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Double Take
WorldCom's Convincing Lies
David Simons, 07.08.02, 6:00 PM ET

NEW YORK - Analysts and fund managers blindsided by WorldCom's (nasdaq: WCOME - news - people ) accounting fraud insist they didn't have a clue. Was there a smoking gun? Even knowing where to look, it's tough to find one among the five quarters of published versions of the financials that were jiggered to the tune of $3.8 billion, allegedly by WorldCom's chief financial officer.

The scam wasn't as complex as that of Enron (otc: ENRNQ - news - people ). At least on the surface it was simple. WorldCom says that operating expenses for using other telecommunications companies' lines--mainly for last-mile access to homes and businesses--were reclassified as capital improvements. Because telco capital costs are charged as depreciation against income over periods ranging from four to 40 years, the reclassification reduced expenses in the past five reported quarters by at least $2.6 billion.

I examined the five quarters of line costs and capital expenses at the company's two main divisions. The WorldCom Group operates the core network and sells voice, data and Internet backbone services to business and government. MCI is the consumer and small-business operation. I also compared the figures' rates of change and ratios to revenue with WorldCom's main competitors, Sprint (nyse: FON - news - people ) and AT&T (nyse: T - news - people ).

I came away with a sense of awe. Far from being ham-handed, the scam was incredibly elegant. All of the numbers behave as would be expected. In fact, the closer the look, the more convincing it becomes.

For example, at the MCI unit, which accounts for 47% of total line costs and 39% of revenue, line costs as a percent of revenue soared from 44% to 51% during the first four quarters of the fraud. That's the opposite of what would be expected if line costs were being transformed to capital costs. The annual report says the increase was due mainly to wholesale price pressure in Internet services.

Indeed, a careful con wouldn't mess with MCI line costs. Access line statistics, while not included in WorldCom's financials, are tracked by the Federal Communications Commission. It's easy to relate numbers of access lines to household subscribers and figure reasonable total line costs.

At the WorldCom division, the ratio is obscured by business and government customers that use many lines. Yet line costs remained flat at 38% of revenue, while total revenue fell 6%--within range of what's reasonable given the division's higher-margin offerings such as Web hosting and private networks. At AT&T's telephone operations, line costs also stayed flat, at 29% of revenue. Sprint doesn't break out line costs, but its 50% gross margins didn't budge.

The capital-expense side of WorldCom's fraud ledger also appears OK. Instead of increasing as the fraud would suggest, capital expense declined at both units by a combined 25%, to $7.9 billion in 2001. That's spot on the $8 billion forecast by WorldCom's year 2000 annual report. At AT&T's phone operations, capital expense decreased 19%, and at Sprint they increased 25%.

The most apparent smoking gun is a $3.5 billion increase in transmission-equipment assets. It's more like a leaky water pistol. The percentage increase is half that notched in the boom year 2000. That's consistent with the overall decline in capital spending.

Now, any junior accountant can tweak a quarter or two. But it takes a real maestro to do it for five full quarters and have the data line up like a business-school case study. In fact, the WorldCom data points look too perfect. Other kinds of costs, such as maintenance-related labor, may have been put in play to fine-tune the tweaks.

Most amazing, though, is that apparently a single person at a company the size and complexity of WorldCom could reclassify $3.8 billion worth of expenses as easily as changing entries on a home-PC personal finance program. Clearly, increased oversight of outside auditors and penalties for perpetrators isn't enough.

The focus should be on foiling fraud before damage is done. That requires real-time bookkeeping controls. The most basic, which would have flagged the WorldCom flimflam, is mandatory review of revision to entries before they are actually made. At the very least, changes that exceed cumulative thresholds should be approved by internal auditors.

Companies should also be required to publicly detail bookkeeping controls and have them independently evaluated by accounting firms other than those who audit the financial statements.
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Link: http://www.forbes.com/columnists/2002/07/08/0708simons.html