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Addis Ababa University School of Business and Economics Post graduate program Analysis of case 5.4 pptl-Qwest
 

Addis Ababa University School of Business and Economics Post graduate program Analysis of case 5.4 pptl-Qwest

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ADDIS ABABA UNIVERSITY

ADDIS ABABA UNIVERSITY
SCHOOL OF BUSINESS AND ECONOMICS
DEPARTMENT OF ACCOUNTING
Post graduateprogram

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    Addis Ababa University School of Business and Economics Post graduate program Analysis of case 5.4 pptl-Qwest Addis Ababa University School of Business and Economics Post graduate program Analysis of case 5.4 pptl-Qwest Presentation Transcript

    • ANALYSIS OF CASE 5.4 QWEST: OCCURRENCE OF REVENUE Prepared by: Group 3 of section 2 1. Sileshi Mirani 2. Shemsu Bargicho 3. Samuel Kassahun 4. Seifu Fiseha 5. 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 problems Premature 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 recognition Ownership 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 transactions i. 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 activity Designing 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!!!!!