Worldcom Concepts

a. (i.) According to FASB Statement of Concepts No. 6, paragraph 25, assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. They represent probable future economic benefits controlled by the enterprise. According to FASB Statement of Concepts No 6, paragraph 80, expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major, or central, operations.

Expenses are gross outflows incurred in generating revenues. (ii.) SCON No. 6, paragraph 148, states that costs should be expensed when they are used up or have expired and when they have no future economic value which can be measured. SCON No. 6, paragraph 178-181, states costs should be capitalized or recorded as assets when the costs have not expired and they have future economic value.

b. According to GAAP Accounting Principles, cost capitalization is observed if a major expense merits recognition as an investment of capital funds instead of being recognized as an expense for the year. A capitalized cost does not appear on the income statement, but instead appears as a debit on the long-term assets account and a credit on the cash account of the balance sheet. However, the depreciation expense related to the capitalized cost will appear as an expense on the income statement. Since the long-term assets account is larger due to the effect of capitalization, the depreciation costs are also proportionately larger. Thus, the timing of expense recognition is changed, but eventually all expenses do get recognized on the income statement.

Process

c. The company reported line costs of $14,739 million for 2001. The journal entry for these transactions is debit to Line Costs Expense for $14,739 million and a credit to Cash for the same amount. Line costs are fees that WorldCom paid to other telecommunication companies to use their networks for long distance calls.

d. WorldCom capitalized $3.8 billion in line cost expenses. These were transactions that involved payment to local telephone companies to use their fiber optic network. These line costs are also called access charges or transport charges and are an operating cost. These costs do not meet the definition of an asset as described in FASB Statement of Concepts No. 6. Telecommunication companies can capitalize the costs and labor of installing lines or cable; however, they should not capitalize fees paid to another company for the use of their lines.

e. WorldCom improperly capitalized the line costs as a debit to the asset account Transmission Equipment for $3.055 billion and credit to cash for the same amount. These costs improperly appear on the balance sheet as an asset under the category of Property and Equipment. These costs are incorrectly categorized as a capital expenditure in the investing section of the Statement of Cash Flows.

Analysis

f. The midpoint range for straight-line depreciation of transmission equipment is 22 years. The $771 million capitalized in the first quarter would be depreciated for a full year ($35,045,455). The $610 million in the second quarter would be depreciated for 9/12 of the year ($20,795,455). The $743 million in the third quarter would be depreciated for 6/12 of the year ($16,886,364).

The $931 million capitalized in the fourth quarter would be depreciated for 3/12 of the year ($10,579,545). The journal entry to record the related depreciation expense for 2001 is a debit to Depreciation and Amortization Expense for $83,306,819 and a credit to Accumulated Depreciation for the same amount. (See attached schedule.)

g. The improperly capitalized accounts resulted in a depreciation expense of $83,306,819 for 2001. This amount should be subtracted from depreciation expense for the year. However, the total line costs of $3.055 billion should have been expensed as line costs for the year. Since the depreciation should not have been expensed, the use of generally accepted accounting principles results in an additional $2,971,693,181 in expenses for 2001. Operating income would be reduced to $542,306,819. Assuming that Other Income stayed the same, Income before Income taxes, minority interest, and cumulative effect of accounting change would be a net operating loss of ($578,693,181).

Applying the 2001 NOL Carryback to 1999 would result in a tax refund of $647,000,000 (rounded). According to 740-20-45-3, “the tax benefit of an operating loss carryforward or carryback (other than for the exceptions related to the carryforwards identified at the end of this paragraph) shall be reported in the same manner as the source of the income or loss in the current year.” Thus, the tax refund results in 2001 adjusted net income of $103,000,000 (rounded). The difference in net income is material because earnings per share figures are materially misstated. (See attached schedule.)

h. The possibility of being fired by the board of directors after missing its earnings estimates for consecutive quarters would be an incentive for management to defer costs. By capitalizing costs that are normally immediately expensed, WorldCom management was able to boost the company’s net income. By increasing net income, management was able to report massive profits for 2001. Massive profits please shareholders and financial institutions, instill public trust in the company, and increase market value. Management was also likely to receive bonuses and stock options based on the performance of the company.

i. The primary source of internal control to prevent fraudulent financial reporting is oversight and governance, which comes from the board of directors. WorldCom also should have implemented transaction-level controls which include: Authorizations, Documentation (source documents), Segregation of Duties, and IT Application Controls (input, processing, and output). By using the segregation of duties, Mr. Sullivan’s duties could have been divided among two or more individuals reducing the risk of error or inappropriate actions performed by any single person.

To be sure segregation of duties was being enforced, WorldCom could have used Monitoring, which is a process that assesses the quality of the performance of the implemented system over a period of time. Arthur Anderson, WorldCom’s auditor, should have been more involved in uncovering the discrepancies. Other employees should have noticed the improper accounting techniques and reported their findings to management.

j. The economic consequences that arise when a publicly traded company’s financial reports are revealed as fraudulent is severe in that it causes great financial loss to investors, the employees lose not only their jobs but also their pension, insurance, and 401k accounts. With so many people out of work less money is being spent causing an economic ripple effect. The company often declares bankruptcy.