From Joshua Kennon,
Your Guide to Investing for Beginners.
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If you've watched television, picked up a newspaper, or read a magazine lately, you've probably heard about Worldcom inflating its numbers by nearly $4 billion dollars. Most investors don't understand how a company as large as the Mississippi telecommunications provider could manage to hide a fraud of this magnitude from the investing community for so long. The answer lies in CFO Scott Sullivan's treatment of capital expenditures and the accrual method, one of the basic principles of accounting.

Understanding the Accrual Method

When a business incurs an expense, accounting rules state that the cost of that expense should be allocated over the entire period it will benefit the company. This attempt to match revenues with the cost it took to generate those revenues is known as the accrual method. An illustration from Investing Lesson 4 will help:

Sherry’s Cotton Candy Co., earns $10,000 profit a year. In the middle of 2002, the business purchases a $7,500 cotton candy machine that is expected to last for five years, and will allow the employees to make twice as much cotton candy per hour. If an investor examined the financial statements, they might be discouraged to see that the business only made $2,500 at the end of 2002 ($10k profit - $7.5k expense for purchasing the new machinery.) The investor would wonder why the profits had fallen so much during the year.

Thankfully, Sherry’s accountants come to her rescue and tell her that the $7,500 must be allocated over the entire period it is going to benefit the company. Since the cotton candy machine is expected to last five years, Sherry can take the cost of the cotton candy machine and divide it by five ($7,500 / 5 years = $1,500 per year.) Instead of realizing a one-time expense, the company can subtract $1,500 each year for the next five years, reporting earnings of $8,500. This allows the investor to get a more accurate picture of the company's economic reality.

In the example, the purchase of the cotton candy machine is a type of "capital expenditure". Capital expenditures are expenses that a company incurs to pay for assets such as a factory, machinery, or equipment. This accrual method of accounting for capital expenditures does not apply to operating expenses such as materials, salaries, and the like.

Do the Hokey-Pokey (or How to Shuffle your Books)

How does this apply to Worldcom? The company's CFO, Scott Sullivan, fraudulently took billions of dollars in operating expenses and spread them out across so-called "property" accounts, which are a type capital expense accounts. This allowed Worldcom to charge the expenses off slowly, and in smaller amounts, instead of reporting them immediately to investors. In 2001, the company reported a $1.4 billion profit. Had the operating costs not been incorrectly hid, Worldcom would have actually lost money for fiscal 2001, as well as first-quarter 2002.