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Accounting puts telecoms on defensive

Qwest and Level 3 issue statements addressing accounting issues for themselves and the industry as questions swirl because of Global Crossing's bankruptcy proceedings.

Two former telecommunications highfliers went on the defensive Wednesday as accounting questions swirled around the sector because of Global Crossing's bankruptcy proceedings.

In separate statements, Qwest Communications International and Level 3 Communications addressed accounting issues for themselves and the industry. Tales of potential accounting problems among upstart telecommunications companies have become almost a daily occurrence since Global Crossing filed for bankruptcy protection in January.

The Securities and Exchange Commission and the FBI are scrutinizing Global Crossing for possible accounting problems, a probe running concurrently with the Enron meltdown that has captured the nation's attention. A former Global Crossing employee charged in a letter to the SEC that the company improperly inflated revenue using a practice known as "round tripping," in which one telecom company swaps capacity with another and both book revenue.

With the concerns about accounting, companies have increasingly set out to defend deals that are now being scrutinized by skeptical analysts and the press. Qwest and Level 3 note that they have used the nationally recognized Generally Accepted Accounting Principles (GAAP).

"It's not inappropriate for these companies to be defensive," said David Bank, an analyst at RBC Capital Markets. "But it won't make a difference. The upshot of all this is most of the accounting that was done was kosher, but not transparent."

Qwest may be a case in point. No stranger to battles with Wall Street over its accounting, Qwest issued a statement Wednesday responding to worries about its dealings with KMC Telecom Holdings, a privately held company in Bedminster, N.J. On Monday, the SEC asked Qwest for information related to the agency's Global Crossing investigation.

The deals with KMC, which were reported in The Wall Street Journal, were not illegal but could be viewed as off-balance-sheet transactions, the practice that got energy company Enron into hot water. According to the Journal, Qwest sold equipment valued at $450 million to KMC over two years and in return bought services from KMC, essentially outsourcing some Internet and telecom services and cutting expenses by putting the equipment on KMC's books.

KMC's regulatory filings related to its scrapped initial public offering last year mentioned the deals, but analysts say the deals were not disclosed in Qwest's filings with the SEC because they weren't "material"--meaning they weren't important enough to mention since they made up a small portion of the company's overall revenue.

Gartner analysts Bob Hafner, Jay Pultz and David Neil say that questions about accounting practices in the telecom industry may be fraying some nerves, and if you've read the telecom news during the last week or so, you can be forgiven for thinking that the whole industry is collapsing.

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It was a different story for KMC, which said in filings that Qwest accounted for 58 percent of its revenue for the nine months ended Sept. 30. KMC had no comment, and representatives for Qwest were not immediately available to comment.

Qwest said in a statement that it had entered into its relationship with KMC to "accelerate Qwest's entry in the fast-growing dial-up Internet market." Qwest, adding that its deals with KMC used standard accounting, disputed the conclusion that the KMC deals were off the balance sheet.

"KMC purchased Internet infrastructure equipment from Qwest to support delivery of the access ports to Qwest and to take advantage of Qwest's ability to buy the equipment at a lower price than KMC would otherwise pay," the company said, adding that it discussed Internet equipment sales on a conference call Oct. 31 and talked about KMC specifically at a meeting Dec. 13.

Analysts said the accounting for the KMC deals isn't as "problematic" as Qwest's 2001 transactions with Calpoint, which also raised a few hackles among analysts.

"This is old news," said David Bench, an analyst at Arnhold & S. Bleichroeder. "But because of Global Crossing and Enron, everyone has refocused on accounting."

In any case, the KMC flap is another black eye for Qwest. "This just ensures continued skepticism," RBC's Bank said. "It's another shoe to drop."

Level 3 playing field
Hoping to pre-empt any worries about Level 3's accounting, CEO James Q. Crowe issued a statement that read like a primer on telecom deals. "My purpose in communicating with you is to provide some general background on industry accounting and some specifics with regard to Level 3's practices," Crowe said.

Crowe said the company has received a number of questions about IRU (indefeasible right of use) sales. Those sales give a customer the right to use a fixed amount of communications capacity for a set period. IRUs are paid up front in cash.

Level 3 has used IRUs to sell capacity and defray costs of building its own network. Crowe said they "have been important contributors" to the company's business, but acknowledged that "accounting for IRUs can be a bit complicated."

Crowe went on to explain the GAAPs behind IRUs before concluding that such sales "are entirely proper and, indeed, a source of substantial value creation for companies like Level 3." But he also noted that a swap of IRUs for essentially the same terms misleads investors and inflates revenue, a charge that critics are leveling against Global Crossing in a host of class-action lawsuits.

For fiscal 2001, Level 3 had seven deals in which it sold IRUs and bought IRUs or services from customers around the same time. Crowe explained that Level 3 has reviewed the deals, which accounted for 2 percent of its 2001 revenue under GAAP.

Will Crowe's pre-emptive confessional work? Analysts said it's doubtful, considering there are more pressing worries for the company--notably, whether it will have enough cash.

Last week, Level 3 disclosed plans to sell shares of its Commonwealth Telephone unit to raise cash, but analysts said it's not enough to help the company fend off creditors.

"Level 3 is not fully funded and will not generate positive cash flow from operations for several years," said Merrill Lynch analyst Adam Quinton, who noted that the company will continue to negotiate with creditors to ease its debt burden.