Case #5.

7 Qwest: Occurrence of Revenue

I. Technical Audit Guidance
To maximize the knowledge acquired by students, this book has been designed to be read in
conjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB Auditing
Standards that are referenced in this book are available for free at:
http://pcaobus.org/Standards/Pages/default.aspx.
In addition, the AU Sections that are referenced in this book are available for free at:
http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisions
of the Sarbanes-Oxley Act of 2002 is available for free at:
http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarban
es-Oxley+Act+of+2002.htm.
II. Recommended Technical Knowledge
PCAOB Auditing Standard No. 5
Paragraph #28-30
Paragraph #39-41
Paragraphs #A4 (in Appendix A)
III. Classroom Hints
This case provides students with an opportunity to appreciate the difficulty associated
with applying the rules of revenue recognition to a complex set of economic transactions (i.e.,
the IRU swap transactions recorded as revenue by Qwest). To properly do so, students are able
to see that an auditor must first understand the true economic substance of a transaction. After
gaining this understanding, the auditor must then determine whether the client has identified and
properly applied the correct technical accounting guidance. Of course, this determination must
be made based on sufficient and competent evidence. Thus, the auditor must take steps to
exercise due professional care in gathering such evidence. In addition, the case provides a
mechanism to illustrate the importance of identifying relevant financial statement assertions and
identifying the related control activities that are designed to support reliable financial reporting
in the post-Sarbanes audit environment.

We believe it is essential for students to carefully read over the recommended technical
knowledge, along with this case reading. The educational psychology literature suggests that the
acquisition of technical/factual type knowledge increases dramatically when such knowledge can
be applied in a realistic context. Thus, we urge instructors to use this case as a mechanism to
impart the relevant post-Sarbanes technical audit knowledge, outlined above.
This case assignment will work best if is scheduled to coincide with the audit evidence
topic or when instructors cover the revenue process in the audit class. Regardless of when the
case is covered, we recommend that instructors spend time in class reviewing the nature of an
IRU swap transaction. This is a difficult economic transaction and students are likely to have
trouble conceptualizing the transaction flow on their own. As a result, we believe that this
provides a terrific opportunity for instructors to stress the importance of fully understanding the
economic substance of any transaction being audited. There are absolutely no shortcuts. The
only possible way to determine whether an audit client is properly accounting for a transaction is
to first understand the nature of the economic transaction in detail. This discussion can be
accomplished quite effectively while going over the response to question #1 in the case.
Importantly, the goal of the previous discussion is not necessarily to make sure that
students are experts in IRU swap transactions. Rather, we believe that it is important to point out
to students that they will encounter difficult economic transactions as an auditor. So, when such
a transaction is encountered, students must take the time to fully understand the economic
substance of that transaction. The professional judgment that is involved in auditing such a
complex transaction also provides an opportunity for instructors to remind students of the
importance of being unbiased and objective when making their audit judgments. Indeed, we
believe that it is helpful to remind students at this point of their responsibility to maintain an

attitude of professional skepticism throughout the audit process. Indeed, one of the primary
goals of the Sarbanes-Oxley Act of 2002 was to take steps to improve the independence and
objectivity of the audit process (e.g., Section 201). As such, we encourage instructors to take this
opportunity to remind students of this responsibility.
This case also provides an opportunity to highlight the importance of identifying the
relevant financial statement assertions about a significant financial statement account, a critically
important task in the post-Sarbanes environment. The discussion of student responses to
question #2 provides instructors with an opportunity to discuss this point. In addition, the
discussion of student responses to question #3 provides an opportunity for instructors to
highlight the importance of being able to identify an internal control activity that is explicitly
designed to support reliable financial statement reporting for a particular financial statement
assertion. Once again, the knowledge required to link an internal control activity to the financial
statement assertion is essential in the post-Sarbanes audit environment. Thus, we encourage
instructors to take the time to make this linkage explicit for students in the present context.
Finally, since the prevention and detection of fraud is so important, the discussion of student
responses to question #4 provides an opportunity for instructors to discuss specific control
activities that are designed to prevent and/or detect fraud.
Overall, a key premise of this book is to help simplify the relationship between a
companys internal control system and the financial statement account balances. Section 404 of
SOX made clear that this relationship is paramount.

However, the knowledge needed to

explicitly link a specific internal control activity to a relevant financial statement assertion is not
easy to impart. We therefore encourage instructors to allocate an appropriate amount of time to
this topic and to use multiple different cases to help illustrate your points. In our experience, it is

very difficult for audit students to make the connection between an internal control activity and a
related financial statement assertion. So, please consider assigning at least 2 or 3 (and perhaps
even 4 or 5) cases from section 5 of this book to provide the repetition that is needed for students
to master this important topic. It is hoped that such repeated task performance will help to better
sensitize students to the importance of internal control activities in helping to prevent and/or
detect fraudulent financial reporting.
IV. Assignment Questions & Suggested Answers
1. Describe why the recognition of revenue for IRU swaps for fiber-optic assets that
were not actually needed by Qwest is inappropriate under GAAP. As an auditor,
what type of evidence would allow you to determine whether the recognition of this
revenue would be appropriate under GAAP?
The recognition of revenue for IRU swaps for assets that are ultimately not used by Qwest is
not appropriate under GAAP because correct recognition requires that Qwest does have a
legitimate business need to purchase the assets. According to the case information, Qwest
essentially used the revenue recognized through the swap transactions to increase revenue and
meet quarterly revenue targets. In many of the instances, Qwest did not even use the assets that
it had purchased and could not resell them, rendering such assets worthless. In other cases,
Qwest returned the unused assets back to the customer more than six months after the fact.
In determining whether the recognition of revenue would be appropriate under GAAP, an
auditor would first want to understand the common practices for swap transactions within the
industry. Importantly, the case information reveals that Qwests accounting practices for swap
transactions were aggressive, as compared to industry standards. Also, an auditor should
consider a review of the Board of Directors minutes to determine the economic basis, if any, for
the swap transaction. In addition, an auditor should seek to examine documentary evidence for
each individual swap transaction. The goals of this examination would be to determine whether

the economic substance of the transaction was properly captured, in accordance with GAAP.
Finally, an auditor should consider reviewing a detailed summary of Qwests fixed assets to
search for duplicate assets. And, if a duplicate is identified, the auditor should carefully discuss
this finding with members of the network planning department. According to GAAP, the asset
purchased must be for a legitimate business need.
2. Consult Paragraphs 28-30 of PCAOB Auditing Standard No. 5. Identify one
relevant financial statement assertion related to the revenue account that is
impacted by an IRU swap. Why is it relevant?
Among other matters, paragraphs #28-30 of PCAOB Auditing Standard No. 5 focuses the
auditors attention on the importance of identifying each of the relevant financial statement
assertions related to significant accounts and disclosures. Indeed, the identification of relevant
assertions is a critical component of the audit of internal control over financial reporting.
Specifically, according to Paragraph # 28, 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. In paragraph #30, auditors might determine
the likely sources of potential misstatements by asking himself or herself what could go
wrong? within a given significant account or disclosure. It is clear that certain financial
statement assertions are more relevant than others for a particular set of financial statements.
In this situation, one of the relevant financial statement assertions related to the revenue
account impacted by an IRU swap would be existence/occurrence. The big question related to
the IRU swaps is whether the swaps should have been recorded as revenue in accordance with
GAAP. Since the facts reveal that Qwest did not have a legitimate business need for the assets
that it acquired during the swap transactions, the company appears to have engaged in these
swaps to merely generate additional revenue to meet their aggressive revenue targets. This is

also indicated by the timing of the transactions. The facts of the case reveal that managers would
often complete these swap transactions frequently at the close of a quarter in order to meet
revenue expectations.
3. Consult Paragraphs 39-41 and Paragraph A4 (in Appendix A) of PCAOB Auditing
Standard No. 5. For the assertion identified in Question 2, identify a specific internal
control activity that would help prevent a misstatement related to the recognition of
revenue for IRU swaps.
According to Paragraph #39, the auditor should test those controls that are important to the
auditor's conclusion about whether the company's controls sufficiently address the assessed risk
of misstatement to each relevant assertion. As a result, it is very important that the auditor take
the time to explicitly link internal control activities to the financial statement assertions being
supported. In paragraph #41, the auditor is provided guidance about the controls that should be
tested. According to the standard, the decision as to whether a control should be selected for
testing depends on which controls, individually or in combination, sufficiently address the
assessed risk of misstatement.
The bottom line is that the auditor should clearly link individual controls with the
significant accounts and assertions to which they relate. Clearly, there are a number of allowable
answers to this question. Importantly, this question is also designed to help the students
understand the differences between preventive controls and detective controls and the importance
of each in a well-functioning internal control system. One example of a preventive control
follows.
For the assertion of existence/occurrence, a specific internal control procedure that would
help to prevent a misstatement related to the recognition of revenue for IRU swaps would be to
implement a policy requiring that the network planning department authorize all IRU swap

transactions (to ensure that there is really a need for the asset). This control procedure would
prevent senior management from acquiring duplicate or unneeded assets in swap transactions.
4. Consult Paragraphs 39-41 and Paragraph A4 (in Appendix A) of PCAOB Auditing
Standard No. 5. For the assertion identified in Question 2, identify a specific internal
control activity that would help detect a misstatement related to the recognition of
revenue for IRU swaps.
According to Paragraph #39, the auditor should test those controls that are important to the
auditor's conclusion about whether the company's controls sufficiently address the assessed risk
of misstatement to each relevant assertion. As a result, it is very important that the auditor take
the time to explicitly link internal control activities to the financial statement assertions being
supported. In paragraph #41, the auditor is provided guidance about the controls that should be
tested. According to the standard, the decision as to whether a control should be selected for
testing depends on which controls, individually or in combination, sufficiently address the
assessed risk of misstatement.
The bottom line is that the auditor should clearly link individual controls with the significant
accounts and assertions to which they relate. Clearly, there are a number of allowable answers
to this question. Importantly, this question is also designed to help the students understand the
differences between preventive controls and detective controls and the importance of each in a
well-functioning internal control system. One example of a detective control follows.
A specific internal control procedure that would help to detect a misstatement related to the
recognition of revenue for IRU swaps would be to have the internal audit department complete
procedures to monitor whether any swap transactions involved duplicate or unneeded assets.
This control would then help detect if revenue was improperly recognized.