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 comparability, 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 separate bottom-line from the assets of the company, distinguishing the companys 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 WorldComs management did not correctly disclose the expense. Managements 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 entitys financial statements or records; or Fails to correct an entitys 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.