According to Varma after understanding the complexity of SPEs and prepays of Enron, the fraud committed by WorldCom is the simplicity itself. During the the last decade of the 20th century, WorldCom was turning to one of the greatest telecommunication companies, getting control over such firms as MCI. Furthermore, WorldCom signed contracts for long-term, fixed-rate line leases.
WorldCom had to face the downturn of the telecom industry, so it took several steps in favour of inflated earnings. The greatest and easiest step was connected to the cost of the lines. Sizeable line costs were lifted from the income statement of the firm then placed in the balance sheet as "Prepaid Capacity". This move resulted over $3.8 billion of line costs indicated as capitalised assets instead of expenses, meaning that the income was overstated as well by the same amount.
This was a simple journal entry which passed with the approval of the Chief Financial Officer, Scott Sullivan, which changed expenses to assets by reclassification without any supporting documentation whatsoever. In the case of WorldCom the internal controls department discovered this huge failure and asked the CFO, how it could happen. Sullivan replied as quoted in the following:
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"At the time of the cost deferral, management had determined that future economic benefit would be derived from these contractual commitments as the revenues from these service offerings reached projected levels. At that time, management fully believed that the projected revenue increases would more than offset the future lease commitments and deferred costs under the agreements. Therefore, the cost deferrals for the unutilized portion of the contract was considered to be an appropriate inventory of this capacity and would ultimately be fully amortized prior to the termination of the contractual commitment." (FASB CON No. 6, par. 26)
The previous auditor of the firm, Andersen refused to accept this explanation together with the current auditing company, KPMG, and pointed out that it is fully contradictory with GAAP. Actually Sullivan's explanation could be meant as a confession that he did not have any good reason for executing his action.
According to Varma(2002) between March 2002 and June 2002, Adelphia Communications Corporation, being the 6th greatest cable television operator in the US, declared that it had hidden $2.6 billion of its indebtedness. The Rigas family held the majority of the Adelphia shares and owned a number of various companies in the same business.
Varma(2002) states: "Adelphia subsidiaries and the Rigas entities borrowed money under a co-borrowing agreement with that made all parties jointly and severally liable for the borrowing regardless of who had drawn down the money. This meant that the debt had to be shown as a debt of the Adelphia subsidiaries (and therefore as part of Adelphia's consolidated debt) and not as a contingent liability."
In March 2002, Adelphia presented the results of Q4 2001 and admitted the existence of $2.3 billion of hidden debt for the first time, and dealt with it as it was a contingent liability.
The disclosure after that clarified that the amount mentioned above was indeed a part of the company's debt instead of being a simple contingent liability. The problem has been revealed that no clear burden being between the drawdowns by Adelphia and the Rigas Entities. The reclassification of the borrowed money was an arbitrage with done at the end of every financial quarter at the time of preparing the financial statements. The SEC stated: "Adelphia management allocated and reallocated co-borrowing liabilities among Adelphia's consolidated subsidiaries and unconsolidated Rigas Entities at will and through a single, quarterly cash management reconciliation of the inter-company receivables and payables outstanding at quarter end between or among Adelphia's subsidiaries and Rigas Entities"
This fraud was not just considered as hiding of debt.
According to Varma(2002) Xerox restated the income in their financial statements for the years between 1997 and 2002 due to not proper accounting practices used in connection with timing and allocation of revenue from bundled leases. The company sold majority of its products and services as bundled contracts which consist of equipment, service and financing parts. For these contracts the customer pays one fee that it negotiated monthly together with different extra service component for page volumes exceeding agreed minimums. The SEC stated that the methodology of allocation of revenues for these contracts performed by Xerox did not fulfil the accounting standards and furthermore the SEC made Xerox to change its method. Originally the fair value of the financing component was estimated by utilising the DCF method based on the cost of equity and debt of the firm, and the service component was estimated based on service gross margins and attributed the balance to equipment. As Varma(2002) states that "according to the method given by SEC, the fair value of the service component and the fair value of the equipment (using cash sale prices) are deducted from the total lease payment to arrive at the financing component as a balancing figure and the implicit financing rate is determined." KPMG who was previously auditing Xerox states that original accounting method which was used previously is the correct one to use and that the new one proposed by SEC and approved by the new auditing firm of Xerox, PricewaterhouseCoopers is incorrect. PwC changed its decision on the methodology under a strong pressure of the SEC. KPMG stated that: "KPMG remains firm in its conviction that the financial statements reported on by us in May 2001, including Xerox's financial statements for 2000 and the restated financial statements for 1997-1999, were fairly presented in accordance with generally accepted accounting principles. KPMG, Xerox and PricewaterhouseCoopers had it right the first time, when the company and three separate teams from PwC all agreed with us that Xerox's lease accounting methodology was GAAP compliant."
AOL Time Warner
Always on Time
Marked to Standard
According to Varma(2002) AOL Time Warner Inc. declared in October 2002 that it had incorrectly raised its revenue in the financial statements by $190 million and earnings before interest, taxes, depreciation and amortization figure, is widely used to measure profitability, by $97 million by usage of wrong accounting for online ad sales and various deals between July 2000 and June 2002. The company itself did not state which were the questionable transactions, however it is more than very probable that these were written in two of the articles of the Washington Post in July 2002. Washington Post declared that AOL used questionable accounting practices to increase advertising revenue at the same time when it was in the middle of the process of acquiring Time Warner as a part of a stock swap deal. Since the end of 2000, stock markets were becoming afraid that the advertising revenue for internet companies was not sustainable anymore. If advertising revenues would have decreased, then the stock prices of AOL would have decreased together with it in a great amount resulting that the merger with Time Warner would have been in trouble. The Washington Post asserted: "AOL converted legal disputes into ad deals. It negotiated a shift in revenue from one division to another, bolstering its online business. It sold ads on behalf of online auction giant eBay Inc., booking the sale of eBay's ads as AOL's own revenue. AOL bartered ads for computer equipment in a deal with Sun Microsystems Inc. AOL counted stock rights as ad and commerce revenue in a deal with a Las Vegas firm called PurchasePro.com Inc". AOL's decision to do this "trick" in accounting was reasonable due to restatements made in the financial statements compared to total revenues and profits are relatively small, compared to not doing it and having a negative hit on share price at a crucial point of the merger deal with Time Warner.
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Memorandum Prepared By WorldCom CFO Scott Sullivan during June 21-24, 2002
Outlining His Position on the Transfers of WorldCom Line Costs to Capital Accounts,
Exhibit 4 of Revised Statement filed by WorldCom with the United States SEC on July 8,
2002 pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934.
Press release dated March 27, 2002 announcing results for last quarter of 2001; Form
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Dot-Com Collapse", Washington Post, July 18, 2002
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