Top 10 risks in telecommunications 2010 - internal briefing for audit - 13.12.10

Top 10 risks in telecommunications 2010Internal briefing for Ernst & Young’s audit teams

14 December 2010

Top 10 business risks for telecommunications in 2010

After the launch of our report Top 10 business risks for telecommunications 2010 to clients earlier this year, we were asked to provide an update for audit teams to use for their year-end reports.

Thanks to our colleagues who have contributed to this update:

Lindsay AbtChristine BaumannKylie BodenhamLuis Hernandez Dominguez Helen LopezMichael Sokulski

Key messages

As the global economy stabilises and the agenda turns toward growth, the telecoms industry finds itself at a defining moment in its evolution.

During the downturn, the defensive nature of telecoms has been seen as a positive trait, with investors regarding the industry as a safe haven.

However, with technology and device companies such as Google and Apple now leading innovations in the sector, and telecoms networks having to cope with a remorseless rise in data traffic, the advantages of this defensive positioning are rapidly diminishing.

The risks we have identified for 2010 do not differ significantly from 2009, but we have indicated on the next page where risks have moved up or down in the rankings.

For further insight, please refer to our full report, Top 10 risks in telecommunications 2010, available via the Global Telecommunications CHS or from your local Global Telecommunications Center contact.

Top 10 business risks for telecommunications in 2010

Losing ownership of the client (1)1.

Failure to maximize customer value (new)2.

Rising regulatory pressures (2)3.

Ineffective infrastructure investment (3)4.

Inability to contain and reduce costs (10)5.

Lack of talent and innovation (new)6.

Inability to manage investor expectations (new)7.

Inappropriate systems and processes to support the business (7)

8.

Poorly managed M&A and partnerships (8)9.

Privacy, security and piracy (9)10.

Top 10 risks — 2010 (2009)

Below the radar

A more pressing green agenda

Concentration of equipment vendors

Difficulties in managing debtand cash

Negative consumer healthconsiderations

Top 10 risks in telecommunications 2010

Losing ownership of

the client Inability to contain and reduce costs

Rising regulatory pressures

Privacy, security and piracy risks

Lack of talent and innovation

Inappropriate systems and processes to support the business

Poorly managed M&A and

partnerships

Inability to manage investor

expectations

Ineffective infrastructure investment

Failure to maximize

customer value

Below the radar risks for telecommunications

What’s below the radar?

Consolidation is an ongoing feature of the telecoms equipment market and investors expect more this year. Operators need to ensure they are not overly reliant on any single equipment manufacturer.

2. Concentration of equipment vendors

While operators entered the economic crisis in better shape than other sectors due to balance sheet repair in 2002-03, a more constrained environment is putting new demands on the sector. More defensive capex programs help maximize operating cash flow.

3. Difficulties in managing debt and cash

The health implications of new telecoms technology continues to be explored; operators must be prepared for ongoing external scrutiny.

4. Negative consumer health considerations

The green agenda is now top of the below the radar risks — operators must move beyond regulatory compliance and ensure that they begin to differentiate via sustainability.

1. A more pressing green agenda

Difficulties in managing debt and cash

Negative consumer health considerations


Losing ownership of

the client Inability to contain and reduce costs

Rising regulatory pressures

Privacy, security and piracy risks

Lack of talent and

innovation


Poorly managed M&A and

partnerships

Inability to manage investor

expectations


Failure to maximize

customer value



1. Losing ownership of the client


Top ten risk Potential impact on financial statements and operations

Audit implications

Losing ownership of the client

• Revenue• Receivables• Allowance• Bad Debt• Inventory

• A result of losing ownership of the client would be decreased revenues, increased bad debts and bills being paid late or not at all which would affect the receivables and the allowance. By not paying the bills the receivables ages increasing the reserve requirement and eventually having to w/o the receivable.

• By losing clients/customers or not being able to generate new customers could lead to the Company being left with large amounts of inventory

• Revenues• Deferred revenue

• Operational risk, reduction in revenue, pressure on EBITDA but minimal audit impact

• -Re-focus audit to help client identify potential reasons, eg. Process deficiency, poor customer service, large number of adjustments to customer accounts

2. Failure to maximize customer value



Audit implications

Failure to maximize customer value

Retention strategies are destroying value; bundle packages in fixed and flat-rate offers in mobile have widened product scope at the expense of product revenue and profitability

• Revenues• Deferred revenue

• Changes in product offerings could impact revenue recognition (e.g., the shift from usage-based pricing to flat-rate pricing of a product could impact revenue deferrals if the Company begins billing for the product in advance instead of in arrears).

• Expectations established for analytical review procedures should be updated

• Revenue• Receivables

• Tied to #1; if not maximizing customer value Company might lose them

• By utilizing bundling packages in order to achieve customer value the risk becomes how to properly account for the bundling and how the Company can shift revenue from 1 revenue stream to another

• Revenues• Deferred revenue• Revenues• Deferred revenue• Operating expenses

• Operational risk, reduction in revenue, pressure on EBITDA but minimal audit impact

• -Re-focus audit to help client identify potential reasons, eg. Process deficiency, poor customer service, large number of adjustments to customer accounts

• -Consider benchmarking client product mix against other Telco’s

3. Rising regulatory pressures



Audit implications

Rising regulatory pressures • Litigation Reserves• Taxes• Revenue/Cost of Sales

• Not keeping up to date on regulatory rulings could impact appropriate pricing. If pricing is inappropriate this could impact regulatory fines as well as potential litigation from customers.

• Audit team needs to be aware of all regulatory actions to confirm pricing and taxes/surcharges are properly billed and remitted

Regulation is continuing to evolve more generally across different segments: roaming and termination rate reductions, prospect of network neutrality, fiber regulation. Telecoms can be a source of government taxation as well as the scene of government investment.

• Revenues• Operating expenses• Contingencies / Accruals

• Expectations established for analytical review procedures in Revenues (roaming, interconnect) should be updated in response to regulatory rate reductions.

• Analysis of the need to book provisions related to government

and local taxation, monitoring the evolution of the lawsuits related the abovementioned taxation.

• Property, plant, and equipment – existence and valuation

• Impairment charges• Depreciation expense

• Increased focus on regulatory compliance in engaged in performing compliance type audit

4. Ineffective infrastructure investment



Audit implications


The industry is characterized by rapidly changing technologies, and capital expenditure intensity remains high.


• Impairment charges• Depreciation expense• Intangibles

• Possible reduced life expectancy of networks and related equipment

• Asset values may be impaired• Investments in new technologies could require updated

accounting policies related to capital vs. expense decisions


• Impairment charges• Depreciation expense• Operating expenses

• Increase focus on audit of PPE• Increased focus on impairment testing of assets• Increased focus on assessment of service life reviews• Increased focus on capex spend, and classification of opex

versus capex • Increased focus on assessment of WIP and potential

impairments

5. Inability to contain and reduce costs



Audit implications Source

Inability to contain and reduce costs

Cost reduction programs are well established, but the low hanging fruit is gone. A new wave of cost cuts will be more difficult to achieve.

• Operating expenses• Restructuring accruals

• Restructuring programs may not be properly reflected in the financial statements

• Planned operational efficiencies or cost reductions that do not take place may cause aggressive accounting practices in other areas

• Personnel reductions may impact internal controls

• Potential for fraud risk - if the company is unable to contain and reduce cost they might look for areas where they can manipulate earnings by taking reserves or capitalize items when they should be expensed.

Christy BaumannVerizon team

• Operating expenses • Operational risk, increase in expenses, pressure on EBITDA but minimal audit impact

Telstra team

6. Lack of talent and innovation



Audit implications

Lack of talent and innovation

• Varies • Lack of innovations; same as items discussed in risk #4 - could result in risk #1

• if not investing in accounting group; could result in inappropriate accounting

• Revenues• Operating expenses

• Operational risk, pressure on EBITDA but minimal audit impact

7. Inability to manage investor expectations



Audit implications

Inability to manage investor expectations

• Varies - P&L focused • Potential fraud risk - manipulation of earnings

• Company feels earnings pressure could lead to aggressive accounting practices and entering into unfavorable transactions

Operators have survived and emerged from the crisis as a “safe haven” for investors -but this status is not enough to sustain investors’ confidence. Telcos can no longer rely on the sector’s defensive nature, and now need to change their story fromshort-term cash generation to longer-term growth and innovation.

• Revenue recognition.• Improper capitalization of

expenses.

• Pressure to meet analysts’ expectations may result in improper revenue recognition or improper capitalization of expenses.

• Equity • Financial/Strategic risk, pressure on share price but minimal audit impact

8. Inappropriate systems and processes to support the business



Audit implications


• Revenue • Could lead to inaccurate billings

• SOX implications - could lead to an ineffective control environment

• In addition if companies don't invest in their infrastructure their billing systems can become obsolete and outdated. It could mean more billing adjustments in the future as the billing systems are not updated with the latest revenue arrangements the company has.


• Increased focus on testing of systems and providing insights to client based on this

• Identify opportunities for increased process efficiency as part of work on processes, share with client key controls tested and discuss other controls not viewed as key, these could potentially be removed

• Identify process deficiencies through process audit

9. Poorly managed M&A and partnerships



Audit implications

Poorly managed M&A and partnerships

• Impairment • Earnings pressure if not meeting synergy targets; could result in aggressive accounting & potentially a fraud risk for a misstatement in earnings

The risks around partnerships are being compounded by the widening array of structures and objectives involved, including network-sharing deals with other operators, revenue sharing with content and application owners, insourcing of capabilities as “industry utilities” and outsourcing to specialist third parties..

• Revenue recognition.• Property, plant, and equipment –

existence and valuation / Impairment charges.

• Concepts as revenue-sharing arrangements, network-sharing deals with other operators,…, could impact revenue recognition and fixed assets existence and valuation, and these situations requires to perform a detailed analysis of terms and conditions of contracts.


• Strategic, minimal audit impact.

• Could share insights with CFO and network M&A specialists into the organisation for advice

10. Privacy, security and piracy



Audit implications

Privacy, security and privacy

• Regulatory• Litigation Reserves• Revenue

• With access issues this could lead to regulatory fines, litigation from customers/clients; there are SOX implications (ineffective control environment); if there are inaccurate billings or the inability to process transactions this will affect revenue.


Below the radar: A more pressing green agenda



Audit implications


• Environmental Reserves • Not following regulatory rulings could impact company with fines; not having a green agenda could result in the need for environmental reserves

Below the radar: Concentration of equipment vendors



Audit implications


• Operating expenses• Restructuring accruals

• Having a concentration of equipment vendors could lead to risks #1 and #2 above; Implications for your inventory reserve; could impact the cost of sales if limited on who buy from.

Below the radar: Difficulties in managing debt and cash



Audit implications

Difficulties in managing debt and cash

• Debt• Cash

• Debt covenants

Below the radar: Negative consumer health considerations



Audit implications

Negative consumer health considerations

• Potential litigation exposure

Top 10 risks in telecommunications 2010 - internal briefing for audit - 13.12.10

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