The WorldCom
failure
PowerPoint slides
Hervé Stolowy
HEC Paris
Updated on November 1, 2008
The WorldCom failure
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A challenge for academics
• From Harvard to Enron (concerning Jeffrey
Skilling)
• “The MBA, the high road to fraud” (Courrier
International)
• From HEC to …
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Presentation outline
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Sources
Structure and key people
History of a success
The back side of a success
The accounting problem
The collapse
Lessons for the future
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Sources
• Cynthia
Cooper:
“Extraordinary
circumstances - The journal of a corporate
whistleblower” , Wiley, 2007.
• Report of investigation by the special
investigative committee of the Board of
Directors of WorldCom (Dennis R. Beresford,
Nicholas de B. Katzenbach, C.B. Rogers, Jr.,
Marc 31, 2003)
(news.findlaw.com/wsj/docs/worldcom/bdspc
omm60903rpt.pdf )
• Second interim report of Dick Thornburgh,
Bankruptcy court examiner (June 9, 2003)
(news.findlaw.com/hdocs/docs/worldcom/bke
xmnr60903rpt2d.pdf)
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Structure and key people
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The WorldCom failure
From a success…
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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)
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… 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
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The WorldCom failure
The fall
• Total improper accounting: $7.182 billion ($11
billion estimated later)
• Value of the Company in June 1999 : $115
billion
• 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
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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 = “line
cost E/R ratio”)
• They reached levels in excess of 50%
– To continue reporting double-digit revenue growth
• Actual growth rates were substantially lower
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Reduction of reported line costs
• Initial discovery: $3.852 billion from line costs
expenses to asset accounts during 2001 and the
first quarter of 2002
• Additional line cost irregularities: total (including
the 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)
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Line costs
• Line costs =
– Costs of carrying a voice call or data transmission
from 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 and
mergers create synergies => keep down line costs
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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 rainyday “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 of
outside vendors
• Release (reversal) is proper when less is needed to pay
than anticipated
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Accounting for accruals (example
taken from the book – chapter 5)
First year (example with electricity – equivalent
to costs associated with lines)
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Accounting for accruals (example
taken from the book – chapter 5)
Second year:
Assume that
transaction  never
recorded
=> Positive impact of
175
Same recording for
costs associated with
lines
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Capitalization of line costs (example)
No use of the production capitalized account (see
chapter 8)
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The capitalization
• Why? Because available accruals exhausted
• Line costs capitalized = ongoing, operating
expenses => to recognize immediately
• With no capitalization => pre-tax loss during
three quarters (out of five)
• Line cost E/R ratio > 50% in reality
• Softening markets do not reduce WorldCom’s
profitability => untrue
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Report Line costs E/R ratio
• Source: annual report 2001
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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 make
accounting 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
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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 and
2001
• Beginning in 1999: large revenue accounting
entries 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
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Summary of improper accounting
entries
Source: Beresford et al. Report, 2003
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Real figures
2003
Revenues
Access costs
Ratio
Revenues
Line costs
Ratio
27,315
13,040
47.7%
2002
32,189
14,651
45.5%
2001
Restated
37,608
16,013
42.6%
2001
Original
35,179
14,739
41.9%
2000
Restated
39,251
16,889
43.0%
2000
Original
39,090
15,462
39.6%
1999
Original
35,908
14,739
41.0%
• Source: Annual reports 2001 and 2003
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How the fraud was discovered
• Whistleblower (“one who reveals wrongdoing
within an organization to the public or to those in
positions of authority”): Kim Emigh
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How the fraud was discovered
• Article published on May 16, 2002 (Fort Worth
weekly)
• Article transmitted on May 21, 2002, by Mark
Abide [WC’s director of property accounting] to
Glyn Smoth [WC internal audit staff]
• Complains about capital expenditures which he
was 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
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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 in
the wrong direction
– The CFO asked the Internal audit to delay their audit
work.
– The Controller insisted that they were wasting their
time and should be auditing other areas of the
company
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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 the
company’s audit committee of all other non-audit
work
• Tougher criminal and civil penalties for securities
violations
• Protection for whistleblowers
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The WorldCom failure
Indirect consequence
• More interest in financial accounting and
reporting:
– Within firms
– From students
– In the press (“It’s hot, it’s sexy, it’s … accounting”,
title taken from the CPA Personnel Report)
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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)
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Lessons and explanations
• Managers’ personality:
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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 for
mergers and acquisitions
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Lessons and explanations
• The pressure of analysts and the markets (Cynthia
Cooper)
– Line cost expense too high
– WC will not meet the earnings guidance executives
previously issued
– The stock price will get hammered
– Analysts will downgrade their opinions, which could
send the company into a downward spiral
– WC depends on its high stock price to acquire
companies [acquisitions in shares]
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Lessons and explanations
• The analysts
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“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 with
industry executive” (Cynthia Cooper)
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Lessons and explanations
• Problem with accounting entries: the boomerang
effect
• 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 regain
their footing” (Cynthia Cooper)
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Lessons and explanations
• 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
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Lessons and explanations
• Rationalization
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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)
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Lessons and explanations
• 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)
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Lessons and explanations
• 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 fraudulent
or misleading financial reports
– Failure to communicate critical assessments with audit
committee and senior management
– Andersen replaced by KPMG in April 2002
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The WorldCom failure
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, conspiracy
and filing false documents with regulators
• Ebbers is currently serving his sentence in a Louisiana
prison and is likely to die in jail
• Scott Sullivan (facing 165 years of potential jail time)
pleaded guilty to three criminal charges and collaborated
with the prosecutor: 5 years sentence
• David Myers and Buford Yates: each sentenced to one
year in prison
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Humor about WorldCom
Transparent 37
How did this happen?
Humor about WorldCom
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Last questions?
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