Question: Accounting Fraud at Worldcom
Case Assignment - Accounting Fraud at WorldCom
1. Discuss the fraud at WorldCom in terms of the objective of financial reporting. How was the objective subverted by the actions taken by the managers of WorldCom?
A. To begin, the primary objective of financial reporting for most companies is to provide useful information to capital providers. Essentially, the objective is "to assist in the efficient functioning of economies and the efficient allocation of resources in capital markets" (pg. 21, textbook). However, in the fraud case at WorldCom, WorldCom's senior managers did not endorse this objective nor made any attempt to provide useful financial information to present and potential equity investors, lenders, and other creditors. Why? The senior managers subverted these objectives by focusing on revenue growth, seen as the key to increasing the company's market value. Now although this focus is encouraged, WorldCom, as one manager says, "encouraged managers to spend whatever was necessary to bring revenue to the door, even if it meant that the long term costs of a project outweighed short term gains" (Accounting Fraud at WorldCom article, pg. 4). Therefore, CFO Sullivan and others subverted the objectives of providing useful information to external users by using accounting entries to achieve targeted performance.
2. The fraud at WorldCom revolved around two accounting irregularities: accrual releases and expense capitalization.
a. Explain how these two accounting treatments increased WorldCom's net income.
b. What effect did these accounting treatments have on the company's balance sheet?
A. In regards to accrual releases, GAAP required expected payments to be estimated and matched with revenues in the income statement. This was accomplished however by improperly releasing accruals to pay expected bills. These accruals were supposed to reflect estimates of the costs associated with the use of lines and other facilities of outside vendors, for which WorldCom had not yet paid. Releasing an accrual is appropriate when it turns out that less is needed to pay the bills than had been anticipated. Therefore, it has the effect of providing a counterpoise against reported line costs in the period when the accrual is released. Thus, it reduces reported expenses and increases reported pre-tax income.
B. As seen above, this accounting treatment reduced expenses causing Net Income to be higher than it was in reality. Reducing the liability accrual by the amount of the cash payment did this. Additionally, because of a decrease (or failure to record expenses) reported retained earnings are higher than they should have been. Consequently, shareholder's equity will be reported higher than it should be. Net: Increase in shareholder's equity.
A. By capitalizing operating expenses, WorldCom shifted these costs from its income statement to its balance sheet and increased its reported pre-tax income and earnings per share. Because capital expenditures do not appear on the income statement and do not immediately reduce the Company' s pre-tax income it also made it appear that mollifying markets were not reducing the company' s profitability, when the opposite was the case. Therefore, WorldCom managed to capitalize $771 million of non-revenue-generating line expenses into an asset account called "construction in progress." Thus, causing net income to be higher than it was actually, which resulted from not recognizing expenses for unused network capacity.
B. Because capital expenditures appear as assets on the company's balance sheet, and when put in service, are depreciated gradually over time. This allowed WorldCom to improperly shift these expenditures from its income statement to its balance sheet, increasing current income and postponing the time when these costs would offset revenue.