How A Small Forensic Accounting Team Discovered A Gigantic Fraud

Posted on Wednesday, December 14, 2022 by Lydia SinclairNo comments

One of the most interesting aspects of forensic accounting jobs is that every major example of impropriety and fraud is caught by a surprisingly small moment.

In the case of Bernie Madoff, his entire empire unravelled because some of the greatest financial minds in the world realised the numbers did not add up. For Enron, the start of the fall came from a local Wall Street Journal article and a short-seller who quietly shorted its stock.

In the case of MCI WorldCom, it started with the suspicions of a single financial analyst who believed he was being asked to commit tax fraud. Within three months he had been fired, and barely 18 months later the then-largest bankruptcy filing in history was filed.

 

The Background Connection

MCI WorldCom was formed from two major telecommunications companies. The first was Microwave Communications Inc founded in 1963, whilst the other was founded as Long Distance Discount Services Inc in 1983, although by 1995 it had changed its name to WorldCom.

WorldCom largely grew through a range of mergers and acquisitions, which ultimately led to what was at the time the largest corporate merger in American history in 1997 between MCI and WorldCom, although by 2000 it was going purely by the latter name.

At one point, until the US Department of Justice and European Union concerns stopped it, WorldCom had planned to merge with Sprint Corporation to become the single largest communications company in America.

It became, by that point, the second-largest long-distance telephone company in the United States, but it was a success that, it was quickly revealed, had been built on a bubble, and the failure of that merger would have major consequences for the company and its CEO, Bernard Ebbers.

After the dot-com bubble began to burst near the tail-end of 2000, WorldCom’s board of directors authorised a series of loans to Mr Ebbers to meet margin calls on WorldCom shares to stop him from being forced to sell, believing he could find a way to navigate the more complex telecommunications landscape.

Amidst this uncertainty, a financial analyst was given a request which began a chain of events that brought WorldCom down.

 

One False Move

Kim Emigh was a financial analyst for WorldCom when in December of 2000 he was asked to allocate capital projects labour for a network systems division project as an expense, rather than assigning it as a capital project.

This would potentially have taken $35m off of WorldCom’s capital spending, but Mr Emigh believed it was not necessarily legal.

He escalated his concerns about tax fraud up to an assistant to WorldCom’s COO Ron Beaumont, which led to the directive being rescinded a day later. However, Mr Emigh would receive a reprimand for his decision and would be laid off just three months later in March 2001.

It turned out that this was one of two main parts of a major accounting fraud, alongside booking line costs as capital expenditures and adding accounting entries from “unallocated” corporate revenue accounts. These fraudulent entries added up to over $3.8bn.

A year later, an article with an interview by Mr Emigh caught the eye of Glyn Smith, an internal audit manager, who informed his boss, internal audit unit vice president Cynthia Cooper, that it may be prudent to start their audit of capital expenditure earlier than planned in May 2002.

By June, after a secret investigation by Ms Cooper and senior associate Eugene Morse, they found a huge number of fraudulent entries. This led to a wave of resignations as well as the withdrawal of accounting firm Arthur Andersen, who were still reeling from their involvement in the Enron scandal.

This then led to a formal SEC investigation, which found that the company had overinflated its asset value by over $11bn, and WorldCom filed for bankruptcy on 21st July 2002 in a filing that was only overtaken by Lehman Brothers and Washington Mutual in 2008 during the peak of the subprime mortgage crisis.

 
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