Canada-based Nortel Networks was one of the largesttelecommunications equipment companies in the world prior to itsfiling for bankruptcy protection on January 14, 2009, in the UnitedStates, Canada, and Europe. The company had been subjected toseveral financial reporting investigations by U.S. and Canadiansecurities agencies in 2004. The accounting irregularities centeredon premature revenue recognition and hidden cash reserves used tomanipulate financial statements. The goal was to present thecompany in a positive light so that investors would buy (hold)Nortel stock, thereby inflating the stock price. Although Nortelwas an international company, the listing of its securities on U.S.stock exchanges subjected it to all SEC regulations, along with therequirement to register its financial statements with the SEC andprepare them in accordance with U.S. GAAP.
The company had gambled by investing heavily in Code DivisionMultiple Access (CDMA) wireless cellular technology during the1990s in an attempt to gain access to the growing European andAsian markets. However, many wireless carriers in theaforementioned markets opted for rival Global System Mobile (GSM)wireless technology instead. Coupled with a worldwide economicslowdown in the technology sector, Nortel’s losses mounted to $27.3billion by 2001, resulting in the termination of two-thirds of itsworkforce.
The Nortel fraud primarily involved four members of Nortel’ssenior management as follows: CEO Frank Dunn, CFO Douglas Beatty,controller Michael Gollogly, and assistant controller MaryannePahapill. At the time of the audit, Dunn was a certified managementaccountant, while Beatty, Gollogly, and Pahapill were charteredaccountants in Canada.
Accounting Irregularities
On March 12, 2007, the SEC alleged the following in a complaintagainst Nortel:1
In late 2000, Beatty and Pahapill implemented changes toNortel’s revenue recognition policies that violated U.S. GAAP,specifically to pull forward revenue to meet publicly announcedrevenue targets. These actions improperly boosted Nortel’s fourthquarter and fiscal 2000 revenue by over $1 billion, while at thesame time allowing the company to meet, but not exceed, marketexpectations. However, because their efforts pulled in more revenuethan needed to meet those targets, Dunn, Beatty, and Pahapillselectively reversed certain revenue entries during the 2000year-end closing process.
In November 2002, Dunn, Beatty, and Gollogly learned that Nortelwas carrying over $300 million in excess reserves. The three didnot release these excess reserves into income as required underU.S. GAAP. Instead, they concealed their existence and maintainedthem for later use. Further, Beatty, Dunn, and Gollogly directedthe establishment of yet another $151 million in unnecessaryreserves during the 2002 year-end closing process to avoid postinga profit and paying bonuses earlier than Dunn had predictedpublicly. These reserve manipulations erased Nortel’s proforma profit for the fourth quarter of 2002 and caused it toreport a loss instead.2
In the first and second quarters of 2003, Dunn, Beatty, andGollogly directed the release of at least $490 million of excessreserves specifically to boost earnings, fabricate profits, and paybonuses. These efforts turned Nortel’s first-quarter 2003 loss intoa reported profit under U.S. GAAP, which allowed Dunn to claim thathe had brought Nortel to profitability a quarter ahead of schedule.In the second quarter of 2003, their efforts largely erasedNortel’s quarterly loss and generated a pro forma profit.In both quarters, Nortel posted sufficient earnings to pay tens ofmillions of dollars in so-called return to profitability bonuses,largely to a select group of senior managers.
During the second half of 2003, Dunn and Beatty repeatedlymisled investors as to why Nortel was conducting a purportedly“comprehensive review” of its assets and liabilities, whichresulted in Nortel’s restatement of approximately $948 million inliabilities in November 2003. Dunn and Beatty falsely representedto the public that the restatement was caused solely by internalcontrol mistakes. In reality, Nortel’s first restatement wasnecessitated by the intentional improper handling of reserves,which occurred throughout Nortel for several years, and the firstrestatement effort was sharply limited to avoid uncovering Dunn,Beatty, and Gollogly’s earnings management activities.
The complaint charged Dunn, Beatty, Gollogly, and Pahapill withviolating and/or aiding and abetting violations of the antifraud,reporting, and books and records requirements. In addition, theywere charged with violating the Securities Exchange Act Section13(b)(2)(B) that requires issuers to devise and maintain a systemof internal accounting controls sufficient to provide reasonableassurances that, among other things, transactions are recorded asnecessary to permit the preparation of financial statements inconformity with U.S. GAAP and to maintain accountability for theissuer’s assets.
Dunn and Beatty were separately charged with violations of theofficer certification provisions instituted by SOX under Section302. The commission sought a permanent injunction, civil monetarypenalties, officer and director bars, and disgorgement withprejudgment interest against all four defendants.
Specifics of Earnings Management Techniques
From the third quarter of 2000 through the first quarter of2001, when Nortel reported its financial results for year-end 2000,Dunn, Beatty, and Pahapill altered Nortel’s revenue recognitionpolicies to accelerate revenues as needed to meet Nortel’squarterly and annual revenue guidance, and to hide the worseningcondition of Nortel’s business. Techniques used to accomplish thisgoal include:
Reinstituting bill-and-hold transactions. The companytried to find a solution for the hundreds of millions of dollars ininventory that was sitting in Nortel’s warehouses and offsitestorage locations. Revenues could not be recognized for thisinventory because U.S. GAAP revenue recognition rules generallyrequire goods to be delivered to the buyer before revenue can berecognized. This inventory grew, in part, because orders wereslowing and, in June 2000, Nortel had banned bill-and-holdtransactions from its sales and accounting practices. The companyreinstituted bill-and-hold sales when it became clear that it fellshort of earnings guidance. In all, Nortel accelerated into 2000more than $1 billion in revenues through its improper use ofbill-and-hold transactions.
Restructuring business-asset write-downs. Beginning inFebruary 2001, Nortel suffered serious losses when it finallylowered its earnings guidance to account for the fact that itsbusiness was suffering from the same widespread economic downturnthat affected the entire telecommunications industry. As Nortel’sbusiness plummeted throughout the remainder of 2001, the companyreacted by implementing a restructuring that, among other things,reduced its workforce by two-thirds and resulted in a significantwrite-down of assets.
Creating reserves. In relation to writing down theassets, Nortel established reserves that were used to manageearnings. Assisted by defendants Beatty and Gollogly, Dunnmanipulated the company’s reserves to manage Nortel’s publiclyreported earnings, create the false appearance that his leadershipand business acumen was responsible for Nortel’s profitability, andpay bonuses to these three defendants and other Nortelexecutives.
Releasing reserves into income. From at least July 2002through June 2003, Dunn, Beatty, and Gollogly released excessreserves to meet Dunn’s unrealistic and overly aggressive earningstargets. When Nortel internally (and unexpectedly) determined thatit would return to profitability in the fourth quarter of 2002, thereserves were used to reduce earnings for the quarter, avoidreporting a profit earlier than Dunn had publicly predicted, andcreate a stockpile of reserves that could be (and were) released inthe future as necessary to meet Dunn’s prediction of profitabilityby the second quarter of 2003. When 2003 turned out to be rockierthan expected, Dunn, Beatty, and Gollogly orchestrated the releaseof excess reserves to cause Nortel to report a profit in the firstquarter of 2003, a quarter earlier than the public expected, and topay defendants and others substantial bonuses that were awarded forachieving profitability on a pro forma basis. Becausetheir actions drew the attention of Nortel’s outside auditors, theymade only a portion of the planned reserve releases. This allowedNortel to report nearly break-even results (though not actualprofit) and to show internally that the company had again reachedprofitability on a pro forma basis necessary to paybonuses.
Siemens Reserve
During the fraud trial, former Nortel accountant Susan Shawtestified about one of the most controversial accounting provisionson the company’s books, relating to a 2001 lawsuit filed againstNortel by Siemens AG. It was long-standing practice across Nortelto establish reserves on a “worst case” basis, which meant at anamount equal to the maximum possible exposure.
Nortel had created an accounting reserve on its books at thetime the Siemens lawsuit was filed to provide for a settlement inthe case, but it was alleged that a portion of the provision wasarbitrarily left on Nortel’s books long after the lawsuit wasresolved in the fourth quarter of 2001. It became part of a groupof extra head office, non-operating reserves that allegedly wasreversed arbitrarily—and with no appropriate business trigger—topush the company into a profit in 2003 and earn “return toprofitability” bonuses for executives.
The $4-million remaining Siemens provision was initially bookedto be reversed into income in the first quarter of 2003, but thenwithdrawn, allegedly because it was not needed to push the companyinto a profitable position in the quarter. It was then booked to beused in the second quarter, and became the only head officenon-operating reserve used in the quarter.
The contention was that the Siemens reserve was used in thatquarter because Nortel needed almost exactly $4 million more incometo reach the payout trigger for the company’s restricted share unitplan at that time. However, lawyer David Porter argued the Siemensamount was triggered in the second quarter because that is when thecompany believed it was no longer needed and should appropriatelybe reversed.
In cross-examination, Porter showed Shaw a working documentrecovered from the files of Nortel’s external auditors at Deloitte& Touche, showing the auditor reviewed Nortel’s justificationsfor keeping the Siemens reserve on the books until that time andfor reversing it in the second quarter of 2003. Deloitte’s notesshowed the auditor reviewed Nortel’s detailed rationale for thereserve and concluded its release in the second quarter was“reasonable.”3
The company said it was holding on to the reserve because thesettlement with Siemens had been “rancorous” and Nortel wanted tobe sure there would be no further claims made after the lawsuit wassettled and $32 million was paid to Siemens in two installments inlate 2001 and late 2002.
In its working notes, Deloitte recorded that Nortel felt it was“prudent” to keep the $4 million on the books until mid-2002. Shawtestified she felt the reserve was being reversed on schedule withthe plan to keep it in place for the first two quarters of theyear. Porter asked Shaw whether the auditors were satisfied at thetime there was an appropriate triggering event to use the reservein the second quarter of 2002, and she replied there was one.
However, the amount became part of a broad restatement ofreserves announced at Nortel at the end of 2003. The company notedin the restatement that the Siemens reserve should have beenreversed in the fourth quarter of 2001 when the lawsuit wassettled.
Role of Auditors and Audit Committee
In late October 2000, as a first step toward reintroducingbill-and-hold transactions into Nortel’s sales and accountingpractices, Nortel’s then controller and assistant controller askedDeloitte to explain, among other things, (1) “[u]nder whatcircumstances can revenue be recognized on product (merchandise)that has not been shipped to the end customer?” and (2) whethermerchandise accounting can be used to recognized revenues “wheninstallation is imminent” or “when installation is considered to bea minor portion of the contract”?4
On November 2, 2000, Deloitte presented Nortel with a set ofcharts that, among other things, explained the US GAAP criteria forrevenues to be recognized prior to delivery (including additionalfactors to consider for a bill-and-hold transaction) and alsoprovided an example of a customer request for a bill-and-hold sale“that would support the assertion that Nortel should recognizerevenue” prior to delivery.
Nortel’s earnings management scheme began to unravel at the endof the second quarter of 2003. On the morning of July 24, 2003, thesame day on which Nortel issued its second Quarter 2003 earningsrelease, Deloitte informed Nortel’s audit committee that it hadfound a “reportable condition” with respect to weaknesses inNortel’s accounting for the establishment and disposition ofreserves. Deloitte went on to explain that, in response to itsconcerns, Nortel’s management had undertaken a project to gathersupport and determine proper resolution of certain provisionbalances. Management, in fact, had undertaken this project becausethe auditor required adequate audit evidence for the upcomingyear-end 2003 audit. Nortel concealed its auditor’s concerns fromthe public, instead disclosing the comprehensive review.
Shortly after Nortel’s announced restatement, the auditcommittee commenced an independent investigation and hired outsidecounsel to help it “gain a full understanding of the events thatcaused significant excess liabilities to be maintained on thebalance sheet that needed to be restated,” as well as to recommendany necessary remedial measures. The investigation uncoveredevidence that Dunn, Beatty, and Gollogly and certain otherfinancial managers were responsible for Nortel’s improper use ofreserves in the second half of 2002 and first half of 2003.
In March 2004, Nortel suspended Beatty and Gollogly andannounced that it would “likely” need to revise and restatepreviously filed financial results further. Dunn, Beatty, andGollogly were terminated for cause in April 2004.
On January 11, 2005, Nortel issued a second restatement thatrestated approximately $3.4 billion in misstated revenues and atleast another $746 million in liabilities. All of the financialstatement effects of the defendants’ two accounting fraud schemeswere corrected as of this date, but there remained lingeringeffects from the defendants’ internal control and other nonfraudviolations.
Nortel also disclosed the findings to date of the auditcommittee’s independent review, which concluded, among otherthings, that Dunn, Beatty, and Gollogly were responsible forNortel’s improper use of reserves in the second half of 2002 andfirst half of 2003. The second restatement, however, did not revealthat Nortel’s top executives had also engaged in revenuerecognition fraud in 2000.
In May 2006, in its Form 10-K for the period ending December 31,2005, Nortel admitted for the first time that its restated revenuesin part had resulted from management fraud, stating that “in aneffort to meet internal and external targets, the senior corporatefinance management team . . . changed the accounting policies ofthe company several times during 2000,” and that those changes were“driven by the need to close revenue and earnings gaps.”
Throughout their scheme, the defendants lied to Nortel’sindependent auditor by making materially false and misleadingstatements and omissions in connection with the quarterly reviewsand annual audits of the financial statements that were materiallymisstated. Among other things, each of the defendants submittedmanagement representation letters to the auditors that concealedthe fraud and made false statements, which included that theaffected quarterly and annual financial statements were presentedin conformity with U.S. GAAP and that they had no knowledge of anyfraud that could have a material effect on the financialstatements. Dunn, Beatty, and Gollogly also submitted a falsemanagement representation letter in connection with Nortel’s firstrestatement, and Pahapill likewise made false managementrepresentations in connection with Nortel’s second restatement.
The defendants’ scheme resulted in Nortel issuing materiallyfalse and misleading quarterly and annual financial statements andrelated disclosures for at least the financial reporting periodsending December 31, 2000, through December 31, 2003, and in allsubsequent filings made with the SEC that incorporated thosefinancial statements and related disclosures by reference.
On October 15, 2007, Nortel, without admitting or denying theSEC’s charges, agreed to settle the commission’s action byconsenting to be enjoined permanently from violating the antifraud,reporting, books and records, and internal control provisions ofthe federal securities laws and by paying a $35 million civilpenalty, which the commission placed in a Fair Fund5 fordistribution to affected shareholders.6 Nortel alsoagreed to report periodically to the commission’s staff on itsprogress in implementing remedial measures and resolving anoutstanding material weakness over its revenue recognitionprocedures.
On January 14, 2009, Nortel filed for protection from creditorsin the United States, Canada, and the United Kingdom in order torestructure its debt and financial obligations. In June, thecompany announced that it no longer planned to continue operationsand that it would sell off all of its business units. Nortel’s CDMAwireless business and long-term evolutionary access technology(LTE) were sold to Ericsson, and Avaya purchased its Enterprisebusiness unit.
The final indignity for Nortel came on June 25, 2009, whenNortel’s stock price dropped to 18.5¢ a share, down from a high of$124.50 in 2000. Nortel’s battered and bruised stock was finallydelisted from the S&P/TSX composite index, a stock index forthe Canadian equity market, ending a colossal collapse on anexchange on which the Canadian telecommunications giant’s stockvaluation once accounted for a third of its value.
Postscript
The three former top executives of Nortel Networks Corp. werefound not guilty of fraud on January 14, 2013. In the court ruling,Justice Frank Marrocco of the Ontario Superior Court found that theaccounting manipulations that caused the company to restate itsearnings for 2002 and 2003 did not cross the line into criminalbehavior.
Accounting experts said the case is sure to be closely watchedby others in the business community for the message it sends aboutwhere the line lies between fraud and the acceptable use ofdiscretion in accounting.
The decision underlines that management still has a duty toprepare financial statements that “present fairly the financialposition and results of the company” according to a forensicaccountant, Charles Smedmor, who followed the case. “Nothing in thejudge’s decision diminished that duty.”
During the trial, lawyers for the accused said that the menbelieved that the accounting decisions they made were appropriateat the time, and that the accounting treatment was approved byNortel’s auditors from Deloitte & Touche. Judge Marroccoaccepted these arguments, noting many times in his ruling thatbookkeeping decisions were reviewed and approved by auditors andwere disclosed adequately to investors in press releases or notesadded to the financial statements.
Nonetheless, the judge also said that he believed that theaccused were attempting to “manage” Nortel’s financial results inboth the fourth quarter of 2002 and in 2003, but he added he wasnot satisfied that the changes resulted in materialmisrepresentations. He said that except for $80 million of reservesreleased in the first quarter of 2003, the rest of the use ofreserves was within “the normal course of business.” Judge Marroccosaid the $80 million release, while clearly “unsupportable” andlater reversed during a restatement of Nortel’s books, wasdisclosed properly in Nortel’s financial statements at the time andwas not a material amount. He concluded that Beatty and Dunn “wereprepared to go to considerable lengths” to use reserves to improvethe bottom line in the second quarter of 2003, but he said thedecision was reversed before the financial statements werecompleted because Gollogly challenged it.
In a surprising twist, Judge Marrocco also suggested the twodevastating restatements of Nortel’s books in 2003 and 2005 wereprobably unnecessary in hindsight, although he said he understoodwhy they were done in the context of the time. He said the originalstatements were arguably correct within a threshold of what wasmaterial for a company of that size.
Darren Henderson, an accounting professor at the Richard IveySchool of Business at the University of Western Ontario, said thata guilty verdict would have raised the bar for management tojustify their accounting judgments. But the acquittal makes itclear that “management manipulation of financial statements is verydifficult to prove beyond a reasonable doubt in a court of law,” hesaid.
It is clear that setting up reserves or provisions is stillsubject to management discretion, Henderson said. “The message . .. is that it is okay to use accounting judgments to achieve desiredoutcomes, [such as] a certain earnings target.”
QUESTION:
The following two statements are made in the case:
Accounting experts said the case is sure to be closely watchedby others in the business community for the message it sends aboutwhere the line lies between fraud and the acceptable use ofdiscretion in accounting.
Darren Henderson opined that “The message . . . is that it isokay to use accounting judgments to achieve desired outcomes, [suchas] a certain earnings target.”
Evaluate these statements from the perspectives ofrepresentational faithfulness and fair presentation of thefinancial results reported by Nortel.
