WorldCom Accounting Scandal: The Wrong Call (Part 2)

This is part 2 of the the two-part series on the WorldCom Accounting Scandal. You can read part 1 here.

The year 2000 was a major year for WorldCom There had been a slowdown in the long distance market for some time, it reached its lowest in 2000. Long distance players like WorldCom and Sprint were looking at new avenues of profit like broadband and were moving away from long distance. The market was way too overcrowded with players big and small eating into each other’s margins. Wall Street and other Venture Capitalists put the stopper on new funds worried over the overheating in stocks. This meant not only was there no new funds; there was also a slowing of revenues generated that would have helped sustain their businesses. The low margins and low demand added to the telecom sectors predicament.

2002 saw WorldCom declaring bankruptcy. It also came to light that there were several accounting violations. WorldCom admitted to a $9 billion adjustment from 1999 through 2002. There was admission of improper accounting where operating expenses were accounted for as capital expenses, making earnings look larger.

This two way reduction of new funds and revenues meant Bernie Ebbers faced margin calls, i.e put up more collateral for outstanding loans. He decided to sell his common share but was prevented by the board saying it would lead to a drop in share prices and reduce investor confidence. He relented to the Board’s decision as he felt the fortunes of WorldCom would improve and the house put in order. Ebbers had borrowed against his shares. The Board had sanctioned loans to Mr. Ebbers against these loans. This is generally considered a poor return on company assets, and in the case of Mr. Ebbers the loans advanced attracted interest rates of just 2%, which were way below the average interest rates.

Arthur Anderson who was supposed to oversee WorldCom’s accounts is said to have a blind eye over several discrepancies. Citigroup provided cheap funding to Ebbers in return for the role of lead underwriter for its $5 billion bond issue through Solomon Smith and Barney, its investment arm, which it owned. Salomon Smith Barney's telecommunication analyst Jack Grubman who was supposed to provide an independent opinion based on fundamentals, hyped the WorldCom stock with ‘buy’ recommendations. Ebbers and Grubman were known to be extremely close with favors extended for good recommendations. Grubmans insider view was seen by many as a conflict of interest. Mr.Grubman continued to give high ratings to WorldCom right until 2002 when he finally deemed it necessary to tag it risky. For his role in recommending a high rating for WorldCom stocks nad misleading investors and conflict of interest. Mr.Grubman was fined $15 million and banned for life from securities transactions. These corporate buddy relationships, with low regard for professional integrity cost investors several million dollars and eroded share value.

This brings us to the question, who uncovered what happened at WorldCom. This was the doing of Cynthia Cooper, internal auditor at WorldCom. As a result of her teams investigations they discovered that WorldCom had manipulated accounts and had been trying to hide almost $4 billion in misallocated expenses and phony accounting entries. She brought to the notice of Arthur Andersons some of the gaps in WorldCom’s accounting but was paid no heed. This only strengthened her concerns and she investigated further. Her report stated that $2 billion accounting entry for capital expenditures that had never been authorized and that it had reported operational expenses as capital expenditure to reflect higher earnings. She was asked by WorldCom CFO Scott Sullivan to delay her report. Cynthia Cooper went ahead and reported her findings to the boards’s audit committee.

In her interview with TIME she had this to say about the fall of WorldCom: “A lot of people think that the fraud caused the downfall of WorldCom. In my view, neither the fraud nor the discovery of the fraud caused the downfall. The company's stock had fallen from a high of $64 in June of 1999 to 83 cents at the time the company announced the [earnings] restatement. So I think you have to understand the role of certain corporate decisions — loading the company with debt, poor acquisition decisions, also the Internet mania that swept the country and the telecomm implosion in general.

WorldCom could have saved itself from Operational risk with better corporate governance, strategies for quick and effective methods to help the acquired companies align with the acquirer strategy, employ ethical and fair methods and report financial accurate details of the company’s accounts.

Investors understand industries and companies face ups and downs, only if WorldCom had understood this and been transparent with its investors, it would have taken a happier trajectory.

If you would like to know more about what went wrong at WorldCom you can view the following video:

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