WorldCom

(WCOME)

investors have already had a crummy year. Now Wall Street accounting sleuths are searching frantically for a cookie jar.

Just days after admitting it buried nearly $4 billion of costs over five recent quarters, the big telco Monday raised the specter that it may disclose another accounting bombshell -- this time concerning reserves taken in previous years. A reserve is the accounting term for setting up a financial cushion against losses, usually for nonpayment of bills by customers.

While the company reviews its accounting, Wall Street is speculating about the scope of any potential reserve manipulation -- including the possibility of a so-called cookie jar fund that could have boosted earnings. WorldCom CEO John Sidgmore said Tuesday that changes in the reserve in 1999 and 2000 "looked odd because they ¿were large," adding that the reserve movements "could turn out to be zero." In any case, one thing is clear: The sheer size of WorldCom's reserves means any changes could have had a sizable impact on financial results.

(Tuesday,

IDT

(IDT) - Get Report

announced it wanted to

buy several WorldCom units.)

Changes Under Review

The crisis-hit telecom said Monday that its audit committee and accounting firm KPMG were reviewing "material" changes to reserves made¿during 1999 and 2000, adding that no conclusion had yet been reached regarding¿ the reserve entries.

Last week, WorldCom said that in 2001 and 2000 it had ¿incorrectly excluded a staggering $3.8 billion of operating costs from its income statement by treating them as investments in plant, which don't get factored into earnings. It's feasible that any reserve tampering that took place ¿could've added hundreds of millions of dollars to earnings in 1999 and 2000.¿

The New York Times

reported Tuesday that possibly questionable reserve accounting could've led to profits being overstated by $1¿billion in those two years, citing an unnamed person who has been briefed on the¿ situation. Revelations of further accounting chicanery could deepen the rift between WorldCom and its bankers, which have the power to push the company into¿ a bankruptcy filing, and contribute to an exodus by customers.

Something in Reserve
WorldCom's bad debt reserve as a percentage of total receivables

Source: Detox, SEC filings.

A WorldCom spokesman declined to comment on its reserve¿ accounting. But Sidgmore held up the possibility that the issue may come to ¿nothing. "We are not convinced that the issues that were highlighted for '99 and ¿'00 are problems," he said Tuesday.

Old Accounting Tricks

Reserve manipulation is an age-old accounting ruse. The classic trick is to set up a¿ so-called cookie-jar reserve that is deliberately too big so that it can benefit¿ earnings in the future. The way this can be done is to make a large addition to¿ a reserve against nonpayment of unpaid bills that have been booked as revenue. ¿The addition to the reserve is booked as a cost in the income statement, but a company can spin that hit as a special charge, or a one-time, nonrecurring¿ expense that investors should ignore.

Drafting "pro forma earnings" statements in this fashion is¿ likely to draw criticism nowadays, but in the '90s they were de rigueur and¿ widely accepted by investors.

With a hefty reserve in place, a company can write down the¿ unpaid bills, or receivables, to what it thinks their true value is. The boost to earnings comes if it ends up collecting more from the doubtful receivables¿ than it had written them down to. If that happens, the reserve can end up being too large, and less needs be added to it in following quarters, benefiting earnings.

This boost from collecting more than had been reserved for is called¿ reserve reversal. In its statement Monday, WorldCom said that "questions have been raised regarding certain¿ material reversals of reserve accounts during 2000 and 1999."

Do publicly available numbers show a pattern of this at ¿WorldCom? Perhaps.

What's Known

First, we know WorldCom wanted investors to think of one big reserve addition as nonrecurring. This¿ happened in the third quarter of 2000. Among other things,

Securities and Exchange Commission

investigators are probing a $685 million charge taken in that period for wholesale accounts that weren't deemed collectible, WorldCom said in March. WorldCom described the $685 ¿million expense in its third-quarter earnings release as a nonrecurring charge. This wouldn't have seemed odd when pro forma earnings releases went unquestioned.

But at WorldCom, even in its earnings releases, additions to this reserve were normally deemed a regular operating cost -- part of selling, ¿general and administrative expense -- and were not broken out as nonrecurring.¿ In its quarterly SEC filing, in which accounting rules have to be strictly¿ followed, the $685 million was included in the SG&A line.

The second piece of evidence¿ for setting up a classic cookie jar would be any indication that WorldCom¿ over-reserved. To a certain extent, the numbers bear this out. As the chart¿ above shows, the doubtful receivable reserve as a percentage of total receivables moved up to 16.3% at the end of 1999 from 14.7% in 1998. Year-end¿ 2000, it was a record 18.4%, or $1.53 billion.

This increase does not necessarily imply over-reserving, since management may have been protecting itself against the rise in delinquent customers as the telecom bust began. It was¿ common even at the height of the tech and telecom bubble for big-name companies to write off debts owed by shaky customers. And on Tuesday, Sidgmore said reserve setting was "highly subjective."

¿ However, in 1999 and 2000, additions to the reserve were well in excess of the amounts written down and thus subtracted from the reserve, according to annual reports. In 2000, WorldCom piled $1.87 billion into its reserve, 1.28 times the¿ $1.46 billion written down in the year. The ratio was 1.24 times in 1999.

But in¿ 2001, the reserve addition was only 0.78 of the write-offs. If it hadn't been for the big additions in 2000 and 1999, WorldCom probably wouldn't have been ¿able to add proportionately less in 2001. That looks mighty like cookie-jar ¿raiding.

Know any companies that the market may be misvaluing? Detox would like to hear about them. Please send all feedback to

peter@eavis.com.

Peter Eavis has no positions in stocks mentioned in this column.