Will SEC Ruling Make a Mess?
An epidemic of earnings restatements is likely to follow the Securities and Exchange Commission (SEC)’s decision to rule invalid the way many carriers have recorded revenues from capacity swaps, observers say.
“This is going to be huge,” says Jeff Kagan, an independent analyst based in Georgia. “It’ll be bad. Like with WorldCom Inc. (OTC: WCOEQ), a $1 billion a year profit can suddenly turn into a $3 billion a year loss." (See WorldCom's at $7.1 Billion and Counting.)
The SEC confirmed this week that it has ruled negatively on how carriers account for swaps of their network capacity by recording transactions involving so-called "indefeasible rights of use" (IRUs). While the agency hasn't made any public statement about its decision, it has asked The American Institute of Certified Public Accountants (AICPA) to distribute a memo outlining the changes to the accounting community.
News that the SEC disapproves of the way many companies have booked revenues from capacity swaps comes as no surprise. Along with several other federal agencies, the SEC has spent many months investigating carriers such as Global Crossing Holdings Ltd. and Qwest Communications International Inc. (NYSE: Q) for their suspicious accounting (see Global Crossing: More Questions, Qwest Prepared to Answer Feds, and Qwest Called on Global Crossing ).
Qwest and Global Crossing wouldn’t comment on what effects the new ruling could have on them, beyond saying that they are cooperating fully with the SEC investigations.
In an industry with so much excess capacity, swaps have become an integral part of the way companies do business. For example, capacity swaps made up nearly 70 percent of Qwest’s revenues from optical capacity sales in 2001 (see Qwest Revises, Retraces, Replies).
The practice, which allows companies to sell access to their network and purchase access to other networks, is not a problem in itself. The trouble arises when the companies involved book revenues as two separate transactions, spreading the cost they incur over time -- sometimes over as much as 25 years -- while simultaneously counting the revenues from the sale of access rights as a one-time lump sum. This can artificially boost a company’s earnings, making it look more profitable and valuable than it really is.
“If you ever wondered where all these amazing numbers came from, now you know,” Kagan says. “They were just a figment of the imagination.”
The AICPA memo reportedly says that not all swaps have been accounted for incorrectly, and that those accounted for as one transaction aren’t at issue. The organization did not return calls by press time.
Observers say the SEC ruling is a bit late in coming. “The SEC is acting after the fact,” says Craig Johnson, an independent analyst based in Oregon. “[E]veryone has already stopped. This should never have been allowed to begin with.”
Considering all the scandals and restatements that have already rocked the telecom industry (see SEC Deadline Triggers Paperwork Storm, Carrier Scandals: Who's Next?, and Qwest Backtracks Fast), Johnson says the implications of the revelations to come will hardly be earth-shattering. “The suspect list really doesn’t change,” he says. “Just take a look at Arthur Andersen’s client list… Almost everyone in long haul was playing the game.”
The one thing that will emerge from the ordeal, Johnson says, is very conservative accounting for all future capacity swaps.
Jeff Kagan agrees, adding that the house-cleaning ahead will ultimately benefit the industry. “Telecom's still important,” he says. “Investors still want to invest in it, but because of the uncertainty [over what the real numbers are] they’re staying away... It’s like having your wisdom teeth pulled out. It’s healthy… The problem here is that we’re pulling them without anesthesia.”
— Eugénie Larson, Reporter, Light Reading