Kenneth R. Carter
Columbia Institute for Tele-Information
Columbia Business School
April 6, 2001
Since the late 1920’s, the need to regulate the broadcast of radio signals into the ether has became apparent.This is due to a fundamental property of radio waves.As multiple radio operators attempted to use the same, limited number of frequencies, their signals cause interference, the waves amplifying canceling one another out.The result was that no one could clearly broadcast or receive.The need to regulate the airwaves has been accomplished with a variety of allocation policies, including give-aways, beauty contests, and eventually auctions.
Today in most countries, a central regulator assigns bands of adjacent frequencies to particular applications, then allocates the exclusive right to those frequencies to minimize the problem of interference.In most cases, the regulator holds an auction to ensure the economic allocation of this scare resource.Potential wireless providers do not actually bid for spectrum, but rather a license granted by the government to the exclusive right to emit electromagnetic waves, into the ether at a given frequency power lever in a specified geographic location.In such auctions, potential providers place bids which they are willing to pay to obtain the licenses, with the highest bidders obtaining the licenses.In the auctions conducted by the Federal Communications Commission (FCC), license fees must be paid prior to the beginning of the license which license lasts for a period of years, typically 6 to 15 years.At the end of the licensee, the government may reassign the right to use the frequency.Once a wireless provider has won a license at auction, it may be bound to provide service and to pay the license fees whether it operates or not.It may further be restricted from reselling the license.Most recently, there have been auctions for licenses to provide 3G wireless services in Europe, Japan, Oceania, and the US.The recipients of licenses in these auctions must then make further capital investments in network infrastructure to provide these services.
Since this exclusive right, by definition, lasts for a period greater than one year, it gives rise to the need to account for the licenses as a long-lived asset.It is not unlike the accounting for any other intellectual asset, such as a patent, which a firm acquires through purchase.Through this accounting, the wireless communications provider is able to track the flow of cash versus the flow of wealth, as the firm (hopefully) generates wealth for its shareholders.
The cash used to acquire a spectrum license is its accounting cost.The decision how much to expense or capitalize is an accounting decision.It affects net income but does not appear on the statement of cash flows.This is because the cash is paid out depending only at the acquisition cost of the license.The value of the spectrum which the carrier has on it balance sheet is its book value.The book value can be greater or less than the value the market places on the asset.In the case of spectrum licenses, there is no secondary market in which to resell the license.In fact, this remains a sunk cost and the license usually requires for the obligation to offer service, so there is no ability to exit the market.The acquisition cost, less accumulated amortization, is the only way to value the license.
However, since there is some discretion in setting amortization, the carrier may have some latitude creating valuation for the balance sheet.To do so, management must select an appropriate amortization.Amortization is an accounting means of measuring how much of the asset is used up in a given period.The goal is to match how much of the asset is used up with that time period and the period when revenues are generated.There are three methods: straight line, declining balance and units of production.
For spectrum, the product (cellular telephone capacity) which the asset can generate is solely a function of time.Every second that passes, whether or not the wireless provider is selling service to an end user, it is consuming the asset of the license.Thus, the consumption of the asset can only measured by use of the duration of the license period as it passes.Because there is a finite capacity of the spectrum, no more or less is used in producing individual units.Therefore, the units of production method of amortization is conceptually the same as straight-line, save for maybe an increment of months or quarters versus minutes or seconds.
Declining balance is preferable when a firm will incur greater maintenance and operational costs in the equipment’s useful life.This matches a lesser book value of the asset with its less productive later stage.The cellular gear, switching, and trunking equipment necessary to provide service may become more expensive to operate as it gets older.Such assets may require upgrades and maintenance and is subject to rapid obsolescence, but this does not apply to the spectrum itself.The spectrum is no less productive later in its useful life.In fact, the reverse seems to be true.New equipment allows for increased capacity over the same amount of spectrum.Since there is a preference for straight-line amortization, it is the most appropriate means.
A firm achieves a steady state after it is gone through one full life cycle of its PP&E assets.In a steady state, the firm is replacing these assets at the same rate in which on-balance-sheet assets reach the end of their useful life.In the steady state, assuming it is accurately estimated, depreciation and amortization are equal to investment in new PP&E.The spectrum has no useful life, but rather a finite duration determined solely by the length of the license.Thus there is no steady state for this asset.However, the wireless provider uses a set aside provision or contra-asset to purchase license renewals in later auctions after the current license expires, it is building an off-balance-sheet liability.
Without having a set sides or a contra account on the balance sheet, the wireless provider develops a future liability which is not shown on the balance sheet.The wireless provider runs the risk of investing in network infrastructure it may not be legally permitted to operate in future.Moreover, it develops a future off-balance-sheet liability, the need to purchase subsequent spectrum licenses.In such a case, it may not be setting a side sufficient reserves and over stating earnings.Thus, the cash which the provider pays to its shareholders in dividends may be greater than the actual wealth it is creating for those owners.