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.