Q1) A learning objective for this chapter is to distinguish between capital expenditures and revenue expenditures (a revenue expenditure is an operating expense). A capital expenditure is charged to an asset account rather than to an expense account. The largest instance of fraudulent financial reporting in U.S. history was largely due to improper capitalization of operating expenditures. WorldCom Inc. (WorldCom) from as early as 1999 through the first quarter of 2002 overstated its reported income by approximately $11 billion, including approximately $7 billion of ordinary operating expenses that were improperly capitalized. The revelation of the fraud led to WorldComs filing for protection from its creditors under the provisions of the U.S. Bankruptcy Code. Although the fraud at Enron had prompted congressional interest in auditing, financial reporting, and corporate governance, by the spring of 2002 congressional efforts to draft a law in response to the Enron fraud had stalled due to disagreements between the two houses of Congress. The fraud at WorldCom broke this congressional logjam and resulted in the passage of the Sarbanes-Oxley Act less than two months after the revelation of the WorldCom fraud. Almost immediately after the revelation of the WorldCom fraudin June 2002the Securities and Exchange Commission (SEC) brought an enforcement action against WorldCom. WorldCom is a major global telecommunications provider, providing services in more than 65 countries. At the time of the fraud, WorldCom was traded on NASDAQ. As the economy began to cool in 1999, demand for WorldComs telecommunications services was reduced, leading to a decline in profits. The slowing economy made it difficult for WorldCom to continue to meet the expectations of Wall Street analysts for reported profitability. WorldComs senior management directed subordinates to take steps to hide the deterioration in WorldComs profitability from analysts and other external parties. A primary means of carrying out the fraud was to transfer ordinary operating expenses, line costs, to a capital asset account, fixed assets. This accounting treatment resulted in the understatement of operating expenses and an increase in income.

Day and Date: Wednesday January 27, 2021 Time: 8:15 am - 10:45 am

2 The fraud at WorldCom has numerous ethical and corporate governance implications. Although the fraud at WorldCom was directed by top management, much of the implementation was carried out by midlevel finance and accounting personnel. WorldCom did not have a code of ethics. Attempts to develop such a code were met by the CEOs description of a code of ethics as a colossal waste of time. The Sarbanes Oxley Act and related SEC interpretations require public companies to disclose whether they have a code of ethics that applies to the CEO, CFO, and chief accounting officer and, if not, why not. Moreover, the NYSE and NASDAQ now require companies listed on these exchanges to have a code of ethics. Although these requirements are a step in the right direction, they will fail to have their intended effect if senior management doesnt fully embrace the written code. (5 Marks) Instructions (a) Who are the stakeholders in this situation? (b) Is the overstatement of income unethical? How this step has affected investors? (c) What is the main reason that Congress passed Sarbanes-Oxley Act? (d) Why NYSE and NASDAQ require companies to have a code of ethics?