WORLDCOM’S CREATIVE ACCOUNTING

In 1996 Betty Vinson landed a midlevel accounting position at WorldCom, a small long-distance telephone company in Jackson, Mississippi. During the next few years, the company grew very rapidly via acquisitions of companies such as Brooks Fiber, a high-speed telecom services company; Skytel, a leading paging firm; and UUNet, a major owner of Internet backbone. Two years after joining WorldCom, Vinson was promoted to a senior manager in the firm’s corporate accounting division, reporting to Buford Yates, Director of General Accounting. She and her staff of 10 compiled quarterly reports and analyzed company operating expenses and loss reserves. The reserves were set aside to cover specific kinds of expenses.

WorldCom’s profits grew rapidly until the middle of 2000 when the telecommunications industry entered a protracted slump. The company’s line costs, lease fees paid to other telephone companies to use portions of their networks, began to increase as a percentage of the firm’s revenue.

This ratio was closely watched by Wall Street as an indicator of the firm’s health. The company’s CEO, Bernard Ebbers, and CFO, Scott Sullivan, warned Wall Street that earrings for the second half of the year would fall below expectations. During the third quarter, due to the failure of some of its small customers, WorldCom was saddled $685 million in unpaid bills.

Vinson, Yates, and Troy Normand, the accountant in charge of monitoring the firm’s fix expenses, searched for ways to cover the shortfall in preparation of the release of the third-quarter report. They were able to locate $50 million that could be applied to the unpaid bills, but that was far cry from $685 million. In October Yates met with Vinson and Normand and told them that Sullivan and David Myers, the firm’s controller, directed him to take $828 million out of the reserve account designated to cover line cost and other items for the telecommunications unit and use it to cover other expenses. That would reduce reported expenses and increase earnings.

Vinson, Yates, and Normand were concerned that the adjustment was not approved accounting transaction. Accounting rules state that reserves can be established only if there is an expectation that a loss will occur in the unit where the reserve is established. The reserve can be depleted only if there is a good business reason for doing so. Because no business reason existed for dipping into the reserve account, Vinson and Normand told Yates that doing so was not following good accounting practices. Yates replied that he was not pleased with the action, but he was assured that this was a one-time transaction and would never happen again; thus, he had agreed to go along with the transfer. On that basis Vinson and Normand agreed to make the transfer.

The company’s third-quarter results were reported on October 26. On that day Vinson told Yates that she was planning to resign. Normand expressed similar inclinations. Ebbers got wind of the unrest in the accounting department and told Myers that the accountants will never again be placed in such an untenable position. Myers and Sullivan met with Vinson and Normand several days later. Sullivan explained that he was working on the firm’s financial problems. He appealed for them to stay until he was able to get things under control and then they could leave if they wanted to, but he needed them to right the ship.

Normand stated that he was concerned that he would be held liable for making the accounting changes. Sullivan told the two that nothing they had done was illegal and that he would resume all responsibility for their actions. He further stated that the profit projections for the coming quarter had been cut in half and an accounting manipulation would not be needed. Following the meeting, Vinson’s resolve to find another position weakened. She told her husband about the meeting and her concern over the accounting irregularities, and he urged her to quit. But she was the chief breadwinner of the family earning more than her husband’s $40,000 a year, and her job provided the family health insurance. She was also worried about finding a new position because she was a middle aged woman.

Vinson rationalized that because Sullivan was considered one of the top CFOs in the country and had approved the transaction, it must be all right. After talking to Normand about how difficult it would be to find another job, both decided to stay. During the first quarter of 2001, things got worse. There were no reserves to tap and the funds gap was $771 million.

Sullivan ordered that the amount of line costs be transferred from an operating expense account to a capital expense account. That moved them from a direct expense against income to a depreciable expense, thus increasing short-term “profitability”. Vinson was shocked with this directive. She knew that line costs were operating costs that could not legally be counted as a capital expense.

In fact, Yates had balked at the plan when Myers had told him about it, and Myers had told Sullivan that the transfer could not be justified when he was given the order. However Sullivan told Myers that the transfer was WorldCom’s only way out of it’s financial troubles. Vinson felt trapped. The threat to resign had already been used and she was afraid to quit her job before she had another one. Vinson, Normand, and Yates met to discuss the order but did not resolve the issue. Vinson decided to update her resume and begin looking for another job.

Vinson, Normand, and Yates finally went along with the order to transfer the expenses. To do so they had to decide which of five capital expense accounts to transfer the expenses to. Myers met with them during this process and they all expressed how unhappy they were with the transaction. But they felt they had to do it to save the company. Vinson executed the entries to transfer the $771 million, changing dates of numerous transactions in the computer. The same process took place during the following three quarters: $560 million for the second quarter, $743 million for the third quarter and $941 million for the fourth quarter. Early the next year, Vinson was promoted from senior manager to Director of Management Reporting, and Normand was promoted to Director of Legal Entity Accounting.   

Answer these QUESTIONS

a. Who are the stakeholders in the case?

b. What actions should Vinson have taken and when? What prevented her from taking such actions?

c. What actions should Vinson’s colleagues have taken?

You have just been hired as a new management trainee by Earrings Unlimited, a distributor of earrings to various retail outlets located in shopping malls across the country. In the past, the company has done very little in the way of budgeting and at certain times of the year has experienced a shortage of cash.

Since you are well trained in budgeting, you have decided to prepare comprehensive budgets for the upcoming second quarter in order to show management the benefits that can be gained from an integrated budgeting program. To this end, you have worked with accounting and other areas to gather the information assembled below.

The company sells many styles of earrings, but all are sold for the same price—$18 per pair. Actual sales of earrings for the last three months and budgeted sales for the next six months follow (in pairs of earrings):

The concentration of sales before and during May is due to Mother’s Day. Sufficient inventory should be on hand at the end of each month to supply 40% of the earrings sold in the following month.

Suppliers are paid $5.4 for a pair of earrings. One-half of a month’s purchases is paid for in the month of purchase; the other half is paid for in the following month. All sales are on credit, with no discount, and payable within 15 days. The company has found, however, that only 20% of a month’s sales are collected in the month of sale. An additional 70% is collected in the following month, and the remaining 10% is collected in the second month following sale. Bad debts have been negligible.

Monthly operating expenses for the company are given below:

Insurance is paid on an annual basis, in November of each year.

The company plans to purchase $23,000 in new equipment during May and $54,000 in new equipment during June; both purchases will be for cash. The company declares dividends of $25,500 each quarter, payable in the first month of the following quarter.

A listing of the company’s ledger accounts as of March 31 is given below:

The company maintains a minimum cash balance of $64,000. All borrowing is done at the beginning of a month; any repayments are made at the end of a month.

The company has an agreement with a bank that allows the company to borrow in increments of $1,000 at the beginning of each month. The interest rate on these loans is 1% per month and for simplicity we will assume that interest is not compounded. At the end of the quarter, the company would pay the bank all of the accumulated interest on the loan and as much of the loan as possible (in increments of $1,000), while still retaining at least $64,000 in cash.

Required:

1. Prepare a master budget for the three-month period ending June 30. Include the following detailed budgets:

a. A sales budget, by month and in total.

b. A schedule of expected cash collections from sales, by month and in total.

c. A merchandise purchases budget in units and in dollars. Show the budget by month and in total. (Round unit cost of purchases to 1 decimal place.)

d. A schedule of expected cash disbursements for merchandise purchases, by month and in total.

2. A cash budget. Show the budget by month and in total. (Cash deficiency, repayments and interest should be indicated by a minus sign.)

Morrisey & Brown, Ltd., of Sydney is a merchandising company that is the sole distributor of a product that is increasing in popularity among Australian consumers. The company’s income statements for the three most recent months follow:

Required:

1. By analyzing the data from the company's income statements, classify each of its expenses (including cost of goods sold) as either variable, fixed, or mixed.

2. Using the high-low method, separate each mixed expense into variable and fixed elements. Express the variable and fixed portions of each mixed expense in the form Y = a + bX.

3. Redo the company’s income statement at the 10,000-unit level of activity using the contribution format.

1. An economy’s use of resources is efficient if . A. the use of resources in the economy can be further rearranged to make everyone better off B. the use of resources fair and income inequality is small C. one person can be made better off by rearranging how resources are used only by making someone else worse off D. government’s policy is unnecessary

2. Which one of the following concepts is not illustrated by a production possibilities frontier? A. scarcity B. opportunity cost C. the trade-off between producing one good versus another D. society’s preferences over different goods

10. Suppose we observe that the price of sweet corns rises when the income of consumers in the market of sweet corns is higher. It is most likely that . A. Sweet corns are an inferior good B. Sweet corns are a normal good C. Sweet corns are neither an inferior good nor a normal good D. Sweet corns are a substitute for sweet potatoes

11. Suppose that, in Toronto, when the price of beef falls, ceteris paribus, the price of broccoli also falls. This information implies that . A. beef and broccoli in Toronto are complements B. beef and broccoli in Toronto are substitutes C. beef is a normal good while broccoli is an inferior good D. Both beef and broccoli are normal goods

Morrisey & Brown, Ltd., of Sydney is a merchandising company that is the sole distributor of a product that is increasing in popularity among Australian consumers. The company’s income statements for the three most recent months follow:

Required:

1. By analyzing the data from the company's income statements, classify each of its expenses (including cost of goods sold) as either variable, fixed, or mixed.

2. Using the high-low method, separate each mixed expense into variable and fixed elements. Express the variable and fixed portions of each mixed expense in the form Y = a + bX.

3. Redo the company’s income statement at the 10,000-unit level of activity using the contribution format.

Camino Company manufactures designer to-go coffee cups. Each line of coffee cups is endorsed by a high-profile celebrity and designed with special elements selected by the celebrity. During the most recent year, Camino Company had the following operating results while operating at 75 percent (60,000 units) of its capacity:

Camino’s cost of goods sold and operating expenses are 80 percent variable and 20 percent fixed. Camino has received an offer from a professional wrestling association to design a coffee cup endorsed by its biggest star and produce 16,000 cups for $8 each (total $128,000). These cups would be sold at wrestling matches throughout the United States. Acceptance of the order would require a $48,000 endorsement fee to the wrestling star, but no other increases in fixed operating expenses.

Required:
1. Complete the incremental analysis of the special order in the table provided below. (Enter per unit answers to 2 decimal places.)



2. Should Camino accept this special order?

3. If Camino were operating at full capacity, what price would Camino require for the special order?

Near the end of 2019, the management of Dimsdale Sports Co., a merchandising company, prepared the following estimated balance sheet for December 31, 2019.

To prepare a master budget for January, February, and March of 2020, management gathers the following information.

1. The company’s single product is purchased for $20 per unit and resold for $57 per unit. The expected inventory level of 5,500 units on December 31, 2019, is more than management’s desired level, which is 20% of the next month’s expected sales (in units). Expected sales are January, 6,750 units; February, 9,500 units; March, 11,250 units; and April, 9,000 units.
2. Cash sales and credit sales represent 25% and 75%, respectively, of total sales. Of the credit sales, 59% is collected in the first month after the month of sale and 41% in the second month after the month of sale. For the December 31, 2019, accounts receivable balance, $125,000 is collected in January 2020 and the remaining $395,000 is collected in February 2020.
3. Merchandise purchases are paid for as follows: 20% in the first month after the month of purchase and 80% in the second month after the month of purchase. For the December 31, 2019, accounts payable balance, $70,000 is paid in January 2020 and the remaining $300,000 is paid in February 2020.
4. Sales commissions equal to 20% of sales are paid each month. Sales salaries (excluding commissions) are $54,000 per year.
5. General and administrative salaries are $144,000 per year. Maintenance expense equals $1,900 per month and is paid in cash.
6. Equipment reported in the December 31, 2019, balance sheet was purchased in January 2019. It is being depreciated over eight years under the straight-line method with no salvage value. The following amounts for new equipment purchases are planned in the coming quarter: January, $38,400; February, $96,000; and March, $28,800. This equipment will be depreciated under the straight-line method over eight years with no salvage value. A full month’s depreciation is taken for the month in which equipment is purchased.
7. The company plans to buy land at the end of March at a cost of $180,000, which will be paid with cash on the last day of the month.
8. The company has a working arrangement with its bank to obtain additional loans as needed. The interest rate is 12% per year, and interest is paid at each month-end based on the beginning balance. Partial or full payments on these loans can be made on the last day of the month. The company has agreed to maintain a minimum ending cash balance of $35,000 at the end of each month.
9. The income tax rate for the company is 41%. Income taxes on the first quarter’s income will not be paid until April 15.

Required:
Prepare a master budget for each of the first three months of 2020; include the following component budgets.

1. Monthly sales budgets.
2. Monthly merchandise purchases budgets.
3. Monthly selling expense budgets.
4. Monthly general and administrative expense budgets.
5. Monthly capital expenditures budgets.
6. Monthly cash budgets.
7. Budgeted income statement for the entire first quarter (not for each month).
8. Budgeted balance sheet as of March 31, 2020.

Near the end of 2019, the management of Dimsdale Sports Co., a merchandising company, prepared the following estimated balance sheet for December 31, 2019.

To prepare a master budget for January, February, and March of 2020, management gathers the following information.

1. The company’s single product is purchased for $20 per unit and resold for $57 per unit. The expected inventory level of 5,500 units on December 31, 2019, is more than management’s desired level, which is 20% of the next month’s expected sales (in units). Expected sales are January, 6,750 units; February, 9,500 units; March, 11,250 units; and April, 9,000 units.
2. Cash sales and credit sales represent 25% and 75%, respectively, of total sales. Of the credit sales, 59% is collected in the first month after the month of sale and 41% in the second month after the month of sale. For the December 31, 2019, accounts receivable balance, $125,000 is collected in January 2020 and the remaining $395,000 is collected in February 2020.
3. Merchandise purchases are paid for as follows: 20% in the first month after the month of purchase and 80% in the second month after the month of purchase. For the December 31, 2019, accounts payable balance, $70,000 is paid in January 2020 and the remaining $300,000 is paid in February 2020.
4. Sales commissions equal to 20% of sales are paid each month. Sales salaries (excluding commissions) are $54,000 per year.
5. General and administrative salaries are $144,000 per year. Maintenance expense equals $1,900 per month and is paid in cash.
6. Equipment reported in the December 31, 2019, balance sheet was purchased in January 2019. It is being depreciated over eight years under the straight-line method with no salvage value. The following amounts for new equipment purchases are planned in the coming quarter: January, $38,400; February, $96,000; and March, $28,800. This equipment will be depreciated under the straight-line method over eight years with no salvage value. A full month’s depreciation is taken for the month in which equipment is purchased.
7. The company plans to buy land at the end of March at a cost of $180,000, which will be paid with cash on the last day of the month.
8. The company has a working arrangement with its bank to obtain additional loans as needed. The interest rate is 12% per year, and interest is paid at each month-end based on the beginning balance. Partial or full payments on these loans can be made on the last day of the month. The company has agreed to maintain a minimum ending cash balance of $35,000 at the end of each month.
9. The income tax rate for the company is 41%. Income taxes on the first quarter’s income will not be paid until April 15.

Required:
Prepare a master budget for each of the first three months of 2020; include the following component budgets.

1. Monthly sales budgets.
2. Monthly merchandise purchases budgets.
3. Monthly selling expense budgets.
4. Monthly general and administrative expense budgets.
5. Monthly capital expenditures budgets.
6. Monthly cash budgets.
7. Budgeted income statement for the entire first quarter (not for each month).
8. Budgeted balance sheet as of March 31, 2020.

Near the end of 2017, the management of Dimsdale Sports Co., a merchandising company, prepared the following estimated balance sheet for December 31, 2017.

To prepare a master budget for January, February, and March of 2018, management gathers the following information.

The company’s single product is purchased for $30 per unit and resold for $55 per unit. The expected inventory level of 5,000 units on December 31, 2017, is more than management’s desired level, which is 20% of the next month’s expected sales (in units). Expected sales are: January, 7,000 units; February, 9,000 units; March, 11,000 units; and April, 10,000 units.

Cash sales and credit sales represent 25% and 75%, respectively, of total sales. Of the credit sales, 60% is collected in the first month after the month of sale and 40% in the second month after the month of sale. For the December 31, 2017, accounts receivable balance, $125,000 is collected in January and the remaining $400,000 is collected in February.

Merchandise purchases are paid for as follows: 20% in the first month after the month of purchase and 80% in the second month after the month of purchase. For the December 31, 2017, accounts payable balance, $80,000 is paid in January and the remaining $280,000 is paid in February.

Sales commissions equal to 20% of sales are paid each month. Sales salaries (excluding commissions) are $60,000 per year.

General and administrative salaries are $144,000 per year. Maintenance expense equals $2,000 per month and is paid in cash.

Equipment reported in the December 31, 2017, balance sheet was purchased in January 2017. It is being depreciated over eight years under the straight-line method with no salvage value. The following amounts for new equipment purchases are planned in the coming quarter: January, $36,000; February, $96,000; and March, $28,800. This equipment will be depreciated under the straight-line method over eight years with no salvage value. A full month’s depreciation is taken for the month in which equipment is purchased.

The company plans to buy land at the end of March at a cost of $150,000, which will be paid with cash on the last day of the month.

The company has a working arrangement with its bank to obtain additional loans as needed. The interest rate is 12% per year, and interest is paid at each month-end based on the beginning balance. Partial or full payments on these loans can be made on the last day of the month. The company has agreed to maintain a minimum ending cash balance of $25,000 at the end of each month.

The income tax rate for the company is 40%. Income taxes on the first quarter’s income will not be paid until April 15.

Required:
Prepare a master budget for each of the first three months of 2018; include the following component budgets:

1. Monthly sales budgets.
2. Monthly merchandise purchases budgets.
3. Monthly selling expense budgets.
4. Monthly general and administrative expense budgets.
5. Monthly capital expenditures budgets.
6. Monthly cash budgets.
7. Budgeted income statement for the entire first quarter (not for each month).
8. Budgeted balance sheet as of March 31, 2018.

ear the end of 2017, the management of Dimsdale Sports Co., a merchandising company, prepared the following estimated balance sheet for December 31, 2017.

To prepare a master budget for January, February, and March of 2018, management gathers the following information.

The company’s single product is purchased for $20 per unit and resold for $57 per unit. The expected inventory level of 4,750 units on December 31, 2017, is more than management’s desired level, which is 20% of the next month’s expected sales (in units). Expected sales are: January, 7,000 units; February, 9,000 units; March, 11,000 units; and April, 11,000 units.

Cash sales and credit sales represent 25% and 75%, respectively, of total sales. Of the credit sales, 63% is collected in the first month after the month of sale and 37% in the second month after the month of sale. For the December 31, 2017, accounts receivable balance, $130,000 is collected in January and the remaining $390,000 is collected in February.

Merchandise purchases are paid for as follows: 20% in the first month after the month of purchase and 80% in the second month after the month of purchase. For the December 31, 2017, accounts payable balance, $70,000 is paid in January and the remaining $305,000 is paid in February.

Sales commissions equal to 20% of sales are paid each month. Sales salaries (excluding commissions) are $54,000 per year.

General and administrative salaries are $132,000 per year. Maintenance expense equals $1,900 per month and is paid in cash.

Equipment reported in the December 31, 2017, balance sheet was purchased in January 2017. It is being depreciated over eight years under the straight-line method with no salvage value. The following amounts for new equipment purchases are planned in the coming quarter: January, $38,400; February, $96,000; and March, $26,400. This equipment will be depreciated under the straight-line method over eight years with no salvage value. A full month’s depreciation is taken for the month in which equipment is purchased.

The company plans to buy land at the end of March at a cost of $150,000, which will be paid with cash on the last day of the month.

The company has a working arrangement with its bank to obtain additional loans as needed. The interest rate is 12% per year, and interest is paid at each month-end based on the beginning balance. Partial or full payments on these loans can be made on the last day of the month. The company has agreed to maintain a minimum ending cash balance of $44,500 at the end of each month.

The income tax rate for the company is 37%. Income taxes on the first quarter’s income will not be paid until April 15.

Required:
Prepare a master budget for each of the first three months of 2018; include the following component budgets:

1. Monthly sales budgets.
2. Monthly merchandise purchases budgets.
3. Monthly selling expense budgets.
4. Monthly general and administrative expense budgets.
5. Monthly capital expenditures budgets.
6. Monthly cash budgets.
7. Budgeted income statement for the entire first quarter (not for each month).
8. Budgeted balance sheet as of March 31, 2018.