This memo is the result of an examination of misstated revenue recognition in the financial statements of Qwest for the years of 2000 and 2001. Issues regarding revenue recognition according to GAAP and directory revenue recognition are addressed. The memo will define the revenue recognition principle, describe Qwest fraud issues discovered in 2000, and address internal control deficiencies and ethics. This case should serve as an example for fraud detection regarding revenue recognition. The conclusion addresses possible changes to directory revenue recognition.
Revenue Recognition Principle Defined
The revenue recognition principle states that revenues are recognized when realized or realizable and when earned; also, revenue from a transaction must meet both criteria to be recognized for recording in the financial statements. Revenues are realized when products are exchanged for cash or claims to cash, and are realizable when related assets received are readily convertible to cash. Revenues are earned when products are delivered or services are performed. These principles are important in defining revenue recognition, which helps auditors identify fraud and misstatements. Users of financial statements will have a better understanding of an entity’s economic landscape with these principles in place. Not using these principle have lead to several methods of revenue inflation such as recording sales of unfinished products, recognizing shipments that never occurred, and early recognition of sales that occurred after the end of the fiscal period but booked in a prior period.
Qwest GAAP Noncompliance
Qwest upper management inappropriately mandated that the Colorado Springs Dex directory revenues be recognized in December, 2000 instead of January, 2001. Qwest also changed accounting methods from GAAP approved amortized revenues, where straight line amortization is often used, to a point of publication accounting method (often used by newspaper media where most revenue is recognized at time of delivery) without disclosure. Revenue recognition of Dex directory sales was not appropriate under GAAP because the principle requires transactions to be both realized and earned to be recognized. Qwest recognized Dex revenue from their 2001 directory sales in December 2000 instead of January 2001 as scheduled. This revenue was realized but not earned, which violates the principle for recognition in 2000 and also violates the SEC criteria for revenue recognition where delivery has occurred or services rendered. This revenue should have been recognized in 2001 and the early recognition of sales that actually occurred after year-end inflated and misstated 2000 financial statements. Qwest also failed to disclose on their 2000 Form 10K that the increase of $28 million in revenue and $18 million EBITDA, which accounted for 30 percent of Dex’s 2000 year-over-year revenue increase, was not earned in 2000 and would be deducted from 2001 revenues. Qwest also practiced “gap closing” strategies of billing customers for 13 periods instead of 12- changing their initial contracts without consent. Qwest was basically billing for more than what the customer ordered. This violates SEC criteria that states the seller’s price to the buyer is fixed or determined.
Qwest Internal Control Concerns
Qwest failed to provide reasonable assurance regarding the reliability of financial reporting and compliance with SEC regulations by overstating Dex’s revenue recognition in 2000. This failure demonstrates an ineffective system of internal controls. An effective control environment consists of five interrelated components which consists of the control environment, risk assessment, control activities, communication and monitoring. The components of internal controls can be defined as deficiencies by Qwest.
The control environment sets the tone for an entity and influences the control consciousness of its people. Qwest’s upper management set aggressive revenue targets which were not achievable by Dex without making misleading revenue disclosures from booking revenues which properly belonged in subsequent quarters. Officials at Qwest instructed Dex management to perform accounting changes that effectively transferred the following year’s revenues (earned in 2001) -to its current year (2000). Despite Dex management objections communicated to upper management, the discipline and structure of Qwest was to make revenue targets at all costs which encouraged the practice of overstating revenues thus violating SEC regulations by including unearned revenue recognition on the financial statements.
Upper management at Qwest failed to assess the risks associated with their activities.Control policies and procedures that would monitor and prevent revenues realized but not earned were not in place; the result was overstated financial statements. When linking internal controls to financial statement assertions for revenue accounts, it is evident that several management assertions were incorrect and not corrected by controls. False management assertions fell into the categories of accuracy, valuation and disclosure. Regarding accuracy and valuation, the management assertion that all items are included in the financial statements at the right amounts was inaccurate because Qwest management recognized 2001 revenues in 2000. Regarding presentation and disclosure (management’s responsibility for ensuring that disclosures are clear and mistake free) Qwest failed to disclose early revenue recognition and changes in accounting methods (from amortized to point of publication methods). Poor internal controls and the lack of ethical standards by upper management lead to misstatements and fraud.
Qwest Ethical Issues
Qwest’s senior management team exerted great pressure to meet aggressive revenue targets. This “tone at the top” had more focus on meeting targets and less concern about ethical standards. Tone at the top can refer to how an organization’s leadership creates an ethical environment in the workplace. Upper management's actions have a trickle-down effect on employees. If top managers uphold ethical values so will employees. However, if upper management appears unconcerned with ethics and focuses entirely on aggressive revenue targets, employees will be more likely to commit fraud and feel that their ethical conduct isn't a priority. Suffice it to say, employees will follow the examples of upper management. Qwest’s tone at the top was unethical and created a high risk of financial misstatements and fraud. In addition to the lack of integrity existing in Qwest’s control environment, management’s philosophy and commitment to competence was a myopic view of making the bottom line- which lacked concern regarding the consequences of overstated revenue recognition. The structure and assignment of authority dictated the Dex management was to follow directives by Qwest’s upper management, despite Dex’s objections to unrealistic targets, accounting practices and disclosure.
Point of publication methods are not allowed by GAAP, but maybe they should be considered, according to a report by Ernst & Young entitled “Media & Entertainment Revenue Recognition” (1). Under current US GAAP, revenue generated from advertising included in the directories typically is recognized on the amortization method over the life of the directory, which is usually one year. With respect to contracts with advertisers, a directory publisher will have performance obligations to print an advertisement, distribute the directory and make available directories for the entire ad period of one year. Qwest was wrong to use point of publication method and especially for changing accounting practices without disclosure.
I believe Dex was wrong by changing accounting methods mid-year and recognizing revenues early in December 2000 as opposed to 2001. However, I believe that control of an advertisement in a printed directory should transfer when the directory is printed and distributed. If so, revenue will be recognized at the time of distribution. This would result in the majority of revenue being recognized in the early part of the contract when the directories are distributed, with some amount deferred and recognized as additional directories are distributed, according to Ernst & Young (1). This would be a significant change in the timing of revenue recognition for printed directories as compared to GAAP’s current principle of revenue recognition.