Case Assignment #1 – Accounting Fraud at WorldCom
1. Discuss the fraud at WorldCom in terms of the objective of financial reporting. How was the objective subverted by the actions taken by the managers of WorldCom?
A. To begin, the primary objective of financial reporting for most companies is to provide useful information to capital providers. Essentially, the objective is “to assist in the efficient functioning of economies and the efficient allocation of resources in capital markets” (pg. 21, textbook). However, in the fraud case at WorldCom, WorldCom’s senior managers did not endorse this objective nor made any attempt to provide useful financial information to present and ...view middle of the document...
Releasing an accrual is appropriate when it turns out that less is needed to pay the bills than had been anticipated. Therefore, it has the effect of providing a counterpoise against reported line costs in the period when the accrual is released. Thus, it reduces reported expenses and increases reported pre-tax income.
B. As seen above, this accounting treatment reduced expenses causing Net Income to be higher than it was in reality. Reducing the liability accrual by the amount of the cash payment did this. Additionally, because of a decrease (or failure to record expenses) reported retained earnings are higher than they should have been. Consequently, shareholder’s equity will be reported higher than it should be. Net: Increase in shareholder’s equity.
A. By capitalizing operating expenses, WorldCom shifted these costs from its income statement to its balance sheet and increased its reported pre-tax income and earnings per share. Because capital expenditures do not appear on the income statement and do not immediately reduce the Company’ s pre-tax income it also made it appear that mollifying markets were not reducing the company’ s profitability, when the opposite was the case. Therefore, WorldCom managed to capitalize $771 million of non-revenue-generating line expenses into an asset account called “construction in progress.” Thus, causing net income to be higher than it was actually, which resulted from not recognizing expenses for unused network capacity.
B. Because capital expenditures appear as assets on the company’s balance sheet, and when put in service, are depreciated gradually over time. This allowed WorldCom to improperly shift these expenditures from its income statement to its balance sheet, increasing current income and postponing the time when these costs would offset revenue.
c. Discuss the effect on the financial statements in terms of the fundamental qualitative characteristics of accounting information (i.e. relevance and faithful representation).
A. The two accounting irregularities of accrual accounting and expense capitalization effect on the financial statements is one that affects the usefulness of decision-making information. Under WorldCom, “for the financial information to be useful, it should possess the fundamental decision-specific qualities of relevance and faithful representation. In the WorldCom case, we can see that the improper releasing of accruals did not represent faithfully the appropriate economic phenomenon and because of this the information becomes useless or irrelevant. Because net income was not matching the actual predictive value, the net income could not possess a confirmatory value; therefore, useless in predicting the company’s future cash-generating ability. And again, the financial statements of WorldCom did not represent faithful representation of the phenomenon; it was bias and filled with material “error.”
3. What were the pressures that...