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The Economic and Institutional Setting

for Financial Reporting

“No one ever said accounting was an exact science.”

I

n late June 2002, WorldCom stunned investors by announcing that it intended to

restate its financial statements for 2001 and the first quarter of 2002.1 According to

the company’s press release, an internal audit of capital expenditures had uncovered $3.8 billion in improper bookkeeping transfers from line cost expense—an income

statement item—to the balance sheet. Without those transfers, the company would have

reported a loss for 2001 and the first quarter of 2002. The company’s chief financial officer was fired, and its controller resigned. Trading in the company’s stock was immediately halted. When trading resumed a few days later, the stock was worth only 6 cents

per share, having lost more than 90% of its value.

The accounting scandal at WorldCom, along with those involving many other highly

visible companies during the late 1990s and early 2000s, were watershed events. Investors, regulators, and politicians worldwide lost confidence in the soundness of U.S.

accounting standards, the transparency of corporate financial reports, the expertise and

independence of auditors, and the integrity of U.S. financial markets. Congress responded

by passing the Sarbanes-Oxley Act, which contained sweeping reforms intended to restore

public confidence. To understand why the reforms were needed, and how they have

shaped today’s financial reporting environment, let’s step back in time to May 2002 and

take a close look at the WorldCom scandal. After all, as the philosopher George Santayana

has said: “Those who cannot learn from history are doomed to repeat it!”

WorldCom’s Curious Accounting

According to a report on the company from a highly regarded Wall Street analyst,

WorldCom is doing surprisingly well despite tough times throughout the...