Fraudulent accounting records and

faithful image: the WorldCom case

The twentieth century has been, for accounting, the most turbulent century. Indeed,
there are more than a hundred international scandals.

Passing from Atlantic Acceptance Corporation (conflicts of interest with the

accountant) in 1965, to Toshiba (exaggerated profits), in 2015.

The accounting practice we will discuss here is the allocation of the expenses of a
company. We will take as case the case WorldCom, extremely (unfortunately)
known. The problem studied will be the following: How should the expenses be
charged in US GAAP, to reflect the economic reality of the company.

THEORY PART
As stated in the Statement of Financial Accounting Concepts No. 5, on "Recognition
and Measurement in Financial Statements of Business Enterprises":

Operating expenses must be immediately recognized in the period incurred, unlike

capital expenditures, which must be capitalized as if it is depreciated over its useful
life.”

An operating expense

An operating expense is an expense to business incurs through its normal business

operations. Often abbreviated as OPEX, operating expenses, equipment, inventory
costs, marketing, payroll, insurance and funds.

A capital expenditure

A capital expenditure, or CapEx, are funds used by a company to acquire,

upgrade, and maintain physical assets such as property, industrial buildings, or
equipment. CapEx is often used to undertake new projects or investments by the
firm.

Therefore, we understand that these two types of expenses are accounted for
differently and do not appear on the same financial statements.
In fact, an operating expense will apply to the income statement, a capital
expenditure, will apply to the balance sheet.

But then, how could WorldCom realize such a fraud?

To answer this question, we will exclude the charges against the Anderson audit
firms.
COMPANY'S STORY
WorldCom was founded in 1994 by the acquisition of IDB Worldcom by LDDS (Long
Distance Discount Service). It specializes in the resale of long distance minutes.

In 1997, she acted the company MCI (3 times larger than WorldCom), for 30 billion
dollars. In 1999, the antitrust authorities rejected WorldCom's attempt to acquire
Sprint for $ 115 billion. As of that date, the group understands that its strategy of
expansion is no longer possible.

It was in 2002 that the financial scandal we are about to discuss was brought to
light. That same year, WorldCom was forced to put itself under the protection of
Chapter 11 of the US Bankruptcy Act:

- The debtor retains control of its operations and is subject to court supervision.

HOW AND WHY WERE THEY ABLE TO COMMIT FRAUD FOR SO LONG?
WorldCom preached the "culture of figures". According to The Guardian: "If the
objectives were not met, the services concerned were publicly insulted in meetings,
the cadres were even insulted."

WorldCom's technological innovations and market losses have forced it to commit

accounting fraud so as not to lose the trust of the stock market players. Indeed, it
can be noted that the charge against the company's management was "improper
remuneration through stock options".

HOWEVER, HOW COULD THEY HIDE THIS FRAUD FOR SO LONG?

During the investigation started after the discovery of the WolrdCom maneuvers, it
has been proved that:

- Leaders kept tight control over access to financial information.

- Only a handful of people knew the spread of fraud.
- Similarly, a small portion of the employees had access to the accounting
system.
- The accounting software was voluntarily restricted for all people posing a
threat.

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We can illustrate these internal practices by the following example:

In 2001, David Mayers (Internal Controller), learned that an internal audit was going
to take place. He then ordered the IT department to block internal auditors' access
to any information that could lead them to notice fraud.

We can also cite another example, the cult phrase of Buddy Yates (chief
accountant), to Gene Morse (manager): "" Show those damn numbers to the f *****
g auditors, I'll throw you out of the window”…

Finally, one last point makes it possible to understand the longevity of this fraud. The
different financial services were geographically isolated. Thus, the head office was
in Mississippi, the legal department in Washington, the accounting department in
Texas, the human resources department in Florida and finally, the computer service
in Virginia.

The information was not circulating in the various departments, and everyone
estimated their costs and revenues.

Thus, we understand that if these frauds could last so long, it is only thanks to the cult
of the silence established within the company.

The few who knew about these accounting manipulations were silenced. In the
same way, the authors of these frauds were when to them, constantly on alert.

The geographical disparity of services also allowed the managers to hide as much
as possible the actions of the company within its own company...

THE ACCOUNTING MALPRACTICE

T O U N D E R S TA N D T H I S F R A U D , W E H AV E T O E X P L A I N W H E R E I T C O M E S
FROM.

The company had long communicated on the only ratio that was essential for it, the
ratio expenses / incomes. These manipulations were intended to maintain an
expenditure-to-income ratio equal to 42% (when, in reality, it was greater than 50 %)
and show double-digit sales growth when it was significantly lower.

As a result, stock market players closely monitored this ratio. It was therefore
essential for WorldCom to have a good ratio.

The fraud begins in 1998. WorldCom has reduced the reserves of its absorbed
companies. Thus, WolrdCom has increased its income line by almost $ 3 million
through this process.

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Under the direction of the CFO, operating expenses were recorded as a long-term
investment.

A long-term investment is an account on the asset side of a company that

represents the company, including stocks, bonds, and cash, that it intends to hold
for more than a year.

Therefore, the fees paid for leasing telephone networks and IT expenses are
removed from the income statement and added to the balance sheet.

WHAT DOES IT MEANS?

When a company records an expense in operating costs, the latter implies an
immediate decline in the profitability of the company. However, if this same
expense is recorded in long-term investment, this allows the company to defer part
of the cost of this expense to future periods. Therefore, profitability seems better than
if the cost had been spent.

The accounting entry can be summarized as follows:

Computer Assets 500

Cash 500

HOW DOES THIS RATIO EVOLVE WITH ACCOUNTING MANIPULATIONS?

This graph shows the evolution of the expenditure / income ratio before and after
adjustment.

The ratio before any manipulation corresponds to the pink line. The ratio before the
accounting manipulations of the costs due to the telephone lines corresponds to
the green line. Finally, the ratio presented officially, after all the accounting
manipulations corresponds to the blue line.

This case study allowed us to show the importance of internal control. Indeed, for 4
years, the company WorldCom managed to conceal several accounting
malpractices.

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 CONCLUSION

Thus, the accounting manipulations make it possible to make the image of a

company better. Therefore, the principle of "faithful image" must be respected.
Registration must be sincere, consistent with reality, and finally regular.

This accounting scandal shows the necessary impetus to make IFRS the set of
accounting standards towards which countries around the world would converge.

We chose here to speak only one of the frauds carried out by the company. Also, if
we want to be exhaustive, we could talk about:

- Fictitious income

- False use of regulation reserves

- The voluntary failure of the verification centres.

Sources :

L’OBS : “La fraude de Worldcom empire” 12 Août 2002

La Libre : “WorldCom: la plus grosse faillite de l’histoire des Etats-Unis” – 22 Juillet 2002 –
Evalorix : “L’affaire WorldCom : Incompétence des auditeurs ou manquement à leur obligation
d’indépendance ?“
FASB: Statement of Financial Accounting Concepts No. 5 Recognition and Measurement in Financial
Statements of Business Enterprises

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