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B.Com(Hons) Section-A Group-A5

BACKGROUND

WorldCom was one of the pioneers of the 1990s telecoms boom. An aggressive acquisition spree saw it grow from a small-time regional operator in the early 1980s to a huge international business. It traces its origins to 1983 when Long Distance Discount Services(LDDS) was formed to purchase long-distance accounts in a deregulating US telecom market. WorldCom was the darling of Wall Street and the Telecom Industry of the 90s Grew rapidly through acquisitions and from increased demand for telecom services High stock price was a powerful currency to make acquisitions

BACKGROUND

During the 1990s, WorldCom was deeply involved in acquisitions and completed several mega-deals Purchased over 60 firms in 2nd half of the 90s WorldCom moved into Internet and data traffic Handled 50% of US Internet traffic Handled 50% of e-mails worldwide By 2001 owned a third of the US data cables Was U.S. 2nd largest long-distance operator in 1998 and 2002 Had over 20 million customers in 2002

Key Events 1996: Acquired MFS (including internet backbone) 1998: Acquired MCI (more than twice its size) 1998: Acquired ISP Compuserve and added a wireless presence via Skytel. 2000: Failed merger with Sprint (would have been the largest merger in history) 2000: Dotcom Bubble Burst (rapid decline in telecom stock values) 2000-02: WorldCom loans $400M to CEO (Ebbers) 2002: Accounting Fraud uncovered 2002: Filed for Bankruptcy Protection 2004: Emerged from Bankruptcy as MCI 2005: Verizon agrees to acquire the

In 1985 Ebbers, a motel property operator, joined as CEO and started a long and ambitious transformation process and undertook many corporate acquisitions. Borrowed hundreds of million dollars to cover losses on stock which was not repaid and to underwrite the inflated prices he had paid for the companys own shares. Secured loans from WorldCom to fund personal investments including a $100 million Canada ranch, $658 million in Mississippi timberlands and a $14 million Georgia shipyard

Worldcom itself, through specific board approvals, extended $415 million in collateralized loans to the Ebbers. In all Ebbers borrowed a total of $1.3 billion over the years, occasionally repaying credits but always drawing down new ones. Netted $140 million from stock sales Facing dismissal, he resigned from WorldCom on April 30, 2002.

Served as CFO, treasurer and secretary Directed staff to make false accounting entries Personally made false and misleading public statements regarding finances Netted $45 million from stock sales WorldCom said its chief financial officer Scott Sullivan improperly booked expenses as investment in order to make the company look much healthier than it actually was.

Financial Overview
Financial Highlights
($ in billions) Revenues Total Assets Employees (in 000's) Market Cap. Debt Total Capitalization $2.2 $3.4 7.5 $3.3 $0.8 $4.1 $37.1 $91.1 97.6 $150.5 $ 13.1 $163.6 $35.2 $103.9 87.8 $42.8 $30.0 $72.8 $20.7 $17.1 40.4 $ 6.4 $ 5.9 $12.3

1994

1999

2001

2004

Source: Original SEC Filings, before restatements for accounting fraud

There were many problems within the company itself that allowed the CEO and CFO to cook the books of accounts. These problems were: Worldcom was dominated by Ebbers and Sullivan, with virtually no checks and constraints placed on their actions. Lack of courage of employees to communicate the fraudulent activates believed it would have cost them their jobs A financial system in which controls were extremely deficient.

From 1998-2000, WorldCom reduced reserve accounts held to cover liabilities of acquired companies and made 400 adjustments, creating $4.6 billion in false revenues. CFO told key staff members to mark operating costs as long-term investments. To the tune of $3.85 billion. Treating operating costs as capital expenditure meant that the costs could be depreciated in pieces over time. Hence this meant that expenses incurred in the year would not have such a great impact on its cash flow, but instead expenses were been pushed into the future. The problem therefore arose because all this was doing was delaying payments in the financial statements, but after all the costs were going to be incurred.

WorldCom's misrepresentation of these expenses led to an artificial inflation of its net income and EBITDA (earnings before interest, taxes, depreciation and amortization).

WorldCom's statement to the SEC also revealed that the company is looking into some "material reversals of reserve accounts, often referred to as cookie-jar accounting. A reserve account could be an allowance for bad debt, for instance, every time you make a sale, you make an estimate for uncollectible debt. As the bad debts are experienced, you write that off against the reserve. At the end of the year, it's the auditors' job to

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. At Worldcom division, line costs remained flat at 38%

Operating Expenses to Assets

-CFOs directions affected the income statement: Revenues xxx (no change) COGS xxx (no change) Operating Expenses:

Removed From Income Statement

Fees paid to lease other companies phone networks: Computer expenses:

xxx (Huge Decrease) xxx (Huge Decrease)

NET INCOME Increase)

xxx (Huge

-CFOs directions affected the balance sheet: Assets: Computer assets Leasing assets

Added to Balance Sheet

xxx (Huge Increase) xxx (Huge Increase)

Liabilities Added to Stockholders Equity: Balance Sheet Retained Earnings Increase)

xxx (no change) xxx (Huge

How the Fraud was discovered

1. Obscure tips were sent into the Internal audit team 2. MCI audit and review of books uncovered accounting irregularities 3. In March 2002, John Stupka(head of Worldcoms wireless business) complained to Internal audit about $400 million he set aside that Sullivan wanted to use to boost WorldComs income. 4. March 7, 2002 - the SEC requests information from WorldCom - How could WorldCom make so much when AT&T is losing money?

How the Fraud was discovered

5. The Internal audit started digging

Found $2 billion company announced for capital expenditures (Internal Auditors found it was never authorized for capital expenditures.) Found the undocumented $500 million in computer expenses that were recorded as assets. Searching WorldComs computers, Mr. Morse( Worldcoms auditor) found $3.8 billion in questionable entries misallocated expenses and phony accounting entries. Understatement of operating expenses of $7B through improper release of accruals and through improper capitalization of operating expenses. Overstatement of revenues of $1 billion.

How the Fraud was discovered

6. June 14, 2002 - The Internal audit team contacted WorldComs audit committee 7. Worldcoms Vice President of internal audit, Cindy Cooper, asked for documents supporting numerous capital expenditures. - No supporting documents were found 8. The controller, David Myers, admits to internal auditors that the accounting treatment is wrong - States no accounting standards support this accounting. 9. June 20, 2002 - Internal audit explains irregularities to the Audit committee. 10.June 25, 2002 - WorldCom announces it inflated profits by $3.8 billion over the previous five quarters

How the Fraud was discovered

11. June 26, 2002 - civil suit filed by SEC, stock trading halted -Ultimately, stock was delisted by NASDAQ 12. July 21, 2002 - WorldCom files for chapter 11, surpassing Enron as the largest bankruptcy ever in the U.S.

Cynthia Cooper(VP, Internal Audit)

She headed a body of 24 auditors and support staffers. She was the main whistleblower and under her guidance Mr. Morse and Mr. Glyn Smith unearthed $3.8 billion in misallocated expenses and phony accounting entries. They first suspected that the company was cooking its books when they could not find any documentation or invoices to back up an accounting entry for $500 million in computer expenses. Although her department did a small amount of financial auditing, it primarily performed operational audits, consisting of measuring the

Cynthia Cooper (contd.)

Some weeks later, Mr. Smith, a manager under Ms. Cooper,received a curious e-mail from Mark Abide, based in Richardson,Texas, who was in charge of keeping the books for the company's property, plants and equipment. Mr. Abide had attached to his May 21 e-mail a local newspaper article about a former employee in WorldCom's Texas office who had been fired after he raised questions about a minor accounting matter involving capital expenditures. Then, the team of Ms. Cooper had run into an inexplicable $2 billion that the company said in public disclosures had been spent on capital expenditures during the first three quarters of 2001. But they found that the money had never been authorized for capital

Cynthia Cooper (contd.)

By2000, WorldCom had started to rely on aggressive accounting to blur the true picture of its badly sagging business. And so Mr.Sullivan began instructing Mr. Myers to take line costs, fees paid to lease portions of other companies' telephone networks, out of operating-expense accounts where they belonged and tuck them into capital accounts. Ms. Cooper, Mr. Smith and Mr. Morse didn't know this. But Mr. Morse sifting through the accounting data and found an account labelled "intercompany accounts receivables" which contained 350,000 transactions per month and consequently Mr. Morse had

Authur Andersen LLP were responsible in providing shareholders with 'reasonable assurance' that the financial statements presented a true and fair view of the company's financial position. In response to these accusations Andersen stated that they were never consulted or notified about the line-cost capitalization. However an accounting professor at Columbia Business School in New York went against them in saying that auditors are supposed to look at material expenditures and make sure they are reported properly, this is accounting 101 (WorldCom Accounting debacle).

Impact of Scam

Shareholders $180 billion of shareholder value lost (based on peak stock price) Debt & Preferred Stock holders $37.5 billion of debt and preferred stock holder value lost Company $750 million settlement paid to SEC Employees 57,000 employees lost jobs All current and former employees lost most of their retirement savings (invested in WorldCom stock) Company could spin off several business units.

In August 2002, Scott Sullivan, CFO, was indicted by a grand jury on one count of fraud and six counts of securities fraud and false filings involving almost $8 billion. He pleaded not guilty. On March 2, 2004, in a superseded indictment, Sullivan pleaded guilty to 3 federal criminal charges for fraud and conspiracy. Faces maximum 25 years in prison. Struck plea

September 2003 pleaded not guilty to 15 felony counts of violating Oklahoma securities laws. Charges dropped. Oklahoma Attorney General to refile charges at a later date. January 19, 2005 - Federal jury trial on charges of fraud to begin in which Scott Sullivan is expected to testify against him. Possible sentence: 25+ years in prison

January 2005 - 10 former directors agreed to pay $54 million to settle a shareholder class-action lawsuit $18 million to be paid by the directors themselves $36 million paid by the liability insurance February 28, 2005 Trial to begin against former auditors/directors who have not settled during class-action.