Financial Statement Analysis (22E00100) Assistant Professor Henry Jarva Aalto University

Transcription

1 Financial Statement Analysis (22E00100) Assistant Professor Henry Jarva Aalto University

2 Accounting Fraud at WorldCom

3 Backgound For a time WorldCom was the United States's second largest long distance telephone company (after AT&T). In June 2002, WorldCom announced that it intend to restate its financial statements for 2001 and the first quarter of in July 2002, WorldCom filed for bankruptcy protection. The WorldCom scandal was, until the Madoff schemes came to light in 2008, the largest accounting scandal in United States history. 3

4 Telecommunication industry The telecommunications industry evolved rapidly in the 1990s. Deregulation act of 1996 was intended to foster competition (it permitted long-distance carriers to compete for local service). Companies attempted to have the capacity to provide their customers a single platform for all telecommunications services. WorldCom became a full-service telecommunications company through big M&As. WorldCom s growth through acquisitions had come to an end in 1999 when the U.S. Department of Justice refused to allow the Sprint merger. 4

5 Corporate Culture WolrdCom s growth through acquisitions (more than 60 acquired companies) led to a mix of people and cultures. Each department had its own rules and management style. CEO Ebbers refused to create a corporate code of conduct ( colossal waste of time ). Culture from the top-down was that employees should not question their superiors. Internal Audit reported directly to CFO Sullivan. Weak board. 5

6 Sales and Expenses WorldCom focused on building sales and aqcuiring capacity to handle expected growth. Sales growth was a key to increase the company s market value. Managers were willing to take economic actions that could have negative long-term consequences to bring sales in the door. WorldCom entered into long-term fixed rate leases for network capacity in order to meet the anticipated increase in customer demand. The leases contained punitive termination provisions. That is, WorldCom would pay for unused line capacity if customer traffic failed to meet expectations. 6

7 Downturn Industry conditions began to deteriorate in 2000 due to highted competition, overcapacity, and the reduced demand for telecommunications services (the dot-com bubble collapse). Existing companies and new entrants were drastically reducing their prices, and WorldCom was forced to match. The competitive situation put severe pressure on WorldCom s most important performance indicator, the E/R ratio (line costs to revenues), closely monitored by analysts and industry observers. 7

8 Common-size income statements 8

9 WorldCom s statement in 10-K 9

10 Accrual Releases WorldCom estimated its line costs monthly. Bills for line costs were often not received or paid until several months after the costs were incurred, GAAP required the company to estimate these expected payaments and match this expense with revenues in its income statement. Since the bill had not been paid, the offsetting entry was an accounting accrual to a liability account for the future payment of the bill (cash outflow). GAAP allows the company to reverse (or release) some of the accrual if the bills came in lower than estimated. 10

11 Accrual Releases Throughout 1999 and 2000, CFO Sullivan told staff to release accruals that he claimed were too high relative to future cash payments. Sullivan directed controller Myers to deal with any resistance from senior managers to accrual releases. Over a seven-quarter period between 1999 and 2000, WorldCom released $3.3 billion worth of accruals, most the direct request of Sullivan or Myers. Several business units were left with accruals for future payments that were well below the actual amounts they would have to pay in the subsequent period. 11

12 Expense Capitalization By the first quarter of 2001, so few accruals were left that this tactic was no longer available to achieve the targeted E/R ratio. Sales, however, continued to decline. How to maintain the 42% E/R ratio? Sullivan devised a creative solution: capitalization excess capacity. GAAP requires operating costs to be expensed. WorldCom incorrectly recorded certain operating expenses as capital expenditures, effectively overstating net income, was considered a cost or expense-related restatement. 12

13 Capital Expenditures As reported to board 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2,648 2,418 2,235 2,033 1,786 1,785 1,250 Actual spend 1,691 1,473 1, The board received information that reflected a steady decrease in capital expenditures. However, the spending cuts were far greater than they were led to believe. 13

14 Balance Sheet Assets 14

15 Balance Sheet Liabilities Year Sales Net Income CFO Assets Liabilities

16 Red Flags? Even ex post it is very difficult to see that WorldCom was cooking its books. WorldCom was doing better than other firms in the industry. In the 1st Qtr of 2002, line costs are holding steady at about 42% of sales. That s odd because line costs as a percentage of sales are arising at AT&T and other companies in the industry. WorldCom decided several years ago to lease large amounts of network capacity instead of building its own global communications network. These leases call for fixed rental payments. The same rental payment each month combined with lower traffic revenue should produce an increase in line costs as a percentage of sales. However, minimum rental commitments are missing from 2000 and 2001 annual filings. 16

17 Selected WorldCom False Statements Form Reported Line-Cost Expenses Actual Line-Cost Expenses Reported Income* Actual Income 10-Q, 3rd Qtr ,867 4,695 1, K, ,462 16,697 7,568 6, Q, 1st Qtr ,108 4, Q, 2nd Qtr ,730 4, (401) 10-Q, 3rd Qtr ,745 4, K, ,739 17,754 2,393 (622) 10-Q, 1st Qtr ,479 4, (578) All numbers in $ millions * before Taxes and minority interest 17

18 The Outside Auditor: Arthur Andersen WorldCom s auditor from 1990 to 2002 was Arthur Andersen. Andersen reviewed processes, tested systems, and assessed whether business unit groups received correct information from the field. Its auditors assumed that the information recorded by General Accounting was valid. Between 1999 and 2001, Andersen s risk management software program rated WorldCom as a high-risk client for committing fraud, a conclusion that its auditors upgraded to maximum risk because of volatility of the telecommunication indistry, the company s active M&A plans, and its reliance on a high stock price for acquisitions. The Andersen audit team for WorldCom did not modify its analytical audit approach and continued to audit WorldCom as a moderate-risk client. 18

19 The Outside Auditor: Arthur Andersen Andersen could have identified fradudelent topside entries (accrual reversals and capitalized line costs) from a review of the company s general ledger, its primary transactional accounting record. WorldCom repeatedly refused Andersen s request to access the computerized general ledger. Andersen s analytical review procedures, properly performed, should have triggered a search for accounting irregularities. WorldCom also witheld information, altered documents, omitted information from requested materials, and transferred millions of dollars in account balancesti mislead Andersen. Andersen rated WorldCom s compliance with requests for information as fair, never informing the audit committee about any restrictions on its access to information or personnel. 19

20 The Fraud Discovery In March 2002, SEC sent a WorldCom a request for information. The SEC wanted to examine company data to learn how WorldCom could be profitable while other telecom companies were reporting large losses. By the beginning of June, internal audit team discovered $3 billion in questionable expenses. On June 20, CFO Sullivan and controller Myers were fired. On June 25, WorldCom announced that its profits had been inflated by $3.8 billion over the previous five quarters. On June 26, the SEC initiated a civil suit of fraud against WorldCom. 20

21 Short-term Consequences Shareholder class action lawsuits were filed against the company and its management. The SEC sued the company for accounting fraud and launched its own investigation. The company defaulted on a $4.25 credit line and was negotiating new payment terms with more than 30 banks. In mid-july 2002, WorldCom filed for bankruptcy. The company was saddled with more than$40 billion in debt and had less than $10 billion in assets that could be readily converted into cash. 21

22 Epilogue Arthur Andersen was never held to account for its WorldCom audits (because of Enron case). The company wrote down about $82 billion (more than 75%) of its reported assets. Company founder and former CEO Bernard Ebbers was sentenced to 25 years in prison, and former CFO Scott Sullivan received a five-year jail sentence, which would have been longer had he not pleaded guilty and testified against Ebbers. 22