From Equity Funding to WorldCom: Why Don’t the Auditors Get It?

By David R. Hancox, CIA, CGFM

Over the last several years, the auditing profession has been under siege. Auditors have been unable to find significant frauds that were occurring in the companies they were auditing resulting in the demise of one major auditing firm and a significant restructuring in the oversight of the auditing profession.

Congress responded to the corporate scandals by passing the Sarbanes-Oxley law. This law required companies to put in place internal controls over financial reporting, have senior management report on the internal controls and to have auditors attest to management’s assertions. While the law serves a useful purpose, it may not stop future frauds if auditors do not focus on the right issues.

The inability by auditors to find significant frauds goes back a long ways. In an October 1997 article for The Internal Auditor on Could the Equity Funding Scandal Happen Again, I concluded the failure to detect fraud in organizations being audited could occur to many auditors and audit organizations in today’s environment.

The fraud that occurred at Equity Funding happened during the late 1960s and 1970s. It included phony accounting entries, phony documents to support transactions, employees willing to carry out unethical acts, auditors willing to go along with management – instead of acting independently, and management acting aggressively in seeking to expand at a rapid rate and engage in activities that would cause unsuspecting people to take unnecessary risks.

The problems confronting the auditors at Equity Funding were classified as follows:

• The ethics and integrity of management and employees.
• Management’s philosophy and operating style.
• The independence of the auditors.
• Professional skepticism of the auditors.
• External impairments to the audit.

Arthur L. Berkowitz in his book, Enron: A Professional’s Guide to the Events, Ethical Issues, and Proposed Reforms cited this article and said, “Every one of these items seemed to reverberate at Enron: management willing to stretch the limits of the rules, auditors limited by their close relationships and desire to maintain a major client, even in the face of internal opposition; and flexible accounting principles that permitted off balance sheet transactions. What lessons did we miss?”

Now let’s examine what occurred at WorldCom and we’ll see the auditing profession simply had not learned from the past. A talent of leading organizations is to be a learning organization. The same applies for people who wish to be at the cutting edge of their profession – we have to continue learning. Unfortunately, the auditing profession did not pay attention to the Equity Funding scandal. It’s time we dramatically rethink our approach to audits and come up with new ways of doing business.

WorldCom’s Growth

WorldCom started in 1983 as a long distance telephone provider called Long Distance Discount Services, Inc. From its start through the 1990s, the company continued to grow and diversify its business through acquisitions. In 1998, it acquired MCI for $40 billion by using its highly valued stock. This merger made WorldCom the second-largest telecommunications provider in the United States.

During 2000, the telecommunications marketplace was a highly competitive environment. The increased competition resulted in deteriorating industry conditions as the marketplace sorted out the strong and weak competitors and supply started exceeding demand. Beginning in 2001, WorldCom found it increasingly difficult to meet Wall Street estimates for revenue growth and cash earnings per share. On June 25, 2002, trading in WorldCom stock ceased after disclosure of improper accounting practices.

Improper Accounting

• The improper accounting practices included:
• Transferring $3.8 billion in line cost expenses to asset accounts, resulting in an improved income statement.
• $2.065 billion in revenue improperly recorded under GAAP.

Other improper accruals to manage results, reclassification of expenses, manipulation of bad debt and tax accruals to improve income, improperly reducing depreciation expenses and improperly allocating costs and revenues between related entities.

The most significant part of the improper accounting related to line costs. Line costs are the costs of carrying a voice or data transmission from its starting point to its ending point. Most of WorldCom’s residential and commercial calls did not flow through its own lines. Rather, other companies provided this service. Therefore, the majority of WorldCom’s line costs were fees paid to lease portions of other companies’ telephone networks.

The Accountants Story

Every fraud is perpetrated by people. The WorldCom story has focused on the prime characters, CEO Bernie Ebbers and CFO Scott Sullivan. But frauds also have supporting characters. Just as the Equity Funding fraud included the accountant who made fictitious entries in certain receivable and income accounts, WorldCom had accountants who made fictitious entries.

As in any large organization, senior management really has to work through others to “get things to happen.” In trying to manage results, senior management had to work with the accountants to make the fictitious entries that would result in the appearance of improved financial performance. Toward that end, a number of ideas were pursued, the most significant one being to make general journal entries moving line cost expenses to capital accounts. This action – capitalizing an item – is one that is taught in accounting 101. If an item is to be capitalized, it has to have a useful life beyond a year, you have to have ownership and someone should be able to verify its existence. The accountants knew line costs at WorldCom did not have a useful life beyond a year because they really represented lease costs for lines owned by other telecommunication companies. They were simply day-to-day operating expenses.

Several accountants told their boss this transfer was not good accounting and should not be done. In fact, WorldCom had an internal accounting policy that prohibited it. Two of the accountants actually thought about resigning instead of making the improper accounting entries. Once senior management heard about the “rebellion” in the accounting department, they held a meeting with the accountants to explain why the entries were necessary (trying to fix the company’s financial problems) and assured them the proposed solutions were not illegal and that senior management would take responsibility for the accounting. Despite these assurances, the accountants continued to agonize over the decision, but ultimately, they rationalized their decision to comply with senior management’s request, agreed not to quit and to make the improper entries. Ultimately, one of the accountants went to prison and the other was sentenced to probation.

Once you start down a certain path, it becomes hard to extricate yourself. In the first quarter of 2001, $771 million in line costs were capitalized, but it didn’t solve the financial problems. Every quarter through the beginning of 2002 required adjustments, totaling more than $3.8 billion. The accountants were increasingly distraught, but were caught in a trap. The line cost transfers would have to continue through 2002 if the company was to meet its financial projections. Finally, the accountants had enough and decided not to make any more transfers. By that time, others were on to the fraud and it was too late for the accountants. Even though they hired a lawyer and confessed to Federal prosecutors, the prosecutors saw the accountants as instrumental to making the scheme work. They didn’t see them as whistleblowers at this late stage of the fraud.

The accountants in the Accounting Department were not the only ones who knew something was wrong at WorldCom. After the general journal was adjusted, it became necessary for the Property Accounting and Capital Reporting Group to adjust its records to reflect the increase in capital assets. Many people in this group knew there was no supporting documentation for these entries and expressed concern – but they did not go outside their group with their questions. One person, who was concerned about his immigration status, received a Post-it-Note from the accountants for an $818 million adjustment. Despite the lack of documentation and his concerns, he made the entry to the Property Accounting records and began actively looking for another job.

The Auditors Story

The Equity Funding scandal was exposed by a Wall Street analyst. When he realized the financial statements were fraudulent he said, “I went to [the CPA firm] truly believing I was doing this nationally ranked auditing firm a favor,” he said. “It [the firm] was about to certify a report I believed was fraudulent. Instead of reporting the matter to the SEC, the auditor applied the most narrow interpretation to his role and went directly to Equity Funding. When I asked him why he had done so, he replied, ‘They’re clients of mine.’ ‘Aren’t you independent auditors?’ I asked. `Sure we’re independent, but we have an obligation to our clients.”‘ It is this obligation to the client that has the potential to impair an auditor’s ability to draw truly independent conclusions.

Unfortunately, a similar scenario played out at Arthur Andersen, WorldCom’s auditors. According to the Special Investigative Committee of the Board of Directors of WorldCom, “…in a presentation to the Audit Committee on May 20, 1999, Andersen stated that it viewed its relationship with WorldCom as a long-term partnership, in which Andersen would help WorldCom improve its business operations and grow in the future. During the same presentation, Andersen told the Audit Committee that it incurred more auditing costs than it billed WorldCom, and that it considered the unbilled costs its [c]ontinuing investment in the Company. Andersen’s work papers documented that its internal targets for audit fees were not met in WorldCom’s case, but an Andersen senior officer nevertheless approved the continuation of the engagement.”

This attitude on the part of the auditors in viewing the organization being audited as a “partner” is the reason professional skepticism suffers. It’s not nice to think your client or partner is a cheater.

But there were numerous red flags the auditors ignored. The most egregious was the direct orders from WorldCom to make requests for documents, information and access to personnel through gatekeepers. Allowing the entity being audited to know ahead of time which records the auditor is seeking is folly. The auditors should have learned this lesson from Equity Funding.

At Equity Funding, the policy files the auditors requested would often be ‘temporarily unavailable.’ That night, a half-dozen to a dozen employees would work to forge the missing files to have them ready the next day. As one participant said, “It takes a long time and you have to be careful about date stamps and other details. But I had fun being the doctor and giving the guy’s blood pressure and all that.”

Incredibly, a similar scenario played out at WorldCom. In a report done for the United States Bankruptcy Court, the authors said, “Most of the schedules provided to Arthur Andersen that have been determined to be false or misleading were manipulated after they had been prepared by employees in the relevant reporting areas and provided to the Company’s former senior management for their review and approval prior to being submitted to the external auditors. While there is no evidence that the auditors were aware that schedules were being modified and manipulated at that level, the fact that they were being ‘herded’ through the Office of the Controller and head of Financial Reporting was well known.”

Keeping the auditors from talking to certain personnel helped WorldCom senior managers. The auditors sought to speak to certain employees of the Property Accounting and Capital Reporting Group, but the gatekeepers were intent on restricting access. The gatekeepers told the auditors the personnel they wanted to talk with were not the appropriate parties. The auditors accepted these restrictions.

Postmortem

The parallels between the Equity Funding and the WorldCom scandals should cause every professional auditor to pause and rethink how we approach our work. Let’s examine the parallels.

The ethics and integrity of management and employees.

The standards on internal control cite the need for ethics and integrity on the part of management and employees. Ethics and integrity are the foundation of a control system.

The Equity Funding scandal was a massive scheme, concocted by management and supported, on at least a passive basis, by a number of employees who knew or should have reasonably suspected something was wrong.

WorldCom suffered from a similar set of characters. Management wanted to present a financial picture that was different from reality. Employees without the courage to act ethically, passively went along with the scheme even though they may have agonized over the decision. I’m sure the decision the accountants made that allowed the scheme to occur would be different today. Serving time in prison changes your perspective.

All too often, auditors spend too much time trying to assess control activities (policies, procedures, segregation of duties) in an organization when in fact, major frauds do not occur because of a lack of policies and procedures. They happen because some managers lack ethics and integrity and because some staff members fear they will lose their jobs if they don’t comply with the managers’ requests. WorldCom had a policy that did not allow line costs to be capitalized. The reason line costs were capitalized is managers lacked integrity and accountants, without the courage to say no, made general journal entries at odds with the policy. As the sentencing judge for the accountants said, “…had [the accountant] refused to do what she was asked, it’s possible this conspiracy might have been nipped in the bud.” Assessing the ethics and integrity of management and employees is not as easy to do as assessing control activities but it is possible and, when done properly, it yields significant useful information.

Management’s philosophy and operating style.

Closely tied to management’s ethics and integrity is management’s philosophy and operating style. In the Equity Funding case, management was intent on becoming a giant conglomerate at all costs. Management was very aggressive, seeking to expand at a rapid rate and engaging in unethical activities. Management wanted to take over other companies, and these acquisitions required money. Therefore, it became critical to maintain Equity Funding’s stock price. To keep the value of the stock up, generating yearly earnings growth was important. The fraud began in 1965, when the CEO told the chief financial officer of Equity Funding to make fictitious entries in certain receivable and income accounts. By inflating these accounts, the earnings per share increased; and the stock price rose to levels higher than warranted.

WorldCom confronted a similar problem. The company’s principal business strategy was growth through acquisitions. As its expansion opportunities started to dwindle and the company fell short of financial targets, management directed the improper accounting entries so the company would appear to meet those targets. This also helped CEO Bernie Ebbers. His personal finances were in jeopardy because he would have to meet margin calls if the stock price of WorldCom declined.

The WorldCom auditors actually understood the risks confronting the company. They rated the company at a “maximum risk” because of the volatility in the telecommunication industry, the company’s future merger and acquisition plans, and the company’s reliance on a high-stock price to fund those acquisitions.

The independence of the auditors.

Most auditors claim to be independent; but often that independence is impaired by a variety of factors that affect their ability to “call it like it is.” The auditors at Equity Funding compromised their independence in a number of instances. The best example is in their thinking. As cited above, when the Wall Street analyst confronted the auditor about the potential fraud and why he would notify the company, the auditor responded, “…we have an obligation to our clients.”

Andersen viewed its relationship with WorldCom as a “long-term partnership” in which Andersen would help WorldCom improve its business operations and grow in the future.

This thinking that the organization being audited is a partner is troublesome. This notion impairs an auditor’s ability to draw truly independent conclusions.

Professional skepticism of the auditors.

In the Equity Funding case, the auditors missed the ongoing fraud, not because they lacked technical know-how, but because they did not follow the basics of auditing. Beyond analytical reviews and examining documentation, a fundamental tenet of auditing is to verify the existence of the asset. If the auditors missed 64,000 phony insurance policies, $25 million in counterfeit bonds, and $100 million in missing assets, they simply weren’t doing their jobs.

The WorldCom auditors also weren’t doing their job. When $3.8 billion in line cost moves from the income statement (expense) to the balance sheet (capitalized item), the auditors should be verifying it exists and that the item is owned by the company. Too often, auditors are focused on accounting records and documentation of transactions, but not on verifying the existence of the item. This lack of professional skepticism on the part of the auditors seems to be at the heart of every major scandal when the auditors fail to find the fraud.

Developing professional skepticism is a challenge. It requires the auditor to challenge conventional thinking; it requires the auditor to be willing to pursue issues until the auditor has sufficient, competent and relevant evidence that persuades the auditor of the correct conclusion. Too often, auditors are willing to accept a plausible explanation and not willing to get out of the office and in to the field to verify records they are reviewing.

External impairments to the audit.

External impairments to an audit occur when an auditor is deterred from acting objectively and from exercising professional skepticism by pressures, actual or perceived, from management and employees of the audited entity.

When auditors allow management extended time periods to pull records needed for the audit, they might as well pack up their bags and go home. Such a situation allows management to cull the records, add data that didn’t exist, clear out data that is harmful and generally to sanitize the information going to the auditors.

This is a shameful situation. I cannot think of a scenario that would require management to do the auditors’ work. If an auditee’s records are computerized, audit retrieval software allows auditors to review records without management’s help. If an individual auditor or the audit team is not proficient in using such software, they should decline such an engagement because they do not collectively possess the skills necessary to adequately complete the job.

This situation occurred at both Equity Funding and at WorldCom. The auditors made requests for information and records through designated individuals. In both cases, management provided fraudulent records to the auditors. Shame on the auditors for allowing it to happen.

Finally, Sarbanes-Oxley required the Securities and Exchange Commission to issue rules on internal controls over financial reporting. Unfortunately, the final rules defined internal controls over financial reporting as policies and procedures over financial operations. That’s too bad – most frauds do not happen because the company lacked policies and procedures. They happen for the reasons cited above.

Lessons Learned

Unfortunately, the auditing profession is not learning. Every major fraud has an autopsy done to learn how the fraud occurred. The auditors though, either do not read the reports produced on the frauds or choose not to learn its lessons. I believe the auditing standards in place provide a solid foundation for producing a quality audit. The failure takes place in executing the audit and in the critical thinking necessary to draw proper conclusions. This is partly perpetuated by the conflict inherent in the system we use to hire auditors. The external auditor fees come from the organizations that hire them. This creates an inherent conflict when tough calls must be made by the auditor. Is the auditor going to question the ethics and integrity of management and its employees when they want to get the contract for the audit next year? I said in the first Equity Funding article, “Until we develop a more rational system, we can not reasonably expect to have auditors who are truly independent in their thinking.” Nothing has changed to diminish that thought.

Professional skepticism is a difficult concept to teach an auditor. If the auditor lacks the ability to constantly ask questions, challenge answers received and to verify the answers, the ability to carry out the audit successfully is diminished. Professional skepticism is the cornerstone of the auditing profession and is fundamental to rooting out the frauds. It needs to be a focus of every audit organization.

Finally, failing to verify the existence of assets was the basis for not finding the fraud at Equity Funding and at WorldCom. It might sound simple to the average person, but verifying an assets existence and its ownership can be a challenge.

The Great Salad Oil Swindle illustrates the challenge. Anthony “Tino” De Angelis was president of Allied Crude Vegetable Oil. De Angelis got banks to float his company large loans secured by tanks full of, in effect, nonexistent salad oil. He was also able to get American Express auditors to certify the existence of his “inventory.” He hoodwinked the auditors because oil floats on water. He had storage tanks filled with water, put a couple of feet of real oil on top and he was able to convince the auditors he had a full tank of oil. He also moved the same “oil” between tanks while he took the auditors to lunch.

As I wrote in 1997, if we want to be worthy of public trust in our competence and credibility, we must be constantly diligent in meeting the standards of our profession and use due professional care. We must try to understand past mistakes, like those made by the Equity Funding and WorldCom auditors; and we then have to challenge ourselves to do better.

Copyright – December 2006