Can you remember one of the largest accounting frauds in American history?
Worldcom was one of the world’s largest telecommunications companies with a market cap of a staggering US$180 billion. It grew its telecom services by acquiring companies. Revenues grew during the dotcom bubble until it burst, and revenues began to fall.
The senior management began ‘cooking the books’ to disguise declining profits. The fraud was carried out by:
- Booking ‘line costs’ as capital expenditure on the balance sheet instead of expenses on the income statement
- Inflating revenues with bogus accounting entries from corporate unallocated revenue accounts.
A former financial analyst at Worldcom had been fired after raising concerns over accounting entries to the Chief Operating Officer. In 2001, The Vice President of Internal Audit, Cynthia Cooper, and her team, looked into these claims. They set out to review the financial statements and discovered profits were overstated by US$3.8 billion by capitalizing expenses.
Worldcom filed for Chapter 11 bankruptcy in July 2002. The CEO was sentenced to 25 years in prison and CFO for 5 years following a plea agreement.
It was later discovered that total assets had been overstated by $11 billion. This was the largest accounting fraud scandal at the time, displacing Enron, the famous 2001 accounting scandal in which the company declared bankruptcy.
So what were the governance failings at Worldcom?
Where were the auditors in this massive fraud?
The auditors for Worldcom were Arthur Andersen. They had also been the auditors of Enron as well as other companies where accounting scandals had occurred. The SEC highlighted the part played by Arthur Andersen’s grossly inadequate auditing and that there were clear flaws in Andersen’s audit approach. They did not carry out the necessary tests that were expected of a professional auditor. Andersen’s collapsed in 2002 as details of its questionable accounting practices were revealed following the Enron and Worldcom scandals.
As the saying goes ‘a fish rots from the head’ and this was true of Worldcom.
There was a complete lack of corporate governance with no effective internal controls and lack of oversight and monitoring by the board of directors.
The board was not independent. The board was like an ‘old boy network’ where a majority of board members were associates of the CEO who received multiple perks from him including millions of dollars in Worldcom stock and use of the corporate jet. Their wealth was tied to the value of the Worldcom stock.
So, it was in their interests to let management make decisions to keep the stock price up. The directors were so tied up with Worldcom financially that they had little incentive to question management decisions for fear of losing their wealth.
The board, compensation and audit committees did not fulfil their duties and obligations to the shareholders, and its stakeholders.
The board approved everything the CEO suggested even multi-billion dollar deals with little discussion or papers to support the decisions and often without a board meeting taking place. The board failed to monitor the debt levels and there was no oversight of management.
The compensation committee approved loans of more than $400 million to the CEO to prevent him selling his Worldcom stock to meet margin calls on his securities account, which would have resulted in the stock price falling further. He used his Worldcom stock to secure loans for other external business activities. Not only is providing loans to executives questionable the board didn’t question the size of the loans or his time commitments in managing the business. Senior management were granted lucrative stock options so there was a greed culture within Worldcom as some executives had done very nicely out of them.
The audit committee did not have a work plan with the internal and external auditors to facilitate proper monitoring and oversight and had initially not acted when the fraud was discovered.
The Internal audit team were under resourced and under qualified to carry out their responsibilities effectively and were not independent of management as they were diverted away from their auditing responsibilities to look at cost savings and efficiencies by management.
If whistleblowing protection had been in place would the issues at Worldcom have been discovered sooner?
Has Sarbanes-Oxley Act reduced the number of accounting scandals in the US?
As a result of the Enron and Worldcom and other scandals, Sarbanes-Oxley Act was passed by congress in 2002 to mandate certain practices in financial record keeping and reporting for corporations.
Unfortunately, the scandals have continued:
- Freddie Mac (2003) – $5 billion earnings misstated
- AIG (2005) – $4 billion accounting fraud
- Lehman Brothers (2008) – $50 billion of loans hidden
- Bernie Madoff (2008) – $65 billion accounting scandal using a Ponzi scheme
Could good governance have prevented these corporate failures?
Many of the above scandals may or could have been avoided had the boards set the tone from the top for the rest of the organisation where an embedded culture of ethics and compliance could have guided the right behaviours.
A strong independent board and committees would have ensured that there was proper oversight and monitoring of management and that proper and robust internal controls were in place. There should have been proper information flows and that the board should have provided challenge to the information they were receiving.
The board should have ensured that there are group policies in place and that they are reviewed and approved by the board at least annually and that the remuneration policy does not promote the wrong behaviours. Having share plan targets that are not just linked to share price and financial performance such as non-financial targets should have been considered.
Conflicts of interest should have been reviewed by the board regularly and that the board should have been made aware of their obligations to declare any conflicts as and when they arose.
The audit committee should have ensured that they met regularly with the auditors and without management present so concerns that arose could have been raised. The audit committee should have ensured that they monitored non-audit services fees to ensure auditors remain independent.
