Throughout the entirety of 2001 and the first fiscal quarter of 2002, over three billion dollars of recorded expenses were logged under “prepaid capacity.” This seemingly innocent piece of accounting jargon has turned into the centerpiece of a massive fraud surrounding former telecommunications giant Worldcom.
Before this record breaking sham is delved into, some overall accounting terms and norms must first be defined. Capital expenses are expenses logged for the purchase and maintenance of capital assets, commonly defined as tangible assets(such as trucks and machines) that allow the company to expand and further monetize. Capital assets are limitedly tax deductible and can be spread out as costs through a wide period of time. Generally, accountants and other financial officers accept capital assets as being objects intended to last more than a year.
Capital expenses are contrasted with operating costs, which are costs incurred from operating the business, and do not have potential for return. Examples include insurance, pensions, payroll, and utilities. Although also tax-deductible in some cases, operating costs can not be logged on the balance sheet as sustained through an extended period of time.
Under the pretense of “capital assets” are billions of dollars worth of operating costs hidden from the balance sheet for Worldcom throughout the entirety of 2001 to the beginning to 2002. Prepaid Capacity is the label for which such a massive operating cost occurred. It is estimated that without “prepaid capacity” entries on the balance sheet, 2002 Q1 earnings would be nearly a $400 million loss rather than the reported approximately $100 million gain.
An internal auditing report’s finding concluded that multiple entities, including managers, directors, accounting associates, and others all entered balance sheet entries under the label “prepaid capacity.” Further inquiry revealed that neither the employees logging the assets, nor the accounting firms, nor the managers directing the accounting, nor the Generally Accepted Accounting Principles understood or were able to provide an adequate definition for what the term meant.
After a continuation of the auditing process, the only definition of the previously unheard term provided, was that of Chief Financial Officer, Scott Sullivan. He additionally requested that the auditing be postponed.
Sullivan stated that prepaid capacity entries were referring to Synchronous Optical Networking Lines and Rings, from which costs were still generating from but profits and usage were largely ceased. The lines were allegedly being capitalized and restructured to compensate for the lack of earnings. Operating costs, in all cases, can not be alternatively logged as capital expenses, although such would be ideal from the standpoint of business as taxes can be deferred. The Generally Accepted Accounting Principles did not permit such a maneuver and no support for the existence of such restructuring actions were provided.
The result of the scandal being uncovered was relatively minimal from the stock market viewpoint, but catastrophic for both the business and its entire sector. Worldcom had already lost over 90% of its market value prior to the incident. However, this scandal, the proportions of which have seldom been witnessed prior, fundamentally changed widely accepted norms across multiple industries and practices. Understandably, this last victim of the DotCom bubble finally filed for bankruptcy under $30 billion worth of debt. This was the largest bankruptcy ever recorded at that time, a record that remains untouched today.