ACCT 622 Week 3 Discussion Board Forum 2 Thread/Case Study Example

Top-Side Entries in Plain Sight: The WorldCom Fraud and the External Auditor's Responsibility to Detect It

What WorldCom Did

WorldCom, the second-largest long-distance carrier in the United States, faced falling revenue and rising line costs, the fees it paid other carriers to complete calls, after the telecommunications boom ended in 2000. To keep its reported expense ratio steady, senior financial managers first released accruals that had been set aside for line costs and then, beginning in 2001, reclassified billions of dollars of line costs as capital expenditures. The entries were made at corporate headquarters, often in large round amounts, and moved costs from the income statement to prepaid capacity accounts on the balance sheet. The special investigative committee of WorldCom's board found that the company's internal audit department, not its external auditor, uncovered the capitalized line costs in 2002 and reported them to the audit committee, and that senior executives had restricted the external auditors' access to information (Beresford et al., 2003). In June 2002, WorldCom announced that it would restate its results, and it filed for bankruptcy the following month. The total misstatement eventually exceeded $10 billion.

How the External Audit Missed It

Arthur Andersen audited WorldCom with an approach that relied heavily on understanding the company's controls and on analytical procedures, comparing reported relationships with expectations, rather than on detailed testing of transactions. The committee's report concluded that Andersen did not test the capitalized amounts in a way that would have exposed them and did not obtain the detail behind the large journal entries that created them (Beresford et al., 2003). Analytical procedures were poorly suited to finding this fraud, because the entries had been designed to keep the expense ratio looking normal. A comparison that confirms management's target tells the auditor nothing if management chose the target. When the fraud is built to make the ratios look right, the ratios cannot reveal it.

Restricted Access as a Warning

The committee's account of how executives limited what the external auditors could see deserves separate attention, because it is itself evidence an auditor must weigh. The fraud standard treats a strained relationship with management, including denial of access to records, facilities or personnel and undue time pressure, as a condition that may signal fraud risk, and it expects the auditor to respond rather than to work around it (PCAOB, n.d.). An engagement team that is told it cannot have the detail behind a large entry has learned something important even before it sees the entry. The right responses include escalating the request to the audit committee, expanding substantive testing of the affected accounts and, in the end, declining to issue an opinion without the evidence. Treating limits on access as an inconvenience rather than as a red flag is one of the clearest lessons of the case, and it is a lesson about professional skepticism as much as about procedure.

The Auditor's Responsibility Under the Fraud Standard

Under the fraud standard, an audit is designed so the auditor can reasonably conclude the statements carry no material misstatement, whether it arose by mistake or by design, and the standard prescribes specific procedures (Public Company Accounting Oversight Board [PCAOB], n.d.). Before fieldwork, team members must talk through where the statements are open to fraud, approaching the question with professional skepticism. It must identify fraud risks, including the risk that management overrides controls. Most relevant here, it must examine journal entries and other adjustments for evidence of misstatement, with attention to entries made by unusual people, at unusual times, to seldom-used accounts or in round numbers, and it must evaluate the business rationale for significant unusual transactions. Each of these procedures pointed toward WorldCom's line cost entries: they were large, round, made at headquarters by senior staff and moved operating costs into capital accounts that rarely received such amounts. An audit that applied these procedures with skepticism would have had a reasonable chance of finding them, which suggests the failure was one of execution and judgment, not simply of deception.

What Research Adds

Hogan et al. (2008), reviewing the academic literature on financial statement fraud, report that fraud is more common at companies under pressure to meet expectations and with weak governance, and that management override is a recurring element, which describes WorldCom's position in 2001. Kuhn and Sutton (2006) analyzed the WorldCom entries and argued that a system of continuous assurance, monitoring transactions as they are recorded with automated rules, could have flagged the capitalization entries well before the year-end audit. Teaching cases built on the board's report reach a similar conclusion about the entries' visibility, noting that the scheme depended on a small number of large manual adjustments rather than on hidden transactions (Zekany et al., 2004). The research does not say the auditors could have found everything. It does say that this particular fraud left the kind of trail the standards now require auditors to follow.

A Christian Worldview Assessment

The people who made WorldCom's entries were not, for the most part, the executives who designed the scheme. Several were mid-level accountants who told investigators they objected but complied after being pressured by their superiors. Scripture warns against following a crowd in doing wrong (English Standard Version Bible, 2001/2016, Exodus 23:2). A Christian worldview takes seriously both the pressure those employees faced and their responsibility for what they recorded. It would have cost them their jobs to refuse, and some were later prosecuted for complying. The internal auditors who kept asking questions, working at night to trace the entries when they were told to stop, show the alternative: faithfulness that is costly, practiced by people with less authority than those they were questioning.

Conclusion

WorldCom, following Enron by months, persuaded Congress to pass the Sarbanes-Oxley Act and to require management and auditors of listed companies to report annually on the controls behind their numbers (Sarbanes-Oxley Act of 2002, 2002). Controls over journal entries became a central focus of those reports. The case's lesson for auditors is that reasonable assurance is not a defense when the procedures that would have found the fraud were available and not performed with skepticism. The internal auditors who uncovered the entries used no special tools; they asked for support, followed the accounts and refused to accept explanations that did not add up, which is all the fraud standard asks of the external auditor as well.

References

Beresford, D. R., Katzenbach, N. deB., & Rogers, C. B., Jr. (2003). Report of investigation by the Special Investigative Committee of the Board of Directors of WorldCom, Inc. WorldCom, Inc.

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Hogan, C. E., Rezaee, Z., Riley, R. A., Jr., & Velury, U. K. (2008). Financial statement fraud: Insights from the academic literature. Auditing: A Journal of Practice & Theory, 27(2), 231-252. https://doi.org/10.2308/aud.2008.27.2.231

Kuhn, J. R., & Sutton, S. G. (2006). Learning from WorldCom: Implications for fraud detection through continuous assurance. Journal of Emerging Technologies in Accounting, 3(1), 61-80. https://doi.org/10.2308/jeta.2006.3.1.61

Public Company Accounting Oversight Board. (n.d.). AS 2401: Consideration of fraud in a financial statement audit. https://pcaobus.org/oversight/standards/auditing-standards/details/AS2401

Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002).

Zekany, K. E., Braun, L. W., & Warder, Z. T. (2004). Behind closed doors at WorldCom: 2001. Issues in Accounting Education, 19(1), 101-117. https://doi.org/10.2308/iace.2004.19.1.101