IV.

ACCOUNTING FRAUD

A. What is fraud and accounting fraud?

Fraud is defined in Article 1338 of the Civil Code of the Philippines as: fraud when,
through insidious words or machinations of one of the contracting parties, the other is induced to
enter into a contract which, without them, he would not have agreed to.
Accounting fraud is the intentional misrepresentation or accounting records regarding
sales, revenues, expenses, and other factors for a profit motive such as inflating company stock
values, obtaining more favorable financing or avoids debt obligations. Employees who commit
accounting fraud at the request of their employers are subject to personal criminal prosecution.
B. What are the driving factors?
The driving factor behind this fraud was the business strategy of WorldComs CEO,
Bernard Ebbers. Ebber was clearly focused on achieving impressive growth through acquisitions.
Ebbers flet the need to show ever-increasing revenue and income. And his only recourse to achieve
this end was financial gimmickry. The problem is that the more one resorts to this sort of deception,
the more complicated it becomes to continue it. Deception is just not suitable in the long run.
Ebbers situation was an industry-wide downturn in telecommunications. During this time,
Wall Street had continuing expectations of double-digit growth for WorldCom because they had
achieved so much in such a relatively short period of time. Ebber did not have the courage to tell
Wall Street that WorldCom needed time for the consolidation and digestion of its acquisitions. In
order to satisfy Wall Streets expectations, Ebbers had to doctor his companys books.
If he had the courage to tell them what was really needed, WorldCom would be alive today
and Ebbers would not be facing the prospect of spending the rest of his life in prison.
Another factor driving this fraud was Ebbers desire to build and protect his personal
financial condition. For this reason, he had to show continually growing net worth in order to avoid
margin calls on his own WorldCom stock that he had pledged to secure loans.
C. Pressures that lead the managers to commit fraud
The main pressures were coming from the economic recession and the aftermath of
dot-com bubble collapse which the cause the industry conditions began to deteriorate in 2000.
The competition among existing company and the new entrants were becoming more
heightened; the company became overcapacity and the demand for telecommunication
services reduced significantly. And the pressure to maintain a 42% of expense-to-revenue (ER
ratio) had also becoming one of the forces that lead the executives and the manager to cook
the books in order to make it look good in the publics eyes.
From the perspective of the executives
The main pressure would be to ensure that the investor or the shareholder to keep on
trusting the company and continue to keep their investment or inject more investment into the
company. This is so much important as the shareholders trust greatly depending on the
company performance. Besides that, the executives were also surrounded by their self-interest.
Therefore, they prefer to cook the books or to cover the real performance by doing some
improper accounting practices.
From the perspective of the managers
The employee benefits that they had received was all because of the great companys
performance. If the company did not improve, then many of them will be fired or lose their job
as a way of saving the companys cost. For example, Betty Vinson, who was previously a
manager in the international accounting division, was having a dilemma after she done her first
fraud of releasing an $828 million of line accruals. Pressure was placed on the accountants
Betty Vinson and Troy Normand to reduce expenses so the firm could meet Wall Streets
Expectations. However, the two accountants were not able to cut enough expenses to make up
for the shortfall. Their boss Buford Yates claimed that CFO Scott Sullivan and the company
controller David Myers had asked them to take the said $828 million from a reserve account set
aside for line cost and used it to pay expenses.
D. Fraud committed by Worldcom

1. Capitalizing Line Cost

One of WorldCom's major operating expenses was its so-called "line costs." In general,
"line costs" represent fees WorldCom paid to third party telecommunication network providers
for the right to access the third parties' networks. Line costs are the costs of carrying a voice call
or data transmission from its starting point to its ending point. Because at the time WorldCom
only maintained its own lines for local service in heavily populated urban areas (and then
largely for business customers), most residential and commercial calls outside these urban areas
must flow in part through non-WorldCom networks, typically belonging to one or more local
telephone companies. WorldCom therefore must pay an outside service provider for carrying
some portion of the call on its network. For example, a call from a WorldCom customer in
Chicago to Paris might start on a local phone companys line, then flow to WorldComs own
network, and then get passed to a French phone company to be completed. WorldCom would
have to pay both the local Chicago phone company and the French provider for the use of their
services. All of these costs are line costs.
To understand why WorldCom committed fraud by capitalizing line costs, we first need
to know the difference between capital expenditures and operating expenses. Operating
expenses are the expenses involved in the normal course of running a business, such as the
electricity bill. They are booked as they are incurred. On the other hand, a capital expenditure is
an expenditure to acquire a long-term asset that results in depreciation over the life of that
asset. A capital expenditure is deducted from profits in increments over an extended period of
time, diluting the impact these expenses have on the companys profit.
Starting at least in 2001, WorldCom engaged in an improper accounting scheme
intended to manipulate its earnings to keep them in line with Wall Street's expectations, and to
support WorldCom's stock price. WorldCom acknowledged it had improperly capitalized costs
and as a result managed to show a profit of $1.4 billion for fiscal 2001, rather than a loss. The
company apparently managed to do this by not subtracting certain costs from income. In a
report to the SEC, WorldCom said it disguised $3.9 billion in expense as capital expenditures
during the past five fiscal quarters. That enabled the company to avoid showing a loss for
those quarters.
By capitalizing line costs, WorldCom avoided recognizing standard operating expenses
when they were incurred, and instead postponed them into the future. The line costs that
WorldCom capitalized were ongoing, operating expenses that accounting rules required
WorldCom to recognize immediately. Under GAAP, these fees must be expensed and may not
be capitalized. Nevertheless, beginning at least as early as the first quarter of 2001,
WorldCom's senior management (Sullivan) improperly directed the transfer of line costs to
WorldCom's capital accounts in amounts sufficient to keep WorldCom's earnings in line with the
analysts' consensus on WorldCom's earnings. Thus, in this manner, WorldCom materially
understated its expenses, and materially overstated its earnings, thereby defrauding investors.
Companies are actually allowed to lists costs as an asset if the cost is for equipment
purchased that will be used over a long period. The company then can depreciate the costs
from net income over time. But, in the WorldCom case, these expenses were not related to the
purchase of equipment. WorldCom did not calculate these line costs as operating expenses and
therefore did not subtract them from income. The result: WorldCom's net income was reported
as being higher than it really was. In fact, according to the SEC document, these line costs were
spread over many accounting categories so that their true nature was not readily apparent.
2. Accruals
The end of each month, during the fraud period at WorldCom was characterized by the
estimation of costs that were associated with using the phone lines of other companies. The
actual bill for the services was usually not received for several months. This meant that some of
the entries they had made to the payables were overestimated or underestimated. As result
liability was overestimated, and when the actual bill was received it would have had a surplus in
liability. Here is the journal entry to show the adjustment for WorldCom:
Accounts Payable 1,000,000
Cash Paid to Suppliers 900,000
Line Cost Expense release 100,000
WorldCom adjusted its accruals in three ways; some accruals were released without even
confirming any accruals. Secondly, they didnt release the accruals in proper time; instead they
kept them as rainy days future fund. Lastly, some of the accruals were released not
establishing any accruals.

In 1999 and 2000, WorldCom reduced its reported line costs by approximately $3.3 billion.
This was accomplished by improperly releasing accruals, or amounts set aside on
WorldComs financial statements to pay anticipated bills. These accruals were supposed to
reflect estimates of the costs associated with the use of lines and other facilities of outside
vendors, for which WorldCom had not yet paid. Releasing an accrual is proper when it turns
out that less is needed to pay the bills than had been anticipated. It has the effect of providing
an offset against reported line costs in the period when the accrual is released. Thus, it reduces
reported expenses and increases reported pre-tax income.
 WorldCom manipulated the process of adjusting accruals in three ways. First, in some
cases accruals were released without any apparent analysis of whether the Company actually
had an excess accrual in the account. Thus, reported line costs were reduced (and pre-tax
income increased) without any proper basis. Second, even when WorldCom had excess
accruals, the Company often did not release them in the period in which they were identified.
Instead, certain line cost accruals were kept as rainy day funds and released to improve
reported results when managers felt this was needed. Third, WorldCom reduced reported line
costs by releasing accruals that had been established for other purposes. This reduction of line
costs was inappropriate because such accruals, to the extent determined to be in excess of
requirements, should have been released against the relevant expense when such excess
arose, not recharacterized as a reduction of line costs.

In particular, WorldCom reported on its Consolidated Statement of Operations contained in

its 2001 Form 10-K that its line costs for 2001 totaled $14.739 billion, and that its earnings
before income taxes and minority interests totaled $2.393 billion, whereas, in truth and in fact,
WorldCom's line costs for that period totaled approximately $17.794 billion, and it suffered
a loss of approximately $662 million.

Further, WorldCom reported on its Consolidated Statement of Operations contained in its Form
10-Q for the first quarter of 2002 that its line costs for that quarter totaled $3.479 billion, and that
its income before income taxes and minority interests totaled $240 million, whereas, in truth and
in fact, WorldCom's line costs for that period totaled approximately $4.276 billion and it suffered
a loss of approximately $557 million.