Walt Pavlo joined MCI in the spring of 1992. At that time, MCI was a growth company in the booming long-distance telecommunications industry that had 15% of the long-distance market, with revenues of

\($11\) billion.

In the 1990s, the major telecommunications companies all shared their fiber-optic networks. This was more efficient than having each company lay its own network to every corner of the country. Each company would use the others’ networks in places where the former did not have cable and vice versa. The cost of routing a call through these fiber-optic networks was measured in pennies per minute. However, MCI and the other telecommunication companies sold the right to use the network to their customers for dimes per minute. It was a lucrative business based on volume.

The more the network was used, the greater the revenue for the telecommunication company. MCI’s stellar revenue growth was due to its sales, and sales personnel were awarded lucrative commissions.

Senior management was given generous stock options. It was heady times.

MCI had a wide array of clients that varied from major corporations, such as American Express, General Electric, and IBM, to small newly formed long-distance discount services (LDDS). These were primarily marketing firms that bought MCI long-distance capacity and that they resold to individuals and small businesses.

Although these LDDS customers represented only 5% of MCI’s annual sales, the profit margins for both MCI and the LDDS companies were quite substantial. For example, in 1992, Telephone Publishing Corp. (TCP) paid \($600,000\) to MCI for long-distance calls that TCP was charging its customers approximately \($5\) million per month. After paying its overhead, TCP was netting, before taxes, about \($20\) million per year. Meanwhile, MCI was often charging a LDDS as much as 28 cents a minute for services that cost about 5 cents. Everyone was making money.

However, many of these LDDS companies were slow in paying MCI for the use of the long-distance service. Collections were a problem because these companies normally had no hard assets. Their offices were rented, the communication switch was leased, and they had no other assets other than cash. Without assets, they were somewhat bulletproof. They could be threatened, but there was nothing to collect in the event the LDDS was successfully sued by MCI. If MCI cut off access to the network, then the LDDS would fold its operations and disappear, often reappearing under a new name as a client of one of the other telecommunication companies.

Walt Pavlo was in charge of the finance unit, responsible for LDDS collections.

Walt was also given some clear guidelines with respect to accounts receivable and bad debts. Accounts that were ninety or more days old should not exceed 7% of total receivables, and bad debt write-offs should be under 2% of total account receivables.

For 1994, the bad debt ceiling was set at

\($12\) million and then reduced to \($10\) million in 1995 even though 1995 revenues had increased. Unfortunately, both delinquent accounts and bad debts exceed these guidelines. So, Walt gathered a small group of bright MBAs, and he tasked them to be creative. How could they stay within the MCI guidelines?

One strategy was to get delinquent accounts to sign promissory notes, thereby moving their balances out of accounts receivable. These customers were also required to pay interest on the note, but because they often had no intention of paying the principal, the interest charge was irrelevant. For example, Voicecom had its account converted to a \($3.5\) million promissory note. It paid \($100,000\) per month for ten months and then defaulted on the balance. Another strategy was to accept the customer’s common stock instead of cash. They lapped payments, posting one customer’s payment to another’s account in order to show activity in the latter’s account. They amortized bad debts, writing off a portion and pretending that the balance would be collected. They also convinced the accounting department to accept a check in the mail. This consisted of a fax of a check and a FedEx tracking number of the check to prove that the check was on its way. When the check arrived, the previous entry would be reversed. None of these procedures was identified and/or challenged by internal audit or the external auditors.

However, these strategies were merely disguising rather than solving the problem.

So, in January 1996, Walt sent a note to his new boss saying that MCI’s bad debts for 1995 were approaching \($88\) million. A month later, he was told that his budget for 1996 was \($15\) million. He was also reminded that there was speculation that MCI would be taken over, so it was everyone’s responsibility to make their targets and budgets. At the time, Walt was being well paid for running an efficient department and staying within budget. He had a stay-at-home wife and two small children.

If MCI were taken over, he would profit handsomely from his stock options.

Questions:-

1. After being told that the guideline for bad debts for 1996 was to be \($15\) million, what should Walt do?
2. What are the risks for MCI in setting an unrealistic allowance for doubtful accounts?