ADVANCED AUDITING

WorldCom: The Expense Recognition Principle

Case 1.7

[Type the author name]

2/17/2014

1. The matching principle requires expenses to be recognized when incurred and the

revenue associated with the expense is recognized. This makes the timing of expenses

and revenues very important. By shifting the timing of when expenses are recognized, a

company can artificially make its business appear more profitable. Therefore, the

accounting standards institute has established clear guidelines to minimize any subjective

judgment regarding when to recognize expenses.

Since, financial statements are periodic; the matching principle promotes compa-

rability, which helps users evaluate the performance of the company. According to this

principle, other costs not expensed are considered as assets or inventories which can later

be recognized as revenues if the sales are made in future period. This helps end users sep-

arate bottom-line from the assets of the company, distinguishing the company’s stability

versus the current performance.

2. WorldCom began violating the matching principle in the beginning of the second quarter

of 1999 when management began demanding the release of line cost accruals usually

without any underlying analysis to support the release. By doing so, they were not

matching the release with any actual expense reduction and thereby falsely reducing

accrual accounts.

Under GAAP, WorldCom was required to estimate its line costs each month and

immediately expense them, even though many of these costs would be paid later. In

order to estimate the cost, a liability account called ‘accrual’ was set up by WorldCom.

As the bills arrived, the company would pay the pills and reduce the balance of the

accrual by the same amount. However, because the accruals were estimates, WorldCom

was allowed by GAAP to re-evaluate the accounts to ensure that they were properly

valued. If actual charges were lower than the estimate, then the accrual is released. An

entry that management could have been using to make reduction of line expenses without

any underlying support would be reporting line cost as a capital expenditure on the

balance sheet.

The management of WorldCom was also not releasing certain line costs in the

period in which they were identified. But rather, these certain line cost accruals were

kept as “rainy-day” funds that could be released when management needed to improve

reported results.

3. WorldCom had not established an effective system of internal control over financial

statements. Control policies and procedures that would have monitored and prevented

management override and the release of line costs, which resulted in overstated financial

statements. When linking internal controls to financial statement assertions for expense

accounts, it is evident that several management assertions were incorrect and not

identified by the controls. False management assertions fell into the categories of

accuracy, valuation presentation and disclosure. The management assertions of accuracy

and valuation, which states that the transactions and events have been recorded accurately

and that account balances have been valued correctly was false because WorldCom’s

management did not correctly disclose the expense. Management’s assertions of

presentation and disclosure, which state that all transactions and events have been

presented correctly and that all relevant information has been disclosed to financial

statement users was also violated. WorldCom failed to disclose the release of line costs

the lowered its expense account and increased its revenues.

4. The PCOAB Auditing Standard No. 15 lists many procedures an auditor can use to

gather evidence to observe the accounting quality of a company. At WorldCom, the

auditors could have used physical examination to check the documents related to the

decline of the line cost. They would have noticed these declines were done through top

side journal entries with no supporting analysis. The auditors could also have used

confirmations with other companies that charged WorldCom to find out the actual

expense amount and if there were any reductions in charges. Auditors could have

analyzed the outcome of the reported information and for significant fluctuations through

analytical procedures. Auditors can also inquire of the client and raise questions about

the particular approach and the validity of it. Auditors could have made recalculations of

the accrual accounts. Since the adjustments were so big, auditors would have easily

identified the issue and then presented to management the correct way of making these

adjustments. If management refused to follow the suggested entries of the auditor, they

should not get a qualified opinion.

5. Ethics Rule 102 Paragraph 1 states that in the performance of any professional service, a

member shall maintain objectivity and integrity, shall be free of conflicts of interest, and

shall not knowingly misrepresent facts or subordinate his or her judgment to others.

Ethics Rule 102 Paragraph 2 states that a member shall be considered to have knowingly

misrepresented facts in violation of rule 102 when he or she knowingly—

Makes, or permits or directs another to make, materially false and misleading

entries in an entity’s financial statements or records; or

Fails to correct an entity’s financial statements or records that are materially false

and misleading when he or she has the authority to record an entry; or

Signs, or permits or directs another to sign, a document containing materially

false and misleading information.

David Schneeman and Charles Wasserott were correct in refusing to make the line cost

accrual adjustments. However, since David Schneeman was the CFO, and was aware

that the vice president and controller had someone else do what he refused, he had the

responsibility to correct those entries as stated in Paragraph 2 of ET 102. David

Schneeman would still be found to have knowingly misrepresented the facts.

References

AICPA, ET Section 102, “Intergrity and Objectivity.” Accessed February 17, 2014.

http://www.aicpa.org/Research/Standards/CodeofConduct/Pages/et_102.aspx

PCOAB, Auditing Standard No. 5, “An Audit of Internal Control Over Financial Reporting That

Is Integrated with An Audit of Financial Statements.” Accessed February 17, 2014.

http://pcaobus.org/Standards/Auditing/Pages/Auditing_Standard_5.aspx.