Assume that WorldCom paid $7,000 million rental fees to other phone companies in

Question

Assume that WorldCom paid $7,000 million rental fees to other phone companies in cash at the beginning of Year 1. Instead of correctly debiting the Rental Expense account (i.e. as a revenue expenditure), WorldCom debited $7,000 million to the "Equipment" account (i.e. as a capital expenditure). And, assume that WorldCom depreciated its long-lived assets such as equipment using the straight-line method over 10 years without salvage value. Explain (using numbers in millions) how would this recording "delay expense recognition to future periods and thus boost net income for Year 1". (Ignore tax as tax rules are different from financial accounting rules.) And, Besides net income in the income statement, total assets in the balance sheet would also be wrong. Indicate how would total assets at the end of Year 1 be wrong ("overstated" or "understated") and by how much (in millions of dollars). (Hint: Writing out the related entries for "acquisition" and "depreciation" might help.)

Explanation / Answer

Correct treatment Debit the rental expense          7,000 This will have reduced the net income by 7000. This will not be shown in balance sheet Incorrect treatment Debit the equipment          7,000 SLM depreciation           (700) Net in Fixed asset          6,300 This takes only 700 in profit and loss account as year 1 expense. Further asset side is inflated by 6300 As we can see the expense in year 1 is recognized as 700 instead of 7000. Net income is increased by 6300 due to this Due to this error, Fixed asset section is overstated by 6300

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