WorldCom's Magic Trick
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How One of the World's Largest Companies Managed to Make $3.8 Billion Disappear
If you 've watched television, picked up a newspaper, or read a magazine, you've probably heard about the WorldCom scandal where WorldCom inflated its numbers by nearly $4 billion dollars.
Most investors don't understand how a company as large as the Mississippi telecommunications provider could manage to hide a fraud of this magnitude from the investing community for so long. The answer lies in CFO Scott Sullivan's treatment of capital expenditures and the accrual method, one of the basic principles of accounting.
Understanding the Accrual Method
When a business incurs an expense, *accounting rules state that the cost of that expense should be allocated over the entire period it will benefit the company. This attempt to match revenues with the cost it took to generate those revenues is known as the accrual method.
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Lets take a fictitious company as an example. "The Charles Tyre Company".
Charles Tyre Co., earns $10,000 profit a year. In the middle of 2002, the business purchases a $7,500 tyre manufacturing machine that is expected to last for five years, and will allow the employees to make twice as many tyres per hour.
If investors examined the financial statements, they might be discouraged to see that the business only made $2,500 at the end of 2002 ($10k profit - $7.5k expense for purchasing the new machinery) The investors would wonder why the profits had fallen so much during the year.
Thankfully, Charles’s accountants come to the rescue and tell them that the $7,500 must be allocated over the entire period for it to benefit the company. Since the tyre machine is expected to last five years, Charles can take the cost of the tyre machine and divide it by five ($7,500 / 5 years = $1,500 per year.)
Instead of realizing a one-time expense, the company can subtract $1,500 each year for the next five years, reporting earnings of $8,500. This allows the investor to get a more accurate picture of the company's economic reality.
In the example, the purchase of the tyre machine is a type of "capital expenditure". Capital expenditures are expenses that a company incurs to pay for assets such as a factory, machinery, or equipment. This accrual method of accounting for capital expenditures does not apply to operating expenses such as materials, salaries, and the like.
Do the Hokey-Pokey or, How to Shuffle your Books
How does this apply to the WorldCom scandal? The company's CFO, Scott Sullivan, fraudulently took billions of dollars in operating expenses and spread them out across so-called *property accounts, which are a type capital expense accounts.
*Property Accounts These are referred to as "fixed assets". In other words, these are the corporation's real estate, buildings, office furniture, telephones, cafeteria trays, brooms, factories, etc. They are the physical assets the company owns but can't quickly convert to cash. |
This allowed WorldCom to charge the expenses off slowly, and in smaller amounts, instead of reporting them immediately to investors. In 2001, the company reported a $1.4 billion profit. Had the operating costs not been incorrectly hid, WorldCom would have actually lost money for fiscal 2001, as well as first-quarter 2002.
What this means for investors
The WorldCom fraud has far-reaching implications for investors. The basis of the American financial system is the integrity of the financial reports released by management. Unless those figures are as accurate as possible, analysts, money managers, and lay-investors alike do not have the resources to properly value a business.
Although CFO Scott Sullivan defends his choice to allocate the expenses in question, he and WorldCom went far beyond the aggressive accounting practices used at some companies.
Remedial Action
The Securities and Exchange Commission (SEC) is going to begin requiring executives at large corporations to sign statements swearing they believe, to the best of their knowledge, the financial statements released by the companies are as accurate as possible. This action could ultimately lead to the government holding executives responsible in the event of corporate fraud.
How did WorldCom go bankrupt?
Executives at telecommunications giant WorldCom perpetrated accounting fraud that led to the largest bankruptcy in history. The fraud was revealed to the public in June 2002 and WorldCom filed for bankruptcy in July 2002.
Evidence shows that the accounting fraud was discovered as early as June 2001, when several former employees gave statements alleging instances of hiding bad debt, understating costs, and backdating contracts. However, WorldCom's board of directors did not investigate these claims. In June 2001, a shareholder lawsuit was filed against WorldCom, but it was thrown out of court due to lack of evidence.
When the Securities and Exchange Commission (SEC) launched its own investigation in March 2002, it was discovered that the prior claims were valid. As a result, the SEC filed a civil fraud lawsuit against WorldCom and federal charges were filed against several executives.
With a different management, WorldCom is operating under its former name MCI again.
Ricky Schmidt
January 31, 2005
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