Corporate & securities law

WorldCom Fraud Financial analysis

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FINANCIAL ANALYSIS

WorldCom’s improper accounting was mainly in two forms:

1.      Report reduced line cost
This served the purpose of reporting the line costs to 42% of the revenues, whereas in reality the line costs were much above 50%. This allowed Ebbers’ to report double digit growth(inflated). Line costs, during 1999 – 2001, were reduced via

1.      Release of improper accruals (amount set aside to pay anticipated bills).

2.      Capitalisation of line costs (recording cost as an asset rather than an expense).

Release of improper accruals was done in three ways:

·         Using accruals without checking for excess available.

·         Using accruals meant for other expenses.

·         Releasing accruals in the period that it did not belong to, i.e. used them as emergency funds for personal gains.

o   (The reduction to line costs by accrual release, capitalisation, etc is shown in appendix B)

o   (The reduction to line costs by accrual release, capitalisation, etc as a percentage of total line cost is shown in appendix C)

By capitalising operating costs, WorldCom shifted the high operating cost (line cost) from its income statement to its balance sheet. This increased its pre-tax income and earnings per share(EPS).
The capitalized line costs in the first and second quarters of 2001 had been booked in “Construction in Progress”. In August, however, employees in Property Accounting transferred the capitalized line cost amounts out of Construction in Progress and into “in-service asset accounts” as some auditors had expressed interest in reviewing the former account.

2.      Exaggerate reported revenues

When market conditions deteriorated during 2000 and 2001, most companies in telecom sector reported reduced growth but WorldCom being a growth oriented company, reported same levels of growth (double digit growth). Due to pressure from CEO, the employees made false, fudged entries as revenues as and when they could. During investigation, SEC found hand written notes calculating the difference between desired and actual revenue(monthly) and appropriate(matching) entries were found in the books.

Most of these fudged entries of revenues were made in the “Corporate unallocated revenue” account. These entries were recorded mostly after the end of the quarter and not during the quarter, suggesting these were adjusting entries. Also, these entries were always in round figures i.e. in millions or tens of millions.

o   (The extent of corporate unallocated account in which the revenues were shown falsely is shown in appendix E)

3.      Other accounting issues

Though in a small proportion, Accounting personnel improperly reduced three other categories of expenses; selling, general and administrative costs(SG&A), depreciation and income taxes.

o   (Summary of improper income statement amounts is shown in appendix A)

CASE LEARNING

1.      Ratios help detect accounting scandal

These tests(ratios) do not indicate a fraud, but, indicate weak and accounting and give hints of financial trouble.

·         Accounts receivables growth versus sales growth: if accounts receivables grow faster than sales, then it means company is extending credit to customers who are not paying or has aggressive revenue recognition policy. Ideally this ratio should be negative, as it indicates that company is generating cash form its operations.

·         Property, Plant and Equipment (PPE) as a percentage of total assets: This ratio should be fairly stable over time. Spike in any direction indicates something is amiss. For example, a large spike indicates that a company is capitalising routine maintenance cost, as was the case in WorldCom.

·         Operating cash flow versus earnings per share(EPS): This ratio should be relatively stable over time and be negative. GAAP allows companies to match expense with revenue, when it is earned. Inventory cost is recorded as an expense when it is sold and not when it is bought. This reduces volatility. This causes the cash flow to decline with no change in earnings. Hence there is a difference between cash flow and EPS, but it should converge with time, as the sale is made. This property is used to detect health of organization. If EPS consistently exceeds operating cash flow, it indicates poor earning quality. Such companies make poor investments.

There are other ratios which help detect fraud and accounting health of an organisation. Such warning signs do not necessarily indicate fraud, but show the health of the company and reflect on their poor performance.

o   (Effect and extent of capitalisation of operating costs is shown in appendix D)

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Pritesh Parikh

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