MISLEADING. There seems to be some degree of confusion, even within the financially literate sector, as to just what happened at Worldcom. What is certain is that over the last couple of years, a reclassification of a substantial part of its normal repairs and maintenance expenses into deferred expenditure (capitalized assets) boosted its earnings results, thereby misleading investors and outside parties into thinking the company was more profitable than it really was.
However, certain reports also claim that Worldcom boosted its “cash flow” position by the same tactics that it used to obscure its earnings results. Could this be the case?
Imagine the case of a small business. Our neighborhood convenience store spends P10,000 in one month—P5,000 to purchase a dough mixer, and P5,000 to pay for its telephone and electricity bills used for the period. The accountant preparing our store’s books would record P5,000 of utilities as an expense for that month, and the other P5,000 as an asset to be amortized over time. Clearly the store had enjoyed the benefit of the utilities already, while it still had to fully benefit from buying the dough mixer, hence, the difference in treatment.
The matching concept (of costs and revenues) that we know from our basic accounting days makes the distinction between both unequivocally clear, and there should be no argument about what belongs to which period. There are instances, however, where the difference may not be so clear.
Let us say that instead of buying a dough mixer, the P5,000 was used to pay for painting the storefront? Is P5,000 then still an expenditure for future periods, or does it become an expense for the month? The answer is not so straightforward. If the painting job is a recurring item, that is, it is done periodically because of normal wear and tear of the store’s façade, the cost should be expensed as incurred. However, if the painting is part of the establishment of the building, or it is deemed to be a significant improvement on the building that would prolong its useful life, then the cost may possibly be capitalized.
MAKING A CHOICE. Worldcom came face-to-face with such a choice regarding its normal repairs and maintenance expenses, and apparently, instead of declaring them as costs when they were made, the company chose to capitalize them as assets, so they would hit the profit and loss account in the future. Though not too terribly clever or sophisticated, it seemed to fool many people up until recently.
But think about it for a second. Whether our store spent P5,000 on a dough mixer or painting the storefront has no impact on how much remains in our owner’s bank account. At the end of the day, the same amount of money is not in his account.
Say our owner had P100,000 last month. This month, he spent P10,000 on the business, and so has P90,000 left. His cash flow for the month must be P10,000, which is the difference between the cash he had in the beginning of the period, and the cash he still had at the end of it. Does it matter that P5,000 was spent to buy a dough mixer or to paint the storefront? And assuming he did the latter, does it make a difference if he classified the painting cost as an asset or an expense for the period? Of course not! Either way, his cash flow is still P10,000.
Coming back to Worldcom, the only thing the company did was to call a few billion dollars of repairs and maintenance costs assets instead of expenses, a situation very similar to that of our storeowner. Why then do many say that Worldcom enhanced its cash flow through accounting manipulation? (More next week).
Published in the Sun Star Daily, Saturday, July 20, 2002 (http://www.sunstar.com.ph/static/ceb/2002/07/20/bus/batuhan.cash.flow.html).