In 1999 WorldCom was the second largest long distance telecommunication company in the US. WorldCom was involved in laying optical fibre network in the USA it also leased cable capacity from competitors in areas it didn’t have coverage for customers.
At its height, WorldCom had a market capitalisation of nearly US$200 billion and employed 70,000 staff
WorldCom had grown very quickly through aggressive acquisitions. It had a record of very high earnings growth and WorldCom’s share price was trading at a very high multiple of earnings.
Value is a function of earnings and value is represented as a multiple of earnings. If earnings are overstated, then the value of the business is overstated by a multiple of the earnings overstatement.
The value multiple is a function of earnings growth. Strong earnings growth drives a high valuation multiple. Overstating earnings implies earnings growth and drives a higher multiple.
In the last quarter of 1999, WorldCom wasn’t going to meet its earnings targets. As a rapidly growing firm, with a highly-inflated market capitalisation, not meeting earnings targets would seriously damage market expectations and the share price. Scott Sullivan, the CFO, needed to do something to improve earnings.
Some of the cable capacity that WorldCom leased, wasn’t being used by customers. The cable capacity wasn’t generating revenue. Sullivan decided that this unused leased cable capacity should be capitalised. Matched against revenue in the future. He recognised the lease expense as an asset and called that asset prepaid capacity. This increased earnings.
The problem was, the fibre capacity being leased could only be used now, in this period, for generating revenue now. The leased capacity couldn’t be deferred and matched against revenue in the future. Sullivan was recognising a prepayment when he should have recognising an expense.
When revenue increased in the next quarter Sullivan planned to reverse out the prepayment. In the next quarter, earnings didn’t improve, they declined. So, Sullivan had to reduce lease capacity expenses further, by increasing prepayments.
One of the problems with shenanigans is that once you start it’s difficult to start. You dig a bigger and bigger hole.
In a few years, Scott dug a very big hole. A $3.8bn dollar hole. Scott capitalised a total of $3.8bn in leased capacity. He recognised $3.8bn as an asset, prepayments, when he should have recognised an operating expense. In other words, he overstated earnings by $3.8bn.
When the markets realised the shenanigans, WorldCom eclipsed Enron to became the largest US bankruptcy in US history.