WorldCom Internal Probe
Uncovers Massive Fraud
Expenses of $3.8 Billion Were Improperly Booked,
Boosting Cash Flow and Profits; CFO Is Dismissed
By JARED SANDBERG, REBECCA BLUMENSTEIN and SHAWN YOUNG
Staff Reporters of THE WALL STREET JOURNAL
NEW YORK -- WorldCom Inc.'s audit committee uncovered what
could be one of the largest accounting frauds in history, with the
discovery of $3.8 billion in expenses improperly booked as capital
expenditures, a gimmick that boosted cash flow and profit over the
past five quarters.
Without the transfers, WorldCom, one of the biggest stock market
stars of the past decade, said it would have reported a net loss for
2001, as well as the first quarter of 2002. WorldCom reported a
profit of $1.4 billion for 2001 and $130 million for the first quarter of
2002.
In turn, WorldCom Tuesday fired its longtime chief financial officer,
Scott Sullivan, and accepted the resignation of David Myers, its senior
vice president and controller. Neither Mr. Sullivan nor Mr. Myers
could be reached to comment.
Clearly, WorldCom's
survival is in question.
WorldCom said it intends
to restate its financial
statements for the five quarters in what could be among the largest
restatements in corporate history. The telecommunications firm
already has been hobbled by an industrywide meltdown, a Securities
and Exchange Commission probe and $30 billion in debt. WorldCom
is one of the world's largest telecom companies, with 20 million
consumer customers, thousands of corporate clients and 80,000
employees.
The company said an irregularity was initially picked up during a
routine internal audit conducted soon after the ouster of WorldCom's
chief executive, Bernard J. Ebbers, in April. WorldCom officials said
they then turned the matter over to the company's audit committee and
its auditors, newly hired KPMG LLP, who determined that the issue
was serious enough to alert the SEC. The agency already had
launched its own investigation into WorldCom in February.
At the SEC, a person familiar with the situation said the agency's
investigation into the WorldCom fraud could "go right to the top" of
the company's management, potentially including the role of Mr.
Ebbers. The person said the SEC's inquiry will now accelerate and
broaden to include the massive financial deception.
"This is a matter that has none of the complexities of Enron," this
person said. "It's a matter of figuring out who knew about it, and what
they thought they were doing."
Mr. Ebbers couldn't be
reached for comment.
John Sidgmore, who took
over as WorldCom's chief
executive in late April,
declined to comment. But
in a statement issued
shortly before 8 p.m.
Tuesday night, Mr.
Sidgmore said, "Our
senior management team
is shocked by these
discoveries ... I have
committed to driving
fundamental change at
WorldCom, and this matter will not deter the management
team from fulfilling our plans."
Mr. Sidgmore said that with no debt maturing during the next two quarters, the restatement of its
operating results for 2001 and 2002 is not expected to have an impact on its cash position and will not
affect its service to customers. WorldCom said it is taking measures to conserve cash, including plans to
lay off 17,000 employees and cut capital spending to $2.1 billion annually.
It remains unclear how the company's banks will handle the news of the accounting problems, and
whether the pending restatement puts the company in default of its bank covenants.
Many details of WorldCom's accounting improprieties remain unclear. In its statement, WorldCom said
only that "certain transfers from line cost expenses to capital accounts" weren't made according to
generally accepted accounting principles. The amount of these transfers totaled $3.8 billion for the four
quarters of 2001 and the first quarter of 2002.
Arthur Andersen LLP, which was WorldCom's longtime accounting firm, advised the company that in
light of the inappropriate transfers, Andersen's audit reports "could not be relied upon" for the five
quarters in question, WorldCom said. WorldCom hired KPMG, which declined to comment Tuesday,
to replace Andersen in May.
Arthur Andersen issued a statement Tuesday night that shifted blame to Mr.
Sullivan. "It is of great concern that important information about line costs was
withheld from Andersen auditors by the chief financial officer of WorldCom,"
the statement said, adding that its work for WorldCom complied with
accounting standards.
Shocked analysts feared there could be more revelations. "This pretty much
closes the chapter on this company," said Lehman Brothers analyst Blake Bath.
"They violated the trust of their financial institutions."
WorldCom has been in difficult negotiations with its banks for a $5 billion line of
credit and in May drew down a $2.65 billion credit line.
Sanford C. Bernstein analyst Jeff Halpern said he expected swift action from WorldCom's banks. "I
would think the banks will foreclose on them immediately," said Mr. Halpern, who said that a Chapter
11 filing is quite possible. "This will send them into a spiral of customer defections."
Last week, one of WorldCom's internal auditors discovered that starting in early 2001, huge amounts of
expenses related to building out their telecom system weren't being treated as a regular cost but were
being booked as a capital expense, these people said. That resulted in a significant boosting of the
company's earnings before interest, taxes, depreciation and amortization, otherwise known as Ebitda,
which WorldCom used as a critical gauge of its growth.
While it's not clear exactly what costs WorldCom capitalized, the process helped boost cash flow
because it treated the costs as an asset that can be written down over time, not immediately. The
accounting treatment means the expenditure doesn't affect the all-important operating cash-flow figure
-- though money actually may be going out the door. Capitalizing costs is prevalent in industries like
cable TV and is allowed under generally accepted accounting principles in some instances. Still, some
investors say the practice helps the cable industry overstate its financial strength.
Based on a preliminary investigation, WorldCom believes that its Ebitda was inflated by about $3.8
billion. The committee turned its findings over to its new auditor, KPMG. The board ousted Mr.
Sullivan and informed the SEC.
Mr. Sullivan, 40 years old, served as a WorldCom director since 1996 and as chief financial officer,
treasurer and secretary of the company since 1994. He became an executive vice president at
WorldCom when Mr. Ebbers resigned April 30.
He initially came to WorldCom, then known as LDDS, in 1992 when his firm, Advanced
Telecommunications Corp. became one of the 75 firms Mr. Ebbers acquired to form his empire. Mr.
Sullivan and Mr. Ebbers worked so closely together over the years as they did acquisition after
acquisition that Mr. Ebbers relied on Mr. Sullivan's approval before going ahead with a deal.
WorldCom's directors and its underwriters could also face liability, in large part because of a bond
offering the company had in May 2001. Henry Hu, a corporate and securities lawyer at the University
of Texas at Austin, said any kind of material misstatement or omission in a prospectus for a bond
offering opens the directors and underwriters to liability. "It's not enough for the directors to say they
didn't know," he said. Anyone who wants to sue "doesn't have to show any necessary bad intent on the
part of the various directors," said Mr. Hu.
The underwriters for the offering could also be in trouble. That's because the underwriters are required
to perform a certain amount of "due diligence" to make sure the information it presented to potential
investors was accurate, said Mr. Hu.
In 4 p.m. Nasdaq Stock Market trading Tuesday, WorldCom's stock was at 83 cents, a far stretch
from its high of $64.50 in June 1999.
-- Yochi Dreazen, Deborah Solomon and Ryan Chittum contributed to this article.
Write to Jared Sandberg at jared.sandberg@wsj.com, Rebecca Blumenstein at
rebecca.blumenstein@wsj.com and Shawn Young at shawn.young@wsj.com
Growing Troubles
Feb. 8, 2002: WorldCom cuts 2002 revenue and earnings projections and announces second-quarter
charge of $15 billion to $20 billion to write down some acquired operations. CEO Bernard Ebbers
owes his company $366 million to cover loans he took out to buy his own shares.
Feb. 15, 2002: WorldCom suspends three star employees and freezes the commissions of at least 12
salespeople over an order-booking scandal in three of its branch offices.
March 12, 2002: The SEC launches inquiries into WorldCom's accounting practices, on the heels of
Enron scandals and Global Crossing's bankruptcy filing.
April 3, 2002: WorldCom plans to lay off as much as 10% of its 75,000 work force.
April 22, 2002: WorldCom slashes at least $1 billion from its revenue projections for 2002.
April 24, 2002: WorldCom debt is downgraded by Moody's and Fitch
April 30, 2002: Bernard J. Ebbers resigns as chief executive of WorldCom.
May 9, 2002: Moody's and Fitch each slash WorldCom's debt three notches, to "junk" status, pushing
shares to a new low.
May 21, 2002: WorldCom eliminates its MCI Group tracking stock, hoping to save money that would
have gone to dividends.
June 5, 2002: WorldCom announces plans to cut up to 20% of its work force in a restructuring that
would involve selling its wireless unit.
June 20, 2002: WorldCom says it will defer interest payments on some preferred securities of MCI
Group, to conserve cash.
June 24, 2002: WorldCom shares fall below $1 after analyst Jack Grubman issues a negative report
about the telecom's finances.
June 25, 2002: WorldCom unveils massive corporate fraud, with $3.8 billion in expenses that were
improperly booked as capital expenditures.
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