ADM4341

Lecture #1
Sept 8, 10
The Crisis of Confidence in the
Auditing Profession
Presented by
Chris Liboiron BBA,CPA, CA, CIA, CFE, CRMA

Enron & WorldCom

What is this Course About?

Course Objectives

1.
2.
3.
4.
5.

This course mixes lectures and student lead seminars.

The objectives of this course are to:
Examine and consider the role of the auditing profession and
of the audit in society;
Develop knowledge of selected current issues facing the
auditing profession today;
Give some helpful hints on how to be a better staff accountant
(and auditing student) at work
Provide a greater understanding of the general assurance
framework and its underlying theories; and
Review specific topics that build upon general auditing
concepts.

Who are you?

Why are you here?
What about auditing interests

you?
Future career paths?
Expectations from me?

How Will I Be Graded?

Course Grading brief discussion
Participation
Midterm
Research Seminar
Final examination

5%
20%
30%
45%
100 %

Participation (5%)

Participation = Completely SUBJECTIVE

Quality and quantity will be considered.
Professionalism
It is important that I know who you are
Attendance is NOT Participation
Quality and Quantity considered.
Lots of 0s and 1s last semester.
Name tags?

Midterm (20%)
All lectures, cases, articles
Definitions, short answer, medium answer
2 hours

October 17, 2015 DMS1150-DMS1130

13:00-15:00

Seminar (30%)
Seminar rules
Group effort joint and several (story)
Will require research
Outline/Consultation
How does my topic relate to the course?
Balance of material
Group Formation
Challenges
Research needed to get comfortable

Final (45%)
Cumulative
Cases, lectures, readings, seminars

Course Materials
i)

Contemporary Auditing: Real Issues and

Cases, 9th, 10th edition, 2006, by Michael C. Knapp
ii) Additional readings have been assigned and
may be assigned throughout the term, as
appropriate.

Tips for the Class

Seminar based class those who are

interested in the material

Those who READ THE CASES and articles,
research their topic; normally outgoing
Prepare, ask questions and are curious to
learn and listen
Participate and interact
I will not post answers to case questions

Miscellaneous

My background
Name tags
QUESTIONS??
Or
By appointment (including before class)
Phone discussion at mutually agreeable time

Where to start?
Tonites Enron, Andersen,
Understand the history of Enron/WC and Andersen;
including
brief overview
of US public
acctg profession
WorldCom
Learning
Objectives
Understand how Enron/WC Execs may have been

driven to fraud
Review recent recommendations to strengthen the
indep audit function
Examine extent to which independent auditor should
be involved in their clients decisions regarding
important accounting and financial reporting issues
Understand the basic mechanics of how the frauds
were committed, including the understanding of SPEs
Understand the Crisis of Confidence and Lessons
Learned from the Enron/WC debacle

We know What Arthur Anderson

is/was butWho was Arthur
Andersen? Family immigrated to Ill from Norway

in 1881
Born 1885
Had fascination with numbers Discipline, honesty, and strong work
ethic were key traits instilled in
Arthur; education
Orphaned as teen
Accepted position with PW (most
prominent firm) in 1908 (CPA at 23)
Formed Andersen and Delaney, and
then Andersen.

1915 - Dilemma

one audit client= operated several

steam freighters that delivered various
commodities to ports located on Lake
Michigan
Following close of fiscal year, but
before Andersen had issued audit
report, one of the ships sank in
Lake Michigan
At time their were few formal rules for
companies to follow in preparing their
annual f/s and certainly no rule to
report subsequent event occurring
after years end like loss of major
asset
Who would this interest?
WWYD?
Describe the added importance to the
auditing profession in the early 1900s

Cont
Andersen insisted on client disclosure on f/s
Reasoning?
3rd parties would want to know about this

happening
Client finally agreed to put event in f/s

Uncompromised integrity
Another example - Dupont/Audit

team argue over how to define

operating income
AA sided with team
Refused to provide unqualified
Dupont dismissed them and
hired another auditor
relied on four word motto
think straight, talk straight
insisted it of his staff and
insisted it of his clients through
talking through f/s

Andersen Qualities
Qualities = opinionated, stubborn, difficult , but

honest and 100% integrity

Businessmanrealized the growth in economy in
1920s = companies involved in the production and
energy dept
Succ focus on utility type companies, was successful
Great depression of the 30s posed huge financial
problems for Andersen audit clients in electric utilities
industry ;
Andersens rep assisted his clients in obtaining
financing; referrals

Cont
Andersen = Successful formula/motto: Mid 40s

AA = strong eastern half of the United States w/

1000+ accountants.
Andersen died in 1947 ; #1 protg to top
position Leonard Spacek

Cont
Spacek had worked for AA

since 1928; sim to AA

Belief = primary role of
independent auditor was to
ensure that their clients
reported fairly and honestly
as then auditors obligation
is to the user
continued to lobby
profession for more
comparable stds so that
different companies may be
compared

EARLY ENRON
Northern Natural

Gas Company ,
Omaha, NB, 1930
Principal inv =Texas
based Company
Lone Star Gas
Corporation.

Early Enron Cont

Depression = cheaper methods

for heating and many turned to

natural gas

Problems with using natural

gas in early 1930s??

Cheap manual labor in the 30s

developed a pipeline to deliver

product
As profits grew, company
merged and acquired other
smaller competitors
Continued growth over next two
decades

Early Enron Cont

During 1970s Northern =principal investor in

dev of Alaskan pipeline; tapped into CDN

resources
1980 changed name to InterNorth Inc.
Continued investing and growing through the
80s
mgmt extended scope by investing in
other ventures including oil exploration,
chemical, coal mining and fuel trading
operations

Early Enron Cont

In 1985 Internorth purchased Houston

Natural gas Company for $2.3B

Controlled 40,000 mile network of Nat
Gas pipeline making it largest Nat gas
Supplier in USA
1986 changes name to Enron
Kenneth Lay former chairman of
Houston Nat Gas = top exec and based
Enron HQ in Houston Texas
Continued aggressive growth strategies

Enron Cont
1986 Hired Jeffrey Skilling
During 1990s Skilling developed plan to alter

Enron scope from being a Nat gas Provider to

Energy Trading Company
2001 Skilling became CEO although Lay
became chairman of board

Enron Pdt Lines

By 2001 E had 5 principle lines?
Enron Energy services(retail)
Enron Transportation Services (pipeline)
Enron Broadband (with Blockbuster)
Capital & Risk Management Services
Enron Wholesale Services (Enron Online)

EnronOnline - Transformation
In November 1999= Enron launched

EnronOnline.

http://www.youtube.com/watc
h?
v=W_NxYUpLE6A&feature=re
lated

New venture
New venture requires =?
What division of a business raises $ for

expansion?
The Enron Global Finance department had to
keep working up more creative financing moves
to keep the company running as Enron Online
needed cash
Until now, how was energy bought and sold?

Enron 2001
Skilling letter to Shareholders:
Enron hardly resembles the company

we were in the early days during 15

year history, we have stretched
ourselves beyond our own
expectations. We have grown from an
asset based pipeline and power
generating company to a marketing
and logistics company whose biggest
assets are its well established
business approach and its innovative
people

Creative FinancingSmoke &

Mirrors
Enron CFO Andrew Fastow awarded
excellence award in capital
structure mgmt for work in
pioneering unique financing
techniques
Skilling was declared No 1 CEO in
USA
Lay revealed ultimate goal to become
worlds greatest company; banner in
lobby
Although successful getting rep for
being cheeky

Fortune 500
ENRON NAMED MOST INNOVATIVE FOR

SIXTH YEAR
FOR IMMEDIATE RELEASE: Tuesday,
February 6, 2001 HOUSTON -- Enron Corp.
was named today the Most Innovative
Company in America for the sixth
consecutive year by Fortune magazine

Enron Stock
In 2001 stock price drifted lower

to $30 in Oct from high of $90

Execs blamed stock price to
falling natural gas prices - long
range concerns for EnronOnline
and overall weakness in USA
economy

Oct 16, 2001

On Oct 16, 2001, Enron issued

qtrly earnings report = There was

a sudden MYSTERIOUS - $1.2 B
reduction in OE and assets
= from reversal of previously
recorded trans involving swap of
stock for Notes receivable from a
related 3rd party who had invested
in limited partnerships organized
by the Company
3 weeks later,Nov 8, Enron
restates its reported earnings for
previous 5 years, wiping out nearly
$600 million of profits

Cont
What happens to

share price when

you restate 5
years worth of
profits?
Investors and
critics?

The Restatement Killed Enron

Pressure from creditors , investigations from

authorities forced Enron into bankruptcy (70B)

Public outcry - Obvious that 1990s performance
had all been a hoax orchestrated by who?
mgmt and.
crafty accountants / auditors
Doubt became wiped out when Sherron Watkins letter to Lay discovered posted virtually every
where

Who was Sherron Watkins?

Sherron Watkins was VP

Corp Dev (she had

worked for AA previously
for 8 years)
Skilling resigned 6 months
into CEO role prompting
Watkins to write letter to
Lay which identified
significant problems
attempts for to discuss
were rebuffed he said
hed rather not see it

Discuss Letter Points

Has Enron become a risky place to work for those of us

who didnt get rich over the last few years, can we afford to
stay?...
Skillings abrupt departure will raise suspicions of
accounting improprieties
I am incredibly nervous that we will implode into a wave of
scandals
I realize that we have a lot of smart people looking at this
and a lot of accountants including AA have blessed the
accounting treatment. None of this will protect Enron if
these transactions are ever disclosed in the bright light of
day
My concern is that the footnotes dont adequately explain
the transactions
Dont you think that several interested companies, be they
stock analysts, journalists, hedge fund managers are trying
to discover the reason Skilling left?...
Letter was in assigned readings - other thoughts re this
article?

SPEs
Watkins very familiar with aggressive acctg

series of large and complex transactions

involving Enron and dozens of ltd partnerships
created by the company
Partnerships called SPEs what are they?
See Special Purpose Entities Are Often a
Clever Way To Raise Debt Levels
http://people.stern.nyu.edu/adamodar/New_
Home_Page/articles/specpurpentity.htm

SPE
A special purpose entity (SPE) (or special

purpose vehicle") is created by a company to

fulfill narrow or temporary objectives,
primarily to isolate financial risk.

Why use SPEs?

Finance international projects ;
IE: Investors wanted risk and reward

exposure limited to a project, not to the

associated company
Corporations may use SPEs to legally isolate
a high risk project/asset from the parent
company and to allow other investors to take
a share of the risk (ie: oil exploration).

 SPE limited by charter

Cash flow from SPE ops used to pay

investors
Risk and reward rests with SPE

Critics
At the timeSEC and FASB guidance:
1 independent owner of SPE must
make substantive capital investment in
SPE and have substantive risk and
rewards of ownership = 3%
2 independent owner must exercise
control over SPE to avoid consolidation

As a result
Companies could use the SPE for external

parties to provide 3% and had the remaining

97% typically contributed by loans from outside
lenders, loans arranged and collateralized by
companies that formed the SPE
3% = Technical Minimum, practical maximum
Fortune Magazine charged that SPEs

were scalpels that performed cosmetic

surgery on balance sheets

What Happened
Enron used the SPEs to move

underperforming assets from the

consolidated b/s
Enron would arrange a 3rd party to invest 3%
capital in an SPE and then sell assets to that
SPE. The SPE would finance the purchase of
these assets (via bank loans) collateralized
by
Enron Common Stock

However
Occurrence of side agreements insulating

SPE Owners from any losses (where is

risk/reward?)
sales of underperforming assets at grossly
inflated prices to SPEs = paper gains in f/s
*Some estimates of personal gains
approximated 60-100M for Lay, Skilling

Example setting up spe

1. Newco
B/S
3 Cash

3 Equity
97 Cash

97 Liab (loan?)

2. Cash 100
Debt - 97
Equity - 3

Transaction
When each SPE was established, E mgmt would transfer
assets (and any related debt) to the SPE at an
appraised value above the net cost of the assets,
recording a gain on the transfer.
For example, assume that an asset that cost $600,000

(appraisal value, $750,000) and related debt of

$250,000 are transferred to an SPE. This transaction
was recorded on Enron's books as follows:

Investment in Special Purpose Entities 500,00

Debt 250,000
Assets 600,000
Gain 150,000

Discussion
Using the previous example, how would you

create a gain of 250K??

Ethics, Enron and First Year Accounting
-http://college.cengage.com/accounting/resou
rces/instructors/air/spring_2002/trends.html

Impact
Huge loophole in acctg practices,

companies could create structures,

SPEs which effectively removed
debt/losses from B/S I/S

Cont
To convince lenders to continue pumping cash into Enron

=need for E high credit rating = need for E to release

impressive f/s each period
Same as expansion years; Stock price needed to be high;
stock triggers & covenants
worst case scenario (ie: Price trigger due to stock price)
Enron would need to dissolve a SPE and merge SPE into
consolidated f/s
stock price declined in 2001, losses suffered by many of
Enrons SPEs on assets purchased from Enron Execs
were forced to pour resources into SPEs to keep them
solvent, and eventually consolidate

Question
Why is it then that if SPEs are legal, that

theres a problem here?

Guns are legal in Texas, but youre not
allowed to rob a bank with them Enron the Smartest
Guys in the Room

1. Technical Compliance
2. Economic Substance
3. Disclosure & Transparency

Cont
October 2001 the falling price of Enrons

stock, weight of losses of SPEs and concerns

raised by Andersen Auditors = Execs had to
transfer some of the SPEs to consolidated
f/s. this was the restatement
6 months earlier Skilling
So in conclusion, 1st quarter results were
great. We are very optimistic about our new
business and are confident that our record of
growth is sustainable for many years to
come

 Lay and Fastow (fired Oct 24, 2001) invoked

5th amendment rights against self

incrimination when asked to testify Skilling
did not. When asked about acctg and
reporting decisions, he calmly replied I am
not an accountant Thoughts?
Harvard comment
Corp execs are responsible for integrity of
their companys f/sfrustrated with lack of
answers Public focused attention on the
AUDITORS
Public outcry as to why AA audits failed to
provide a transparent, reliable f/s for the
company over 15 year history

Cont
Joseph Berardino succeeded

Leonard Spacek.
Andersen partners and legal had
become fully aware of Enrons
rapidly deteriorating condition
(and the repercussions involved)
and became deeply involved with
Enron to cope.
Efforts included restructuring

several of the SPEs so they

could requalify as
unconsolidated.
Documentation showed that
Andersen officials suggested
dropping them as a client

Andersen & SPEs

Dec 12, 2001 Berardino testified re SPE

analysis we made a professional judgment

about the appropriate acctg treatment that
turned to be wrong When Andersen
discovered the error, they notified Enron
Execs and told them to correct it. 20% of
the $600 Million restatement of prior earnings
was due to this item
LJM1

Cont
The remaining 80%=another SPE that Enron

had created in 1997 Unknown to Andersen

half of the 3% external equity had been
contributed by Enron as a result the entity
did not qualify and should have qualified for
SPE treatment
Chewco

In addition
AA also claimed they had been minimally

involved in transaction that resulted in $1.2B

reduction of OE reported on Oct 16, 2001
bulk of transactions had been prepared
preceding 2001 y/e audit and quarterly f/s not
required for audit

Cont
Failed to impress Andersen critics specifically on 3

issues:
?
1. Scope of Services acctg firms extended product
line to include prof services. Study showed that for
every $1 audit had $2.69 of non audit services
(consulting) feasibility studies, IA, acctg system
design, other IT

Cont

2. Andersens role in aggressive accounting

that Andersen personnel had been involved in
many SPE creations analyzing and reviewing
SPE transactions
3. Shredding of Documents Houston office
destroyed significant but undetermined amount of
documents relating to the company and its finances
suggestion was that prevention of conducting
justice

Cont
Jan. 15 - Andersen fires auditor David

Duncan for shredding documents. The New

York Stock Exchange removes Enron from
the board. The stock closes at 67 cents per
share, down from a high of $83 per share on
Jan. 24, 2001.
Andersen business plummets

Cont
Berardino defense was to repeat that

poor business decisions, responsible

for downfallAt the end of the day,
we do not cause companies to fail

Chief Editor of Accounting Today said If you

accept the audit and collect the fee then be

prepared to accept the blame -Otherwise
youre not part of the solution, but rather part
of the problem
WHAT DO YOU THINK???

Could This Have Been

Foreseen???
Is Enron Overpriced? Maclean
http://www.youtube.com/watch?

v=OsINoW2zLXo&feature=related
Read For Next Week

Conclusion
Andersen found guilty on obstruction of justice;

Results saw immediate layoffs of 25% of workforce

David Duncan testified against former firmand in
June 2002 had to sever all ties with remaining
public clients.
Partners and Employees were finished jokes and
ridicule regarding Andersen embarrassing ALL
accountants

Fastow

Pleaded guilty- 10 years (reduced to 6) and forfeit

of $25M of personal assets; cooperated with

Prosecution
Released December 17, 2011
June of 2013, Fastow addressed more than 2,000
anti-fraud professionals at the
Association of Certified Fraud Examiners' 24th
Annual ACFE Global Fraud Conference

What About the Banks?

http://www.youtube.com/watch?v=9zxAJO7owy8

The Enron Nine

J.P. Morgan Chase, Citigroup, Credit Suisse First
Boston, Canadian Imperial Bank of Commerce, Bank
of America, Merrill Lynch, Barclays, Deutsche Bank
and Lehman Brothers most if not all settled

May 25, 2006

Lay, Skilling = guilty
Skilling was convicted of 19 of 28 counts of securities

fraud and wire fraud and acquitted on the remaining

nine, including charges of insider trading.
24 years coming in prison, 60 million assets
liquidated
Lay was convicted of all six counts of securities and
wire fraud for which he had been tried, and could
have faced a total sentence of up to 45 years in
prison. Died July 5, 2006 of heart attack.

GUILTY:
The

jury sent an
unmistakable
message: You cant
lie to shareholders.
No matter how rich
and powerful, you
must play by the
rules, - prosecutor
Sean Berkowitz

So Who Lost?
Employees
Executives worldwide
Auditors
Shareholders
Financial Institutions
Profession

Question
The Enron debacle created what one public

official reported was a crisis of confidence

on the part of the public in the accounting
profession.
List the parties who you believe are most
responsible for that crisis.
Briefly justify your choices

Who do you blame?

Leadership of Andersen

Firm
Internal Auditors?
Enron Corp Executives
Analysts
Individual auditors

Regulatory authorities
Academics

Sherron Watkins
Enron "Whistleblower" and

TIME Magazine "Person of

the Year"
Has embraced spotlight as
whistleblower has coauthored a book , involved in
whistleblower protection.
Popular public speaker; yet
proclaims she is now
unemployable in Corp America

Part 2 WorldCom

Rise of WorldCom
1983 Bernie Ebbers founded Long Distance Discount Services

(later LDDS) and went public in 1989 through a merger with

Advantage Companies, Inc.
LDDS purchased long dist capacity at wholesale from the major
long distance carriers and resold it to the public.
In 1995 the company changed its name to WorldCom
Under Ebbers, WorldCom grew steadily throughout the 1990s,
chiefly through acqs of other LDCs in which WorldCom's
common stock was used as currency.
One of these acquisitions brought on board Scott Sullivan, who
became WorldComs CFO.
Sullivan worked closely with Ebbers; rep as whiz kid among
telecommunication executives.

Acquisitions
Decision making process lacked certain

protocols
Like:

Strategic planning
Boards role = passive
Multibillion $ Intermedia Comm acquired in 60
minutes of due diligence and 35 minute conf
call with Board
No written materials re acqs!!!
= Awful Corporate Governance

Rise of WorldCom
1998, WC made its

largest acq ever,

purchasing MCI for
$40B of WorldCom's
common stock.
At the time of the
acquisition, MCI's
revenues were more
than 2.5XWC's.
= moved WorldCom
ahead of Sprint to
become 2nd largest US
telecom provider

Rise of WorldCom
During 1990s, WCs revenues grew at a tremendous

rate.
Stock $=$8.17 in 1994 to $47.91 at q3 1999.
What did WC pay acquisitions with?
stock; vital to the success of the company's growth
strategy to have its stock price constantly increase.

Beginning of Problems
WorldCom stumble in October 1999

proposal to acquire Sprint -a deal valued at

unprecedented $115 billion. Refused by the
Justice Department's Antitrust Department to
approve the merger and the deal was called
off.
significant event to WorldCom strategically
why??

Beginning of Problems
WC philosophy= through

acquisitions of other telecom

companies, rather than
through growth in operations.
no other large
telecommunications
companies available for
merger
without mergers the company's
phenomenal revenue growth
would come to a halt.

Beginning of Problems
Then the dot.com bubble popped
WC discovered that increases in bandwidth had significantly

outpaced the growth in demand = glut of capacity in an overbuilt

market. Supply far exceeded demand
4Q1999, demand, prices softened and revenues fell
dramatically.
Operational problem, as revenue decrease compounded by the
fixed expenses that WorldCom had committed to through longterm lease contracts for line costs.
What are line costs?
Line costs are the costs of carrying voice or data transmissions
from its starting point to its ending point.

Would W/C own all of their lines?

Beginning of Problems
WC LEASED majority of lines - only

maintained its own lines for local service

in heavily populated areas (and then
largely for business customers),
Was single biggest WC I/S Expense (half
of expenses)

Beginning of Problems
With demand issues, the ratio of these line costs to total

revenues began to increase.

E & S = commitment to analysts that synergies of m&as would
keep line costs down
Touted to analysts that a ratio of line cost expense to revenues
of only 42 percent, while that of AT&T and Sprint were above 50
percent.
But they werent

Accrued Line Cost Expense

What is an ACCRUED LINE COSTS?

WHAT if you accrued too much?
GAAP requires that any reduction in the

accrued line cost liability be offset against line

cost expense in the period in which it is
determined that the excess accrual exists.
difficult to accurately accrue foreign/ external
costs and the estimates ( given changes in
demand industry wide!)

How Fraud Began Hindsight is

20/20 But
Pre 2000 - Senior management had little interest in

controlling costs.
Focused instead on increasing revenues (as
opposed to net income) and building a network to
take advantage of the perceived boom in the
technology sector.
Legacy systems did not reconcile; competition
within WC based on succeed at all cost culture,
GROW REVENUES

How Fraud Began

False picture to the market painted by

Ebbers, the burden fell to

Sullivan to "make the numbers work"
-- that is, to make Ebbers predictions
come true.
not possible using WC actual
operating results, (or business Model)
so beginning in 1999 Sullivan became
"creative.

WC Manipulated F/S in 3 Main

Ways

1. Accruals were reversed without any apparent analysis of whether the company
actually had excess accrual in its accounts.

2. When there were excess accruals, the company did not reverse them in the period
in which they were identified.

Instead, WC planned and managed the release of those over accrued

liabilities in a regular manner over time to smooth operating results and
avoid sharp spikes in reported line costs.

3. WorldCom reduced line costs by reversing accruals that had been established for
other purposes. These included:

$75 million accrued for Universal Service Fee,

$281 million in the federal income tax accrual,
$127 million moved from the allowance for bad debts all of which
were offset as a reduction to line cost expense.

How Fraud Began

Beginning in the second quarter of 1999, Sullivan began reducing

various accruals against line cost expense. The totals of

inappropriate releases of accruals were as follows:

Quarter 2 1999 $40,000,000

Quarter 3 1999 131,000,000
Quarter 4 1999 329,000,000
Quarter 1 2000 493,000,000
Quarter 2 2000 679,000,000
Quarter 3 2000 828,000,000
Quarter 4 2000 797,000,000
Total $ 3,297,000,000

Most of the releases had several things

in common.
They were all directed by senior
management.
They did not occur as part of the month-tomonth operations, but instead were recorded
just days before the quarterly reports were
filed with the SEC.
The timing and amounts of the releases
were not supported by analysis or
documentation (often there was none).
WC employees understood this was wrong...
(Myers)

Now What? - Capitalization of Line

Costs
By the end of 2000, WC ran out of excess

accruals
In the first quarter of 2001, Sullivan decided that the
company would begin capitalizing a portion of the
line cost expense as a long life asset. The leases
related to the line cost were clearly operating leases
under GAAP and, therefore, had to be recorded as
an expense over the life of the lease.
There is no evidence that any attempt was made by
management or the accounting department to
justify the accounting treatment of capitalizing the
costs.

Cap of Line Costs

The amounts of the adjustments were determined by Sullivan

and the entries were made in large, round-dollar amounts a

few days prior to the quarterly SEC filings (45 days after the
end of the quarter).:
Quarter 1 2001 $ 771,000,000
Quarter 2, 2001
610,000,000
Quarter 3 2001
743,000,000
Quarter 4 2001
941,000,000
Quarter 1 2002
818,000,000
Total
$ 3,883,000,000

The Fraud Meeting Expectations

WC consistently emphasized throughout 2001 that its

line cost E/R ratio (expense to revenue) stayed the

same about 42 percent quarter after quarter.
If the company had not improperly capitalized line
costs, WorldCom's line cost E/R ration would have
exceed 50 percent in most periods, bringing it into
line with other telecom companies.
So this is in simple terms outright cheating

WorldCom Culture
Many WorldCom employees became aware in varying degrees

of senior management's misconduct

Who could they have gone to?

Legal department,
the Internal Audit Department (IA),
the Audit Committee of the Board

Board of Directors,
Arthur Andersen,
or the SEC.
Why didnt they?

Tone at the Top

Profit motivated; greed
Ego
Unreasonable targets
blind trust in senior officers even in the face of

evidence that they were action improperly.

This environment left few, if any, outlets
through which employees believed they could
safely raise their objections.

How the Fraud was Discovered

IA focus on cost reduction; vs

financial audit
IA discovery of Pre paid Capacity
(PPC) came with Cap Exp audit
that commenced in 2002
Was follow up to 2001operational
audit of cap ex
2001 audit raised suspicions; de
ided to conduct fin audit

How the Fraud was Discovered

IA met with personnel resp for approving capex to

obtain understanding re differences
Explanation that accrual basis included line-cost labor
and corporate accruals and adjustments including
PPC
IA had never heard of PPC ; requested support for
PPC none provided
Continued to reconcile $3B difference btwn cash and
accrual #s
Cooper went to Sullivan, who insisted she stop audit =
waste of time

How the Fraud was Discovered

Cooper met with Chair of A/C and informed of

discrepancies on June 12, 2002
At request of Chair; met with new auditors KPMG
June 20 A/C meetings

KPMG indicated that cap of line costs did not

comply with GAAP
Sullivan attempted to explain in writing his rationale
Submitted rationale that WorldComs attempt to
defer these costs so there would be better
matching of costs with associated revenues
He was terminated 5 days later

How the Fraud was Discovered

Meeting June 24 - Andersen said they could

not accept cap of line costs as compliant with

GAAP
Also could not explain why their audit failed to
uncover cap line costs

How the Fraud was Discovered

June 25

WorldCom would restate f/s for 2001 and 1st Q

2002
KPMG engaged to reaudit 2001
Inform SEC
Issue press release announcing reduction of
$3.8B in EBITDA for 2001

Potential Reasons Why Andersen

Did Not Discover the Fraud
WHAT do you think?
Independence - Anderson had 20 yr

relationship with WorldCom; served as

auditor since 1990.
Considered WorldCom a flagship client and
a Crown jewel and a committed member of
(WorldComs) team.

Potential Reasons Why Andersen

Did Not Discover the Fraud
Andersen claimed blatant misrep by WorldCom personnel

did not provide Andersen all the information it needed

(access to GL)
altered documents,
were not forthcoming in a number of other respects.
Thoughts?
Previously rated as Max risk client

Guess What?
PwC found hundreds of huge,

round dollar journal entries

made by the staff of the
accounting department without
proper support. This
apparently took 2 hours
concluded that these
deficiencies alone made
reliance on internal controls
impossible and stated that they
could not understand how this
could have escaped Andersen
in audit

WorldCom Legal Fallout

Bernard Ebbers guilty =

25 years

Guilty plea = Sullivan

gets 5 years; sell all

assets

In summary What Went Wrong?

What caused this fraud?
Who do you blame?

Who to blame?
Corporate Governance/ Audit Committee:

No appreciation for accounting issues

Wrongly assumed coordination between IA/EA
No appreciation for risk-based audit approach
by AA
No input into changes made to Annual IA Audit
plan
Fully relied on representations by Sullivan,
Cooper, Andersen

Who to blame?
Internal Audit

scope of operations; narrow focus on operational

audits
Little coordination with EA
Reporting relationship to CFO
Lacked comprehensive risk based audit plan where
risk and effectiveness of controls evaluated
Evaluated ways to control costs rather than function as
I/C police

Who to Blame?
Andersen
Deficient audits
Failed to perform sub tests in many areas

warranted by risks
Extensively relied on reps by WorldCom mgmt
Failed to detect material weaknesses relating to
i/c
Failed to communicate info to A/C including
disagreements, difficulties w audits

Who to Blame?
The Company
No support for journal entries
Unresolved reconciling items with legacy systems of
acquired cos and WorldCom
Lacked procedures re g/l reconciliation, rec on sub
ledgers
Failure to review interco accounts
Needed seg of duties, responsibilities, mgmt review

Review
1. What similarities/ differences do you see

between Enron and WorldCom?

2. Lessons Learned?

Recap: Additional Assigned

Readings

1. Special-Purpose Entities Are Often A Clever Way to Raise Debt Levels

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/specpurpentity
.htm

2. Ethics, Enron and First Year Accounting Needles

http://college.hmco.com/accounting/resources/instructors/air/spring_2002/trends
.html

3. Accounting Issues at Enron - Alan Reinstein and Thomas R. Weirich http://www.nysscpa.org/cpajournal/2002/1202/features/f122002.htm

4. Is Enron Overpriced?
http://money.cnn.com/2006/01/13/news/companies/enronoriginal_fortune/index.
htm
5. Sherron Watkins letter to Enron http://www.itmweb.com/f012002.htm