The Faltin Group Research

Executive Summary

On June 26, 2002, news media reported that an internal audit at WorldCom had uncovered misstated expenses of $3.8 billionóenough to entirely wipe out 2001 profits, and to call the already ailing companyís survival into question. Later that day, WorldCom became the subject of a civil complaint by the Securities and Exchange Commission, and over the coming months, further restatements, bankruptcy, and criminal indictments followed.

relationships which, collectively, provide a basis for evaluating and tracking a companyís financial performance. Using the companyís own past experience, and/or that of comparable firms, these tools provide an objective yardstick for determining whether key measures of business performance (ìmetricsî) remain within established historical or industry norms. Corporate monitoring plans based on this paradigm can detect unusual behavior attributable to wide range of potential causes. This approach can be applied to investment analysis, internal auditing, regulatory compliance monitoring, oró perhaps most pressinglyóas a foundation for disclosure controls and procedures required by Section 302 of the Sarbanes-Oxley Act.

The outcome of pending legal proceedings may ultimately hinge on whether the specific accounting practices employed were provably illegal. From a shareholderís perspective, though, it hardly matters. The far more pertinent question is, were WorldCom Case Study the manipulative financial practices

followed at WorldCom discernible earlier, prior to the companyís acknowledgementsóperhaps even prior to the final catastrophic tumble of WorldComís stock price?

Six Sigmaówhich has been adopted by leading companies worldwide to revolutionize all aspects of corporate performanceóis a quality methodology that integrates organizational, analytical, and management techniques into a coherent improvement discipline. When augmented with concepts from economics and finance, Six Sigma provides the basis of a new paradigm for financial reporting (Reference 1). As detailed elsewhere (see Reference 3), the resulting approach can be employed to identify financial measures and

For purposes of the current study, however, the goal was to determine whether events at WorldCom could have been detected by metrics that might reasonably have been monitored as part of a general program for tracking corporate performance. Toward that end, a collection of metrics was developed which tracked various aspects of WorldComís revenues, expenses, debt, etc. Only publicly available data from SEC filings and WorldComís annual reports in the form originally published were used in conducting the analysis.

The principal issue in WorldComís initial disclosure to the SEC was the reclassification of routine expenses as long-term capital investments.

Copyright The Faltin Group 2002 info@FaltinGroup.com

2

3

Investment dollars receive different accounting treatment from expenses, and therefore affect corporate performance measures differently, as well. In high-level financial documents such as quarterly reports, this reallocation would directly impact only a few values, such as operating expenses and capital expenditures. It would, of course, also indirectly impact other quantities calculated from theseó including earnings, which was presumably the point of the alleged fraud. Although routinely scrutinized in public filings by dozens of analysts, regulators, investment managers, and others, these entries failed to tip off observers to what had occurred. So the question becomes, might Six Sigma have identified metrics that would somehow have pointed sooner to WorldComís impending demise?

Perhaps. Publicly available annual reports and SEC filings are high-level summaries of company financial data.

The irrecoverable loss of information that results from such aggregation makes construction and tracking of financial metrics far more difficult from an external perspective, than when conducted as part of an internal corporate Financial Quality program as we have advocated elsewhere (References 3, 4). Nonetheless, it is interesting and instructive to take a retrospective view of WorldComís data, to provide a glimpse of what might have been apparent had the world been watching more closely. And it goes without saying that anything which would have been visible from the outside, should have been even more readily apparent internally, had a Six Sigma monitoring system been in place to support internal audits from, say, 1999 or 2000 onward.

Figure 1 shows a plot of a simple metric that calculates, approximately, the total new debt taken on by WorldCom each year from 1995 through 2001.

14 12 10

8 6 4 2 0

Figure 1 WorldCom New Debt*

1996 1997 1998 1999 2000 2001 Year

1995

* 1998 & 2001 values exclusive of debt attributable to acquisitions

Copyright The Faltin Group 2002

info@FaltinGroup.com

Billions of US$

4

The huge spike in financing activity during 2000-2001 started around the time that accounting irregularities are now alleged to have begun, and continued into the period during which civil and criminal complaints assert the improper expense restatements occurred.

The next three figures deal with WorldComís debt structure. Figures 2 and 3 show the ratio of WorldComís

short-term debt to its long-term debt annually in 1999 and 2000, and quarterly during 2001 and the first quarter of 2002 (unfortunately, historical comparisons of this ratio to prior years are not meaningful due to extensive merger activity during 1998). In Figure 2 the data is plotted over time; in Figure 3 WorldComís debt ratio is compared to that of five similarly sized competitors in its industry.

Figure 2 Worldcom Short-term Debt / Long-term Debt

0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0

Dec-1999 Dec-2000 Mar-2001 Jun-2001

Sept- 2001

Dec-2001 Mar-2002

1.2 1 0.8 0.6 0.4 0.2 0

Figure 3 Worldcom and Top 5 Competitors Short-term Debt / Long-term Debt

01234567

1=Verizon