WorldCom Ethics Case GAAP Issues

1. WorldCom Ethics CaseGAAP 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 1999 - 2002, 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. http://www.sec.gov/litigation/complaints/comp17829.htm

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

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

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

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?