Carrier Channel: Tricks of the Trade: Accounting for Swaps

Posted: 09/2002

Tricks of the Trade: Accounting
for Swaps

By Josh Long

SHARE PRICES FOR QWEST
Communications International Inc. plummeted to a record low in late July
following the latest accounting scandal to rock the embattled telecommunications
sector. The Denver-based company, which is being investigated by the Securities
and Exchange Commission and U.S. Attorney’s Office, announced July 28 it had
improperly accounted for up to $1.16 billion in sales of optical capacity,
including swaps, over three years.

Qwest sales of optical capacity in
2000 and 2001 represented 2.8 percent and 5.1 percent of total reported revenue
in those periods, or $468 million and $1.013 billion respectively. Qwest also
withdrew its annual forecast and noted it would restate financial results for
1999, 2000 and 2001 — a move analysts said could result in lower earnings and
bank covenant violations.

The disclosures come on the heels of
a separate accounting scandal that brought telecom titan WorldCom Inc. to
bankruptcy. Qwest is not the only one in the hot seat for how it has booked
revenue for sales and purchases of long-term leases, or IRUs (indefeasible
rights of use), of optical capacity. The SEC and FBI are investigating Global
Crossing Ltd., a carrier that filed for bankruptcy protection in January and
once boasted a higher market value than General Motors.

Roy L. Olofson, former
vice-president of finance for Global Crossing Development Company, claims he was
ostracized and then fired after questioning accounting methods that allegedly
helped his employer artificially inflate revenue off long-term swaps.

A lawsuit Olofson filed against
current and former Global Crossing executives, including Chairman Gary Winnick,
details instances in which the Bermuda-based operator swapped capacity in IRU
agreements, booking the sales as revenue even though the company essentially
broke even on the deals.

Generally accepted accounting
principles (GAAP) allow each party to an IRU swap to record the sale of the IRU
it sold as revenue, and treat the IRU it bought as a capital expense.

However, even if the
telecommunications providers abided by GAAP, critics charge they leveraged the
broad rules to manipulate their financial performance, a possible breach of
securities laws. In other words, by artificially boosting its revenue through a
swap, for example, a carrier could potentially increase its capitalization in
equity markets.

Thus, there is a more important
question authorities are likely to probe: Did Global Crossing, Qwest and others
conspire in so-called hollow swaps — buying and selling capacity from one
another when they had no real use for the asset — in order to comply with
revenue covenants and meet Wall Street’s expectations?

Paul Murphy, a partner with O’Neill,
Lysaught & Sun LLP, the law firm representing Olofson, said Global Crossing
engineers discovered in an internal report that a high percentage of capacity or
fiber the carrier bought in swap IRU agreements was deemed to be worthless.
Either Global Crossing didn’t need the asset or the company had no way to link
it to its network, Murphy said.

Global Crossing asserts all its IRU
agreements — including those in which the company sold and bought capacity from
a company at virtually the same time — were legitimate. "These
transactions were entirely lawful, were reported in a manner in accordance with
applicable accounting principles and were fully disclosed," Global Crossing
CEO John Legere and CFO Dan Cohrs submitted in a March letter to the House
Committee on Financial Services before a hearing. "Neither these
transactions nor our account for them had anything to do with the
telecommunication industry’s — or our company’s — difficulties."

At the very least, the accounting
rules have given Global Crossing, Qwest and WorldCom flexibility in recording
their revenue. For starters, companies can book revenue off an IRU, or at least
part of it, upfront. Meanwhile, they can treat the cost of buying capacity as an
expense over the life of a long-term IRU contract.

Since depreciation expenses fall
below the EBITDA (earnings before interest, taxes, depreciation and
amortization) line, a key metric Wall Street evaluated in determining the
financial health of a company, the cost of a pricey IRU was not reflected in
that number.

To make matters more convoluted,
Global Crossing showed revenue using another metric, "cash revenue,"
that is not in accordance with GAAP. Using that number Global Crossing disclosed
its revenue over the life of an IRU. Consequently, that number was much higher
than it would have been following GAAP. Again, Global Crossing maintains it
fully explained the meaning of "cash revenue" in every press release
and filing, including the fact that it was not a GAAP term.

Olofson and others claim Global
Crossing booked artificial revenue with carriers including 360Networks Corp.
when it did not actually receive any money off the transaction. In one instance,
Olofson particularly was concerned about a transaction with 360Networks in which
Global Crossing "booked $150 million in ‘cash revenue’ even though it had
not received a penny in cash," according to the complaint Olofson filed.

In the meantime, Qwest’s problems
came to a head on July 9 when it was informed by the Department of Justice (DOJ)
that the U.S. Attorney’s office had begun a criminal investigation into the
carrier’s dealings. While the U.S. Attorney’s office did not disclose the nature
of the investigation, it has been assumed to follow the same lines as the SEC’s
formal investigation undertaken in April. That probe focuses in part on how
Qwest booked revenue in 2000 and 2001 for long-term capacity swaps with other
carriers.

The carrier also stated in March
that for 2002 and thereafter, it does not expect sales of IRUs to have a
material effect on its financial condition or results of operations as it does
not anticipate making any optical capacity asset sales in 2002 due to changes in
market demand.