CASE

 

WorldCo­m took the telecom industry by storm when it began a frenzy of acquisitions in the 1990s. The low margins that the industry was accustomed to weren't enough for Bernie Ebbers, CEO of WorldCom. From 1995 until 2000, WorldCom purchased over sixty other telecom firms. In 1997 it bought MCI for $37 billion. WorldCom moved into Internet and data communications, handling 50 percent of all United States Internet traffic and 50 percent of all e-mails worldwide. By 2001, WorldCom owned one-third of all data cables in the United States. In addition, they were the second-largest long distance carrier in 1998 and 2002.

Unfortunately for thousands of employees and shareholders, WorldCom used questionable accounting practices and improperly recorded $3.8 billion in capital expenditures, which boosted cash flows and profit over all four quarters in 2001 as well as the first quarter of 2002. This disguised the firm’s actual net losses for the five quarters because capital expenditures can be deducted over a longer period of time, whereas expenses must be subtracted from revenue immediately. WorldCom also spread out expenses by reducing the book value of assets from acquired companies and simultaneously increasing the value of goodwill. The company also ignored or undervalued accounts receivable owed to the acquired companies.

These accounting practices made it appear as if WorldCom’s financial situation was improving every quarter. As long as WorldCom continued to acquire new companies, accountants could adjust the values of assets and expenses. Internal investigations uncovered questionable accounting practices stretching as far back as 1999. Investors, unaware of the alleged fraud, continued to purchase the company’s stock, which pushed the stock’s price to $64 per share.

Even before the improper accounting practices were disclosed, however, WorldCom was already in financial turmoil. Declining rates and revenues and an ambitious acquisition spree had pushed the company deeper in debt. The company also used the rising value of their stock to finance the purchase of other companies. However, it was the acquisition of these companies, especially MCI Communications, that made WorldCom stock so desirable to investors.

How the fraud happened

In 1999, revenue growth slowed and the stock price began falling. WorldCom's expenses as a percentage of its total revenue increased because the growth rate of its earnings dropped. In an effort to increase revenue, WorldCom reduced the amount of money it held in reserve (to cover liabilities for the companies it had acquired) by $2.8 billion and moved this money into the revenue line of its financial statements.

That wasn't enough to boost the earnings that the CEO wanted. In 2000, WorldCom began classifying operating expenses as long-term capital investments. Hiding these expenses in this way gave them another $3.85 billion. These newly classified assets were expenses that WorldCom paid to lease phone network lines from other companies to access their networks. They also added a journal entry for $500 million in computer expenses, but supporting documents for the expenses were never found.

These changes turned WorldCom's losses into profits to the tune of $1.38 billion in 2001. It also made WorldCom's assets appear more valuable.

How it was discovered

After tips were sent to the internal audit team and accounting irregularities were spotted in MCI's books, the Securities Exchange Commission requested that WorldCom provide more information. The SEC was suspicious because while WorldCom was making so much profit, AT&T (another telecom giant) was losing money. An internal audit turned up the billions WorldCom had announced as capital expenditures as well as the $500 million in undocumented computer expenses. There was also another $2 billion in questionable entries. WorldCom's audit committee was asked for documents supporting capital expenditures, but it could not produce them. The controller admitted to the internal auditors that they weren't following accounting standards. WorldCom then admitted to inflating its profits by $3.8 billion over the previous five quarters. A little over a month after the internal audit began, WorldCom filed for bankruptcy.

Causes

Internal Environment

The executive and strategic decisions at WorldCom were characterized by rapid growth through acquisitions. ‘Growth, growth, growth...’ was the moto. By 1998, WorldCom had been involved in mergers with sixty companies. Together, these transactions were valued at more than $70 billion, the largest of which, MCI Communications Corporation (‘MCI’), was completed on September 14, 1998, and was valued at $40 billion. Once WorldCom acquired the new companies, it failed to properly integrate the systems and policies that not only led to very high levels of overheads in proportion to the revenues but also to an extremely weak internal control environment. Due to the fast pace of the acquisitions as well as management’s neglect, the accounting systems at WorldCom were unable to keep up with integration and efficiency. The lack of internal controls allowed manual adjustments to be made in the system without the emergence of any red flags, thereby minimizing any chance of detection

Company Culture

The growth through acquisitions ‘strategy’ at WorldCom was enforced and reinforced by top management. The consistent pressures from top management created an aggressive and competitive culture that did not contain any communication of the need for honesty or truthfulness or ethics within the company. There was a large focus on revenues, rather than on profit margins and the lack of integration of accounting systems allowed WorldCom employees to move existing customer accounts from one accounting system to another. The employees at WorldCom did not have an outlet to express concerns about company policy and behavior either. Special rewards were given to those employees who showed loyalty to top management while those who did not feel comfortable in the work environment were faced with obstacles in their need to express their concerns. The combined management allowed the creation of a culture that was more suitable for a sole proprietorship than for a billion dollar corporation. The aggressive nature of the managing style such as the plethora of acquisitions as well as the failure to integrate them properly created an environment where employees were pressured to report high growths quarter by the quarter.

Board of Directors

The directors at WorldCom were from different backgrounds. While some had widespread knowledge and experience of business and legal issues, others were appointed due to their connections with Ebbers. The mix of the Board and the close ties to Ebbers led to the Board‟s lack of awareness on WorldCom‟s issues. The Board was inactive and met only about four times a year, not enough for a company growing at the rate that it was.

Audit Committee and Internal Audit

The lack of independence and awareness of the Board as a whole trickled down to the audit committee. The committee‟s chairman, Max Bobbitt, was very loyal to Ebbers. Hence, the members of the committee, including Bobbitt, were either unaware or had known about the fraudulent misstatements for the years 1999, 2000, and 2001 and choose to ignore it. According to Breeden (2003), the Committee oversaw the $30 billion revenue company when it met for about three to six hours once a year.

WorldCom‟s Audit Committee failed to meet with the Internal Auditors of the company, who had the duty to provide the Audit Committee with an independent and objective view on how to improve and add value to WorldCom’s operations. Not only were the personnel in the internal audit department not enough for a large company, but they also lacked the proper training and experience to conduct the testing of the company’s controls.

The Misstatement of Line Costs

Line costs are the costs associated with carrying a voice phone call or data transmission from the call’s origin to its destination. If a WorldCom customer made a call from New York City to London, the call would first go through the local phone company’s line in New York City, then through WorldCom’s long distance, and finally through the local phone company in London. WorldCom would have to pay both the local companies in New York City and London for use of the phone lines; these costs are considered line costs. Not only were line costs WorldCom’s biggest expense but were also approximately half of WorldCom’s total expenses. Especially after the collapse of the dot com bubble in early 2000, cost savings became extremely important, so important that line cost meetings were the only meetings with regular attendance by top management. WorldCom’s top management strived to achieve a low line cost to revenue ratio (‘line cost E/R ratio’), because a lower ratio meant better performance whereas a higher ratio meant poorer performance. To report better performance and growth, Sullivan implemented two improper accounting methods to reduce the amount of line costs: release of accruals from 1999-2000 followed by the capitalization of line costs in 2001 through early 2002.

Releasing Accruals

During the fraud period at WorldCom, was characterized by the estimation of costs that were associated with using the phone lines of other companies. The actual bill for the services was usually not received for several months. This meant that some entries made to the payables could be overestimated or underestimated. In the case that the liability was overestimated, when the actual bill was received there would be a surplus of liabilities that when ‘released’ would result in a reduction of the line costs:

Accounts Payable 1,000,000
            Cash Paid to Suppliers 900,000

Line Cost Expense ‘release’ 100,000

WorldCom adjusted its accrual in three ways.

Some accruals were released without even confirming if any accruals existed in the first place.

Second, if WorldCom had accruals on its balance sheet it would not release them for the proper period and instead keep them as ‘rainy day’ funds for future uses.

Lastly, some of the accruals released were not even established for line costs, thereby violating GAAP by using one expense type to offset another.

Line costs were very significant to WorldCom‟s bottom line. Ebbers made public promises to stockholders and Wall Street that WorldCom would keep those costs low. Therefore, the managers at WorldCom were continuously under pressure to find ways to reduce those costs. With the burst of the Internet and telecomm bubbles, the pressure increased and more ways had to be discovered to keep on reporting the false numbers. WorldCom‟s competitors such as Sprint and AT&T had line costs that were 52% of revenues. WorldCom reported line costs of about 42% of revenues, in reality these costs were 50%-52% of revenues. Although WorldCom‟s line cost ratio was in line with the telecomm companies in the industry, it chose to report lower line costs because that is what the analysts expected. By meeting analyst expectations, WorldCom would make Wall Street happy. Wall Street‟s contentment with WorldCom would result in an increase in investments and thereby a higher stock price for WorldCom. The higher the stock price, the cheaper it would become for WorldCom to acquire other companies.

The pressure worsened by early 2001 as Sullivan tried to find different ways to reduce expenses. He directed General Accounting to reduce the line cost expense for the Wireless division by $150 million. The Wireless division saw this and told Sullivan that there was no support to the entry and he was forced to reverse it. He then ordered the managers of the General Accounting department to make large ‘round-dollar’ journal entries that weren‟t related to the Wireless division without any documentation. They did not hesitate the first time because they believed in Sullivan‟s integrity and thought that he had most likely discovered an accounting loophole. Two years later, as the fraudulent reporting continued, the managers were very uncomfortable with what they were doing and the only reason they did not report the fraud was because they feared the loss of their well paying jobs.

Over the two year period, WorldCom had made inappropriate accrual releases both in the domestic and international divisions that amounted to about $3.3 billion. As the accruals started to run out, Sullivan came up with another strategy: capitalization of line costs.

Capitalizing Line Costs

The 4% utilization of the fiber optic cables meant that WorldCom was still paying for the leases on the cables even though it was generating no revenue on them. According to Morse 28 (personal communication, February 8, 2011), WorldCom had leased the lines in a 2-5 year agreement that could not be canceled. However, the costs associated with the lines were causing the line cost E/R ratio to increase. Thus, when no more accruals could be released, Sullivan turned to capitalize these costs, another violation of GAAP.

By capitalizing the costs from the cables, the 2-5 year leases now had 20-30 year lives which would slowly depreciate over the next two or three decades (Morse, personal communication, February 8, 2011). GAAP requires these costs to be recognized immediately. A Line Cost to Revenue report was generated for top management to which round number adjustments were made a week or so before the numbers were announced to the public (Zekany, Braun, & Warder, 2004).

By the time the fraud was discovered, Sullivan had managed to improperly reduce the line costs by approximately $3.883 billion. Capitalizing the expenses resulted in shifting the items from the income statement onto the balance sheet, allowing the overstatement of income as well as the overstatement of assets.

           

Admission of guilt

WorldCom admitted to violating generally accepted accounting practices (GAAP), and adjusted their earnings by $11 billion dollars for 1999-2002. Looking at all of WorldCom’s financial activities for the period, experts estimate the total value of the accounting fraud at $79.5 billion.

After Bankruptcy

WorldCom was renamed MCI. Former CEO Bernie Ebbers and former CFO Scott Sullivan were charged with fraud and violating securities laws. Ebbers was found guilty on all counts in March 2005 and sentenced to 25 years in prison, but is free on appeal. Sullivan pleaded guilty and took the stand against Ebbers in exchange for a more lenient sentence of five years.

Re-Organization

WorldCom took many steps toward reorganization, including securing $1.1 billion in loans and appointing Michael Capellas as chairman and CEO. WorldCom also tried to restore confidence in the company, including replacing the board members who failed to prevent the accounting scandal, firing many managers, reorganizing its finance and accounting functions, and making other changes designed to help correct past problems and prevent them from reoccurring. Additionally, the audit department staff is was increased and reported directly to the audit committee of the company’s new board. However, this reorganization was not enough to restore consumer and investor confidence, and Verizon Communications acquired MCI in December 2005. Verizon obtained the freshly minted MCI for $7.6 billion, but not the $35 billion of debt MCI had when it declared bankruptcy

Aftermath

The WorldCom accounting fraud changed the entire telecommunications industry. As part of their overvaluing strategy, WorldCom had also overestimated the rate of growth in Internet usage, and these estimates became the basis for many decisions made throughout the industry. AT&T, WorldCom/MCI’s largest competitor, was also acquired. Over 300,000 telecommunications workers lost their jobs as the telecommunications struggled to stabilize. Many people have blamed the rising number of telecommunication company failures and scandals on neophytes who had no experience in the telecommunication industry. They tried to transform their startups into gigantic full-serproviders like AT&T, but in an increasingly competitive industry, it was difficult for so many large companies could survive.