WorldCom Ethics CaseWorldCom Ethics CaseGAAP IssuesGAAP Issues

Denise BauerDenise BauerChristopher MezaChristopher MezaJonathan SchmitzJonathan SchmitzBreanne WilhelmBreanne Wilhelm

BackgroundBackground

Major telecommunications companyMajor telecommunications company WorldCom “continued to post WorldCom “continued to post

impressive revenue growth numbers”impressive revenue growth numbers” Competitors dropped from 330 to Competitors dropped from 330 to

150150 Was meeting or exceeding Was meeting or exceeding

expectations while others expectations while others experienced difficultiesexperienced difficulties

BackgroundBackground

Pressures both externally and internally to Pressures both externally and internally to repeat success in 2001repeat success in 2001• Ebbers’ stock was pledged as collateral to Ebbers’ stock was pledged as collateral to

finance the purchase of his personal outside finance the purchase of his personal outside business interestsbusiness interests

• Double-digit rate of revenue growth was Double-digit rate of revenue growth was expectedexpected

In effort to reduce expenses and meet In effort to reduce expenses and meet expectations, capitalized expenses and expectations, capitalized expenses and improperly recognized revenueimproperly recognized revenue

WorldCom Ethics CaseWorldCom Ethics Case

Was WorldCom’s accounting Was WorldCom’s accounting methodology in accordance with methodology in accordance with GAAP? GAAP? • Journal entries made without detailed Journal entries made without detailed

supportsupport• Line Costs were capitalizedLine Costs were capitalized• Scott Sullivan’s justification for Scott Sullivan’s justification for

capitalizing themcapitalizing them• Revenue Recognition issuesRevenue Recognition issues• Common reporting problems foundCommon reporting problems found

WorldCom and Journal EntriesWorldCom and Journal Entries

Journal entries were made without Journal entries were made without detailed supportdetailed support• Line costs were capitalizedLine costs were capitalized• Liability accrual releaseLiability accrual release

WorldCom and Journal EntriesWorldCom and Journal Entries

Was it a proper accounting practice Was it a proper accounting practice without detailed support?without detailed support?• $150 million and $771 million journal $150 million and $771 million journal

entriesentries• Usually need approval in businessesUsually need approval in businesses

Became a matter of internal controlsBecame a matter of internal controls Approval came from Sullivan Approval came from Sullivan Internal Audit – reported to managementInternal Audit – reported to management

• Changes in accounting methods need Changes in accounting methods need disclosures and footnotesdisclosures and footnotes

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

What is a line cost?What is a line cost?

WorldCom paid outside service providers WorldCom paid outside service providers to carry some portions of its calls.to carry some portions of its calls.

WorldCom paid the outside service WorldCom paid the outside service providers for carrying WorldCom providers for carrying WorldCom customers’ calls on their linescustomers’ calls on their lines• Ex. A call from a WorldCom customer in Chicago to Ex. A call from a WorldCom customer in Chicago to

London might start on a local Chicago phone company’s London might start on a local Chicago phone company’s line, flow to WorldCom’s own network, and then get line, flow to WorldCom’s own network, and then get passed to a British phone company to be completed.passed to a British phone company to be completed.

WorldCom had to pay the Chicago and British phone WorldCom had to pay the Chicago and British phone companies a line cost since WorldCom’s customers companies a line cost since WorldCom’s customers used the Chicago and British linesused the Chicago and British lines

Why were line costs important to Why were line costs important to WorldCom?WorldCom?

They accounted for roughly half of They accounted for roughly half of WorldCom’s total expenses. WorldCom’s total expenses.

A key measurement of line costs to A key measurement of line costs to analysts is the ratio of line costs expense analysts is the ratio of line costs expense to revenue.to revenue.• Line cost E/R ratioLine cost E/R ratio• An increase indicates deteriorating An increase indicates deteriorating

performanceperformance• Hovered around 42% from 1999 - 2002, while Hovered around 42% from 1999 - 2002, while

the rest of the industry experienced a lot of the rest of the industry experienced a lot of volatilityvolatility

Managing the E/R ratioManaging the E/R ratio

In 2001, WorldCom estimated their line In 2001, WorldCom estimated their line costscosts• Prepared an adjusting entry each month to Prepared an adjusting entry each month to

immediately recognize the estimated cost as a immediately recognize the estimated cost as a period expense by capitalizing the expense as period expense by capitalizing the expense as an accrued liabilityan accrued liability

• The bills were not received or paid for several The bills were not received or paid for several months, typically in a different periodmonths, typically in a different period

Managing the E/R ratioManaging the E/R ratio

As bills arrived, WorldCom would pay As bills arrived, WorldCom would pay them and reduce the accrued liability them and reduce the accrued liability from the previous periodfrom the previous period

If the line cost was overestimated, If the line cost was overestimated, based on prior period estimates, based on prior period estimates, WorldCom would offset the amount WorldCom would offset the amount they overestimated against the they overestimated against the reported line cost in the current periodreported line cost in the current period• reduced the total line cost for the later reduced the total line cost for the later

periodperiod

The IssueThe Issue

In early 2001, the CFO directed general In early 2001, the CFO directed general accounting to reduce the Wireless accounting to reduce the Wireless Division’s line costs by $150 million due to Division’s line costs by $150 million due to savings from the prior periodsavings from the prior period

Delores DiCicco, VP of the Wireless Delores DiCicco, VP of the Wireless Division refused because there was no Division refused because there was no support for the entrysupport for the entry

Daniel Renfroe in general accounting, who Daniel Renfroe in general accounting, who had a history of preparing large, round-had a history of preparing large, round-dollar entries, prepared the entry anywaydollar entries, prepared the entry anyway

Based on GAAP, was this an Based on GAAP, was this an appropriate entry?appropriate entry?

According to GAAP, line costs must According to GAAP, line costs must be reported as an expense on a be reported as an expense on a company's income statement.company's income statement.• WorldCom capitalized the line expense, WorldCom capitalized the line expense,

rather than expensing itrather than expensing it• Put it on the balance sheet as an Put it on the balance sheet as an

accrued liability rather than on the accrued liability rather than on the income statement as an operating income statement as an operating expenseexpense

Why did WorldCom do this?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 ResultOverall Result

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

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

Capitalizing Line CostsCapitalizing Line Costs

Senior management wanted a reduction in Senior management wanted a reduction in reported line costs E/R ratioreported line costs E/R ratio

Sullivan reduced reported line costs E/R to Sullivan reduced reported line costs E/R to 42%42%

Entered into various network leases to Entered into various network leases to obtain access to large amounts of capacityobtain access to large amounts of capacity • Under the theory that revenue would follow and Under the theory that revenue would follow and

fully absorb these costs and to expedite “time to fully absorb these costs and to expedite “time to market”market”

• Believed future revenues would be matched up Believed future revenues would be matched up with costs of leaseswith costs of leases

Capitalizing Line CostsCapitalizing Line Costs

Portion of the commitments not Portion of the commitments not utilized were deferred until the utilized were deferred until the related revenue was utilizedrelated revenue was utilized

Management believed projected Management believed projected revenues would more than cover the revenues would more than cover the future lease commitments and future lease commitments and deferred costsdeferred costs• Cost of deferrals for unutilized portion Cost of deferrals for unutilized portion

considered to be appropriate inventory considered to be appropriate inventory

Capitalizing Line CostsCapitalizing Line Costs

Classified costs as asset followed Classified costs as asset followed FASB Concept No. 6 FASB Concept No. 6

Expense or a loss would be Expense or a loss would be recognized upon evidence that recognized upon evidence that previously recognized asset benefits previously recognized asset benefits would not be realizedwould not be realized

Electronic Data Systems ContractElectronic Data Systems Contract

In 2001Business Operations employees In 2001Business Operations employees searched for revenue opportunities to searched for revenue opportunities to “close the gap”“close the gap”

A 1999 contract required EDS to outsource A 1999 contract required EDS to outsource some services to WorldComsome services to WorldCom

Contract required minimal commitments Contract required minimal commitments measured at the end of a five year period, measured at the end of a five year period, if not met EDS paid a penaltyif not met EDS paid a penalty

Electronic Data Systems ContractElectronic Data Systems Contract

In the third quarter of 2001 the employees In the third quarter of 2001 the employees recognized $35 million on potential recognized $35 million on potential penalty fees as revenue, and $5 million penalty fees as revenue, and $5 million each following quartereach following quarter

During this time EDS still had three years During this time EDS still had three years to meet minimum use requirementsto meet minimum use requirements

Electronic Data Systems ContractElectronic Data Systems Contract

Not in conformity with GAAP, specifically Not in conformity with GAAP, specifically SAB 101SAB 101

No revenue had been realized, or earnedNo revenue had been realized, or earned

The penalties, if enforced, could not be paid The penalties, if enforced, could not be paid until 2005 as stated in the contract.until 2005 as stated in the contract.

Electronic Data Systems ContractElectronic Data Systems Contract

The reporting decision is inconsistentThe reporting decision is inconsistent

The estimation was not based on any The estimation was not based on any historical datahistorical data

Entries were made to purposely Entries were made to purposely overstate incomeoverstate income

Capitalization & Revenue Capitalization & Revenue RecognitionRecognition

Two misstatements do not often Two misstatements do not often violate GAAP when used in the violate GAAP when used in the correct contextcorrect context

Statements have some gray areaStatements have some gray area

Entries allowed WorldCom to quickly Entries allowed WorldCom to quickly overstate income and assets in a overstate income and assets in a discreet waydiscreet way

ConclusionConclusion

In many situations employees were able to In many situations employees were able to twist statements which follow GAAPtwist statements which follow GAAP

Employees were easily convinced they Employees were easily convinced they were doing the right thingwere doing the right thing

Anyone who was unwilling to participate Anyone who was unwilling to participate was ignoredwas ignored

Substantial concerns were not brought up Substantial concerns were not brought up until the scandal was out of handuntil the scandal was out of hand

Questions?Questions?