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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. 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.
What this means
for investors
The Worldcom fraud
has far-reaching implications for investors. The basis of the American
financial system is the integrity of the financial reports released by
management. Unless those figures are as accurate as possible, analysts,
money managers, and lay-investors alike do not have the resources to properly
value a business. Although CFO Scott Sullivan defends his choice to
allocate the expenses in question, he and Worldcom went far beyond the
aggressive accounting practices used at some companies.
Remedial action
The Securities and
Exchange Commission (SEC) is going to begin requiring executives at large
corporations to sign statements swearing they believe, to the best of their
knowledge, the financial statements released by the companies are as accurate as
possible. This action could ultimately lead to the government holding
executives responsible in the event of corporate fraud.
Copyright © 2002 Joshua Kennon