audit failure

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Group 1

• WorldCom, first named LDDS (Long Distance
Discount Services), grew largely by
aggressively acquiring other
telecommunications companies in 1990s.
• For a time, it was the United State's second
largest long distance phone company (after

However, the year 2002 comes…
• In March, the SEC began to investigate
WorldCom as it reported large profit while
AT&T reported loss.
• In May, Arthur Anderson was replaced by
KPMG as the audit of WorldCom.

• In June, a small team of internal auditors at
WorldCom unearthed $3.8 billion in fraud and
made known of the company’s audit committee
and board of directors. Then, Sullivan, the CFO,
was fired; Arthur Andersen withdrew its audit
opinion for 2001; and SEC launched an
investigation into these matters.
• In July, WorldCom filed for bankruptcy
protection, in the largest such filing in United
States history at the time.

The fraud was accomplished primarily in two ways:
• Underreporting ‘line costs’ (interconnection
expenses with other telecommunication
companies) by capitalizing these costs on the
balance sheet rather than properly expensing
• Inflating revenues with bogus accounting entries
from "corporate unallocated revenue accounts".

Reasons for the fraud:
1. Internal control defects
2. Economic motivation
3. External Audit failure

1.Internal control defects
• Weak internal audit:
a. It didn’t cover financial
statement auditing;
b. It were not independent as
internal auditors was responsible
for CFO;
c. Its advices were not valued even
though reported drawbacks.

1.Internal control defects
• Management override: Corporate
headquarters asked subsidiaries to
adjust accounts directly, providing
no documentation or authorization
• Poor incentives: Financial incentive
program made managers eager to
make profit as managers’ bonus
was based on financial

2.Economic motivation
• Ebbers, the CEO, who owned a
large number of WorldCom
stocks, came under increasing
pressure from banks to cover
margin calls on his WorldCom
stock that was used to finance his
other businesses.
• WorldCom needed to keep high
price of stock to attract

2.Economic motivation
However, the actual situation was
as follows:
• Telecommunications industry
entered a downturn.
• And WorldCom’s aggressive
growth strategy suffered a serious
setback when it was forced to
abandon its proposed merger
with Sprint.
• Thus, WorldCom’s stock was

3.External audit failure
• General standard:
The examination should be
performed and the report
prepared by a person or persons
having adequate technical
training and proficiency in
auditing, with due care and with
an objective state of mind.

3.External audit failure
• Examination standard:
(ii) The auditor should obtain
an understanding of the entity
and its environment, including
internal control, sufficient to
identify and assess the risks of
material misstatement of the
financial statements whether due
to fraud or error, and sufficient to
design and perform further audit

3.External audit failure
(iii) The audit should obtain
sufficient appropriate audit
evidence to be able to draw
reasonable conclusions on which
to base the audit opinion.
But, the audit done by Arthur
Anderson went against the rules.

(a) Independence

Arthur Andersen service charged in WorldCom:$168,000,000

(a) Independence
The specific examples of independence violation:
• Arthur Andersen offered WorldCom consulting,
auditing and other services all together. And as
the above picture shows, earnings from auditing
is only one-fourth of the total profits Arthur
Anderson got from WorldCom.
• WorldCom is the biggest client Arthur Andersen
had in Mississippi, and they have been in
partnership for about...
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