WorldCom generally maintained its own lines for local service in heavily populated urban areas. However, it relied on non-WorldCom networks to complete most residential and commercial calls outside of these urban areas and paid the owners of the networks to use their services. For example, a call from a WorldCom customer in Boston to Rome might start on a local (Boston) phone companys line, flow to WorldComs own network, and then get passed to an Italian phone company to be completed. In this example, WorldCom would have to pay both the local Boston phone company and the Italian provider for the use of their services.1 The costs associated with carry- ing a voice call or data transmission from its starting point to its ending point are called line cost expenses.

Through the end of 2000, WorldCom incurred substantial line cost expenses when it made large capital investments to increase the size of its Internet back- bone and expand its local and data networks. To do so, it entered into long-term, fixed-rate leases for network capacity to take advantage of a perceived boom in the technology sector. However, customer traffic did not grow as rapidly as antic- ipated. In addition, the telecommunications market became extremely competi- tive, forcing WorldCom to reduce the fees it charged to customers. As a result, in late 2000 and early 2001, WorldComs ratio of line cost expense to revenue (line cost E/R ratio) was trending upward.2

Construction in Progress

In its first-quarter 2001 earnings announcement, WorldCom reported a line cost E/R ratio of 42 percent, which was in line with previously reported E/R ratios. WorldCom achieved this result in large part by capitalizing $544.2 million in line costs (rather than expensing the costs), despite the fact that the company had never previously capitalized these costs. In fact, WorldComs internal ac- counting policy prohibited the capitalization of these operating line cost ex- penses. Importantly, the company did not disclose this change in accounting policy in its public filings.3

Once again, in the second quarter of 2001, WorldCom capitalized $560 million of operating line costs. The capitalized line costs in both the first and second quarters of 2001 were booked in asset accounts labeled Construc- tion in Progress. Employees in the Property Accounting group, which over- saw the companys assets, later transferred the capitalized line cost amounts from Construction in Progress to in-service asset accounts. Interestingly, the transfer of capitalized line cost amounts happened at about the same time that WorldComs outside auditors expressed an interest in reviewing certain Construction in Progress accounts (as part of their normal substantive testing procedures).4

Due to the line cost capitalization entries in the first two quarters of 2001, line cost expenses were significantly below the amount budgeted for operat- ing line cost expenses. In September of 2001, the companys Budget group was directed to retroactively reduce the line cost budget for 2001 by $2.7 billion. WorldCom also capitalized $743 million of operating line costs for the third quarter. By the fourth quarter of 2001, employees in Property Accounting and Capital Reporting began refusing to make such entries without proper docu- mentation.5

The Audit Committee

In May 2002, the Internal Audit department began investigating the capitaliza- tion of line costs. In June 2002 the Internal Audit team informed Max Bobbitt, the chair of the audit committee of the board of directors, of entries that amounted to a total of $2.5 billion in capitalized line costs. Between June 21 and June 24, the board of directors engaged several attorneys and other professionals to review the issue in detail.6

WorldCom CFO Scott Sullivan explained his rationale for the line cost capi- talizations in a document submitted to the board of directors. He supported his conclusion that the lease costs should not be expensed until WorldCom had recognized matching revenue. Sullivan reasoned that the cost deferrals for the unutilized portion of line leases were an appropriate inventory of this capacity which would be amortized before the expiration of the contractual commitment. The audit committee and the full board of directors rejected Sul- livans reasoning. They determined that WorldCom should restate its financial statements for 2001 and the first quarter of 2002. They also decided to termi- nate Sullivan without severance.7

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