Capital expenditure — or 'capex' as financial analysts like to refer to it — is one of those boring things that appears in corporate reports, along with the accounts receivable, operating leases and all those other items of balance sheet arcana. Unfortunately for investors, such tedious accounting terms have taken on vast importance over the past year or so, since that's where most of the corporate bombs have been hiding.
It's an issue that affects more than just investors in one specific company, however. WorldCom shareholders may be the latest winners (or losers) of the 'Who's A Bigger Fraud' contest that seems to be under way in the United States at the moment, but the impact of such scandals is much broader than just one company or its shareholders. In a very real way, it affects not just the stock market, but the health of the economy itself.
WorldCom is a particularly good (or bad) example, because the fraud that it has been accused of perpetrating involved overstating its capital expenditures by a staggering $4-billion (U.S.) in a little over a year. The company apparently took money spent on routine maintenance of its network — such as upgrading of switches or paying other companies a fee for the use of their networks — and treated it as a long-term investment.
One of the main effects of this was to overstate the company's cash flow or earnings before interest, taxes, depreciation and amortization (EBITDA), since capital expenditures are treated differently than routine maintenance costs, and don't affect cash flow directly. According to WorldCom CEO John Sidgmore, the company should have reported a sizable loss instead of the $1.4-billion profit it said it had in 2001.
That's the company-specific effect of the fraud. One of the larger issues — apart from the general deterioration in confidence and trust it has contributed to — is that WorldCom's capital expenditures are part of the overall corporate spending picture, activity that economists and market-watchers look at in order to gauge the health of the U.S. economy. And $4-billion of that spending now turns out to be a complete fiction.
During 2000 and much of 2001, the economy was seen as booming in part because of the vast amounts of money that companies were shovelling out the door in capital expenditures — normally thought of as big-ticket items, such as new production facilities, new office buildings, or the acquisition of fibre-optic capacity. Telecom accounted for capex of $77-billion in 2001, and this year it's expected to be $45-billion.
That means WorldCom's alleged fraud was equivalent to about 10 per cent of this year's spending. Not a lot, perhaps, but still meaningful, even in the context of the U.S. economy as a whole. Obviously, the fact that one telecom player misstated its capital expenditure doesn't mean the economy's entire capital spending level is built on quicksand, but it has to raise at least a few concerns about some of the numbers economists use.
After all, telecom spending was one of the main growth engines of the economic miracle that was allegedly taking place in the U.S. from 1998 to 2000 or so, as telecom carriers such as WorldCom — and Qwest, Sprint, AT&T Wireless, Global Crossing, Level Three, Williams Communications, and so on — were spending billions laying fibre-optic cable.
That spending in turn became part of the productivity boom many economists pointed to as an offshoot of the technology revolution. One of the things that market-watchers clung to through the downturn was the fact that productivity was holding firm, meaning companies were producing the same growth rates with fewer employees. But how much of that was a sham? That's just one of the fears caused by the spread of Enron-itis.
As far as anyone can tell to this point, WorldCom actually spent the money it booked as capital expenditures — it just spent it on things that should have been accounted for as immediate costs, rather than capitalized over a long period of time. So in broad terms it still contributed to the growth of the economy somehow, even if it didn't do so in the way it should have; it still paid people salaries and bought equipment, although it accounted for that spending in an unacceptable manner.
But the fact remains that economy-watchers pay attention to capital spending as a key indicator of whether the economy is really gathering steam or not. "What happens to capital spending is at the heart of whether the economy is on the right course or whether it still has more excesses to purge," James Glassman, chief economist at J.P. Morgan Chase, told Reuters. And that means accounting frauds like the one WorldCom has been accused of go straight to the heart of the economic recovery.
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