WorldCom case study

WorldCom: Most Brazen Creation of Fictitious Profit and Cash Flow

WorldCom Inc. began life in 1983 as the American telecommunications company Long Distance Discount
Services (LDDS). In 1989, LDDS merged into a shell company called Advantage Companies in order to
become publicly traded, and in 1995, LDDS changed its name to LDDSWorldCom. Throughout
WorldCom’s history, its growth came largely from making acquisitions. (As we will explain later,
acquisition-driven companies offer investors some of the greatest challenges and risks.) The largest of
these occurred in 1998 with the $40 billion acquisition of MCI Communications. Accordingly, the name
was again changed, this time to MCI WorldCom. A few years later, the name was finally shortened to
WorldCom.

The Accounting Games at WorldCom

Almost from the beginning, WorldCom used aggressive accounting practices to inflate its earnings and
operating cash flows. One of its principal shenanigans involved making acquisitions, writing off much of
the costs immediately, creating reserves, and then releasing those reserves into income as needed. With
more than 70 deals over the company’s short life, WorldCom continued to “reload” its reserves so that
they were available for future release into earnings. This shenanigan would probably have been able to
continue had WorldCom been allowed to acquire the much larger Sprint in a $129 billion deal
announced in October 1999. Antitrust lawyers and regulators at the U.S. Department of Justice and their
counterparts at the European Union disapproved of the merger, citing monopoly concerns. Without the
acquisition, WorldCom “lost” the expected infusion of new reserves that it needed, as its prior ones had
rapidly been depleted by being released into income.

By early 2000, with its stock price declining and intense pressure from Wall Street to “make its numbers,”
WorldCom embarked on a new and far more aggressive shenanigan—moving ordinary business
expenses from its Statement of Income to its Balance Sheet. One of WorldCom’s major operating
expenses was its so-called line costs. These costs represented fees that WorldCom paid to thirdparty
telecommunication network providers for the right to lease their networks. Accounting rules clearly
require that such fees be expensed and not be capitalized. Nevertheless, WorldCom removed hundreds
of millions of dollars of its line costs from its Statement of Income in order to please Wall Street. In so
doing, WorldCom dramatically understated its expenses and inflated its earnings, while duping investors.
This trick continued quarter after quarter from mid-2000 through early 2002 until it was uncovered by
internal auditors at WorldCom.

Investors would have found some clear warning signs in evaluating WorldCom’s Statement of Cash Flows
(SCF), specifically, its rapidly deteriorating free cash flow. WorldCom manipulated both its net earnings
and its operating cash flow. By treating line costs as an asset instead of an expense, WorldCom
improperly inflated its profits. In addition, since it improperly placed those expenditures in the Investing
rather than the Operating section of the SCF, WorldCom similarly inflated operating cash flow. While
reported operating cash flow appeared consistent with reported earnings, the company’s free cash flow
told the story.
Tyco Case study
Similar to WorldCom, Tyco International Ltd. loved doing acquisitions, making hundreds of them over a
few short years. From 1999 to 2002, Tyco bought more than 700 companies for a combined total of
approximately $29 billion. While some of the acquired companies were large businesses, many were so
small that Tyco did not even bother disclosing them to investors in its financial statements. Tyco probably
liked the businesses that it was buying, but more than that, the company loved to be able to show
investors that it was growing rapidly. However, what Tyco seemed to like best about these acquisitions
was the accounting loopholes that they presented. The acquisitions allowed the company to reload its
dwindling reserves, providing a consistent source of artificial earnings boosts. Moreover, the frequent
acquisitions allowed Tyco to show strong operating cash flow, even though it merely resulted from an
accounting loophole. (We will come back to this in Cash Flow Shenanigan No. 3: Inflating Operating Cash
Flow Using Acquisitions or Disposals.) Indeed, Tyco loved the acquisition accounting benefits so much
that it even used them when no acquisitions at all occurred.

Tyco’s Clever Accounting Games

Tyco’s Clever Accounting Games Consider how Tyco accounted for payments that it made in soliciting
new security-alarm business in its ADT subsidiary. Rather than hire additional employees, Tyco decided
to use an independent network of dealers to solicit new customers. Tyco was so enamored with
acquisition accounting that it decided to use this technique to record the purchase of these contracts
from agents. In so doing, Tyco inflated its profits by failing to record the proper expense. Moreover, Tyco
inflated its operating cash flow by recording these payments in the Investing section of the Statement of
Cash Flows. But Tyco had many more tricks up its sleeve. It increased the price paid to dealers for each
contract, and in return, required the dealers to pay that increased amount back to it as a “connection
fee” for doing business. While this arrangement clearly had no impact on the underlying economics of
the transaction, Tyco inappropriately decided to record this connection fee as income, providing an
artificial boost to both earnings and operating cash flow. The boosts really added up when you consider
that Tyco played this game with hundreds of thousands of contracts that it purchased.

Detailed cash flow analysis would have helped investors notice problems at Tyco. For acquisitive
companies, however, we suggest computing an adjusted free cash flow that removes total cash outflows
for acquisitions. By adjusting the free cash flow calculation for acquisitions, investors would have a
clearer picture of a company’s performance. As a theme discussed throughout the book, acquisitions
present numerous opportunities for companies to inflate earnings and both operating and free cash
flow. In the case of Tyco, we spotted big drops in adjusted free cash flow. As shown in Table 1-8, between
2000 and 2002, Tyco generated a cumulative negative free cash flow (net of acquisitions), although it
reported very large operating cash inflows for those years.
Lehman brothers
The Lehman Brothers accounting scandal is considered one of the most notorious accounting
fraud cases in history. The global financial services firm hid more than $50 billion in loans by
selling toxic assets to Cayman Island banks and disguising them as sales. The firm took
advantage of a loophole in accounting standards that allowed it to move repurchase
agreements, or liabilities, off its balance sheet. Lehman Brothers used this to its advantage
during the subprime crisis to decrease leverage and maintain investor confidence, even as asset
quality deteriorated.
The scandal was discovered after Lehman Brothers filed for bankruptcy in September 2008,
which was the climax of the subprime mortgage crisis. The firm's independent auditors, Ernst &
Young (EY), were supposed to detect fraud and communicate issues to Lehman's board audit
committee, but they failed to do so. A lawsuit alleged that executives also misrepresented the
firm's financial position and failed to disclose their use of the controversial accounting
technique, which resulted in an inflated market price for the firm's securities.

Accounting fraud was facilitated by REPO 105

Repurchase agreement (repo) transactions have historically been used by companies to manage
their short term needs for cash but in Lehman’s case, these transactions took on an unusual
spin that were designed to make Lehman’s balance sheet appear to look healthier than they
actually were. Traditional repurchase transactions normally involve an investment banking firm
giving a counterparty highly liquid securities in exchange for cash. These are simply financing
arrangements and are accounted for as loans with collateral.
As such, if the investment bank is unable to repay the loan, the lender sells the assets and gets
its money back. The cash received by the company is normally repaid at a later date plus a small
amount of interest (normally 2 percent) to get the securities back. Additionally these
transactions would generally be accounted for as financing arrangements.
To maintain its stellar reputation, Lehman engaged in this common arrangement but instead of
utilizing the normal practices, Lehman employed creative but deceitful accounting practices
known as Repo 105. Essentially, Repo 105 is an aggressive and deceitful accounting off-balance
sheet device which was used to temporarily remove securities and troubled liabilities from
Lehman’s balance sheet while reporting its quarterly financial results to the public. These
transactions were recorded as sales rather than as loans.
Steps for misusing REPO 105
Steps in Lehman’s Repo 105 Transactions The steps involved the purchase of bonds through a Special
Financing Unit and intercompany transactions with a London Affiliate. It worked as follows as adapted
from (Wilchins, Dan & DaSilva, Silvio, 2010):

Step 1: Lehman Brothers bought a government bond from another bank using its Lehman Brothers
Special Financing unit in the United States.

Step 2: Just before the end of the quarter, the U.S. unit transferred bonds to a London affiliate, known as
Lehman Brothers International (Europe).

Step 3: The London affiliate gave assets to its counterparty and received cash and agreed to buy back the
assets at the beginning of the next quarter at a higher price. Essentially, the assets given were at least
105 percent of the cash received.

Step 4: The monies received were then used to pay off a large amount of Lehman’s liabilities.

Step 5: The reduction of assets and liabilities now showed healthier quarterly financial statements and
the corresponding leverage and other risk ratios. These healthy ratios were then issued to the regulators,
investors and the general public.

Step 6: At the beginning of the quarter and armed with these healthy financial statements, Lehman then
went to banking and other lending institutions and obtained loans.

Step 7: A few days later, Lehman Brothers Holding would repurchase the securities from their London
Affiliate at 105 percent of the values of the assets. Lehman’s assets and liabilities would grow accordingly
and the company’s leverage would spike back up and its balance sheet and would return to its true
inferior position less the 5 percent interest paid.

These transactions usually occurred for a period of seven to ten days around the end of the quarter and
created a materially misleading picture of the firm’s financial condition. In this accounting maneuver,
Lehman would obtain a short term cash loan from its counterparty in exchange for its assets. Lehman
would then record this transaction as a sale, when in fact it was simply a secured financing arrangement.
Since this was only borrowing money, Lehman should have kept the assets on its books. However, they
did not follow proper accounting rules and instead they removed the troubled assets from their books
and recorded the transaction as a sale. The proceeds obtained from these “alleged” sales were used to
pay down liabilities. Hence, on the quarterly financial reporting date, Lehman would show a balance
sheet composed of less risky assets, less debt and possibly more cash. To outsiders, it appeared as if
Lehman was less leveraged and in really great condition. This resulted in the appearance of healthy
financial statements and the related healthy financial leverage and other risk ratios. In fact, the
bankruptcy Examiner showed that Lehman temporarily reported a net leverage ratio of 15.4 when it
should have been 17.3 if it had not used Repo 105.