The WorldCom Fraud That Changed Everything
Oct 31, 2019 | By John Siegel
With Jack-o'-lanterns in place and faux-cobwebs sprinkled liberally around the office, FloQast is feeling particularly spooky these days. To really get into the Halloween spirit, we decided to tell a few scary stories, but with a twist — they're all true. In today's episode of Accounting Horror Stories, we take a look at the epic WorldCom fraud that contributed significantly to sweeping auditing and financial regulations that are hyper-relevant today.
To those unaccustomed to the regular upheaval in the world of finance, the last few decades might indicate that accounting fraud was the cool thing to do.
Companies large and small have had their hands caught in the cookie jars, and while it’s easy to assign blame to the corporate giants, the fact is that it’s often individuals or small groups working together to falsify just how many cookies are in said jars.
This leads us to WorldCom. While not as sexy as the Enron scandal that happened right around the same time, WorldCom really set the bar high.
In this company's case, it all comes back to the idea of performance-based pay. Performance-based pay and bonuses can be a great incentive to work hard. Unfortunately, they can also incentivize fraud among executives looking to boost their paycheck or inflate the value of their stocks.
If you’re lucky, you probably don’t remember the explosion of long-distance phone service providers during the 1980s and 1990s. You know what I’m talking about — the commercials featuring Christopher Lloyd, Hulk Hogan, Alf, or John Stamos in preposterous situations necessitating a long-distance call.
By 2001 and 2002, WorldCom — a telecommunications company based out of Virginia — had grown fat and happy providing telecom services during the growing Dotcom boom. The company’s market cap was around $175 billion. The future looked bright until the bubble burst and many of WorldCom’s biggest clients either disappeared or drastically slashed expenses to keep their heads above water.
As profits turned into losses, CEO Bernie Ebbers and CFO Scott Sullivan decided to cook the books in a huge way, showing a $1.4 billion profit in place of an even larger loss. Honestly, it’s stories like this that make me wonder whether or not there were actually laws before 2004.
The WorldCom Fraud
Despite it being just 17 years ago, 2002 was a much simpler time. While I was finishing up middle school, I’d like to imagine Ebbers and Sullivan in some overly-corporate setting proposing to each other that, instead of using a minus-sign, they use a plus-sign. Really, come on, guys.
First, WorldCom paid “line cost” fees for the right to use the lines and networks of third-party telecom companies. These fees are an expense under GAAP, but WorldCom capitalized around $3 billion of these line costs between 2001 and 2002, inflating their profits by the same amount.
To make matters worse, they also recorded false transactions to inflate revenues. At the time it was discovered, WorldCom had inflated its assets by close to $11 billion. It still holds the record as the largest accounting fraud in U.S. history.
Though I have the benefit of hindsight (and the internet) on my side, it still boggles my mind at just how this all went down.
Just like in the Disney films, where the cartoonishly-evil bad guys are countered by a group of upstart youths generally against the idea of theft, murder, money laundering, etc…, the WorldCom fraud saga features a team of do-gooders.
Having discovered that Sullivan had decided to use his unit’s reserves to reduce expenses, Vice President of Internal Audit, Cynthia Cooper, raised the issue to WorldCom’s audit committee, defeating Sullivan in fierce debate while gathering enough motive to start a more formal investigation. The following day, the SEC, in what was considered a shocking move, slapped WorldCom with a “Request for Information," perhaps noticing that all of WorldCom’s closest competitors were losing big, while our villain was somehow prospering.
This was all enough for Cooper and her team of internal auditors, who were normally tasked with operational audits. Between the SEC’s request, Sullivan’s sketchiness, and the fact that the company’s external auditors were none other than Arthur Andersen — it was a bad few years for AA — Cooper and her team began conducting financial audits of their own.
Within a few months, the team had discovered $2 billion that the company reported had been spent on capital expenditures during the first three quarters of 2001. Cooper and her team, however, concluded that the money had never been authorized for capital spending. Whoops!
Immediately, they began to suspect that the $2 billion in capital costs were actually representing operation costs in disguise with the intent of making the company look more profitable.
As the internal auditors tried — and failed — to get answers from the company’s director of financial planning and corporate controller, internal auditor Gene Morse uncovered an entry for $500 million in undocumented computer expenses logged as a capital expenditure. Though they didn’t know it, Cooper and her internal audit team had started to uncover evidence that the $36 billion company was keeping two sets of numbers, one of which was blatantly fraudulent.
At this point, you’re probably wondering how the team of internal auditors were able to hide the fact that they were basically being paid by WorldCom to investigate an alleged WorldCom fraud so brazen it still boggles the mind. As it turns out, Cooper, Morse, and Senior Manager Glyn Smtih were wondering the same thing.
Morse had started working nights so as to not overload the company’s servers to do things like download a dubious account titled “intercompany accounts receivables,” which contained an inexplicable 350,000 transactions per month. During the day, he worked from a 12-by-12 windowless storage room, and even bought a CD burner (remember those!?) to ensure the company wouldn’t be able to destroy evidence.
Ultimately, Sullivan, the CFO, caught on. During a meeting meant to discuss upcoming promotions, Smith and Cooper let slip — intentionally trying to sound casual — the progress their investigation had made. Sullivan was stunned. He pleaded with them to delay their investigation to the next quarter. They declined.
After approaching WorldCom’s new outside auditors, KPMG, Cooper and her team began working to firm up their investigation’s findings. The resulting meeting with the board’s audit committee determined that Sullivan was to resign. In a classic bad-guy move, he refused, so they fired him.
The following day, WorldCom stunned the world by announcing that it had inflated its profits by $3.8 billion over the previous five quarters. Later that month, the SEC slapped the company with a civil fraud suit and the company was ultimately delisted by the Nasdaq Stock Market.
Corporate fraud impacts people on many different levels. Trust in the market, in industries, and in accounting firms can all be eroded. The impact of the WorldCom fraud was one of the biggest in accounting history. Here’s a glimpse of the quantifiable damage:
- $750 million dollar SEC settlement to compensate investors
- Nearly 30,000 jobs lost
- 25-year prison sentence for CEO Bernie Ebbers
- 5-year prison sentence for CFO Scott Sullivan
- Sarbanes-Oxley Act passes just months later
By the end of 2003, it was estimated that the company’s total assets had been inflated by about $11 billion, making the WorldCom fraud the largest accounting fraud in American history. That is, until 2008, when a guy named Bernard Madoff was exposed.