WorldCom: The Revenue 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 it had filed for bankruptcy. It was later revealed that WorldCom had engaged in improper accounting that took two major forms: overstatement of revenue by at least $958 million and 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.

Hit the Numbers

Even as conditions in the telecommunications industry deteriorated in 2000 and 2001, WorldCom continued to post impressive revenue numbers. In April 2000 CEO Ebbers told analysts that he remain[ed] comfortable with 13.5 to 15.5 percent revenue growth in 2000. In February 2001 Ebbers again expressed confidence that WorldCom Group could repeat that performance: On the WorldCom side of the business, we are sticking with our 12 percent to 15 percent revenue growth guidance for 2001. Let me restate that. On the WorldCom side of the business, we are sticking with our 12 percent to 15 percent revenue growth guidance for 2001.

Monitoring of Revenue at WorldCom

According to several accounts, revenue growth was emphasized within WorldCom; in fact, no single measure of performance received greater scrutiny. On a regular basis, the sales groups performances were measured against the revenue plan. At meetings held every two to three months, each sales channel manager was required to present and defend his or her sales channels performance against the budgeted performance.

Compensation and bonus packages for several members of senior management were also tied to double-digit revenue growth. In 2000 and 2001, for instance, three executives were eligible to receive an executive bonus only if the company achieved double-digit revenue growth over the first six months of each year.

Monthly Revenue Report and the Corporate Unallocated Schedule

The principal tool by which revenue performance was measured and monitored at WorldCom was the monthly revenue report (MonRev), prepared and distributed by the revenue reporting and accounting group (hereafter referred to as the revenue accounting group). The MonRev included dozens of spreadsheets detailing revenue data from all of the companys channels and segments. However, the full MonRev also contained the Corporate Unallocated schedule, an attachment detailing adjustments made at the corporate level and generally not derived from the operating activities of WorldComs sales channels. WorldComs Chief Financial Officer and Treasurer Scott Sullivan had ultimate responsibility for the items booked on the Corporate Unallocated schedule.

In addition to CEO Ebbers and CFO Sullivan, only a handful of employees outside the revenue accounting group regularly received the full MonRev. Most managers at WorldCom received only the portions of the MonRev that were deemed relevant to their positions. Sullivan routinely reviewed the distribution list for the full MonRev to make sure he approved of everyone on the list.

The total amounts reported in the Corporate Unallocated schedule usually spiked during quarter-ending months, with the largest spikes occurring in those quarters when operational revenue lagged farthest behind quarterly revenue targets the second and third quarters of 2000 and the second, third, and fourth quarters of 2001. Without the revenue that was recorded in the Corporate Unallocated account, WorldCom would have failed to achieve the double-digit growth it reported in 6 out of 12 quarters between 1999 and 2001.

Process of Closing and Consolidating Revenues

WorldCom maintained a fairly automated process for closing and consolidating operational revenue numbers. By the 10^th day after the end of the month, the revenue accounting group prepared a draft preliminary MonRev that was followed by a final MonRev, which took into account any adjustments that needed to be made. In non-quarter-ending months, the final MonRev was usually similar, if not identical, to the preliminary MonRev.

In quarter-ending months, however, top-side adjusting journal entries, often very large, were allegedly made during the quarterly closing process in order to hit revenue growth targets. Investigators later found notes made by senior executives in 1999 and 2000 that calculated the difference between act[ual] or MonRev results and target or need[ed] numbers, and identified the entries that were necessary to make up that difference. CFO Scott Sullivan directed this process, which was allegedly implemented by Ron Lomenzo, the senior vice president of financial operations, and Lisa Taranto, an employee who reported to Lomenzo.

Throughout much of 2001, WorldComs revenue accounting group tracked the gap between projected and targeted revenue an exercise labeled close the gap and kept a running tally of accounting opportunities that could be exploited to help make up that difference.

Many questionable revenue entries were later found within the Corporate Unallocated revenue account. On June 19, 2001, as the second quarter of 2001 was coming to a close, CFO Sullivan left a voicemail message for CEO Ebbers that indicated his concern over the companys growing use of nonrecurring items to increase revenues reported:

Hey Bernie, Its Scott. This MonRev just keeps getting worse and worse. The copy, um the latest copy that you and I have already has accounting fluff in it all one time stuff or junk thats already in the numbers. With the numbers being, you know, off as far as they are, I didnt think that this stuff was already in there. We are going to dig ourselves into a huge hole because year to date its disguising what is going on the recurring, uh, service side of the business.

A few weeks later, Ebbers sent a memorandum to WorldComs COO Ron Beaumont that directed him to see where we stand on those onetime events that had to happen in order for us to have a chance to make our numbers. Yet Ebbers did not give any indication of the impact of nonrecurring items on revenues in his public comments to the market in that quarter or in other quarters. For that matter, the company did not address the impact of nonrecurring items on revenues in its earnings release or public filing for either that quarter or prior quarters.

Case Question

Consult Paragraph 25 of PCAOB Auditing Standard No. 5. Define what is meant by control environment. Next, explain why the control environment is so important to effective internal control over financial reporting at a company like WorldCom.