17 Feb WorldCom Fraud
The cronies at WorldCom pulled off one of the largest corporate frauds in United States history, duping thousands of investors out of billions of dollars. While this blog is generally devoted to M&A, I often like to blog about ethics and interesting topics in finance and accounting. Because the WorldCom case is so interesting, we’re going to delve into it a bit as we examine what took place, how the fraud was perpetrated and what can be done in the future to prevent such action.
Brief History of the Company
WorldCom was founded in 1983 as LDDS (Long-Distance Discount Service). In 1985, Bernie Ebbers was named CEO of the company. It was not until 1995 that the company officially changed its name to WorldCom. Three years later the company acquired telecom giant MCI. For a short time the merged entity was known as MCI-WorldCom, but eventually the company kept true to the roots of its 1995 creation: WorldCom.
In 2000 the firm proposed an acquisition of Sprint, but the idea was abandoned due to opposition from the U.S. government over potential anti-trust issues.
WorldCom’s strategy was growth through corporate acquisition. Because of the forecasted growth for continued huge increases in demand for telecommunications, WorldCom was intent on riding the predicted wave through acquiring some of the largest telecommunications networks then available, the biggest being MCI. However, the dot-com bust of around the year 2000 led to many company failures which contributed to a large excess capacity on WorldCom’s and others’ telecom networks. The networks themselves were largely made of fixed costs and telecom companies saw revenues fall and/or flatten. This led to an almost universal decrease in profits across the industry.
Competitive Forces at Work
WorldCom saw many of the standard forces working against them during this time which may have contributed to the pressure and problems the company had faced. Direct competitors in the industry at the time included AT&T, Sprint, SBC, Verizon and T-Mobile. Indirect competitors included mail, email, UPS, FedEx etc. Potential indirect competitors included VOIP calling services such as Skype and others. Cable and software companies were potential direct competitors which also loomed closely on the horizon. Because WorldCom was be measured against some of the fastest growing tech and telecom companies in the world, it created a large amount of pressure to perform and “make the numbers.”
Three specific performance metrics which the company was gauged on included earnings targets, revenue growth and line cost/revenue (the E/R ratio in the telecom world). The fraud which was perpetrated by WorldCom executives Bernie Ebbers and Scott Sullivan had to do directly with line costs. Line costs involved the transmitting of calls across the telephone/network “lines.” These were often paid to other telecom companies who may have actually owned the network itself.
For instance, if I were to place a call to my sister living in Shenzhen, China the call would start on the U.S. West network, pass through the WorldCom network and then end by passing through China Mobile’s wireless network. The cost in 2000 would have equated to about $15.
In general this transaction would have included a debit to AR and a credit to revenue for $15 with a debit to line costs and a credit to liability for line costs of $6. Hence the gross profit on the call would be $9. Keep in mind, the $6 was an “estimated” liability because WorldCom was not able to tell right away what the cost would be to them. So when WorldCom received a bill from U.S. West and China Mobile some time later they would debit liability for line costs for the $6 and then credit both accounts payable and line costs for the actual amount and the difference (this would work in the case that the actual amount was less than the estimate). The actual gross profit on the call could go up or down after the actual bill came in, depending on what the costs were.
WorldCom could have done a number of things here which were unethical. Namely the company could have overstated line costs in early quarters and released the excess over to show a higher profit in future quarters. This is known as a “cookie jar reserve.” If they release the overstated accruals overtime, they could show greater profits in future quarters to meet or beat intended targets.
There were very few things the company could have done to increase the bottom line and thus increase the stock, etc. They could have done something more ethical and increased revenue through more sales or they could lower the line costs. Revenue increases were certainly not occurring as the industry itself was suffering from outside pressures. The pressure to decrease the line costs was very high.
There were a couple of ways in which the company could have revised estimates of the line costs. They could have done it with a reasonable cause if they felt the estimates were over/under-stated. They could also do some trickery and revise the estimates without a cause. What the executives chose to do was capitalize the line costs, moving them from one place on the balance sheet to another.
The line costs at WorldCom represented their largest inherent uncertainty. As part of their attempt to improve the E/R ratio, the company could have underestimated the accrual or “released the accrual.” What management did was to move “line cost expense” to a “pre-paid asset” account on the assets side of the balance sheet. What is interesting was that it got to a point where the line costs actually became extremely predictable. Meaning, the company auditors were reporting the same line costs quarter after quarter. Eventually the fraud was detected by CPA Cynthia Cooper and the whole thing fell apart.
What does this have to do with M&A
My intent in writing about this was to demonstrate how unethical behavior can seem so simple and yet be so disastrous. When selling your business, there is an extreme motivation many times to overstate revenues, understate costs and paint a much rosier picture than what meets the eye. This temptation has led many an advisor down a similar path as Bernard Ebbers and Scott Sullivan and Co. Ethical reporting and proper accounting not only keeps people safe, but keeps trust—which is essential to any business transaction—paramount in the minds of both buyers and sellers.