Acct 2210 Zeigler: ATC 8-7 - Capitalizing vs. Expensing Issues (pg 471)
Note: This scenario is very similar to the approach taken by WorldCom during the late 1990’s and early 2000’s. Fraudulent reporting was deemed to have taken place and the WorldCom CEO, Bernie Ebbers, is still in prison. See our class website for the discussion link about this fraud and Mr. Ebbers “history”.
a. As stated in the problem, operating expenses reduce the amount of net income on the Income Statement. Mr. Blowhard’s scheme takes “line costs”, which should be operating expenses, and classifies them as capital assets. As such, lower expenses are recognized and increases the amount of net income reported (i.e. overstated Net Income). Also, because of the capitalization of the line costs, the company’s balance sheet will show more assets than appropriate (i.e. overstated assets). The “best” of both worlds here!
b. The accountant violated Article I, “Responsibilities” (see pg 85).
He did not exercise sensitive professional and moral judgment by implementing his scheme. He certainly violated Article II, The Public Interest, because the purpose of his scheme was to inflate earnings and thus mislead shareholders, creditors, and the general public. He also violated Article III, Integrity, and Article V, Due Care, because he did not act with integrity or observe the profession’s technical or ethical standards.
c. The three elements identified in the fraud triangle (pg 86-88) are:
(1) the availability of an opportunity,
(2) the existence of some form of pressure leading to an incentive and (3) the capacity to rationalize.
Mr. Blowhard’s opportunity was that he was the owner of the company and could instruct the accountant to capitalize rather than expense the line cost.
Mr. Blowhard’s pressure was that he wanted to sell the company and retire wealthy, and he needed his company’s net income to keep increasing rapidly.
He also had a capacity to rationalize, probably believing that because he had provided the leadership that saw his company go from a small communications company to a larger, expanding entity, he deserved to retire a wealthy man.