Telecom Tangle: Industry Under Fire

Feb. 20, 2002 -- Telecommunications companies have spent years wrapping their high-speed cables around the globe. But more and more, it appears they've gotten their finances all tangled up as well.

Bankrupt firm Global Crossing, under investigation from the Securities and Exchange Commission, has brought renewed attention to the business and accounting practices of the telecoms, adding to the woes of an industry already reeling from multiple bankruptcies and scant customer interest in high-speed Internet connections.

At the center of the SEC inquiry is an apparently common practice used by many telecom firms, in which they swap quantities of communications bandwidth with each other, counting the exchanges as revenue and making their balance sheets look better in the process.

But Global Crossing is not the only telecom with problems. McLeodUSA declared bankruptcy this month, Qwest recently had its credit rating lowered and Level 3 lost $3.3 billion in the fourth quarter of 2001 amid dramatic plunges in their share prices. Last year, firms like PSI Net, Covad and Winstar all filed for bankruptcy.

Why the Telecoms Bombed

The Global Crossing case may seem similar to the Enron scandal — and not only because accounting firm Arthur Andersen has handled the bookkeeping for both firms. As with Enron, the Global Crossing controversy also involves a huge bankruptcy, a former CEO who cashed in hundreds of millions in stock options, high-level political connections, and a whistleblower memo from last August.

But the January bankruptcy of Global Crossing was not caused by startling revelations of hidden losses like Enron's. Rather, the deflation of the telecom sector has been painfully obvious to many investors and analysts for at least a year.

The essential problem is that numerous start-up telecoms spent billions laying cable across continents and under oceans in the last several years, in hopes that the dramatic initial growth of the Internet would lead to a huge demand for high-speed telecommunications networks.

Modest public demand for broadband-style connections, however, means the telecoms have been starved for revenue — and happy to report swaps as income.

But the very nature of these transactions has put the whole industry under scrutiny: It takes two to conduct a swap. Qwest, for example, has received a subpoena related to the Global Crossing inquiry.

Global Crossing, Level 3 and other firms contacted for this piece have declined, however, to list the firms they have made swaps with.

Swaps: Double Bonus for the Bottom Line

In the telecom business, the exchanges are known as an Indefeasible Right of Use deal, or IRU. The telecom firms themselves argue that IRUs have valid uses: For instance, a pair of companies with built-up networks in separate regions can simply lease each other's lines instead of laying down more cable, making the deals more than merely redundant "hollow swaps."

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The telecoms claim there is a sound business rationale for the swaps, while industry observers are more skeptical. Some analysts agree that there is a logic to making deals like that — although many of the exchanges have not paid off.

"In the normal business cycle, swaps end up paying off in the long run," says David Cooperstein, research director for the telecom industry for Forrester Research in Cambridge, Mass. "The problem is when the market doesn't grow the way you continue to expect."

Either way, observers say even the most legitimate deals can lead to accounting complexities.

"The swaps themselves I guess I don't have a problem with," says Wayne Shaw, a professor of accounting at Southern Methodist University in Dallas. "The problem is, some of the accounting for them has been unusual at best."

In accounting terms, IRUs have two potential benefits: first, telecoms can count the exchange as a sale of bandwidth, adding to their revenue. And the firms can realize tax benefits by writing off the "purchase" part of the bandwidth swap as a capital expenditure which depreciates over time. Thus, says Shaw, telecom firms could, in theory, be using each swap to realize a double boost for the company's bottom line.

"When they buy they treat it as a long-term investment, but when they sell it appears as though they treat the sale as immediate revenue," Shaw notes.

And others believe there is little to defend the practice. J. Edward Ketz, a professor of accounting at Penn State University in State College, Pa., says that with rare exceptions, "I can't think of any reason to call it a gain in value," adding that such an approach to corporate accounting is "improper."

‘On the Edge’ of Being Reasonable?

In the face of such criticism, some telecoms have begun to voluntarily disclose their swap activities. European telecom KPNQwest announced last week that swaps comprised 15 percent of its revenue, while Level 3 said IRUs accounted for 2 percent of its revenue.

Global Crossing has not released a similar figure, although the Wall Street Journal reported on Tuesday that an internal company study showed only 20 percent of its swaps adding value to the network.

The full extent of swapping is something the SEC — while not commenting publicly on its investigation — is almost certainly looking into. By Global Crossing's admission, the SEC is also examining a whistle-blowing memo penned in August 2001 by Roy Olafson, a former Global Crossing vice president for finance, alleging accounting improprieties which the firm denies.

Besides the memo, controversy has been inflamed by revelations that Global Crossing's former chairman, Gary Winnick, cashed in more than $700 million in company stock, and by the firm's extensive lobbying in Washington. The company has made $3.5 million in political contributions to both parties since 1999. Former president George Bush received Global Crosing stock as a speaking fee, while the Democratic Party chairman, Terry McAuliffe, cashed in company shares.

But for many start-up telecoms — as well as shareholders who held telecom stocks while they sank — the bottom line about the bandwidth swaps may ultimately be that they were part of a big network-building gamble the telecoms wound up losing.

Cooperstein, who says IRUs are "a little bit on the edge of what I'd consider reasonable," notes that many telecoms expected consumer dollars to take the place of the "barter dollars" they got in swaps from their competitors. To date, they have wound up sorely disappointed.