WorldCom scandal

The WorldCom scandal was a major accounting scandal discovered in June 2002 at WorldCom, then the second-largest long-distance telephone company in the United States. Between 1999 and 2002, senior executives led by founder and CEO Bernard Ebbers engaged in accounting fraud to inflate earnings and maintain the company's stock price.[1]

The fraud was discovered by the company's internal audit unit under vice president Cynthia Cooper, who identified over $3.8 billion in fraudulent balance sheet entries. Subsequent investigations revealed that WorldCom had overstated its assets by over $11 billion, making it the largest accounting fraud in American history at that time. WorldCom filed for bankruptcy approximately one year after the scandal's disclosure.

Background

In December 2000, WorldCom financial analyst Kim Emigh was told to allocate labor for capital projects in WorldCom's network systems division as capital expenditure rather than operating costs. By Emigh's estimate, the order would have affected at least $35 million in capital spending. Believing that he was being asked to commit tax fraud, Emigh pressed his concerns up the chain of command, notifying an assistant to WorldCom chief operating officer Ron Beaumont. Within 24 hours, it was decided not to implement the directive. However, Emigh was reprimanded by his immediate superiors and subsequently laid off in March 2001.[2]

Emigh, who was from the MCI half of the 1997 WorldCom/MCI merger, later told Fort Worth Weekly in May 2002 that he had expressed concerns about MCI's spending habits for years. He believed that things had been reined in somewhat after WorldCom took over, but he was still unnerved by vendors billing WorldCom for exorbitant amounts.[2] The Fort Worth Weekly article was eventually read by Glyn Smith, an internal audit manager at WorldCom headquarters in Clinton, Mississippi. After examining it, he suggested to his boss, Cynthia Cooper, that she should start that year's scheduled capital expenditure audit a few months early. Cooper agreed, and the audit began in late May.[3]

Prepaid capacity

During the audit, corporate finance director Sanjeev Sethi informed auditors that discrepancies in capital spending expenditures were related to "prepaid capacity," a term unfamiliar to Cooper. When questioned further, Sethi claimed he did not understand the term despite his division's role in approving capital spending requests, and referred the auditors to corporate controller David Myers. Cooper requested an auditor with technical skills to locate the entries in the accounting system. Eugene Morse, an accountant who had worked at WorldCom since 1997, was assigned to assist with the investigation.[4][3]

Cooper approached Mark Abide, head of property at WorldCom, for clarification on prepaid capacity. Abide claimed unfamiliarity with the term despite having made multiple entries related to it in the computerized accounting system. He identified the relevant accounts as furniture, fixtures, and other equipment, as well as transmission and communications equipment.[3]

Morse searched the accounting system for references to prepaid capacity and located entries that showed unusual movement of large amounts between accounts. The audit team used basic T accounts to analyze the entries, which revealed funds moving from WorldCom's income statement to its balance sheet in an irregular pattern.[3]

Discovery and escalation

WorldCom chief financial officer Scott D. Sullivan met with Cooper regarding audit projects and requested a review of recently completed audits. When questioned about the prepaid capacity entries, Sullivan explained they referred to costs related to SONET and lines with low or no usage. He stated these costs were being capitalized because line lease costs remained fixed despite declining revenue. Sullivan indicated he planned to take a restructuring charge in the second quarter of 2002, after which WorldCom would allocate these costs between restructuring charges and expenses. He requested that Cooper postpone the capital-expenditure audit until the third quarter.[3]

Cooper and Smith contacted Max Bobbitt, a WorldCom board member and chairman of the Audit Committee, to discuss their findings. Bobbitt directed Cooper to consult with Farrell Malone of KPMG, WorldCom's external auditor.[3] KPMG had acquired the WorldCom account when it purchased Arthur Andersen's Jackson practice following Andersen's indictment in the Enron accounting scandal.[3]

Fraud revealed

Cooper questioned the accountants who made the prepaid capacity entries to obtain supporting documentation. Kenny Avery, Andersen's former lead partner on the WorldCom account before KPMG's takeover, was unfamiliar with prepaid capacity and stated that no Generally Accepted Accounting Principles (GAAP) standards allowed for capitalizing line costs. Andersen had not tested WorldCom's capital expenditures in this area.[3]

Betty Vinson, the accounting director who made the entries, admitted she had processed them without understanding their purpose or seeing supporting documentation, acting on directions from Myers and general accounting director Buford Yates. Yates also claimed unfamiliarity with prepaid capacity and stated that accountants under his supervision booked entries at Myers' direction.[3]

Myers acknowledged there was no support for the entries, stating they had been booked "based on what we thought the margins should be" without accounting standards justification. He admitted the entries should not have been made but claimed it became difficult to stop once started. Although uncomfortable with the entries, he had not anticipated having to explain them to regulators.[3]

KPMG's Farrell concluded that the rationale for the entries made sense "from a business perspective, but not an accounting perspective" after meeting with Sullivan and Myers.

SEC investigation

On June 25, after confirming the amount of illicit entries, the board accepted Myers' resignation and terminated Sullivan when he refused to resign. WorldCom executives briefed the SEC the same day, revealing that the company would need to restate earnings for the previous five quarters.[5][3] WorldCom publicly disclosed that it had overstated its income by over $3.8 billion over the previous five quarters.[6]

Prior to the scandal's disclosure, WorldCom's credit rating had been reduced to junk status, and its stock had declined over 94 percent. The company was already facing a separate SEC accounting investigation that had begun earlier in 2002, and carried $30 billion in debt. WorldCom announced plans to lay off 17,000 employees.[7] The company filed for Chapter 11 bankruptcy protection on July 21, 2002.[8]

Trial

In 2005, a jury found CEO Bernard Ebbers guilty of fraud, conspiracy, and filing false documents with regulators. He was subsequently sentenced to 25 years in prison.[10] However, he was released in December 2019 due to declining health. Ebbers died February 2, 2020.[11]

Aftermath

The Sarbanes–Oxley Act was passed in the wake of several business scandals, including at WorldCom and Enron.[12]

WorldCom, renamed MCI, was acquired by Verizon Communications in January 2006.[13]