The revelation of a massive black hole in the accounts of Worldcom, the giant US telecommunications company, could hardly have come at a worse time. US financial markets were already suffering a crisis of confidence fuelled by earlier revelations of poor accounting practice and increased questioning of the role of brokers and investment banks in the markets.
Now it transpires that a major company incorrectly allocated $3.8 billion of expenses as investment, grossly distorting its accounts. Worldcom has blamed its chief financial officer, who has been fired, but such is the scale of the fraud that the corporation itself has almost certainly suffered terminal damage.
In recent months investors have had to deal with successive revelations about off-balance sheet financing - most dramatically in Enron. In turn this has put a spotlight on a range of other accounting practices. However what went on in Worldcom has none of the complexity of Enron's manoeuvres. What happened was simply that expenses incurred in running its business were counted not as costs, but rather as an investment, thus increasing its cash flow and boosting certain measures of its earnings. It is the kind of basic fraud which the company auditor should pick up as a matter of course. However the company's auditors, Andersen, did not notice. Incredibly, they yesterday said that this was because the company did not tell them what it was doing. But if auditors are not able to check out what a client company tells them then they are of no value.
The scale of the scandalrocked the financial markets. Share markets fell sharply and confidence has been severely dented. Another nervous few weeks on the markets now lie ahead, as the full details emerge and other company accounts come under fresh examination. There are two main lessons from Worldcom and the other related scandals. The first and obvious one is the need for improved audit regulation, including the regular rotation of auditors for big firms and the banning of audit firms undertaking other major projects for client firms, which could compromise their willingness to undertake a proper audit.
The second lesson is that investors, when examining the health of a company , need to look at the whole picture and not be taken in by selected earnings measures which are said to indicate future potential. In other words they must be sceptical. Many have learned this through costly experience. During the dot.com bubble many companies flagrantly inflated their earnings and their share values have since collapsed, often along with the companies themselves. Since then other accounting practices have come under the spotlight. Much of this has been driven by the relentless pressure on companies to boost earnings quarter by quarter to please the markets. Perhaps it is too much to ask that the focus be changed from this short-term performance to the longer-term efforts of companies to build a business and increase their value.