Mergers & Acquisitions: Buyer's Due Diligence

In the context of mergers and acquisitions within the telecommunications industry, a buyer's due diligence of the proposed transaction (e.g., diligent review of the stock purchase agreement, schedules, ancillary agreements, and continuing property records (CPR)) is of paramount importance. Retaining an attorney who knows the laws and regulations relative to the industry is necessary. But retaining an attorney who understands intricacies of how the value of a telecommunications company is derived, is crucial.

Within the telecommunications industry, companies’ financial and operational transactions are separated into accounts and recorded in companies’ CPR. Certain natural groupings of these transactions are often referred to as transaction cycles, business processes, functions, or activities. The concept, however, is the same in each case (i.e., the natural groupings represent what happens within the company on a consistent and continuing basis).

Certain recurring functions (natural groupings) take place in the course of providing products and services to subscribers. These accounts reflect those functions (e.g., the primary basis of the accounts containing the investment in telecommunications plants are the functions performed by the assets). Additionally, because of the anticipated effects of future innovations, the telecommunications plant accounts are intended to permit technological distinctions. Similarly, the primary basis of plant operations, subscriber operations, and corporate operations expense accounts are the functions performed by individuals. The revenue accounts, on the other hand, reflect a market perspective of natural groupings based primarily upon the products and services purchased by subscribers.

These accounts, then, are intended to reflect a functional and technological view of the telecommunications company and provide a stable and consistent foundation for the recording of financial data. The financial data contained in the accounts, together with the detailed information contained in the underlying financial and other plant/network records provides the information necessary to support separations (e.g., regulated and non-regulated activities; competitive and non-competitive services), cost of service, and management reporting requirements. Moreover, telecommunications companies are required to follow this system of accounts in recording all financial and statistical data irrespective of an individual item’s materiality under generally accepted accounting principles (GAAP), unless a waiver has been granted.

Further, the CPRs detail the date of placement, location, description of property, and the original cost of the property record units. The CPR and other underlying records of construction (e.g., system maps, key maps and related subparts, staking and as-built sheets,[1] permits, (collectively, the “Plant Records”)) and network equipment (e.g., AH Fiber Multiplexer, Advanced Fiber Communications Concentrator, Digital Subscriber Line Access Multiplexer, Session Initiation Protocol Gateway, Service Routers, Ethernet‐Over‐Copper/Fiber Delivery Systems, and related software) are required to be maintained so that, upon retirement of one or more retirement units or of minor items without replacement (when not included in the costs of retirement units), the actual cost of the plant retired can be determined.

It is a customary practice in the telecommunications industry to update the Plant Records as adjustments to the plant facilities are made. Generally, this begins with updating or creating a staking sheet, and upon completion of the adjustments, finalizing the staking sheet into an as-built sheet. From these sheets, existing system and key maps are updated. Moreover, CPRs are necessary to ensure that the plant accounts accurately reflect those assets in service.

CPR records provide data for cost allocations studies used in state regulatory proceedings. In addition, these records provide material-only costs for accounting for transfers, reallocations, and adjustments of plant.[2] Plant costs directly impact depreciation, return, cash outflow, and debt service of a company. Therefore accurately identifying the plant and capital costs of providing service is essential in order to appropriately configure the rates that will be charged to subscribers. Relative to depreciation, accounting standards spread the cost of an asset over its useful life through an operating expense.

Companies generate revenue to cover the depreciation expense of the asset. Spreading the costs of all plant assets over their useful life matches the benefits of using the investment with the revenues generated to cover the cost. In the absence of depreciation accounting, during the year in which that the asset was put into service, expenses would be very high, while during the remaining years the asset is used, expenses would be low. Without depreciation, rates charged to subscribers would fluctuate to cover the expense of the asset, even though the asset is used uniformly over its life. Further, state regulators rely heavily on the CPR records in their local ratemaking processes[3] and determination of tax liabilities.

Errors in the CPRs fundamentally question the soundness of the financial and operational information therein, because CPRs are relied on to make important decisions relative to allocation of costs (e.g., between regulated and non-regulated, competitive and noncompetitive services, reported earnings, legacy cost issues, and universal service support). If the CPRs are not accurate, only a physical inspection of the entire plant (which is typically exorbitantly expensive and time-consuming) can determine the actual plant cost, and the functional and technological capacity of the telecommunications company.

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[1] Staking and as-built sheets are the specific documents that describe the date of placement, location, description of property record units, and the original cost of the property record units. Staking and as-built sheets are baseline documents upon which the CPRs are created.

[2] In re 2000 Biennial Regulatory Review – Comprehensive Review of Accounting Requirements and ARMIS Reporting Requirements, et al., 16 FCC Rcd 19911, 19958 (¶ 121) (FCC 01-305) (2001) (Report and Order).

[3] Id. at 19959.

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