The WorldCom Scandal

Found in 1983 in Hattiesburg, Mississippi, WorldCom began its operation as a long

distance telephone service provider. The company rapidly grew to become the second largest in
the telecommunication market through the strategic acquisition of MCI Communications in the
late 1997. Arthur Andersen, who had just been at the focal of Enron scandal, was the
independent auditor of WorldCom. Although the accounting fraud was simple in nature, the size
of the fraud led WorldCom to become the largest insolvent company in the history of the US in
2002 (Jones, 2011).

Reasons for the financial scandal

WorldCom’s financial position collapsed in June 2002 when the company disclosed
reporting $3.8 billion of operating expenses as assets which was a major departure from the
expense recognition principle stated by Generally Accepted Accounting Principles (GAAP). The
company had capitalized expenditures that it had paid to third-party network service providers
for having access to phone lines, and included it with the property plant and equipment in the
balance sheet. This misclassification of revenue expense as capital had twofold effect. First of
all, by lowering expense WorldCom overstated its net profit and earnings per share making it
appear more profitable to investors. Secondly, the balance sheet reported assets that did not exist.

Another way by which WorldCom carried out the fraud was by manipulating reserve
accounts. These reserve accounts were specially prepared at the time of acquisition to cushion
future possible costs arising from business combination, like the cost associated with employee
redundancy or termination of lease. Although these reserves were only chargeable upon the
payment of such costs, WorldCom overstated and used them reversibly to increase earnings by
$2.8 billion between 1998 and 2000, violating the revenue recognition principle by GAAP.

WorldCom also overstated its asset and equity through overvaluation of goodwill
purchased during acquisition (Jones, 2011). Although companies are allowed to report the excess
of consideration given over the fair value of assets during acquisition as goodwill by GAAP, it
was also required to check for impairment of goodwill. In 2003, its total assets were found
overstated by approximately $11 billion. Bemie Ebbers, the president then, was also found to
leverage his fiduciary position to receive personal loans of around $366 million.
Role of Auditors

WorldCom’s case provided a rare example of internal auditors demonstrating ethical

professional conduct in situations where external auditors failed to show such. WorldCom’s
accounting manipulation was initially detected by its internal auditor Cynthia Cooper who
approached Arthur Andersen (WorldCom’s external auditor) with the issue. Ms. Cooper was
reprimanded for her act and asked not to discuss about WorldCom’s accounting information with
auditors, to which she realized the existence of an elaborate fraud. When KPMG replaced
Arthur Andersen in May 16, 2002, Ms. Cooper turned in the information to them (Lyke &
Jickling, 2002). Upon auditors’ inquiry, the management admitted to misclassification of
expenses which led to the dismissal of WorldCom’s Chief Financial Officer (CFO) Scott D.
Sullivan.

The role of Arthur Andersen in this case could not be reasonably traced; however,
questions arose of how the auditors failed to detect a misstatement that pervasive and material
(Jones, 2011; p-422). According to Lyke & Jickling (2002), approximately $750 million were
added to assets each quarter which could have caused the event to appear less risky than it was. It
was argued that auditors did not consider from the vulnerable financial position of WorldCom
that there was a possibility of the company going bankrupt following the issuance of audit report.
Therefore, the auditors took higher risk, failed to assess the risk of not detecting material
misstatement made by management to cover up losses, which in turn adversely affected their
audit procedure and accumulation of evidence before issuing audit report.

The users of financial statement rely on the professional judgment of the auditors to make
financial decisions. This creates a responsibility upon the auditors to conduct audit in a way that
the audit report could be considered reasonably assuring. Failure to assess risk increases the
possibility of material misstatement which may cause an adverse situation opined as clean in the
auditors’ report.
Effect of WorldCom scandal on audit practice, regulations and accounting standards

Many accounting scandals followed closely around the same time of WorldCom’s
scandal which raised a public outcry in the US stock market. The collapse of Enron and
WorldCom alone made investors lose around $254 billion and 320,000 employees redundant
(Ferrell, 2014). This called for a major reform in the US financial reporting landscape brought by
the Sarbanes Oxley Act passed by Congress in 2002. The Act prompted the establishment of the
Public Company Accounting Oversight Board and vested it with the power to make standards for
auditing and ethical conduct. The Board monitored the audit activities of certified public
accountants and initiated disciplinary actions against unethical conduct. The Act reinforced the
independence of auditors by limiting the types of non assurance services that can be provided by
their accounting firms, and stipulating the maximum amount of time they can work with a
particular company. The Act also extended responsibility of management in the creation of
independent audit committee and strengthening the internal control and responsibility of auditors
to assess the effectiveness of such control systems. In order to prevent fraudulent financial
reporting, the Act required CEO and CFO of the company to sign a report asserting the fair
presentation of financial information, keeping in mind that any future revelation of fraud will
penalize them.
Satyam

Found by B. Ramalinga Raju in 1987, Satyam Computer Services Limited became the
fourth largest multinational IT business in India. Price Waterhouse Coopers (PwC) India was the
external auditor of Satyam.The financial scandal of Satyam came into the light following Satyam
Company’s failed attempt to acquire Maytas Infrastructure and Maytas Properties owned by
Raju’s sons, with an intention to replace non-existent assets with real ones. 1 The size of
accounting fraud made by Satyam is so extensive that it is often compared to that of Enron,
WorldCom, and Parmalat.

Reasons for the financial scandal

The fictitious financial position of Satyam crumbled on January 2009 when B. Ramalinga
Raju publicly admitted to have had overstating the assets by Rupees 78,000 ($1.04 billion)
(KPMG, 2013). Simultaneously, the liabilities were also understated. It has been speculated that
Ramalinga Raju, who received global recognition as an exemplary leader in corporate
governance world, forged financial information to match the expectation of the market. Basilica
et al. (2012) has cited this as a classic example of management exploiting the fiduciary position
and neglecting ethical standards to achieve personal goals against the interest of the company
and stakeholders.

Raju produced numerous counterfeit bank statements to falsify sales and interest income
(KPMG, 2013). He embezzled the money transferred by the company to 6,000 fake salary
accounts perpetrated by him. The internal audit joined hands in this fraud by creating fake sales
invoices and non-existent customer profiles. This situation violates the key management
assertion because sales reported as income did not occur, and the balances presented in the
financial statement did not exist. According to an Indian based editorial The Statesman, Satyam
under the directives of Raju overstated the following account by respective by following amount
in the second quarter of financial year 2008-2009.

1
(The Statesman, Kolkata, 8 January 2009, p. 1)
 Table 1 Reported versus Actual Figures (in million Rupees) as at 30 September 2008

Particulars Reported Amount Actual Amount Overstatement

Revenue 27,000 21,120 5,880
Interest revenue 376 0 376
Cash balance 53,610 3,210 50,400
Debtors 26,510 4,900 21,610
Source: KPMG, 2013

It can be observed that revenue and subsequently operating profit of Satyam was inflated
by more than 27% of the actual amount. Over the course of year, cash balance and debtors were
overvalued by more than 15 times and 4 times the actual amount respectively to accommodate
false earnings. In addition to these, Satyam also underreported liability of approximately Rupees
12,300 million (Bhasin, 2016). More strikingly, the entire amount reported as interest revenue
never occurred.

Role of auditors

The auditors of PwC assured that the records of the company were being maintained
properly. The auditors had signed the accounts which were later revealed to have pervasive
amount of misstatement. The Institute of Chartered Accountants of India issued a notice to PwC
to produce a show cause letter explaining the plausible reason behind their failure to detect such
extensive and material misstatement in their audit procedures. According to the editorial The
Statesman, PwC defended the quality of their audit report by stating that the auditors did not find
any evidence of fraud by the management. However, the chances of the auditors not detecting a
single evidence of fraudulent bank statements or fake salary accounts or sales invoice have been
debated. At the same time, the fact that the audit fee of Satyam of increased threefold between
the financial year ending at 2006 and 2007 also received numerous speculations. This is because
while revenue only increased by 28%, the audit fee increased by 219% (Jones, 2011; p-244),
which made it difficult to justify the increase in audit fee. Nonetheless, PwC was only charged
for negligence in audit engagement. Audit is done on sample basis, thus, the chances that either
the auditor's sample missed misstatements or that the misstatement extrapolated from the sample
didn't exceed the tolerable limit exist. This is why, even in the presence of circumstantial
evidence, auditors cannot be charged guilty of fraud.

Effect of Satyam scandal on audit practice, regulations and accounting standards

 Following the scandal of Satyam, major changes were brought in corporate governance
code. In 2009, The Government of India passed a Bill containing modification of company
legislation and guidelines in Company Act 1956. Consequently, the Companies Act 1956 was
superseded by Company Act 2013. Corporate governance was constructively modified under the
provisions introduced in the Act.

Under section 149, various changes were brought in the corporate structure including
minimum and maximum numbers of directors (Minimum 3 directors in public company and 2
directors in private company), mandatory appointment of at least one female director and
mandatory appointment of independent director. In addition to this, The Act introduced stringent
conditions relating to recording maintain of transaction pertaining to related party transaction

The Act requires the companies to constitute four different committee including Audit
Committee, Stakeholders Relationship Committee, Nomination and Remuneration Committee
and Corporate Social Responsibility Committee. Satyam scandal had shaded light on the need of
adequate audit of financial. As such, the Act has given the responsibility of overseeing financial
reporting to the Audit Committee. To maintain the fairness of the Audit Committee, it must
comprise of at least 3 directors, majority of which must be independent directors, Satyam scam
was an example of management ignoring the interest and losses of shareholders. Considering
such, the formation of Stakeholders Relationship Committee was mandated to represent the
interest of the stakeholders. The chairperson of such committee must be a non-executive as
required by the Act. NRC was responsible to decide on the nomination and remuneration of
directors and the CSR committee was responsible for the implementation of CSR policies.

The new Act also addressed the shortcomings of Companies Act 1954 regarding the role
of auditors. The Act promulgated that an auditor must take statutory break after 5 years of
auditing one client. The auditors are also restricted from providing non-audit services to audit
clients. The Act also introduced penalty and criminal punishment of auditors in case of
fraudulent activities.
1. E. Basilico, H. Grove and L. Patelli, “Asia’s Enron: Satyam,” Journal of Forensic &
Investigative Accounting, Vol. 4. No. 2, 2012, pp. 142-160.    [Citation Time(s):1]
The Kanebo Fiasco

Based in Japan, Kanebo was one the largest producer of cosmetics and textile that grew
rapidly in the local and international market since its inception in 1887. ChuoAoyama, who was
the external auditor of Kanebo when the scandal broke out, was an affiliate of the globally
renowned Price Waterhouse Coopers (PWC). Kanebo’s accounting fraud was disclosed during
the period when the company was going through a restructuring operation under the supervision
of a government-affiliated body- Industrial Revitalization Corporation of Japan (IRCJ). Suda
(2007) compared Kanebo’s accounting fraud to that of the Enron scandal in size and impact on
society as the largest ever amount of earnings manipulation in Japan.

Reasons for the financial scandal

Kanebo’s liabilities exceeded its assets starting as early as from 1996 and continued for
nine financial years through 2004. Financial Services Agency found evidence of Kanebo
falsifying the financial statements from the financial year 1998 when the Takashi Hoashi entered
the management as the president. The company reported a negative net worth only in the
financial year 1999 and 2003. This violated the listing rules of the Tokyo Stock Exchange which
delisted any firm with a negative net worth for more than three consecutive years. 

Between the financial years 1999 and 2003, the company overstated profit by around 28
billion and group net balance by 30 billion yen by reporting sales that did not occur and showing
incomplete records of expenses. The Japan Times reported some of the diverse methods used by
Kanebo’s management to inflate profit including sale of merchandise near the end of the
financial year just to repurchase them in beginning of the next financial year and deferred
advertising and sales promotion expenses.

Kanebo’s sold shares of the subsidiary to affiliated businesses partner near the end of the
financial year and bought them back later to avoid consolidating loss of approximately 66 billion
yen of 15 subsidiaries. The company had valued inventory without adjustment for obsolescence
and after the proper valuation of assets, inventory, and loans receivable from group companies,
overvaluation of balances as large as 121 billion yen was found. In the two financial years 2001
and 2002, accounting fraud conducted by management amounted to more than 160 billion yen
through misrepresentation of large negative income as a relatively small positive income. In
March 2003, findings of an internal investigation revealed accounting fraud estimated to amount
around 215 billion yen (The Japan Times, March 2006) and the negative net worth amounted to
be approximately 357.6 billion yen.

Over the span of five years, Kanebo’s management had window dressed the financial
position to the users until the situation of the company’s net worth became gravely negative,
leading to the financial scandal. It is speculated that the intention of the management in falsifying
accounting information was to prevent bank credit refusal due to negative net worth and to avoid
bankruptcy.2

Role of auditors

Kanebo’s case provides us an insight into the impact of auditors not being independent in
their attitude and act, and deviation from auditing standards. This is because the fraud was jointly
perpetrated by the management and auditors (Hamada, 2008). Two of the involved auditors of
ChuoAoyama had audited Kanebo for at least 15 years and one auditor for 30 years (Hayabusa,
2006). According to Konishi (2010) the close relationship between the auditors and client was
the root cause of this financial scandal. The auditors of ChuoAoyama issued a clean report
despite of having knowledge of the material misstatements in the financial information of
Kanebo.

In financial year 2001, the auditors did not disclaim losses amounting to 81.9 billion yen
and signed the audit report assuring fairness of the financial statement of Kanebo. The auditors
proceeded with their biased opinion in the subsequent year assuring a consolidated profit of 70
million yen profit and consolidated net assets of 926 million yen when consolidated losses for
the financial year amounted to 80.6 billion yen. The auditors not only issued fraudulent audit
report but assisted Kanebo’s management to conceal losses.

Although the auditors were sentenced to prison initially, the Judge took consideration of
the fact that the auditors had been forced to give up on their independence due to threat of
revelation of ChuoAoyama’s prior improper audit procedures by Kanebo’s management 3 The
Japanese Financial Services Agency (FSA) found evidence of ChuoAoyama’s involvement in

2
https://www.japantimes.co.jp/news/2005/04/14/national/kanebo-committed-200-billion-yen-accounting-fraud/
3
Knight Ridder Tribune Business News, 10 August 2006
the concealment of fraud of Kanebo and suspended the audit firm from carrying activities for
two months.

Effect of Kanebo financial scandal on audit practice, regulations and accounting standards

According to Konishi (2010) the Kanebo financial scandal called for major changes in
regulation in field of corporate accounting and auditing in Japan. The US Sarbanes Oxley Act
was used as guidance to the establishment of Certified Public Accountants and Auditing
Oversight Board (CPAAOB) in 2004, to monitor and supervise audit activities conducted by
accounting firms. After a rigorous revision of the Securities and Exchange Law by Diet, Japan,
the Financial Instruments and Exchange Law4 came into force in 2006 which was also known as
the Japanese Sarbanes-Oxley Act (J-SOX). This law mandated improvement of internal controls
of the company and reinforcement of the auditing standards.

4
Heisei-18-Nen Houritsu Dai-65-Gou (Law No. 65 of 2006)
Ferrell, O.C. "WorldCom's Bankruptcy Crisis.": 1-9. Daniels Fund Ethics Initiative. Web. 5
Apr. 2014.

Hamada, Y. (2008). Kaikei-Fusei: Kaisha no ‘Joshiki’ Kansanin no ‘Ronri’ (Accounting

Fraud: Corporate ‘Common Practice’ and Accounting Auditor’s ‘Logic’). Tokyo: Nihon
Keizai Shimbun Shuppansha.

Hayabusa, N. (2006). Kigyo-Sukyandaru to Kansa-Houjin: Naze Fushoji wa Zokuhatsu

surunoka (Corporate Scandals and Auditing Firm: Why a Succession of Scandals Occurred).
Tokyo: Sairyusha.

Konishi, T. (2010). Fraud by Certified Public Accountants in Japan and the United States.
Asian Journal of Criminology, 5(2), 99–107. doi:10.1007/s11417-010-9089-0 

https://www.researchgate.net/profile/Madan_Bhasin/publication/308916938_Fraudulent_Fin
ancial_Reporting_Practices_Case_Study_of_Satyam_Computer_Limited/links/57f75c0808ae
886b89833eef.pdf

Suda, K. (2007). Funshoku-Kessan to Kaikei-Sousa no Shosou (Aspects of Window-

Dressing Accounting and Accounting Manipulation). In K. Suda, T. Yamamoto, & S.
Otomasa (Eds.), Kaikei-Sousa: Sono Jittai to Shikibetsuhou, Kabuka eno Eikyou
(Accounting Manipulation: Its Realities, Identification, and Influence on Stock Prices) (pp.
2–58). Tokyo: Diamond.