In June 2002, it was discovered that Worldcom, a large US telecommunication comp
ID: 2551755 • Letter: I
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.
Explanation / Answer
.a) Income Statement:
Balance Sheet:
Statement of Cash flows:
.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
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
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