THE CFO WHO CHANGED ONE NUMBER AND MADE A COMPANY LOOK COMPLETELY DIFFERENT
The company wasn't suddenly making more money.
The accounting changed.
And that was enough to make WorldCom look dramatically more profitable than it really was.
THE NUMBER WAS AN EXPENSE
In the early 2000s, WorldCom was one of America's largest telecommunications companies.
But its business was under pressure.
WorldCom had to pay other telecommunications companies for access to their networks.
These payments were known as line costs.
Normally, those costs were operating expenses.
They reduced the company's profit immediately.
And that was becoming a problem.
THEN THE CFO CHANGED HOW THE COSTS WERE RECORDED
WorldCom's CFO, Scott Sullivan, directed the company to begin moving some of these operating costs into capital accounts.
That sounds like an accounting detail.
It wasn't.
Under normal accounting rules, an operating expense is recognized in the period in which it is incurred.
A legitimate capital expenditure, however, is recorded as an asset and generally expensed gradually through depreciation.
So moving a cost from:
Expense → Asset
could dramatically change the current income statement.
The SEC later alleged that WorldCom's treatment violated GAAP and was used to manipulate earnings.
WATCH WHAT HAPPENS TO THE PROFIT
Imagine a company earns:
$1 billion in revenue
and has:
$800 million in normal operating costs.
Its pre-tax income is:
$200 million.
Now imagine $100 million of those costs are improperly moved from expenses into capital assets.
The income statement might now show:
$1 billion revenue
minus
$700 million expenses
equals
$300 million pre-tax income.
The company didn't generate an extra $100 million.
The accounting classification changed.
That is why accounting classification matters so much.
WORLDCom DID THIS WITH BILLIONS
This wasn't a small adjustment.
WorldCom initially disclosed that approximately $3.852 billion of line costs had been improperly transferred to asset accounts during 2001 and the first quarter of 2002.
Later investigations identified much more.
A WorldCom investigation found that the company had improperly reduced reported line costs by more than $7 billion between the second quarter of 1999 and the first quarter of 2002.
The SEC separately alleged that WorldCom had materially overstated its income by approximately $9 billion through several improper accounting practices.
THE COMPANY SUDDENLY LOOKED PROFITABLE
This is where the accounting became especially powerful.
For 2001, WorldCom reported:
$14.739 billion in line costs
and
$2.393 billion in pre-tax income.
But according to the SEC, the actual figures were approximately:
$17.794 billion in line costs
and a $662 million pre-tax loss.
So the published accounts showed a profitable company.
Without the improper accounting treatment, WorldCom would have reported a loss.
The same thing happened in the first quarter of 2002.
WorldCom reported:
$240 million pre-tax income
while the SEC said the company actually had approximately a:
$557 million pre-tax loss.
One accounting treatment had created an enormous difference.
WHY WALL STREET CARED ABOUT ONE RATIO
WorldCom frequently highlighted its line-cost-to-revenue ratio.
The company reported that line costs were staying around 42% of revenue.
That made the business appear relatively stable.
But the investigation found that without the improper accounting, the ratio would typically have been above 50%.
That mattered because investors weren't only looking at the absolute profit.
They were looking at the underlying economics of the telecommunications business.
If the cost of providing the service was rising much faster than revenue, that was a serious warning sign.
The accounting entries helped hide it.
THE ENTRIES WERE MADE AFTER THE QUARTER ENDED
One of the strangest details was the timing.
The WorldCom investigation found that many of the capitalization entries were made after the quarter had closed, shortly before earnings were announced.
The entries were often large, round-dollar amounts.
According to the investigation, approximately $3.5 billion of line costs were improperly capitalized from the first quarter of 2001 through the first quarter of 2002.
This wasn't simply an automated accounting system producing an unexpected result.
People were making entries.
THEN INTERNAL AUDITORS STARTED ASKING QUESTIONS
The scheme eventually began to unravel through WorldCom's internal audit department.
Cynthia Cooper, the company's vice president of internal audit, and her team investigated unusual capital expenditure entries.
They discovered that some of the costs being treated as assets didn't make sense.
WorldCom's internal auditors worked with the audit committee and external auditors as the investigation expanded.
On June 25, 2002, WorldCom announced that approximately $3.9 billion of transfers from access-cost expenses to capital accounts had not complied with GAAP.
The following day, CFO Scott Sullivan was fired.
THE ACCOUNTING WASN'T THE WHOLE PROBLEM
It's tempting to look at WorldCom and think:
"They changed the accounting, and that destroyed the company."
The reality was bigger.
WorldCom already faced deteriorating business conditions, enormous costs and pressure to meet Wall Street expectations.
The accounting manipulation helped conceal those problems.
It didn't create them.
The SEC said the scheme was intended to keep reported earnings in line with analyst expectations and support the company's stock price.
WHY THIS STORY MATTERS
Accounting can sometimes look like a collection of boring categories:
Expense
Asset
Revenue
Liability
But changing the classification of a number can change almost everything investors see.
A cost on the income statement:
↓
reduces current profit.
The same cost improperly placed on the balance sheet:
↓
doesn't hit current profit in the same way.
↓
Reported earnings rise.
↓
Profitability appears stronger.
↓
Investors can receive a completely different picture of the business.
The underlying economics haven't changed.
Only the reported picture has.
MAACAT PERSPECTIVE
The WorldCom scandal is one of the clearest examples of why investors cannot look at net income alone.
A company can appear profitable while its underlying economics are deteriorating.
The crucial question isn't always:
"How much profit did the company report?"
Sometimes it is:
"What had to happen inside the accounting system for that profit to appear?"
At WorldCom, billions of dollars of operating costs were moved into capital accounts.
The company didn't suddenly become more efficient.
It simply made its financial statements look better—until the accounting entries could no longer hide what was happening underneath.
