Things are going to get a lot worse before they get better. WorldCom Inc.’s (Nasdaq: WCOME) shocking revelations last Tuesday may have ruined investor confidence for a long time, and, observers warn, other scandals are looming on the horizon.

While they may not reach the scope and scale of the fraud WorldCom is accused of committing, there’s little doubt that new revelations of accounting scandals and insolvency issues in the telecom space are on their way. For WorldCom isn’t the only carrier that has seen its debt levels skyrocket out of control over the past year or that has struggled to come to terms with its tumbling stock prices from ridiculous highs to ridiculous lows. WorldCom executives weren’t the only ones worrying that their company’s poor performance would be reflected in lower executive compensation. And the soon bankrupt carrier was certainly not the only company to have been audited by Arthur Andersen LLP, now notorious for its willingness to allow companies to bend the rules in order to improve their images.

“Whether it is swaps (like Qwest Communications International Inc. [NYSE: Q] and Global Crossing Holdings Ltd.), or off-balance-sheet games (like Enron and Adelphia Communications Corp. [Nasdaq: ADLAC]), or balance sheet games (like WorldCom and Lucent Technologies Inc. [NYSE: LU]), the whole idea is to 'hide' what you are doing,” writes Craig Johnson, an independent analyst based in Portland, Ore., in an email to Light Reading.

While most companies don’t cross the line to the extent that WorldCom did, there are plenty of ways to artificially boost earnings that are within (or balancing along) the boundaries of what’s permissible.

“Even the best companies… play games,” Johnson says. “That’s what pro forma was all about.”

One of the easiest places to hide bad results is in pro forma numbers, which allow a company to basically leave out whatever losses they see fit from their earnings announcements. Of course, the real numbers have to go into earnings reports and Securities and Exchange Commission (SEC) filings, but, especially if there’s a problem, they don’t tend to be in bold.

“No accounting firm will put a big red flag on the front of an earnings statement,” Craig Goodman of the National Energy Marketers Association (NEM) says. Instead, he says, most of the interesting stuff is impossible to read since it’s hidden at the bottom in a 2-point font.

“There are plenty of techniques,” agrees Frank Dzubeck, president and CEO of Communications Network Architects, “and they’re all legal.”

Examples of such legal, but aggressive accounting can be seen in Qwest’s booking last year of approximately $1.3 billion in fiber optic and equipment sales as one-time revenue, instead of recognizing it over several years, observers say. Since the company reported what it had done to the SEC, however, it does not constitute fraudulent behavior along the lines of what WorldCom is accused of doing.

“With [the Qwest case], an accounting firm could stand up in court and defend it,” Dzubeck says. “As long as everyone understands the rules, it’s OK. The biggest problem in [the WorldCom] case is that no one knew they had done it. No one in their right minds would have done it. This one must be close to the end. It’s the peak of stench.”

Other observers, however, say they expect that the industry has at least a few more scandals in store before the storm blows over.

Back in March, Light Reading’s paid research service, Optical Oracle, predicted that a long line of carriers were facing very uncertain futures. Qwest and Level 3 Communications Inc. (Nasdaq: LVLT) topped the charts in that report -- and they still do. “Qwest and Level 3 remain the two most likely near-term candidates, in our view,” Optical Oracle analyst Chris Bulkey wrote in response to the WorldCom scandal. “Qwest’s use of reserves to obscure weakness at US West and Level 3’s persistent use of massive one-time charges are among the early warning signs.”

Other companies that are teetering on the edge are Allegiance Telecom Inc. (Nasdaq: ALGX), Broadwing Inc. (NYSE: BRW), and Time Warner Telecom Inc. (Nasdaq: TWTC), according to Bulkey. And if we let history serve as a guide, the most interesting ones to watch will certainly be Qwest, Level 3, and Allegiance, all of which, until quite recently, were being audited by [drum roll...] Arthur Andersen.

“If [Qwest’s] shares go to zero, people shouldn’t scream about it,” says F. Drake Johnstone, an analyst with Davenport & Co. LLC. “There’s been plenty of evidence of wrongdoing.”

American companies are not the only ones in jeopardy. With a more than $120 billion combined debt load, France Telecom SA, and Deutsche Telekom AG (NYSE: DT), for instance, have about the same level of debt as Argentina. While European telecoms are usually backed by their respective governments and are not required to adhere to the same levels of financial scrutiny as American companies, some observers think that troubling revelations may soon surface.

The gravity of the situation is reflected in reports that the French government is contemplating renationalizing France Telecom due to the company’s loss of investor confidence.

“There’ll be uglies,” Johnson says of the European telecoms, “but not like WorldCom.”

“The next one to hit the fan will be KPNQwest NV (Nasdaq/Amsterdam: KQIP),” says Frank Dzubeck, referring to the Dutch-based bankrupt service provider that once carried nearly half of all Internet traffic in Europe. Bondholders at that company are pushing for an investigation into how the company, which has been warning for the last month that it may soon have to shut down its entire network, could have fallen apart so quickly. Only two months before the carrier filed for bankruptcy it completed the acquisition of Ebone, which carried about 25 percent of all European Internet traffic.

With all the dirty laundry being aired in the industry, it’s no wonder investors are wary. To restore investor confidence, most observers agree that at least some of the executives responsible for the mess will have to do some hard jail time.

“We really haven’t seen anyone taste any medicine yet,” Johnson says. “We have to see some people go to jail.”

— Eugénie Larson, Reporter, Light Reading
http://www.lightreading.com

Editor's Note: Light Reading is not affiliated with Oracle Corporation.