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

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

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

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

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

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

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.

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

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 1999 - 2002, while the rest of the industry experienced a lot of volatility

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

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

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

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

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

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. http://www.sec.gov/litigation/complaints/comp17829.htm

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

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

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

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

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

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.

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

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

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

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