SEC Comes Down on Capacity Swaps

Posted: 10/2002

SEC Comes Down on Capacity Swaps

By Josh Long

THE
SECURITIES AND EXCHANGE Commission has ruled carriers swapping similar assets
cannot book the transactions as a gain on their income statements, a practice
federal authorities are investigating to determine whether telecommunications
providers swapped capacity they didn’t need to artificially inflate their
revenue.

The SEC previously stated if
companies are trading similar assets, they essentially have to book the sale at
carrying value — what they spent to develop the asset — rather than at fair
market value. The Financial Accounting Standards Board sets the accounting
rules, but the SEC often clarifies them and has the final authority.

Accounting experts say the ruling
means telecommunications companies who traded capacity will have to comb through
their financial statements over the last few years, although many providers
already have retained accounting firms to re-audit their books.

"The staff expects that
registrants will apply this guidance historically to IRU capacity swap
transactions that occurred in prior years and, if appropriate, restate their
financial statements," according to a memo the American Institute of
Certified Public Accountants (AICPC) issued to its members Aug. 2. An SEC
spokesman was not available to comment further on its ruling.

The SEC has not clearly defined what
makes an asset similar or dissimilar. For instance, it is not clear whether the
sale of capacity on a route from New York to Los Angeles would be considered a
similar asset as the purchase of capacity on a route from Boston to London under
the accounting rules. Experts say the accounting rules frequently are murky.

"That is the difficult part.
There is no firm definition of what similar and dissimilar is," says Brett
Trueman, an accounting professor at the University of California, Berkeley.
"I guess the SEC saw sufficient possibility for abuse that they just shut
down that possibility."

During the telecom boom new-age
carriers booked billions of dollars in revenue by selling capacity over their
global networks to rivals. The SEC is investigating whether telecom providers
conspired to trade capacity they didn’t need at inflated values in order to
boost their revenue. Global Crossing Ltd. and Qwest Communications International
Inc. are the subjects of SEC investigations.

Global Crossing has asserted all its
transactions were legitimate. However a lawyer suing the firm on behalf of a
former Global Crossing finance manager claims the carrier’s engineers discovered
in an internal report a high percentage of capacity or fiber the company
purchased in swap 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, says
Paul Murphy, a partner with O’Neill, Lysaught & Sun LLP.

Qwest revealed this summer it had
improperly accounted for up to $1.16 billion in sales of optical capacity,
including swaps, over three years.

Investigators are combing through
the sales of long-term leases known as indefeasible rights of use (IRU). With
the telecom industry struggling, IRU sales in the United States basically have
come to a halt. Carriers that need to fill gaps in their network or expand their
footprint are buying capacity from their rivals in short-term lease agreements.

In the fiber swaps, carriers were
allowed to book part, or all, of the revenue up front while treating the
purchase as an expense over the life of the contract.

Edward Ketz, an accounting professor
at Penn State, argues the capacity swaps were similar and should be treated as
such under the accounting rules. "I would argue it is similar," he
says. "It is like creating a Dodge for a Ford. It is still a car. It’s not
enough in my judgment to say they are dissimilar."

If some cash is involved in the
swap, the provider can show a proportional gain or loss in the transaction, Ketz
says.

FCC Action

The SEC is not the only government
agency to take action on accounting rules that apply to the telecom industry.
The Federal Communications Commission recently delayed action to eliminate
additional accounting requirements affecting incumbent local exchange carriers
beyond 2003. FCC Chairman Michael K. Powell also announced his intent to convene
a federal-state joint conference on accounting.

FCC Commissioner Michael J. Copps
issued a statement in favor of the agency decision to delay action to eliminate
accounting requirements, particularly since the telecommunications industry is
mired in several accounting scandals. Last fall Coops voted against a notice of
proposed rulemaking that would have alleviated the accounting requirements
placed on the incumbents.

"I feel even more strongly
about it now amidst all the tawdry evidence of accounting practices gone wildly
astray," he says.

However, FCC spokesman Mike Balmoris
emphasizes the federal agency is not going to scour financial records to nab
companies for accounting fraud. Although Powell says it would be
"prudent" to take a closer look at the financial statements in light
of the recent wave of accounting scandals, the FCC is in no way "attempting
to do the SEC’s job," he says.

The incumbent local exchange
carriers file various records with the FCC, including financial and
network-related data that help federal and state regulators shape policy.

The proposal the FCC put on hold to
modify the accounting requirements would not just create less of a burden for
the incumbent local exchange carriers, Balmoris says. It included adding some
accounting requirements while eliminating and aggregating others. "It
wasn’t just a total elimination of accounts," he says.

In March the FCC disbanded the
accounting safeguard division and routed its accountants to various units, such
as the enforcement bureau and pricing division, where tariffs are filed. Their
roles have not changed, Balmoris says.