Crossed wires for telecoms

Investors looking at the recently-released annual results announcement by Thus plc, the company behind internet service provider Demon, will be struck by something rather unusual.

Right at the top, before you even get to the results themselves, is a prominent sentence stating: ‘Thus adopts very conservative accounting policy for IRU transactions setting the benchmark for best practice in the telecommunications industry.’

Two questions immediately strike those whose who do not conscientiously follow the affairs of the telecoms industry. What on earth are IRUs? And why does this prominent British telecoms player feel compelled to talk about the way it accounts for them so prominently?

The motivation of Thus and other telecoms players stems from an outbreak of paranoia among investors in the sector that companies are artificially inflating their revenues by the way they account for ‘network capacity swaps’.

These originated in the days, mainly during the 1990s, when telecoms providers were busy investing huge sums in building their fibre-optic cable networks for the brave new world of electronic communication.

Endless miles of these cables now cross oceans and continents carrying electronic data and information. As the networks developed, it became common for companies to buy capacity, known as ‘bandwidth’, from rivals, or swap capacity with them, in order to bridge the gaps in their own networks.

These agreements are known as Indefeasible Rights of Use (IRU) contracts – which is what Thus, whose network extends to almost 6,000km, was referring to so prominently on its results statement. There is nothing wrong with these deals in themselves – they are perfectly legitimate and in most cases perfectly commercially sound ones. The problem, however, lies in the way that some companies have been accounting for them.

The wave of panic among telecoms investors really kicked off in early February when US telecoms giant Global Crossing, one of the pioneers of cable-building, announced it was under investigation by the Securities and Exchange Commission over the way it accounts for these transactions.

The US watchdog’s investigation followed allegations, made by a former employee of Global Crossing, that its revenues were allegedly inflated by including amounts which did not actually represent cash received by the company, including situations where there had been exchanges of capacity – which have become known as ‘hollow swaps’.

The SEC has yet to announce the completion of its investigation, which have now widened to include other US telecoms players, but the repercussions are are being felt by telecoms companies around the world – including the UK.

Investors, who have had their confidence in financial reporting severely shaken by the Enron affair, have started scrutinising the assumptions that lie behind telecoms companies’ reported financial performance far more closely.

Those who have significant holdings in the telecoms sector are particularly worried at the moment given collapsing share values across the sector due to factors such as the heavy debt burden acquired by many players during the 1990s, and disappointing take-up of new services.

Billions were borrowed to fund new networks, services and marketing operations, but customers have not materialised in anything like the numbers hoped for.

Global Crossing, for example, suffered because far too much cable was actually constructed and the hoped-for expansion in demand has failed to materialise – the company and its rivals have been forced to accept knockdown prices for ‘bandwidth’ on their cables. Global Crossing, struggling with huge debts incurred by building up its network, has filed for bankruptcy.

It is against this background of declining confidence, both in the financial performance of the sector and in the way it presents its accounts, that a wave of accounting conservatism is sweeping the telecoms market.

Companies in the sector are being forced to explain their accounting policies and justify them to investors. And, even where they fall within current accounting rules, many are erring on the side of conservatism, and not just when it comes to hollow swaps.

Some telecoms companies recognise the non-cash value of non-swap IRU transactions at the time of sale, even though the capacity may have been sold over a 20-year contract. In such cases, the prudent view is that such revenue should be deferred over a 20-year period, although the less conservative argue the full cash amount is generally received at the point the contract is signed.

Ernst & Young partner Richard Ireland recently wrote a paper on the issue, in which he says: ‘In a post Enron environment, it is hardly surprising that telecoms companies are seeing their accounting policies put under the microscope.

‘As the values of those companies which were seen as the leading lights of the sector only a few months ago have tumbled dramatically, analysts, journalists, regulators and shareholders have begun to scrutinise the treatment of such deals, which allowed a number of companies in the sector to announce quarter on quarter high revenue growth.

‘In what is still seen as a maturing sector, where EBITDA is king, the accusation of falsely enhancing a company’s financial performance has been levelled at a number of telecoms companies.’

One of the companies that has been forced to justify its accounting treatment of swaps is Cable & Wireless, which suffered a share price drop in February amid investor fears prompted by an investigation by Australian regulators accounting practices at Optus, its former Australian subsidiary.

Experts in the sector expect more companies to therefore follow the decision of Thus to adopt a more conservative way of accounting for IRUs.

Whereas previously, the company had recorded all sales under IRU agreements as turnover, it has now started showing the resulting profit in the accounts as a gain on the disposal of fixed assets.

Where the deal is a swap of capacity, it will be booked as a sale and purchase transaction at fair value, with the gain arising on the sale treated as unrealised and recorded in the statement of total recognised gains and losses.

The change in policy means a reduction in the Thus’s reported turnover for the year to 31 March 2002 of #24m, and a reduction in gross margin of #17m.

Accounting regulators around the world are looking at the issue. For example, in the UK the Accounting Standards Board is addressing it as part of its campaign against aggressive revenue recognition practices.

But, when it comes to the beleaguered telecoms sector, this outbreak of conservatism is being led by the market, rather than the watchdogs.

Thus’s results statements can be read at www.thus.co.uk For more on revenue recognition, visit www.asb.org.uk