The first inklings of the debacle that has consumed WorldCom emerged last week, when an internal company auditor stumbled across something curious.
Expenses the company had incurred in 2001 for its telecommunications network did not appear where they should have in its internal books. Instead, those costs to the tune of billions of dollars had been systematically sprinkled across a series of accounts for capital expenditures.
According to people who work with the company, the internal auditor quickly recognized the shift in expenses for what they were: a huge, and potentially fraudulent, misreporting of WorldCom's financial performance, in a way that deceived investors.
That moment set off a scramble for the accountants, executives and board members of WorldCom, as they struggled to understand what had been done at the once-highflying company. The chief financial officer, Scott D. Sullivan, tried to explain what had happened, but to no avail, according to a person briefed on the situation. By Tuesday, Mr. Sullivan, and the company's controller, David Myers, were both out the door, and WorldCom was pushed to the brink of bankruptcy.
Coming in the wake of a seemingly endless series of corporate scandals from Enron to Tyco, Adelphia to Dynegy WorldCom might seem just one more carcass on the pile and one that had already been picked at for months because of questions about its accounting. But experts on accounting say this case is extraordinary because of the amount of money involved and because of the relative simplicity of the accounting maneuvers used to disguise the truth.
"The magnitude of this is just mind-boggling," said John Fahy, a certified public accountant and former prosecutor. "Auditors cannot miss something like this. It is just inexcusable."
At its foundation is one fact: not all corporate expenses are the same, and for good reason. The costs of a company's operations salaries, materials and the like are treated on a company's books as expenses in the year they are incurred. But the purchase price for certain long-lasting, big-ticket items like buildings or heavy machinery are treated differently. Rather than forcing companies to recognize such large expenses all in one year, accounting rules effectively allow them to recognize a portion of the cost over the many years in which the items will be used.
Such accounting allows companies to make large investments known as capital expenses without incurring huge hits to profits. So large expenses can appear small, emerging a little bit at a time as each new annual report is issued.
That is what has made the capital expense section of a company's books such an attractive area in the past for profit manipulation. By treating, say, $100 of operating expenses as a capital cost, a company only has to recognize a small percentage of that expense in any single year. Reported costs are driven down, pushing reported profits up.
But intentionally mislabeling costs in such a way is illegal because it misrepresents the true nature of a company's financial performance.
Indeed, the distinction between a capital investment, a portion of which can be deferred, and routine expenses is one of the most basic and most discussed issues auditors face, said Roman Weil, a professor of accounting at the University of Chicago Graduate School of Business.
When the auditor discovered the troubling data at WorldCom, phone calls quickly went out to the audit committee formed by members of WorldCom's board, including Max E. Bobbitt, who serves as the committee's chairman, according to people who work with the company. They in turn, summoned WorldCom's new accountants from KPMG to examine the books closely to determine how much damage had been wrought.
KPMG quickly discovered a series of disturbing records. Documents known as journal entries showed that, at the end of each of the last five quarters, Mr. Sullivan had shifted certain telecommunication system expenses across an array of what are called property accounts, which are capital expenditures. No single account received the bulk of the expenses; rather, they were spread out in what appeared to be an effort to keep them from being more easily detected, said a person briefed on the situation.
Armed with the information, on Friday, the KPMG accountants struggling through the records at WorldCom's offices in Clinton, Miss., telephoned the company's former auditor, Arthur Andersen, which just days before had been convicted of obstruction of justice in the investigation of Enron, another of its former clients.
Had anyone at Andersen, the KPMG auditors asked, been told about the shifts of expenses for the telecommunication system into the property accounts?
The Andersen team was stunned. No one from its engagement team on WorldCom had ever been asked about such a shift, they told KPMG, and the firm would never have approved it, according to the person briefed on the situation. Moreover, Andersen reported, the auditors asked at the end of each year to review the journal entries for all nonrecurring expenses. Such a request should have resulted in the documents detailing the expense shifts being turned over to the accountants, but Andersen said that no such data was ever given to them.
Confronted with the evidence of what had happened, Mr. Sullivan was asked to write an explanation of his accounting decisions, both for the audit committee and for KPMG. Last weekend, Mr. Sullivan prepared the document, explaining his rationale.
Mr. Sullivan explained that what he had done, according to a person who has been briefed on Mr. Sullivan's explanation, was make a judgment call. He believed that the expenses were an investment in telecommunication line capacity, which would provide increasing revenue in future quarters. Therefore, he reasoned, it was appropriate to defer expenses to future quarters.
This does not follow generally accepted accounting principles, according to accounting experts. However, it was a procedure that was used by telecommunications companies before the deregulation of the industry. Under that system, public utility commissions allowed for the creation of models through which expenses of underutilized assets could be deferred in this way. Such rules, however, are not permitted under the current deregulated system, and are not accepted under accounting rules.
As the weekend ended, the WorldCom board and KPMG engaged in a series of meetings and conference calls.
By Tuesday morning, they had their answer: About $3.7 billion in expenses had been accounted for improperly. Mr. Sullivan was formally dismissed by the board, and Mr. Myers was allowed to resign. That afternoon, the company contacted the Securities and Exchange Commission, informing it of the scope of what had been discovered.
Mr. Sullivan could not be reached for comment.
John Sidgmore, who took over as WorldCom's chief executive in late April, went from Washington to New York later that day to inform the company's bankers of the problem and to try to persuade them to keep open the possibility of extending new loans. But instead, the banking world was quickly swirling with talk of a new corporate scandal, on a far greater scale than any of the recent ones.
Mr. Sidgmore's efforts failed to win any quick support. Tuesday evening, the company announced its findings. The name of WorldCom, once a darling of Wall Street, had now become the latest shorthand for corporate scandal.