1. WorldCom Ethics Case GAAP Issues
Denise Bauer
Christopher Meza
Jonathan Schmitz
Breanne Wilhelm

2. Background Major telecommunications company
WorldCom “continued to post impressive revenue growth numbers”
Competitors dropped from 330 to 150
Was meeting or exceeding expectations while others experienced difficulties

3. Background
Pressures both externally and internally to repeat success in 2001
Ebbers’ stock was pledged as collateral to finance the purchase of his personal outside business interests
Double-digit rate of revenue growth was expected
In effort to reduce expenses and meet expectations, capitalized expenses and improperly recognized revenue

4. WorldCom Ethics Case
Was WorldCom’s accounting methodology in accordance with GAAP?
Journal entries made without detailed support
Line Costs were capitalized
Scott Sullivan’s justification for capitalizing them
Revenue Recognition issues
Common reporting problems found

5. WorldCom and Journal Entries
Journal entries were made without detailed support
Line costs were capitalized
Liability accrual release

6. WorldCom and Journal Entries
Was it a proper accounting practice without detailed support?
$150 million and $771 million journal entries
Usually need approval in businesses
Became a matter of internal controls
Approval came from Sullivan
Internal Audit – reported to management
Changes in accounting methods need disclosures and footnotes

7. Based on GAAP, describe the propriety or impropriety of releasing $150 million in line cost accruals in the Wireless division over Deloris DiCicco’s objections. Support your position using authoritative accounting literature.

8. What is a line cost?
WorldCom paid outside service providers to carry some portions of its calls.
WorldCom paid the outside service providers for carrying WorldCom customers’ calls on their lines
Ex. A call from a WorldCom customer in Chicago to London might start on a local Chicago phone company’s line, flow to WorldCom’s own network, and then get passed to a British phone company to be completed.
WorldCom had to pay the Chicago and British phone companies a line cost since WorldCom’s customers used the Chicago and British lines

9. Why were line costs important to WorldCom?
They accounted for roughly half of WorldCom’s total expenses.
A key measurement of line costs to analysts is the ratio of line costs expense to revenue.
Line cost E/R ratio
An increase indicates deteriorating performance
Hovered around 42% from , while the rest of the industry experienced a lot of volatility

10. Managing the E/R ratio In 2001, WorldCom estimated their line costs
Prepared an adjusting entry each month to immediately recognize the estimated cost as a period expense by capitalizing the expense as an accrued liability
The bills were not received or paid for several months, typically in a different period

11. Managing the E/R ratio
As bills arrived, WorldCom would pay them and reduce the accrued liability from the previous period
If the line cost was overestimated, based on prior period estimates, WorldCom would offset the amount they overestimated against the reported line cost in the current period
reduced the total line cost for the later period

12. The Issue
In early 2001, the CFO directed general accounting to reduce the Wireless Division’s line costs by $150 million due to savings from the prior period
Delores DiCicco, VP of the Wireless Division refused because there was no support for the entry
Daniel Renfroe in general accounting, who had a history of preparing large, round-dollar entries, prepared the entry anyway

13. Based on GAAP, was this an appropriate entry?
According to GAAP, line costs must be reported as an expense on a company's income statement.
WorldCom capitalized the line expense, rather than expensing it
Put it on the balance sheet as an accrued liability rather than on the income statement as an operating expense

14. Why did WorldCom do this?
WorldCom transferred the amounts in order to keep earnings in line with the analysts’ projected earnings
This materially understated the company’s expenses, and materially overstated its earnings

15. Overall Result
WorldCom falsely portrayed itself as a profitable business when it was not, and concealed large losses it suffered by improperly reducing reserves held against "line costs" and by transferring certain "line costs" to its capital asset accounts.

16. Capitalizing Line Costs
Senior management wanted a reduction in reported line costs E/R ratio
Sullivan reduced reported line costs E/R to 42%
Entered into various network leases to obtain access to large amounts of capacity
Under the theory that revenue would follow and fully absorb these costs and to expedite “time to market”
Believed future revenues would be matched up with costs of leases
Said “The Company” followed SAB 101 and FASB 91
They aren’t obtaining customers, the lease is used because they are customers to other telecom companies. They are leased the services. Therefore, the cannot defer or amortize any direct or indirect costs over the revenue stream associated with obtaining a customer. 16

17. Capitalizing Line Costs
Portion of the commitments not utilized were deferred until the related revenue was utilized
Management believed projected revenues would more than cover the future lease commitments and deferred costs
Cost of deferrals for unutilized portion considered to be appropriate inventory 17

18. Capitalizing Line Costs
Classified costs as asset followed FASB Concept No. 6
Expense or a loss would be recognized upon evidence that previously recognized asset benefits would not be realized
FASB Concept No. 6 “Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” 18

19. Electronic Data Systems Contract
In 2001Business Operations employees searched for revenue opportunities to “close the gap”
A 1999 contract required EDS to outsource some services to WorldCom
Contract required minimal commitments measured at the end of a five year period, if not met EDS paid a penalty

20. Electronic Data Systems Contract
In the third quarter of 2001 the employees recognized $35 million on potential penalty fees as revenue, and $5 million each following quarter
During this time EDS still had three years to meet minimum use requirements

21. Electronic Data Systems Contract
Not in conformity with GAAP, specifically SAB 101
No revenue had been realized, or earned
The penalties, if enforced, could not be paid until 2005 as stated in the contract.

22. Electronic Data Systems Contract
The reporting decision is inconsistent
The estimation was not based on any historical data
Entries were made to purposely overstate income

23. Capitalization & Revenue Recognition
Two misstatements do not often violate GAAP when used in the correct context
Statements have some gray area
Entries allowed WorldCom to quickly overstate income and assets in a discreet way

24. Conclusion
In many situations employees were able to twist statements which follow GAAP
Employees were easily convinced they were doing the right thing
Anyone who was unwilling to participate was ignored
Substantial concerns were not brought up until the scandal was out of hand

25. Questions?