CASE 1 China?s Tainted Baby Milk Powder: Rumored Control of Online News On July 16, 2008, it was announced that several Chinese producers of baby milk powder had been adding melamine, a chemical usually used in countertops, to increase the ?richness? of their milk powder and to increase the protein count. Shockingly, the melamine-tainted milk powder was responsible for the deaths of four infants and the sickening of more than 6,200 more.1 Milk manufacturers had been using melamine as a low-cost way of ?enriching? their product in both taste and protein count. Melamine, a toxic chemical that makes countertops very durable, damages kidneys. 2 This fact came to world attention on March 16, 2007, when Menu Foods of Streetsville, Ontario, Canada, recalled dog and cat foods that it had mixed in Canadafrom Chinese ingredients that were found to include melamine.3 Very quickly thereafter,pet owners claims and class action lawsuits threatened to put the company into bankruptcy until settlements were worked out.4 A subsequent investigation by the U.S. Food and Drug Administration (FDA) led to the recall of pet food by major manufacturers, including Del Monte, Nestle Purina, Menu Foods, and many others.5 On February 6,2008, ?the FDA announced that that two Chinese nationals and the businesses they operate, along with a U.S. company and its president and chief executive offi cer, were indicted by a federal grand jury for their roles in a scheme to import products purported to be wheat gluten into the United States that were contaminated with melamine.?6 It will be interesting to follow what penalties are ultimately paid by the Chinese manufacturers. Although the story of melamine-tainted ingredients broke in mid-March 2007, the similarly tainted-milk powder link did not come to light in China until sixteen months later. Governmental follow-up has not been speedy even though unmarked bags of ?protein powder? had probably been added to several other products, including baking powder and feed for chickens thus contaminating eggs and meat.7 On October 8, 2008, the Chinese government stopped reporting updated fi gures of infant milk powder suff erers ?because it is not an infectious disease, so it?s not necessary to announce it to the public.?8 Knowledgeable members of the Chinese public, however,have been using the suitcases of their visiting relatives to import U.S.- and Canadian-made milk formula for their children. It is also fascinating to consider another aspect of life in China?rumored control of online news. Although there is no proof of the rumors, which might have been started by competitors, the Wall Street Journal ?s (WSJ) online service has reported that Baidu.com Inc., the company referred to as the ?Googleof China,? is under attack for accepting payments to keep stories containing a specific milk manufacturing company?s name from online searches about the tainted milk scandal even when the manufacturer was recalling the product. Local government offi cials also declined to confi rm the milk manufacturer?s problem during the same period. Baidu.com ?said it had been approached this week by several dairy producers but said that it ?fl at out refused? to screen out unfavorable news and accused rivals of fanning the flames.?9 In a statement, it said: ?Baidu respects the truth, and our search results refl ect that commitment.?Currently, there is no evidence that Baidu. com did accept the screen-out payments as rumored, but it does face some challenges of its own making in trying to restore it reputation. For example, unlike Google that separates or distinguishes paid advertisements from nonpaid search results, Baidu.com integrated paid advertisements into its search listing until critics recently complained. In addition, companies could pay more and get a higher ranking for their ads. According to the WSJ article, a search for ?mobile phone? generates a list where almost the entire fi rst page consists of paid advertisements. Also, competitors fearing increased competition and new products from Baidu.com, which recently increased its market share to 64.4 percent, have begun to restrict Baidu?s search software (spiders) from penetrating websites that the competitors control. Baidu.com?s profi t growth had been strong, but for how long? Baidu.com, Inc. is traded on the U.S.?s NASDAQ Stock Market under the symbol BIDU. Since the rumors surfaced in late August/early September 2008, BIDU?s share price has declined from $308 to almost $110 on November 20, 2008. Questions 1. Given strong profit growth, has there been any damage to Baidu.com?s reputation? 2. What would future reputational damage affect, and how could it be measured? 3. What steps could Baidu.com take to restore its reputation, and what challenges will it have to overcome? 4. Governments throughout the world have been slow to react publicly to serious problems such as SARS, mad cow disease, and now melamine contamination. Who benefits and who loses because of these delays? 5. In some cultures, a ?culture of secrecy? or manipulation of the news is tolerated more than others. How can this be remedied by other governments, corporations, investors, and members of the public? Case 2 WorldCom: Th e Final Catalyst This case presents, with additional information, the WorldCom saga included in this chapter and in Chapter 9. Questions specifi c to WorldCom activities are located at the end of the case. WorldCom Lights the Fire WorldCom, Inc., the second largest U.S. telecommunications giant and almost 70 percent larger than Enron in assets, announced on June 25, 2002, that it had overstated its cash flow by $3.8 billion.1 This came as a staggering blow to the credibility of capital markets. It occurred in the middle of the furor caused by: | The Enron bankruptcy on December 2, 2001, and the related Congress and Senate hearings and Fifth Amendment testimony by Enron executives | The depression of the stock markets | The pleas by business leaders and President Bush for restoration of credibility and trust to corporate governance, reporting, and the financial markets | Responsive introduction of governance guidelines by stock exchanges and the Securities and Exchange Commission | Debate by the U.S. Congress and Senate of separate bills to improve governance and accountability | Th e conviction of Arthur Andersen, auditor of both Enron and WorldCom, for obstruction of justice on June 15, 2002 WorldCom?s Accounting Manipulations WorldCom?s accounting manipulations involved very basic, easy-to-spot types of fraud.2 Overstatements of cash flow and income were created because one of WorldCom?s major expenses, line costs, or ?fees paid to third party telecommunication network providers for the right to access the third parties networks,? 3 were accounted for improperly. Essentially, line costs that should have been expensed, thus lowering reporting income, were offset by capital transfers or charged against capital accounts, thus placing their impact on the balance sheet rather than the income statement. In addition, WorldCom created excess reserves or provisions for future expenses, which they later released or reduced, thereby adding to profits. The manipulation of profit through reserves or provisions is known as ?cookie jar? accounting. The aggregate overstatement of income quickly rose to more than $9 billion4 by September 19, 2002, for the following reasons: | $3.85 billion for improperly capitalized expenses, announced June 25, 2002. | $3.83 billion for more improperly capitalized expenses in 1999, 2000, 2001, and the first quarter of 2002, announced on August 8, 20026 | $2.0 billion for manipulations of profit through previously established reserves, dating back to 1999 Ultimately, the WorldCom fraud totaled $11 billion. Key senior personnel involved in the manipulations at WorldCom included: | Bernard J. Ebbers, CEO | Scott D. Sullivan, CFO | Buford Yates Jr., Director of General Accounting | David F. Myers, Controller | Betty L. Vinson, Director of Management Reporting, from January 2002 | Troy M. Normand, Director of Legal Entity Accounting, from January 2002 According to SEC?s complaint against Vinson and Normand:7 4. WorldCom fraudulently manipulated its fi nancial results in a number of respects, including by improperly reducing its operating expenses in at least two ways. First, WorldCom improperly released certain reserves held against operating expenses. Second, WorldCom improperly recharacterized certain operating costs as capital assets. Neither practice was in conformity with generally accepted accounting principles (?GAAP?). Neither practice was disclosed to WorldCom?s investors, despite the fact that both practices constituted changes from WorldCom?s previous accounting practices. Both practices artifi cially and materially inflated the income WorldCom reported to the public in its fi nancial statements from 1999 through the fi rst quarter of 2002. 5. Many of the improper accounting entries related to WorldCom?s expenses for accessing the networks of other telecommunications companies (?line costs?), which were among WorldCom?s major operating expenses. From at least the third quarter of 2000 through the first quarter of 2002, in a scheme directed and approved by senior management, and participated in by VINSON, NORMAND and others, including Yates and Myers, WorldCom concealed the true magnitude of its line costs. By improperly reducing reserves held against line costs, and then?after effectively exhausting its reserves?by recharacterizing certain line costs as capital assets, WorldCom falsely portrayed itself as a profitable business when it was not, and concealed the large losses it suffered. WorldCom?s fraudulent accounting practices with respect to line costs were designed to and did falsely and fraudulently inflate its income to correspond with estimates by Wall Street analysts and to support the price of WorldCom?s common stock and other securities. 6. More specifically, in the third and fourth quarters of 2000, at the direction and with the knowledge of World-Com?s senior management, VINSON,NORMAND and others, by making and causing to be made entries in WorldCom?s books which improperly decreased certain reserves to reduce WorldCom?s line costs, caused World-Com to overstate pretax earnings by $828 million and at least $407 million respectively. Then, after WorldCom had drawn down WorldCom?s reserves so far that the reserves could not be drawn down further without taking what senior management believed was an unacceptable risk of discovery, VINSON, NORMAND and others, again at the direction and with the knowledge of senior management, made and caused to be made entries in World-Com?s books which improperly capitalized certain line costs for the next five quarters, from the first quarter 2001 through the first quarter 2002. This accounting gimmick resulted in an overstatement of WorldCom?s pretax earnings by approximately $3.8 billion for those five quarters. The motivation and mechanism for these manipulations is evident from the SEC?s description of what happened at the end of each quarter, after the draft quarterly statements were reviewed. Steps were taken by top management to hide WorldCom?s problems and boost or protect the company?s stock price in order to profit from stock options, maintain collateral requirements for personal loans, and keep their jobs. These steps were required, in part, to offset the downward pressure on WorldCom?s share price caused by U.S. and European regulators? rejection of WorldCom?s US $115 billion bid for Sprint Communications. 8 Ebbers? company had been using takeovers rather than organic growth to prop up earnings, and the fi nancial markets began to realize this would be increasingly diffi cult. According to the SEC: 27. In or around October 2000, at the direction and with the knowledge of WorldCom senior management, VINSON, NORMAND and others, including Yates and Myers, caused the making of certain improper entries in the company?s general ledger for the third quarter of 2000. Specifically, after reviewing the consolidated financial statements for the third quarter of 2000, WorldCom senior management determined that WorldCom had failed to meet analysts? expectations. World-Com?s senior management then instructed Myers, and his subordinates, including Yates, VINSON and NORMAND, to make improper and false entries in WorldCom?s general ledger reducing its line cost expense accounts, and reducing?in amounts corresponding to the improper and false line cost expense amounts?various reserve accounts. After receiving instructions through Yates, VINSON and NORMAND ensured that these entries were made. There was no documentation supporting these entries, and no proper business rationale for them, and they were not in conformity with GAAP. These entries had the effect of reducing third quarter 2000 line costs by approximately $828 million, thereby increasing WorldCom?s publicly reported pretax income by that amount for the third quarter of 2000. 9Manipulations followed the same pattern for the fourth quarter of 2000, but a change was required for the first quarter of 2001 for fear of discovery. 29. In or around April 2001, after reviewing the preliminary consolidated financial statements for the first quarter of 2001, WorldCom?s senior management determined that WorldCom had again failed to meet analysts? expectations. Because WorldCom?s senior management determined that the company could not continue to draw down its reserve accounts to offset line costs without taking what they believed to be unacceptable risks of discovery by the company?s auditors, WorldCom changed its method of fraudulently inflating its income. WorldCom?s senior management then instructed Myers, and his subordinates, including Yates, VINSON and NORMAND, to make entries in WorldCom?s general ledger for the first quarter of 2001 which fraudulently reclassified line cost expenses to a variety of capital asset accounts without any supporting documentation or proper business rationale and in a manner that did not conform with GAAP. 30. Specifically, in or around April 2001, at the direction and with the knowledge of WorldCom?s senior management, defendants VINSON, NORMAND and others, including Yates and Myers, fraudulently reduced first quarter 2001 line cost expenses by approximately $771 million and correspondingly increased capital asset accounts, thereby fraudulently increasing publicly reported pretax income for the first quarter of 2001 by the same amount. In particular, in or about April 2001, NORMAND telephoned WorldCom?s Director of Property Accounting (the ?DPA?) and instructed him to adjust the schedules he maintained for certain Property, Plant & Equipment capital expenditure accounts (the ?PP&E Roll-Forward?) by increasing certain capital accounts for ?prepaid capacity.? NORMAND advised the DPA that these entries had been ordered by WorldCom?s senior management. Correspondingly, a subordinate of NORMAND made journal entries in WorldCom?s general ledger, transferring approximately $771 million from certain line cost expense accounts to certain PP&E capital expenditure accounts. In future periods, the increase of certain accounts for ?prepaid capacity? remained the manipulation of choice. WorldCom?s Other Revelations It should be noted that Ebbers was not an accountant?he began as a milkman and bouncer, and became a basketball coach and then a Best Western Hotel owner before he entered the Telcom business,11 where his sixty acquisitions and style earned him the nickname ?the Telcom Cowboy.? However, he was ably assisted in these manipulations by Scott Sullivan, his Chief Financial Officer, and David Myers, his Controller. Both Sullivan and Myers had worked for Arthur Andersen before joining WorldCom. Other spectacular revelations offer a glimpse behind the scenes at WorldCom. The company, which applied for bankruptcy protection in July 21, 2002, also announced that it might write off $50.6 billion in goodwill or other intangible assets when restating for the accounting errors previously noted. Apparently other WorldCom decisions had been faulty. The revelations were not yet complete. Investigation revealed that Bernard Ebbers, the CEO, had been loaned $408.2 million. He was supposed to use the loans to buy WorldCom stock or for margin calls as the stock price fell. Instead, he used it partly for the purchase of the largest cattle ranch in Canada, construction of a new home, personal expenses of a family member, and loans to family and friends. Finally, it is noteworthy that: ?At the time of its scandal, WorldCom did not possess a code of ethics. According to WorldCom?s Board of Director?s Investigative Report, the only mention of ?ethics? was contained in a section in WorldCom?s Employee Handbook that simply stated that ?. . . fraud and dishonesty would not be tolerated? (WorldCom 2003, p. 289). When a draft version of a formal code was presented to Bernie Ebbers . . . for his approval before the fraud was discovered in 2001, his response was reportedly that the code of ethics was a ?. . . colossal waste of time? (WorldCom 2003, 289).?13 Why Did Th ey Do it? According to U.S. Attorney General John Ashcroft: the alleged Sullivan-Myers scheme was designed to conceal fi ve straight quarterly net losses and create the illusion that the company was profitable. In view of Ebbers? $408.2 million in loans, which were largely to buy or pay margin calls on WorldCom stock and which were secured by WorldCom stock, he would be loathe to see further deterioration of the WorldCom stock price. In short, he could not afford the price decline that would follow from lower WorldCom earnings. In addition, according to the WorldCom?s 2002 Annual Meeting Proxy Statement,15 at December 31, 2001, Ebbers had been allocated exercisable stock options on 8,616,365 shares and Sullivan on 2,811,927. In order to capitalize on the options, Ebbers and Sullivan (and other senior employees) needed the stock price to rise. A rising or at least stable stock price was also essential if World-Com stock was to be used to acquire morecompanies. Finally, if the reported results became losses rather than profits, the tenure of senior management would have been shortened significantly. In that event, the personal loans outstanding would be called and stock option gravy train would stop. In 2000, Ebbers and Sullivan had each received retention bonuses of $10 million so they would stay for two years after September 2000. In 1999, Ebbers received a performance bonus allocation of $11,539,387, but he accepted only $7,500,000 of the award. An Expert?s Insights Former Attorney General Richard Thornburgh was appointed by the U.S. Justice Department to investigate the collapse and bankruptcy of WorldCom. In his Report tothe U.S. Bankruptcy Court in Manhattan on November 5, 2002, he said: One person, Bernard Ebbers, appears to have dominated the company?s growth, as well as the agenda, discussions and decisions of the board of directors, . . . A picture is clearly emerging of a company that had a number of troubling and serious issues . . . [relating to] culture, internal controls, management, integrity, disclosure and financial statements. While Mr. Ebbers received more than US $77 million in cash and benefits from the company, shareholders lost in excess of US $140 billion in value. The Continuing Saga The WorldCom saga continues as the company?s new management try to restore trust it its activities. As part of this effort, the company changed its name to MCI. ?On August 26, 2003, Richard Breeden, the Corporate Monitor appointed by the U.S. District Court for the Southern District of New York, issued a report outlining the steps the Company will take to rebuild itself into a model of strong corporate governance, ethics and integrity . . . (to) foster MCI?s new company culture of ?integrity in everything we do.??18 Th e company is moving deliberately to reestablish the trust and integrity it requires to compete effectively for resources, capital, and personnel in the future. The SEC has fi led complaints, which are on its website, against the company and its executives. The court has granted the injunctive relief the SEC sought. The executives have been enjoined from further such fraudulent actions, and subsequently banned by the SEC from practicing before it, and some have been banned by the court from acting as officers or directors in the future. WorldCom, as a company, consented to a judgment:. . . imposing the full injunctive relief sought by the Commission; ordering an extensive review of the company?s corporate governance systems, policies, plans, and practices; ordering a review of WorldCom?s internal accounting control structure and policies; ordering that WorldCom provide reasonable training and education to certain offi cers and employees to minimize the possibility of future violations of the federal securities laws; and providing that civil money penalties, if any, will be decided by the Court at a later date Bernie Ebbers and Scott Sullivan were each indicted on nine charges: one count of conspiracy, one count of securities fraud, and seven counts of false regulatory findings. Sullivan pleaded guilty on the same day he was indicted and later cooperated with prosecutors and testified against Bernie Ebbers ?in the hopes of receiving a lighter sentence.? Early in 2002, Ebbers stood up in church to address the congregation saying: ?I just want you to know that you?re not going to church with a crook.?22 Ebbers took the stand and argued ?that he didn?t know anything about WorldCom?s shady accounting, that he left much of the minutiae of running the company to underlings.? But after eight days of deliberations, on March 15, 2005, a federal jury in Manhattan didn?t buy his ?awshucks,? ?hands-off ,? or ?ostrich-in-the-sand? defense. The jury believed Sullivan, who told the jury that Ebbers repeatedly told him to ??hit his numbers??a command . . . to falsify the books to meet Wall Street expectations.? They did not buy Ebbers? ?I know what I don?t know? argument, ?especially after the prosecutor portrayed a man who obsessed over detail and went ballistic over a US $18,000 cost overrun in a US $3-billion budget item while failing to pick up on the bookkeeping claim that telephone line costs often fluctuated?fraudulently?by up to US $900-million a month. At other times, he replaced bottled water with tap water at WorldCom?s offices, saying employees would not know the difference. On July 13, 2005, Ebbers was sentenced to twenty-fi ve years in a federal prison. Once a billionaire, he also lost his house, property, yacht, and fortune. At 63 years of age, he is appealing his sentence. Sullivan?s reduced sentence was for five years in a federal prison, forfeiture of his house, ill-gotten gains, and a fine. Investors lost over $180 million in WorldCom?s collapse, and more in other companies as the confidence in credibility of the financial markets, governance mechanisms and financial statements continued to deteriorate. Questions 1. Describe the mechanisms that World-Com?s management used to transfer profit from other time periods to inflate the current period. 2. Why did Arthur Andersen go along with each of these mechanisms? 3. How should WorldCom?s board of directors have prevented the manipulations that management used? 4. Bernie Ebbers was not an accountant, so he needed the cooperation of accountants to make his manipulations work. Whydid WorldCom?s accountants go along? 5. Why would a board of directors approvegiving its Chair and CEO loans of over $408 million? 6. How can a board ensure that whistleblowers will come forward to tell them about questionable activities? Assignment 3: Article Research Locate an article of your choice from a reputable source (journal, periodical, newspaper) that documents ethical violations within a firm that include violations of accounting standards. The article can be no more than 5 years old and cannot be on a firm or scandal featured in your text. You are to provide a 2-page summary of the events, in APA format, and include a citation for the article.
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