The Worldcom Scandal Explained
How One of the World's Largest Companies Made $3.8 Billion Disappear
This article was originally published on May 24, 2003.
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, or wanted a quick overview of the story, here are the basics of the situation.
In 2001, Worldcom, a household name and one of the world's largest telecommunication companies, and also a core dividend-paying stock that many retirees held in their portfolios, attempted to falsely inflate the earnings on its profit and loss statement by nearly $4 billion.
It did this by manipulating its financial data, which affected the income statement and balance sheet, Form 10-K filing, and the company's annual report. Worldcom carried out the fraudulent accounting through the machinations of upper management.
To grasp how the events happened, you'll need to understand how Chief Financial Officer Scott Sullivan treated capital expenditures and expenses as well as understanding the accrual accounting method, which is a basic principle of accounting.
Understanding the Accrual Method
When a business incurs an expense, certain 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. The following illustration 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 that year.
Thankfully, Sherry’s accountants come to her rescue and tell her that she needs to allocate the $7,500 over the life of the cotton candy machine, or 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 large expense in one year, the company can expense $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 above, 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. The accrual method of accounting for capital expenditures does not apply to operating expenses such as raw materials, salaries, marketing costs, or office supplies.
How Worldcom Shuffled Its 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 of capital expense account. This allowed Worldcom to show the expenses in smaller amounts over a span of years, instead of reporting them immediately to investors. As a result, in 2001, the company reported a $1.4 billion profit. Had the operating costs been correctly reported, Worldcom would have lost money for fiscal 2001 as well as first-quarter 2002.
WorldCom CEO Bernard Ebbers was sentenced to 25 years in jail for his role in the scandal, and Sullivan was sentenced to five years. The company went bankrupt, recording the largest bankruptcy in American history until the financial crisis of 2008. Thousands of people lost their jobs. Worldcom emerged from bankruptcy and re-emerged as MCI. (MCI is now a subsidiary of Verizon.)