WorldCom: The Expense Recognition Principle

Qwest: The Revenue Recognition Principle
Synopsis When Joseph Nacchio became Qwest's CEO in January 1997, the company's existing strategy began to shift from just building a nationwide fiber-optic network to include increasing communications services. By the time it released earnings in 1998, Nacchio proclaimed Qwest's successful transition from a network construction company to a communications services provider. "We successfully transitioned Qwest into a leading Internet protocol-based multimedia company focused on the convergence of data, video, and voice services."1 During 1999 and 2000, Qwest consistently met its aggressive revenue tar- gets and became a darling to its investors. Yet, when the company announced its intention to restate revenues in August 2002, its stock price plunged to a low of $1.11 per share in August 2002, from a high of $55 per share in July 2000.2 Civil and criminal charges related to fraudulent activity were brought against several Qwest executives, including CEO Joseph Nacchio. Nacchio was convicted on 19 counts of illegal insider trading, and was sentenced to six years in prison in July 2007. He was also ordered to pay a $19 million fine and forfeit $52 million that he gained in illegal stock sales.
Background4 Qwest executives allegedly made false and misleading disclosures concerning revenues from its directory services unit, Qwest Dex Inc. (Dex). In addition, executives were charged with having manipulated revenue from Dex for 2000 and 2001 by secretly altering directory publication dates and the lives of directories. Dex's Changes to Publication Dates and Lives of Directories Dex published telephone directories year-round in approximately 300 markets in 14 states. It earned revenue by selling advertising space in its directories. Each of its directories typically had a life of 12 months, and Qwest traditionally recognized directory revenue over the life of the directory. However, in late 1999 Dex adopted a "point of publication" method of accounting and began to recognize all advertising revenue for a directory as soon as Dex began deliveries of that directory to the public. In August 2000 Dex executives allegedly informed Qwest senior management that Dex would be unable to achieve the aggressive 2000 earnings' targets that management had set for it. As one option for making up for the shortfall, Dex suggested that it could publish Dex's Colorado Springs directory in December 2000 rather than January 2001 as scheduled, thereby allowing Qwest to recognize revenue from the directory in 2000 rather than 2001. One Dex executive expressed opposition, citing his concern that such a schedule change would merely reduce 2001 revenue and earnings. He also expressed his view that Qwest probably would be required to disclose the change in the regulatory filings with the SEC. Despite this executive's opposition, Qwest senior management allegedly instructed Dex to move forward with the pro- posed change. By recognizing revenue from the Colorado Springs directory in 2000, Qwest generated $28 million in additional revenue and $18 million in additional earnings before interest and tax, depreciation, and amortization (EBITDA) for the year. The additional revenue generated in 2000 accounted for about 30 percent of Dex's 2000 year-over-year revenue increase. It further allowed Dex to show 6.6 percent year-over-year revenue growth versus 4.6 percent if the schedule change had not been made. In Qwest's 2000 Form 10-K, Qwest informed investors that Dex's revenue for 2000 increased by almost $100 million. It wrote that the increase was due in part to "an increase in the number of directories published." At the same time, it failed to inform investors that Dex generated nearly one-third of that amount by publishing the Colorado Springs directory twice in 2000. It also did not inform investors that the schedule change would produce a corresponding decline in Dex revenue for the first quarter of 2001.
For 2001 Qwest senior management established revenue and EBITDA targets for Dex that were higher than what Dex management believed was possible to achieve. In fact, the EBITDA target was allegedly $80-100 million greater than the amount Dex management believed was achievable. The SEC found that Dex management complained to Qwest's senior management about the unrealistic targets. Yet Qwest's senior management not only allegedly refused to change the targets but also did not allow Dex a reduction in the targets to compensate for the revenue from the Colorado Springs directory that was recognized in 2000. In March 2001 Dex management met with some of Qwest's senior management to discuss "gap-closing" ideas for the first two quarters of 2001 in an attempt to achieve its 2001 financial targets. One idea was to advance the publication dates of several directories, thus allowing Dex to recognize revenue in earlier quarters; another idea was to lengthen the lives of other directories from 12 to 13 months, thereby allowing Dex to bill each advertiser for one additional month of advertising fees in 2001. Senior managers at Qwest allegedly instructed the Dex managers to implement the changes, as well as other changes to allow it to meet its third- and fourth-quarter financial targets. During 2001 Dex advanced the publication dates or extended the lives of 34 directories. Those schedule changes produced $42 million in additional revenue and $41 million in additional EBITDA. Qwest's Form 10-Qs for the first three quarters of 2001 stated that period-over-period improvements in Dex's revenue were due in part to changes in the "mix" and/or the "lengths" of directories published. Like the 2000 Form 10-K, these reports did not include any information about the directory schedule changes or the reasons for those changes.
1. Consider the principles, assumptions, and constraints of Generally Accepted Accounting Principles (GAAP). Define the revenue recognition principle and explain why it is important to users of financial statements.
2. Describe specifically why the revenue recognition practices of Dex were not appropriate under GAAP.
3. Consult Paragraph A5 (in Appendix A) of PCAOB Auditing Standard No. 5 and Paragraph 68 of PCAOB Auditing Standard No. 12. Do you believe that Qwest had established an effective system of internal control over financial reporting related to the revenue recorded by Dex in its financial statements? Why or why not?
4. Consult Paragraph 25 of PCAOB Auditing Standard No. 5. Next consider the impact of the pressure exerted by Qwest's senior management team to meet aggressive revenue and earnings targets. Comment about why such a "tone at the top" would have a pervasive effect on the reliability of financial reporting at a company like Qwest.
5. Consider the role of an upper manager at Dex. Do you believe that a "point of publication" method of accounting is allowable under Generally Accepted Accounting Principles? Whether you do or not, please make an argument that supports the recognition of revenue related to the Colorado Springs directory in December 2000, as opposed to 2001. Consult Paragraphs 1-2 of Ethics Rule 102 (ET 102). Assuming that they were CPAs, do you believe that the actions of the upper managers at Dex were ethical? Why or why not?

WorldCom: The Expense Recognition Principle
Synopsis On June 25, 2002, WorldCom announced that it would be restating its financial statements for 2001 and the first quarter of 2002. Less than one month later, on July 21, 2002, WorldCom announced that it had filed for bankruptcy. It was later revealed that WorldCom had likely engaged in improper accounting that took two major forms: the overstatement of revenue by at least $958 million and the understatement of line costs, its largest category of expenses, by over $7 billion. Several executives pled guilty to charges of fraud and were sentenced to prison terms, including CFO Scott Sullivan (five years) and Controller David Myers (one year and one day). Convicted of fraud in 2005, CEO Bernie Ebbers was the first to receive his prison sentence: 25 years. Line Cost Expenses WorldCom generally maintained its own lines for local service in heavily populated urban areas. However, it relied on non-WorldCom networks to complete most residential and commercial calls outside of these urban areas and paid the owners of these networks to use their services. For example, a call from a WorldCom customer in Boston to Rome might start on a local (Boston) phone company's line, flow to WorldCom's own network, and then get passed to an Italian phone company to be completed. In this example, WorldCom would have to pay both the local Boston phone company and the Italian provider for the use of their services. The costs associated with carrying a voice call or data transmission from its starting point to its ending point were called line cost expenses.
Line cost expenses were WorldCom's largest single expense. They accounted for approximately half of the company's total expenses from 1999 to 2001. World- Com regularly discussed its line cost expenses in public disclosures, emphasizing, in particular, its line cost E/R ratio—the ratio of line cost expense to revenue.2 GAAP for Line Costs Under Generally Accepted Accounting Principles (GAAP), WorldCom was required to estimate its line costs each month and to expense the estimated cost immediately, even though many of these costs would be paid later. To reflect an estimate of amounts that had not yet been paid, WorldCom would set up a liability account, known as an accrual, on its balance sheet. As the bills arrived from its outside parties, sometimes many months later, WorldCom would pay them and reduce the previously established accruals accordingly.3 Because accruals are estimates, a company is required under GAAP to reevaluate them periodically to see if they have been stated at appropriate levels. If charges from service providers were lower than estimated, an accrual is "released." The amount of the release is set off against the reported line cost expenses in the period when the release occurred. For example, if an accrual of $500 million was established in the first quarter and $25 million of that amount was deemed excess or un- necessary in the second quarter, then $25 million should be released in that second quarter, thus reducing reported line cost expenses by $25 million.4 WorldCom's Line Cost Releases Beginning in the second quarter of 1999, management allegedly started ordering several releases of line cost accruals, often without any underlying analysis to sup- port the releases. When requests were met with resistance, management allegedly made the adjustments themselves. For example, in the second quarter of 2000, David Myers, a CPA who served as senior vice president and controller of World- Com, requested that UUNET (a largely autonomous WorldCom subsidiary at the time) release $50 million in line cost accruals. UUNET's acting CFO David Schneeman asked that Myers explain the reasoning for the requested release, but Myers insisted that Schneeman book the entry without an explanation. When Schneeman refused, Myers wrote to him in an e-mail, "I guess the only way I am going to get this booked is to fly to DC and book it myself. Book it right now, I can't wait another minute." After Schneeman refused again, Betty Vinson in general accounting allegedly completed Myers's request by making a "top-side" corporate- level adjusting journal entry releasing $50 million in UUNET accruals.5
In 2000, senior members of WorldCom's corporate finance organization allegedly directed a number of similar releases from accruals established for other reasons to offset domestic line cost expenses. For example, in the second quarter of 2000, Senior Vice President and Controller David Myers asked Charles Wasserott, director of Domestic Telco Accounting, to release $255 million in domestic line cost accruals to reduce domestic line cost expenses. Wasserott refused to release such a large amount. It later emerged that the entire $255 million used to reduce line cost expenses came instead from a release of a Mass Markets accrual related to WorldCom's Selling General & Administrative expenses.6 The largest release of accruals from other areas to reduce line cost expenses occurred after the close of the third quarter of 2000. During this time, a number of entries were made to release various accruals that reduced domestic line cost expenses by $828 million.7 In addition to allegations that WorldCom's management released line cost accruals without proper support for doing so and released accruals that had been established for other purposes, there were also allegations that management often did not release certain line costs in the period in which they were identified. Rather, certain line cost accruals were kept as "rainy-day" funds that could be released when management needed to improve reported results.
1. Consider the principles, assumptions, and constraints of Generally Accepted Accounting Principles (GAAP). Define the matching principle and explain why it is important to users of financial statements.
2. Based on the case information provided, describe specifically how World- Com violated the matching principle. In your description, please identify a journal entry that may have been used by WorldCom to commit the fraud.
3. Consult Paragraph A5 (in Appendix A) of PCAOB Auditing Standard No. 5. Do you believe that WorldCom had established an effective system of internal control over financial reporting related to the line cost expense recorded in its financial statements? Why or why not?
4. Consult Paragraphs 13-21 of PCAOB Auditing Standard No. 15. As an auditor at WorldCom, what type of evidence would you want to examine to determine whether the company was inappropriately releasing line costs? Please be specific.
5. Consult Paragraphs 1-2 of Ethics Rule 102 (ET 102). Next, consider the actions of David Schneeman and Charles Wasserott. Assuming that they were CPAs, do you believe that these employees should have recorded the journal entries as directed by Senior Vice President and Controller David Myers? Why or why not?