Question 1: The definition of assets is in FASB Concept Statement 6, paragraph 25: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
Paragraph 26 then describes the trio of characteristics that qualify an item as an asset: an asset has three essential characteristics: (a) it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, (b) a particular entity can obtain the benefit and control others’ access to it, and (c) the transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred.
Question 2: The capitalized line costs were operating expenses and should not have been treated like a capital asset. On the one hand, one of WorldCom’s major operating expenses was its so-called “line costs. ” These were fees paid to third party telecommunications network providers for the right to access the third parties’ networks. Under GAAP (Generally Accepted Accounting Principles), these fees cannot be capitalized.
They must be taken as immediate expenses and subtracted from income. On the other hand, the increased line cost lies in the long-term, fixed-rate leases for network capacity WorldCom initiated in order to meet the anticipated increase in customer demand. And as later the demand was not as expected, the Company has to pay for the leases that were substantially underutilized to avoid punitive termination provisions.
The line costs that WorldCom capitalized were ongoing, operating expenses that accounting rules required WorldCom to recognize immediately. Instead of expense the cost currently, WorldCom capitalized it to exaggerate its pre-tax income. Future economic benefit is the essence of an asset. WorldCom capitalized excess capacity costs that were not generating revenue, which violates GAAP. Expense or a loss would be recognized upon evidence that previously recognized asset benefits would not be realized.