WorldCom: How did we get here?

Last week's admission by WorldCom Inc. that it improperly booked almost US$4 billion of expenses in 2001 and the first quarter of 2002 may be the ghost of the 1990s telecom boom that finally forces a major U.S. government crackdown on accounting practices.

WorldCom said Tuesday it had booked costs as capital expenses -- about $3.05 billion in 2001 and $797 million in the first quarter of 2002 -- in violation of U.S. Generally Accepted Accounting Procedures (GAAP). As a result, the company said it would restate its results from those periods to show losses instead of profits. At the same time, WorldCom said it had fired Chief Financial Officer Scott Sullivan and accepted the resignation of David Myers, who was senior vice president and controller.

The company said it had asked its recently hired external auditor, KPMG LLP, to carry out a comprehensive audit of those results, and had informed the U.S. Securities and Exchange Commission (SEC). Its previous auditor was Arthur Andersen LLP.

The disclosure, which the SEC called "unprecedented," kicked off a series of legal actions.

-- On Wednesday, the SEC filed suit against WorldCom in the U.S. District Court for the Southern District of New York, charging the company with fraud and asking a court to block any destruction of documents and the payment of extraordinary bonuses to executives.

-- Also Wednesday, the U.S. House of Representatives' Energy and Commerce Committee launched an investigation into WorldCom's accounting. Citing similarities to the Enron Corp. financial scandal, Rep. Billy Tauzin, a Louisiana Republican and the chairman of the committee, ordered the panel's investigative staff to review the facts surrounding the matter.

-- U.S. President George W. Bush on Wednesday called the disclosure "outrageous" and promised a full investigation. In a speech Thursday, he condemned financial improprieties by U.S. companies and vowed, "there will be consequences for those who have done wrong."

-- On Thursday, the House Financial Services Committee announced plans to hold a hearing July 8 on WorldCom. The committee announced plans to subpoena former WorldCom Chief Executive Officer Bernard Ebbers; current President and CEO John Sidgmore, who replaced Ebbers; former Chief Financial Officer Sullivan, and Jack Grubman, a telecommunications analyst at Salomon Smith Barney Holdings Inc.

-- Also Thursday, a judge in Mississippi issued a temporary restraining order barring WorldCom, its former employees, and its current and former auditors from destroying any documents or records that could be subject to a Mississippi investigation into the scandal. WorldCom is based in Clinton, Mississippi.

-- On Friday, adding to the furor over corporate financial behavior, Xerox Corp. announced that it would have to restate its 1997 to 2001 earnings due to accounting irregularities, a move that will reduce the company's pretax income over that period by US$1.4 billion.

WorldCom's disclosure has led many observers to predict that the company, one of the world's largest providers of voice and data services, will seek bankruptcy protection and undergo reorganization. That prospect, disruptive as it sounds, follows the financial collapse of some major service providers and accounting woes at others, including Qwest Communications International Inc.

The financial problems and accounting practices at WorldCom are part of the dues the industry is paying for a heady period of growth in the late 1990s, when carriers built out network capacity for an expected boom in Internet-based commerce and entertainment, analysts said. When that boom fizzled, revenue couldn't cover the cost of expansion and some carriers were stuck trying to meet inflated profit projections.

Faced with the prospect of fundamental changes in communications and business that the Internet has the potential to deliver, carriers and others in the industry didn't know how to predict future demand or business success, analysts said. Helping to fuel the overblown expectations was a flood of money from America's baby-boom generation as they invested in the stock market.

The Internet really did represent a new age as significant as the Industrial Revolution, said Michael Howard, principal analyst at Infonetics Research Inc., in San Jose, California.

"What we didn't know at the start of that new age was that it wasn't going to happen as soon as we thought," Howard said.

Internet traffic is still doubling every year, he added, but most carriers haven't built out their businesses in a way that allows them to take full advantage of that opportunity. Carriers such as WorldCom expanded with a focus on market share instead of well-defined market opportunities.

Grabbing for sheer market share and trying to compete through low prices has hurt the big carriers, said Mark Seery, an analyst at RHK Inc., in South San Francisco, California.

"Service providers are competing on price, not competing on value, and they really need to turn that around," Seery said. "Companies have really focused on market share way too much and not on developing a differentiated positioning in the marketplace.

"Unfortunately, WorldCom is going to accelerate this problem," Seery added, as competitors such as AT&T Corp. and Sprint Corp. try to attract weary WorldCom customers.

Even in the event of a bankruptcy, enterprises are unlikely to be left without a service provider, said Frank Dzubeck, president of Communications Network Architects Inc., in Washington, D.C. WorldCom probably would sell off its voice telecommunications business in one piece and hold on to its lucrative corporate and data services operations.

However, the upheaval in the IT industry has taught corporations some hard lessons, he added.

"Going forward ... you must have a primary and secondary supplier in everything you do. You have to seriously think about whether the least-cost alternative was the best alternative," Dzubeck said.

"The one that gets hurt the most is the small and medium-sized business who can't afford a primary and a backup," he added.

Those businesses are the best target of service providers that want to fill up their excess capacity and boost revenue, according to Infonetics' Howard. Carriers now are trying to figure out how to create packaged services that can be customized somewhat but aren't as expensive as the fully custom services they create for large enterprises, he said.

Even with the security of a backup, however, the loss of trust resulting from the disclosures at WorldCom and other carriers and vendors rightly makes IT managers jittery, said Craig Mathias, a principal at Farpoint Group, in Ashland, Massachusetts.

"What they have done is the same thing the terrorists did when they brought down the World Trade Center. They caused us to lose confidence, and that's unacceptable," Mathias said.

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