It is one of the largest scandals yet at a time when almost every week seems to call forth another case of corporate wrongdoing. Telecom firm WorldCom, the No. 2 U.S. long-distance telephone and data services provider, announced on June 25 that it would have to revise its recent financial statements to the tune of $3.85 billion. Investors, analysts, and the public were left shaking their heads as previously reported profits suddenly turned out to be losses. The accounting irregularities were brought to light during an internal audit.

As everyone now knows, events have moved swiftly in the days since that declaration. CFO Scott Sullivan, who was once regarded as an accounting wunderkind, has been sacked. The Securities and Exchange Commission has charged WorldCom with fraud. As the prospect of bankruptcy seems near-certain, Wall Street has punished WorldCom’s stock, which was already in the pits even before the announcement; it closed at 10 cents on July 2. Analysts have warned that more bad news could be on the way, and that by the time the dust settles, WorldCom’s failure could be more expensive than Enron’s.

How did this happen? And even more importantly, how much confidence should investors place in companies’ financial statements? According to experts from Wharton and elsewhere, accounting reforms are essential – but it will take much more than that to restore integrity and accountability in the corporate world.

“What’s surprising about WorldCom is the very basic nature of what happened,” says Karen Nelson, a professor of accounting at Stanford Graduate School of Business. “Enron was all about complex partnerships and accounting for special purpose entities. But what WorldCom did wrong is something that’s taught in the first few weeks of a core financial reporting class. That’s why people are asking, given its basic nature and its magnitude, how could it have been missed.”

On July 1, WorldCom provided the SEC with a statement detailing what the company knew to date about its accounting problems. The statement explained that in 2001 as well as the first quarter of 2002, WorldCom had taken line costs — mostly fees associated with its use of third-party network services and facilities — and wrongly booked them as capital expenditures.

These transfers were apparently discovered by Cynthia Cooper, WorldCom’s vice president – internal audit. When informed about what happened, both the company’s current auditor, KPMG, and its former auditor, Andersen, agreed that these transfers were not in accordance with generally accepted accounting principles (GAAP). Following a review by the company’s audit committee, WorldCom’s board terminated Sullivan and accepted the resignation of David F. Myers, senior vice president and controller. The SEC suit came a day later.

“The transfer of obvious expenses into capital expenditures is absolutely fraudulent. There’s no excuse for this kind of misrepresentation. Almost everyone in the industry would agree that if you’re paying a service charge to lease local lines, that’s a clear expense,” says Robert A. Howell, a visiting professor of business administration at Dartmouth’s Tuck School who graduated from Wharton in 1962. Such expenses must be immediately recognized in the period incurred, unlike expenditures which can legitimately be capitalized as assets and depreciated over their useful life. WorldCom’s misrepresentation of these expenses led to an artificial inflation of its net income and EBITDA (earnings before interest, taxes, depreciation and amortization).

If the company felt that treating the line costs as capital expenditures was somehow correct despite the rules, as Sullivan claimed, this should have been made public earlier, notes Nelson. “Unlike the situation at Enron, the accounting issues here are much better defined. Sure, the CFO can try to argue that he believed the accounting was correct. But if so, why was it not disclosed in the first footnote in the annual report? If you think this is the way to handle those costs, put it in the footnote and make it transparent,” she says.

Auditors aren’t off the hook, either, she adds. “Certainly you can’t audit every single line, but I think even an application of basic sampling techniques should have unearthed this kind of entry. It seems to have been a pretty systematic procedure,” says Nelson.

Peter Knutson, emeritus professor of accounting at Wharton, characterizes the transfers as somewhat similar to embezzlement – in effect, siphoning money from one place to another. “What I suspect – though this is mere speculation – is that with the ’borrowed’ funds, the CFO may have felt that the company was going to be able to meet its obligations, and that this would tide WorldCom over until it made the money,” he says. “The writedown could be delayed, but it had to be done at some point, so I suspect he knew it wasn’t a healthy business.”

“There was no misstatement of cash, so in that sense, it’s not ’cash fraud.’ It’s just putting it in the wrong portion of the cash flow statement, as investing vs. operating cash,” says Nelson.

WorldCom’s statement to the SEC also revealed that the company is looking into some “material reversals of reserve accounts,” often referred to as cookie-jar accounting. “A reserve account could be an allowance for bad debt, for instance,” explains Howell. “Every time you make a sale, you make an estimate for uncollectible debt. As the bad debts are experienced, you write that off against the reserve. At the end of the year, it’s the auditors’ job to see whether the reserves were excessive, whether they were adequate, etc. They look at the history of bad debts and make a judgment. There’s some flexibility in this process in terms of when you choose to reverse the reserves. That bumps up your earnings.

“You can see this coming – you could calculate the percentage allowance for bad debt against receivables,” he notes. If it keeps changing dramatically from year to year, says Howell, it’s something to question. But many reserves aren’t necessarily reflected on the public financial statements, so people don’t often focus on it.

Warning Signs

It’s the million-dollar question: Could anyone have seen the writing on the wall? Peter Wysocki, a professor of accounting at MIT Sloan School of Management, notes that investors can look for certain red flags that might help in detecting potential earnings management and accounting fraud. He advises the following:

  1.  “Compare companies in the same industry and the same sector. For example, are the terms of leases similar? Are the allowances for bad debts the same? In the case of WorldCom, one could compare trends in capitalized investments and expenditures across companies. However, it is still often difficult to detect fraud because companies do not provide detailed information on specific trends in capital investments and expenditures.
  2. “Look at time trends in changes in cash flow versus changes in earnings as calculated under GAAP. If there is a wide and growing divergence in these numbers, this is a warning sign that managers may be manipulating them.
  3. “A useful early warning sign is a recent disagreement between a company, its managers, and its professional advisory firms. For example, did the firm recently change auditors or legal counsel? Also, did senior executives recently leave the firm under questionable circumstances? Did a senior executive leave because of potential disagreements about overly aggressive booking of sales?”

Nelson suggests that reserve accounts should also be scrutinized. “Wherever you see companies that always meet earnings expectations, and when you see consistently smooth earnings growth, you have to ask if they are creating a cookie jar to which they contribute in good periods and draw from in bad periods. Over the past couple of years, we’ve seen more difficult economic times. So can companies still show stable earnings growth? I think it’s important for analysts to exercise skepticism, to look at corporate governance, and to ask, Do we trust these people? Does this kind of growth make sense?”

Planned figures and actual figures can also provide a clue, says Howell. “If the amount planned for capital expenditures in 2001 was around $5 billion, and the amount actually reported was $8 billion, someone should have picked up on that, especially if they were following the company’s financial statements, and had a sense for the level of capital expenditures planned,” he notes.

Gaps in GAAP?

In light of the recent string of accounting scandals, some have called for changes to GAAP, asserting that the complexity and length of the accounting rules might entice companies to try to get around them.

Knutson believes that relying too much on the rules can create problems. “GAAP has pretty much done away with gray areas. If everything is black and white, I can structure a transaction so that it is just barely to one side of the line. Enron did something like this, often in accordance with GAAP. If there were gray areas, we’d be better off. It has removed professionalism from the auditors,” he says.

But changing GAAP won’t fix the problems, say many. “The cases of Xerox, Enron, and WorldCom demonstrate that U.S. managers still have incentives to commit outright accounting fraud,” says Wysocki. “Would an overhauled and less detail-oriented version of GAAP have prevented these cases of fraud? The answer is probably no. What appears to be the root of this problem is that many corporate insiders still sense that they have too much to lose (i.e., an immediate stock-price drop) if they quickly and truthfully reveal the company’s poor performance to outsiders. The benefits of gambling on accounting fraud appear to outweigh the potential costs of being caught for committing this fraud. This suggests that current U.S. civil and criminal penalties for committing accounting fraud are not strong enough to deter this type of behavior.”

Christian Leuz, a professor of accounting at Wharton, agrees, noting that the debate between principles and rules is often exaggerated. “Yes, you need specific guidelines for accounting, but you also need principles so people don’t game the bright lines that rules set. The U.K., for instance, has a provision that you can go against the rules if following the rules doesn’t provide a true and full view of a company’s accounts. So that way, the override can catch you. People point out that maybe the rules in the U.S. are too narrow. But actually, the U.S. accounting standards are based on principles — and they often do have overrides in there. So changing accounting standards alone is unlikely to fix the problem.

“Even if you have a strong system, strongly enforced by the SEC, shareholder litigation, etc., you can still have accounting manipulations,” he adds. “Managers may try to manipulate the numbers if they have the incentives to do so.  We need to fix the underlying governance and incentive problems first; then you will get higher quality accounting numbers,” says Leuz.

Caveat Investor

Leuz warns that investors need to be aware that financial accounting numbers are filled with estimates and judgments. “The public has to be skeptical to some extent, and must realize that there are certain judgments that can turn out to be wrong. Investors may have had too much faith in what an earnings number means. One cannot excuse what has happened — the recent allegations are about fraud and manipulations. But even when accounting rules are properly followed, there are always judgments.”

On June 28, the SEC called for CEOs and CFOs of large companies to personally certify the accuracy of their recent financial statements, and published a list of more than 900 firms, all with reported revenues totaling more than $1.2 billion, that will be asked to do so.

Leuz points out that there are many issues to think about when considering such measures. “On the one hand, we do need accountability, but one also has to be realistic about what the CEO can know about each transaction and the accounting thereof. In principle, it’s a good idea to hold managers accountable for companies’ financial statements. But it is difficult, if not impossible, for a CEO to be aware of and check every transaction. One has to be realistic about the job and the level at which the CEOs are seeing financial information. However, that doesn’t mean they should be off the hook. It is the responsibility of the CEO to make sure the people in the organization report the numbers in a trustworthy manner. It is probably correct to ask managers as well as auditors to stand behind the numbers.”

Knutson cautions that CEOs in huge companies cannot possibly be aware of all of their firms’ financial transactions. “How is a CEO to certify that the financials are accurate? Think of GE, for instance, and [former CEO] Jack Welch. Could Welch know whether the firm’s numbers were accurate? He had to rely on the controller, the chief accounting officer. He relied on the officer in the controller’s department whose job it is to prepare the annual report. They have to have people they can rely on.” The idea of CEO certification sounds good, and it makes for good press, says Knutson, but it’s not always realistic.

Nelson believes that making top brass responsible will help only if there is adequate enforcement. “I think that if there are teeth behind the rules, and there are consequences when something is fraudulent and you’ve certified it as CEO, then it will be effective. I think it’s reasonable to expect some kind of certification. After all, it’s their company, and they’re being paid – often very well – to manage it,” she says.

“People used to pick up a company’s annual report and think that it was hard fact,”  Nelson adds. “Now it’s just summer beach reading. They believe everything’s made up. I think this should definitely be of concern to the accounting profession.”

Auditing Responsibility

Strong internal and external control mechanisms are key, agree the experts. “External auditors generally perform an annual fiscal audit, where they are in once a year. But systematic problems as in WorldCom’s case, where numbers were misclassified quarter after quarter, should have been caught by the audit staff. Internal controls are more timely in many respects,” says Nelson.

“One can’t minimize the role of the CFO here; when you have a CFO who has an agenda and knows how to cook the books and how to deal with auditors, and who is aware of the auditing procedures, then he can direct auditors to look at what he wants them to look at, and the auditors aren’t being as skeptical as they should be,” she adds.

“The auditing task is not simple. If someone wants to hide things from auditors, they can probably find a way,” adds Leuz. “Auditors often adopt a risk-based strategy, where they look in areas thought to be most prone to contain errors. It is impossible to audit each transaction with the same level of scrutiny. So it is a daunting task. But that doesn’t mean people should get away with fraud. If that’s taking place at highest level, you’re accusing the CFO – so the internal auditor should have someone else to talk to.”

Wysocki notes that oversight bodies are increasingly cracking down on suspect practices in the industry. “Auditors who failed to provide independent assessments of firms’ accounting numbers in the past are now facing the penalties for such misdeeds. In this environment, regulators and other parties are unlikely to tolerate accounting firms’ providing both traditional auditing and consulting services to the same client. While one can say that ’competition for fees’ may have led to the current problems, the accounting firms are now paying the price for their shortsighted strategies,” he says.

Nelson agrees. “There’s definitely reform needed in the auditing industry. It’s been self-policing for far too long. It’s not necessarily a change in the rules that’s needed, but a hard look at who has oversight responsibility,” she adds.