Answer Question number 5: Betty Vinson: victim or villain? Should criminal fraud charges have been brought against her? How should employees react when ordered by their

27 Mar Answer Question number 5: Betty Vinson: victim or villain? Should criminal fraud charges have been brought against her? How should employees react when ordered by their

Posted at 05:29h in Finance / Accounting by

Answer Question number 5:

Betty Vinson: victim or villain? Should criminal fraud charges have been brought against her? How should employees react when ordered by their employer to do something they do not believe in or feel uncomfortable doing?

Accounting Ethics Case

Accounting Ethics Case will be graded out of 100 points. Grading will be based on the

technical merit, completeness, professionalism, and clarity.

Please answer the following questions after reading the case. To obtain the case, visit

https://store.hbr.org/product/accounting-fraud-at-worldcom/104071?sku=104071-PDF-ENG and

purchase the case.

1. What were the pressures that lead executives and managers to “cook the books”?

2. What is the boundary between earnings smoothing or earnings management and fraudulent

financial reporting? What would be the indications that WorldCom crossed the boundary

into fraudulent financial reporting?

3. Why were the actions taken by WorldCom managers not detected earlier? What processes

or systems should be in place to prevent or detect quickly the types of actions that occurred

in WorldCom?

4. Were the external auditors and board of directors blameworthy in this case? Why or why

not?

5. Betty Vinson: victim or villain? Should criminal fraud charges have been brought against

her? How should employees react when ordered by their employer to do something they

do not believe in or feel uncomfortable doing?

Additional Notes:

(1) Include a cover page where title, last names, first names and IDs are clearly indicated.

(2) Create the title: Your team can choose any title that can highlight your team’s thoughts.

(3) (If needed) Add “References” right after the main body where your team list up the

articles, academic research papers and other materials your team used.

(4) Double-spaced 10 pages or less (1″ margin for all sides) excluding cover page and

references.

(5) 12-point Time New Roman.

(6) Due April 8, 2024 (Mon) – NO LATE SUBMISSION: E-mail submission only by

12:55pm.

(7) Your team must complete without taking help from any other fellow students or another

people.

https://store.hbr.org/product/accounting-fraud-at-worldcom/104071?sku=104071-PDF-ENG

Reproduction, distribution, and/or transmission of these slides and the presentation in any form and/or by any means including (but not limited to) photocopying, recording, and/or other electronic and/or mechanical methods, are strictly prohibited.

Accounting Ethics Case

⚫ Each team will need to answer all questions based on reading the

case, reading and researching additional information and/or materials,

and team discussions.

⚫ The case needs to be purchased.

⚫ Accounting Ethics Case is an opportunity to study an example

of underlying causes for fraudulent financial reporting (i.e.,

earnings manipulation)

General

⚫ Discuss pressures WorldCom encountered, which caused fraudulent

financial reporting.

1. What were the pressures that lead executives and managers to “cook the books”?

⚫ Discuss boundary between earnings management (i.e., earnings

smoothing) and earnings manipulation (i.e., fraudulent financial

reporting) based on understanding from Earnings Management Paper.

2-1. What is the boundary between earnings smoothing or earnings management and fraudulent financial reporting?

⚫ Based on understanding boundary between earnings management

(i.e., earnings smoothing) and earnings manipulation (i.e., fraudulent

financial reporting), discuss indications that WorldCom engaged in

fraudulent financial reporting.

2-2. What would be the indications that WorldCom crossed the boundary into fraudulent financial reporting?

⚫ Key performance index: E/R (line-cost expenditures to revenues)

Ratio

⚫ Target E/R ratio = 42%

⚫ Hard to grow revenues

⚫ Hence, would need to reduce expenditures to keep E/R ratio of 42%

* Accrual release (i.e., Accrual reverse)

* Expense capitalization

WorldCom Accounting (1/3)

⚫ Accrual release (i.e., Accrual reverse)

– For line costs, estimate expected future payments when they are incurred, and

book journal entry below

Expense xxx (based on estimated expected future payments)

Payable xxx (based on estimated expected future payments)

(Book “Payable” since bills were paid several months after costs were incurred)

– When paid, book journal entry below

Payable xxx (based on actual payments)

Cash xxx (based on actual payments)

– Sullivan argued line cost expense had been over-estimated so journal entry

below was prepared by reversing previously booked journal entry (i.e., Accrual

release): This way, WorldCom reduced “Line cost expense”

Payable xxx (based on estimated previously over-estimated amount)

Expense xxx (based on estimated previously over-estimated amount)

(Total amount of Accrual reverse over 7 quarters was $3.3 billions)

– Would it be justifiable? Maybe, Sullivan had his own good reasons.

However, what about internal resistance and relying on Accrual release to

meet the target?

WorldCom Accounting: Accrual Release (2/3)

⚫ Expense capitalization

– Excess or unused network capacity (= non-revenue-generating line expenses)

was treated as “CAPITAL EXPENDITURE (= book “asset” on B/S)” rather than

“OPERATING COST (= book “expense” on I/S)”

– Would it be justifiable? Maybe, Sullivan had his own good reasons as stated

“Contracted excess capacity gave company an opportunity to enter the market

quickly at some future time when demand was stronger than current levels (i.e.,

expected future benefits)”. However, what about shock in General Accounting

Department, and relying on Expense capitalization to meet the target?

WorldCom Accounting: Expense Capitalization (3/3)

Assume that Cost of Excess Network Capacity is 100,000 in Year 1

I/S effect for Operating Cost I/S effect for Capital Expenditure

Year 1

(Target year) -100,000 0

Year 2 0 Some expense in case previously excess

network capacity utilized

Year 3 0 Some expense in case previously excess

network capacity utilized

⚫ Discuss reasons why fraudulent financial reporting were not detected

earlier, focusing on following aspects:

– Leadership

– Culture

– Internal controls

– Internal audit

– External audit

– Board of directors

3. Why were the actions taken by WorldCom managers not detected earlier? What processes or systems should be in place to prevent or detect quickly the types of actions that occurred in WorldCom?

⚫ Based on reasoning in Q3, discuss whether External auditors and

Board of directors were to be blamed.

4. Were the external auditors and board of directors blameworthy in this case? Why or why not?

⚫ What do you think of Betty Vinson? Should she be charged with

criminal fraud?

⚫ Throughout career, employees (especially when it comes to financial

performance measures) may encounter undue pressures. By putting

yourself in Betty Vinson’s shoes, think about how employees should

react when ordered by their employer to do something they do not

believe in or feel uncomfortable doing.

5. Betty Vinson: victim or villain? Should criminal fraud charges have been brought against her? How should employees react when ordered by their employer to do something they do not believe in or feel uncomfortable doing?

Accounting Ethics Case is NOT a formal paper but answering case questions so each team just answer questions in their submission (but create title that best suits your team’s answers)!

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Slide 12: Accounting Ethics Case is NOT a formal paper but answering case questions so each team just answer questions in their submission (but create title that best suits your team’s answers)!

9-104-071 R E V : S E P T E M B E R 1 4 , 2 0 0 7

________________________________________________________________________________________________________________ Professor Robert S. Kaplan and Senior Researcher David Kiron, Global Research Group, prepared this case. The case was developed from published sources and draws heavily from Dennis R. Beresford, Nicholas deB. Katzenbach, and C.B. Rogers, Jr., “Report of Investigation,” Special Investigative Committee of the Board of Directors of WorldCom, Inc., March 31, 2003. References to this report are identified by alphabetic letters which refer to information in the endnotes. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2004, 2005, 2007 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1- 800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

R O B E R T S . K A P L A N

D A V I D K I R O N

Accounting Fraud at WorldCom

WorldCom could not have failed as a result of the actions of a limited number of individuals. Rather, there was a broad breakdown of the system of internal controls, corporate governance and individual responsibility, all of which worked together to create a culture in which few persons took responsibility until it was too late.

— Richard Thornburgh, former U.S. attorney general1

On July 21, 2002, WorldCom Group, a telecommunications company with more than $30 billion in revenues, $104 billion in assets, and 60,000 employees, filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. Between 1999 and 2002, WorldCom had overstated its pre- tax income by at least $7 billion, a deliberate miscalculation that was, at the time, the largest in history. The company subsequently wrote down about $82 billion (more than 75%) of its reported assets.2 WorldCom’s stock, once valued at $180 billion, became nearly worthless. Seventeen thousand employees lost their jobs; many left the company with worthless retirement accounts. The company’s bankruptcy also jeopardized service to WorldCom’s 20 million retail customers and on government contracts affecting 80 million Social Security beneficiaries, air traffic control for the Federal Aviation Association, network management for the Department of Defense, and long-distance services for both houses of Congress and the General Accounting Office.

Background

WorldCom’s origins can be traced to the 1983 breakup of AT&T. Small, regional companies could now gain access to AT&T’s long-distance phone lines at deeply discounted rates.3 LDDS (an acronym for Long Distance Discount Services) began operations in 1984, offering services to local retail and commercial customers in southern states where well-established long-distance companies, such as MCI and Sprint, had little presence. LDDS, like other of these small regional companies, paid to use or lease facilities belonging to third parties. For example, a call from an LDDS customer in New Orleans to Dallas might initiate on a local phone company’s line, flow to LDDS’s leased network, and then transfer to a Dallas local phone company to be completed. LDDS paid both the 1 Matthew Bakarak, “Reports Detail WorldCom Execs’ Domination,” AP Online, June 9, 2003.

2 WorldCom’s writedown was, at the time, the second largest in U.S. history, surpassed only by the $101 billion writedown taken by AOL Time Warner in 2002.

3 Lynne W. Jeter, Disconnected: deceit and betrayal at WorldCom (Hoboken, NJ: John Wiley & Sons, 2003), pp. 17–18.

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104-071 Accounting Fraud at WorldCom

New Orleans and Dallas phone company providers for using their local networks, and the telecommunications company whose long-distance network it leased to connect New Orleans to Dallas. These line-cost expenses were a significant cost for all long-distance carriers.

LDDS started with about $650,000 in capital but soon accumulated $1.5 million in debt since it lacked the technical expertise to handle the accounts of large companies that had complex switching systems. The company turned to Bernard J. (Bernie) Ebbers, one of its original nine investors, to run things. Ebbers had previously been employed as a milkman, bartender, bar bouncer, car salesman, truck driver, garment factory foreman, high school basketball coach, and hotelier. While he lacked technology experience, Ebbers later joked that his most useful qualification was being “the meanest SOB they could find.”4 Ebbers took less than a year to make the company profitable.

Ebbers focused the young firm on internal growth, acquiring small long-distance companies with limited geographic service areas and consolidating third-tier long-distance carriers with larger market shares. This strategy delivered economies of scale that were critical in the crowded long- distance reselling market. “Because the volume of bandwidth determined the costs, more money could be made by acquiring larger pipes, which lowered per unit costs,” one observer remarked.5 LDDS grew rapidly through acquisitions across the American South and West and expanded internationally through acquisitions in Europe and Latin America. (See Exhibit 1 for a selection of mergers between 1991 and 2002.) In 1989, LDDS became a public company through a merger with Advantage Companies, a company that was already trading on Nasdaq. By the end of 1993, LDDS was the fourth-largest long-distance carrier in the United States. After a shareholder vote in May 1995, the company officially became known as WorldCom.

The telecommunications industry evolved rapidly in the 1990s. The industry’s basic market expanded beyond fixed-line transmission of voice and data to include the transport of data packets over fiber-optic cables that could carry voice, data, and video. The Telecommunications Act of 1996 permitted long-distance carriers to compete for local service, transforming the industry’s competitive landscape. Companies scrambled to obtain the capability to provide their customers a single source for all telecommunications services.

In 1996, WorldCom entered the local service market by purchasing MFS Communications Company, Inc., for $12.4 billion. MFS’s subsidiary, UUNET, gave WorldCom a substantial international presence and a large ownership stake in the world’s Internet backbone. In 1997, WorldCom used its highly valued stock to outbid British Telephone and GTE (then the nation’s second-largest local phone company) to acquire MCI, the nation’s second-largest long-distance company. The $42 billion price represented, at the time, the largest takeover in U.S. history. By 1998, WorldCom had become a full-service telecommunications company, able to supply virtually any size business with a full complement of telecom services. WorldCom’s integrated service packages and its Internet strengths gave it an advantage over its major competitors, AT&T and Sprint. Analysts hailed Ebbers and Scott Sullivan, the CFO who engineered the MCI merger, as industry leaders.6

In 1999, WorldCom attempted to acquire Sprint, but the U.S. Justice Department, in July 2000, refused to allow the merger on terms that were acceptable to the two companies. The termination of this merger was a significant event in WorldCom’s history. WorldCom executives realized that large- scale mergers were no longer a viable means of expanding the business.a WorldCom employees

4 Jeter, p. 27.

5 Jeter, p. 30.

6 CFO Magazine awarded Sullivan its CFO Excellence award in 1998; Fortune listed Ebbers as one of its “People to Watch 2001.”

This document is authorized for use only by Si Yu Wang ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies.

Accounting Fraud at WorldCom 104-071

noted that after the turndown of the Sprint merger, “Ebbers appeared to lack a strategic sense of direction, and the Company began drifting.”b

Corporate Culture

WorldCom’s growth through acquisitions led to a hodgepodge of people and cultures. One accountant recalled, “We had offices in places we never knew about. We’d get calls from people we didn’t even know existed.” WorldCom’s finance department at the Mississippi corporate headquarters maintained the corporate general ledger, which consolidated information from the incompatible legacy accounting systems of more than 60 acquired companies. WorldCom’s headquarters for its network operations, which managed one of the largest Internet carrier businesses in the world, was based in Texas. The human resources department was in Florida, and the legal department in Washington, D.C.

None of the company’s senior lawyers was located in Jackson. [Ebbers] did not include the Company’s lawyers in his inner circle and appears to have dealt with them only when he felt it necessary. He let them know his displeasure with them personally when they gave advice— however justified—that he did not like. In sum, Ebbers created a culture in which the legal function was less influential and less welcome than in a healthy corporate environment.c

A former manager added, “Each department had its own rules and management style. Nobody was on the same page. In fact, when I started in 1995, there were no written policies.”7 When Ebbers was told about an internal effort to create a corporate code of conduct, he called the project a “colossal waste of time.”d

WorldCom encouraged “a systemic attitude conveyed from the top down that employees should not question their superiors, but simply do what they were told.”e Challenges to more senior managers were often met with denigrating personal criticism or threats. In 1999, for example, Buddy Yates, director of WorldCom General Accounting, warned Gene Morse, then a senior manager at WorldCom’s Internet division, UUNET, “If you show those damn numbers to the f****ing auditors, I’ll throw you out the window.”8

Ebbers and Sullivan frequently granted compensation beyond the company’s approved salary and bonus guidelines for an employee’s position to reward selected, and presumably loyal, employees, especially those in the financial, accounting, and investor relations departments. The company’s human resources department virtually never objected to such special awards.9

Employees felt that they did not have an independent outlet for expressing concerns about company policies or behavior. Several were unaware of the existence of an internal audit department, and others, knowing that Internal Audit reported directly to Sullivan, did not believe it was a productive outlet for questioning financial transactions.f

7 Jeter, p. 55.

8 Personal correspondence, Gene Morse.

9 Kay E. Zekany, Lucas W. Braun, and Zachary T. Warder, “Behind Closed Doors at WorldCom: 2001,” Issues in Accounting Education (February 2004): 103.

This document is authorized for use only by Si Yu Wang ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies.

104-071 Accounting Fraud at WorldCom

Expense-to-Revenue (E/R) Ratio

In the rapid expansion of the 1990s, WorldCom focused on building revenues and acquiring capacity sufficient to handle expected growth. According to Ebbers, in 1997, “Our goal is not to capture market share or be global. Our goal is to be the No. 1 stock on Wall Street.”10 Revenue growth was a key to increasing the company’s market value.11 The demand for revenue growth was “in every brick in every building,” said one manager.g “The push for revenue encouraged managers to spend whatever was necessary to bring revenue in the door, even if it meant that the long-term costs of a project outweighed short-term gains. . . . As a result, WorldCom entered into long-term fixed rate leases for network capacity in order to meet the anticipated increase in customer demand.”h

The leases contained punitive termination provisions. Even if capacity were underutilized, WorldCom could avoid lease payments only by paying hefty termination fees. Thus, if customer traffic failed to meet expectations, WorldCom would pay for line capacity that it was not using.

Industry conditions began to deteriorate in 2000 due to heightened competition, overcapacity, and the reduced demand for telecommunications services at the onset of the economic recession and the aftermath of the dot-com bubble collapse. Failing telecommunications companies and new entrants were drastically reducing their prices, and WorldCom was forced to match. The competitive situation put severe pressure on WorldCom’s most important performance indicator, the E/R ratio (line-cost expenditures to revenues), closely monitored by analysts and industry observers.

WorldCom’s E/R ratio was about 42% in the first quarter of 2000, and the company struggled to maintain this percentage in subsequent quarters while facing revenue and pricing pressures and its high committed line costs. Ebbers made a personal, emotional speech to senior staff about how he and other directors would lose everything if the company did not improve its performance.i

As business operations continued to decline, however, CFO Sullivan decided to use accounting entries to achieve targeted performance. Sullivan and his staff used two main accounting tactics: accrual releases in 1999 and 2000, and capitalization of lin

27 Mar Answer Question number 5: Betty Vinson: victim or villain? Should criminal fraud charges have been brought against her? How should employees react when ordered by their

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