to understand the inherent process behind the large-scale financial statement fraud of the telecom giant Worldcom. In this context, the power, decision-making skills and recruitment of the conspirators are significant as they are the major drivers of poor corporate culture. The Worldcom case has shown that aggressive corporate culture somehow boosts the competitive factors while missing the strategic planning and alignment of business objectives The major wrongdoers in the case were driven by the personal goals and made the company different from a proper business entity. The policy was reflected in employee retention, talent acquisition and earning management policy. Using the fraud triangle of the classical fraud theory the research has identified how the power was misused in the company making the auditors and BOD passive for a long time. Moreover, the external environment was not adequate to deal with the issue as the SOX bill came after the consequences of the case become visible creating the public unrest (Ashraf, 2011). Although it costs the company $400 million and 17,000 jobs as well as bankruptcy but it also becomes the alarming point of several other market entities who can save themselves in right time. Finally, it can be said that the SOX bill and PCAOB establishment are the two key positive consequences in this FSF case which can change the future.