Case 1.11
WorldCom: The Definition of an Asset
Line Cost Expenses
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 company’s line, flow to WorldCom’s 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, WorldCom’s 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