July 03, 2002

How Did WorldCom Get Away With It For Even an Instant?

Amey Stone tries to understand how WorldCom could have gotten away for so long with what was really a simple, simple, transparent fraud stream. Certainly the auditors--Arthur Anderson--should have caught it. And why didn't the analysts following WorldCom catch it? They were supposed to have a good sense of what WorldCom's investments plans were.

BusinessWeek Online: How Everyone Missed WorldCom |

JULY 3, 2002 COMMENTARY By Amey Stone: The accounting fraud was obvious -- only to the few who had full access to its books. At least now real reform is almost certain A major source of the gnawing sense of insecurity generated by the WorldCom (WCOME ) scandal is that so many people missed what seems to have been the most basic of accounting tricks. The foundering telecom giant admitted on June 25 that it essentially disguised billions of operating expenses as capital expenditures, allowing it to report fictitious profits. With outside auditors, stock and bond analysts, bankers and regulators, even journalists, all scouring the finances of this already ailing company, how could they not notice that billions in operating expenses had gone missing? Chief Executive John Sidgmore did his best to build confidence in the new management team during a July 2 news conference, but he couldn't resolve all the lingering doubts about who knew what when. Shouldn't dozens, if not hundreds, of people with fairly close knowledge of the company have intuitively known whether or not it was a money-making proposition. Shouldn't they have smelled a rat if WorldCom was reporting large and unreal profits?

WARNING SIGNS. The answers are a very unsatisfactory yes and no. Yes, it's likely that a handful of people inside the company and among its outside audit team knew the numbers didn't add up. After all, "It's pretty hard to miss a $3 billion overstatement, particularly one as simple in concept as this one," says Ed Kuriansky, senior managing director at investigative consulting firm Citigate Global Intelligence & Security, whose former job as a commissioner in the New York City Investigations Dept. was to look for fraud in city government. "People fairly high up the line must have had some idea," he surmises. However, no, there's little chance that anyone who didn't have direct access to WorldCom's books had any idea. There were plenty of warning signs, given the large debt levels and the severe problems in the telecom industry, says Barbara Lougee, assistant professor of accounting at the University of California, Irvine. But an outsider would have no real way to tell if management simply lied. The fact that WorldCom's apparent chicanery was quite easy to miss underscores just how hard it will be to fix the accounting woes now plaguing Corporate America...

JULY 3, 2002

COMMENTARY
By Amey Stone

How Everyone Missed WorldCom

The accounting fraud was obvious -- only to the few who had full access to its books. At least now real reform is almost certain

A major source of the gnawing sense of insecurity generated by the WorldCom (WCOME ) scandal is that so many people missed what seems to have been the most basic of accounting tricks. The foundering telecom giant admitted on June 25 that it essentially disguised billions of operating expenses as capital expenditures, allowing it to report fictitious profits. With outside auditors, stock and bond analysts, bankers and regulators, even journalists, all scouring the finances of this already ailing company, how could they not notice that billions in operating expenses had gone missing?

Chief Executive John Sidgmore did his best to build confidence in the new management team during a July 2 news conference, but he couldn't resolve all the lingering doubts about who knew what when. Shouldn't dozens, if not hundreds, of people with fairly close knowledge of the company have intuitively known whether or not it was a money-making proposition. Shouldn't they have smelled a rat if WorldCom was reporting large and unreal profits?

WARNING SIGNS. The answers are a very unsatisfactory yes and no. Yes, it's likely that a handful of people inside the company and among its outside audit team knew the numbers didn't add up. After all, "It's pretty hard to miss a $3 billion overstatement, particularly one as simple in concept as this one," says Ed Kuriansky, senior managing director at investigative consulting firm Citigate Global Intelligence & Security, whose former job as a commissioner in the New York City Investigations Dept. was to look for fraud in city government. "People fairly high up the line must have had some idea," he surmises.

However, no, there's little chance that anyone who didn't have direct access to WorldCom's books had any idea. There were plenty of warning signs, given the large debt levels and the severe problems in the telecom industry, says Barbara Lougee, assistant professor of accounting at the University of California, Irvine. But an outsider would have no real way to tell if management simply lied.

The fact that WorldCom's apparent chicanery was quite easy to miss underscores just how hard it will be to fix the accounting woes now plaguing Corporate America. The underlying problem that created the WorldComs, Enrons (ERNQ ), and Adelphias (ADELQ ) of today is the culture of greed nourished by the heady bull market of the '90s. "You cannot legislate, prosecute, regulate, or audit fraud out of existence," says Kuriansky. "The answer lies in companies realizing it's in their long-term interest to become good corporate citizens."

EXTRA-LARGE PIE. Part of the problem is that companies have gotten incredibly large and complex. "There's no way that any business of any size is simple enough that someone can intuitively look at it and know if it's a successful business or not," says Peter Cohan, an author and consultant in Marlborough, Mass.

Plus, very few people, especially at huge global companies, are privy to the complete picture. "Everybody has responsibility for their own slice of the pie," says Robert Rini, an attorney who specializes in telecommunications transactions at Manatt, Phelps & Phillips, a law firm in Washington, D.C. "There aren't that many people who see the whole pie."

Sidgmore admitted that this was part of the problem. "WorldCom is a far-flung organization," and no single operating unit knows what's going on at all the others, he said during the conference call. "It all came to gether at Scott Sullivan's level," he said, pinning the mistatements on the company's ousted CFO.

COMPROMISED AUDITS. Congress, the Securities & Exchange Commission, and the stock exchanges are pursuing a multifaceted approach to reform that could go a long way to make companies realize it truly is in their best interests to be honest and straightforward. Eliminating the myriad conflicts of interest that exist between a company and its financial analysts, bankers, and outside auditors will help. Investment bankers and outside auditors clearly don't have enough incentive to disclose major problems at their client companies.

The University of California's Lougee thinks the outside auditor, Arthur Andersen in WorldCom's case, should have found the apparent accounting manipulation. But she believes these firms have been compromised by their quest for consulting fees. In a telling example, she recently had a student look at fees paid to Arthur Anderson by the 500 largest companies in 2001 and found that only 26% of $16.8 billion in total fees paid went for audits. The rest were listed as "other" -- essentially consulting projects.

The reform package being debated in the Senate includes several measures that get at these issues, including setting up an oversight board to audit auditors. Gary Gensler, former Treasury Under Secretary who consults on matters of public policy and finance, thinks the bill will result in real reform even after it's reconciled with a weaker House bill. He expects it to pass by late September. With President Bush, SEC Chairman Harvey Pitt, and even financial industry leaders lining up, "I think everybody understands the public needs it," he says.

HARD TIME . Further changes in executive compensation and corporate governance are needed as well. Clearly, management has too much incentive to manipulate numbers when business faces a rough patch. Reform can be achieved either by making CEO compensation less tied to the stock price, or -- better yet -- increasing the penalties executives face for fraud. That's a major reason why there's a growing cry to send to corporate criminals to jail. Then the penalties from getting caught would at least have a shot at offsetting the potential rewards from keeping the stock price aloft.

Stronger internal-compliance procedures could encourage knowing underlings to step forward. And more independent corporate boards are crucial. That's something the New York Stock Exchange has taken the lead on with its new rules. "Right now, if management is determined to make up the numbers, there's really no current mechanism to keep them from doing that," says Cohan. "They control everything."

"Until [recent scandals], people believed the numbers on the papers they saw," says Rini. He was at a telecom conference the day the WorldCom news broke and says industry participants were horrified. "This is not just bad news. It's quite shocking and incredible and unprecedented," he says.

It's not going to be easy to restore the public's faith in Corporate America. But as tales of business greed and excess mount, the silver lining is that real change seems more and more likely. Says Kuriansky: "We need a major attitude adjustment at the highest level -- and we might just have a chance at getting it at this point."

Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column
Posted by DeLong at July 03, 2002 10:15 AM | Trackback

This is such an orgy of hindsight, I'm almost embarrassed to watch! Can you explain to me exactly why line charges should be expensed rather than capitalised? Can Amey Stone? Ivery much doubt it. Remember that this was an environment in which Amazon and AOL both capitalised *marketing* expenses, with the approval for the most part of the accountants and the SEC.

There is no way on earth that an analyst, from the outside, could have caught this. It is true that WCOM did appear to have a surprisingly high proportion of marketing expenses in its cost base, and perhaps a low overall level of costs relative to its asset base. But anyone who said, on the basis of no other evidence than these two ratios, that they were "Obviously" inappropriately capitalising, would have been regarded as a loony, and rightly so.

If I had been covering this company, I think I would not have been keen on it for two reasons; I don't like companies with a lot of debt, because I am a terrible worrywort, and I don't like companies which grow fast by acquisition, because they become impossible to analyse due to the accumulated one-off charges and such. But nobody would have listened to me, not least because on the same basis, I would have been catastrophically wrong in making the same call on General Electric and Lord knows how many other good, sound companies.

Here's a contrarian proposition for you; the Worldcom accounts, in fact, gave an accurate picture of the company. At least, the cashflow statements did; nobody is suggesting that this key statement was falsified. Furthermore, even the falsification of the earnings statement did not actually materially mislead anyone; it gave a picture of a telecoms company which was expanding very rapidly, taking on a lot of debt and acquisitions to do so, and which was not making a distributable profit, because it hoped that its investments would pay off big-time in the future. Anyone who invested in it did so on that basis; they would have made out like bandits if overall credit conditions had stayed loose enough for long enough to pay down the debt and if the customers being added turned out to be "monetisable". Anyone investing in this company because the EBITDA margin was X+5% rather than X% has a right to be outraged, but if you can find one such peson, I'll buy him a drink.

So the answer to your titular question ("How did they get away with it for even a second?") is that large and complicated telecoms companies are, well, large and complicated, and that there can be principled disagreements between honourable men over what should be expensed and what should be capitalised. It is very likely that all concerned viewed the treatment made as "aggressive" rather than "intentionally fraudulent".

We've had this argument in a number of contexts (usually with you standing proxy for Andrei Shleifer), and I always come back to the same point; explanations of the massive malinvestment of the late 1990s which are based on bad accounting distorting peoples' information really do have to come up with an explanation of why eToys was given a larger market capitalisation than Toys-R-Us. The whole "accounting scandal" thing is a red herring analytically, and many of the press stories to me seem to have been written by people who have never cracked the spine on a set of accounts.

Posted by: Daniel Davies on July 3, 2002 11:48 PM

>>But nobody would have listened to me, not least because on the same basis, I would have been catastrophically wrong in making the same call on General Electric and Lord knows how many other good, sound companies.<<

I think this is the real key: after a wild-eyed happy-juice bull market, anyone who isn't an overoptimistic nut-boy is simply not listened to, because everyone remembers how often they have been wrong in the past several years.

Brad DeLong

Posted by: Brad DeLong on July 5, 2002 08:12 AM

I'm happy to concede that accounting ledgerdemain was a second- or third-order cause of the NASDAQ craziness. But I don't know how to fix the first-order causes. And getting accountants to do a better job would do at least some good...

Posted by: Brad DeLong on July 5, 2002 06:49 PM