SMARTMONEY.COM: On The Street: Telecom Accounting Bombs27 Feb 20:11
By Cintra Scott Of SMARTMONEY.COM
ONLY A COLLAPSE as titanic as Enron's (ENRNQ) could upstage the massive
telecom meltdown. Yet Global Crossing's (GBLXQ) implosion has the same key
elements as Enron's. They both involve allegations of accounting fraud,
unheeded whistleblowers and even the same auditor, Arthur Andersen. It's almost
uncanny.
In Global Crossing's case, the Securities and Exchange Commission and the FBI
are examining what's known in industry jargon as "indefeasible rights of use,"
or IRUs. An IRU grants a customer a certain amount of communications capacity
or portion of a network for a fixed amount of time. For example, a carrier may
lease some fiber from Global Crossing's undersea network for 20 years, instead
of paying to build its own. As a general rule, IRUs are paid for up front by
the buyer and thus recognized as revenue by the seller right away.
Things get tricky when two carriers swap IRUs, ostensibly for their own
strategic purposes. Sometimes, these swaps add more to investor confusion than
they do a carrier's network capacity. For the buyer, the IRU is usually
considered a capital expense that can be depreciated over the term of the
contract. But as we said earlier, for the seller, the IRU may be recognized as
revenue in the current period. Global Crossing thus was able to swap capacity
and record it as a sale upfront while spreading its cost over time. In this
case, even swaps where no cash changed hands appeared as a profitable
transaction in the short term.
Hollow swapping may follow the letter of the law, but it doesn't follow its
spirit. And the dubious practice may be widespread in the telecom sector.
Surprised? Don't be. It's an emerging industry with accounting that's subject
to interpretation. It needs a constant flow of affordable captial, which comes
only with pristine credit ratings or a stock that's much in demand. And top
that with sky-high investor expectations. You have the recipe for some fancy
numbers games.
Here are some of the other tricks played in the telecom sector - and how
investors can spot them. Revenue-Recognition Games
Revenue is the first figure on an income statement and the raw material from
which earnings are crafted. This is where most creative accounting occurs,
because "it's so darn easy," says Charles Mulford, accounting professor at
Georgia Institute of Technology and co-author of "The Financial Numbers Game:
Detecting Creative Accounting Practices." Problems arise when revenues are
recorded prematurely or, in the worst case, fictitiously.
So far in our accounting series, we've highlighted a number of ways companies
can manipulate their revenue figures. Telecom carriers and equipment makers are
no strangers to most of them. For instance, Lucent Technologies (LU) came
under SEC investigation in February 2001 for apparently "stuffing the channel"
with its telecom equipment. Back in December 2000, the company had restated its
revenues for the fiscal fourth quarter (ended Sept. 2000) by $679 million. Of
that adjustment, $452 million was for equipment it took back from distributors
when they didn't sell it.
"The investigation is continuing and we are cooperating fully," says Lucent's
spokeswoman. "We have nothing new to report."
The company also notes that it voluntarily brought these issues to the SEC's
attention in Nov. 2000, three months before the official investigation was
launched.
As in the software industry, telecom's revenue recognition practices run the
gamut from superconservative to outright fraud. To detect aggressive policies,
watch the accounts-receivable figure on a company's balance sheet. If
receivables grow faster than total revenues, that's a red flag.
Hollow Swaps
As the Global Crossing debacle shows, asset swapping is particularly
worrisome to telecom investors. Remember: It takes two to swap. Fellow carriers
Qwest (Q) and 360Networks (TSIQX) have been implicated in the Global Crossing
investigation. Their records have been subpoenaed by the SEC, and they could
very well be under investigation themselves. A Qwest spokesman says the
third-party subpoena appeared to be a routine request for documents and that
there was no reason to believe it would be the subject of an SEC
investigation. 360Networks, now in bankruptcy court, said it couldn't comment
at this time.
In addition, Level 3 Communications (LVLT) has recently disclosed some IRU
swaps - seven in its 2001 fiscal year, to be precise. But Level 3's chief
executive, James Crowe, issued a statement on Feb. 13 to allay concerns. "We
have recently completed a review of each of [the seven] transactions and have
reconfirmed that, in each case, the transaction had a valid business purpose
and that the accounting treatment was proper," he said in a press release. "In
any event, the total amount of revenue Level 3 recorded in connection with
these transactions was immaterial, representing only 2% of our GAAP revenue for
2001."
Meanwhile, at Qwest, something akin to IRU swapping has also popped up. As
discussed in its Feb. 14 conference call, Qwest has recorded some mutually
beneficial transactions with KMC Telecom Holdings in 2001. Qwest maintains that
leasing KMC's Internet services was important for its business strategy, and
not merely a guise to artificially inflate its own revenues, as some have
alleged. Qwest bought data equipment that it then sold to KMC. Meanwhile,
Qwest leased KMC's dial-up ports for a monthly fee. As with IRU swaps, Qwest's
equipment sales added to its top line, while its related costs were spread out
over the terms of the contracts. A company spokesman says the transactions were
properly accounted for and that leasing KMC's dial-up ports allowed Qwest to
offer customers - such as MSN and AOL - faster and more economical services.
But these transactions also helped Qwest'squarterly income statements look a
little meatier. How can an investor detect hollow swaps?
"Take a step back," says Georgia Institute of Technology's Mulford.
First, make sure you understand how the company makes money. That's the easy
part. Mulford also suggests reading all those footnotes regarding special
expenses. Be suspicious if capital expenses aren't obviously necessary to a
company's strategy.
"Creative accounting practices are possible to detect," Mulford says. "You
may not detect the 'perfect fraud'," but not even Enron was a perfect fraud in
his view.
Troubling transactions were apparent to close readers of Enron's filings.
Big Baths
Another way to boost earnings is to lighten expenses. One common way telecom
companies do this is via a "big bath." That's when a company cleans up its
balance sheet by taking a massive restructuring charge all at once. The
benefits are seen in the future, when expenses that have already been written
off would otherwise be applied. As a result, future earnings look better than
they otherwise would.
Cisco Systems (CSCO) aroused suspicions when it took a $2.25 billion
inventory write-down last year. The company lumped in charges for raw materials
it said it was unlikely ever to use because of changes in technology and
customer demands. But analysts noted at the time that if Cisco could find use
for these written-off raw materials, it most certainly would - and its margins
would appear higher because its cost of goods would be zero. Indeed, in the
quarters since then, Cisco has resold and used certain materials, netting a
couple hundred million dollars in the process. But note that it excluded these
gains from its pro-forma earnings per share - the number most closely watched
by Wall Street.
In 1998, when Arthur Levitt was chairman of the SEC, he cited big-bath
charges and revenue recognition as two ways companies play the numbers game.
Four years later, little has changed.
For more information and analysis of companies and mutual funds, visit
SmartMoney.com at smartmoney.com. (END) DOW JONES NEWS 02-27-02
08:11 PM |
