Question

In June 2002, it was discovered that Worldcom, a large US telecommunication company, committed one of the largest accounting frauds. Worldcom illegally capitalized $3.8 billion access fees during the year 2001 and the first quarter of 2002. The fees were paid to local network operators to connect calls from Worldcom services to telephones linked to local networks. This is a typical operating expense item for telecommunication companies. However, Worldcom capitalised these expenditures as assets and amortized them over future fiscal periods. Worldcom was persecuted and the penalties and corrections to the accounts eventually led it into bankruptcy.

The amount of capitalized access fees for each of the quarters are detailed as follows (in USD millions):

Quarter 1, 2001 $780

Quarter 2, 2001 $605

Quarter 3, 2001 $760

Quarter 4, 2001 $920

Quarter 1, 2002 $790

Required:

a) Describe how Worldcom’s accounting treatment of access fees affect the line items in the income statements, balance sheets and statements of cash flows.

b) Which accounting principle did Worldcom violate?

c) Assume that capitalized access fees were amortized over 5 years using the straight-line method. Compute the amount of misstatement for each quarter.

d) Without considering tax effects, prepare the journal entries for correcting the misstatements as of the reporting date of Quarter 1, 2002.

Answer 1

.a) Income Statement:

• Operating expenses: REDUCED
• Net Income:INCREASED

Balance Sheet:

• Retained earning: INCREASED

   Statement of Cash flows:

• Operating Income: INCREASED
• Cash flow from operating activities: INCREASED
• Cashflow from Investing activities:DECREASED

.b) Accounting principles violated:

The Matching Principle was violated in this case. Matching principle requires that all expenses for a period should be matched with the revenue of the period in order to determine the income for the period.

In this case, during the year 2001 (in each quarter) and first quarter of 2002, a large amount of operating expenses were not matched with the revenue of the quarter, thus stating inflated income in the financial statement

.c) Amount of misstatement in each quarter:

Amortization period=5 years(straight line)=20 Quarters

Amortization amount per quarter=(1/20)=0.05=5%

		Year 2001				Year 2002
		Q1	Q2	Q3	Q4	Q1
A	Amount of capitalized access fees( $million)	$780	$605	$760	$920	$790
B=0.05*780	Amortization expense for assets of Q1		$    39.00	$    39.00	$    39.00	$    39.00
C=0.05*605	Amortization expense for assets of Q2			$    30.25	$    30.25	$    30.25
D=0.05*760	Amortization expense for assets of Q3				$    38.00	$    38.00
E=0.05*920	Amortization expense for assets of Q4					$46.00
F=B+C+D+E	Total amortization expenses reported in the quarter	$0	$    39.00	$    69.25	$ 107.25	$ 153.25
G=A-F	Amount of misstatement during the quarter	$780	$566	$691	$813	$636.75

d. JOURNAL ENTRY FOR CORRECTING MISSTATEMENT AS ON Q1 2002(31-03-2002)

	JOURNAL ENTRY
Date	Account Title	Debit	Credit
.March 31,2002	Operating expenses	$790
	Asset-access fees		$636.75
	Amortization expenses		$153.25