Worldcom: The Matching Principle

WorldCom: The Matching Principle

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 information.

The matching principle requires a company to match expenses with related revenues in order to report a company's profitability during a specified time interval. The matching principle related to WorldCom in terms of revenue recognition, recording of expenses, taxes, investor relations, and managerial decisions.

2. Based on the case information provided, describe specifically how WorldCom violated the matching principle.

WorldCom violated the matching principle beginning in the second quarter of 1999, when management allegedly started ordering several releases of line cost accruals, often without any underlying analysis to support the releases. Therefore, they were not matching the releases with any actual expense reduction. In essence, the accrual accounts were being falsely reduced.

Under GAAP, WorldCom was required to estimate the line costs each month and immediately expense them, even though some of these would be paid later. In order to estimate the costs, a liability account called accrual was set up by WorldCom. As the bills arrived, the company would pay the bills and reduce the amount of the accrual by the same amount. However, because accruals are estimates, WorldCom was required by GAAP to routinely evaluate the accounts to ensure they were valued correctly. If actual charges were lower than the estimate, then the accrual is released. The line cost expense is reduced by the release in the period that the lease occurred.

The information discussed above is what should have happened. However, through WorldCom violating the matching principle through fraudulent accrual releases, the company inflated their profits by over $3.8 billion in the span of five quarters. (Time Magazine) Close to the third quarter in 2000, a number of entries were made to release various accruals that reduced domestic line cost expenses by $828 million. Because they were releasing large amounts of the accrual accounts, they were not matching their expenses with their revenues. The expenses were basically being capitalized by the company spreading them out over several years, thus inflating their cash flow and profits.

There were several employees that questioned WorldCom management about the releases and refused to make the adjustments when no explanation was provided. However, other employees went ahead and made the adjustments, thus allowing the fraudulent activity to continue. At the end of the scheme, WorldCom had overstated revenues by at least $958 million and understated line costs expenses by over $7 billion.

3. Consult Paragraph 2 and 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?

According to paragraph 2 of PCAOB Auditing Stnadard No. 5, effective internal control over financial reporting provides reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes. If one or more material weaknesses exist, the company's internal control over financial reporting cannot be considered effective. Based on the standard, it appears that WorldCom did not have effective internal control over financial reporting. There were clearly several accruals that were released, which means that there was more than one material weakness. In addition, paragraph A5 of Appendix A says that internal control over financial reporting is a process designed to provide reasonable assurance for the reliability of financial statements in accordance with GAAP. This process was supposed to be designed by the company's principal