What Went Wrong?

The Securities and Exchange Commission on Wednesday said the alleged $3.9-billion fraud at WorldCom Inc. was “directed and approved” by top managers “to keep [earnings] in line with Wall Street’s expectations and to support WorldCom’s stock price.”

The allegation, contained in a fraud suit filed in federal court in Manhattan, contends that “WorldCom falsely portrayed itself as a profitable business” when it should have reported a total of $1.2 billion in losses for last year and the first three months this year.

“This portends that the agency is going to turn this suit around and go after senior management,” said Washington lawyer Jacob Frenkel, a former SEC enforcement officer.

WorldCom, which briefed the agency earlier this week on the accounting irregularities it found, provided few new details Wednesday to explain improper accounting transfers or why the company engaged in such tactics.

Spokesman Brad Burns said William McLucas, the former SEC enforcement chief WorldCom hired to conduct an independent investigation, will determine the reason that prior executives wrongly moved certain routine expenses off the company’s profit-and-loss statement.

Burns, in an interview before the suit was filed, said the costs involved were normal expenses for connecting both commercial and residential customers to the company’s fiber-optic network, but he could not provide further details.

The SEC alleges in its suit that the costs were fees the company paid to local Baby Bell carriers and other third-party companies for access to their customers.

The accounting fiasco first surfaced last week when an internal WorldCom auditor found that expenses incurred last year didn’t appear where they should have in the company’s books, according to a report today in the New York Times. Instead, the costs were sprinkled across a series of accounts for capital expenditures. The auditor quickly figured that the shift in expenses was a big event that was potentially fraudulent, the report said.

Analysts and telecommunications experts said they were stunned by the alleged accounting fraud that would dwarf all others and could force the nation’s second-largest long-distance company into the biggest corporate bankruptcy ever.

Analysts had thought little more could happen to the bedraggled telecommunications industry, already beset by too much capacity on fiber-optic lines and too little demand for services.

“Events at WorldCom leave us virtually lost for words,” analyst Adam Quinton at Merrill Lynch Global Securities said in a note to investors.

The sheer size of WorldCom’s errors--combined with the dire financial and accounting problems that already have battered WorldCom, Global Crossing Ltd. and other telecom companies--makes it hard to believe that WorldCom simply misjudged how the costs should be treated, accounting experts said.

At the heart of the scandal is an often murky way of determining when costs are part of ordinary day-to-day business and when they can be considered capital expenditures.

Ordinary costs are immediately deducted from revenue, lowering earnings. Capital expenditures--outlays of money for long-term assets such as fiber-optic cable, routers and other hardware and software--are depreciated over time.

“What happens is, firms start by capitalizing things that are required to be capitalized, then they move to optional items, then they keep pushing the line and finally they’re capitalizing things that shouldn’t be capitalized at all,” said W. Steve Albrecht, associate dean of the Marriott School of Management at Brigham Young University. “I can’t tell you how many cases I’ve seen where something starts out as aggressive accounting and somewhere switches over to fraud.”

In WorldCom’s case, Burns said, normal costs for connecting customers to its fiber-optic network were wrongly transferred from the profit-and-loss statement to the balance sheet as capitalized expenditures.

He said the improper transfers involved costs both at the company’s WorldCom group, which caters to large commercial customers, and at its MCI group, which serves residential and small-business customers.

Burns said he could not provide additional details about the expenses that were transferred. Nor could he say why the transfers were made.

“You’d have to ask Mr. Sullivan,” he said, referring to Scott D. Sullivan, the longtime chief financial officer who was fired Tuesday as the company released information about the accounting irregularities.

But experts around the country had little doubt about the motive.

“They wanted to keep their stock price up,” said Brett Trueman, an accounting professor at UC Berkeley.

Though WorldCom’s problems steadily mounted last year, its stock traded within a range of $10 to $20 a share in the period, aided by the firm’s public reports of continued profits: The company said it earned a net $1.4 billion last year and $130 million in this year’s first quarter.

But those profits were phantom earnings in light of WorldCom’s latest announcement.

To be sure, Wall Street’s fixation on near-term results feeds the pressure on corporate executives to match or exceed investors’ expectations of performance, analysts said. So do the stock options that are showered on executives and other employees, who profit only if the company’s earnings and stock price climb higher.

Debate over normal costs versus capital expenses has been raging for years.

Whenever a company spends money, either in cash or on credit, to buy a new asset--from miles of cable to a bucket of paint--it must ask how long the asset will continue to have value. If the answer is less than a year, the expenditure probably should be treated as an ordinary business expense and deducted from earnings in the same quarter, experts said.

But if the asset will keep generating revenue into the next year or longer, there might be a good argument for “capitalizing” it, turning it into an asset that can be depreciated over a number of years instead of deducted from earnings right away.

In a 1999 speech, Lynn Turner, then chief accountant for the SEC, said improper capitalization was the second most common accounting problem the watchdog agency encountered, after improper revenue recognition.