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a)
i) SCON 6 defines ‘assets’ as those economic resources which are acquired by an entity through events or transactions done in the past. These resources certainly have future economic benefits and are under the control of the entity which uses them.
SCON 6 defines ‘expenses’ as cash outflows which are incurred due to the operating activities of an entity. These activities are the day-to- day operations which run an enterprise. Expenses are incurred when assets are used up or when liabilities are generated.
ii) Costs should be expensed when they do not have future economic benefits. These only generate economic benefits in the period which they are incurred. On the other hand, costs which have the ability to generate benefits and cash inflows for more than a year should be capitalized as assets.
b) Costs are termed as assets when they are capitalized. After initial capitalization, these costs are amortized over several periods within which they are expected to generate returns.
When costs are capitalized, the balance sheet shows an increase in total assets with a corresponding increase in depreciation charge. The income statement shows an increase in net profit and a decrease in depreciation expense thus, leading to an increase in tax payments. It also results into an increase in net profit distributed to shareholders thereby, increasing the profitability ratios and earnings per share.
f)
g)
Had WorldCom, Inc. not improperly capitalized line costs amounting to $3055 million in 2001, the company would have incurred a net loss of $449 million as shown above. The difference in net income due to capitalization of costs is highly material since it shows that the company was desperate to hide its losses from its stakeholders.
h) WorldCom Inc. engaged itself into fraudulently capitalizing line costs as it was incurring massive losses in 2001. It wanted to show a healthier and profitable pattern in its net earnings. Capitalizing costs also deceived the investors into believing that the company had substantial assets and had a healthy solvency position. Doing so also impacted the liquidity, activity and investment ratios in a better way. The company’s management also feared a fall in the share price of WorldCom’s shares if they had revealed the losses being incurred.
j) When a publicly traded company’s shares are revealed as fraudulent, an immediate negative effect can be seen on the global share market. Investors incur massive losses due to the revelation of fraud and several workers have to lose their jobs. Other companies belonging to the same industry are also directly affected as investors lose confidence. Several investigations and lawsuits ensue against the company committing the fraud. The economy and share market come to a standstill as creditors, customers, employees, shareholders and other stakeholders get directly affected by the density of the fraud.
