The Fraud

Group Members:
Jake - Cenk Tolunay
Yan Wang
Hong Ma
Yuhong Zhang
Background
Started as a small long
distance service provider called
LDDS in Mississippi in 1983
Grew with acquisitions in the 90s
- Gone public in 1989
- 4
th
largest in with $1.5 billion revenue in 1993
Changed its name to WorldCom in May 1995
Background
Became number two telecom
company in 1998 after MCI
merger ($34.5 billion)
Aggressive accounting
practices surfaced in 01
Bankrupt in December
2001
What Happened
Bernard J. Ebbers (CEO) principal
business strategy: growth through
acquisitions
The currency is the WorldCom stock
The peak: Acquisition of MCI in 98
End of acquisitions with the forced
abandon of Sprint merger because of
antitrust objections
CEOs pressure on subordinates (Mr.
Sullivan CFO) to feed Wall Streets
double digit expectations
What Happened
Line costs are network
lease cost which is more
than half of expenditures
The target: maintain the
line cost to revenue ratio
constant at 42% all cost
What Happened
$3.8 billion of line costs
transferred to capital
expenditures between 2001
and 2002
Another $3.8 billion was in
improperly reported earnings
before taxes for 99, 00, 01
and first quarter 02.
$ 80 billion write off on the
assets
What Happened
Use two main methods to manipulate earnings
Reduction of line cost
June 25, 2002, $3.852 billion
August 8,2002, $3.330 billion
Total $7.182 billion
Inflation of revenue
Identified improper $958 million
Questionable $1.107 billion
Total $2.065 billion.
Line Cost Reduction
1999 and 2000
Releases of Accruals to Reduce Line Costs
2001 and early 2002
Capitalization of operating line costs
103
140
396
493
683
832
862
771
606
744
942
798
0
200
400
600
800
1000
2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02
Releases of Accruals to Reduce Line Costs
Proper accounting procedure for the accruals
Line Cost Reduction
Estimate cost
Recognize & Expense
Accrual the liability
Pay bill & reduce accrual
Adjustment of accrual
WorldComs violation
1. Release accrual without
analysis
2. Kept excess accruals
3. Release reserved accruals
to reduce cost
Capitalization of Line Costs
Increase in line cost
$17,802 $18,332 $14,980
2001 2000 1999
Why:
Long-term, fixed rate contract
Line Cost Reduction
Line Cost Reduction
Capitalization of line cost
Ongoing, operating expenses need
recognize immediately.
Capitalized it to exaggerate its pre-tax
income
I/S

Line Cost

Depreciation
..
Pre-tax
income

B/S

Capital
expenditure
A/D

Total asset

Shift to
Postpone offset to
revenue
Line Cost Reduction
99 Adjusted 2000 Adjusted 2001 Adjusted 2002 1Q Adjusted
Revenu
e
35,908 35,908 39,090 39,090 35,179 35,179 8,120 8,120
Line
cost
14,739 15,337 15,462 18,332 14,739 17,802 3,479 4,277
Gross
Profit
21,169 20,571 23,628 20,758 20,440 17,377 4,641 3,843
Operatin
g income
7,888 7,290 8,153 5,283 3,514 451 843 45
Net
Income
4,013 3,415 4,153 1,283 1,501 -1,562 172 -626
Asset 91,072 91,072 98,903 98,903 103,914 101,226 103,803 100,297
Gross
Margin
59% 57% 60% 53% 58% 49% 57% 47.30%
Profit
Margin
11% 9.50% 10.60% 3.30% 4.20% -4.40% 2.10% -7.70%
ROA 4.40% 3.70% 4.20% 1.30% 1.40% -1.50% 0.18% -0.60%
Line
cost E/R
41% 42.70% 39.50% 47% 41.80% 50.60% 42.80% 52.60%
Revenue Inflation
WorldCom revenue manage mechanism
MonRev
MCI billings WorldCom billings
Sales channels and
segments
Detailed Revenue
data
trends in the
business
segments,
customer
analyses
Corporate Unallocated
sale of a corporate asset
change of accounting policy

Revenue Inflation
Specific Revenue items
Minimum Deficiency reserves
4
th
Q of 99 4
th
Q of 2001 : $312 million
Arise from customer agreements that
permit a telecommunications company to
bill customers for usage amounts that fall
below contractual minimum.
Those charges are rarely collected later.
Revenue Inflation
Minimum Deficiency reserves
When collectibility cannot be established
with reasonable assurance, GAAP does
not permit recognition of revenue
From the second quarter of 2000, release
Collectibility is established
B/S:
A/R
Recognize
I/S:
revenue
Offset
Revenue Inflation
Specific Revenue items
Customer Credits
2
nd
Q of 2001 1
st
Q of 2002 : $215
million
Be treated as discounts, rebates or
adjustments.
It should be reported as a reduction of
revenue on the income statement.
Contra-revenue account Bad debt expense
Customer Credit Miscellaneous expense
Revenue Inflation
Specific Revenue items
Early Termination Charges
2
nd
Q of 2001 3
rd
Q of 2001 : $30
million
Based on rarely enforced contractual
provisions with customers
Main part of this amount from an
account will never collect.
Revenue Inflation
Adjustment of financial data for revenue only
99 Adjusted 2000 Adjusted 2001 Adjusted 2002 1Q Adjusted
Revenu
e*
35,908 35,703 39,090 38,762 35,179 34,821 8,120 8,053
Line
cost
14,739 14,739 15,462 15,462 14,739 14,739 3,479 3,479
Gross
Profit
21,169 20,964 23,628 23,300 20,440 20,082 4,641 4,574
Net
Income
4,013 3,808 4,153 3,825 1,501 1,313 172 150
Asset 91,072 91,072 98,903 98,903 103,914 103,914 103,803 103,803
Gross
Margin
59% 58.70% 60% 60% 58% 57.60% 57% 56%
Profit
Margin
11% 10.60% 10.60% 9.80% 4.20% 3.70% 2.10% 1.80%
ROA 4.40% 4.20% 4.20% 3.90% 1.40% 1.26% 0.18% 0.13%
E/R 41% 41.20% 39.50% 39.80% 41.80% 42.30% 42.80% 43.20%
*Questionable revenue inflation is not included.
What Happened
Adjustment of financial data for line cost and revenue
99 Adjusted 2000 Adjusted 2001 Adjusted 2002 1Q Adjusted
Revenu
e*
35,908 35,703 39,090 38,762 35,179 34,821 8,120 8,053
Line
cost
14,739 15,337 15,462 18,332 14,739 17,802 3,479 4,277
Gross
Profit
21,169 20,366 23,628 20,430 20,440 17,019 4,641 3,776
Net
Income
4,013 3,210 4,153 955 1,501 -1750 172 -648
Asset 91,072 91,072 98,903 98,903 103,914 101,226 103,803 100,297
Gross
Margin
59% 57% 60% 52.70% 58% 48.80% 57% 46.90%
Profit
Margin
11% 8.90% 10.60% 2.50% 4.20% -5% 2.10% -8%
ROA 4.40% 3.50% 4.20% 1% 1.40% -1.70% 0.18% -0.62%
E/R 41% 42.90% 39.50% 47% 41.80% 51% 42.80% 53.10%
*Questionable revenue inflation is not included.
Management Incentives
Conceal the poor performance
Maintain high stock value
Boost compensations
CEOs generous giveaways
One of the highest pay for a CEO in the US
Bonus plan that promoted the short term growth
Management Incentive
Mr. Sullivans Estate
$15 million mansion
in Florida
18-seat movie
theater
Two-story boathouse
Domed exercise
room
Art gallery
Warning Signs
From 1999 to 2000
Revenue increased
from $37,120M to
$39,090M
Cost of goods sold
decreased from
$15,951M to
$15,462M
Operation efficiency
constant
0
5000
10000
15000
20000
25000
30000
35000
40000
45000
1999 2000
Revenue COGS
Warning Signs
From 1999 to 2000
Net income increased from $4,013M to
$4,153M
Accounts receivable increased from
$5,746M to $6,815M
Free cash flow decreased from $2,289M
to $(3,818)M
Warning Signs
From 1998 to 2001
The increase of expense
exceed the growth of
revenue
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
1999 2000 2001
Revenue change(%)
Expense change(%)
Consequences
Stock
Mid 1999 - $64.50 a share
Prior fraud announcement
- $2 a share
After announcement
- below $1 a share
Today - $.06 a share
Consequences
Consequences
Bankruptcy
July 21st, 2002 WorldCom filed
for Chapter 11 bankruptcy protection
Layoff
New CFO
Fraud Charge
Federal prosecutors charged former CFO and
controller with securities fraud, conspiracy and
filing false statements with the SEC
WorldCom Today
April 14, 2003 a brand name change to MCI
August 27, 2003 Oklahoma filed
criminal fraud charges.
Former CEO Bernard Ebbers
Question
Is it really worth manipulating the
financial numbers for the long term?