What happened?
On June 25, 2002, U.S. telecommunications company WorldCom announced that it would restate its financial statements after determining that $3.852 billion of line costs had been transferred from expenses to asset accounts during 2001 and the first quarter of 2002. Line costs were a major operating expense associated with carrying calls and data over telecommunications networks.
On July 21, 2002, WorldCom and substantially all of its active U.S. subsidiaries filed for Chapter 11 reorganization. The Board established a Special Investigative Committee the same day to conduct an independent investigation of the accounting irregularities and other matters it considered relevant.
The Committee concluded that from 1999 through 2002 more than $9 billion in false or unsupported accounting entries were made to achieve desired reported financial results. Its schedule of improper income-statement items totaled about $9.25 billion, of which roughly $7.329 billion involved line costs.
The Report says the fraud was implemented under CFO Scott Sullivan’s direction, with Controller David Myers directing unsupported entries. As to CEO Bernard Ebbers, the Committee said there was clear evidence he knew of certain practices used to inflate reported revenue, while it did not have direct evidence that he knew about the capitalization of line costs.
Background: WorldCom (Wikipedia)
12 passages that stood out
Hundreds of millions of dollars in adjustments were passed along on Post-it Notes, while potential revenue entries were listed under “conservative,” “moderate” and “aggressive.” Beyond the accounting totals, these twelve passages show employees struggling to explain entries, emails pressuring colleagues to book them, and changes to reports provided to the outside auditor.
The English article works from the original English-language report. Page references are the printed page numbers in the report filed on SEC EDGAR.
The Report itself is dated March 31, 2003. WorldCom’s Form 8-K states that publication was withheld at the request of the U.S. Attorney’s Office and that the report was released publicly on June 9, 2003; that public-release date is used as the report publication date here.
$544 million was split into ten assets of exactly $54.4 million each
In the first quarter of 2001, WorldCom improperly capitalized part of its line costs rather than recording them as operating expenses. The $544 million amount initially sat in Construction in Progress.
After word circulated internally that external auditor Arthur Andersen planned to examine that account, Property Accounting executive Mark Abide moved the $544 million into an asset clearing account on August 22.
He then created ten fixed assets of exactly $54.4 million each in the Fiber Optic Cable account.
The remaining $0.2 million was put into another asset. The 11 assets were tagged “SS Capacity,” which witnesses told the Committee stood for “Scott Sullivan Prepaid Capacity.”
$742 million, then $818 million: two quarters of capitalization adjustments passed on Post-it Notes
During the close for the third quarter of 2001, Senior Vice President David Myers handed Sanjeev Sethi, who worked in Capital Reporting, a Post-it Note that said “assume $742 million.”
In a subsequent conversation, Myers and Sethi confirmed that the number on the note was the line-cost capitalization adjustment for the quarter. General Accounting ultimately booked $742.725 million.
In the first quarter of 2002, Betty Vinson booked two entries—$718 million and $100 million—for a total capitalization of $818 million. When Sethi later went to Vinson for the amount to include in capital reporting, she handed him another Post-it Note carrying the $818 million adjustment.
By then some employees were refusing to participate in the entries. In another internal email, Buddy Yates asked Myers, “Where do I sign my confession?”
The people handling “prepaid capacity” told Internal Audit they did not know what it was
In May 2002, Internal Audit began trying to reconcile differences among WorldCom’s capital-expenditure reports. That was when auditors first encountered the term “prepaid capacity.”
Sethi said the adjustments had been running at roughly $800 million per quarter but that he did not understand the prepaid-capacity entries. Abide likewise said he was not sure what prepaid capacity was, even though he had booked it into property, plant and equipment accounts.
The Report also notes that both men knew considerably more about the capitalization than they disclosed: neither described the level of his involvement or supplied the schedules tracking the adjustments.On June 17, Internal Audit asked Vinson about an entry she had made. She said she did not know what it was for and referred the auditors to Yates or Myers. Yates said he had no idea what prepaid capacity was and sent them to Myers.
Myers then said he had no support for the entries, would not create support, and was uncomfortable with them—but that once the entries had started, they had become difficult to stop.
With full system access, the entries took minutes to find — they 'jumped off the page'
In April 2002, Business Operations employee Robert Pierson noticed that internal line-cost figures did not reconcile with figures reported outside the company. His questions to Myers and Yates did not produce a satisfactory explanation.
A month later, Pierson received full access to WorldCom’s accounting system for a different project.
He looked at the line-cost entries and, within minutes, found entries that he said “jumped off the page.”
They were large, round-dollar credits to line costs labeled as prepaid capacity. Pierson also found that they explained discrepancies between internal and externally reported capital-expenditure figures.
At that stage, however, Pierson did not know the accounting treatment was improper because he did not know exactly what prepaid capacity was.
The 'conservative' column vanished from a revenue list; $279m in 'aggressive' entries was booked
In the third quarter of 2000, potential accounting entries that could help WorldCom meet its revenue target were tracked in spreadsheets called the “Sept Hit List.”
An early version had three columns: “conservative,” “moderate,” and “aggressive.” Under the conservative treatment, recorded revenue would have to fall by $7.8 million; under the moderate treatment, WorldCom could add $65 million; under the aggressive treatment, it could add as much as $273 million.
Later versions dropped the conservative option entirely, added more opportunities, and showed an aggressive increase of $279 million. What the Committee identified as the apparent final version showed the full $279 million as booked.
WorldCom reported 12% year-over-year revenue growth for the quarter. The Committee calculated that without the $279 million of self-described aggressive entries, growth would have been 8.6%.
The CFO himself called items in the numbers 'accounting fluff' and 'junk'
By the second quarter of 2001, WorldCom was using a process called “Close the Gap” to identify items that could bridge the difference between operating revenue and management’s targets.
On June 19, CFO Scott Sullivan left CEO Bernard Ebbers a voicemail.
Sullivan said the latest monthly revenue report already contained what he himself called “accounting fluff” and “junk”—one-time items that were obscuring what was happening in the recurring service business.
He warned that the company was going to dig itself into a huge hole. Yet about three weeks later, Ebbers instructed another executive to check where the company stood on the one-time events that “had to happen” for it to have a chance to make its numbers.
An internal email called 12% the 'magic number'
In the second quarter of 2001, WorldCom’s underlying revenue growth was deteriorating.
Michael Higgins of Business Operations emailed Myers that the company had become too quick to supplement deterioration in core performance with one-time, non-recurring items. He added that the various outlooks had been tied to the “12% magic number.”
On July 26, WorldCom’s earnings release highlighted 12% year-over-year revenue growth for WorldCom Group. A July 13 internal presentation estimated that approximately $249 million in Close the Gap initiatives would be booked in the quarter. The Report says most of the identified accounting opportunities were ultimately recorded as revenue.
Michael Higgins email on one-time revenue items (excerpt)
I’m distraught over June results. […] They became necessities because of the continued shortfalls.The email sharing revenue opportunities said: 'do not discuss any issues in mail/writing'
By the third quarter of 2001, the gap between WorldCom’s actual revenue growth and its double-digit target had widened further.
On October 2, Revenue Accounting executive David Lomenzo forwarded a schedule of September revenue opportunities to several employees.
In the email, he relayed an instruction from Sullivan: “do not discuss any issues in mail/writing.”
The same email said the process was intended to keep everyone on the same page and that ownership of the schedule could be shared so Sullivan would get the same answer from each person.
At the time, year-over-year revenue growth was 5.5%. Even with already approved opportunities it was 6.6%. WorldCom calculated that another $263 million was needed to reach 12%, and in the quarter’s close more than $274 million had been booked into the Corporate Unallocated revenue account.
A $9.75m entry changed rounded earnings per share to $0.46 — with no supporting analysis found
In the second quarter of 2000, WorldCom released about $100 million from reserves against billings for customers’ failure to meet contractual minimum usage into revenue. The last of three entries was $9,748,245.
The Committee found no legitimate accounting analysis supporting the entries, and none of the witnesses it interviewed could recall why the additional revenue entry was made or why it was offset against the Minimum Deficiency reserve.
Without the entry, pro forma earnings per share would have been $0.4532. With it, EPS became $0.4552.
The latter rounded to $0.46 rather than $0.45, crossing the rounding threshold by just two one-hundredths of a penny per share.WorldCom’s reported EPS then matched Wall Street projections to the penny. The Committee did not say the amount had been selected for that purpose; it said the last-minute entry appeared to have enabled WorldCom to hit the EPS target.
An employee refused an unsupported entry; Myers threatened to fly in and book it himself
The Report gives several examples of senior financial management responding aggressively when employees questioned accounting adjustments.
At UUNET, senior employee David Schneeman was asked to reduce line costs by $50 million without supporting analysis.
When he refused and asked Myers to explain the reasoning, Myers emailed that if necessary he would fly from Mississippi to Washington, D.C. and book the entry himself.
Schneeman still refused; the adjustment was ultimately booked elsewhere.David Myers email to an employee who refused an entry (excerpt)
Book it right now, I can’t wait another minute.In a separate episode, another employee told the Committee that he went to Yates for an explanation of a large discrepancy and was berated. According to the employee’s account in the Report, Yates said that if he showed those numbers to the auditors, Yates would throw him out the window.
The first episode is documented in emails; the second is presented by the Committee as the employee’s testimony.
The monthly revenue report prepared for the outside auditor moved $211 million into sales regions and different months
WorldCom called its monthly consolidated revenue report the “MonRev.” After the third quarter of 2001, a changed version was prepared before a MonRev was given to external auditor Arthur Andersen.
The biggest change was moving $211 million of Corporate Unallocated revenue into the sales regions.
That reduced the Corporate Unallocated amount for the quarter from $299 million to $88 million, a 71% decrease. Some items were moved into regions to which they had no logical connection, and amounts concentrated in September were also spread across July, August and September.Witnesses disagreed about the purpose. Stephanie Scott said the revisions corrected classifications and represented the final MonRev. David Lomenzo, Lisa Taranto and Taranto’s direct report said Scott had initiated and directed the revisions. Taranto and her direct report said the changes were intended to reduce the chance that Andersen would question particular items or unusual fluctuations.
Contemporaneous emails and handwritten notes referred to the revised version as the “AA MonRev” or “Special MonRev.” Senior management received the original version, sales commissions were based on the original, and later MonRevs carried forward the original numbers. The Committee said these circumstances strongly suggested that the altered version was prepared specifically for Andersen.
The CEO borrowed $9 million without advance approval; a Compensation Committee member said he was a 'grown up'
On May 16, 1994, Bernard Ebbers, then CEO of WorldCom predecessor LDDS, borrowed $9 million from the company.
Company records did not show advance approval by the Board or Compensation Committee. The Board later ratified the loan. The Committee called it shocking that a public-company CEO could simply take $9 million out of the company without serious consequences.
The Report also says the Committee found no evidence that anyone on the Board chastised Ebbers for taking the money without advance Board knowledge or consent, or that anyone considered procedures to prevent a repeat.
Stiles Kellett, who had been on the Compensation Committee, explained in an interview that he had said nothing to Ebbers because he thought Ebbers was “a grown up” who could manage his own affairs.
LDDS’s filings indicate that Ebbers repaid the 1994 loans within four to five months.
What the report says about the background
The Committee did not treat WorldCom’s accounting fraud as the work of a few journal-entry operators in isolation. It described a combination of pressure created by promises of double-digit growth, unsupported entries directed through senior finance, weak controls that allowed enormous manual adjustments with little documentation, an environment in which employees were reluctant to challenge senior management, restrictions on information available to the outside auditor, and a passive Board.
Corrections to this article
Clarified that the Post-it amounts concern 3Q01 and 1Q02; corrected the Japanese description of consecutive quarters. Recast the prepaid-capacity explanation as employees’ statements and made the Committee’s qualification that they knew more than they disclosed explicit. Corrected $249 million in Close the Gap initiatives to an estimate of anticipated bookings, aligned quarter-close timing and witnesses’ inability to recall the additional entry and reserve offset, and attributed the explanation about avoiding auditor questions to Taranto and her direct report. Expanded references for Pierson’s knowledge, revenue growth, EPS rounding, and the disputed motive and Committee assessment of the auditor-facing MonRev.