Just when you thought things couldn't get any worse in the telecommunications market, they got much worse.

In disclosing possibly the largest corporate accounting fraud in history, WorldCom Inc. (Nasdaq: WCOM) said Tuesday night it will restate all of its financial earnings for 2001 and the first quarter of 2002 (see WorldCom: 'Oops!').

The accounting errors stem from "transfers" of expenses to capital costs that were not taken in accordance with generally accepted accounting principles (GAAP), says the company. The amount of these transfers was $3.055 billion for 2001 and $797 million for first-quarter 2002, according to the company.

According to a company release, "it was determined that certain transfers from line cost expenses to capital accounts during this period were not made in accordance with generally accepted accounting principles (GAAP)."

Scott Sullivan, the chief financial officer and secretary of WorldCom, has been fired. The company has also accepted the resignation of David Myers as senior vice president and comptroller.

Accounting firm Arthur Andersen LLP was WorldCom's auditor until May of this year. In today's statement, WorldCom said that it recently brought in KPMG to undertake a comprehensive audit of its financial statements for 2001 and 2002.

The internal investigation showed that without the transfers, the company’s reported EBITDA would be reduced to $6.339 billion for 2001 and $1.368 billion for first-quarter 2002, and the company would have reported a net loss for 2001 and for the first quarter of 2002, the company statement says. Given the scale of the restatement, WorldCom’s problems may even exceed Enron's woes.

The news comes as a culmination of WorldCom's many troubles, which have been building over the months and have included credit problems, mounting losses, shareholder lawsuits, and an SEC investigation into its accounting practices (see WorldCom Accounting: What's Up?, WorldCom's Woes Mount, Is It Too Late to Rescue WorldCom? , WorldCom's Junk Status Fuels Fears, and Stockholders Sue WorldCom).

In a statement today, the SEC announced that it is stepping up its investigation of the company (see SEC Comments on WorldCom). Even the President of the United States jumped into the brouhaha. Speaking to reporters at the Group of Eight summit in Canada today, President Bush indicated that there would be a federal investigation into WorldCom's accounting practices.

"The good news is, most corporate leaders in America are good, honest, open people who care deeply about shareholders and employees, and our economy is strong,” the President said. “But when we find egregious practices such as the one revealed today, we'll go after them."

The accounting discoveries cast major doubt on WorldCom's survival prospects. Although it currently has enough cash to support operations, WorldCom’s $32 billion debt load had already subjected the company to speculation that it might soon be forced to file for bankruptcy. And after yesterday’s revelation, observers say that the new financing the company was seeking from several banks will certainly not materialize, and that there is no longer any way around a bankruptcy filing.

"My strong feeling is that WorldCom is hosed,” says Bart Schachter, a general partner at Blueprint Ventures. “It’s going to go into bankruptcy and force a consolidation in the industry.”

Many of WorldCom's potential accounting and financial problems have been detailed by Light Reading's own paid research product, Optical Oracle (see LR Analyzes Carrier Financial Crisis).

"Of the 'big three' telcos, potential insolvency issues are most prevalent at WorldCom," wrote the Optical Oracle in its March newsletter, Carrier Crisis Report: "Management and sell-side analysts completely dismiss this notion, citing WorldCom’s strong balance sheet and access to capital. There are, however, some very disturbing items that could lead to trouble in coming months. If one believes that the market is the best discounting vehicle for future performance, WorldCom’s outlook is bleak."

In the post-Enron (and Global Crossing) world, the news rocked telecommunications and financial markets, sending the indexes spiraling downward. In the first half-hour of trading, the Nasdaq Composite Index dropped 32.58 (2.29%) to 1,391.41; and the Light Reading Index dropped 4.21 (3.75%) to 108.14, an all-time low since the Index was launched in 2000.

Many of the large service providers have already started feeling the sting of what observers call guilt by association. Qwest Communications International Inc. (NYSE: Q), which has been plagued by many of the same problems that WorldCom has been facing (and which also until recently was audited by Arthur Andersen), saw its stock price plummet by nearly 50 percent in trading today.

Fears that WorldCom will soon be filing for bankruptcy have also affected the stock prices of several equipment vendors that claim the company as a customer. Juniper Networks Inc. (Nasdaq: JNPR), which gets more than 10 percent of its revenues from the carrier, has seen its stock price plummet nearly 22 percent. And although Nortel Networks Corp. (NYSE/Toronto: NT) claims to have no material exposure to WorldCom, the scandal probably played a role in its stock price dropping to a year-low of $1.33 a share.

Like Nortel, Lucent Technologies Inc. (NYSE: LU) claims to have minimal exposure to WorldCom, but other vendors, including Alcatel SA (NYSE: ALA; Paris: CGEP:PA), Ciena Corp. (Nasdaq: CIEN), Fujitsu Ltd. (KLS: FUJI.KL), Redback Networks Inc. (Nasdaq: RBAK), and Riverstone Networks Inc. (Nasdaq: RSTN), will almost certainly be hit hard if the carrier files for bankruptcy.

With a scandal of this proportion, the guilt by association has, however, not only affected the telecom sector. There are already indications that WorldCom’s demise will prolong the crunch in the overall economy. “The ripple effects are severe,” says Frank Dzubeck, president and CEO of Communications Network Architects, saying that he spent the night in interviews with foreign news agencies trying to convince them that fraudulent behavior is not endemic to the American business system. “The nuclear winter keeps going.”

This morning, trading in WorldCom stock was halted after dipping below $1 for the first time on Monday. It last traded at $0.83.

The company said its board has retained William R. McLucas, of the law firm of Wilmer, Cutler & Pickering, and former Chief of the Enforcement Division of the SEC, to conduct an independent investigation.

"Our senior management team is shocked by these discoveries," said John Sidgmore, WorldCom CEO, in today’s statement.

The company said it expects to further cut capital expenditures for 2002 and that it is continuing its downsizing effort, reducing the workforce by 17,000, beginning this Friday. This is a continuation of cost-cutting efforts that had been previously announced (see WorldCom Strips Down).

— R. Scott Raynovich, US Editor, and Eugénie Larson, Reporter, Light Reading
http://www.lightreading.com Check out Light Reading's July Research Poll on this topic to find out what others think about who's to blame for Worldcom's woes, and whether there are other skeletons in its closet.



Editor's Note: Light Reading is not affiliated with Oracle Corporation.