In July 2002, Qwest, a telecommunications company based in Denver, Colorado, acknowledged that it had improperly recorded revenue for 2000, 2001, and 2002. The company restated its financial results for 2000 and 2001 and reduced its estimate of earnings for 2002. 3 With 61,000 employees and yearly sales revenue of $19.7 billion in 2001, Qwest provides telecommunication services to residential, business, and government customers. Its revenue misstatements originated from its handling of revenue from transactions in which it sold long-term capacity on its network and bought similar capacity from its trading partners (referred to as swap transactions or round-trip trades ).
Arthur Andersen, LLP, advised several telecommunications clients how to structure swap transactions in a 48-page document referred to as the “white paper.” 4 According to the document, swap transactions are not barter arrangements, which would prevent the two firms from recognizing revenue. The document suggests that two given companies structure their transactions so the capacity sold is an operating asset and the capacity bought is a capital asset. This practice allows the seller to recognize revenue and to record the cost of providing the capacity as a capitalized cost rather than an expense, moving the cost off the income statement and putting it in a capital asset account on the balance sheet. From Andersen’s point of view, because the risks and rewards of buying capital leases were different than those of operating leases, the companies involved in the swaps were no longer exchanging similar assets. If the assets exchanged were not similar, it was possible to recognize revenue on the capacity swapped in the transaction. Companies in the telecommunications industry relied heavily on the use of swap transaction accounting to inflate revenue, which was commonly believed to be the most reliable measure of a company’s health. These companies included Qwest, Global Crossing, and WorldCom. Arthur Andersen was the auditor for many telecommunications firms. Officials of the Securities and Exchange Commission (SEC) were concerned that such revenue-increasing tactics were widely used by these companies to “give the appearance of economic activity and growth when there was none.” 5 These companies, in effect, were following advice similarto that given in the Andersen “white paper.” SEC officials believed that telecommunications companies’ swap transactions had no business purpose other than to increase revenue.
In August 2002, the SEC formally concluded that the telecommunications companies improperly booked revenue from capacity swaps with other companies.
This SEC decision officially put an end to the widely used industry practice that had inflated revenue for many telecommunications companies. 6 The ruling resulted in earnings restatements by several companies and prompted shareholder lawsuits alleging accounting fraud.
Joseph Nacchio, the chief executive officer of Qwest, resigned under pressure in June 2002. He and other top Qwest executives had sold Qwest stock during the years the swap accounting was used. His stock sales alone netted $130 million in profit. Qwest insiders sold stock worth $530 million between January 2000 and July 2001, raising questions about their interest in keeping the stock price as high as possible by reporting growth in sales revenue. 7
a. Evaluate the revenue recognition principle used by Qwest to record revenue based on swap transactions.
b. What is the role of the auditor in evaluating the audit client’s revenue recognition policy? Would you have approved it? What is wrong with the policy?
c. Do you believe that company executives engaged in fraudulent activity by their use of swap transactions to increase revenue? Do you think the executives should be shielded from liability for swap transactions that occurred before the
SEC issued a formal statement prohibiting these companies from recognizing revenue using these transactions?
d. If company executives received stock options based on performance, how could this have influenced their choice of accounting method for revenue recognition? How should the auditor evaluate the audit client’s use of stock options for executives? How would you include stock options in the audit risk model?