Legitimate Business Tool Creates Scrutiny

Telecoms are notorious for their murky, hard-to-understand accounting practices. Even professional analysts who follow these firms for a living — though admittedly not accountants — have trouble following some of their book-keeping.

Much of the trouble can be traced to the use of a legitimate tool in the telecommunications industry’s arsenal: the IRU or
Indefeasible Right of Use. An IRU is the right to use a fixed amount of communications capacity, or a certain communications facility, for a defined period of time.

And in light of the esoteric nature of the IRU especially in today’s skeptical environment, some analysts say the Securities and Exchange Commission’s (SEC) scrutiny of Global Crossing, or the increasing attention that is now paid to companies like Qwest and Level 3 Communications, is not really surprising. In fact, there is reason to suspect that many more telecommunications firms will wind up on the receiving end of an in-depth examination before all is said and done.

“I think everybody is under the microscope right now, as I think they probably should be,” said Seth Libby, analyst with the
Wholesale Communications Group of research firm The Yankee Group. “What the telecommunications industry needs right now is clarity.”

He added, “Anybody who entered the scene in the last five years is going to come under scrutiny. That’s not to say there’s going to
be a lot of problems, but there’s going to be a top-down analysis.”

IRUs came into vogue back in the days of Ma Bell’s monopoly, when they allowed competitors to utilize the large undersea cables that
were part of the AT&T’s fief. To this day, the IRU remains a legitimate business tool.

For instance, a company might purchase an IRU giving it the right to use an OC-48 wavelength (the equivalent of about 32,000
simultaneous telephone calls) for five years, or might purchase two fibers in a network for 20 years. Most IRUs seem to average
between 20 and 25 years.

A long-haul carrier might be interested in extending its
business into a region it believes will be lucrative but where it has no capacity or facilities. Through an IRU, that firm could
lease capacity or a facility in the region, allowing it to enter the market but bypass the costs associated with a buildout.

“Typically, major users of communications capacity purchase IRUs to, in effect, ‘build’ a communications network using components
like fiber or conduits or, more recently, optical wavelengths,” said James Q. Crowe, chief executive officer of Level 3
Communications. “IRUs give such a company the longer term assurance that these components will be available for periods of time that
meet their needs while avoiding the huge expense of building a complete network from the ground up.”

As a general rule, IRUs are paid for up front in a single cash payment.

So far, so good. However, accounting for IRUs, even under Generally Accepted Accounting Principles (GAAP), can be a tricky business
with large gray areas. As Libby puts it, buying an IRU is a little like leasing a fleet of trucks to make deliveries for your
business. That fleet becomes a capitalized asset that depreciates over time.

“Accounting for IRUs can be a bit complicated,” Crowe said. “Under current [GAAP], if the IRU is for capacity in a land-based
network, the revenue from the sale is generally recognized, i.e. reported in GAAP financial statements, over the term of the IRU.
For submarine capacity, to the extent that certain conditions are met, GAAP generally requires that the entire amount of the revenue
be recorded in the current period. In most cases, the cost of the IRU for the buyer is considered a capital expense and is
depreciated over the IRU term.”

But wait, here’s where dealing with IRUs can get really murky. Companies can sell or even trade IRUs, either back to the party they
originally bought them from or even to a third party. Now bankrupt @Home Corp. attempted to stave off its bankruptcy with just such
a maneuver — selling a 20-year IRU it bought from
AT&T in 1998 back to the company and negotiating for a year-to-year deal. The deal helped @Home realize $85 million in additional
financing, though that wasn’t enough in the end.

But these sorts of sales and trades can be used to inflate revenue. And that is one of the possibilities that caused the Securities
and Exchange Commission to sit up and take notice of Global Crossing.

“As a general matter, IRU sales are entirely proper and, indeed, a source of substantial value creation for companies like Level 3,”
Crowe said. “However, an issue can arise if two companies sell each other IRUs for substantially the same capacity, or facility, at
approximately the same time. Such transactions can be misleading to investors when they have no good business purpose other than
artificially inflating reported revenues. Such transactions (sometimes referred to as ‘hollow swaps’) can cause those who read the
resulting financial statements to believe that IRU seller’s revenues are higher than in reality, and that the IRU buyer’s cost of
such artificial revenues is a legitimate capital expense.”

According to Libby, dealings in IRUs got very popular in the past five years, as new carriers — especially wholesalers — broke
onto the scene and needed to build out networks rapidly. Libby said their popularity has waned recently as visibility in the market
has disappeared and firms opt for shorter-term deals until they can reliably price their purchases.

“What we’ve seen in the capital markets now is that a lot of service providers are opting out of these long-term deals anyway,” he

Of those deals that remain on the books, the ones to watch out for are those in which a firm is selling IRUs to companies it also
buys IRUs from. Those might be legitimate swaps, but it could also be a sign of collusion. In that instance, Libby said, companies
have little incentive to get the best price in their transactions and may actually view a higher price as better because it can be
written off as a larger expense.

In the end, when looking at one of these companies, the best thing to do, Libby said, is stick to the basics.

“The basics hold true,” he said.

That means examining revenues and the drivers of those revenues. It also means looking at the customer mix. Is it primarily dotcoms?
Incumbents? Large enterprises? A mix? He also stressed the importance of talking to customers and figuring out who is executing and
how well they do it.

However, it is important to remember that an IRU on the books in not necessarily a sign of wrongdoing.

“I don’t think more scrutiny would be bad,” Libby said. “If the IRU transactions were carried out as they were designed, I don’t
think that’s a bad thing. Certainly there is a viable use of an IRU.”

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