3 The Anonymous Caller: Recognizing It’s a Fraud and Evaluating What to Do

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“Over the weekend I had time to think about the situation, and now I am even more

convinced that this is clearly fraud. My CEO and CFO have been arm-twisting the accounting staff

to book sales transactions before sales occur. They have recorded sales transactions for some of our

customers who regularly do business with us. The problem is, however, the customers have not

placed any orders with us for those transactions. Rather, the CEO and CFO are anticipating that the

orders will be coming in very soon based on the customers' prior ordering history. But, at this point

no orders have been received and no goods have been shipped related to the sales included in the

financials that have been submitted to the bank. The CEO and CFO noted that booking these kinds

of credit sales transactions is a common business practice, even if it isn’t technically compliant with

GAAP given that the transactions represent sales expected in the very near future, perhaps even next

week.”

“As it turns out, the CEO even instructed the accounts payable clerk, while I was out of

the office for a couple of days, to record entries the CEO had handwritten on a piece of paper. The

accounts payable clerk has never worked with sales and receivables. The CEO told the clerk, who

works part time while finishing his accounting degree at your university, not to mention the entries

to me, unless I specifically asked. In that event, the clerk was supposed to tell me that the entries

related to new sales generated by the CEO and that all was under control. Fortunately, the student

clerk is currently taking your auditing course, where financial statement fraud is a topic, and he was

uncomfortable with what had transpired. He immediately updated me on the day I returned about

what had happened. These bizarre entries make up almost half of our first quarter’s sales. Of course,

given that these are quarterly financial statements, they are unaudited. Because we are not a publicly

traded company, our external auditor has not performed any kind of interim review of the interim

financial statements.”

“Do you think this is limited to just one quarter?” Dr. Mitchell asked.

“I think so,” the caller replied. “As I mentioned, I joined the company three and a half months

ago. One of my first tasks involved closing out the prior fiscal year and assisting the external auditors

with the year-end audit. As best I can tell, these unusual activities began just recently given our poor

results in the first quarter of this year. Our company is a start-up enterprise that has been operating

at a net loss for a while. Just last week, the bank stopped clearing checks drawn off the company

account. They weren’t necessarily bouncing them, but they were not funding the line of credit until

the first quarter results were presented on Friday. Interestingly, the bank immediately started funding

the line late Friday and, I understand based on phone calls with my staff this morning, the bank is

continuing to fund the line this morning. I really think the earnings misstatements first occurred

this quarter and that the prior year audited financial statements are not misstated. Unfortunately, I

had to sign a bank commitment letter only two weeks after joining the company. That commitment

letter related to funding the loan right at the close of the last fiscal year. So, my signature is on file

at the bank related to prior-year financial results. But, given the current events, I refused to sign the

documents delivered to the bank on Friday. One of my accounting clerks resigned last week due to

similar concerns. Our vice president of human resources (HR) discussed the resignation with me

after learning about the clerk’s concern during a final exit interview. I might add, however, that the

HR vice president is the wife of the CEO.”

“Anyway, I’m just not sure what responsibilities I have to disclose the earnings misstatements

to outside parties. I am considering all sorts of options and thought I would see what advice you

could offer. What do you think I should do, Dr. Mitchell?”



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R EQ U I R E D

[1]

[2]

[3]



[4]

[5]



[6]



[7]

[8]



[9]



Do you think situations like this (i.e., aggressive accounting or even financial statement fraud)

are common in practice?

Which financial statement assertion related to sales transactions did management violate when

it issued the falsified financial statements?

The Financial Accounting Standards Board (FASB) and the International Accounting Standards

Board (IASB) recently completed a joint project to develop a common revenue standard for

U.S. GAAP and IFRS to improve revenue recognition practices and to remove inconsistencies

and weaknesses in revenue requirements. The updated guidance is contained in the Accounting

Standards Codification as Topic 606, Revenue from Contracts with Customers. Review that

guidance to summarize the core principle for recognizing revenue and briefly describe the

five steps needed to achieve the core principle. Also, describe how the core principle was not

achieved in this situation.

What types of audit procedures could an external auditor perform that might help the auditor

detect this fraudulent activity?

People who study instances of financial statement fraud often note that three conditions are

generally present for fraud to occur. First, the person perpetrating the fraud has an incentive or

pressure to engage in fraud. Second, there is an opportunity for that person to carry out the fraud.

Third, the person’s attitude or ethical values allows the perpetrator to rationalize the unethical

behavior. Describe examples of incentive, opportunity, and attitude conditions that were present

in this situation.

In 2014, the AICPA's Professional Ethics Executive Committee adopted a revised Code of

Professional Conduct that is effective December 15, 2014. Briefly describe how the new Code is

structured and indicate where would you find guidance about the importance of integrity.

(a) What would you recommend to the caller if you were Dr. Mitchell? (b) What are the risks of

continuing to work with the company? (c) What are the risks of resigning immediately?

What responsibility, if any, does the caller have to report this situation directly to the bank

involved? Before you respond, think about the risks present if the caller does inform the bank

and it later turns out that the caller’s assessment of the situation was inaccurate, i.e., there was

no fraud.

(a) What other parties, if any, should be notified in addition to the bank? (b) What concerns do

you have about notifying the external auditors?



[10] (a)



What pressures or factors will executives use to encourage accounting managers and staff to

go along with this type of situation? (b) What arguments can you use to resist those pressures?

(c) How does one determine whether a company is aggressively reporting, but still in the

guidelines of GAAP, versus fraudulently reporting financial information?



P R O F ES SIONAL JU DG M E NT QUESTION S

It is recommended that you read the Professional Judgment Introduction found at the beginning of

the book prior to responding to the following questions.

[11] One of the environmental factors affecting judgment is the "rush to solve" judgment trap. Briefly



describe that trap and how it applies to the situation affecting the anonymous caller.



[12] Consulting



with others is an important step in making important judgments. Could the state

board of accountancy be a source of advice?

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C A S E



Mark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

L EA R N ING OB JE C T IVE S

After completing and discussing this case you should be able to

[1]

[2]



Understand the pressures a person faces when he

or she becomes aware of an accounting fraud

Describe possible actions a person can take

when he or she suspects fraud may exist



[3]

[4]



Recommend characteristics of an effective

corporate whistleblower program

Describe key requirements in the Sarbanes−

Oxley Act related to whistleblower and code of

ethics processes for public companies



BACKGROUND1

Don’t ever tell yourself, “that won’t happen to me.” Just ask Cynthia Cooper, former Vice President

of Internal Audit at WorldCom.

Cynthia Cooper was a typical accounting student as an undergrad at Mississippi State

University. Raised in Clinton, Mississippi, Cynthia was “the girl next door.” Growing up in a family

with a modest income, she attended the local high school, worked as a waitress at the local Golden

Corral, and headed off to one of the state’s well-known universities.

After graduating from college, she later completed her Master of Accounting degree at

the University of Alabama and became a certified public accountant. Her career began like most

accounting graduates in the field of public accounting, working with one of the major accounting

firms in Atlanta.

Most likely, she never thought she would face the challenge of her lifetime before reaching

the age of 40. However, a few short weeks in May and June of 2002 changed her life forever. This

case summarizes how she unraveled a $3.8 billion fraud that ultimately grew to over $11 billion and

sent one of the country’s largest and most visible companies to its knees in bankruptcy. Consider

how you would have handled the situation if you had been in her shoes.



WORKING FOR WORLDCOM

Cynthia Cooper joined the company that eventually became WorldCom after returning from

Atlanta to her hometown of Clinton, Mississippi in the early 1990s. Following a recent divorce,

she moved with her two-year-old daughter to be closer to family. She first joined Long Distance

Discount Service (LDDS), which later became known as WorldCom, as a consultant in the finance

department earning $12 an hour. She left LDDS for a short stint to join SkyTel, a paging company,

but later returned to LDDS to head up its internal audit department in the mid-1990s.

1



Amanda Ripley, “The Night Detective;” Ricardo Lacayo and Amanda Ripley, “Persons of the Year,” Time, New York, December 30, 2002-January

6, 2003, Volume 160, Issue 27/1 pp. 32 and 45. Gary Perilloux, “WorldCom Whistleblower Speaks to Mississippi State University Students,”

Northeast Mississippi Daily Journal, November 18, 2003. Kurt Eichenwald and Simon Romero, “Inquiry Finds Effort at Delay at WorldCom,” The

New York Times, July 4, 2002, pg C-1.



The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and

Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective

handling of an administrative situation.



©



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WorldCom started as a small “mom and pop” company in the early 1980s. Bernie Ebbers

moved the WorldCom headquarters to Clinton, Mississippi, because it was the college town of his

alma mater, Mississippi College. By 1997, the company had emerged within the telecom industry

and caught the eye of many on Wall Street when it issued a bid to acquire the much larger and better

known company, MCI.

Cynthia Cooper enjoyed the rising status of WorldCom’s growth in the business community.

She was promoted to Vice President of Internal Audit in 1999, leading the internal audit function

in what became the 25th largest company in the United States. WorldCom’s stock price continued

to rise through 2000, and she and her colleagues dreamed of retiring early and starting their own

businesses. Cynthia dreamed of opening a bead shop and actually purchased a couple hundred

thousand beads that she stored in her garage.

Establishing internal audit’s role in the company wasn’t easy. WorldCom’s CEO, Bernie

Ebbers, was forceful about his distaste for the term “internal controls” and allegedly banned the use

of the term in his presence. At one point, Cynthia called a meeting with her boss, WorldCom CFO

Scott Sullivan, Bernie Ebbers, and a few others to help them see how an internal audit department

could help the company’s bottom line. Despite being almost 30 minutes late to the meeting, Ebbers

was the last person to leave the meeting. At that point, internal audit’s focus on efficiency of

operations became its primary charge, leaving the financial audit-related tasks in the hands of the

external auditor, Arthur Andersen, LLP. Cynthia, as Vice President of Internal Audit, would report

to the CFO, Scott Sullivan.

While WorldCom’s growth skyrocketed throughout the 1990s, the telecom market was

saturated by 2001 and WorldCom’s earnings began to fall. WorldCom executives began to feel

tremendous pressure to maintain their stellar track record of financial performance.



UNRAVELING OF A FRAUD

According to press reports, Cynthia Cooper and her internal audit team didn’t know about any

unusual accounting manipulations until March 2002. It wasn’t until a worried executive in a division

of WorldCom told Cynthia about the handling of certain expenses in his division. At that point,

Cynthia learned that the corporate office accounting team had taken $400 million out of the

division’s reserve account to boost WorldCom’s consolidated income.

As Cynthia and her team pursued the matter with WorldCom’s CFO, Scott Sullivan, she

immediately faced tremendous resistance and pressure. In fact, Sullivan informed Cynthia that there

was no problem and that internal audit shouldn’t be focused on the issue. She received a similar

reaction when she approached the external auditors at Arthur Andersen, who told Cynthia there

was no problem at all with the accounting treatment.

Fortunately, Cynthia did not let the intimidation of her boss or the opposition of a major

national accounting firm dampen her concerns about getting to the truth. In fact, Sullivan’s harsh

reaction only increased her skepticism surrounding the matter. She and others within the internal

audit team began to secretly work on the project late at night. At one point, they began making

backup copies of their files in response to fears that if their investigation was revealed, files might

be destroyed.

Within two months—at the end of May 2002—Cynthia and her team had unraveled the

key aspects of the fraud. They discovered that the company had erroneously capitalized billions

of dollars of network lease expenses as assets on WorldCom’s books. The accounting gimmickry

allowed the company to report a profit of $2.4 billion instead of a $662 million loss.

In some ways the fraud was simple. The corporate accounting team led by Sullivan had merely

transferred normal operating lease expenses to the balance sheet as an asset. The expenses were for

normal fees WorldCom paid to local telephone companies for use of their telephone networks and

were not capital outlays.



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