Introduction:

WorldCom was a provider of long distance phone services to businesses and residents. It started as a
small company known as Long Distance Discount Services (“LDDS”) that grew to become the third
largest telecommunications company in the United States due to the management of Chief Executive
Officer Bernie Ebbers. It consisted of an employee base of 85,000 workers at its peak with a presence in
more than 65 countries. LDDS started in 1983. In 1985, Ebbers was recruited as an early investor of the
company and became its CEO. It went public four years later. Ebbers helped grow the small investment
into a $30 billion revenue producing company characterized by sixty acquisitions of other telecomm
businesses in less than a decade. On June 25, 2002, the company revealed that it had been involved in
fraudulent reporting of its numbers by stating a $3 billion profit when in fact it was a half-a-billion dollar
loss. After an investigation was conducted, a total of $11 billion in misstatements was revealed.

Literature Review:

1. Qwest Communications announced on July 28th that it had erroneously accounted for
telecommunications capacity swaps with other companies and will restate its previous earnings.

2. According to the July 4th The New York Times, a June 24th memo prepared by Scott D. Sullivan,
the chief financial officer at the time, attempted to justify the capitalization by arguing that
WorldCom was paying for excess capacity that it would need in the future, i.e., that the line
costs in question were a cost of obtaining customers. (In some instances, accounting rules do
allow for costs of obtaining customers to be capitalized.)

3. 2 Ex-Officials at WorldCom Are Charged in Huge Fraud(By KURT EICHENWALD)

4. According to wall street journal Article on Feb.29,1996, WorldCom provided investors with
returns of 57.3 percent a year over the previous 10 years. (The article states: "A $100
investment in WorldCom in 1989, for instance, would be worth $1,580 by January; that,
according to the company, is about 10 times the best return generated by WorldCom's primary
competitors, the Big Three of long distance: AT&T Corp., MCI Communications Corp. and Sprint
Corp.)
Scandal Issue

On June 25, 2002, WorldCom long distance Telecommunication Company, announced that it had
overstated earnings in 2001 and the first quarter of 2002 by more than $3.8 billion. WorldCom admitted
that the company had classified over $3.8 billion in payments for line costs as capital expenditures
rather than current expenses. Line Cost are what WorldCom pays other companies for using their
communication network, they consists access fees, and transport charges for messages for WorldCom
customers. Reportedly, $3.055 billion was misclassified in 2001 and $797 million in the first quarter of
2002. According, to the company $14.7 billion in 2001 line cost was treated as a CURRENT EXPENSE.

By transferring part of a current expense to a capital account, WorldCom increased both its net income
(since expenses were understated) and its assets (since capitalized costs are treated as an investment).
Had it not been detected, the maneuver would have resulted in lower net income in subsequent years
as the capitalized asset was depreciated (depreciation is an expense that reduces net income).
Essentially, capitalizing line costs would have enabled the company to spread its current expenses into
the future, perhaps for 10 years or even longer.

WorldCom’s accounting had been questioned before its June 25. In March 2002, the SEC requested data
from the firm about a range of financial reporting topics, including:

(1) disputed bills and sales commissions,

(2) 2000 charge against earnings related to wholesale customers,

(3) Accounting policies for mergers,

(4) Loans to the CEO,

(5) Integration of WorldCom’s computer systems with those of MCI, and

(6) WorldCom’s tracking of Wall Street analysts’ earnings expectations.

On July 1, 2002, WorldCom announced that it was also investigating possible irregularities in its reserve
accounts. Companies establish these accounts to provide a cushion for predictable events, such as
future tax liabilities, but they are not supposed to manipulate them to change reported earnings.

On August 8th, WorldCom admitted that it had improperly used its reserves in recent years. The
indictments issued August 28th charged that reserve accounts were reduced in order to provide credits
against line expenses.

How Fraud Happened

The fraud was characterized mainly by the improper reduction of line costs and false adjustments to
report revenue growth.  The Misstatement of Line Costs  Releasing Accruals  Capitalizing Line Costs 
Revenue.
The Misstatment of LINE COSTS

Line costs are the costs associated with carrying a voice phone call or data transmission from the call’s
origin to its destination. If a WorldCom customer made a call from New York City to London, the call
would first go through the local phone company’s line in New York City, then through WorldCom’s long
distance, and finally through the local phone company in London. WorldCom would have to pay both
the local companies in New York City and London for use of the phone lines,these costs are considered
line costs. Not only were line costs WorldCom’s biggest expense but were also approximately half of
WorldCom’s total expenses. Especially after the collapse of the dot com bubble in early 2000, cost
savings became extremely important, so important that line cost meetings were the only meetings with
regular attendance by top management.

WorldCom’s top management strived to achieve a low line cost to revenue ratio because a lower ratio
meant better performance whereas a higher ratio meant poorer performance. To report better
performance and growth, Sullivan implemented two improper accounting methods to reduce the
amount of line costs, release of accruals from 1999-2000 followed by the capitalization of line costs in
2001 through early 2002.

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Conclusion