When WorldCom Inc. (WCOM ) revealed on June 25 that it had uncovered a $3.8 billion accounting fraud, everyone from the smallest investors to President George W. Bush reacted with shock and outrage. How was this possible? How could such an established company have hidden such huge expenses from the investing public? Here's a look at what WorldCom did and how the company did it.
What exactly did WorldCom do?
During 2001 and the first quarter of 2002, the company counted as capital investments $3.8 billion that it spent on everyday expenses. This makes a difference because capital investments are treated differently from other expenses for accounting purposes. Capital spending is money used to buy long-lasting assets, like fiber-optic cables or switches that direct telephone calls, so the cost is spread out over several years.
For example, if WorldCom spent $10 million on switches it expected to last 10 years, it would book a $1 million expense for 10 years. In contrast, if it spent $10 million on office space, it has to count all of that expense in the period in which it occurred. The company says the expenses that were counted as capital expenditures involve "line costs," which are fees WorldCom pays to other telecom players for the right to access their networks.
How does this affect profits?
Counting everyday expenses as capital investments boosts net income because expenses that are supposed to be counted in one quarter are spread out over years. WorldCom originally reported net income of $1.4 billion in 2001 and $172 million in the first quarter of 2002. Now the company says it lost money the whole time. "You do this to make your bottom line look better," says Rosemarie Kalinowski, an analyst with debt rating agency Standard & Poor's.
How is cash flow affected?
Different people use the term "cash flow" to mean different things. What WorldCom did affects cash generated from operations, a closely watched line in financial statements. WorldCom originally reported that its operating activities in 2001 produced $7.7 billion in cash. Now, it says that figure really was $4.6 billion.
But WorldCom's overall cash flow isn't affected because the restatement will lower the amount of cash reported as used in investing activities, which include capital investments. So the two changes cancel each other out. It does, however, affect another measure of cash flow, something called EBITDA.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Investors see this as a more accurate barometer of a company's health than cash flow from operations. This is where WorldCom's accounting games had the biggest impact. The company originally reported that its EBITDA for 2001 was $10.5 billion. Now it says the figure really was $6.3 billion. In the first quarter, it reported EBITDA of $2.1 billion, while the real figure was $1.4 billion.
In other words, WorldCom was in much worse shape than investors and banks thought. "This is an industry where companies trade based on EBITDA," says Robert Willens, an accounting expert at Lehman Brothers Inc. "Capitalizing expenses has a direct impact on EBITDA."
Does this mean investors can no longer rely on cash flow?
Not necessarily. Capitalizing expenses is not that common because it's so easy to detect. While there are some gray areas, it's pretty clear what should be counted as everyday expenses and what should be counted as capital expenditures. "This is sort of obvious to anyone who bothers to look at it," says Willens. "This doesn't involve offshore partnerships or special purpose entities. This is Accounting 101."
So where were the auditors?
Good question. WorldCom's auditors were from Arthur Andersen LLP, which says its work for the company complied with all accounting standards. The WorldCom fraud came to light when John W. Sidgmore became chief executive in April and ordered an internal review of the company's books. The probe was conducted by WorldCom's new auditor, KPMG, as well as WorldCom employees. At its completion, WorldCom announced the restatement and fired its chief financial officer, Scott D. Sullivan.
If there is a silver lining in the WorldCom fiasco, it's that this sort of accounting fraud can be uncovered quite easily -- you just need accountants who are looking for it.
By Peter Elstrom in New York