Auditing

| March 5, 2014

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SUMMATIVE ASSIGNMENT
Background
Cynthia Cooper was a typical accounting student as an undergraduate at Mississippi State University in the USA. Growing up in a family with a modest income, she attended the local high school and worked part-time as a waitress. After graduation, she went on to complete a Masters in Accounting at the University of Alabama and became a chartered public accountant.
Like most, Cynthia never thought she would face the challenge of her lifetime before reaching the age of 40. However, a few short weeks in May and June of 2002 changed her life forever. The case summarises how she unravelled a $3.8 billion fraud that ultimately grew to over $11 billion and sent one of the USA’s largest and most visible companies to its knees in bankruptcy.
Working for WorldCom
Cynthia joined the company that eventually became Worldcom after returning from Alabama to her hometown of Clinton, Mississippi in the early 1990s. WorldCom started as a small, closely held company in the early 1980s. Bernie Ebbers moved the headquarters to Clinton, Mississippi because it was the college town of his alma mater, Mississippi College. By 1997 the company had emerged within the telecom industry and caught the eye of many on Wall Street when it launched a bid to acquire the much larger and better know company MCI.
Cynthia enjoyed the rising status of WorldCom’s growth in the business community. She was promoted to Vice President of internal audit in 1999, leading the internal audit function in what became the 25th largest company in the US. WorldCom’s stock price continued to rise through 2000, and she and her colleagues dreamed of retiring early and starting their own businesses.
Establishing internal audit’s role in the company wasn’t easy. WorldCom’s CEO, Bernie Ebbers, was forceful in his dislike for the term “internal controls” and allegedly banned the use of the term in his presence. At one point, Cynthia called a meeting with her boss, WorldCom CFO Scott Sullivan, Bernie Ebbers and a few others to help them see how an internal audit department could help the company’s bottom line. Despite being almost 30 minutes late to the meeting, Ebbers was the last person to leave the meeting. At that point, internal audit’s focus on efficiency of operations became its primary focus, leaving the financial audit-related tasks in the hands of the external auditor, Arthur Anderson, LLP. Cynthia, as Vice President of Internal Audit, would report to the CFO, Scott Sullivan.
While WorldCom’s growth skyrocketed throughout the 1990s, the telecom market was saturated by 2001 and WorldCom’s earnings began to fall. WorldCom executives began to feel enormous pressure to maintain their fantastic record of financial performance.
Unravelling of a Fraud
According to press reports, Cynthia and her internal audit team didn’t know about any unusual accounting manipulations until March 2002. It wasn’t until a worried executive in a division of WorldCom told Cynthia about the handling of certain expenses in his division. At that point, Cynthia learned that the corporate office accounting team had taken $400 million out of the division’s reserve account to boost WorldCom’s consolidated income.
As Cynthia and her team pursued the matter with WorldCom’s CFO, Scott Sullivan, she immediately felt tremendous resistance and pressure. In fact, Sullivan informed Cynthia that there was no problem and that the internal audit shouldn’t be focused on the issue. She received a similar reaction when she approached the external auditors at Arthur Andersen, who told Cynthia there was no problem at all with the accounting treatment.
Fortunately, Cynthia did not let the intimidation of her boss or the opposition of a major international accounting firm dampen her concerns about getting to the truth. In fact, Sullivan’s harsh reaction only increased her scepticism surrounding the matter. She and others within the internal audit team began to secretly work on the project late at night. At one point, they began making back-up copies of their files in response to fears that if their investigation was revealed, files might be destroyed.
Within two months, Cynthia and her team had unravelled the key aspects of the fraud. They discovered that the company had erroneously capitalized billions of dollars of network lease expenses as assets on WorldCom’s books. The creative accounting treatment allowed the company to report a profit of $2.4 billion instead of a $662 million loss.
In some ways, the fraud was quite simple. The corporate accounting team led by Sullivan had merely transferred normal operating lease expenses to the balance sheet as an asset. The expenses were for normal fees WorldCom paid to local telephone companies for use of their networks and were not capital outlays.
On June 11, 2002 Scott Sullivan summoned Cynthia to his office demanding to know what was going on with her investigation. At that meeting, Sullivan asked Cynthia to delay her audit investigation until later in the year. Cynthia stood her ground and told him at that meeting that the investigation would continue. Imagine the pressure Cynthia felt as she faced her boss, believing that he was covering up the large accounting fraud.
Cynthia decided to go over Sullivan’s head, which was a huge gamble for her. She would not only be risking her career, but she would also personally suffer following any devaluation of her investment in WorldCom stock. Furthermore, it was likely that she would experience rejection from others for upsetting a good thing. In any event, on the very next day, June 12, 2002, Cynthia contacted Max Bobbit, chairman of WorldCom’s audit committee. Feeling enormous pressure from the encounter, Cynthia cleaned the personal items from her desk in anticipation of the backlash she might face.
At first, Cynthia was disappointed to see the audit committee chairman delay taking action based on her report. However, he soon passed her report along to the company’s newly appointed external auditors, KPMG LLP. WorldCom had replaced its former auditor, Arthur Andersen, due to Andersen’s quick demise following the firm’s guilty verdict in the Enron scandal. This occurred about the same time as Cynthia and her team were investigating the WorldCom fraud.
Later that week, Max Bobbit and the KPMG lead partner, Farrell Malone went to Mississippi to meet Cynthia face to face. Over the next several days, Cynthia and the KPMG partner began interviewing several people in the corporate office, including Scott Sullivan. Bobbitt presented information to the audit committee at a June 20, 2002 meeting. Scott Sullivan was instructed to attend along with Cynthia Cooper and key members of her internal audit team to discuss the matter. Scott Sullivan, at that meeting, made every attempt to justify the accounting treatment. Despite his reasoning, KPMG tactfully offered the firm’s view that the treatment did not meet generally accepted accounting principles.
The audit committee instructed Sullivan to document his position in writing, which he did in a three page memo, four days later. The main theme of his argument was that WorldCom was justified in classifying the lease expenses as assets. The expenses, he argued, related to payments for network capacity that would be used in future years as business demand increased and new customers were added to the WorldCom network. In essence, he argued that the company needed to spend money on additional network capacity to entice new customers to come on board.
Most experts, including the audit committee, did not accept Sullivan’s justification. No other company in the industry took a similar approach. Instead they expensed network lease costs as they were incurred. Later that day, the audit committee informed Sullivan and the WorldCom controller, David Myers, that they would be terminated if they didn’t resign before the board meeting the next day. Myers resigned, but Sullivan refused and was fired. By August 2002, Sullivan had been indicted by a grand jury.
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