CREATIVE ACCOUNTING

CASE STUDY:WORLDCOM

VIKASH KUMAR

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Creative accounting refers to accounting practices that seem to follow the letter of the applicable
accounting standards but deviate from the spirit of those standards. It is the use of accounting methods to
hide aspects of a company's financial dealings in order to make the company appear more or less
successful than it is in reality. In other words, Creative accounting is the transformation of financial
accounting figures from what they actually are to what preparers desire by taking advantage of the
existing rules and/or ignoring some or all of them.

The motivation to indulge in these practices is anticipation of rewards which may include higher share
prices, improved credit rating resulting in lower borrowing costs, higher incentive compensation for
executive management etc. Some of the creative accounting schemes perpetrated by companies include
improper revenue and expense recognition, faulty accounting in connection with business combinations,
and wrongful use of off- balance-sheet arrangements. . Listed companies engage in creative accounting
practices include the usual smooth earnings, balance-sheet financing, abuse of mergers and acquisitions
accounting, any changes to accrual method of manipulating the consolidated financial statements, asset
replacement and so on. These fraudulent schemes can be devastating to users like shareholders, lenders,
employees, board of directors and other stakeholders.

The conflicts of interest among different interest groups represent the real causes of creative accounting.
The managers are interested in paying fewer taxes and dividends, the shareholders in gaining higher
dividends, the employees in obtaining better salary and higher profit share, the authorities in collecting
more taxes. It can be easily seen that the interests are tremendous divergent and creative accounting is
deepening it. But creative accounting puts one group or two to advantageous position at the expense of
others. Sometimes for investors taking a company’s financial statements at Face value can be ‘a recipe for
disaster’.

Reasons for creative accounting

1) Income smoothing. Companies generally prefer to report a steady trend of growth in profit rather than
to show volatile profits with a series of dramatic rises and falls. This is achieved by making unnecessarily
high provisions for liabilities and against asset values in good years so that these provisions can be
reduced, thereby improving reported profits, in bad years. It is argued that it is a measure against the
'short-termism' of judging an investment on the basis of the yields achieved in the immediate following
years. It also avoids raising expectations so high in good years that the company is unable to deliver. But,
if the trading conditions of a business are in fact volatile then investors have a right to know this and it
may conceal long-term changes in the profit trend.

2) A variant on income smoothing is to manipulate profit to tie in to forecasts. This perfectly respectable,
and highly conservative, accounting policy means that future earnings are easy to predict. E.g.
Accounting policies at Microsoft are designed, within the normal accounting rules, to match reported
earnings to profit forecasts. When Microsoft sell software a large part of the profit is deferred to future
years to cover potential upgrade and customer support costs. It allows them to match reported earnings to
profit forecasts.

3) Company directors may keep an income-boosting accounting policy change in hand to distract
attention from unwelcome news. E.g. A change in accounting method boosted K-Mart's quarterly profit
figure by some $160 million, by a happy coincidence distracting attention from the company slipping
back from being the largest retailer in the USA to the number two slot.
4) Creative accounting may help maintain or boost the share price both by reducing the apparent levels of
borrowing, so making the company appear subject to less risk, and by creating the appearance of a good
profit trend. This helps the company to raise capital from new share issues, offer their own shares in
takeover bids, and resist takeover by other companies.

5) If the directors engage in 'insider dealing' in their company's shares they can use creative accounting to
delay the release of information for the market, thereby enhancing their opportunity to benefit from inside
knowledge.

Scope of creative accounting

1) Flexibility in regulation. Generally the regulation, particularly the accounting regulation permits
flexibility in choosing a policy to follow; the International Accounting Standards let the financial
management to choose between valuation of the non-current assets at depreciated historical value or at
revaluated value. The management may decide the change of the policies, and these shifts are difficult to
be identified a few years later.

2) Certain entries in the accounts involve an unavoidable degree of estimation, judgment, and prediction.
In some cases, such as the estimation of an asset's useful life made in order to calculate depreciation,
these estimates are normally made inside the business and the creative accountant has the opportunity to
decide on the side of caution or optimism in making the estimate. Management can use their discretionary
position in order to obtain the financial position and stability they assumed; for example, the managers
decide the increase or reduce of the provisions for bad debts.

3) The timing of some transactions offers to the management the opportunity to increase the revenues,
when the operating profit is not satisfactory, and to create the desired impression in the accounts. The
existing stocks in company’s patrimony, that have a significant higher value compared to the historical
value, may be sold only when the operating profit is not satisfactory.

4) Artificial transactions can be entered into both to manipulate balance sheet amounts and to move
profits between accounting periods. This is achieved by entering into two or more related transactions
with an obliging third party, normally a bank. For example, supposing an arrangement is made to sell an
asset to a bank then lease that asset back for the rest of its useful life. The sale price under such a 'sale and
leaseback' can be pitched above or below the current value of the asset, because the difference can be
compensated for by increased or reduced rentals.

5) Reclassification and presentation of financials are relatively less analyzed in accounting literature.
However, in reality the companies often proceed to make up the amounts in order to obtain good level of
profitability, liquidity or leverage ratios. Most of the times, the numbers are smoothly modified in order to
improve the investors’ perception. ‘the idea behind this behavior is that humans may perceive a profit of,
say, 301 million as abnormally larger than a profit of 298 million’. Some minor massaging of figures does
take place in order to reach significant reference points.

6) Companies may increase their earnings by hiding the pension Liabilities, by capitalizing the expenses
instead of writing them off, by realizing a faster increase of The receivables or inventories versus sales,
by reaching negative cash flow, by consolidating the Affiliates’ incomes and net worth, and) by following
seemingly conservative practice in a situation of Reverse direction.
Accounting regulators who wish to curb creative accounting have to tackle
each of these approaches in a different way:
1) Scope for choice of accounting methods can be reduced by reducing the number of permitted
accounting methods or by specifying circumstances in which each method should be used. Requiring
consistency of use of methods also helps here, since a company choosing a method which produces the
desired picture in one year will then be forced to use the same method in future circumstances where the
result may be less favorable.

2) Abuse of judgment can be curbed in two ways. One is to draft rules that minimize the use of judgment.
In the UK Company accountants tended to use the 'extraordinary item' part of the profit and loss account
for items they wished to avoid including in operating profit. The UK Accounting Standards Board (ASH)
responded by effectively abolishing the category of 'extraordinary item'. Auditors also have a part to play
in identifying dishonest estimates. The other is to prescribe 'consistency' so that if a company chooses an
accounting policy that suits it in one year it must continue to apply it in subsequent years when it may not
suit so well.

3) Artificial transactions can be tackled by invoking the concept of 'substance over form', whereby the
economic substance rather than the legal form of transactions determines their accounting substance.
Thus linked transactions would be accounted for as one whole.

4) The timing of genuine transactions is clearly a matter for the discretion of management. However, the
scope to use this can be limited by requiring regular revaluations of items in the accounts so that gains or
losses on value changes are identified in the accounts each year as they occur, rather than only appearing
in total in the year that a disposal occurs.

Effects of creative accounting

1) It creates confusion among the stock exchange investors, because the figures shown by financial
statements are often inflated and the difficult to distinguish between the fair and unfair statements.

2) The prospectuses of the listed companies do not always offer a detailed picture the financial positions
and performance.

3)The techniques used by creative accounting can “impress the investors only over short time periods,
while the financial position goes worse, this cannot be hidden anymore and these methods are helpless.

4) The long time effect of such practice is the distrust of the investors conducted by the collapse of
companies that take advantage of these techniques.

WorldCom Case Study

Background

WorldCom was a large telecom company that enjoyed an almost meteoric rise during the 1990s but ran
into trouble in the early 200Os. 2001 was particularly difficult. At its peak in 1999 the
telecommunications giant, WorldCom, was valued at $180 billion. In 2002 the company was forced to
file for bankruptcy due to the discovery of an $11 billion accounting fraud.

The company was founded in 1983 as Long Distance Discount Services, Inc. (LDDS) in Hattiesburg,
Mississippi. In 1985 LDDS selected Bernard Ebbers to be its CEO. The company went public in 1989
through a merger with Advantage Companies Inc. The company name was changed to LDDS WorldCom
in 1995. The company’s growth was fueled primarily through acquisitions during the 1990s and reached
its apex with the acquisition of MCI. On November 10, 1997, WorldCom and MCI Communications
announced their US$37 billion merger to form MCI WorldCom, making it the largest merger in US
history. On September 15, 1998 the new company, MCI WorldCom, opened for business. The name was
subsequently changed to WorldCom. At its peak, WorldCom was the second largest long-distance
telephone company, and the largest mover of internet traffic in the United States. In no more than 15
years, WorldCom had evolved aggressively into one of the leading players of the telecommunications
industry. At its height, WorldCom employed over 80 000 people and Bernard Ebbers laid claim to a
personal fortune of just over $1.4 billion.

Introduction

The year 2001 was a tumultuous time in the telecom industry. The number of competitive local telephone
companies in operation dropped to 150 from 330 the previous year, and long distance carriers lost pricing
power and market share to the regional and local telephone companies. Many companies had entered the
market for Internet services in the late 199Os, and the resulting expansion in network capacity led to a
glut in the market.

Beginning at least in or about July 2000, WorldCom's expenses as a percentage of its total revenue began
to increase, resulting in a decline in the rate of growth of WorldCom's earnings .The decline in earnings
created a substantial risk that, unless WorldCom's performance improved, its earnings would fail to meet
analysts' expectations and the market price of WorldCom's securities would therefore decline. Thus, the
pressure was on to keep WorldCom stock from declining further. This intense pressure came not just from
external investors and analysts, but also from within WorldCom from the CEO himself, whose financial
well-being was precariously dependent on WorldCom's stock price. CEO Ebbers pledged his vast
holdings of WorldCom stock as collateral for loans to finance the purchase of his personal outside
business interests. If WorldCom's stock price fell substantially, the collateral would be of insufficient
value to secure his loans, thus forcing margin calls that he could not meet.
Another performance pressure came from the fact that WorldCom marketed itself as a high-growth
company, with revenue growth playing a significant role in WorldCom's early success. Analysts marveled
at WorldCom's ability to outgrow an industry that was, itself, outgrowing the overall economy. Ebbers
repeatedly heralded the Company's impressive record on revenue growth during his quarterly conference
calls with analysts. He believed that continuing revenue growth was crucial to increasing WorldCom's
stock market value so the stock could be used as currency for corporate expansion through acquisitions.
In addition, top executive compensation and bonuses were dependent on achieving a double-digit rate of
revenue growth. Corporate performance just had to meet expectations. Miraculously, even as market
conditions throughout the telecommunications industry deteriorated, WorldCom continued to post
impressive revenue growth numbers.

The Growth through Acquisition

WorldCom achieved its position as a significant player in the telecommunications industry through the
successful completion of 65 acquisitions. WorldCom spent almost $60 billion in the acquisition of these
companies and accumulated $41 billion in debt. Two of these acquisitions were particularly significant.
The MFS Communications acquisition enabled WorldCom to obtain UUNet, a major supplier of Internet
services to business, and MCI Communications gave WorldCom one of the largest providers of business
and consumer telephone service. By 1997, WorldCom's stock had risen from pennies per share to over
$60 a share.

WorldCom used a liberal interpretation of accounting rules when preparing financial statements. In an
effort to make it appear that profits were increasing, WorldCom would write down in one quarter millions
of dollars in assets it acquired while, at the same time, it "included in this charge against earnings the cost
of company expenses expected in the future. The result was bigger losses in the current quarter but
smaller ones in future quarters, so that its profit picture would seem to be improving. The acquisition of
MCI gave WorldCom another accounting opportunity. While reducing the book value of some MCI
assets by several billion dollars, the company increased the value of "good will," that is, intangible assets-
a brand name, for example-by the same amount. This enabled WorldCom each year to charge a smaller
amount against earnings by spreading these large expenses over decades rather than years. The net result
was WorldCom's ability to cut annual expenses, acknowledge all MCI revenue and boost profits from the
acquisition.

Accounts receivable
WorldCom managers also tweaked their assumptions about accounts receivables, the amount of money
customers owe the company. For a considerable time period, management chose to ignore credit
department lists of customers who had not paid their bills and were unlikely to do so. In this area,
managerial assumptions play two important roles in receivables accounting. In the first place, they
contribute to the amount of funds reserved to cover bad debts. The lower the assumption of
noncollectable bills, the smaller the reserve fund required. The result is higher earnings. Secondly, if a
company sells receivables to a third party, which WorldCom did, then the assumptions contributes to the
amount or receivables available for sale.

So long as there were acquisition targets available, the merry-go-round kept turning, and WorldCom
could continue these practices. The stock price was high, and accounting practices allowed the company
to maximize the financial advantages of the acquisitions while minimizing the negative aspects. In 2000,
the government refused to allow WorldCom's acquisition of Sprint. The denial stopped the carousel, put
an end to WorldCom's acquisition-without-consolidation strategy and left management a stark choice
between focusing on creating value from the previous acquisitions with the possible loss of share value or
trying to find other creative ways to sustain and increase the share price.

Line cost Accruals (The key aspect)

Line costs are the costs of carrying a voice or data transmission through any portion of its path from its
origin to its destination. Since WorldCom's own network could not directly connect all potential phones
and electronic devices in the world, WorldCom paid outside service providers to carry some portion of its
calls. Managing line costs was tremendously important to WorldCom's profitability since they represented
approximately half of the Company's total expenses. As a result, WorldCom's management and outside
analysts paid significant attention to line cost ratios and trends. WorldCom regularly discussed its line
costs in its public disclosures. WorldCom's key measure of line cost management-both internally and
externally-was the ratio of line cost expense to revenue, called the "line cost E/R ratio." An increase in the
line cost E/R ratio indicates deteriorating performance: either under-usage of leased capacity or
overpayment for leased capacity.

At the end of each month, WorldCom estimated the costs associated with using "off-net" facilities and
connections. While some of the related bills may not have been received or paid for several months,
WorldCom prepared an adjusting journal entry each month to recognize immediately the estimated cost
as a period expense for financial reporting purposes. Until WorldCom paid the bills, the accrued amounts
would remain in a liability account on its balance sheet. As bills arrived from the outside parties,
sometimes many months later, WorldCom would pay them and reduce the previously established liability
accordingly.
Since these accruals were based on estimates and Line cost accrual estimates are very difficult to make
with precision, especially for international service, they required later adjustment. WorldCom routinely
adjusted its accruals as it learned more about applicable charges it would expect.

If an accrual was decreased (or released) because charges from service providers were lower than
estimated, then the amount of the release was set off against reported line costs in the period when the
release occurred. Thus, if an accrual of $100 million was established in the first quarter and $8 million of
that amount was deemed excess, or was no longer needed, in the second quarter, then $8 million would be
released in that second quarter, thereby reducing reported line costs by $8 million for that quarter.

Given the significance of line costs to WorldCom's bottom line and Ebbers' public promise to manage
those costs, WorldCom managers were regularly pressed to find ways to reduce line cost expenses.

Capitalization of Line Costs

The sluggish revenue growth and excess "off-net" capacity pushed WorldCom's actual line cost E/R ratio
up in late 2000 and early 2001.About this time, the Company was considering capitalizing excess
capacity costs that were not generating revenue.

At a line cost meeting company management learned that the line cost E/R ratio had continued to increase
despite their exhortations. Employees in the Domestic Telco Accounting group considered the task of
reducing the line cost E/R ratio to publicly reported levels in 2000 to be impossible, because 2000 results
had been accomplished by releasing accruals that the group no longer had available. The Domestic Telco
Accounting group calculated that, in order to reach 41 percent line cost E/R ratio target, domestic line
costs would have to be reduced by $1.5 billion and domestic Internet line costs by $700 million annually.
Current and former employees assigned to create this plan told us that they viewed it as pure fantasy.

Company agreed to capitalize excess line capacity costs and bring reported line cost E/R to 42 percent.
Management felt it was important for the Company to "have the ability to enter the market quickly, and
offer the best network to our customers with very little provisioning time". As a result, WorldCom
significantly increased its capital investment based upon the common belief at the time that the Internet
and data demand would continue at the 8 times annual growth factor the industry was experiencing. It
was this growth that supported the Company's goal of maintaining a strong double-digit growth rate while
expanding margins from using its own facilities

Additionally, the Company also entered into various network leases to complement the service offerings
for data, Internet, and local service. The lease commitments were entered into to obtain access to large
amounts of capacity under the theory that revenue would follow and fully absorb these costs. The
commitments were entered into with the knowledge that they would incur an expense prematurely and the
revenues would be earned subsequent to that date. The Company was willing to absorb this cost prior to
recognizing the revenue stream because it believed that the future revenues would be matched up with
these costs. These commitments were entered into as the result of customers for which services would be
rendered and the lease commitments were entered into to expedite the customer provisioning and as per
accounting standards direct and indirect costs associated with obtaining a customer may be deferred and
amortized over the revenue stream associated with that contract.

Subsequent to the asset being put into service, the Company continued to incur costs associated with
network lease commitments as noted above. The portion of these commitments that were not being
utilized was deferred until the related benefit (i.e., revenues) was generated. 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 were considered to be an appropriate inventory of this capacity and
would ultimately be fully amortized prior to the termination of the contractual commitment.

The classification of these costs as an asset does not contradict the definition of an asset "Assets are
probable future economic benefits obtained or controlled by a particular entity as a result of past
transactions or events." Thus, WorldCom began to capitalize "line costs" as prepaid capacity.

At all times, management understood that an expense or loss would be recognized upon evidence that
previously recognized future economic benefits of an asset would not ultimately be realized.

Revenue Accounting's "Close the Gap" Exercise

Senior WorldCom management was intensely focused on achieving double-digit revenue growth in
quarter-ending months. It was done with the adjustments (in millions or tens of millions of dollars) being
booked to the Corporate Unallocated revenue account, separate from revenues recorded in the operating
activities of WorldCom's sales channels.

WorldCom's business Operations and Revenue Accounting groups tracked the shortfall between projected
and budgeted revenue in an exercise called "Close the Gap."

The Company in its earnings release or in any other public filings did not mention that WorldCom was
using nonrecurring revenue items.

On October 22, 1999, WorldCom had signed a substantial exchange-of-services contract with Electronic
Data Systems Corporation ("EDS"), which in part bound EDS to outsource its network and
communication services to WorldCom over an eleven-year period, the usage of which was valued to
WorldCom at approximately $6 billion. This contract proved to be the source for several close the Gap
opportunities. Under the terms of the contract, EDS agreed to minimum commitments for such
outsourcing services, including an agreement on penalty payments if EDS failed to meet these required
minimums on an annual basis, or cumulatively measured at the end of five-year, eight-year, and eleven-
year periods.

In the second quarter of 2001, as Business Operations employees searched for revenue opportunities to
close the gap, they began to focus on the EDS Ratable Accrual. By mid-June 2001, internal forecasts
were showing that EDS would again [for the second year in a row] fall short of its annual Take or Pay
commitment. Under the terms of the contract, if EDS continued on this trend over the next several years,
Business Operations was forecasting that it was likely EDS would miss the five-year minimum
commitment, and would therefore be required to refund the $100 million prepayment starting in 2005.

WorldCom started recognizing revenue for the payments EDS might be obligated to make starting in
2005.The EDS Ratable Accrual was recorded as revenue in the third quarter of 2001. The Revenue
Accounting group recorded a $35 million EDS Ratable Accrual item to the Corporate Unallocated
revenue account for September 2001. WorldCom continued to record EDS Ratable Accrual revenue, at a
rate of $5 million per quarter, in the fourth quarter of 2001 and the first quarter of 2002.

Consequences

In July 2002, WorldCom filed for bankruptcy protection after several disclosures regarding accounting
Irregularities. Among them was the admission of improperly accounting for operating expenses as capital
expenses in violation of generally accepted accounting practices (GAAP). WorldCom has admitted to a
$9 billion adjustment for the period from 1999 through the first quarter of 2002.Shortly after WorldCom’s
announcement the SEC filed a civil lawsuit against the company, charging it with fraud. The company
was forced to sell off most of its peripheral business units and cut 17 000 jobs. In 2003 WorldCom was
forced to pay a $500 million penalty to the SEC. After the scandal WorldCom changed its name to MCI
Telecommunications Corporation.

ANALYSIS

The fraud was accomplished primarily in following ways:

1. Underreporting ‘line costs’ (interconnection expenses with other telecommunication companies) by
capitalizing these costs on the balance sheet rather than properly expensing them. In order to improve the
appearance of the company’s financial situation, company recorded expenses as capital investments.
Operating expenses are immediately deducted from revenue, whilst capital investments are subject to
depreciation over a number of years. This incorrect spreading of operating costs resulted in the
overstatement of WorldCom’s profits.

2. Inflating revenues with bogus accounting entries from "corporate unallocated revenue accounts"

3. WorldCom allegedly inflated the value of its reserves so as to create a hefty ‘slush fund’ that could be
used to boost profits. The manipulation of reserves resulted in a profit irregularity of roughly $3.3 billion.

4. Abuse of mergers and acquisitions accounting: WorldCom used to reduce the book value of acquiring
company assets, thus allowing the company to increase the value of "good will," that is, intangible assets-
a brand name, for example-by the same amount. This enabled WorldCom each year to charge a smaller
amount against earnings by spreading these large expenses over decades rather than years.

5. Company used its judgment to keep a small reserve fund for bad debts. Thus, resulting in higher
earnings.

Reasons

1. The stock price was dependent upon the earnings of company and the company management wanted to
stop stock prices from declining. Thus they involved in practices which will help them to inflate earnings.

2. CEO financial well-being was precariously dependent on WorldCom's stock price. CEO Ebbers
pledged his vast holdings of WorldCom stock as collateral for loans to finance the purchase of his
personal outside business interests. If WorldCom's stock price fell substantially, the collateral would be of
insufficient value to secure his loans, thus forcing margin calls that he could not meet. So, he was
pressurized to report high earnings and maintain stock prices.

3. Management fully believed that the projected revenue increases would more than offset the future lease
commitments and deferred costs.