MARKET COMMENT
Lessons From The WorldCom Disaster

By Bruce Jackson (TMFGoogly)
June 26, 2002

The following two sentences sent shockwaves through the financial markets, sending the FTSE 100 index down some 4% this morning. They are part of a press release from WorldCom, Inc. (Nasdaq: WCOM), one of the largest telecoms companies (by revenue) in the world, and employer of over 60,000 people.

"As a result of an internal audit of the company's capital expenditure accounting, it was determined that certain transfers from line cost expenses to capital accounts during this period were not made in accordance with generally accepted accounting principles (GAAP). The amount of these transfers was $3.055 billion for 2001 and $797 million for first quarter 2002."

What Does It Mean In Plain English?

They've been fiddling the books. Essentially, instead of accepting and recognising that expenses incurred in 2001 and the first quarter of 2002 were a charge against profits in the period in which they were incurred, for accounting purposes, WorldCom effectively deferred writing off those expenses. The net result was that profits have effectively been over-stated in 2001 and 2002, although it won't affect their cash position.

Lesson 1: Accounting Is An Opinion, Not A Fact

I'm an accountant. Well, an ex-accountant now, but I still know, if I so desired, how to fiddle the books, and how to pull the wool over an auditor's eyes.

The one thing to understand about accounting is that it is far from a precise art. When presenting a company's profit and loss statement and balance sheet, many aspects are open to interpretation. For example, company A may present research and development (R&D) expenditure as a straight expense, hence reducing profits in the year that cash was spent. Company B may, quite legally, present R&D as an asset and write off (against profits) that expenditure over a number of years. The net effect on stated profits between company A and company B can, legally, be very materially different.

And that's just one example. There are many others. Heard about the one where, late on December 31st, the company's year end, the sales director dispatches a lorry full of 'sold' goods, destined for delivery to one of his bigger customers? He gleefully books the 'sale' and so secures his bonus for the year. On January 1st, the lorry returns to the depot, still full of the same 'sold' goods. A credit note is 'issued', cancelling out last year's 'sale'. The sales director has 12 months to make up for the shortfall. If he fails, he loses his job, but not last year's bonus.

Profits can be legally manipulated to suit.

Lesson 2: Focus On Cash

The one thing companies can't fiddle is cash. Cash is cash is cash. Regardless of how a company 'treats' (in an accounting sense) its sales and expenses, the bank account doesn't lie.

Investors should focus on a company's cashflow statement before looking at its profit and loss statement. A material difference between cash profits and accounting profits is a warning sign.

Lesson 3: Concentrate On Management Integrity

Up until a few months ago, Bernie Ebbers was the CEO of WorldCom. He was the person who led them on an acquisition spree. At one stage, courtesy mainly of his generous stock option package and WorldCom's soaring share price, his net worth was estimated at $1.4 billion. But, in recent times, things have began to unravel for Mr Ebbers.

It was revealed earlier this year that WorldCom had lent Ebbers $366m to keep him from selling WorldCom stock to cover his losses as the share price of WorldCom fell off a cliff. The Securities and Exchange Commission (SEC) is looking into the loan. Separately, WorldCom is also facing a SEC probe into its accounting practices and acquisition strategy.

In April 2002, after months of pressure from both inside and outside the company, Ebbers resigned as WorldCom CEO.

Is this management in which you'd trust your investment? I suspect not.

What To Do Now

The stock market has plunged on news of yet another accounting scandal. The investing public has, rightly so, lost confidence in the accounting profession. But, let me assure you, that by far the majority of accountants are honest, hard working people. If you've ever been involved in an audit, you'll know how thorough and professional auditors are.

Sure, there are one or two bad eggs out there, just as there are in all professions. They key for investors is to be vigilant, as they should always have been, and to keep an eye out for any warning signs of foul play.

The bottom line - by far the majority of companies will never be affected by accounting irregularities.

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