Accounting Fraud at Worldcom
Discuss the fraud at WorldCom in terms of the objectives of financial reporting. How were the objectives subverted by the actions taken by the managers of WorldCom?
To start with, one of the reasons for financial reporting is to determine future cash flows in order to determine the value of the firm. This will enable the external users (i.e. investors, creditors) to make educated judgment in making decisions about the risks and return of the firm. The financial reporting will provide them with the information in making decisions whether to invest or to loan to the corporation. All of these objectives were subverted by the actions of the managers of WorldCom.
In order to achieve the targeted performance, CFO Sullivan started using accounting entries in the form of accrual releases and expense capitalization of hit those targeted numbers. Thusly, reporting false numbers in the financial statement and misleading the public on the real value of the company. The financial statement that WorldCom provided was not useful in the sense that the reporting was not accurate in making a difference in decision making.
WorldCom, in efforts to maintain a 42% E/R ration, failed to recognize line-costs in the time period that they had occurred by dissolving accrual accounts in order to increase profits for the given period. After running out of accrued funds, WorldCom started recognizing operating expenses as capital investments, when line bandwidth was not usable outside the period that it was incurred. While Ebbers’ plans to maintain E/R were accomplished in the short term, the actions created a snowball effect making it more difficult to find ways to maintain E/R as well as hide the actual financial implications of the firm.
The fraud at WorldCom revolved around two accounting irregularities: accrual releases and expense capitalization.
Briefly explain how these two accounting treatments increased WorldCom’s net income
Accruals Releases: Costs are recognized when they are incurred. GAAP requires this expense to be estimated and according to the matching principle, this expense is to be matched with revenues. If WorldCom got a bill for the line cost that is lower than estimated, the company released more accruals than it should and therefore, net income increased. Accrual release removed the liability, decreasing the expenses prior to payment and increasing the profitability.
Expense capitalization: WorldCom decided to stop recognizing expense for excess network capacity. Even though the used network capacity was an expense that WorldCom has already committed to. The Expense was fixed, meaning that it had to be paid no matter what. Otherwise, WorldCom would have to pay a punitive fee to terminate to avoid making the payment. The amount spent to get the capacity was much greater than