worldcom presntation

8/12/2019 WorldCom presntation

1/29

The FraudGroup Members:

Jake - Cenk TolunayYan Wang

Hong Ma

Yuhong Zhang


2/29

Background

Started as a small long

distance service provider calledLDDS in Mississippi in 1983

Grew with acquisitions in the 90s- Gone public in 1989

- 4th

largest in with $1.5 billion revenue in 1993 Changed its name to WorldCom in May 1995


3/29

Background

Became number two telecom

company in 1998 after MCI

merger ($34.5 billion)

Aggressive accounting

practices surfaced in 01 Bankrupt in December

2001


4/29

What Happened

Bernard J. Ebbers (CEO) principalbusiness strategy: growth through

acquisitions The currency is the WorldCom stock

The peak: Acquisition of MCI in 98

End of acquisitions with the forcedabandon of Sprint merger because ofantitrust objections

CEOs pressure on subordinates (Mr.Sullivan CFO) to feed Wall Streetsdouble digit expectations


5/29

What Happened

Line costs are network

lease cost which is more

than half of expenditures The target: maintain the

line cost to revenue ratioconstant at 42% all cost


6/29

What Happened

$3.8 billion of line coststransferred to capitalexpenditures between 2001and 2002

Another $3.8 billion was inimproperly reported earningsbefore taxes for 99, 00, 01

and first quarter 02. $ 80 billion write off on the

assets


7/29

What Happened

Use two main methods to manipulate earnings

Reduction of line costJune 25, 2002, $3.852 billion

August 8,2002, $3.330 billion

Total $7.182 billion

Inflation of revenue

Identified improper $958 millionQuestionable $1.107 billion

Total $2.065 billion.


8/29

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


9/29

Releases of Accruals to Reduce Line CostsProper 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


10/29

Capitalization of Line Costs

Increase in line cost

$17,802$18,332$14,980

200120001999

Why:

Long-term, fixed rate contract

Line Cost Reduction


11/29

Line Cost Reduction

Capitalization of line cost

Ongoing, operating expenses needrecognize immediately.

Capitalized it to exaggerate its pre-tax

incomeI/S

Line Cost

Depreciation

..

Pre-tax

income

B/S

Capitalexpenditure

A/D

Total asset

Shift to

Postpone offset to

revenue


12/29

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

Linecost 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%


13/29

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


14/29

Revenue Inflation

Specific Revenue items

Minimum Deficiency reserves 4th Q of 99 4th Q of 2001 : $312 million

Arise from customer agreements that

permit a telecommunications company tobill customers for usage amounts that fallbelow contractual minimum.

Those charges are rarely collected later.


15/29

Revenue Inflation

Minimum Deficiency reserves

When collectibility cannot be established

with reasonable assurance, GAAP doesnot permit recognition of revenue

From the second quarter of 2000, release

Collectibility is establishedB/S:

A/R

Recognize

I/S:

revenue

Offset


16/29

Revenue Inflation


Customer Credits

2nd Q of 2001 1st Q of 2002 : $215million

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


17/29

Revenue Inflation


Early Termination Charges 2nd Q of 2001 3rd Q of 2001 : $30

million

Based on rarely enforced contractualprovisions with customers

Main part of this amount from anaccount will never collect.


18/29

Revenue Inflation

Adjustment of financial data for revenue only


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

GrossMargin

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.


19/29

What Happened

Adjustment of financial data for line cost and revenue


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.


20/29

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

M t I ti


21/29

Management Incentive

Mr. Sullivans Estate

$15 million mansionin Florida

18-seat movie

theater Two-story boathouse

Domed exerciseroom

Art gallery


22/29

Warning Signs

From 1999 to 2000

Revenue increasedfrom $37,120M to$39,090M

Cost of goods solddecreased from$15,951M to$15,462M

Operation efficiency

constant

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

1999 2000

Revenue COGS

i Si


23/29

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


24/29

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(%)


25/29

Consequences

Stock

Mid 1999 - $64.50 a share

Prior fraud announcement

- $2 a share

After announcement

- below $1 a share

Today - $.06 a share


26/29

Consequences

C


27/29

Consequences

BankruptcyJuly 21st, 2002 WorldCom filed

for Chapter 11 bankruptcy protection

Layoff

New CFO

Fraud ChargeFederal prosecutors charged former CFO andcontroller with securities fraud, conspiracy and

filing false statements with the SEC


28/29


29/29

Question

Is it really worth manipulating the

financial numbers for the long term?

worldcom presntation

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