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3) Mr Dewy, of the CPA firm Dewy, Cheatem, & Howe (DCH), has told his audit juniors
that internal auditors are fellow professionals and that, as such, they and their audit work
can always be a trusted.
Required:
a) Is Mr. Dewy correct in the above assertion?
b) What factors must the external auditor be satisfied with, if s/he is to rely on the work
of the internal auditor?

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Beverley Smith
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4–28. Multiple Choice Questions
Select the best answer for each of the following questions and explain the reasons for your
choice.
a. If a CPA performs an audit recklessly, the CPA will be liable to third parties who were
unknown and not foreseeable to the CPA for:
(1) Strict liability for all damages incurred.
(2) Gross negligence.

(3) Either ordinary or gross negligence.
(4) Breach of contract.
b. Which of the following approaches to auditors’ liability is least desirable from the CPA’s
perspective?
(1) The Ultramares approach.
(2) The Rosenblum approach.
(3) The Restatement of Torts approach.
(4) The Foreseen User approach.
c. In cases of breach of contract, plaintiffs generally have to prove all of the following,
except:
(1) The CPAs had a duty.
(2) The CPAs made a false statement.
(3) The client incurred losses related to the CPAs’ performance.
(4) The CPAs breached their duty.
d. If the CPAs provided negligent tax advice to a public company, the client would bring suit
under:
(1) The Securities Act of 1933.
(2) The Securities Exchange Act of 1934.
(3) The federal income tax law.
(4) Common law.
e. Which of the following cases reaffi rmed the principles in the Ultramares case?
(1) Credit Alliance Corp. v. Arthur Andersen & Co.
(2) Rosenblum v. Adler.
(3) Ernst & Ernst v. Hochfelder.
(4) Escott v. BarChris Construction Corporation.
f. Under common law, the CPAs who were negligent may mitigate some damages to a client
by proving:
(1) Contributory negligence.
(2) The CPAs’ fee was not material.
(3) The CPAs were not competent to accept the engagement.
(4) The CPAs’ negligence was caused by the fact that they had too much work.
g. Under the Securities and Exchange Act of 1934, auditors and other defendants are faced
with:
(1) Joint liability.
(2) Joint and several liability.
(3) Proportionate liability.
(4) Limited liability.
h. A CPA issued an unqualifi ed opinion on the fi nancial statements of a company that
sold common stock in a public offering subject to the Securities Act of 1933. Based on
a misstatement in the fi nancial statements, the CPA is being sued by an investor who
purchased shares of this public offering. Which of the following represents a viable
defense?
(1) The investor has not proved fraud or negligence by the CPA.
(2) The investor did not actually rely upon the false statement.
(3) The CPA detected the false statement after the audit date.
(4) The false statement is immaterial in the overall context of the fi nancial statements.
i. Which of the following elements is most frequently necessary to hold a CPA liable to a
client?
(1) Acted with scienter or guilty knowledge.
(2) Was not independent of the client.
(3) Failed to exercise due care.
(4) Did not use an engagement letter.

j. Which statement best expresses the factors that purchasers of securities registered under
the Securities Act of 1933 need to prove to recover losses from the auditors?
(1) The purchasers of securities must prove ordinary negligence by the auditors and reliance
on the audited fi nancial statements.
(2) The purchasers of securities must prove that the fi nancial statements were misleading
and that they relied on them to purchase the securities.
(3) The purchasers of securities must prove that the fi nancial statements were misleading;
then, the burden of proof is shifted to the auditors to show that the audit was
performed with “due diligence.”
(4) The purchasers of securities must prove that the fi nancial statements were misleading
and the auditors were negligent.
k. The most signifi cant result of the Continental Vending case was that it:
(1) Created a more general awareness of the possibility of auditor criminal prosecution.
(2) Extended the auditor’s responsibility to all information included in registration
statements.
(3) Defi ned the CPA’s responsibilities for unaudited fi nancial statements.
(4) Established a precedent for auditors being held liable to third parties under common
law for ordinary negligence.
l. The 1136 Tenants’ case was important because of its emphasis upon the legal liability of
the CPA when associated with:
(1) A review of annual statements.
(2) Unaudited fi nancial statements.
(3) An audit resulting in a disclaimer of opinion.
(4) Letters for underwriters.

How Three Unlikely Sleuths Exposed Fraud at WorldCom

Firm's Own Employees Sniffed Out Cryptic Clues and FollowedHunches

By

Susan Pulliam and

Deborah Solomon Staff Reporters of The Wall Street Journal

Updated Oct. 30, 2002 4:58 p.m. ET

CLINTON, Miss. -- Sitting in his cubicle at WorldCom Inc.headquarters one afternoon in May, Gene Morse stared at anaccounting entry for $500 million in computer expenses. He couldn'tfind any invoices or documentation to back up the stunningnumber.

"Oh my God," he muttered to himself. The auditor immediatelytook his discovery to his boss, Cynthia Cooper, the company's vicepresident of internal audit. "Keep going," Mr. Morse says she toldhim.

A series of obscure tips last spring had led Ms. Cooper and Mr.Morse to suspect that their employer was cooking its books. Armedwith accounting skills and determination, Ms. Cooper and her teamset off on their own to figure out whether their hunch was correct.Often working late at night to avoid detection by their bosses,they combed through hundreds of thousands of accounting entries,crashing the company's computers in the process.

By June 23, they had unearthed $3.8 billion in misallocatedexpenses and phony accounting entries. It all added up to anaccounting fraud, acknowledged by the company, that turned out tobe the largest in corporate history. Their discoveries sentWorldCom into bankruptcy, left thousands of their colleagueswithout jobs and roiled the stock market.

At a time when dishonesty at the top of U.S. companies isdominating public attention, Ms. Cooper and her team are a case ofmiddle managers who took their commitment to financial reporting toextraordinary lengths. As she pursued the trail of fraud, Ms.Cooper time and again was obstructed by fellow employees, some ofwhom disapproved of WorldCom's accounting methods but wereunwilling to contradict their bosses or thwart the company'sgoals.

WorldCom is under investigation by the Justice Department andthe Securities and Exchange Commission. Scott Sullivan, WorldCom'sformer chief financial officer and Ms. Cooper's boss, has beenindicted. He has denied any wrongdoing. Four other officers havepleaded guilty and are cooperating with prosecutors. Federalinvestigators are still probing whether Bernard J. Ebbers, thecompany's former chief executive, knew about the accountingimproprieties. Since the initial discoveries, WorldCom's accountingmisdeeds have grown to $7 billion.

WORLDCOM'S FALL

Browse quick profiles of the major WorldCom players.

See additional coverage of WorldCom's troubles atwsj.com/WorldCom, including related articles, a clickable stockchart and an online discussion.

PLUS

Continuing coverage of corporate accounting issues at Called toAccount

Behind the tale of accounting chicanery lies the untolddetective story of three young internal auditors, whotemperamentally didn't fit into WorldCom's well-known cowboyculture. Ms. Cooper, 38 years old, headed a department of 24auditors and support staffers, many of whom viewed her as quiet butstrongwilled. She grew up in a modest neighborhood near WorldCom'sheadquarters and had spent nearly a decade working at the company,rising through its ranks. She declined to be interviewed for thisstory. Mr. Morse, 41, was known for his ability to use technologyto ferret out information. The third member of the team was GlynSmith, 34, a senior manager under Ms. Cooper. In his spare time hetaught Sunday school, took photographs and bicycled. His mom hadtaught him and Ms. Cooper accounting at Clinton High School.

Frightened that they would be fired if their superiors found outwhat they were up to, the gumshoes worked in secret. Even so, theirinitial discrete inquiries were stonewalled. Arthur Andersen,WorldCom's outside auditor, refused to respond to some of Ms.Cooper's questions and told her that the firm had approved some ofthe accounting methods she questioned. At another critical juncturein the trio's investigation, Mr. Sullivan, then the company's CFO,asked Ms. Cooper to delay her investigation until the followingquarter. She refused.

Ms. Cooper's first inkling that something big was amiss atWorldCom came in March 2002. John Stupka, the head of WorldCom'swireless business, paid her a visit. He was angry because he wasabout to lose $400 million he had specifically set aside in thethird quarter of 2001, according to two people familiar with themeeting. His plan had been to use the money to make up forshortfalls if customers didn't pay their bills, a common occurrencein the wireless business. It was a well-accepted accountingdevice.

But Mr. Sullivan decided instead to take the $400 million awayfrom Mr. Stupka's division and use it to boost WorldCom's income.Mr. Stupka was unhappy because without the money, his unit wouldlikely have to report a large loss in the next quarter.

Mr. Stupka's group already had complained to two Arthur Andersenauditors, Melvin Dicke and Kenny Avery. They had sided with Mr.Sullivan, according to federal investigators.

But Mr. Stupka and Ms. Cooper thought the decision smelledfunny, although not obviously improper. Under accounting rules, ifa company knows it is not going to collect on a debt, it has to setup a reserve to cover it in order to avoid reflecting on its bookstoo high a value for that business. That was exactly what Mr.Stupka had done. Mr. Stupka declined to comment.

Ms. Cooper decided to raise the issue again with Andersen. Butwhen she called the firm, Mr. Avery brushed her off and made itclear that he took orders only from Mr. Sullivan, according to theinvestigators. Mr. Avery and Mr. Dicke declined to comment. PatrickDorton, a spokesman for Andersen, said his firm thought that the$400 million wireless reserve was not necessary.

"That was like putting a red flag in front of a bull," says Mr.Morse. "She came back to me and said, 'Go dig.' "

Some internal auditors would have left it at that and moved on.After all, both the company's chief financial officer and itsoutside accountants had signed off on the decision. But that wasnot Ms. Cooper's style. One favorite pastime among the auditors whoreported to her was applying the labels of the Myers-Briggs &Keirsey personality test to their fellow staffers. Ms. Cooper wascategorized as an INTJ -- introspective, intuitive, a thinker andjudgmental. "INTJs," according to the test criteria, are "naturalleaders" and "strong-willed," representing less than 1% of thepopulation.

HUNTING DOWN FRAUD

March: A WorldCom executive complains to Cynthia Cooper, vicepresident of internal audit, that CFO Scott Sullivan has decided touse his unit's reserves to reduce expenses.

March 6: Ms. Cooper raises issue with audit committee. Mr.Sullivan backs down.

March 7: SEC issues request for documents. Ms. Cooper launchesfinancial audit.

May 28: An auditor uncovers $500 million in fraudulent computerexpenses.

June 11: Mr. Sullivan, the CFO, asks Ms. Cooper to delay heraudit. She refuses.

June 17: Ms. Cooper confronts other WorldCom officials about theincreasing number of accounting problems her staff isdiscovering.

June 20: She presents her findings to WorldCom's board. Fourdays later Mr. Sullivan is fired.

June 25: WorldCom announces it has inflated its profits by $3.8billion over the previous five quarters.

And so Ms. Cooper decided to appeal the decision. As head ofauditing, it was her responsibility to bring sensitive issues tothe audit committee of WorldCom's board. She brought the reservesquestion to the attention of the committee's head, Max Bobbitt. Ata committee meeting at the company's Washington offices on March 6,she and Mr. Sullivan presented their cases, according to minutesfrom the meeting. Mr. Sullivan backed down, according to peoplefamiliar with his decision.

The next day he tracked down Ms. Cooper. Unable to reach herimmediately, Mr. Sullivan called her husband, a stay-at-home dad totheir two daughters, to get her cellphone number. He finally caughtup with her at the hair salon. In the future, she was not tointerfere in Mr. Stupka's business, Mr. Sullivan warned, accordingto people familiar with the reserves question.

The confrontations put Ms. Cooper in a sticky position. Mr.Sullivan was her immediate supervisor. Plus, her vague discomfortwith the way WorldCom was handling its accounting led her intoareas that were not normally her bailiwick. Although her departmentdid a small amount of financial auditing, it primarily performedoperational audits, consisting of measuring the performance ofWorldCom's units and making sure the proper spending controls werein place. The bulk of the company's financial auditing was left toArthur Andersen. But neither of those things dissuaded Ms. Cooperfrom following her nose to the root of the ill-defined problem.

A Surprise Request

On March 7, a day after Ms. Cooper had visited with the auditcommittee, the SEC surprised the company with a "Request forInformation." While WorldCom's closest competitors, includingAT&T Corp. , were suffering from a telecom rout and losingmoney throughout 2001, WorldCom continued to report a profit. Thathad attracted the attention of regulators at the SEC, who thoughtWorldCom's numbers looked suspicious.

But investigators had grown frustrated as they combed throughpublic filings looking for evidence of wrongdoing, according topeople familiar with the inquiry. So they asked to see data oneverything from sales commissions to communications withanalysts.

Concerned about why the SEC was sniffing around, Ms. Cooperdirected her group to start collecting information in order tocomply with the request.

She also was growing concerned about another looming problem.Andersen was under fire for its role in the Enron case, which soonwould lead to the accounting firm's indictment. It was clear thatWorldCom would have to retain new outside auditors.

Ms. Cooper set off on an unusual course. Her own departmentwould simply take on a role that no one at WorldCom had assignedit. The troubles at Enron and Andersen were enough to warrant asecond look at the company's financials, she explained to Mr. Morseone evening as they walked out to WorldCom's parking lot. Her plan:her department would start doing financial audits, looking at thereliability and integrity of the financial information the companywas reporting publicly.

It was a major decision, which would necessitate a lot more workfor Ms. Cooper and her staffers. Still, Ms. Cooper took onfinancial auditing without asking permission from Mr. Sullivan, herboss, according to investigators and a person familiar with Ms.Cooper's decision.

"We could see a strain in her face,'' recalls her mother, PatsyFerrell, about that time period. "She didn't look happy. We knewshe was working late and some of the other people were workinglate. We would call and say, 'Can we bring some sandwiches?' andher father would bring them sandwiches."

A Curious E-Mail from Afar

Several weeks later, Mr. Smith, a manager under Ms. Cooper,received a curious e-mail from Mark Abide, based in Richardson,Texas, who was in charge of keeping the books for the company'sproperty, plants and equipment.

Mr. Abide had attached to his May 21 e-mail a local newspaperarticle about a former employee in WorldCom's Texas office who hadbeen fired after he raised questions about a minor accountingmatter involving capital expenditures. "This is worth looking intofrom an audit perspective," Mr. Abide wrote. Mr. Smith, whodeclined to be interviewed, forwarded the e-mail to Ms. Cooper,according to investigators and a lawyer involved in the case.

The e-mail piqued Ms. Cooper's interest. As part of theirinitial foray into financial auditing, Ms. Cooper and her team hadalready stumbled on to the issue of capital expenditures, a subjectthat would prove to be crucial to their quest.

The team had run into an inexplicable $2 billion that thecompany said in public disclosures had been spent on capitalexpenditures during the first three quarters of 2001. But theyfound that the money had never been authorized for capitalspending.

Capital costs, such as equipment, property and other majorpurchases, can be depreciated over long periods of time. In manycases, companies spread those costs over years. Operating costssuch as salaries, benefits and rent are subtracted from income on aquarterly basis, and so they have an immediate impact onprofits.

Ms. Cooper and her team were beginning to suspect what was upwith the mysterious $2 billion entry: It might actually representoperating costs shifted to capital expenditure accounts -- astealthy maneuver that would make the company look vastly moreprofitable.

When Ms. Cooper and Mr. Smith asked Sanjeev Sethi, a director offinancial planning, about the curious adjustment, he told them itwas "prepaid capacity," a term they had never heard before. Furtherinquires led them to understand that prepaid capacity was a capitalexpenditure. But when they asked what it meant, Mr. Sethi told themto ask David Myers, the company's controller, according to Mr.Morse and a person familiar with Ms. Cooper's situation. Mr. Sethidid not return phone calls.

Ms. Cooper and Mr. Smith opted instead to call Mr. Abide, whohad pointed out a capital expenditures problem in his e-mail. Whenthey asked him about "prepaid capacity,'' he too answered verycryptically, explaining that those entries had come from BufordYates, WorldCom's director of general accounting.

While perusing records looking for accounting irregularitieslater that same day, May 28, Mr. Morse made the big discovery ofthe $500 million in undocumented computer expenses. They also werelogged as a capital expenditure. "This stinks," Mr. Morse recallsthinking to himself. He immediately went to Ms. Cooper to tell herwhat he'd found. She called a meeting of her department. "I knew itwas a horrific thing and she did too, right off the bat," says Mr.Morse.

Several days later, Ms. Cooper and Mr. Smith met to try to makesense of their growing list of clues. Particularly puzzling werethe cryptic comments made by Mr. Sethi and Mr. Abide. Finally thetwo auditors came up with a plan of action to test their sense thatwhen it came to the booking of capital expenditures, something wasvery wrong at WorldCom. Ms. Cooper would send Mr. Smith an e-mailsaying she wanted to know more about prepaid capacity as soon aspossible, and asking how much harder they should press Mr. Sethi.They would copy Mr. Myers on the e-mail.

Mr. Myers shot back an e-mail. Mr. Sethi should be working forhim and did not have time to devote to Ms. Cooper's inquiries, hewrote. Ms. Cooper had been stonewalled yet again.

A Secret Plan

Ms. Cooper and Mr. Smith didn't know it, but they had stumbledonto evidence that some executives were keeping two sets of numbersfor the then-$36 billion company, one of them fraudulent.

By 2000, WorldCom had started to rely on aggressive accountingto blur the true picture of its badly sagging business. A viciousprice war in the long-distance market had ravaged profit margins inthe consumer and business divisions. Mr. Sullivan had tried torespond by moving around reserves, according to his indictment. Butby 2001 it wasn't enough to keep the company afloat.

And so Mr. Sullivan began instructing Mr. Myers to take linecosts, fees paid to lease portions of other companies' telephonenetworks, out of operating-expense accounts where they belonged andtuck them into capital accounts, according to Mr. Sullivan'sindictment.

It was a definite accounting no-no, but it meant that the costsdid not hit the company's bottom line -- at least in the version ofthe books that were publicly scrutinized. Although some staffersobjected, the scheme progressed for the next five quarters.

Ms. Cooper, Mr. Smith and Mr. Morse didn't know this. They onlyknew that accounting entries had been hopscotching inexplicablyaround WorldCom's balance sheets and that nobody wanted to talkabout it. To put all the pieces together, they would need to plumbthe depths of WorldCom's computerized accounting systems.

Full access to the computer system was a privilege that normallyhad to be granted by Mr. Sullivan. But Mr. Morse, a bit of atechie, had recently figured out a way around that problem.

Without explaining what he was up to, Mr. Morse had asked JerryLilly, a senior manager in WorldCom's information technologydepartment, for better access to the company's accounting journalentries. Mr. Lilly was testing a new software program and gave Mr.Morse permission to road test the system, too.

The beauty of the new system, from Mr. Morse's perspective, wasthat it enabled him to scrutinize the debit and credit sides oftransactions. By clicking on a number for an expense on aspreadsheet, he could follow it back to the original journal entry-- such as an invoice for a purchase or expense report submitted byan employee, to see how it had been justified.

Sifting through the data for answers to still-vague questionsabout capital expenditures amounted to a frustrating task, Mr.Morse says. He combed through an account labeled "intercompanyaccounts receivables," which contained 350,000 transactions permonth. But when he downloaded the giant set of data, he slowed downthe servers that held the company's accounting data. That promptedthe IT staff to begin deleting his requests because they wereclogging and crashing the system.

Mr. Morse began working at night, when there was less demand onthe servers, to avoid having his work shut down by the ITdepartment. During the day, he retreated to the audit library -- awindowless, 12-by-12 room piled with files from previous projectsand tucked away in the audit department -- to avoid arousingsuspicion.

By the first week of June, Mr. Morse had turned up a total of $2billion in questionable accounting entries, he says.

The Sleuths Get Nervous

Having found the evidence they were looking for, the sleuthswere suddenly faced with how serious the implications of theirendeavor really were.

Mr. Morse grew increasingly concerned that others in the companywould discover what he had learned and try to destroy the evidence,he says. With his own money, he went out and bought a CD burner andcopied all the incriminating data onto a CD-Rom. He told no oneoutside of internal audit what he had found.

Mr. Morse even kept his wife, Lynda, in the dark. Each night,he'd bring home documents he was studying. He instructed his wifenot to touch his briefcase. His wife thought the usually gregariousfather of three looked drained.

Ms. Cooper had begun confiding in her parents, with whom she wasespecially close. Without going into detail, she told her motherthat she was worried about what her team was finding, and that itwas definitely a very big deal, according to a person close to Ms.Cooper.

Meanwhile, Mr. Sullivan began to ask questions about what Ms.Cooper's team was up to. One day the finance chief approached Mr.Morse in the company cafeteria. When Mr. Morse saw him coming, hefroze. The auditor had only spoken to Mr. Sullivan twice during hisfive-year tenure at WorldCom.

"What are you working on?" Mr. Morse later recalled Mr. Sullivandemanding. Mr. Morse looked at his shoes. "International capitalexpenditures," he says he replied, referring to a separate, andless-threatening auditing project. He quickly walked away.

Days later, on June 11, Ms. Cooper got an unexpected phone callfrom Mr. Sullivan. He told her that he would have some time laterin the day, and invited her to come by and tell him what herdepartment was up to, according to a person familiar with Ms.Cooper's situation.

That afternoon, Ms. Cooper, Mr. Smith and another auditorarrived at Mr. Sullivan's office. They talked about pendingpromotions and other administrative matters, according to lawyersinvolved in the case.

As the meeting was breaking up, Ms. Cooper turned to Mr. Smithand suggested that he tell Mr. Sullivan what he was working on. Itwas meant to seem like a casual comment. In fact, the two auditorshad planned it out beforehand, so that they could gauge Mr.Sullivan's reaction, according to a person familiar with Ms.Cooper's situation.

Mr. Smith briefly described the audit, without going into theexplosive material they already had found.

Mr. Sullivan urged them to delay the audit until after the thirdquarter, saying there were problems he planned to take care of witha write-down, according to several people familiar with themeeting.

Ms. Cooper replied that no, the audit would continue. Mr.Sullivan didn't respond, and the meeting ended in a stalemate.

Concerned now that Mr. Sullivan might try to cover up theaccounting improprieties, Ms. Cooper and Mr. Smith appealed to Mr.Bobbitt, the head of WorldCom's audit committee. Mr. Bobbitt had totravel to Mississippi from his home in Florida for a board meetingscheduled for June 14, so the day before he met with Ms. Cooper andMr. Smith at a Hampton Inn in Clinton.

The two auditors told Mr. Bobbitt what they had found. He askedMs. Cooper to contact KPMG, the company's new outside auditors, andbrief them on what was happening. Mr. Bobbitt did not raise Ms.Cooper's suspicions at the board meeting the next day, according toa document WorldCom later submitted to the SEC. James Sharpe, Mr.Bobbitt's lawyer, declined to comment.

Farrell Malone, the KPMG partner in charge of the WorldComaccount, urged Ms. Cooper to make sure she was right.

On June 17, Ms. Cooper's team began a series of informalconfrontations meant to convince themselves that there was no legalexplanation for the accounting entries.

That morning, Ms. Cooper and Mr. Smith went to the office ofBetty Vinson, director of management reporting, and asked her fordocumentation to support the capital-expense-accounting entries.Ms. Vinson told the two that she had made many of the entries butdid not have any support for them, according to an internal memoprepared by Ms. Cooper and Mr. Smith. Ms. Vinson's lawyer did notreturn phone calls.

Next they walked a few feet to Mr. Yates's office. He said hewas not familiar with the entries and referred Ms. Cooper and Mr.Smith to Mr. Myers.

The duo then paid a call on Mr. Myers. When confronted, headmitted that he knew the accounting treatment was wrong, accordingto the memo. Mr. Myers said that he could go back and constructsupport for the entries but that he wasn't going to do that. Ms.Cooper then asked if there were any accounting standards to supportthe way the expenses were treated, according to the memo, which waslater made public by a Congressional committee.

Mr. Myers answered that there were none. He said that theentries should not have been made, but that once it had started, itwas hard to stop.

Mr. Smith asked how Mr. Myers planned to explain it all to theSEC. Mr. Myers replied that he hoped it wouldn't come to that,according to the memo.

An hour or so later, Ms. Cooper returned to her department tobrief Mr. Morse and her other auditors. "They have no support," shetold them, according to Mr. Morse.

It was clear to Ms. Cooper's team that their findings would bedevastating for the company, and the prospect of going before theboard with their evidence was sobering. They worried about whethertheir revelations would result in layoffs and obsessed aboutwhether they were jumping to unwarranted conclusions that theircolleagues at WorldCom were committing fraud. Plus, they fearedthat they would somehow end up being blamed for the mess.

Ms. Cooper's staffers began to notice that she was losingweight. Mr. Morse's wife noticed he was preoccupied and shorttempered.

During the third week in June, Mr. Smith called his mother, whowas vacationing in Albuquerque, according to a person familiar withthe conversation. Without providing specifics, he told her that hewas about to take actions at WorldCom that were not going to makepeople happy. He asked his mother, Ms. Cooper's former high schoolaccounting teacher, to remember him in her prayers and to pray forhim to be strong.

Ms. Cooper prepared for several meetings with the auditcommittee. At one, on June 20, Mr. Sullivan was scheduled to defendhimself.

One evening, as Ms. Cooper worked late with accountants fromKPMG, she suddenly dropped her head into her arms on theconference-room table. Mr. Malone of KPMG led her onto a balcony,put his arm around her and showed her the sunset, according to aperson familiar with the meeting.

Ms. Cooper, Mr. Smith and Mr. Malone headed to Washington tobrief the board's audit committee. At the meeting on Thursday, June20, Mr. Malone described the transfer of line costs to capitalaccounts and told the audit committee that, in his view, thetransfers didn't comply with generally accepted accountingprinciples, according to a document WorldCom later submitted to theSEC.

Mr. Sullivan tried to give an explanation for the accountingadjustments but asked for more time to support the line-costtransfers. The committee gave Mr. Sullivan the weekend to explainhimself. He got to work constructing what he called a white paperthat argued that the accounting treatments he used were proper,according to the document.

It didn't work. On June 24, the audit committee told Mr.Sullivan and Mr. Myers they would be terminated if they didn'tresign before the board meeting the next day. Mr. Sullivan refusedand was fired. Mr. Myers resigned.

The next evening, WorldCom stunned Wall Street with anannouncement that it had inflated profits by $3.8 billion over theprevious five quarters.

Afterward, Ms. Cooper drove to her parents' house, which wasnear WorldCom's headquarters. She sat down at the dining-room tablewithout saying anything, says Ms. Ferrell, her mother. "She wasdeeply, deeply pained. She was grief stricken that it was true andthat all these people would feel the consequences of having goneastray,'' Ms. Ferrell says. "We were all so proud of WorldCom andit's just been the saddest, most tragic thing.''

Mr. Morse worked late that night, and his wife phoned after shewatched the news. The anchors were calling the company World-Con,she reported. Did he know anything about it?

The SEC on June 26 slapped the company with a civil fraud suit,and trading of WorldCom's stock was halted. Ultimately the companywas delisted by the Nasdaq Stock Market.

Mr. Sullivan is preparing to go to trial. "We will demonstrateat the appropriate time that a number of the negative points thatWorldCom's internal auditors have recently suggested about Mr.Sullivan are not accurate,'' says Irvin Nathan, a lawyer for Mr.Sullivan. "The fact is that he was always supportive of internalaudit and was instrumental in the promotion of Cynthia Cooper andsecuring resources for her staff.''

Mr. Myers, Mr. Yates, Ms. Vinson and Troy Normand, the directorof legal entity accounting, have all pleaded guilty to securitiesfraud and a variety of other charges. David Schertler, an attorneyfor Mr. Yates, says that while his client pleaded guilty, "all theevidence would suggest he was acting under the orders ofsupervisors.''

Ms. Cooper and her team have continued to work at WorldCom'sClinton headquarters and are responding to requests related to thevarious investigations of the company. Ms. Cooper, Mr. Smith andMr. Morse have been interviewed by FBI agents in connection withthe Justice Department's investigation.

Some WorldCom employees have told the auditors that they wishthey had left the accounting issues alone.

How Three Unlikely Sleuths Exposed Fraud at WorldCom

refer to walstreet journal article: How Three UnlikelySleuths Exposed Fraud at WorldCom (by Susan Pulliam and DeborahSolomon Staff Reporters of The Wall Street Journal) and answerquestions below.

Issues to address in paper:

1. What were the potential consequences of the actionsCynthia Cooper and her team took as they investigated theaccounting discrepancies? What were the potential consequences oftheir not pursuing these discrepancies? Be sure toconsider potential effects upon all stakeholders. Wouldutilitarianism support their actions?

2. Consider the accounting discrepancies from a Kantianperspective – could WorldCom’s accounting practices beuniversalized? Who was WorldCom treating as a means and not an end?What would Kant say about Ms. Cooper’s actions?

3. What aspects of Ms. Cooper’s character were virtuousand what virtues were demonstrated by her actions? Or, a relatedquestion: What sorts of virtues would be needed for someone to actas Ms. Cooper and the others on her team did in factact?

4. Ms. Cooper’s team pressed ahead with activities thatled to their “blowing the whistle” within the company and withArthur Anderson. Given a little more time, their activities mighthave led them to “blow the whistle” on WorldCom to the SEC.Should they have pursued these activities? Would it be theduty of others, finding themselves in a similar situation, to actas Ms. Cooper and her team acted? Draw together your answers to theprevious questions, along with Bowie’s five conditions forwhistle-blowing, to support your conclusion.

A member of the audit team of Ernst & Young in Canada becameconcerned about the accounting for inventory by its Canadianclient, Sino-Forest, a Chinese company in the forestry business andheadquartered in Ontario province. He sent an e-mail to themanager: “ How do we know the trees owned by the company? Theycould show us trees anywhere and we wouldn’t know the difference.”The manager answered, “ Yeah, it’s possible.”

Background:

Sino-Forest owned and managed tree plantationas well as other manufacturing operations in China. Based inMississauga, in Southern Toronto, Canada, and headquartered in HongKong with operations in mainland China, Sino-Forest was once thelargest forestry firm listed in Canada, boasting a market valuationin excess of $6 billion. The company raised more than $3 billionfrom investors hoping to cash in on China’s soaring economic growththrough the timber sector. Sino-Forest share price imploded in 2011when short-seller Carson Block and his form Muddy Waters LLClabeled the company a fraud in a research report, questioned theownership of its forestry assets, and likened the company to aPonzi scheme.

A Toronto Globe and Mail investigation raised serious questionsabout the company’s operations and in March 2012, the company wasgranted court protection from its creditors under the Company’sCreditors Arrangement Act. In May 2012, the Ontario Sec. Commission(OSC) filed a fraud allegations against the company and six of itslong executive including the co-founder and former Chairman AllenChan. The OSC alleged the company and some of its former executiveswere involved in a “complex…scheme to inflate the assets andrevenue of Sino-Forest,” made “materially misleading statements,”and falsified the evidence of ownership for the vast majority ofits timber holdings by engaging in a deceitful documentationprocess.” The scheme allegedly involved transactions betweencompanies that Sino-Forest secretly controlled.

In an e-mailed statement at the time of the investigation,E&Y which was the company’s auditor from 2007-2012, said it wasconfident it did its work in compliance with GAAS and met allprofessional standards. “The evidence we will present to the OSCwill show that E&Y Canada did extensive audit work to verifyownership and existence of Sino-Forest’s timber asset,”

On Sep 30, 2012, E&Y admitted no wrongdoing in its audits ofSino-Forest Corp. but it did agree to pay an $8 million penalty tothe Ontario Sec Com, cooperate with the investigation and changeits internal policies on emerging markets. The OSC approved a $117million settlement with E&Y in 2013 to resolve allegations thatit performed negligent work. A separate settlement was reached withformer Sino-Forest CFO David Horsley for $5.6 million.

On January 26, 2015, a group of big-name Bay street financialinstitutions that underwrote stock and debt issues for Sino-Forestagreed to pay $32.5 million to burned investors. In the settlementdeal filed with the OSC, the underwriters made no admissions ofliability and denied any liability in the plaintiff’s claims. Butthe $32.5 million payment released them from needing to defendthemselves in the class action.

Business in China:

The company case reveals that business is done in China throughthe informal agreements with state or party officials, who grantaccess to licenses, resources, and markets only if they are paidunder the table. There can be no official records of thesepayments. Typically, auditors are not allowed to see bank accounts,and transactions are muddled by a proliferation of secretarrangements through authorized intermediaries.

The main job of foreign managers in China is not business per sebut the cultivation and maintenance of personal relationship withofficials. If they play this game well, they win- as didSino-Forest prior to these embarrassing disclosures.

Sino-Forest’s earnings depend on how its management dividessurpluses between the company and its Chinese patrons. If theybecome greedier and demand more generous payoffs, reported earningssuffer. In effect, confidential agreements and corruption determineearnings per share more than real business operations.

Company’s annual report references the three key risk factorsthat an insider to Chinese business would understand, but outsiderswould likely miss:

We rely on our relationship with local plantation land ownersand/or plantation land use rights holders authorizedintermediaries, key customers, suppliers, and third-party serviceproviders.

We are heavily dependent on the expertise of our seniormanagement and the relationships cultivated by them with our majorcustomers and others. This concentration of authority creates riskin terms of measurement and completeness of transactions, which maylead to the possibility of inaccurate financial reporting.

Violations of PRC laws or regulation could result in civil andcriminal penalties, including the revocation of licenses requiredfor our business.

Cultural Issues:

Lawyers for executives of collapsed Sino-Forest, once a highflyer on the Toronto Stock Exchange, said their clients nevercommitted fraud but followed common business practices accepted inChina. To refute such claims, Hugh Craig and OSC lawyer said: “Itwas a Canadian company, it raised money from Canadians in Canada. Aculture of accountability must be recognized.” But a lawyer forAllen Chan, as well as legal representative for four other, wasquoted as saying Canadian regulators made the mistake of lookingthrough “a North American lens” when interpreting Sino-Foresttimber ownership and sales contract in China. “These events did nottake place on Bay Street or even rural Ontario.” Emily Cole, alawyer for Mr. Chan, told a three-member panel of OSC commission.“The panel should not draw conclusions about them as if theydid.”

Cole explained that her witness, Dr. Randall Peerenboom, anAmerican who had lived in China for more than 20 years, wouldexplain how business practices viewed as surprising, if notshocking, to Canadian regulators were the only way to do businessin China where money could not be exchanged freely and local bankaccounts were impossible to get. She claimed the OSC’s fraudaccusations centered in part on Company’s practice of buying andselling timber assets without any cash passing through the company.Purchasers bypassed the company entirely by paying Sino-Forest’ssuppliers. Cole explained that the accusation presupposed theycould have sent money to Sino-Forest, but that wasn’t possible. “Keep an open mind about these differences in business and culture.”She urged the OSC panel.

During the trial, Markus Koehnen, who was representing formersenior Sino-Forest executives Alfred Hung, Albert Ip, George Ho andSimon Yeung, spent more than two hours walking the panel throughsuch concepts at guanxi or relationship building. He saidunderstanding the key component of Chinese business that goes wellbeyond networking would clear up concern over declaring revenuebased on agreements made in farmer’s field, and the perceivedimpropriety of a series of close business connections betweenSino-Forest and key customers and suppliers. The OSC had allegedthat Sino-Forest’s top executives hid these relationships thathelped perpetrate the fraud and included the fabrication of assetand revenue.

Charges against E&Y

The OSC alleged that E&Y failed to properly understand thelegal basis of Sino-Forest’s claim to its assets and relied on anopinion prepared by the forestry company’s legal firm Jingtian andGongchen Attorneys at Law. The OSC also accused EY ofinappropriately relying on the valuation work of Poyry ForestIndustry, Ltd., a company hired by Sino-Forest to prepare periodicvaluation of its timber holdings.

The OSC alleged that EY failed to adequately review or questiondocumentation related to Sino-Forest’s ownership of standing timberreserves the company held in China. The purported assetsconstituted the vast majority of Sino-Forests assets and producednearly all of its reported revenue.” “E&Y’s lack of diligencein these areas therefore resulted in significant negativeconsequences for Sino-Forest’s shareholders.”

The OSC stated it had found significant evidences that the firmdid not go far enough to prove that Sino-Forest’s stated timberholding exist, pointing out the E&Y never obtained two keyelements of the company’s purchase contracts: the villager’s letterof authorization and the certificate of forest proprietorship. Theprecise location of the forestry assets was also not described inthe purchase contracts. “Both of these deficiencies should haveprompted E&Y to make further enquiries of Sino-Forestmanagement and to perform further audit procedures.”

In its statement of allegation, the OSC alleged that E&Yfailed to verify the ownership and existence of Sino-Forest’s mostsignificant forestry assets. The OSC said that the specificlocation of purchased assets was not delineated in purchasecontracts, which should have raised questions by auditors. And thecommission said EY did “very limited” site visits to inspect thefirm’s purported assets, which were widely scattered throughoutChina. The regulator said an internal email between members ofE&Y’s audit team shows staff were asking questions about sitevisits, which were done along with third-party forestry consultantsPoyry Forest Interest Ltd., hired by Sino-Forest.

OSC enforcement director Tom Atkinson said that “If auditorsfail to abide by Canadian auditing standards and securities laws,we will hold them accountable.” Class action lawyer DimitriLascaris who had represented Sino-Forest’s shareholders said hebelieved audit firms would now “exercise a higher degree ofprofessional skepticism going forward.” “Any time you areconfronting circumstances of this nature and a liability of thismagnitude, you are going to have a very powerful economic incentiveto be very careful.”

The OSC maintained the company did not show enough “professionalskepticism” in conducting its audits. OSC lawyer told thesettlement hearing that the accounting firm overlooked flaws in itsclients’ accounting and did not conduct proper reviews. But shealso said there is no evidence of “dishonest” conduct by theaccounting firm. The OSC also expressed a concern about the auditteam itself. It noted that several of the senior EY partnersinvolved in the Sino-Forest audits did not speak Chinese, and thefirm did not translate many of the key Sino-Forest documents intoEnglish.

E&Y ‘s lawyer told the hearing that the “honesty andintegrity of E&Y and its people were never in question.” Shesaid the settlement avoids the time, expense, and uncertainty ofwhat would have been lengthy hearings.

In addition to the financial payment, E&Y told the OSC thatit put in place new policies for auditing companies that havesignificant operations in emerging markets, and it had done a“focused assessment” of audits on companies based in China.

Lascaris said the E&Y settlement reinforces his argumentthat individuals or organizations are not motivated to signno-contest settlements because of a concern over follow-up civilsuits. The real motivation for no contest settlements is that firmsand individuals want to protect their reputations, and theirability to generate new business.

Overall, the settlement should send a message to E&Y, andother capital markets participants, that audits need to beconducted with proper levels of diligence. OSC vice-chairman JamesTurner, who approved the settlement, said it underlines the vital“gate keeping” role that auditors play, and that auditors need toshow sufficient scrutiny, skepticism, and diligence.

“This is a wake-up call for the audit profession.” Said forensicaccountant Charles Smedmor, who teaches accounting at TorontoSeneca College. “It underlines the need to drill down to getsufficient appropriate audit evidence to support auditopinions.”

Questions:

1.Should operational and culturalconsiderations play a role in determining whether Sino-Forestcommitted a fraud? Explain

2.Did Sino-Forest manageearnings?

3.Critically evaluate the audit work ofE&Y from the perspective of GAAS and professional ethics. Wasthis a failed audit?

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