Finance Case Study: WorldCom's Financial Fraud Analysis

This case study analyzes the financial fraud at WorldCom, a telecommunications company, detailing the pressures that led executives to manipulate financial records. It examines the techniques used, such as accrual releases and expense capitalization, and the failure of internal and external auditors to detect the fraud early on. The analysis explores the boundaries between earnings smoothing, earnings management, and fraudulent reporting, as well as the culpability of the external auditors and board directors. The case also discusses the ethical dilemmas faced by employees, such as Betty Vinson, and the implications of their actions. Furthermore, the study covers important accounting concepts such as useful life, residual value, cost model versus revaluation model, and impairment of assets, as well as investment properties, borrowing costs, government grants, and non-current assets. The study provides a comprehensive overview of the events, the accounting principles involved, and the ethical considerations surrounding the WorldCom financial scandal.

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Summary of the case
WorldCom, a telecommunication company based in US initially operating in the southern states
of the country with less presence of the then well established telecommunication companies such
as MCI, begun its operation around the year 1984 after breakup of another telephony company
by the name AT&T. With the availability of long distance phones lines due to the breakup,
WorldCom, then operating as LDDS (Long Distance Discount Service), sized the opportunity to
begin the telecommunication business. The young company was however forced to lease
network and phone lines form other entities among them defunct AT&T in order to be able to
provide telecommunication services to its customers. The huge expenditure in leases meant that
the young company struggled to make profits and it soon accumulated $1.5 million in debt. The
company turned into one of its original nine investors, Mr. Bernie Ebbers to run the company
and steer it back to profitability. Mr. Ebbers had been previously employed as Truck driver,
Milkman, basketball teacher and bar bouncer among other jobs that he held. (Kaplan and Kiron,
2007)
Mr. Ebbers steered the young company into profitability through internal growth and acquisition
other small long-distances companies and consolidating the markets they were already serving.
The logic behind growth in acquisition was that the volume of bandwidth determined the cost of
operation. If a company could acquire more bandwidth, then its cost operation will come down
thereby increasing the profit margin an indicator which defines the success of a company. LDDS
continued to make other major acquisitions in the market as a expansion strategy and this paid
off with the company expanding to all other parts of America as well as gaining access to
international markets. In the year 1995, LDDS, merged with Advantage companies, a public
listed company and officially adopted the name WorldCom after shareholder vote. (Kaplan and
Kiron, 2007)

During 1990’s, telecommunication industry went through rapid transformations with
technological advancements and revelation of other markets such as data market beyond its fixed
lines phones. Mr. Ebbers continued with his initial expansion strategy through acquisitions but
faced challenges when WorldCom attempted to acquire Sprint, a transaction denied by US
Justice department. The CEO appeared to have lacked sense of direction after this last merger
attempt was denied. Having invested in long term contracts to acquire phone lines in anticipation
of market expansion in future, WorldCom stated facing problems marinating its good financial
track record it had been enjoying for more than two decades. One of its performance indicators
was Expense – Income ratio (E/R), which was supposed to be kept as low as possible preferably
well below 50% to indicate company’s good performance. But with competition from other
emerging and established companies through price cuts, WorldCom struggled to match its
expense with revenues realized to get a good E/R ratio. The management resorted to two ways to
manipulate the company’s financial records and hide the financial struggle the company was
going through. (Maintaining financial records, 2011) The techniques devised by its Chief financial
Officer to cheat the system were accrual releases and expense capitalization. These two
techniques went on uninterrupted for long time being perpetrated by senior company official lead
by the CEO, MR. Ebbers, up until the discovery was made by the company head of internal audit
MS. Sharon Cooper. Its is clear from the case study that there were systematic attempts to
circumvent the system by the company’s senior management in order to retain good ratings in
the market and business circles while its peers struggled to remain afloat in business. The
company’s board of directors was also inadequately constituted in terms of necessary expertise
to oversee the company’s operations especially on financial reporting and representation. (Kaplan
and Kiron, 2007)

1. What are the pressures that lead executives and managers to "cook the books"
The pressures that lead the management into falsifying the financial records of the company were
desire to remain profitable company in wake of intense competition in telecommunication
industry business in US as well as other parts of the world. The pressure was also due to long
term phone-lines commitments with punitive termination measures that WorldCom had entered
into in anticipation of future growth which was not attained as envisaged, this lead to servicing
of non-profit generating expenses. (Maintaining financial records (international stream), 2010)
2. What is the boundary between earnings smoothing and earnings management and fraudulent reporting?
Earnings smoothing is a process whereby a company or an entity levels offs its profits such that
they are constant for a certain period of time as opposed to fluctuating between different levels of
performance. (Ronen and Yaari, 2011) Earning management on the other hand is use of accounting
techniques to overly show positive financial performance of a company than it would have been
if fair and reasonable judgment on the books of the company would have been made while
fraudulent reporting on the other hand is a deliberate misrepresentation or omission of
accounting information with intention to deceive investors. (Mohammadi Shaban. Shirzad Ali.
Haghighi Reyhaneh., 2015)
3. Why were the actions taken by WorldCom managers not detected earlier?
The actions taken by WorldCom were not detected earlier because the internal audit of the
company was always being sidelined on the financial happenings of the company such that it
was difficult for them to obtain necessary information for them to make detected any foul play in
the company books. The audit committee of the company was also detached from the company
dealings and it did not have requisite expertise to offer proper oversight of the company financial
performance. The external auditor was also reluctant focusing more on financial gains he used to

get form WorldCom than offering auditing services in expected and professional manner. To be
able to detect such dealings in a company quickly, access to relevant information should not be
restricted to auditors at all times. The audit committee section of the board of management
should have personnel with accounting skills that can easily detect any misrepresentation of
accounting information within reasonable time. (Maintaining financial records (international stream),
2010)
4. Were the external auditors and board directors blameworthy in this case? Provide detailed explanation for
your position
Yes. The external auditor did not make enough efforts to find relevant accounting information
that his office needed to make sound judgment on the company financial records. He focused
more on whether there could have been transactions entered into the company’s book of accounts
mistakenly rather than looking into the possibility of malice in such errors. He flagged
WorldCom’s willingness to provide crucial information “fair” even when the company out-
rightly denied his office access to certain accounting information. The board, through its audit
committee should have provided a close oversight of the company’s financial transactions in
order to be certain about the financial position of the company.
5. Betty Vinson: victim or villain? Should criminal charges have been brought against her? How should
employees react when ordered by their employer to do something they do not believe in or feel
uncomfortable doing?
Villain, yes, Ms Vinson, allowed irregular entries to be made into the company’s books of
accounts by transferring accruals from different departments of the company books into income
section of the company’s financials. If employees face situations like this it is better to resign
from the job rather than engaging in a malpractice that can possibly land you in court and
possible prison in future. (Epstein and Lee, 2010)

Discussion questions
Useful life and residual value
Useful life means the period within which an asset can still offer intended service to the company
or the owner while on the other hand residual value is the amount a company expects to receive
after disposing off an asset at the end of its useful life less any disposal expenditure that may be
incurred by the company in the process of disposing off the said asset. The change in either
useful life or residual life should be represented in the next financial year records while noting
down the new depreciation rate at the end of the accounting period. (Kaliski, Passalacqua and
Schultheis, 2009)
As an example, Assume WorldCom has purchased a car worth $60,000 and calculated that in 20
years time the residual value would be $0 then the depreciation rate is $3,000 per annum. If after
5 years WorldCom increased the number of years it would expect to earn $0 in residual value to
30 years then the new depreciation rate would be $2,000 per annum. The change in residual
value that is ($3,000- $2,000) = $1,000 per annum can be represented in percentage form at end
of the financial year 6 results.
Cost model verses revaluation model
Cost model is usually done at the beginning of a project. The value of the project is obtained
right at the start and the same is maintained without obtaining the ne value. An advantage of this
model is that it gives a cost value of the project that will be needed for budgeting and planning
purposes. Its limitation is that it does not give an up to-date value of the project considering there
is always appreciation and deprecation value of assets. On the other hand revaluation model is

beneficial in terms of giving regular and up to-date value of the property such that it’s real value
is always known. It is however not a constant value as it keeps on changing with time thus
requiring constant recalculation to obtain the new value. Example is when constructing a
building the cost value is done to get the cost of the construction for budgeting purposes
subsequently the value of the building will change depending on whether it is appreciating in
vale or depreciating. The new recalculations will be revaluation values and will be entered into
books according to the date.
Impairment of assets according to International accounting standard
This is a regulation which ensures no asset is carried in balanced sheet more than its recoverable
amount or the amount an entity will obtained if same asset is put into use. This amount is entered
into books following its real recoverable value. There are internal and external indicators that
suggest impairment needs to be done. Internal sources of impairment are as follows.
Obsolescence or when the asset is physically damage. Example is when a company processing
machine is corroded by chemicals at higher rate than expected. When this happens, the value of
the asset changes and an impairment loss needed to be determined and accounted for in the
balance sheet of the company. Poor economic performance of the asset than envisaged is also
another internal source of impairment as its recoverable value change to reflect the current or
established usefulness of the machine. (Kaliski, Passalacqua and Schultheis, 2009)
Asset’s market value decline is an example of external source of asset impairment process. Once
there is a market change in the value of the product then the balance sheet value should be
changed to reflect the new value. Under this case the value can be either a gain or a loss to the
company in terms of the value. Changes in the laws or technology also necessitates for

revaluation of the asset in order to determine the new value. It could be that the laws have
changed such that the asset like a building in certain area is now a prime property, therefore this
new increased value should be determined.
Investment Properties, Borrowing Costs, Government Grants and Non-current Assets
Investment properties are interest such as in buildings, land or both. These properties are
basically held foe the purposes of generating wealth rather than consumption purposes. These
properties are entered into the balance sheet at their open market value rather than the
progressive values that change from time to time. They are therefore treated differently in such a
way that their depreciation values are not factored into their respective values as entered into the
company’s balance sheet.
Borrowing cost on the other hand is treated differently depending on its use when being entered
into the financial records. If borrowing cost is directly attributable to acquisition, production or
qualifying asset then this cost is entered as cost of the asset in the accounting books. On the other
hand if the borrowing cost is not used for any acquisition then this cost is treated as expenses and
is therefore entered in the books of accounts as an expense. (Christensen, Cottrell and Budd, 2016)
Government grants should be recognized in the company’s profit a loss account if it were
received as a contribution or compensation for an expenditure incurred by the company. Under
this case the grant will become an income for the company. If grant is used to acquire an asset or
for a specific expenditure then the government grant should be recognized over the useful period
of the acquired asset.

Non-current assets held for sales are not depreciable assets and measured or entered into books at
lower carrying amount less the cost of disposal. These types of assets are presented separately in
the company’s financial statements. (Christensen, Cottrell and Budd, 2016)

References
Christensen, T., Cottrell, D. and Budd, C. (2016). Advanced financial accounting.
New York, NY: McGraw-Hill/Irwin.
Epstein, M. and Lee, J. (2010). Advances in Management Accounting, 18. Bradford:
Emerald Group Publishing.
Kaliski, B., Passalacqua, D. and Schultheis, R. (2009). Keeping financial records for
business. Cincinnati, OH: South-Western.
Kaplan, R. and Kiron, D. (2007). Accounting Fraud at WorldCom. [online] Hbs.edu.
Available at: http://www.hbs.edu/faculty/Pages/item.aspx?num=31127 [Accessed
9 Oct. 2017].
Maintaining financial records (international stream). (2010). London: BPP.
Maintaining financial records. (2011). London: BPP.
MOHAMMADI SHABAN. SHIRZAD ALI. HAGHIGHI REYHANEH.
(2015). EARNINGS MANAGEMENT. [S.l.]: LAP LAMBERT ACADEMIC
PUBL.
Ronen, J. and Yaari, V. (2011). Earnings management. New York: Springer.