I.

BACKGROUND OF THE STUDY

1. Introduction

The past two decades have witnessed three huge bubbles and crashes with deep

and long bear markets, namely the uncontrolled exuberance during the 1990s

followed by the Asian Financial Crisis, the dot-com bubble at the turn of the

Century, and the bubble in the run up to the 2007 peak of over 30,000, followed

by the crashes and bust after the bursting of the U.S. housing bubble. Many

institutional investors suffered losses, in spite of well-established tests to detect

bubbles in the stock market, namely excess volatility tests, co integration tests,

duration dependence tests, and the intrinsic bubbles model.

This paper will focus on the analysis of WorldCom and how it was affected by the

Dot com bubble financial crisis.

WorldCom was a provider of long distance phone services to businesses and

residents. It started as a small company known as Long Distance Discount

Services (“LDDS”) that grew to become the third largest telecommunications

company in the United States due to the management of Chief Executive Officer

(“CEO”) Bernie Ebbers. It consisted of an employee base of 85,000 workers at its

peak with a presence in more than 65 countries. LDDS started in 1983. In 1985,

Ebbers was recruited as an early investor of the company and became its CEO. It

went public four years later. Ebbers helped grow the small investment into a $30

billion revenue producing company characterized by sixty acquisitions of other

telecomm businesses in less than a decade. In 1999, Ebbers was one of the richest

Americans with a $1.4 billion net worth. From the outside, WorldCom appeared to
be a strong leader of growth. The appearance was nothing more than a perception.

On June 25, 2002, the company revealed that it had been involved in fraudulent

reporting of its numbers by stating a $3 billion profit when in fact it was a half-a-

billion dollar loss. After an investigation was conducted, a total of $11 billion in

misstatements was revealed.

A. Purpose- The purpose of this paper is to analyze the events that have occurred

before and after the fraud, the accounting tactics utilized to accomplish this

fraud, and the lessons learned from each of the problems.

B. Implications- Economically; the impact of the WorldCom scandal was

staggering. Tens of thousands of WorldCom employees lost their jobs because

of the company going bankrupt. Not to mention the competition between other

telecommunication companies that thought WorldCom was profiting during a

soft market. Those companies, including AT&T fired thousands of people in

the late 90’s to compete with WorldCom’s low costs. Other companies like

Global Crossing and Qwest ended up committing fraud themselves to try and

compete with major companies like WorldCom. All because one major

corporation failed to exercise its responsibility to adhere to generally accepted

accounting principles. WorldCom could file for bankruptcy and was allowed to

keep most of its assets. As a result they are still a nemesis to other

telecommunication companies in respect to low costs because they have less

debt. (Colvin, 2005). Another economic perspective looks at the impact that the

WorldCom scandal had on the stock market. The scandal caused the company

stock to plummet. Shareholders lost billions of dollars when the stock value
 seemed to go from gold to pennies overnight. (Colvin, 2005). Socially,

WorldCom was not acting as a responsible company. WorldCom had a

responsibility to uphold ethical business practices. By committing accounting

fraud the company had lost the trust of investors, employees, other countries

that were in business with WorldCom and the American public. The scandal

within WorldCom was another reason for people to not trust corporate America

and all during a time when we needed to be trusted the most. (Corporate social

responsibility, 2012)

2. Body of Related Literature

To further this acquisition problem, the MCI merger caused WorldCom to take on

a huge debt load. In addition, MCI had a residential customer base with slower

growth rates while WorldCom had historically served business customers, a

customer base consisting of high margins and less turnover. (Katz & Homer,

2008).

The beginning of WorldCom‟s fall came with its attempt to merge with the second

largest telecommunication company at the time: Sprint (WorldCom being the third

largest). The plan was terminated by the U.S. Department of Justice due to the

lack of anti-competitiveness it would create within the telecommunications

industry. With no other companies to merge with, WorldCom’s growth through

acquisitions strategy came to a screeching halt (Clikeman, 2009).

One employee stated that WorldCom was never a happy place to work, even when

the company was doing well, the employees were forced to work 10, 12, or even

15 hour days but it balanced out with the higher compensation. However, when

the stock dropped, the employees were still 6 required to work the long hours even

when compensation was all but gone (L. Jeter, personal communication, October

17, 2010).

On top of the lack of an ethical code and an outlet for concerns was the concept

of employee compensation with stock options. Employees at WorldCom received

a lower salary than their counterparts at competitors such as AT&T and Sprint (J.

Chalmers personal communication, October 21, 2010). According to Chalmers, a

lawyer who dealt with many WorldCom employee cases after the fraud, the gap

between the competitors‟ compensation and WorldCom employee compensation

was filled through stock options which further enforced Management’s ideology of

focus on revenues. The higher the revenues, the better the company appeared to

Wall Street which in turn led to a higher stock price and higher compensation for

both employees and management. However, when WorldCom fell, so did the stock

price, leaving its employees with worthless stock options. Gene Morse (personal

communication, October 22, 2010), one of the internal auditors who helped

discover the accounting fraud, had been given the senior level director’s stock

options package. If the stock had returned to its high and WorldCom had not fallen,

his options would have been worth over $900,000. Morse stated that he never sold

the options because he too, like the majority of other employees and stakeholders,

believed in Ebber’s optimism about WorldCom.

Ebbers had started out by managing hotels in 1974 (Clikeman, 2009). He

continued his “hands on” managerial style throughout his involvement in

WorldCom even when the company had revenues amounting to billions of dollars

(in re). He was known for taking risks (Katz & Homer, 2008) no matter how

aggressive, towards making WorldCom‟s stock a highly demandable one.

According to Romney & Steinbart (2008), a work environment that emphasizes

“integrity and commitment to both ethical values and competence” depicts good

business, yet it all has to start at the top. Management that required and rewarded

integrity and honest behavior (Romney & Steinbart, 2008) may have prevented

what occurred at WorldCom. Furthermore, if management had envisioned a more

stable and long-term outlook for the company, the quick paced acquisitions may

not have occurred. Unfortunately, they did. The approval for these acquisitions was

given by the Board of the Directors.

II. IDENTIFICATION OF THE RESEARCH PROBLEMS/SUB-PROBLEMS

In 1999, WorldCom’s revenue growth slowed, and stock price began to fall.

WorldCom’s expenses increased as its earnings growth rate dropped. This meant

WorldCom’s earnings might not meet Wall Street analyst’s expectations.

To increase revenue, the company reduced the amount of money it held in

reserve by $2.8 billion to cover liabilities for the acquired companies and moved

this money into the revenue line of its financial statements. In 2000, Ebbers began

to classify operating expenses as long-term capital investments for $3.85 billion.

With the alliance of WorldCom’s Chief Financial Officer, Accounting Department

Director, Management Reporting Department Director, Controller and Legal Entity

Accounting Director, Ebbers made entries to falsify financial reports with no

documentation or justification. These changes turned WorldCom’s losses

into profits and made WorldCom’s assets appear more valuable.

In 2002, the Securities Exchange Commission requested for more

information as accounting irregularities were spotted in WorldCom’s books. The

SEC was suspicious because WorldCom was making so much profit, while another

huge communication company, AT&T was having losses. Internal auditor, Cynthia

Cooper had found the improper accounting and questionable entries amounted $2

billion. The controller of WorldCom, David Meyers admitted to internal

auditors that they didn’t follows accounting standards. WorldCom admitted to

inflating their profits by $3.8 billion over the previous five quarters. The company

filed for bankruptcy on the same year. As a result, WorldCom was renamed to MCI

after it emerged from bankruptcy in 2004.Former CEO, Ebbers and Former CFO,

Sullivan were charged with fraud and violating securities laws. Ebbers found guilty

and sentenced to 25 years in prison while Sullivan pleaded guilty and requested

for lenient sentences.

III. Research Objectives

The objectives of this study are:

1.) To analyze the events that has occurred before and after the fraud

2.) To identify the accounting tactics utilized to accomplish fraud

 3.) To determine the causes and effects

IV. Analysis

a. Point of View

Management- the misstated billions are also very bad news for ordinary

WorldCom workers: 17,000 of the employees will be fired. WorldCom said it

will restate its financial results for all of 2001 and the first quarter of 2002 to

take almost $3.8 billion in cash flow of its book, wiping out all profit during times.

Auditor- Cynthia Cooper, the former vice president of the internal audit group

at WorldCom, knows a thing or two about being caught up in workplace ethical

dilemmas. In 2002 she was the key whistleblower in her company’s $3.8 billion

accounting fraud case, which was the time was the largest instance of

corporate fraud in the industry.

Others- because of the scandal that happened to WorldCom, many of their

customers switch to another telecommunications carrier.

b. Desired States

Mr. Ebbers was a wall street favorite. One analyst described Mr. Ebber’s

meetings with wall street analysts as “prayer meetings” in which no one asked

any questions or challenged any numbers. Few analysts ever questioned Mr.

Ebbers or WorldCom’s nearly impossible financial performance. Mr. Ebbers

made it clear to Wall Street as well as WorldCom’s employees that his goals

rested in the financial end of the business, not in the fundamentals. He

reiterated his lack of interest in operations, billing, and customer service and
 his obsession with not just being the number one telecommunications

company but also being the best in Wall Street. Mr. Ebbers described his

business strategy succinctly in 1997: “our goal is not to capture market share

or be global. Our goal is to be the No. 1 stock in wall street.” In a report

commissioned by the bankruptcy court on the company’s downfall, former US

Attorney General Dick Thornburgh referred to WorldCom as a “culture of

greed.”

c. What happened

- WorldCom and other telecommunications firms have faced reduced

demand as the dot com boom ended and the economy started recession.

- Revenues fall short of expectation, while debt remains.

- Inflated assets by as much as $11 billion, leading to 30,000 lost jobs and

$180 billion in losses for investors.

- Market value of the company’s common stock plunged from about $150

billion in January 2000 to less than $150 million as of July 1,2002.

- Corporate Culture

o Autocratic style of management and followed a top down approach

- Lack of courage of employees to communicate the fraudulent activities –

believed it would have cost them their jobs

- A financial system in which controls were extremely deficient

- The BOD and Audit committee did not appear to have had an adequate

understanding of the company and culture.

 - Inadequate audits by independent auditors.

d. Conclusion

The Internal Environment of WorldCom is a chaos. It appears that the company

would still collapse even without the fraud and it really did and this was because

of its Internal Environment. But other than that WorldCom's external environment

also became a big factor that caused the company to go down and due to lack of

proper personnel the company wasn't able to detect and fix the problem.

The internal problems such as the demand for higher returns, weak internal

control, lack of competitive strategy and the failure of looking for what was for the

shareholders and stakeholders these factors exhausted WorldCom.

It would be essential for the company if it will be focusing on their long-term report

rather than only on the next quarterly report. This means that the company creates

a value not only for Wall Street but also for their customers which are one of their

drivers for success and growth. Employees of a company are also drivers for its

growth and success, but WorldCom's competitive culture was known by their

loyalty to management with no regards to ethics, honesty, or integrity. The internal

control that was exercised by the Board of Directors was a failure because they

couldn’t correct the weakness of the company that the management failed to see,

prevent and fix due to lack of independence from the company. Within the Board

was the Audit Committee that had the obligation to communicate with the internal

and external auditors. Since it only met three to six hours a year, it did not fully

communicate with either of the auditors. Although, Arthur Andersen did inform the
Committee that WorldCom had misapplied GAAP, the committee members chose

to ignore it.

The external environment added fuel to the fire. It burns down a structure that is

already not in good shape. The effect of bubble bursting led to a continuous decline

in stock price it only slowed down because Jack Grubman's continuous buying of

ratings for WorldCom. But the stock price fell so drastically in the end WorldCom

had to file for bankruptcy.

The lessons learned from these causes are ethics training and compliance don't

work in a culture that is exclusively materialistic and that devalues the dignity of

work and workers. Leadership training must be holistic, emphasizing free will,

personal responsibility and transparency. Lastly, is to make sure that internal

audits and control are functioning as planned.

e. Recommendation

- Ensuring the auditing is done independently

- Ensuring internal audits and controls are functioning as planned

- Creating ethical policy throughout the company

V. Key Learnings

Lessons for us all from WorldCom's fall

While the world waits to see if WorldCom will rise from the ashes as MCI Corp.

and if its former executives will pay for their alleged crimes, here are a few lessons

learned from the fallen industry giant.

Lessons learned for investors

Diversify. The old adage is true: Don't put all your eggs in one basket. Avoid

individual stocks unless you buy them for fun with mad money you can afford to

lose.

Don't chase returns. Many transaction- or commission-driven investment

professionals appeal to the greed factor in all of us. They might say, "Let me show

you this investment that's made 25% a year for the last five years," or "Let me

show you this stock that's at $20; our people say it's going to $100 by year end."

They want you to start doing the numbers in your head: If I invest $10,000 at $20

and it goes to $100, I'll have $50,000 -- a $40,000 profit by the end of the year!

However, to sell you on the idea, they are showing you historical data, and that is

why most people bought into the Internet and technology craze after most of the

run-up had occurred. By the late 1990s, everybody got in and pushed tech stocks

to a frenzy -- and soon watched the lack of profitability put an end to those sky-

high values.

Do your homework. As we all learned from Salomon Smith Barney telecom analyst

Jack Grubman's involvement in the WorldCom debacle, Wall Street isn't always

right. You wouldn't hire a doctor to perform a risky medical procedure unless you

had scrutinized references, researched the procedure and sought a second

opinion. Definitely seek professional advice because if it seems too good to be

true, it probably is.

Don't let emotions blur your decision-making ability. Too many people make

financial decisions based on greed or fear. When markets are going up, decisions
are based on greed. When they're tanking, decisions are based on fear and people

wind up getting out when they should be getting in.

One weakness of our accounting system was exposed in the WorldCom debacle.

Prudent investors have long done their homework by reading companies' financial

statements. While we've always known a financial statement is not necessarily

representative of a corporation's fiscal condition, few if any observers could have

seen the fraud behind WorldCom's statements. Now that we know about its past

accounting practices, it would not have mattered how thoroughly we analyzed

financial statements. Fortunately, with the penalties imposed by federal law

adopted after the collapse of WorldCom and Enron Corp., corporations are being

compelled to provide a more complete fiscal picture. As long as the laws have

teeth, doing your homework should be a legitimate exercise.

Lessons for Corporate America

Clean up your act. Now that the federal government has passed tough new laws

against corporate misdeeds and books are facing unprecedented scrutiny,

corporations are doing a better job of disclosure. There's still more work to be done.

Enron and WorldCom showed us how pitifully easy it is to cook books--and to keep

them simmering.
References