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The WorldCom failure 1

The WorldCom failure

PowerPoint slides

Hervé StolowyHEC Paris

Updated on November 1, 2008


A challenge for academics

• From Harvard to Enron (concerning JeffreySkilling)

• “The MBA, the high road to fraud” (CourrierInternational)

• From HEC to …


Presentation outline

• Sources

• Structure and key people

• History of a success

• The back side of a success

• The accounting problem

• The collapse

• Lessons for the future


Sources• Cynthia Cooper: “Extraordinary

circumstances - The journal of a corporatewhistleblower” , Wiley, 2007.

• Report of investigation by the specialinvestigative committee of the Board ofDirectors of WorldCom (Dennis R. Beresford,Nicholas de B. Katzenbach, C.B. Rogers, Jr.,Marc 31, 2003)(news.findlaw.com/wsj/docs/worldcom/bdspcomm60903rpt.pdf )

• Second interim report of Dick Thornburgh,Bankruptcy court examiner (June 9, 2003)(news.findlaw.com/hdocs/docs/worldcom/bkexmnr60903rpt2d.pdf)


Structure and key people


From a success…• 1983: creation of LDDS

• 1985: Bernie Ebbers appointed as CEO of LDDS

• 1995: name changed to WorldCom

• 1998: Acquisition of MCI

• By the end of 1999:– Had executed 70 acquisitions with a value of more than $50

billion

– Owned a network of 150,000 Km of telephone lines

– Had more than 80,000 employees (62,000 by the end of 2001)

– Operated in 65 countries

– Had a revenue of $36 billion (vs. $3.8 billion in 1995)


… to a failure• March 2002: first SEC investigations regarding

accounting practices and loans to CEO• Bernie Ebbers fired in April 2002 because of loans

granted by WC to him for huge amounts ($366m)• June 25, 2002:

– Loss in the first quarter instead of a $130 million profit– Loss in 2001 instead of a $ 1.4 billion profit– Intention to restate its financial statements for 2001 and the

first quarter of 2002• Had discovered improper transfer of $3.852 billion from

line cost expenses to asset accounts• August 8, 2002: WC announced additional irregularities

in 1999 through 2002: $3.330 billion


The fall

• Total improper accounting: $7.182 billion ($11billion estimated later)

• Value of the Company in June 1999 : $115billion

• Value of the share : $ 64.5 (pick in June 1999)

• Value of the share on Wednesday June 26, 2002:$0.10

• Bankruptcy (Chapter 11): July 21, 2002


Accounting fraud

• Reduction of reported line costs– WorldCom largest category of expenses

• Exaggeration of reported revenues

• Objective of these manipulations:– To hold reported line costs to approximately 42% of

revenues (ratio of line costs expense to revenue = “linecost E/R ratio”)

• They reached levels in excess of 50%

– To continue reporting double-digit revenue growth• Actual growth rates were substantially lower


Reduction of reported line costs• Initial discovery: $3.852 billion from line costs

expenses to asset accounts during 2001 and thefirst quarter of 2002

• Additional line cost irregularities: total (includingthe first announcement): $6.412 billion

• Other manipulation of line costs discovered• From 1999 through the first quarter of 2002: $7

billion• Two different “methods”:

– Release of accruals (1999-2000)– Capitalization of operating line costs (2001-2002)


Line costs• Line costs =

– Costs of carrying a voice call or data transmissionfrom it starting point to its ending point

– Fees paid to lease portions of other companies’telephone network

• Largest single expense

• Official view from WC: Acquisitions andmergers create synergies => keep down line costs


Release of accruals• Estimates in accounting, especially during acquisitions• Companies sometimes overstate liabilities and expenses• Has to be corrected once the exact numbers have been

determined• Some companies choose to leave them in place, creating

what’s known in accounting, disapprovingly, as rainy-day “cookie-jar reserves”

• Accruals: amounts “set aside” to pay anticipated bills• Accruals supposed to reflect estimates of the costs

associated with the use of lines ad other facilities ofoutside vendors

• Release (reversal) is proper when less is needed to paythan anticipated


Accounting for accruals (example taken from the book – chapter 5)

First year (example with electricity – equivalentto costs associated with lines)


Accounting for accruals (example taken from the book – chapter 5)

Second year: Assume that transaction never recorded=> Positive impact of 175Same recording for costs associated with lines


Capitalization of line costs (example)

No use of the production capitalized account (seechapter 8)


The capitalization

• Why? Because available accruals exhausted

• Line costs capitalized = ongoing, operatingexpenses => to recognize immediately

• With no capitalization => pre-tax loss duringthree quarters (out of five)

• Line cost E/R ratio > 50% in reality

• Softening markets do not reduce WorldCom’sprofitability => untrue


Report Line costs E/R ratio

• Source: annual report 2001


People involved• To change the financial statements => To pull several of

mid-level accountants into the plan• David Myers and Scott Sullivan are at high enough

levels in the company that they don’t actually makeaccounting entries in the system

• The trusted inner circle will have to grow• General accounting group (Clinton, Mississipi)• Property Accounting Group (Richardson, Texas) (in

charge of all capital assets)• Concern raising during the second quarter of 2001• More and more concern• But the practices continued until Internal Audit

discovered the capitalization in June 2002


Exaggeration of reported revenues• “Make the numbers”• Revenue growth = critical component of WC’s

early success• To maintain double-digit rates despite the

deterioration of the telecom industry in 2000 and2001

• Beginning in 1999: large revenue accountingentries after the close of many quarters

• Use of “Corporate unallocated” revenue accounts• $958 million between the first quarter of 1999

and the first quarter of 2002


Summary of improper accounting entries

Source: Beresford et al. Report, 2003


Real figures

• Source: Annual reports 2001 and 2003

2003 2002 2001 2000 Restated Restated Revenues 27,315 32,189 37,608 39,251 Access costs 13,040 14,651 16,013 16,889 Ratio 47.7% 45.5% 42.6% 43.0% 2001 2000 1999 Original Original Original Revenues 35,179 39,090 35,908 Line costs 14,739 15,462 14,739 Ratio 41.9% 39.6% 41.0%


How the fraud was discovered• Whistleblower (“one who reveals wrongdoing

within an organization to the public or to those inpositions of authority”): Kim Emigh


How the fraud was discovered• Article published on May 16, 2002 (Fort Worth

weekly)

• Article transmitted on May 21, 2002, by MarkAbide [WC’s director of property accounting] toGlyn Smoth [WC internal audit staff]

• Complains about capital expenditures which hewas instructed to record as expenses

• Tips sent to the Internal Audit

• Beginning of an audit on capital expenditures

• Small problem started a very big ball rolling


How the fraud was discovered• Internal audit began to grow increasingly

suspicious of some entries in WorldCom’s books– The more they investigated, the stranger the reactions

from some of they colleagues became– No one gave a straight answer– People who helped make the entries said they didn’t

know what they represented, or tried to lead them inthe wrong direction

– The CFO asked the Internal audit to delay their auditwork.

– The Controller insisted that they were wasting theirtime and should be auditing other areas of thecompany


Direct consequence: Sarbanes-Oxley Act of 2002

• Certification of financial reports by CEOs and CFOs• Ban on personal loans to Executive Officers and

Directors• Increased accounting transparency• Auditor independence, including outright bans on

certain types of work and pre-certification by thecompany’s audit committee of all other non-auditwork

• Tougher criminal and civil penalties for securitiesviolations

• Protection for whistleblowers


Indirect consequence

• More interest in financial accounting andreporting:– Within firms

– From students

– In the press (“It’s hot, it’s sexy, it’s … accounting”,title taken from the CPA Personnel Report)


Lessons and explanations

• Growth with acquisitions– Importance of the share price (payment with shares)– Difficulty to harmonize the procedures within the group– Internal control problems

• Importance of the internal audit department– Difficulty to develop the department– Difficulty to gain acceptance as a key player => focus on

projects that “add value” rather than on internal control– Lack of resources– Not independent (reporting to the CFO and CEO)– Lack if interactions with external auditors (focus on operational

audits)



• Managers’ personality:– Scott Sullivan: appointed CFO at the young age of 33

– Highly respected

– Wall Street: “financial wizard” and “straight shooter”

– 1997: compensation of more than $19 million =>highest-paid CFO in the U.S.

– 1998: CFO Magazine => CFO Excellence Award formergers and acquisitions



• The pressure of analysts and the markets (CynthiaCooper)– Line cost expense too high

– WC will not meet the earnings guidance executivespreviously issued

– The stock price will get hammered

– Analysts will downgrade their opinions, which couldsend the company into a downward spiral

– WC depends on its high stock price to acquirecompanies [acquisitions in shares]


Lessons and explanations• The analysts

– “Skeptics remain– Chief among them Dan Reingold– The top Merrill Lynch telecom analyst– Dan and Jack Grubman have been adversaries for

years– The two are opposites in demeanor as well– Dan is quietly methodological, deriving his reports

from hundreds of hours of research– Jack is more flamboyant, just as ready to rely on

intuition and the close relationships he’s built withindustry executive” (Cynthia Cooper)



• Problem with accounting entries: the boomerangeffect

• Slippery slope– “Some executives lost their way and led others astray

as well

– They embarked on a slippery slope

– Once they had begun to deceive, they did not regaintheir footing” (Cynthia Cooper)



• Firm’s culture

• Kim Emigh portrayed WC as:– Being plagued by “loose business practices

– Inadequate financial disclosure

– And widespread internal chicanery and corruption”

• Long before the accounting scandal


Lessons and explanations• Rationalization

– Line costs expense too high– “Scott is at a dangerous crossroads– He rationalizes that the cost of telling the truth is too high– In any case, there must be an error– It’ll surely correct itself the following quarter.– Change the numbers, he instructs David– Scott’s instructions are stressful for David– But David has always felt loyal to his boss, so he, too,

rationalizes– This will be temporary– There must be an error– Scott is sure of it” (Cynthia Cooper)



• Rationalization– “Troy [senior accountant] wonders if maybe he’s

making too much out of this

– After all, Scott’s very smart and highly regarded

– He must know what he’s doing” (Cynthia Cooper)



• The auditor (Andersen) [Thornburgh report]– Failure to design adequate procedures or perform planned

procedures• Too much emphasis on analytical audit (ratio comparison) [and Scott

Sullivan knew it!]

– Management’s influence over the audits• No access to the general ledgers and other ledgers and journals

– Unfounded reliance on integrity of management and fraudulentor misleading financial reports

– Failure to communicate critical assessments with auditcommittee and senior management

– Andersen replaced by KPMG in April 2002


A life after the collapse• MCI, Inc emerges from Chapter 11 protection from

bankruptcy (April 20, 2004)• Two reorganisation plans to eliminate the company’s

debt• Bernie Ebbers: convicted (September 22, 2005) to 25

years in Federal prison for securities fraud, conspiracyand filing false documents with regulators

• Ebbers is currently serving his sentence in a Louisianaprison and is likely to die in jail

• Scott Sullivan (facing 165 years of potential jail time)pleaded guilty to three criminal charges and collaboratedwith the prosecutor: 5 years sentence

• David Myers and Buford Yates: each sentenced to oneyear in prison

Transparent 37

Humor about WorldCom

How did this happen?


Humor about WorldCom


Last questions?

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