Strategic Audit - Essay Example

Strategic Audit Required Structure for Assignment Strategic Audit (FINM012) Assessment WorldCom Case Study Submitted by: and ID) 2013/2014 Introduction In past few decades, the business world has encountered a number of accounting scandals, which had led to disastrous consequences for global economy and companies. The renowned company called WorldCom, which was regarded as the second largest long distance telecommunication company, had met its downfall in 2002 when it filed for Bankruptcy Protection. This was recorded as the largest filing in history of United States. The essay elaborates reasons behind the collapse of WorldCom in details, portraying the role of each person who was involved in the scandal. The essay also depicts role of the external auditors in collapse of the company since their conspiracy with the company management acted as a facilitator. There are few key elements, which are responsible for increasing audit quality of an organisation. The elements are highlighted in the essay in order to prove that they had the ability to save WorldCom from the failure (Humphrey, Kausar, Loft and Woods, 2011). WorldCom Worldcom was regarded as world’s second largest long distance telecommunications company (Lyke, 2002). It was established in 1983 by Bernard Ebbers as a long distance discount service (LLDS) provider. It initially sold AT&T WATS lines to small businesses. WorldCom was successful in selling LDDS and thus, the business grew rapidly (Lyke, 2002). The company acquired about 70 small and medium sized companies. The acquired companies included IDB WorldCom, largest international carrier; WilTel, telecom carrier; and lastly, international phone company and parent of UUNET, MFS Communications (Lyke, 2002). The main business activity of the company was to provide LLDS services to clients. The WorldCom website highlighted the following main activities: 1) WorldCom provided mission-critical communications services for a number of businesses worldwide. 2) It carried the highest number of international voice traffic in the telecommunication industry. 3) The company housed a considerable amount of internet traffic worldwide. 4) It had owned the global Internet Protocol (IP) backbone and its operations. It provided the internet connectivity to about 2,600 cities and 100 countries (Lyke, 2002). 5) WorldCom also operated 75 data centres in five continents (Lyke, 2002). During the period 1997, the operational networks of CompuServe and America Online formed part of the giant company, WorldCom. The company also merged with Brooks Fiber and thereafter, it had acquired MCI. The merger and acquisition had rendered the company the second largest long distance carrier in United States. However, prosperous position in the market of United States had not sustained as the company had to file bankruptcy in 2002 (Lyke, 2002). WorldCom filed for bankruptcy since it had encountered huge financial deficit. The company disclosed to have earned inflated profit of $ 3.8 billion for the previous two years. Nevertheless, the amount was observed to rise beyond $ 10 billion, rendering it the “largest accounting fraud in U.S. corporate history” (Yahoo! Inc., 2007; Lyke, 2002). The external auditor of WorldCom was Arther Anderson LLP and later, KPMG. The former external auditor was blamed as it had the largest share in collapse of the telecom giant” (Yahoo! Inc., 2007; Lyke, 2002). Arther Anderson LLP was regarded among the biggest five accounting firms, which performed tasks of consulting services and auditing tax for renowned corporations (Tran, 2002). Reasons behind the collapse of WorldCom There are many reasons that had led to collapse of the telecom giant, WorldCom. However, few of them had played relatively greater roles to bring about the downfall. The first reason was the economic problem that the company had been experiencing due to excess supply in telecommunications capacity (Tran, 2002). The company had taken a sudden decision of introducing fiber optic networks and planned for constructing infrastructure based positive projects, which helped in boosting growth of internet worldwide. Even so, as the recession struck worldwide, WorldCom along with other telecommunications companies encountered reduced demands for dot-com boom. The revenues of WorldCom had fallen below expectations and debt burdens increased as projects continued to fail (Jackson, 2006). The second reason behind the collapse was accounting manoeuvre. In the 25th statement of WorldCom that was published in July 2002, the company admitted that it had to pay about $ 3.8 billion as line costs for the capital expenditures and not for the current expenses (Addam, 2002). Line costs were those payments that the company used to make for using its communications networks, which consists of charges that are levied on transportation of messages of customers of WorldCom as well as access fees. It was recorded that about $ 3.055 billion and about $ 797 million were misrepresented in 2001 and during the first quarter of 2002, respectively (Addam, 2002). The company revealed that another huge amount of $ 14.7 billion was held as line costs in 2001, which was treated as current expense (Rapoport, 2010; McKenna, 2010a). The company transferred part of current expense to the capital account through which it increased both net income and assets. If the company had not manipulated the capital account, then it could have resulted in lower income in the subsequent years because of depreciation of the capitalized assets (Addam, 2002). Nonetheless, accounting of the company was questioned well before the 25th statement. It was noticed that in March 2002, Security Exchange Commission (SEC) had requested for data pertaining to a wide range of topics in the financial reports, such as, sales commission and disputed bills, charge against earnings pertaining to general customers in 2000, accounting policies that were followed during the merger and acquisition, cheap loans that were provided to Chief Executive Officers, accounting related to merger of WorldCom and MCI and lastly, earnings expectations of the Wall Street analysts (Sullivan, 2002). During July 2002, the company declared that it was encountering certain irregularities in reserve accounts. WorldCom established this type of accounts for cushioning predictable events like, tax liabilities for future (Mcclam, 2005). However, the company was not supposed to manipulate reserves for changing the reported earnings. Soon in August 2002, the company announced that it had not used the reserves properly and investigations revealed that reserve accounts were reduced to garner credits for the company against the line expenses (Ashraf, 2011). The third reason directs to mishandling of the accounts by auditors. In May 2002, Cynthia Cooper, internal auditors of WorldCom, had first identified that the line cost were being treated as capital expenditures (Addam, 2002). Cooper did her duty by discussing this misclassification with Scott D. Sullivan, financial officer and David F. Myers, controller of WorldCom, at that period of time. On June 12, 2002, Cooper also reported the issue to Max Bobbitt, who was then the head of audit committee, which operated under board of directors of the company. Bobbitt asked the external auditor, KMPG, to investigate regarding the issue (Reecce, 2011; ProQuest, 2009; Teather, 2002). On 16th May, 2002, the company had replaced the external auditor, Arthur Andersen LLP with KPMG. Sullivan was inquired to give justification to the treatment of the line cost as the capital expenditure. Later he was dismissed during June 2002 when there was the public announcement of 25th accounting statement. Mr. Myers also resigned during the announcement session. It was identified that Mr. Sullivan had not consulted with its external auditor, Arthur Andersen for classifying the line costs as the capital expenditures. However, Andersen had also maintained the misrepresentation and did not identify it to the company (Beltran, 2002; Martin and Milas, 2009). On 15th July, 2002, Tauzin who was the chairman of House Energy and Commerce Committee, had identified that internal documentation of the company and e-mails messages signalled that executives had knowledge regarding improper treatment of accounting since the year 2000 (Mandelbrot and Hudson, 2004). It is obvious that internal auditors form the line of defence for a company against any kind of accounting frauds and errors. So, it could not be understood that why internal auditors had taken more than a year time to identify the misclassification. They simply argued that amounts were capitalised and these had affected income and assets of the company (Todea and Stanciu, 2009; Teather, 2005; Hermanson, D. M. Ivancevich, and S. H. Ivancevich, 2008). The fifth reason can be cited as the fall in share price of WorldCom prior to announcement of the 25th statement of accounting. Before the 25th accounting statement was published in June 2002 highlighting the accounting problems, stock price of WorldCom had fallen from $ 64.50 per share less than $2 per share (Addam, 2002). After the announcement, price of the share had promptly fallen below $1 per share. The change in stock price had resulted from irregular accounting practices that were followed by the company. Decline of financial position of the company was basically owing to its changing economic prospects (Committee on Financial Services U.S. House Of Representatives, 2002). The accounting misrepresentation had harmed investors who had continued to buy shares of the company, hoping for greater return in the future. Also, the employees who owned company shares in their retirement plans had suffered losses due to slump in financial position of the company. It was observed than during 2000, 32% of the retirement funds, which amount to $642.3 million, were in forms of company shares (Neumeister, 2005). The investment had fallen below 4%, which amounted to about $18.7 million of funds (Romero, 2002). Hence, employees encountered huge loss due to weakened financial condition of the company. The investors also suffered for the same reason. The company wanted investors to sell the shares at low price (Laws, 2014). On 21st July, 2002, WorldCom had filed Bankruptcy Protection under Chapter 11. The main aim of Chapter 11 bankruptcy “is to keep the firm in business under a court-supervised rehabilitation plan”(Hitzig, 2002). The company reported that it had $103.8 billion as assets at the end of March 2002, but had to pay a debt of $41 billion. Hence, bankruptcy of WorldCom is regarded as the largest in the history of United States (Summon, 2011; The Economist Newspaper Limited, 2014). The sixth reason that can be highlighted for collapse of WorldCom was frequent switching of the telecommunications carriers by customers. On 1st July, 2002, under Bush Administration, it was announced that WorldCom was disqualified from the federal government contracts. A huge number of employees was fired and their number fell to 17,000 from 85,000 (Mitchell, 2003). All reasons mentioned above had contributed to collapse of the giant telecom company. The issue with the greatest contribution among above reasons was accounting manoeuvre. The internal and external auditors were accused of failing to perform their responsibilities appropriately. Following that, KPMG was appointed as the external auditor, but even this failed to bring about any considerable improvement in financial condition of the company. The Role of the Arthur Andersen in the collapse of WorldCom (Answer to Question 2) Arthur Andersen LLP was the external auditor firm, who was responsible for auditing the financial statements of WorldCom, before the collapse. It was regarded as the best accounting firm among top five accounting firms in the world. The company performed tasks of consulting services and auditing tax for renowned global corporations. The auditors play a pivotal role in the economy for preparing a flawless statement that is directed towards investors. The investors gain confidence by going through these reports, which are expected to be accurately prepared. According to the International Standard on Auditing the auditors prepare reports in order to sketch financial performance of a company as well as to examine the financial statement for any misrepresentation (Harvard Business Review, 2014; Chen and Zhang, n.d.; Dogar and Rowe, n.d.). The role of an auditor is not only to anticipate future incidents, but also to bear responsibility of ensuring that a particular company presents a fair view of its financial performance to public. However, it had been noticed that Arthur Andersen LLP was not successful in performing its duty towards WorldCom. It could not identify misrepresentation of the line of cost, which was framed as capital expenditure. When they identified the fraud, they did not mention so in the audit report, thereby failing to perform their exact duty. Despite being aware of the fraud, internal auditors of the company did not confide it to the external auditors. So, investors were fooled as they invested more in the company shares, anticipating a higher return in future (Alvarez, 2013). Lord Justice Lopes of Appeal Court had stated that auditors are “watchdog but not a bloodhound” (Sarup, 2004). He advocated that main duty of the auditors is to work on their skills and warn the companies regarding fraud and misstatements in the financial statements. They are not detectives and should not approach their work with suspicion; rather, they should adopt approaches that will detect mistakes and assist companies to rectify the same. Thus, auditors are referred as watchdog and not a bloodhound (Dunphy, 2009; McLean and Elkind, 2003). The famous judgment made by Lord Justice Lopes unintentionally had shaped philosophy for the audit profession for centuries to come. Similar to a watchdog, the auditors formulated and adopted passive approach to auditing along with inherent presumptions that representations done by the management of institutions or companies can be relied upon. It can be concluded that Andersen LLP failed to perform the duty of a watchdog and instead, contributed to WorldCom’s downfall. The major issue regarding misrepresentation of the line of cost contributed the most to collapse of the company (McKenna, 2010). The misrepresentation of the line of cost was hidden by WorldCom’s internal auditors when they had approached the external auditor, Arthur Andersen LLP. Andersen was not informed about the fact that WorldCom had capitalised the line of cost that was irrelevant to accounting policies. It was pointed out that Andersen should have detected the misclassification by rigidly designing the audit. Despite great magnitude of the misclassifications, the external auditors could not initially recognize the fraud. Nevertheless, they later on was able to identify, but had not disclosed it to the company. This had worsened the company’s financial condition. It was claimed that the external auditor should have considered the increasing instability in financial condition of WorldCom as an indication of undesired expense. Rather they focussed on the aggressive accounting practices (Dunphy, 2009). Andersen did not comply with the main areas of audit profession as the company had not formed a robust audit team and procedure in order to detect misrepresentation done by the company’s financial officers. The company was unable to perform their basic duty. There was violation of the audit standards, as per which audit firms should abide by the set rules and regulations. They did not follow the accounting principles that were formulated by the accounting officials of US in form of GAAP. The expenses disguised as capital expenditures signify initial mistake of the audit firm, which was ignored during the audit process. There were evidences in the court against Andersen regarding its failure to correctly examine the treatment of line costs by WorldCom. The audit firm relied upon financial reports of the company and did not verify the accounts. The District Court of United States had declared that Andersen should have revealed the fraud by the way of conducting a fair review during the audit process. Elements of the audit quality – WorldCom Case According to the International Standard on Auditing, the main elements of audit quality are independence, ethics, integrity and objectivity (IAASB, 2014; KPMG, 2013). The audit quality basically judges the duty of the auditors since it denotes whether the auditor is successful enough to review the audit process carefully. The audit is independent of any biasness. If biasness is there then the statement analysis is questioned for its accurateness. The biasness in the statement analysis harms the ethics of the auditing and also breaches the audit standard. Independence, ethics, objectivity and integrity should be maintained by the auditors in order to give justice to their audit profession. The independence of few accountants in case of WorldCom had led to the disastrous end. The company could have implemented different channels for communication, which could have given company employees the chance to blow whistle against the fraud. The scandals basically revolved around ethical issues on part of the accountants. The bad debts were concealed by the controllers of WorldCom so as to increase the reported earnings (Centre for Audit Quality, 2014). The controllers should have blown the whistle on identifying the issue and subsequently, protected integrity of the company; instead, they encouraged financial accountants to hide the expenses as capital expenditure, which had no effect on net income or asset of the company (Sikka, 2009). The issue of the misrepresentation was first highlighted by an internal auditor of the company, Cynthia Cooper, on May 2002. She had initiated an investigation on capital expenditure of the company, which eventually brought the malpractices into light. Therefore, it can be concluded that accountants and auditors, who had prepared and audited the accounts, should have followed the basic rules of ethics during preparation of the accounting statements. If they had performed their tasks appropriately, then WorldCom could have avoided such a disastrous ending. Conclusion WorldCom, the second largest long distance Telecommunication Company, collapsed due to several reasons but the major one was the accounting scandal. The internal auditors and the accountants did not follow the general accounting principles and breached the policies that should be obeyed by the company. The internal management of the company framed the line of cost of the company as the capitalised expenditure which is irrelevant and wrong according to the accounting principles. This not only affected the net income of the company in the later years of 2002 but the company encountered bankruptcy as the debt burden increased. Arthur Andresen LLP, the external auditor of the company, was blamed for the incident since it did not recognise the misrepresentation in the initial stage and did not also follow a strict review for auditing. All the reasons have lead to the collapse of WorldCom and it not only affected the employees of the company but it also affected the economy as a whole. Reference List Addam, P., 2002. Worldcom Fraud Was Brazen, Easy To Spot, Experts Say. [online] Available at: [Accessed 28 April 2014]. Alvarez, A., 2013. Truth and Consequences: Lessons from WorldCom. [online] Available at: [Accessed 28 April 2014]. Ashraf, J., 2011. The Accounting Fraud @ Worldcom: The Causes, The Characteristics, The Consequences, And The Lessons Learned. [pdf] Springer. Available at: [Accessed 28 April 2014]. Beltran, L., 2002. Worldcom Files Largest Bankruptcy Ever. [online] Available at: [Accessed 28 April 2014]. Centre for Audit Quality, 2014. Audit Quality Reporting. [pdf] Centre for Audit Quality. Available at: [Accessed 28 April 2014]. Chen, H. and Zhang, M., no date. Audit Reaction on Financial Crisis. [pdf] n.p. Available at: [Accessed 28 April 2014]. Committee on Financial Services U.S. House Of Representatives, 2002. Problems at Worldcom. [pdf] Committee on Financial Services U.S. House Of Representatives. Available at: [Accessed 28 April 2014]. Dogar, R. and Rowe, S., no date. Asleep At The Wheel (Again)? Bank Audits During The Lead-up To The Financial Crisis. [pdf] n.p. Available at: [Accessed 28 April 2014]. Dunphy, J., 2009. Who is to Blame for the Financial Crisis? [online] Available at: [Accessed 28 April 2014]. Harvard Business Review, 2014. Accounting Fraud at WorldCom. [online] Available at: [Accessed 28 April 2014]. Hermanson, D. R., Ivancevich, D. M. and Ivancevich, S. H., 2008. Tone at the top: insights from Section 404. Strategic Finance, 90(5), pp. 39-46 Hitzig, N., 2002. The Hidden Risk in Analytical Procedures: What WorldCom Revealed. [online] Available at: [Accessed 28 April 2014]. Humphrey, C., Kausar, A., Loft, A. and Woods, M., 2011. Regulating audit beyond the crisis: a critical discussion of the EU green paper. European Accounting Review. 20(3), pp. 431-457. IAASB, 2014. A Framework For Audit Quality Key Elements That Create An Environment For Audit Quality. [pdf] IAASB. Available at: [Accessed 28 April 2014]. Jackson, M., 2006. Grim realities of financial reporting. New Jersey: Cengage Learning. KPMG, 2013. Our System of Audit Quality Controls. [pdf] KPMG. Available at: [Accessed 28 April 2014]. Laws, 2014. All About WorldCom. [online] Available at: < http://finance.laws.com/worldcom > [Accessed 28 April 2014]. Lyke, B., 2002. WorldCom: The Accounting Scandal. [online] Available at: [Accessed 28 April 2014]. Mandelbrot, B. B. and Hudson, R. L., 2004. The (mis)behaviour of markets: A fractal view of risk, ruin, and reward. London: Profile Books. Martin, C. and Milas, C., 2009. Causes of the Financial Crisis: an Assessment Using UK Data. The Rimmi Centre for Economic Analysis, pp. 1 – 21. Mcclam, E., 2005. Former Worldcom Exec Describes Falsified Records. [online] Available at: [Accessed 28 April 2014]. McKenna, F., 2010. NY Fraud Case Against Ernst & Young Puts Feds In Bind. [online] Available at: < http://www.forbes.com/sites/francinemckenna/2010/12/20/ny-ag-will-file-fraud-charges-against-ernst-young-re-lehman/ > [Accessed 28 April 2014]. McKenna, F., 2010a. In Financial Crisis Autopsy Auditors Nowhere To Be Found. [online] Available at: < http://www.forbes.com/sites/francinemckenna/2011/01/31/in-financial-crisis-autopsy-auditors-nowhere-to-be-found/ > [Accessed 28 April 2014]. McLean, B. and Elkind, P., 2003. The smartest guys in the room: The amazing rise and scandalous fall of Enron. New York: Penguin Books. Mitchell, L. E., 2003. Lessons from Enron, how did corporate and securities law fail? The Sarbanes-Oxley act and the reinvention of corporate governance. Villanova Law Review, 48, pp. 1189–1215. Neumeister, L., 2005. Arthur Andersen Settles Worldcom Investors Lawsuit. [online] Available at: < http://mg.co.za/article/2005-04-26-arthur-andersen-settles-worldcom-investors-lawsuit > [Accessed 28 April 2014]. ProQuest, 2009. Preventing The Next Wave Of Unreliable Financial Reporting: Why US Congress Should Amend Section 404 Of The Sarbanes – Oxley Act. [online] available at: [Accessed 28 April 2014]. Rapoport, M., 2010. Role of Auditors in Crisis Gets Look. [online] Available at: [Accessed 28 April 2014]. Reecce, D., 2011. Auditors Should Not Be Blamed For The Financial Crisis Any More Than MPs. [online] Available at: [Accessed 28 April 2014]. Romero, S., 2002. Worldcoms Collapse: The Overview; Worldcom Files For Bankruptcy; Largest U.S. Case. [online] Available at: < http://www.nytimes.com/2002/07/22/us/worldcom-s-collapse-the-overview-worldcom-files-for-bankruptcy-largest-us-case.html > [Accessed 28 April 2014]. Sarup, D., 2004. Watchdog or Bloodhound? The Push and Pull Toward a New Audit Model. [pdf] Information Systems Audit and Control Association. Available at: < http://documents.routledge-interactive.s3.amazonaws.com/9780415508117/articles/watchdog.pdf > [Accessed 28 April 2014]. Sikka, P. 2009. Financial crisis and the silence of auditors. Accounting, Organizations and Society, 34 (6), pp. 868-873. Sullivan, A., 2002. Worldcom Cooked The Books Back In 2000. [online] Available at: < http://mg.co.za/article/2002-01-01-worldcom-cooked-the-books-back-in-2000 > [Accessed 28 April 2014]. Summon, 2011. Accounting Standards and Financials Reporting, Guilty For The Actual Crisis. [online] Available at: [Accessed 28 April 2014]. Teather, D., 2002. Architect Of Worldcom Collapse Is Jailed. [online] Available at: [Accessed 28 April 2014]. Teather, D., 2005. Ebbers Found Guilty Over $11bn Fraud At WorldCom. [online] Available at: < http://www.theguardian.com/business/2005/mar/16/corporatefraud.usnews > [Accessed 28 April 2014]. The Economist Newspaper Limited, 2014. Accounting For Change. [online] Available at: < http://www.economist.com/node/1200748 > [Accessed 28 April 2014]. Todea, N. and Stanciu, I., 2009. Auditor Liability In Period Of Financial Crisis. [pdf] Annales Universitatis Apulensis Series Oeconomica. Available at: [Accessed 28 April 2014]. Tran, M., 2002. WorldCom Goes Bankrupt. [online] Available at: [Accessed 28 April 2014]. Yahoo! Inc., 2007. WorldCom Scandal: A Look Back at One of the Biggest Corporate Scandals in U.S. History. [online] Available at: < http://voices.yahoo.com/worldcom-scandal-look-back-one-biggest-225686.html > [Accessed 28 April 2014]. Read More