This is the final article in a series of eight examining different forms of accounting manipulation. Previous articles included pieces on channel stuffing and improper revenue recognition.
Improper capitalization occurs when a company recognizes an asset on the balance sheet for costs that should typically be recorded as an expense on the income statement. It represents an incorrect classification that artificially inflates a company's earnings in the short term, as it defers the recognition of expenses to later periods.
The best way to learn about improper accounting practices is to see real-life examples. With this in mind, we provide five famous examples of improper asset valuation: Waste Management, WorldCom, America Online (AOL), Satyam Computer Services, and Comverse Technology.
All of these companies subsequently collapsed and were liquidated or acquired. These examples illustrate the danger of manipulation. Manipulation robs future earnings and allows management to hide problems that should be addressed, creating even greater difficulties at some future point. Those seeking a greater understanding of improper capitalization of expenses will find these companies a great place to start.
Where possible, we complement these examples with readings from the Transparently Risk Engine, an AI-powered system that detects accounting manipulation. The TRE scores the quality of a company’s accounting on a 0-100% scale, in the process assigning them a rating of A+ to F. In some of the cases below, the TRE certainly picked up risky signals well before the problems bubbled to the surface.
Waste Management
Waste Management, a waste disposal company from the 1990s, is one of the best-known examples of a company engaged in improper capitalization of expenses.
The company capitalized a significant portion of its environmental remediation costs. These are the costs associated with cleaning up contaminated landfills. It treated these costs as assets but should have expensed them immediately.
In addition, Waste Management significantly extended the estimated useful lives of its garbage trucks and landfills. By stretching out the depreciation period, it reduced its annual depreciation expense. These aggressive capitalization practices allowed Waste Management to report higher profits and inflate the value of its assets on its balance sheet.
The SEC investigated Waste Management and found that the company had engaged in a systematic scheme to inflate its earnings and mislead investors. Waste Management paid $132 million in fines and penalties. The company had to restate its earnings by $1.7 billion, one of the largest restatements in US history at the time. Several former executives of Waste Management faced criminal charges related to the accounting fraud.
The Transparently Risk Engine gave Waste Management’s 1997 accounts a risk score of 64%, putting it in the worst 13% of companies globally for accounting quality. The system’s top concerns for that year included suspect growth signals, credit and income quality.
WorldCom
WorldCom was a telecommunications giant in the late 1990s and early 2000s. The company capitalised its "line costs," which were fees paid to other telecom companies for using their networks. These costs were a significant operating expense for WorldCom and should have been expensed as incurred.
Instead of expensing these line costs immediately, WorldCom classified them as capital expenditures. This manipulation understated Worldcom’s expenses and grossly inflated its profit.
WorldCom's actions were outright fraud. The company eventually admitted to improperly capitalizing $11 billion in expenses. The scandal led to the largest bankruptcy filing in US history at the time. Several executives, including CEO Bernard Ebbers, faced criminal charges. Ebbers was convicted of securities fraud and sentenced to 25 years in prison.
WorldCom emerged from bankruptcy as a rebranded MCI entity in 2004, which was acquired by Verizon Communications two years later. WorldCom’s network assets are now part of a Verizon division that serves corporate and government customers.
America Online (AOL)
AOL was an internet service provider during the dot-com boom in the late 1990s.
The company spent heavily on marketing, particularly on free trial CDs which it distributed widely. Instead of expensing these marketing costs immediately, as required by accounting standards for expenses that don't provide future benefits, AOL capitalized a significant portion of them.
It then amortized these capitalized marketing costs over extended periods, sometimes as long as 24 months, arguing that the benefits of these marketing campaigns would last for several years. This practice significantly understated AOL's marketing expenses and inflated its reported profits during a period of rapid growth in internet users.
The SEC investigated AOL's accounting practices and found that the company had improperly capitalized over $1 billion in marketing expenses. AOL agreed to pay a $300 million fine and to restate earnings. The scandal tarnished AOL's reputation and eroded investor confidence in the company. In June, 2015, Verizon Communications acquired AOL for $4.4 billion - a mere fraction of its dot-com bubble valuation.
Satyam
Satyam Computer Services, an Indian IT services company, engaged in fraudulent capitalization of expenses in the 2000s as part of a broader accounting fraud.
As part of an elaborate accounting fraud, Satyam's founder and executives created fictitious fixed assets, such as software development projects or infrastructure investments. These assets existed only on paper and were used to inflate the company's balance sheet.
Management then capitalized expenses related to these fictitious assets, spreading the costs over several years instead of expensing them immediately. This manipulation allowed Satyam to understate expenses and inflate their reported profits, creating a false impression of financial health.
The Satyam scandal broke in 2009. It was one of the largest corporate accounting frauds in India's history, shook investor confidence in Indian stocks and led to calls for greater transparency and accountability in corporate governance.
Satyam's founder and several other executives were arrested and convicted for their roles in the fraud. After the scandal, Satyam lacked customer confidence to continue as a viable operation. Tech Mahindra, another Indian IT services company, eventually acquired Satyam after a competitive bidding process.
The Satyam case demonstrates that aggressive capitalization of expenses can be a component of broader accounting fraud schemes. It highlights the importance of scrutinizing a company's asset base and ensuring that capitalized expenses are genuinely related to assets that provide future economic benefits.
The risk reports generated by theCapitalizing an expense, or capitalization, occurs when a cost is recorded as an asset rather than as an expense. This most frequently occurs with long-lived assets, which are depreciated over time rather than expensed, and intangibles which can be amortized. for Satyam prior to 2003, the year in which manipulation supposedly began, suggested extreme manipulation risk. The risk engine awarded Satyam’s 2002 accounts a rating of “F” and a risk score that put the IT firm in the worst 2% of all listed companies globally for accounting quality. At the time, Satyam had a market capitalization of $1.7 billion. Risk scores of E or F are typically reserved for much smaller companies experiencing significant financial strain.
Comverse Technology
Comverse Technology, a software company specializing in telecom billing systems, faced scrutiny in the early 2000s for its accounting to stock option expenses.
Employee stock options are a capitalized compensation cost, meaning that stock-based compensation may be capitalized similar to the treatment of some other employee benefit costs.
Comverse was accused of backdating stock options granted to executives. Backdating involves manipulating the grant date of options to coincide with a period when the company's stock price was lower, maximizing the potential profit for the recipient. By backdating options, Comverse avoided recognizing the full compensation expense associated with those options. This manipulation boosted the company's reported earnings and made its financial performance appear better than it was.
The SEC investigated Comverse and found that the company had engaged in a systematic scheme to backdate stock options. Comverse was forced to restate its earnings for several years, reducing its previously reported profits. Several top executives, including the CEO, were indicted on criminal charges related to the stock option backdating. Some executives fled the US to avoid prosecution. The accounting scandal severely damaged Comverse's reputation and led to numerous shareholder lawsuits. The company was eventually liquidated in 2013.
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