WorldCom: A Bunch of Dirty

Rotten Fraudsters

MGT 506: Financial Fraud

Randy Kim
Marina Malyshkina
Dominic Ong

WorldCom: Overview

Global communications company offering Internet, voice, and

data services for business

Market Capitalization of $120 billion in Summer 1999

MCI: WorldComs business and residential communication service

division. MCI is the nation's second-largest long-distance provider and
serves 20 million consumers and thousands of corporate customers.
Current examples of $120 billion companies: Coca-Cola, Altria, Merck,
and Bank of America

Key Executives (Crooks):

CEO Bernie Ebbers

CFO Scott Sullivan
Controller David Myers

Quick Review of Accounting 101 (aka MGT870)

Operating Expenses: salaries, insurance, equipment rental, electricity, maintenance

contracts.

Capital Expenditures result in the acquisition of, or improvement to, the companys
assets. Examples are purchases of real estate, manufacturing equipment, and
computer equipment.

subtracted from revenue on income statement.

Are NOT counted against revenues on income statement. Instead, they are booked as
capital assets on the balance sheet.

Reserves: set up to cover adverse developments such as bad debts, anticipated

restructuring costs, or warranty claims

Balance sheet item (approx $10 billion at WorldCom)

Companies have discretion on how large to make them.
Releasing an accrual is proper when it turns out that less is needed to pay the bills
than had been anticipated. It has the effect of providing an offset against reported
expenses in the period when the accrual is released. Thus, it reduces reported expenses
and increases reported pre-tax income.

Accounting Fraud #1: Improperly Releasing Reserves Held

Against Operating Expenses (1999 - 2000)

WorldCom has set reserves to pay anticipated bills, reflecting estimates of (unpaid) costs associated with
the used of lines and other facilities of outside vendors

In the third quarter of 2000, WorldCom starts to manipulate true line cost expenses by releasing reserves
(reduced 3Q line costs by $828 million, and 4Q line costs by $407 million).

How WorldCom manipulated the process of adjusting reserves

First , in some cases accruals were released without any apparent analysis of whether the Company actually had an
excess accrual in the account. Thus, reported line costs were reduced (and pre-tax income increased) without any
proper basis.
Second , even when WorldCom had excess accruals, the Company often did not release them in the period in which
they were identified. Instead, certain line cost accruals were kept as rainy day funds and released to improve reported
results when managers felt this was needed.
Third , WorldCom reduced reported line costs by releasing accruals that had been established for other purposes. This
reduction of line costs was inappropriate because such accruals, to the extent determined to be in excess of
requirements, should have been released against the relevant expense when such excess arose, not recharacterized as
a reduction of line costs.

In 1999 and 2000, WorldCom reduced its reported line costs by approximately $3.3 billion through this
fraud.
Sources:

WorldComs 6/9/03 8K report to the SEC and Report of Investigation by the Special Investigative Committee of
the Board of Directors of WorldCom, Inc., March 31, 2003

Accounting Fraud #2: Recharacterizing Certain Expenses as

Capital Assets (2001 2002)

Line Costs: Fees WorldCom paid, under long-term contracts, to third-party

telecommunication carriers for the right to access their network in order to
service their customers.

WorldComs largest operating expense and typically reached 50% of revenue.

By booking line costs as capital assets instead of as an operating expense,

WorldCom.
1. reduced their operating expenses (and increased pre-tax income)
2. increased the value of their capital assets (and total assets)
3. increased the value of the companys net worth

In April 2001, WorldCom starts making false general ledger entries which
transfer a significant portion of line cost expenses to a variety of capital asset
accounts. Violates GAAP.
In 2001 and 2002, WorldCom improperly capitalized $3.5 billion of line costs.
Sources:

WorldComs 6/9/03 8K report to the SEC and Report of Investigation by the Special Investigative Committee of the
Board of Directors of WorldCom, Inc., March 31, 2003

A Bunch of Dirty Liars

WorldCom's False Statements in Filings With SEC

Form Filed
With the
Commission

Reported Line
Cost Expenses

Reported Income
(before Taxes
and Minority
Interests)
10-Q, 3rd Q. 2000
$3.867 billion
$1.736 billion
10-K, 2000
$15.462 billion
$7.568 billion
10-Q, 1st Q. 2001
$4.108 billion
$988 million
10-Q, 2nd Q. 2001
$3.73 billion
$159 million
10-Q, 3rd Q. 2001
$3.745 billion
$845 million
10-K, 2001
$14.739 billion
$2.393 billion
10-Q, 1st Q. 2002
$3.479 billion
$240 million
Source: SECURITIES AND EXCHANGE COMMISSION v. WORLDCOM, INC.,

Actual Line
Cost Expenses

$4.695 billion
$16.70 billion
$4.879 billion
$4.290 billion
$4.488 billion
$17.754 billion
$4.297 billion
Civ No. 02-CV-4963 (JSR)

Actual Income
(before Taxes
and Minority
Interests)
$908 million
$6.33 billion
$217 million
-$401 million
$102 million
-$622 million
-$578 million

A Bunch of Dirty Liars (cont.)

1000
800
600
400
200
0
-200
-400
-600
-800
1st Qtr
2nd Qtr 3rd Qtr
2001
2001
2001

4th Qtr
2001

1st Qtr
2002

Reported income
Actual income

How Was Fraud Uncovered?

On May 21, 2002, a WorldCom employee sent a featured article to an internal

auditor, indicating that the issues raised in the article might warrant investigation

On June 12, 2002, the Internal Audit team contacted Max Bobbitt, the Chairman
of the Audit Committee of the Board of Directors.

Article was from the May 16 edition of Fort Worth Weekly Online and was based upon
interviews with a former WorldCom employee who was allegedly fired for whistle
blowing.
WorldComs Internal Audit Department began an investigation concerning the
capitalization of line costs.

$2.5 billion in line costs that had been capitalized.

Mr. Bobbitt requested that these issues be discussed with KPMG prior to a meeting of
the Audit Committee on June 14, 2002.

On June 25, 2002, the Board determined that WorldCom would restate its
financial statements for 2001 and the first quarter of 2002.

KPMG would reaudit the Companys financial statements for 2001

It decided to terminate Mr. Sullivan without severance and to accept the resignation of
Mr. Myers without severance.

Effect of Fraud

WorldCom/MCI has acknowledged that it committed more fraud than it

original reported, raising the estimate from $3.8 billion (June 25, 2002) to
$7.2 billion (August 9, 2002) to $9 billion (September 19, 2002).

WorldCom/MCI overpaid taxes and sought to recover $300 million in federal

tax payments that it made to cover up its fraudulent activity.

Misrepresented cash position to analysts as solid while facing cash

crunch. Made loan to Ebbers constituting 30% of WorldComs cash.
WorldCom continued to issue securities using fraudulent and materially
false financial statements and information.
American investors in WorldCom/MCI lost an estimated $176B in value
in WorldCom stock, laid off 25,000 employees and caused another 73,000
job losses in the industry.
Source: Gray Panthers, June 25, 2003

WorldCom Files for Bankruptcy on July 21, 2002

Image borrowed from www.clarionleger.com

WorldCom: The Poster Child For Corporate Governance Failures

WorldCom was dominated by Messrs. Ebbers (CEO) and Sullivan (CFO) with
virtually no checks or restraints placed on their actions by the Board of Directors or
other Management.
WorldCom Management provided the Companys Directors with extremely limited
information regarding many acquisition transactions. Several multi-billion dollar
acquisitions were approved by the Board of Directors following discussions that
lasted for 30 minutes or less and without the Directors receiving a single piece of
paper regarding the terms or implications of the transactions (e.g. Intermedia -$6B
acquisition, 60 90 min due diligence, 35 min telephone Board meeting)
No evidence of meaningful debt planning. The ability to borrow was facilitated by
massive accounting fraud. In 4 years issued more than $25 billion in debt securities at
complete discretion of Ebbers and Sullivan. Board rubber-stamped Pricing
Committee decisions.
The Compensation and Stock Option Committee approved Company loans of more
than $400million to Mr. Ebbers without initially informing the full Board or taking
appropriate steps to protect the Company (no due diligence of collateral, use of
proceeds).
The Board never questioned non-WorldCom business activities of CEO and
effectively funded those with the company money.

WorldCom: The Poster Child For Corporate Governance Failures

(cont.)

Audit committee had little power, was under funded and understaffed; concentrated
only on operational audit. Also improper oversight by external audit Arthur
Andersen.
Screwed up compensation structure. Decisions single-handedly taken by CEO.
Most Board members also had stock-based compensation.
Board members had poor oversight on corporate strategy. Very little meaningful or
coherent strategic planning at WorldCom. Absence of proper corporate governance
protocols.The Companys approach to acquisitions and significant outsourcing
transactions was ad hoc and opportunistic.
Loyalty of Board was ensured by members whose companies had been acquired by
WorldCom (6 out of 10) and whose personal fortunes through ownership of the
Companys stock had, for a long period of time, been greatly enhanced during
Ebbers leadership of WorldCom.
WorldCom was a company that grew tremendously in both size and complexity in
a relatively short period of time. Its management, systems, internal controls and
other personnel did not keep pace with that growth. WorldCom grew in large part
because the value of its stock rose dramatically.

Source: FIRST AND SECOND INTERIM REPORTS OF DICK THORNBURGH, BANKRUPTCY COURT
EXAMINER, Kirkpatrick & Lockhart LLP, 2002 2003.

Potential Solutions - Actual Steps Taken Following SEC

Investigation:

On April 30, 2002, the Company announced that Mr. Ebbers had resigned as
President, CEO and Director.
KPMG became the Companys independent auditor and accountants effective
May 14, 2002, replacing Arthur Andersen.
In May 2002, the Companys Internal Audit Department began an investigation
concerning the capitalization of line costs.
The Board has terminated jobs of CFO Sullivan and Chief Controller Myers.
Appointed 3 independent directors professionals in financial fraud
investigations.

Potential Solutions Same Recommendations As For Qwest?

Improve Boards
Greater independence
Rotate auditors

Corporate
Governance

Improve Management
Integrity and ethics
Correct incentive scheme

Culture