Addis Ababa University School of Business and Economics Post graduate program Analysis of case 5.4 pptl-Qwest
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
• 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
• 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
GAAP for up-front revenue
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
an assessment of fair market value of the revenue
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)
• Qwest continuously involves significantly with all IRUs sold in
the form of ongoing administrative, operating and
• 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
• Qwest prohibited customers from assigning, selling or
transferring without its prior written consent
• 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
• 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
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).
• Some sales transactions require customers to
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
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
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;
4. Collectability is reasonably assured. (SEC, SAB-104, p.
• Generally revenue to be recognized at the time of
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)
• 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
• 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.
• 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
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
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.
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
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
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.
• 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
• Audit evidence provided by original documents is more reliable
than audit evidence provided by photocopies or facsimiles.
The answer is no, because:
In the concept of sufficiency, the auditor did not show:
its commitment to collect sufficient independent
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
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
• 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
account balances and
presentation and disclosure
Assertions for classes of transactions
i. Occurrence. Transactions and events that have
been recorded have occurred and pertain to the
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
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 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
• 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
Assertions about presentation and disclosure:
• Occurrence and rights and obligations. Disclosed
events and transactions have occurred and pertain to
• Completeness. All disclosures that should have been
included in the financial statements have been
• 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
• This assertion helps the auditor to critically
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
• 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.
• 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.