The WorldCom Fraud © 2003, 2005 by the AICPA

This presentation is intended for use in higher education for instructional purposes only, and is not for application in practice. Permission is granted to classroom instructors to photocopy this document for classroom teaching purposes only. All other rights are reserved. Copyright © 2003, 2005 by the American Institute of Certified Public Accountants, Inc., New York, New York.

WorldCom’s Background Awoke the sleeping giant by leading the telecom industry into profitability in the 90’s. Telecom industry faced low margins and Bernie Ebbers decided growth=survival During the 1990’s, WorldCom was deeply involved in acquisitions and completed several “mega-deals” Purchased over 60 firms in 2nd half of the 90’s WorldCom moved into Internet and data traffic Handled 50% of US Internet traffic Handled 50% of e-mails worldwide © 2003, 2005 by the AICPA

WorldCom’s Background (con’t) Purchased MCI for $37 billion in 1997 Not allowed to purchase Sprint in 2000 because of antitrust regulation. In 1999 revenue growth halted; stock price dropped By 2001 owned a third of the US data cables Was U.S.’ 2nd largest long-distance operator in 1998 and 2002 Had over 20 million customers in 2002 © 2003, 2005 by the AICPA

Bernard Ebbers, CEO Bernie Ebbers classic resignation statement: Borrowed $366 million to cover losses on stock which was not repaid Secured loans from WorldCom to fund personal investments including a $100 million Canada ranch, $658 million in Mississippi timberlands and a $14 million Georgia shipyard Netted $140 million from stock sales Facing dismissal, he resigned from WorldCom on April 30, 2002 Bernie Ebbers classic resignation statement: "I am confident that WorldCom will continue to lead the industry, setting the standards others will follow.” © 2003, 2005 by the AICPA

Scott Sullivan, CFO Served as CFO, treasurer and secretary Directed staff to make false accounting entries Personally made false and misleading public statements regarding finances Netted $45 million from stock sales © 2003, 2005 by the AICPA

How the Fraud took place From 1998-2000, WorldCom reduced reserve accounts held to cover liabilities of acquired companies WorldCom added $2.8 billion to the revenue line from these reserves Reserves didn’t cut it; An e-mail was sent in December 2000 to a division in Texas directing misclassification of expenses. CFO told key staff members to mark operating costs as long-term investments. To the tune of $3.85 billion. © 2003, 2005 by the AICPA

How the Fraud took place (con’t) Operating Expenses to Assets -CFO’s directions affected the income statement: Revenues xxx (no change) COGS xxx (no change) Operating Expenses: Fees paid to lease other companies phone networks: xxx (Huge Decrease) Computer expenses: xxx (Huge Decrease) NET INCOME xxx (Huge Increase) Removed From Income Statement Removed From Income Statement © 2003, 2005 by the AICPA

How the Fraud took place (con’t) Operating Expenses to Assets -CFO’s directions affected the balance sheet: Assets: Computer assets xxx (Huge Increase) Leasing assets xxx (Huge Increase) Liabilities xxx (no change) Stockholders Equity: Retained Earnings xxx (Huge Increase) Added to Balance Sheet Added to Balance Sheet =HAPPY INVESTORS © 2003, 2005 by the AICPA

How the Fraud took place (con’t) Operating Expenses into Assets WorldCom’s journal entry for $500 million in computer expenses: Computer Assets 500 million Cash 500 million The documents supporting the expenses were not found! © 2003, 2005 by the AICPA

How the Fraud took place (con’t) Huge losses turned into enormous profits. $1.38 billion in net income in 2001 Inflated the company’s value in its assets © 2003, 2005 by the AICPA

How the Fraud was discovered Obscure tips were sent into the Internal audit team MCI audit and review of books uncovered accounting irregularities In March 2002, John Stupka complained to Internal audit about $400 million he set aside that Sullivan wanted to use to boost WorldCom’s income. © 2003, 2005 by the AICPA

How the Fraud was discovered (con’t) March 7, 2002 - the SEC requests information from WorldCom How could WorldCom make so much when AT&T is losing money? The Internal audit started digging Found $2 billion company announced for capital expenditures (Internal Auditors found it was never authorized for capital expenditures.) Found the undocumented $500 million in computer expenses that were recorded as assets. Searching WorldCom’s computers, Mr. Morse found $2 billion in questionable entries © 2003, 2005 by the AICPA

How the Fraud was discovered (con’t) June 14, 2002 - The Internal audit team contacted WorldCom’s audit committee Internal auditor, Cindy Cooper, asked for documents supporting numerous capital expenditures. No supporting documents were found The controller admits to internal auditors that the accounting treatment is wrong States no accounting standards support this accounting © 2003, 2005 by the AICPA

How the Fraud was discovered (con’t) June 20, 2002 - Internal audit explains irregularities to the Audit committee. June 25, 2002 - WorldCom announces it inflated profits by $3.8 billion over the previous five quarters June 26, 2002 - civil suit filed, stock trading halted Ultimately, stock was delisted by Nasdaq July 21, 2002 - WorldCom filed for bankruptcy © 2003, 2005 by the AICPA

Post-Fraud Happenings 17,000 jobs cut to save $1 billion. WorldCom may write off $50.6 billion in intangible assets. Added additional board members to serve on a special investigative panel to review accounting practices: Former US Attorney General Nicholas Katzenbach Dennis Beresford, Former Chairman of the FASB WorldCom is trying to secure loans © 2003, 2005 by the AICPA

Post-Fraud Happenings (con’t) John Sidgmore, the CEO replacing Ebbers, stated he wants to move forward: “We want the bad guys exposed. We want the bad guys punished. And we want to move on with our lives at WorldCom." © 2003, 2005 by the AICPA

Post-Fraud Happenings (con’t) WorldCom was renamed MCI in 2004 when it emerged from bankruptcy Possible court-approved debt reductions Company could spin off several business units © 2003, 2005 by the AICPA

Post-Fraud Happenings (con’t) Scott Sullivan In August 2002, Scott Sullivan, CFO, was indicted by a grand jury on one count of fraud and six counts of securities fraud and false filings involving almost $8 billion. He pleaded not guilty. On March 2, 2004, in a superseded indictment, Sullivan pleaded guilty to 3 federal criminal charges for fraud and conspiracy. Faces maximum 25 years in prison. Struck plea deal with government to testify against Bernie Ebbers. Sullivan to be sentenced after Ebbers trial. © 2003, 2005 by the AICPA

Post-fraud happenings (con’t) Bernie Ebbers September 2003 – pleaded not guilty to 15 felony counts of violating Oklahoma securities laws. Charges dropped. Oklahoma Attorney General to refile charges at a later date January 19, 2005 - Federal jury trial on charges of fraud to begin in which Scott Sullivan is expected to testify against him Possible sentence: 25+ years in prison © 2003, 2005 by the AICPA

Post-fraud happenings (con’t) Directors January 2005 - 10 former directors agreed to pay $54 million to settle a shareholder class-action lawsuit $18 million to be paid by the directors themselves $36 million paid by the liability insurance February 28, 2005 – Trial to begin against former auditors/directors who have not settled during class-action © 2003, 2005 by the AICPA