The WorldCom scandal was one of the most shocking frauds to rock Wall Street in the years when it took place. WorldCom was once one of the world's largest telecommunications companies and a core dividend-paying stock that many retirees held in their portfolios. In 2001, it attempted to fake an increase in earnings on its profit-and-loss statement by nearly $4 billion. It did so by manipulating its financial data, which affected its income statement, balance sheet, form 10-K filing, and annual report.
WorldCom carried out its bad accounting through the actions of its leaders. Its chief financial officer (CFO), Scott Sullivan, didn't treat capital expenditures and expenses properly. Learn about the accrual method of accounting to understand what went wrong at WorldCom.
Understanding the Accrual Method
When a business incurs an expense, certain accounting rules state that the cost of that expense should be spread over the entire time that it will benefit the company. This attempt to match revenues with the cost it took to create them is known as the "accrual method."
Imagine a firm called Sherry's Cotton Candy Co., which earns $10,000 profit per year. Sherry's purchases a $7,500 cotton candy machine that is expected to last for five years. This machine will allow the workers to make twice as much cotton candy per hour. If an investor were to look at the financial statements, they might be shocked to see that Sherry's only made $2,500 in a year. They would wonder why profits had fallen so much.
Since the cotton candy machine is expected to last five years, the company can instead take its cost and divide it by five, getting $1,500. Instead of having a large expense in one year, the company can expense $1,500 each year for the next five years. Then it would be able to report yearly earnings of $8,500. This gives a more truthful picture of the company's financial health.
The purchase of the cotton candy machine is a type of capital expense, which is a cost that a firm incurs to pay for assets. These assets might include things such as a factory, machines, or equipment.
The accrual method of accounting for capital expenses does not apply to costs such as raw materials, salaries, or office supplies. These are called "operating expenses," and they should be reported in the year they occur.
How WorldCom Shuffled Its Books
Sullivan, WorldCom's CFO, took billions of dollars in operating expenses and spread them out across so-called property accounts. These are a type of capital expense account. This action let WorldCom show the expenses in smaller amounts, over a span of years, instead of reporting them right away.
As a result, in 2001, the firm inflated revenue by roughly $3 billion and stated a $1.4 billion profit instead of a loss. Had the operating costs been reported the right way, the books would have shown that WorldCom lost money for the 2001 fiscal year and first quarter of 2002.
In June 2002, WorldCom admitted to nearly $4 billion in accounting fraud, and on July 22, 2002, the company filed for bankruptcy. That bankruptcy was one of the biggest in American history. The filing led to an increase of scrutiny for the firm's leaders and prompted legal investigations into WorldCom's CEO Bernard Ebbers and CFO Scott Sullivan.
The accounting errors figure would eventually increase from $4 billion to $11 billion.
Ebbers was convicted on nine counts of securities fraud and sentenced to 25 years in prison for his role in the scandal. Sullivan was charged with seven counts and sentenced to five years after entering a guilty plea.
After massive scandals by companies such as WorldCom and Enron, Congress enacted the Sarbanes-Oxley Act (SOX). This law was designed to increase confidence in stock markets and public companies so people would feel confident enough to invest. To do this, the new law made some big changes. Some of things it required included:
- More audit committees.
- Internal controls for public companies.
- No more than two board members can be certified public accountants.
- Bigger criminal penalties for securities fraud.
- Companies must change audit partners every five years.
Before the act, there were many loopholes that firms could take advantage of to mislead and defraud investors. SOX was a way to try to close these loopholes.