Worldcom's Magic Trick - The Worldcom Scandal Explained

How One of the World's Largest Companies Managed to Make $3.8 Billion Disappear

The Worldcom Accounting Scandal Explained
The Worldcom accounting scandal was caused when the executives of the company committed accounting fraud by capitalizing costs that should have been expensed. This caused reported profits to appear much higher than they really were. Getty Images / alashi

You've probably heard about the Worldcom scandal, one of the most shocking and widespread frauds to rock Wall Street in a generation.  In case you haven't and need a quick explanation, it basically comes down to this: Worldcom, one of the world's largest telecommunication companies, a core dividend stock holding for many retirees, and a household name throughout the entire country, attempted to inflate its earnings numbers by nearly $4 billion by manipulating its financial statements, particularly the income statement and balance sheet, found in its Form 10-K filing and annual report.

 It did this through the machinations of upper management.  To grasp how this happened, you need to understand how Chief Financial Officer Scott Sullivan treated capital expenditures, which are capitalized, and expenses, which are expensed, as well as something known as the accrual method, which is a basic principle of accounting.

To Explain the Worldcom Scandal, I Need To Teach You About 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. An illustration from Investing Lesson 4 will help:

Sherry’s Cotton Candy Co., earns $10,000 profit a year. In the middle of 2002, the business purchases a $7,500 cotton candy machine that is expected to last for five years, and will allow the employees to make twice as much cotton candy per hour. If an investor 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 investor would wonder why the profits had fallen so much during the year.

Thankfully, Sherry’s accountants come to her rescue and tell her that the $7,500 must be allocated over the entire period it is going to benefit the company. Since the cotton candy machine is expected to last five years, Sherry can take the cost of the cotton candy 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 cotton candy 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, office supplies, and the like.

Do the Hokey-Pokey (or How to Shuffle your Books)

How does this apply to Worldcom? 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 account. 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 hidden, Worldcom would have lost money for fiscal 2001 as well as first-quarter 2002.

This article was originally published on May 24, 2003.

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.