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In 1998, the telecommunications industry began to slow
down and WorldCom's stock was declining. CEO came under
increasing pressure from banks to cover margin calls on his
WorldCom. Beginning in 1999 and continuing through May
2002, WorldCom used shady accounting methods to mask its
declining financial condition by falsely professing financial
growth and profitability to increase the price of WorldCom's
stock.
HHISHAPPÊ
he fraud was accomplished in two main ways.
First, WorldCom's accounting department
underreported 'line costs' (expenses with other
telecommunication companies) by capitalizing these
costs on the balance sheet rather than properly
expensing them.
Second, the company inflated revenues with bogus
accounting entries from corporate unallocated revenue
accounts.
H
     
NE INCOME
xxx (Huge Increase)

àevenues xxx COGS xxx


(no change)
(no change)
CFOǯs directions
affected the income
statement:
Fees companies phone
Computer expenses:
networks: xxx xxx
(Huge Decrease) (Huge Decrease)
 A
x Overstatement of current assets(marketable securities)
x Overstating pension assets
x Capitalizing as assets amounts that should be expensed
x Failing to record depreciation/amortization expense
x Overstating assets through mergers and acquisitions
x Overstating inventory and receivables
HAS IS!Ê
he first discovery of illegal activity was by WorldCom's
own internal audit department who uncovered "#$%b. of
the fraud in June &''&. he company's audit committee
and board of directors were notified of the fraud.
he Securities and Exchange Commission (SEC)
launched an investigation. By the end of &''#( it was
estimated that the company's total assets had been
inflated by around "))billion.
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Ñ scores for WorldCom based on its annual 10  reports .We found


that the company indeed experienced a rapid deterioration in its
Ñ score.
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I donǯt belief this


happen to me .
    
  ;
x December 2, 2001 Enron declares
bankruptcy

x July 19, 2002 MCI WorldCom declares


bankruptcy

x August 31, 2002 Arthur Anderson agrees to


stop auditing public
companies
H
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x Earnings pressure x Dependency on consulting fees
x Lack of mandated disclosure x Assumed good intent of their
of company reporting model client
x Minimal oversight into x Inability to continuously monitor
corporate business practices a companyǯs internal controls
x No documented or enforced x Unable to identify violations of
internal controls internal controls
How Did
Congress Respond?

„    !
S9 < =+A 
"# "#
x „ †our auditor (and therefore, you should)
maintain all audit related records, including electronic
ones, for seven years.
x „ Firms that audit your companyǯs books
can no longer provide you with I related services.
x „ †ou must provide systems or procedures
that allow employees to communicate effectively with
the audit committee.
S9 < =+A 
"# "# 
x „ †our CEO and CFO must sign
statements verifying the completeness and accuracy of
financial reports.
x „ CEOǯs, CFOǯs and outside auditors must
attest to the effectiveness and accuracy of financial
reports.
x „ Companies must report material
changes in their financial conditions Dzon a rapid and
current basis.dz he act calls it Dzreal timedz disclosure but
is unclear on what it means.
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he jobs of the CEO, CFO & CIO got tougher on
July 30, 2002 the day the Sarbanes Oxley Act
was signed. he legislation requires significant
changes to financial practices and corporate
governance, and touches all corporate areas
including technology. For the first time ever, the
CFO and CEO can look a CIO in the eye and say,
'Guess what, you're on the hook with us.'
S+  Ê= 
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x àeport parameter changes are documented
x Data that generates financial statements is accurate
x  
x Costing is accurately assigned
x r  
x Approved suppliers are used
x Approval limits cannot be easily manipulated
x   
x Duplicate customers
x Credit limits
  0  Ê= 
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x Accurate reporting
x „ ! 
x Separation of functions to minimize risk of fraud
x Audit changes to sensitive data
x Approval processes for creation of financial data
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x Ensure all month/year end activities are completed
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x On October 22, 2001, the Securities and
Exchange Commission (SEC) begins an
inquiry into Enronǯs accounting practices.

x On December 2, 2001, Enron files for  ,


the largest bankruptcy in US history up to that time
 A 
x housands of employees lost their jobs and even their
life savings in 401(k) plans tied to the energy company's
stock.
x Disastrous falling down on the whole stock market
during the following months, especially in the financial
service industry.
x Arthur Andersen, which at the time was one of the five
largest accounting firms in the world, was dissolved.
H
  
x he company used shortcomings of àule Based US
GAAP , special purpose entities, and poor financial
reporting to hide billions in debt from failed deals
and projects.
x Enron's audit committee failed to follow up on
high risk accounting issues
x Andersen was pressured by the company to ignore
accounting practices.
H
   B$  
1993 2001: Enron senior management used.

/     
x     
 
 
x   
   
  
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x to engineer off balance sheet schemes to direct
        


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condition in public reports.
Ê= 0   
x Enronǯs creation of over 3000 (!) partnerships
started about 1993 when it teamed with Calpers
(Calif. Public àetirement System) to create JEDI
(Joint Energy Development Investments) fund.
x Why partnerships? According to GAAP , as long
as Enron could find another partner to take at least
a 3% stake, Enron was not required to report the
partnerships financial condition in its own
financial statements.
Ê= 0   BB  
x Enron used partnerships to hide bad bets it made
on speculative assets by selling these assets to the
partnerships in return for IOUs backed by Enron
stock as collateral! (over $1 billion by 2002)
x In November 1997, Calpers wanted to cash out of
JEDI.
x o keep JEDI afloat, Enron needed a new 3%
partner.
x It created another partnership Chewco to buy
out Calpersǯ stake in JEDI.
Ê= 0   BB  
x Chewco needs $383 million to give Calpersǥ
x It getsǥ..
Ȅ $240 million loan from Barclayǯs bank
guaranteed by Enron
Ȅ $132 million credit from JEDI (whose only asset
is Enron stock)
x Chewco still must get 3% from some
outside source to avoid inclusion in
Enronǯs books
Ê= 0   BB  
Chewco Capital Structure: Outside 3%
x $115,000 from M. opper (worked at
the time for Enron)
x $11.4 million loans from Big àiver and
Little àiver (two new companies formed
expressly by Enron for this purpose who
get a loan from Barclayǯs Bank)
Ê= 0   BB  
x Barclayǯs Bank begins to doubt the strength of the new
companies Big àiver
and Little àiver.
x It requires a cash reserve to be deposited (as security)
for the $11.4 million dollar loans.
x his cash reserve is paid by JEDI, whose net worth by
this time consists solely of Enron stock, putting Enron
in the at risk position for this amount
P0 Ê  0  ;
x $10 million in guarantee fee + fee based on loan
balance to JEDI. A total of $25.7 million revenues from
this source.
x Increase in price of Enron stock held by
JEDI. Enron recognized $126 million in
the first quarter of 2000 from this.
x But everything began to fall apart
when Enronǯs share price started to
drop in Fall 2000.
3 +A A   
P  &''&Ô
x Auditing companies often consult for the
companies they audit (conflict of interest).
x Audit company partners often later accept
jobs from their client companies.
x Companies often retain the same auditing
company for long periods of time.
x Auditing companies have been allowed to police
themselves.
x Appointment of auditor company is in theory by
shareholders but in practice by senior management
ÊÊÊÊS
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