10-Q 1 d10q.txt VERIZON SOUTH 2ND QUARTER FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------- FORM 10-Q --------------------- (Mark one) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 2-36292 VERIZON SOUTH INC. A Virginia Corporation I.R.S. Employer Identification No. 56-0656680 1095 Avenue of the Americas, Room 3868, New York, New York 10036 Telephone Number (212) 395-2121 ------------------------- THE REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(a) AND (b) OF FORM 10-Q AND IS THEREFORE FILING THIS FORM WITH REDUCED DISCLOSURE FORMAT PURSUANT TO GENERAL INSTRUCTION H(2). Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Verizon South Inc. PART I - FINANCIAL INFORMATION Item 1. Financial Statements CONDENSED STATEMENTS OF INCOME

See Notes to Condensed Financial Statements. 1 Verizon South Inc. CONDENSED BALANCE SHEETS ASSETS ------

See Notes to Condensed Financial Statements. 2 Verizon South Inc. CONDENSED BALANCE SHEETS LIABILITIES AND SHAREOWNER'S INVESTMENT ---------------------------------------

See Notes to Condensed Financial Statements. 3 Verizon South Inc. CONDENSED STATEMENTS OF CASH FLOWS

See Notes to Condensed Financial Statements. 4 Verizon South Inc. NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited) 1. Basis of Presentation Verizon South Inc. is a wholly owned subsidiary of GTE Corporation (GTE), which is a wholly owned subsidiary of Verizon Communications Inc. (Verizon Communications). The accompanying unaudited condensed financial statements have been prepared based upon Securities and Exchange Commission rules that permit reduced disclosure for interim periods. These financial statements reflect all adjustments that are necessary for a fair presentation of results of operations and financial position for the interim periods shown including normal recurring accruals. The results for the interim periods are not necessarily indicative of results for the full year. The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For a more complete discussion of significant accounting policies and certain other information, you should refer to the financial statements included in our 2001 Annual Report on Form 10-K. We have reclassified certain amounts from prior year's data to conform to the 2002 presentation. 2. Adoption of New Accounting Standards Goodwill and Other Intangible Assets Effective January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 no longer permits the amortization of goodwill and indefinite-lived intangible assets. Instead, these assets must be reviewed annually (or more frequently under prescribed conditions) for impairment in accordance with this statement. This impairment test uses a fair value approach rather than the undiscounted cash flows approach previously required by SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." The goodwill impairment test under SFAS No. 142 requires a two-step approach, which is performed at the reporting unit level, as defined in SFAS No. 142. Step one identifies potential impairments by comparing the fair value of the reporting unit to its carrying amount. Step two, which is only performed if there is a potential impairment, compares the carrying amount of the reporting unit's goodwill to its implied value, as defined in SFAS No. 142. If the carrying amount of the reporting unit's goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized for an amount equal to that excess. Intangible assets that do not have indefinite lives are amortized over their useful lives and reviewed for impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The adoption of SFAS No. 142 did not impact our results of operations or financial position because we had no goodwill or other intangible assets at December 31, 2001 and 2000. Impairment or Disposal of Long-Lived Assets Effective January 1, 2002, we adopted SFAS No. 144. This standard supersedes SFAS No. 121 and the provisions of Accounting Principles Board (APB) Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," with regard to reporting the effects of a disposal of a segment of a business. SFAS No. 144 establishes a single accounting model for assets to be disposed of by sale and addresses several SFAS No. 121 implementation issues. The adoption of SFAS No. 144 did not have a material effect on our results of operations or financial position. 3. Recent Accounting Pronouncements Asset Retirement Obligations In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This standard provides the accounting for the cost of legal obligations associated with the retirement of long-lived assets. SFAS No. 143 requires that companies recognize the fair value of a liability for asset retirement obligations in the period in which the obligations are incurred and capitalize that amount as a part of the book value of the long-lived asset. That cost is then depreciated over the remaining life of the underlying long-lived asset. We are required to adopt SFAS No. 143 effective January 1, 2003. We are currently evaluating the impact this new standard will have on our future results of operations or financial position. 5 Verizon South Inc. Debt Extinguishment In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 145, among other things, eliminates the requirement that all gains and losses on the extinguishment of debt must be classified as extraordinary items on the income statement, thereby permitting the classification of such gains and losses as extraordinary items only if the criteria of APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," are met. We are required to adopt this provision of SFAS No. 145 no later than January 1, 2003 and upon adoption we will reclassify in our statements of income previously reported extraordinary charges for the early extinguishment of debt to income from continuing operations. Exit or Disposal Activities In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This standard addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." EITF Issue No. 94-3 required accrual of liabilities related to exit and disposal activities at a plan (commitment) date. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The provisions of this standard are effective for exit or disposal activities that are initiated after December 31, 2002. 4. Dividend On August 1, 2002, we declared and paid a dividend from Reinvested Earnings in the amount of $41.5 million to GTE. 5. Debt During the first half of 2001, we redeemed $12.4 million of 10.54% twenty year first mortgage bonds due in 2008. As a result of this early extinguishment of debt, we recorded an extraordinary charge that reduced net income by $.3 million (net of an income tax benefit of $.2 million). 6. Shareowner's Investment

Net income and comprehensive income were the same for the six months ended June 30, 2002 and 2001. 7. Commitments and Contingencies Various legal actions and regulatory proceedings are pending to which we are a party and claims which, if asserted, may lead to other legal actions. We have established reserves for specific liabilities in connection with regulatory and legal matters that we currently deem to be probable and estimable. We do not expect that the ultimate resolution of pending regulatory and legal matters in future periods will have a material effect on our financial condition, but it could have a material effect on our results of operations. Several regulatory matters may require us to refund to customers a portion of the revenues collected in the current and prior periods. The outcome of each pending matter, as well as the time frame within which each matter will be resolved, is not presently determinable. Regulatory conditions to the Bell Atlantic - GTE merger include commitments to, among other things, promote competition and the widespread deployment of advanced services, while helping to ensure that consumers continue to receive high-quality, low cost telephone services. In some cases, there are significant penalties associated with not meeting these commitments. The cost of satisfying these commitments could have a significant impact on net income in future periods. 6 Verizon South Inc. 8. Investment in Verizon Ventures III Inc. In December 2000, we transferred certain advanced data assets to an affiliated company, Verizon Ventures III Inc. (Ventures III) in exchange for common stock of Ventures III. This transfer was done to satisfy a condition of the Federal Communications Commission's (FCC) approval of the Bell Atlantic - GTE merger, which required the provision of advanced data services through a separate affiliate. Throughout 2000 and 2001, we continued to invest in Ventures III through the transfer of additional assets. As a result of the transfers, we acquired an ownership interest in Ventures III, which we accounted for under the equity method of accounting. In September 2001, the FCC issued an order eliminating this merger condition. Following the FCC order, we made necessary filings with our state regulatory commissions for approval of the transfer of these assets back to us. During the fourth quarter of 2001, Ventures III transferred assets to us, after required state regulatory approvals were obtained, in the jurisdictions of Kentucky, Virginia and South Carolina. Ventures III transferred advanced data assets back to us, after required state regulatory approvals were obtained, with an aggregate net book value of $2.4 million in Alabama and North Carolina on January 1, 2002. In consideration of the transfer of these assets, we have surrendered our common stock in Ventures III and remitted cash compensation. In connection with this reintegration, we received a capital contribution from our parent of $2.1 million in the first quarter of 2002. This equity was immediately contributed to Ventures III. No gain or loss was recognized as a result of the reintegration of the advanced data assets to us. This reintegration did not have a material effect on our results of operations or financial condition. 9. Employee Severance and Other Items In connection with the Bell Atlantic-GTE merger on June 30, 2000, we incurred charges associated with employee severance of $25.7 million. These costs, as recorded under SFAS No. 112, "Employers' Accounting for Postemployment Benefits," represent the benefit costs for the separation of management employees who were entitled to benefits under pre-existing separation plans, as well as an accrual of ongoing SFAS No. 112 obligations for GTE employees. As of June 30, 2002, the severances in connection with the Bell Atlantic-GTE merger are complete. During the fourth quarter of 2001, we recorded a charge of $3.5 million for the voluntary and involuntary separation of employees in accordance with SFAS No. 112. During the second quarter of 2002, we recorded a charge of $3.0 million in accordance with SFAS No. 112 associated with employee severance. As of June 30, 2002, a total of approximately 60 employees have been separated under the 2001 and 2002 severance programs. The remaining severance liability relating to these programs is $3.1 million, which includes future payments to employees separated as of June 30, 2002. We expect to complete the severance programs within a year of when the charge was recorded. In addition, during the second quarter of 2002, we recorded an impairment charge of $7.6 million driven by our financial statement exposure of WorldCom Inc. 10. Subsequent Events - Sales of Telephone Operations in Alabama and Kentucky On July 1, 2002, Verizon South Inc. and Contel of the South, Inc. (both wholly owned indirect subsidiaries of Verizon Communications Inc.) completed the sale of their telephone access lines (approximately 300,000 lines) and related local exchange operations in Alabama to CenturyTel of Alabama, L.L.C. for approximately $1.0 billion in cash, pursuant to an agreement entered into in the fourth quarter of 2001. Verizon South Inc. owned and operated approximately 170,000 of these access lines and received cash proceeds from the sale of approximately $572 million. Verizon South Inc. expects to record a gain as a result of the sale of its Alabama operations. On July 31, 2002, Verizon South Inc. completed the sale of its telephone access lines (approximately 600,000 lines) and related local exchange operations in Kentucky to Kentucky ALLTEL, Inc. for approximately $1.9 billion in cash, pursuant to an agreement entered into in the fourth quarter of 2001. Verizon South Inc. expects to record a gain as a result of the sale of its Kentucky operations. The net assets pertaining to the Alabama and Kentucky operations, principally plant, property and equipment of $752.6 million at June 30, 2002 and $703.8 million at December 31, 2001, are classified in our balance sheets as "Net assets held for sale." Given the decision to sell, no depreciation was recorded for these assets during the second half of 2001 and the first half of 2002, in accordance with Statements of Financial Accounting Standards Nos. 121 and 144. Accordingly, depreciation expense was lower by $26.8 million in the three months ended June 30, 2002 and $53.6 million in the six months ended June 30, 2002. 7 Verizon South Inc. The Alabama and Kentucky operations represent approximately 37% of the access lines that we had in service at June 30, 2002, and contributed approximately 37% to operating revenues for both the six months ended June 30, 2002 and the year ended December 31, 2001. 11. Subsequent Event - Early Extinguishment of Debt On August 1, 2002, we recorded an extraordinary charge associated with the early extinguishment of $16.5 million of 8.88% twenty year first mortgage bonds due on November 30, 2009, which reduced net income by $.4 million (net of an income tax benefit of $.2 million). 8 Verizon South Inc. Item 2. Management's Discussion and Analysis of Results of Operations (Abbreviated pursuant to General Instruction H(2).) This discussion should be read in conjunction with the Condensed Financial Statements and Condensed Notes to Financial Statements. RESULTS OF OPERATIONS --------------------- We reported net income of $188.1 million for the six month period ended June 30, 2002, compared to net income of $171.5 million for the same period in 2001. Our reported results for the first half of 2002 included the following special items: Employee Severance and Other Items During the second quarter of 2002, we recorded a charge of $3.0 million in accordance with Statement of Financial Accounting Standards (SFAS) No. 112, "Employers' Accounting for Postemployment Benefits," associated with employee severance. In addition, during the second quarter of 2002, we recorded an impairment charge of $7.6 million driven by our financial statement exposure of WorldCom Inc. Verizon Ventures III During 2000 and 2001, pursuant to one of the Federal Communications Commission's (FCC) requirements for the Bell Atlantic - GTE merger, we transferred our advanced data assets to Verizon Ventures III Inc. (Ventures III) in exchange for an ownership interest in Ventures III, which we accounted for under the equity method of accounting. In September 2001, the FCC issued an order eliminating this merger condition. In the fourth quarter of 2001 and the first quarter of 2002, after required state regulatory approvals were obtained, these assets were transferred back to us and we surrendered our ownership in Ventures III. (See Note 8 to the Condensed Financial Statements.) This reintegration principally affected our comparison of Network access services revenues, Operations and support expenses, Other income and (expense), net, and the Provision for income taxes, as described below. OPERATING REVENUES ------------------ (Dollars in Millions)

We recognize service revenues based upon usage of our local exchange network and facilities and contract fees. We recognize product and other service revenues when the products are delivered and accepted by the customers and when services are provided in accordance with contract terms. 9 Verizon South Inc. LOCAL SERVICES 2002 - 2001 (Decrease) -------------------------------------------------------------------------------- Six Months $(64.5) (14.3)% -------------------------------------------------------------------------------- Local service revenues are earned from the provision of local exchange, local private line, wire maintenance, voice messaging and value-added services. Value-added services are a family of services that expand the utilization of the network, including products such as Caller ID, Call Waiting and Return Call. The provision of local exchange services not only includes retail revenues, but also includes local wholesale revenues from unbundled network elements (UNEs), interconnection revenues from competitive local exchange carriers (CLECs), certain data transport revenues and wireless interconnection revenues. Local service revenues were affected by the settlement of a state regulatory matter in the state of Virginia. This settlement resulted in refunds to customers from both local service revenues and network access revenues in the first quarter of 2001. The effect of these refunds was entirely offset by the reversal of an accrual in 2001 which was recorded in local service revenues. Price reductions and the effects of the economic slowdown and competition, as reflected by a decline in our switched access lines in service of 1.2% from June 30, 2001, also contributed to the decrease in local service revenues. Technology substitution, as indicated by lower demand for residential access lines, and lower billings to CLECs for interconnection of their network with our network, further contributed to the decrease in local service revenues. NETWORK ACCESS SERVICES 2002 - 2001 Increase -------------------------------------------------------------------------------- Six Months $38.4 13.1% -------------------------------------------------------------------------------- Network access service revenues are earned from end-user subscribers and from long distance and other competing carriers who use our local exchange facilities to provide usage services to their customers. Switched access revenues are derived from fixed and usage-based charges paid by carriers for access to our local network. Special access revenues originate from carriers and end-users that buy dedicated local exchange capacity to support their private networks. End-user access revenues are earned from our customers and from resellers who purchase dial-tone services. The increase in network access service revenue in the first six months of 2002 was primarily due to the effect of the settlement of a regulatory matter in the state of Virginia in the first quarter of 2001. This settlement resulted in refunds to customers which was entirely offset by the reversal of an accrual recorded in local service revenues in 2001, as described above. In addition, higher customer demand for special access services, particularly for high-capacity, high-speed digital services, and the reintegration of Ventures III also contributed to the revenue increase, but to a lesser extent. These increases were partially offset by the effect of mandated price reductions on interstate and intrastate access services and other regulatory decisions. In addition, growth in switched access service revenue declined in the first half of 2002 due to the impact of the slowing economy, as reflected by a decline in minutes of use from carriers and CLECs. LONG DISTANCE SERVICES 2002 - 2001 (Decrease) -------------------------------------------------------------------------------- Six Months $(3.0) (19.1)% -------------------------------------------------------------------------------- Long distance revenues are earned primarily from calls made to points outside a customer's local calling area, but within our service area (intraLATA toll). IntraLATA toll calls originate and terminate within the same LATA, but generally cover a greater distance than a local call. These services are regulated by state regulatory commissions except where they cross state lines. Other long distance services that we provide include 800 services and Wide Area Telephone Service (WATS). We also earn revenue from private line and operator services associated with long distance calls. Long distance service revenues declined in the first six months of 2002 primarily due to the effects of competition, technology substitution and the slowing economy. Mandated price reductions on some long distance services also contributed to the decline in long distance revenues, but to a lesser extent. 10 Verizon South Inc. OTHER SERVICES 2002 - 2001 (Decrease) -------------------------------------------------------------------------------- Six Months $(8.0) (12.8)% -------------------------------------------------------------------------------- Our other services include such services as billing and collections for long distance carriers and affiliates, facilities rentals to affiliates and nonaffiliates, public (pay) telephone and customer premises equipment (CPE). Other service revenues also include fees paid by customers for non-publication of telephone numbers and multiple white page listing, fees paid by an affiliate for usage of our directory listings and fees paid by an affiliate for the provision of sales agent services. Other service revenues decreased in the first six months of 2002 primarily due to lower revenue from CPE sales. This decrease was partially offset by an increase in sales and services to affiliates. OPERATING EXPENSES ------------------ (Dollars in Millions) OPERATIONS AND SUPPORT 2002 - 2001 (Decrease) -------------------------------------------------------------------------------- Six Months $(7.5) (2.2)% -------------------------------------------------------------------------------- Operations and support expenses consist of employee costs and other operating expenses. Employee costs consist of salaries, wages and other employee compensation, employee benefits and payroll taxes. Other operating expenses consist of contract services including centralized services expenses allocated from affiliates, rent, network software costs, operating taxes other than income, the provision for uncollectible accounts receivable, reciprocal compensation, and other costs. The decrease in operations and support expenses was primarily attributable to effective cost control measures, as well as the effect of declining workforce levels. These decreases were substantially offset by higher centralized services expenses allocated to us by Verizon Services, as well as an increase in the provision for uncollectible accounts receivable. The reintegration of Ventures III and employee severance costs recorded in the second quarter of 2002 further offset the decline in operations and support expenses for the six months ended June 30, 2002. DEPRECIATION AND AMORTIZATION 2002 - 2001 (Decrease) -------------------------------------------------------------------------------- Six Months $(52.9) (34.7)% -------------------------------------------------------------------------------- Depreciation expense is principally based on the composite group remaining life method and straight-line composite rates. This method provides for the recognition of the cost of the remaining net investment in telephone plant, less anticipated net salvage value, over the remaining asset lives. This method requires the periodic revision of depreciation rates. Depreciation and amortization expense decreased in the first six months of 2002 primarily due to our decision to dispose of certain properties and, as a consequence, we no longer depreciate these assets in accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." (See Note 10 to the Condensed Financial Statements.) 11 Verizon South Inc. OTHER RESULTS ------------- (Dollars in Millions) OTHER INCOME AND (EXPENSE), NET 2002 - 2001 Increase -------------------------------------------------------------------------------- Six Months $5.3 220.8% -------------------------------------------------------------------------------- Other income and (expense), net includes equity income (losses), interest income and other nonoperating income and expense items. As a result of the reintegration of Ventures III in the fourth quarter of 2001 and the first quarter of 2002, we no longer recognize equity income (losses) from this investment. The increase in other income and (expense), net, was primarily attributable to an increase in interest income on a note receivable with an affiliate and the effect of equity losses recognized in 2001 from our investment in Ventures III. INTEREST EXPENSE 2002 - 2001 Increase -------------------------------------------------------------------------------- Six Months $4.6 13.3% -------------------------------------------------------------------------------- Interest expense includes costs associated with borrowing and capital leases, net of capitalized interest costs. We capitalize interest associated with the acquisition or construction of plant assets. Capitalized interest is reported as a cost of plant and a reduction in interest expense. Interest expense increased in the first six months of 2002, over the same period in 2001, primarily due to the effect of refinancing short-term debt from an affiliate with long-term debt at a higher interest rate and, to a lesser extent, lower capitalized interest costs resulting from lower levels of average telephone plant under construction. EFFECTIVE INCOME TAX RATES Six Months Ended June 30, -------------------------------------------------------------------------------- 2002 39.3% -------------------------------------------------------------------------------- 2001 39.9% -------------------------------------------------------------------------------- The effective income tax rate is the provision for income taxes as a percentage of income before provision for income taxes and extraordinary item. Our effective income tax rate was lower for the six months ended June 30, 2002, compared to the same period in 2001, primarily due to the effect of equity losses associated with our investment in Ventures III, which were recorded in 2001, for which we did not recognize income tax benefits and by a decrease in non-recurring income tax expense. EXTRAORDINARY ITEM During the first half of 2001, we redeemed $12.4 million of long-term debt prior to stated maturity and recorded an after-tax extraordinary charge of $.3 million (net of tax benefits of $.2 million). See Note 5 to the Condensed Financial Statements. 12 Verizon South Inc. OTHER MATTERS ------------- Recent Accounting Pronouncements Asset Retirement Obligations In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This standard provides the accounting for the cost of legal obligations associated with the retirement of long-lived assets. SFAS No. 143 requires that companies recognize the fair value of a liability for asset retirement obligations in the period in which the obligations are incurred and capitalize that amount as a part of the book value of the long-lived asset. That cost is then depreciated over the remaining life of the underlying long-lived asset. We are required to adopt SFAS No. 143 effective January 1, 2003. We are currently evaluating the impact this new standard will have on our future results of operations or financial position. Debt Extinguishment In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 145, among other things, eliminates the requirement that all gains and losses on the extinguishment of debt must be classified as extraordinary items on the income statement, thereby permitting the classification of such gains and losses as extraordinary items only if the criteria of APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," are met. We are required to adopt this provision of SFAS No. 145 no later than January 1, 2003 and upon adoption we will reclassify in our statements of income previously reported extraordinary charges for the early extinguishment of debt to income from continuing operations. Exit or Disposal Activities In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This standard addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." EITF Issue No. 94-3 required accrual of liabilities related to exit and disposal activities at a plan (commitment) date. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The provisions of this standard are effective for exit or disposal activities that are initiated after December 31, 2002. Compensation for Internet Traffic We continue to incur expenditures related to reciprocal compensation arrangements with CLECs and other carriers to terminate calls on their network. On April 27, 2001, the FCC released an order addressing intercarrier compensation for dial-up connections for Internet-bound traffic. The FCC found that Internet-bound traffic is interstate and subject to the FCC's jurisdiction. Moreover, the FCC again found that Internet-bound traffic is not subject to reciprocal compensation under Section 251(b)(5) of the 1996 Act. Instead, the FCC established federal rates per minute for this traffic that decline from $0.0015 to $0.0007 over a three-year period. The FCC order also sets caps on the total minutes of this traffic that may be subject to any intercarrier compensation and requires that incumbent local exchange carriers must offer to pay reciprocal compensation for local traffic at the same rate as they are required to pay on Internet-bound traffic. On May 3, 2002 the U.S. Court of Appeals for the D.C. Circuit remanded the April 27, 2001 FCC order for further proceedings. It did not vacate the interim pricing rules established in that order and they remain in effect. Several parties, including Pac-West Telecomm and Focal Communications Corp. have requested rehearing, asking the court to vacate the underlying order. A decision on the rehearing petitions remains pending, and the FCC's underlying order remains in effect. Subsequent Events - Sales of Telephone Operations in Alabama and Kentucky On July 1, 2002, Verizon South Inc. and Contel of the South, Inc. (both wholly owned indirect subsidiaries of Verizon Communications Inc.) completed the sale of their telephone access lines (approximately 300,000 lines) and related local exchange operations in Alabama to CenturyTel of Alabama, L.L.C. for approximately $1.0 billion in cash, pursuant to an agreement entered into in the fourth quarter of 2001. Verizon South Inc. owned and operated approximately 170,000 of these access lines and received cash proceeds from the sale of approximately $572 million. Verizon South Inc. expects to record a gain as a result of the sale of its Alabama operations. 13 Verizon South Inc. On July 31, 2002, Verizon South Inc. completed the sale of its telephone access lines (approximately 600,000 lines) and related local exchange operations in Kentucky to Kentucky ALLTEL, Inc. for approximately $1.9 billion in cash, pursuant to an agreement entered into in the fourth quarter of 2001. Verizon South Inc. expects to record a gain as a result of the sale of its Kentucky operations. The Alabama and Kentucky operations represent approximately 37% of the access lines that we had in service at June 30, 2002, and contributed approximately 37% to operating revenues for both the six months ended June 30, 2002 and the year ended December 31, 2001. Subsequent Event - Early Extinguishment of Debt On August 1, 2002, we recorded an extraordinary charge associated with the early extinguishment of $16.5 million in First Mortgage Bonds due November 30, 2009, which reduced net income by $.4 million (net of an income tax benefit of $.2 million). 14 Verizon South Inc. PART II - OTHER INFORMATION Item 1. Legal Proceedings There were no proceedings reportable under this Item. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: Exhibit Number ------ 3.1 Amended and Restated Articles of Incorporation of Verizon South Inc. 3.2 Amended and Restated Bylaws of Verizon South Inc. 12 Computation of Ratio of Earnings to Fixed Charges. (b) There were no Current Reports on Form 8-K filed during the quarter ended June 30, 2002. 15 Verizon South Inc. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Verizon South Inc. Date: August 14, 2002 By /s/ Edwin F. Hall -------------------------------- Edwin F. Hall Controller UNLESS OTHERWISE INDICATED, ALL INFORMATION IS AS OF AUGUST 7, 2002. 16 EXHIBIT INDEX

VERIZON SOUTH INC 10-Q