ANALYSIS OF CASE 5.4QWEST: OCCURRENCE OF REVENUE

Prepared by: Group 3 of section 2

1. Sileshi Mirani2. Shemsu Bargicho3. Samuel Kassahun4. Seifu Fiseha5. Solomon Mekonnen

Summary of the case-synopsis

• Before the CEO Joseph Nacchio joined in January 1997, Qwest was engaged in constructing fiber optics network across major cities in the United States.

• Just after Joseph Nacchio joined, its strategy began to shift toward a communications services as well.

• In 1998, by releasing the earnings, the CEO proclaimed the successful transition of Qwest from network constructing company to a leading internet protocol-based multimedia company (focusing on the convergence of data, video, and voice services)

• Qwest become darling to its investors by consistently meeting its aggressive revenue targets during 1999 and 2000

• When the company announced its intention to restate revenues the stock price dropped from $ 55 in July 2000 to $ 1.11 per share in August 2002, market capitalization declined by $ 91 billion to 1.9 billion

Summary cont’d……

• Civil and criminal charges were brought on CFO Robin Szeliga, CEO Joseph Nacchio and other Qwest executives related to their fraudulent activities

• The CFO pleaded guilty in a federal court to a single count of insider-trading and sentenced to a two year probation, six months of house arrest and $ 250.000 fine

• The CEO was convicted on 19 counts of illegal insider-trading and sentenced to six years prison, ordered to pay $ 19 million and forfeited $ 52 million gained from illegal stock

• All stakeholders are affected in this fraudulent activity

Company activity

• IRU is an Irrevocable Right to Use specific fiber optic cable or fiber capacity for a specified period.

• The company involves in IRUs sales type lease, which allow:o Qwest to treat a lease transaction as a sales of an asset with complete,

up-front revenue recognition.

Intention to commit fraud

• The financial fraud was committed between 1999 and 2002 and

• the intention was, benefiting from an inflated stock price/ illegal stock sale

• Sources indicate that the financial fraud during this period was massive, (as high as $ 3 billion)

GAAP for up-front revenue recognition GAAP requires the following four conditions to a sales of an asset

with complete upfront revenue recognition: Completion of the earning process the asset sold remained fixed & unchanged no continuing involvement by the seller (full transfer of

ownership) an assessment of fair market value of the revenue components

and the asset being sold had to be explicitly and specifically

identified as part of the completion of the earning process

Problems in the case

Verbal assurance/ secrete side agreement • Qwest had ported at least 10 % of assets sold as IRUs by

mid 2001 • Qwest generally allowed customers of IRUs to port, or

exchange IRUs for another IRUs. • customers however, were granted a verbal

assurance/secret aside agreement for the right to port change (for example Qwest recognized $ 108 million & $102million in up-front revenue by such agreement in the first quarter of 2001 , that customers could exchange,when the capacity that the customer actually wanted became available)

Ownership transfer• Qwest continuously involves significantly with all IRUs sold in

the form of ongoing administrative, operating and maintenance matters

• Ownership title remains with Qwest, even though IRU sales agreement generally says title transfer is at the end of the lease period without the existence of statutory title transfer system for IRUs (no real property exists)

• Qwest do not have the right to sublease (did not received title from third party) some of the IRUs purchased from third party and when resold , Qwest could not provide legally those rights to third party

• The purchaser did not receive any ownership interest in the fibers.

• Qwest prohibited customers from assigning, selling or transferring without its prior written consent

Other problemsPremature revenue• Qwest’s up-front revenue recognized from IRUs sales

was premature because it neglected to identify the assets sold (the exhibits of the sales contracts simply say ‘to be identified)

• Difficulty in identifying the geographic termination of some of the IRU sold to customer

• Moving/changing already sold IRUs to different routs and wavelength without customer consent (called ‘grooming’) these specifically couldn’t be restored to their original routes, for all these Qwest recognized revenue in advance. the senior management rejected the proposal for reversing such revenues , instead continued to reroute

Independent auditor • The external auditor unreasonably relied on

managements & its legal counsel false representations for both:Inappropriate revenue recognitionOwnership title transfer

• due to this and other reasons SEC has ordered that the managing director of the external auditor to be denied its privilege of appearing as an accountant for a minimum of 5 years

Case questions

1. Describe specifically why the up-front revenue recognition practice for sales of IRUs by Qwest was not appropriate under Generally Accepted Accounting Principles (GAAP).

2. Based on your understanding of audit evidence, did Arthur Andersen rely on sufficient and competent audit evidence in its audit of Qwest’s up-front revenue recognition processes? Why or why not?

3. Consult Paragraphs 28–30 of PCAOB Auditing Standard No. 5. Identify one relevant financial statement assertion related to revenue recognized for IRU sales by Qwest. Why is it relevant?

4. Consult Paragraphs 39–41 and Paragraph A5 (in Appendix A) of PCAOB Auditing Standard No. 5. For the assertion identified in Question 3, identify a specific internal control activity that would help to prevent or detect a misstatement related to the practice of up-front revenue recognition of IRUs by Qwest.

Definition of Revenue• Revenue is an element of the financial statements,

and currently defined as,:o inflows or other enhancements of assets of an entity or

settlements of its liabilities (or combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations(FASB, SFAC 6, par. 78).

Up-front revenue/fees

• Some sales transactions require customers to pay: up-front fees for services that will be provided

over an extended period of time. Companies may attempt to recognize the full

amount of the contract or the amount of the fees received before the services are performed (and before revenue is earned).

In some instances, the scheme may involve the falsification or modification of accounting records

Revenue recognition According to the GAAP rules (FASB Statement of Financial

Accounting Concepts No. 5.), For revenue to be recognized, by a business:

a transaction must have occurred, a payment must have been made or promised, and the service that the revenue is intended for must be

completed. The four key elements in recognizing revenue, according to SAB 104, are: 1.Persuasive evidence of an arrangement exists; 2. Delivery has occurred or services have been rendered; 3. The seller’s price to the buyer is fixed or determinable; and 4. Collectability is reasonably assured. (SEC, SAB-104, p. 11).

Cont.…

• Generally revenue to be recognized at the time of sale; delivery should takes place or there must be a specific agreement as to when to

deliver the sold good, and the buyer should pay • If a company provides a service or the right to use an

asset over a period of time, and if there is a contract in place as to how the buyer will pay for these services or use of assets, the company may recognize revenue as time passes (leases)

Sales-type leases

• A sales-type lease is a lease that gives rise to a manufacturer’s or dealer’s profit (or loss) to the lessor and that meet one of the following criteria:

The lease terms include a transfer of ownership.The lease terms contain a bargain purchase option

(the ability of the lessee to buy the asset being leased either during or at the completion of the lease period at a bargain price).

1. The up-front revenue recognition by Qwest is in appropriate because,

• According to GAAP –SAB 104 The performance obligations are satisfied when goods and services transfer from the entity to the customer.

• Once revenue is recognized the following must happen:– item sold identified, – ownership title transferred to buyer– all the rights and risks passed to buyer.

• However, Qwest fails to • transfer ownership title, • To specifically identify the assets sold (assets to be identified)• significantly involves with all IRUs sold in the form of ongoing administrative, operating and

maintenance matters.

• Even Qwest has recognized revenue on routes sold to customers that it has purchased from third parties for which , it has no title, no subleasing agreement, & their ‘right way’ is expired prior to the end of the IRU terms. Thus Qwest actually could not provide right to buyers, since it has no right to do so.

Cont.….

• Upfront sales to be recognized: assets sold remain fixed and unchanged. But Qwest often moved & rerouted IRUs

previously sold with out customer consent & the assets couldn’t be restored to their original routes, for these revenue was already recognized & the senior management resist to reverse the revenue recognized

2. Did Arthur Andersen rely on sufficient & competent audit evidence? Why or

why not?Concept of Audit Evidence

• Audit evidence is all the information used by the auditor in arriving at the conclusions on which the audit opinion is based and includes: the information contained in the accounting records underlying the

financial statements and other information. Auditors are not expected to examine all information that may exist. Audit evidence, which is cumulative in nature, includes

audit evidence obtained from audit procedures performed during the course of the audit and

may include audit evidence obtained from other sources, such as previous audits and a firm's quality control procedures for client acceptance and continuance, etc.

Cont.… Sufficient & Appropriate/ competent Audit Evidence

Sufficiency is the measure of the quantity of audit evidence. Appropriateness is the measure of the quality of audit evidence, that is,

o its relevance and its reliability in providing support for, or o detecting misstatements in, the classes of transactions, account balances,

and disclosures and related assertions.

The auditor should consider the sufficiency and appropriateness of audit evidence to be obtained when assessing risks and designing further audit procedures.

The quantity of audit evidence needed is affected by the risk of misstatement (the greater the risk, the more audit evidence is likely to be required)

and also by the quality of such audit evidence (the higher the quality, the less the audit evidence that may be required). Accordingly, the sufficiency and appropriateness of audit evidence are interrelated.

However, merely obtaining more audit evidence may not compensate if it is of a lower quality.

Evidence cont.…..• Audit evidence is more reliable when it is obtained from

knowledgeable independent sources outside the entity.• Audit evidence that is generated internally is more reliable when

the related controls imposed by the entity are effective.• Audit evidence obtained directly by the auditor (for example,

observation of the application of a control) is more reliable than audit evidence obtained indirectly or by inference (for example, inquiry about the application of a control).

• Audit evidence is more reliable when it exists in documentary form, whether paper, electronic, or other medium (for example, a contemporaneously written record of a meeting is more reliable than a subsequent oral representation of the matters discussed).

• Audit evidence provided by original documents is more reliable than audit evidence provided by photocopies or facsimiles.

Cont.…The answer is no, because: In the concept of sufficiency, the auditor did not show:

its commitment to collect sufficient independent evidence, it only relies on the information/ statement received from the

management of Qwest for both the appropriateness of revenue recognition & ownership title transfer

in the concept of audit evidence competence /reliability, the auditor unreasonably and intentionally relies on the false

representation of the management, for both inappropriate revenue recognition and title transfer. However,

in reality there was improper revenue recognition and no ownership title transfer.

3. Relevant assertion

According to paragraph 28-30 of PCOAB, auditing standard No.5 • The auditor should identify significant accounts and

disclosures and their relevant assertions. • Relevant assertions are those financial statement

assertions that have a reasonable possibility of containing a misstatement that would cause the financial statements to be materially misstated.

Assertions are categorized into classes of transactions, account balances and presentation and disclosure

Assertion cont.…..Assertions for classes of transactionsi. Occurrence. Transactions and events that have been

recorded have occurred and pertain to the entity.ii. Completeness. All transactions and events that

should have been recorded have been recorded.iii. Accuracy. Amounts and other data relating to

recorded transactions and events have been recorded appropriately.

iv. Cutoff. Transactions and events have been recorded in the correct accounting period.

v. Classification. Transactions and events have been recorded in the proper accounts.

Assertions cont.….Assertions related to account balances at period end:• Existence. Assets, liabilities, and equity interests exist.• Rights and obligations. The entity holds or controls

the rights to assets, and liabilities are the obligations of the entity.

• Completeness. All assets, liabilities, and equity interests that should have been recorded have been recorded.

• Valuation and allocation. Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded

Assertion cont.….Assertions about presentation and disclosure:• Occurrence and rights and obligations. Disclosed events

and transactions have occurred and pertain to the entity.• Completeness. All disclosures that should have been

included in the financial statements have been included.• Classification and understandability. Financial

information is appropriately presented and described and disclosures are clearly expressed.

• Accuracy and valuation. Financial and other information are disclosed fairly and at appropriate amounts

Occurrence

• This assertion helps the auditor to critically identify: transactions and events that have been recorded

have occurred and pertain to the entity. However, the up-front revenues recognized here are not actually occurred as titles are not transferred, customers have the right to port & right to exchange

4 Specific internal control activityDesigning and Implementing Antifraud Control Activities:• Control activities are policies and procedures designed to address

risks and help ensure the achievement of the entity’s objectives. • Control activities occur throughout the organization, at all levels

and in all functions.• Antifraud control activities can be preventative and/or detective

in nature. Preventative controls are designed to mitigate specific fraud risks and can deter frauds from occurring, while detective control activities are designed to identify fraud if it occurs.

• Detective controls can also be used as a monitoring activity to assess the effectiveness of antifraud controls and may provide additional evidence of the effectiveness of antifraud programs and controls.

Cont.…..

• Special consideration should be given to the risk of override of controls by management.

• Some programs and controls that deal with management override include; (1) active oversight from the audit committee; (2) whistle-blower programs and a system to receive

and investigate anonymous complaints; and (3) reviewing journal entries and other adjustments

for evidence of possible material misstatement due to fraud.

Thank you!!!!!