WorldCom Ethics Case
GAAP Issues
Denise Bauer
Christopher Meza
Jonathan Schmitz
Breanne Wilhelm
Background
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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
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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
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In effort to reduce expenses and meet
expectations, capitalized expenses and
improperly recognized revenue
WorldCom Ethics Case
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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
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Journal entries were made without
detailed support
• Line costs were capitalized
• Liability accrual release
WorldCom and Journal Entries
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Was it a proper accounting practice
without detailed support?
• $150 million and $771 million journal
entries
• Usually need approval in businesses
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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?
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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?
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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
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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
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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
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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, rounddollar entries, prepared the entry anyway
Based on GAAP, was this an
appropriate entry?
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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?
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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
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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
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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
Capitalizing Line Costs
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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
Capitalizing Line Costs
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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
Electronic Data Systems Contract
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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
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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
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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
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The reporting decision is inconsistent
The estimation was not based on any
historical data
Entries were made to purposely
overstate income
Capitalization & Revenue
Recognition
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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
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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
Questions?