Once the largest provider of internet-based communication services and the second largest long-distance telephone company in the US, WorldCom became one of the most popular case studies for corporate ethics, financial frauds and senior management irresponsibility along with Enron.
This article contains analysis of the fall of WorldCom employing four-stage fundamental analysis. The article starts with discussions of business strategy in general and analysis of strategies that exposed WorldCom to major risks in particular. This is followed by analysis of analysis of accounting practices used at WorldCom. Moreover, the article contains discussions devoted to financial analysis and the role of auditors in relation to WorldCom case study, as well as, prospective analysis that addresses valuation models employed by WorldCom accountants. This article is completed by reflecting upon important lessons to be gained from this particular case study for international business practices.
Business strategy analysis is the first stage of the four-stage fundamental analysis of the business entity. Business strategy analysis associated with in-depth study of effectiveness and sustainability of competitive advantage of the company. Business strategy is a broad topic with multiple facets with varying levels of impacts on firms’ competitiveness and long-term growth.
According to the framework of Porter’s Generic strategies (1985) businesses can base their competitive advantage on differentiating products and services or offering products and services for competitive prices. Importantly, the choice between is faced by overall businesses entity, as well as, separate segments within the entity.
Primarily, WorldCom’s business strategy was most related to cost advantage, offering discount long-distance telephone services, according to the former name of the company Long Distance Discount Services Inc. (LDDS). However, as the company entered the phase of massive expansion during starting from 1985 purchasing a wide range of other businesses in the industry (Gershon, 2009), focus on WorldCom core competitive advantage was compromised to a certain extent triggering CEO Bernard Ebbers and CFO Scott Sullivan to engage in falsifications explained below in greater details.
Ansoff’s Growth Matrix (1957) represents an alternative tool that can be used for effective business strategy analysis. The Matrix specifies four different growth opportunities to businesses: market development, market penetration, product development and diversification. The choice of any particular growth strategy by businesses depends on a set of factors such as financial situation of the firm, intensity of competition, the nature of industry, macro-economic situation in the market etc.
Uncompromising stance towards market dominance at all costs marks a noteworthy strategic flaw at WorldCom. Strategic level management at WorldCom attempted to employs several growth strategies such as market development, market penetration, product development and diversification in a blatant and simultaneous manner with little regard to cost implications of the growth. According to this strategy, more than 70 firms were acquired by LDDS (renamed WorldCom in 1995) for a total amount of more than USD 100 billion during the period between 1985 and 2001 (Wilmarth, 2007).
In other words, while the practice of employing one or more business growth strategies within the framework of Ansoff’s Growth Matrix (1957) can prove to be effective business strategy, in case of WorldCom in particular, aggressively pursuing growth strategy with disregard to other factors, and consequent engagement in accounting falsifications led to highly negative outcome for the company.
WorldCom management had associated sustainability of the company’s ever-intensive growth strategy with continuous rise of its stock price, and this fact can be specified as the most significant strategic mistake commitment by senior management. Problems began to surface after WorldCom’s plan to merge with Sprint, another major telecom firm failed in 2000 in the face of rapidly intensifying competition in telecommunications sector.
Moreover, WorldCom CEO Ebbers downplaying the role of lawyers and auditors throughout his tenure, and dubbing corporate Code of Conduct as ‘a colossal waste of time” (Hayes, 2011) has also had immense negative impact on corporate culture that has contributed to the emergence of the scandal to a certain extent.
Accounting analysis can be specified as the second stage of four-stage fundamental analysis of a business. Accounting rules and conventions are developed to serve as a compulsory guidance for private sector organisations to ensure appropriateness and consistency of financial reporting.
There are instances of falsification with adjusted accounting measures of performance in order to report higher revenues and profitability as it was the case with WorldCom. Specifically, accounting fraud was engaged by WorldCom senior management when disparity between firm’s performance and expectations of Wall Street analysts became evident and CFO Sullivan with the knowledge of CEO Ebbers has instructed his subordinates to engage in a set of accounting frauds. Moreover, one of the major strategic mistakes committed by WorldCom senior management relates to aggressive attempt to increase the value of stocks according to expectations of analysts from Wall Street.
Increasing levels of operational costs were making achievement of this objective highly challenging. For example, “many leases required WorldCom to make fixed monthly payments regardless of whether WorldCom or its customers actually used the leased lines” (Wilmarth, 2007, p.144). Accounting misconducts taken place in WorldCom include but not limited to announcing higher revenues that the actual amount through drawing down accounting reserves that included reserves related t mergers (Hayes, 2011). Specifically, severely violating GAAP standards, WorldCom accountants used more than USD 3.3 billion of reserves to absorb line costs in order to report more earnings during the period of 1999 – 2011.
Reporting expenses as capital expenditures is one of the main financial falsifications engaged by WorldCom head of finance. Specifically, WorldCom CFO Sullivan instructed network access costs of about USD 3.9 billion to be listed as capital expenditures, when in reality this amount needed to be reflected as expense (Davis et al., 2011). Moreover, the practice of illegal capitalisation of line cost conducted by WorldCom Chief Financial Officer (CFO) Scott Sullivan, reportedly because of the pressure by CEO Ebbers decreasing the volume of official expenses and increasing profits reported.
Sullivan has attempted to justify the decision of listing USD 3.9 billion spent on network access as capital expenditure by using the term ‘investment in capacity’ (Davis et al., 2011), however, this explanation was not accepted as valid by financial regulators due to obvious reasons. Specifically, opposite to Sullivan’s claim, regulators concluded that deviations in accounting practices were initiated in order to report higher profits.
Other accounts of accounting and financial misconducts at WorldCom found by investigators included the practices of double counting revenues from the same customers in systematic manner and keeping delinquent accounts on books for several years after the cease of contracts with customers listing them as revenues (Davis et al., 2011).
The third stage in four-stage fundamental analysis of businesses involves financial analysis.
Financial analysis is associated with analysis of financial ratios and a range of measures of manipulating with cash flow. Core objective behind financial analysis can be specified as evaluation of the levels of effectiveness of strategy of the business and facilitating financial forecasts (Cassis, 2011).
Dependence on universal banks in terms of obtained finances to allow rapid expansion can be specified as one of the major financial issues that were faced by WorldCom. While reliance on financial institutions to a certain extent for further growth is an acceptable business practice traditionally practiced by a wide range of businesses, WorldCom senior management had increased the level of such dependence to a great extent by associating its survival with continuous rise of its share prices of the company.
Arguably, WorldCom incident is the most notable case in history for failure of auditors in multiple levels. Failure of auditors, analysts and investors to question the practice of using financial reserves to cover costs related to mergers, and thus boosting revenues and profitability has enabled severe financial misconducts to take place at WorldCom.
Interestingly, WorldCom was audited shortly before the scandal erupted by Arthur Andersen LLP, a global auditor, without identification of significant misconducts. Officially Arthur Andersen attempted to justify its failure to identify accounting misconducts during the audit by blaming WorldCom CFO Sullivan for providing misleading information, however, the validity of this claim is compromised taking into account direct involvement and conviction of Arthur Andersen in another major fraud case of Enron (Rovella, 2005, online).
Prospective analysis is the last, fourth stage in four-stage fundamental analysis of an organisation. Prospective analysis is associated with valuation models in accounting such as discounted cash flow models and other relevant techniques (Palepu et al., 2008).
A set of factors such as intensifying levels of competition in telecom, internet and wireless communication industry in the end of 1990’s, ‘dot com’ collapse in 2000, combined with the failure of merger with Sprint caused gradual decline of WorldCom share prices, but CEO’s determination to avoid such as decline at all costs led him to initiate or allow unlawful manipulations with financial data presented to organisational stakeholders.
From the viewpoint of prospective analysis, illegal manipulations with financial results were engaged by WorldCom mainly in two ways. Firstly, the amounts of operating expenses were decreased through illegally releasing reserves that were kept against operating expenses. Secondly, reduction of the levels of operational expenses was achieved through wrongfully classifying a range of expenses as capital assets.
Importantly, both of these practices represented deviations from previous accounting practices at WorldCom, nevertheless, the company intentionally failed to communicate these changes in accounting practices to investors and other organisational stakeholders for obvious reasons.
WorldCom filing for Chapter 11 bankruptcy reorganisation on July 21, 2002 and its eventual acquisition by Verizon after being renamed as MCI for only USD 8.5 billion (Wilmarth, 2007) clearly illustrates the extent of negative consequences of financial and accounting misconducts by top management.
Former WorldCom CEO Ebbers and CFO Sullivan being sentenced to 25 and 5 years in prison respectively in 2005 does no good in terms of reimbursing significant losses caused to private and institutional investors, as well as, broader damages caused to the national economy as well.
Important lessons to be gained from this particular case study for international business practices can be illustrated through the following three points:
Firstly, clear, unambiguous and universal accounting standards need to be introduced and its adherence needs to be ensured. Manipulation with accounting entries has allowed WorldCom senior management to report incorrect increased earnings with highly negative implications in the national scale. Introduction and increasing popularity of IFRS since WorldCom case study has improved the situation to a certain extent; nevertheless there is still improvement potential in this direction.
Secondly, banks should not push businesses to pursue aggressive growth strategy without appropriate evaluations. Universal banks such as Citygroup, Bank of America and Chase played a major role in motivating WorldCom management to pursue aggressive growth strategy disproportionate with capabilities of the company by proving massive loans for growth without assessing real financial situation. The case study of WorldCom stresses the need for greater responsibilities on behalf of financial institutions when offering large loans for businesses pursuing aggressive growth strategy.
Thirdly, the overall levels of transparency of operations of major business organisations need to be increased. The extent of damage at WorldCom could have been reduced or the incident could have been avoided altogether if accounting practices used in the company were subjected to investor scrutiny in a regular manner. The role of national government and its agencies are critical in addressing the issues of transparency of business entities.
Ansoff, I. (1957) “Strategies for Diversification” Harvard Business Review, Vol.35, Issue:5
Cassis, Y. (2011) “Crises and Opportunities: The Shaping of Modern Finance” Oxford University Press
Davis, R., Miksiewicz, D., Nitta, L, Rothenberg, T. & Scalera, L. (2011) “WorldCOm and GE: an Analysis of Ethical Business Practices”
Gershon, R.A. (2009) “Telecommunications and Business Strategy” Routledge
Hartley, R.D. (2008) “Corporate Crime: A Reference Handbook” ABC-CLIO
Hayes, J.L. (2011) “Business Fraud – From Trust to Betrayal: How to Protect Your Business in 7 Easy Steps” Bascom Hill Publishing
Palepu, K. & Healy, P. (2008) “Business Analysis & Valuation: Using Financial Statements” 4th edition, Thompson Learning
Porter, M.E. (1985) “Competitive Advantage: Creating and Sustaining Superior Performance” Free Press
Rovella, D.E. (2005) “WorldCom Auditor Arthur Anderson Settles Fraud Suit” Bloomberg, Available at: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aABiGyQ.vDv0
Wilmarth, A.E. Jr. (2007) “Conflicts of interest and corporate governance failures at universal banks during the stock market boom of the 1990s: the cases of Enron and WorldCom” in Corporate Governance in Banking: A Global Perspective, Editor Benton, E. G.