Famous Frauds - WorldCom

WorldCom may have crashed and burned a decade ago, but it still remains one of the biggest accounting frauds in history. Could it have been detected or stopped sooner? Yes. There were a number of red flags, and many people knew enough to blow the whistle.

MCI WorldCom was formed in the then-largest merger in US history, giving AT&T some serious competition in the telecom sector.  Earlier mergers and acquisitions by CEO Bernie Ebbers had transformed a small, regional long distance company into an international telecom giant. 

But there were signs something wasn't right. WorldCom's revenues and profits kept growing, despite a downturn in the telecom sector as businesses slashed spending. How did WorldCom fare so well when everyone else was suffering? It didn't, once a $4 billion financial statement fraud was uncovered in the financial statements.

Financial statements provide a snapshot of a company's performance. Revenues and expenses on those statements are measured and classified according to specific, well-defined accounting criteria.  In WorldCom's case, this didn't happen.

WorldCom recorded customer interconnection costs as an asset, rather than the expense it really was. The customer connection cost is mostly the labor involved to connect the customer to the utility's infrastructure. If those customers walk away, you can't resell that labor cost to someone else. Yet WorldCom assigned an asset value to it, recording it just like real estate, vehicles or any other investment on the company balance sheet.

Not only did that overstate the company's assets, it also meant that expenses that should have been offset against the sales weren't.  The company appeared more profitable than it was.

In WorldCom's case, there were warning signs of an underlying problem:

1. Outperforming the competition despite a business sector downturn.
2. Agressive growth strategies (these often can drive agressive, or even fraudulent accounting treatments)
3. Management loans (some to cover margin calls on WorldCom stock losses)
4. Management heavily invested in the stock - big personal impacts if the stock price dropped

The last two points are major conflicts of interest, and likely contributed to the first two scenarios happening in the first place. I'll talk more about those in a future post.

If you're investing, make sure you check out the company's financial statements. If you don't read them and understand them, you shouldn't be investing. Never invest in something you don't understand, and never blindly follow the crowd.

Read more about fraud and forensic accounting at http://colleencross.com
Colleen is the author of Exit Strategy, a Katerina Carter suspense thriller available at Amazon.com here or Amazon.co.uk here.