Case Essays

Case Essays Case Essay Case Essay It described the ordeal of Kim Neigh, a former World financial analyst who was laid off from the company after complaining for many years about potential abuses related to capital spending. Glen Smith, a senior manager in Internal Audit, suggested to Cooper that they do an internal audit of capital expenditures immediately. Cooper agreed. The first sign of a problem was when one of the Finance directors provided capital spending schedules for the audit and two of them disagreed in amount. The director said the difference was due to something called prepaid capacity. When asked to explain the director couldnt and said that David Myers, the controller of World, provides the data to record. He added: David provides [me] with the amounts for [the] schedule. Later on a member of the internal audit team with technology knowledge, Gene Morse, is asked to examine the system and see if there was anything designated as prepaid capacity. Morse found prepaid capacity amounts Jumping all over the place, from account to account. There were numerous examples of items moved from account to account apparently to mask the true nature of the expenditures. As news breads of the internal audit of capital expenditures, Myers suggested that the team was wasting its time on the audit and that their time would be better spent to find ways to save money in operating cost. The reaction of Myers only made Cooper more suspicious of what may really be going on. Cooper then approached Farrell Malone, the external-audit partner at KEMP, the firm that replaced Andersen after its collapse following the Enron audit. Cooper explained about the movement of amounts to accounts and unexplained prepaid capacity designations. Farrell recommended not going to the audit committee at this time. Still, Cooper decided to take a closer look. Morse downloaded thousands of entries searching accounts with more than 300,000 transactions each month spread across a hundred legal entities. Cooper learned that Scott Sullivan, the CUFF, had found out about the audit. He questioned Morse about the work. This increased Coopers suspicion since Sullivan rarely took such a direct interest in an internal audit matter. She asked her staff what they thought about Morsels discovery. Most believed there is a good explanation. But Cooper knew as auditors they were obligated to stay with leads and keep reviewing the issues. At times, it is a slow, plodding process of checking and re-checking facts, developing theories, trying to find connections, and thinking through the issues until you get it right. On June moving large amounts from the income statement to the balance sheet $743 million in the third quarter of 2001, $941 million in the fourth quarter of 2001, and $100 million in the first quarter of 2002. The auditors went about tracing the amounts from account to account through the system to see where they landed. The next morning Cooper received a message that Sullivan wanted to speak to her right away. He talked about becoming more involved in internal audit matters, an unusual step for him. Cooper also overheard a conversation while in Sullivan office that Max Obit, the chairman of the Audit Committee, would be leaving the audit committee. This was of concern to Cooper since she reported functionally to the Audit Committee and administratively to Sullivan. The Audit Committee provided Internal Audit with independence from management. She worried that the conversation may have been for her benefit to inform her that Obit may not be there to support her. Cooper was prepared for the meeting. She asked Sullivan bluntly about prepaid capacity. He explained that it represented costs associated with no or low-utilized Sonnet Rings and [telecommunication] lines which were being capitalized. He stated: While revenues have declined, the costs related to certain lease are fixed, creating a matching problem. Although not clear at the time, Cooper came to realize that the amounts represented costs related to the companys leased fiber [optic] lines that had little or no customer usage because of the implosion of telecommunications in the late sass and early sass. The company continued to pay for the leased capacity UT they brought in little, if any, value. Instead of expensing the lease costs as they were incurred, the company reclassified the amoun ts as capital assets and expensed them over a longer period of time allowing it to stretch out the deduction to company earnings, buying time for revenue to catch up. Sullivan told her he was aware of the issues with the accounting treatment but they will be cleared up in the second quarter of 2002. At that time he said a restructuring charge related to prepaid capacity would be recorded effectively writing off most of the amounts that had been capitalized. After that, the company would no longer capitalize line costs as prepaid capacity, instead allocating these costs between a restructuring charge and an expense. Sullivan asked Cooper to postpone the audit until the third quarter of 2002 to look at the second quarter numbers. Cooper thought about what had transpired in her meeting with Sullivan. She realized that some aspects of accounting depended on Judgment. She thought, maybe the prepaid capacity was aggressive, but perfectly legal, accounting. She was uncomfortable with the matter in light of Farewells admonition not to go to the audit committee. Cooper called Obit to discuss the matter. She thought even though he was coming off the audit committee, that he would be interested in her findings. She told Obit that her staff had identified accounting entries made in the third and fourth quarter of 2001 and the first quarter of 2002 that totaled $2. 5 billion, and she was concerned about the accounting. Obit told her to meet with Farrell, the KEMP partner, to discuss the issues. The next day Obit came to town for an audit committee meeting and asked Cooper to meet with her and Farrell. At first, a stressed-out Obit chastised Cooper entries. Cooper felt she needed to have Obit focus on the real issue. However, Obit had already decided not to discuss the matter with the whole committee and he was supported by Farrell. At this point Cooper and Smith decided to interview Betty Vinson, the accounting director who entered some of the amounts into the accounting system. She asked for support for the prepaid capacity entries. Vinson admitted to making the entries but stated she did not know what they were for and had no support. Cooper asked where the amounts for the entries came from. Vinson said David Myers, the controller, or Buddy Yates, the director of general accounting. Cooper and Smith went to see Yates who told them to see Myers. Incredulously, she asked: Can a person reporting to you book a billion-dollar Journal entry without your knowledge? Yates told her that Myers called people who report to him all the time to book entries. Besides, most of the accounting is done in the field and not in my group. She thanked him for his answer but was in a state of disbelief. Cooper then went to see Myers who told her while he could construct support for the entries, he wouldnt do it. She asked him if there are NY accounting standards to support the entries. He stated there arent and that: We probably shouldnt have capitalized the line cost. But once it was done the first time, it was difficult to stop. He professed to be uncomfortable with the entries from the first time they were recorded. Smith wondered whether this was some sort of aggressive accounting technique. She asked Myers whether he was aware of other companies in the telecommunications industry who were using the same accounting treatment. He answered no but offered that other companies must have been doing the same thing to keep their cost structure low. Cooper decided to inform Obit of what had transpired. Obit suggested she should update Farrell and call him back after that. Farrell seemed surprised by the situation but said he would contact Obit and Myers. Cooper called Myers to give him a heads-up. Later in the day, Obit asked her to fly to Washington, D. C. To meet with him and Farrell the next morning. At the meeting Cooper expressed her concern that only one member of the audit committee knew about the entries. Obit cautioned that they had to be sure before going further and suggested it was now an external audit issue for KEMP, not an internal audit matter. Cooper offered that she didnt care whose issue it [was] as long as it [was] addressed appropriately. They agreed that Farrell would meet with Sullivan, the CUFF, who was the mastermind behind the accounting and give him an opportunity to explain his rationale. Farrell told Cooper that Sullivan explanation may have made sense from a business perspective, but not an accounting perspective. Sullivan had tried to find amounts inappropriately recorded in the opposite direction that is, expensed instead of capitalized to offset the prepaid-capacity entries and attempt to avoid restating many earnings. By June 20, over $3 billion of improperly classified costs had been found. It had been eight days since Cooper first called Obit about the audit findings and she was growing increasingly concerned that others on the audit committee were kept in the dark. She told Farrell that if Obit didnt call a meeting of the audit committee immediately, she would. Later in the day Obit called Cooper and told her there to. She asked why he seemed so agitated. Obit remarked that Do you have any idea what Im about to have to do? Im about to blow up this company! Farrell admitted at the meeting that he was not aware of any provision in GAP that would support the line-cost entries. Sullivan defended the transfers by stating that: Starting in 1999, World invested heavily in assets to expand the telecoms network, anticipating enormous future demands in customer traffic. World not only purchased equipment and fiber, but also signed a significant number of ling- term fiber leases with third parties to carry the expected telecoms traffic. But when the telecoms industry imploded, starting in 2000 and continuing through 2002, the customer usage anticipated never materialized. Now, large pieces of both owned and leased portions of the telecoms network wither [had] no or very little customer traffic. Sullivan had business reasons but no accounting rationale for the entries. He tried to use the matching principle to Justify the accounting. However, it only applied if the original Journal entries to account for the leases were correct. He also talked about taking an impairment charge in the second quarter of 2002, to write off the line cost amounts booked as capital assets. He insisted the entries werent made to meet earnings; that the accounting for line costs required Judgment and the transfers ere made using estimates. He also said there was no reason to consult anyone from Andersen on these matters. Following the audit committee meeting, Coopers team found 49 prepaid capacity accounting entries, totaling $3. Billion, recorded over all four quarters of 2001 and the first quarter of 2002. As she looked at the entries she concluded they were sinister in intent. The pattern of movement between accounts changed from one quarter to the next but the entries had the same end result. She concluded that it was a spider-web of amounts moving as many as three times and finally spread in mailer dollar increments across a multitu de of assets, mostly telecoms fiber and equipment. If the amounts are funneled through enough accounts and then spread out, someone seems to have thought, theyd come out on the other end less detectable by the external auditors. On June 24, Cooper and Smith met with Troy Normandy, the mid-level accounting director, who claimed to have relayed his concerns to Sullivan about another matter the drawing down of rainy-day line cost reserves, thereby reducing expenses. This occurred in 2000 when Normandy observed that Sullivan was forced to manipulate Hess amounts to meet the earnings guidance he had provided to Wall Street. Sullivan drew on the business purpose of the transactions and assured Normandy everything would be okay. Normandy felt he didnt know enough to refute Sullivan explanation so he went along with it. He shared with Cooper that he had considered resigning and never told internal or external audit about any of the entries because he was concerned for his Job and had a family to support. He concluded that: In hindsight, I wish I had. This case addresses the fundamental issues with weightlessness. Students should be able to differentiate between internal and external weightlessness and the consequences one might face if they choose to tell the truth. Under demonology Cynthia had a duty to the profession and the public to tell the truth. The fairness theory also requires that one do the act which is fair and promotes Justice to all. Ask students if they have ever had to tell on a friend? A co- worker? What kind of pressures did they face if they told the truth or if they kept silent? Questions 1 . What are the rules in accounting for determining whether to expense certain costs against revenue versus capitalizing and depreciating the costs? How do the different treatments affect earnings? Explain the reasons given by Scott Sullivan for capitalizing line costs. Why did Cooper believe the treatment did not conform to GAP? Accounting rules on leases proscribe which leases qualify as an operating lease (a current expense), and which qualify as a capitalizing lease (capitalized and depreciated over the life of the asset). By capitalizing and depreciating the cost over the life of the asset, the expense amount is smaller and matches the expense of the set with the revenues earned by the asset. Scott Sullivan explained that the prepaid capacity was fiber optic lines leases that were being capitalized, instead of expensed. The revenues on the leased fiber lines had declined, so the leases were being capitalized to better match the expense with the revenues. He later admitted that he was trying to use the matching principle to justify the capitalization of the lease costs. ) Cooper realized that capitalization of leases is based upon the lease being a financing lease to purchase the asset, not matching of the costs of the fiber lines with he revenues from the lines. Sullivan had also explained that the lines had little value and would be written off through a restructuring charge. Thus, there were red flags on the treatment of lease costs and impairment of assets.. 2. Analyze Cooper and the internal auditors professional Judgment. How do their actions relate to Rests four stages of moral development? Cooper and the internal auditors used objectivity and skepticism in looking at the prepaid capacity costs. They did not accept glib answers after being stonewalled on questions and requests for support and documentation. Their actions relate to the Rests four-component model of morality: moral sensitivity, moral Judgment, moral motivation, and newcomer and the internal auditors used objectivity and skepticism in looking at the prepaid capacity costs. They did not accept glib answers after being stonewalled on questions and requests for support and documentation. Their actions relate to the Rests four-component model of morality: moral sensitivity, moral judgment, moral motivation, and moral character. The auditors realized the dilemma; knew that the accounting entries were not following generally accepted accounting reminisces; were motivated to find answers and not accept glib answers and the audit committee. 3. What do you think motivated the behavior and actions of the following key people in this case: (a) Max Obit, chair of the audit committee Max Obit was stepping down as chair of the Audit Committee. He had overseen the change of auditors from Andersen to KEMP. In many ways he may have wanted to avoid conflict. When first approached by Cynthia Cooper, he may not have known for sure there was an accounting problem, as much as a conflict between Cooper and Sullivan. As he learned more of the accounting problem, he may have preferred a arsenal conflict between Cooper and Sullivan. (b) Farrell Malone, the KEMP partner. KEMP had taken over the audit of World after Andersen was put out of business from the Enron scandal. Farrell Malone wanted to keep the new client happy as he learned the audit situation. At that time, partners of Big 4 firms were compensated for new business brought to the firm. Additionally, a new audit often does not make money the first year, even if the firm has not low-balled the contract. Malone would have wanted to keep World as a client to make a profit for KEMP and to increase his personal compensation. C) Scott Sullivan the CUFF of World Scott Sullivan wanted World to make expected earnings to keep the stock price high. This could be due to not wanting to admit that expected earnings were wrong, and wanting the stock price high so that Coots stock options would have a high value and keep his personal worth high. (d) David Myers, the controller In a presentation at Baylor, David stated that he knew that the adjustment was wrong, but was convinced that it was a onetime adjustment. When the adjustments needed to be made going forward, David rationalized using utilitarianism that the retreat good for his friends, neighbors, co-workers, and residents of Clinton, Mississippi, would be to continue to go along with the adjustments. He was concerned that refusing to go along with Scott Sullivan or blowing the whistle would cause World to fail and negatively affect the economy of Clinton. In hindsight that is what happened, including David serving time in prison. (e) Betty Vinson and Troy Normandy, from the accounting department. Betty and Troy wanted to keep their Jobs so did as they were told. Since they were following orders from their supervisor it is possible that they thought they were not doing anything wrong.