June 27, 2002
From the desk of Jane Galt:WorldCom's in a big mess,
WorldCom's in a big mess, and many of you have questions about it, so I thought that I would, in my ham-fisted, amateur way, attempt to answer them. Most of your questions run something like this:
What the [Expletive Deleted]!!!!!!!
Good question. Let me see if I can answer that.
One of the driving forces at the end of the nineties was that most research analysts were rather like fiancees. They had developed unrealistic expectations of the future based on the very short, and unusually rosy, period through which they had just lived. In the case of the equity analysts, they had begun to feel that they were entitled to see beautifully rising earnings each and ever quarter even though it was clear that if one extrapolated their expectations into the not-so-distant future, Toys 'R Us would be producing more revenue than the entire US economy. Much like a fiancee who is told that she should not expect her prospective groom to indefinitely continue to give up his best friend's superbowl party in order to escort her to the mall, research analysts got very cranky when they were told that their dreams of infinitely expandable earnings might be a tad unrealistic.
Like prospective grooms, CEO's were very anxious to please the equity analysts, because they were very afraid that if they didn't meet expectations, their beloved would start throwing the wedding china at someone's head. Ha-ha, no, what they were really afraid of was that the analysts, and the shareholders who listened to the analysts, would hammer their share price. Of course, this would lower the value of their stock-based compensation. It might also lower the value of the rest of their compensation -- to zero, when the angry shareholders kicked them out. CEO's have wives, and wives say things like "You'd better not expect to hang around here all day, because the servants have work to do, and I'm not having you interrupt my bridge party, so if you lose your job at WorldCom, you'd better start talking to the assistant manager down at the Tasti-Freez ASAP." This combination of greed and fear bred an unhealthy willingness to shade the truth.
However, shading the truth just created more problems. Like the bridegroom who attempts to assuage his demanding fiancee by cancelling his tee-time in order to drive her to her hair appointment, they found that meeting unreasonable expectations once simply established more firmly in the analysts minds the belief that their expectations were reasonable and deserved to be met, and thereby worsened the tempest that would follow if such expectations were, for any reason, disappointed. CEO's were further incented to cheat, and each round of cheating both increased the size of the "adjustment" that would be necessary next quarter, and increased the consequences that would follow if the adjustment were not made. CEO's were praying for a boom to bail them out, much as the internet boom rescued AOL from its shoddy accounting in the mid-90's. When the boom failed to materialize, eventually the scam got so large that it could no longer be hidden, and the entire house of cards came tumbling down.
Does that answer your question?
What, exactly, did WorldCom Do?
Well, when WorldCom started feeling the heat, they looked around for ways to increase revenue. Unfortunately, what with all this competition stuff in the telecomm area, they found the same thing that you have probably found when you looked for ways to increase your revenue: that it's would require more effort than you care to expend. So they started looking around for ways to reduce costs. And just as with your last cost-cutting drive, this too foundered on the rocks of self-interest, so rather than trying to actually reduce costs, they sought ways to look like they were reducing costs, figuring that, as in most relationships, it doesn't matter what you feel inside, as long as the other party buys your act.
Specifically, WorldCom took one of its biggest expenses and changed it from an operating expense to a capital investment. The expense was the fees that they paid local carriers in order to complete long distance calls; they treated it, accounting-wise, as if it were the same thing as building new fiber capacity or putting up a new switching station.
So either way, it says they spent money; what's the difference?
The difference is in the accounting. Normally, when a firm spends money to provide a service, that money is recorded as having gone out the door, poof, hit the road jack and don't you come back no more. This is what's known as an Operating Expense, or what a layman would call "What I'm spending to stay alive". Capital Expenditures, on the other hand, produce a corresponding asset on the balance sheet: whatever the money purchased, such as land, machinery, or valuable fur-bearing trout farms. This is what a layman would call "My investments".
Think of operating expenses as your grocery bill; you spend the money, you eat the food. Your net financial position has deteriorated by whatever your grocery bill was this month.
Capital expenditures, on the other hand, are like buying a house. On the one hand, you've got less cash in the bank, and probably a hefty mortgage to boot; on the other hand, you've also got a house, which is presumably worth at least what you paid for it. Your net financial position doesn't change; you've simply changed your asset base from cash to house.
We, as wage slaves, are accustomed to thinking of income in a very narrow way: what we got paid. But the root idea of an income statement is to capture the change in the financial position of the company, otherwise known as its net assets: its assets (things is has, or has a reasonable expectation of getting, like factories or accounts receivable) minus its liabilities (things it's pretty sure it's going to have to give to someone else, like debt payments or accounts payable). Okay, breathe, little butterfly. You don't have to understand all the jargon; all you need to know is that when you record something as a capital expenditure, you don't record any net change in your financial position, because the decrease in cash, or increase in debt, is balanced by the asset that you are supposed to have purchased with your cash or debt; while when you record an operating expense, the decrease in cash, or increase in debt, is not counterbalanced by another asset, so that your net financial position gets worse; in other words, you lose income.
Clear? Next question.
Is this legal? Do we need to fix the law, or what?
Not hardly. You don't need another law for this one; it's quite clear. Capitalizing the fees they paid to local carriers to complete the calls made on their long distance network is the equivalent of your trying to tell your banker that the groceries you bought are actually a capital expense because they're, you know, in your house. Accruing mold at the rate of 1% a day, no doubt.It's totally illegal, not even a vaguely close call, at least according to my CPA buddies. We don't need a new law; we need to find the executives who did this and throw them in the pokey for a long time.