Nortel Accounting Scandal Comprehensive Study

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Abstract

Nortel is engaged in the supply of telecommunications equipment for Canada’s telephone systems. It engaged in an infamous accounting scandal. Top executives of Nortel Networks Corporation rather supplied cooked-up figures to the Board and the audit committee and based on the representation’s made b the Nortel top management, they approved the quarterly results and the issuance of bonuses to top executives. This research essay discusses the accounting scandal in detail.

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Introduction

For more than 10 decades, Nortel is engaged in the supply of telecommunications equipment for Canada’s telephone systems. In the 1890s, the company started manufacturing manually, operated switchboards, which have later turned into establishing the fiber-optic systems for the Internet today.

Nortel Networks Corporation is having its headquarters in Brampton, Ontario, Canada was considered as one of the leaders of the telecommunications industry during the late 1990s. About three-fourths of the Internet traffic of North America was transacted through Nortel equipment. Nortel had around 73,000 employees around the world. The company’s share was listed on both at the “Stock Exchanges” of Canada and New York (www.Nortel.com).

Nortel had a market capitalization at a peak price of C$ 124.5O and had over 3.8 billion shares worth C$473.1 billion as of July 2000. Nortel accounted for over thirty percent of the value of the S & P / TSE 300 Composite index.

Nortel has been forefather in establishing many significant technological advances. Regrettably, its luminous technological expertise has not been corroborated by its ability to administer itself. In its history, the company has been highly praised and blamed. The company has also been blamed for how it pitched bad news.

During the 1990s. Nortel was flourishing, and the company was regarded for reporting enviable gains in the new economy by shifting and by embracing Internet technology from manufacturing phone equipment. Nortel was on the victorious spree as it reframed to make the company more aggressive, had outsourced its production, and made key acquisitions. In the 1990s, Nortel equipment was carrying about three-fourth of the Internet traffic in North America.

Nortel’s CEO John Roth, in the late 1990s, expended more than US$22 billion to make Nortel the pioneer on the Internet information highway. In the fiber optics section, Roth acquired 16 companies to build upon Nortel’s strengths. Roth was regarded as Canada’s most farsighted executive by National Post Business Magazine and Time, and by other publications and institutions, and had managed the leading expansion of share capital in Canada’s corporate annals. In July 2000, Nortel was at its climax which was worth about $265 billion, a tenfold increase since Roth became CEO.

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However, things turned topsy-turvy later. By 2001, Nortel virtually vaporized and lost 99 percent of its value. About 60 000 employees lost their jobs, and the company witnessed difficult issues about its solvency. (www.Nortel.com).

Analysis of Nortel Accounting Scandal

By September 2002, due to the infamous dot-com bubble burst, Nortel stock closed at C$0.63. John Roth, CEO of Nortel who was named as ” Canada’s business leader of the year ” in 2000, later informed that he would resign from CEO in April 2001.

Nortel’s collapse commenced when its patrons— data and telephone carriers—started to cut back on buying Nortel’s differentiated equipment. Sales figures of Nortel were declined by fifty percent. The net worth of the companies Nortel had acquired declined too. Within twelve months, companies that Nortel had acquired for many billions, there had been deterioration in their investment values. Efforts were initiated to arrest what appeared like a free-drop—top executives were appointed and dismissed, more than sixty percent of jobs were slashed down, but the company could not be resurrected to its earlier status. During this period, investors became so furious with how a company was being administered that they initiated lawsuits against Nortel.

Allegations were made in 2001 that the Nortel had wrecked its trading rules in a number of its stock transactions, and Nortel’s shares dropped to just 70- cents—plummeted by 99 percent lower than what they had been worth twenty-four months earlier.

Since then, many efforts have been made to strengthen the feasibility of the company. When Nortel reported its first quarterly profit in three years in 2004, it has appeared as if Nortel might revert on its feet again. However, its stock fell again, when Nortel held up its filing of audited financial statements for 2003. Both the Canadian and American stock exchange commissions-initiated probes of Nortel’s reported earnings. A criminal probe was ordered into Nortel by the U.S. Attorney’s Office and a class-action lawsuit against Nortel a few days later was initiated by the Ontario Public Service Employees Union Pension Trust.

Nortel reported more losses (for the last quarter of 2005, a loss of US$2.2 billion). A major part of this loss was due to lawsuits filed by various stakeholders.

On October 15, 2007, Nortel Networks Corp was sued by the Securities and Exchange Commission on charges of indulging in accounting fraud. SEC alleged that Nortel overstated its revenue in 2000 mainly to defraud outsiders thereby giving an impression that Nortel was performing better than its competitors, especially during tough market scenarios.

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Until Roth’s departure, Nortel was regarded to have had an excellent code of conduct and corporate culture. Frank Dunn, who was the then CFO was elevated to the position of CEO in November 2001. Dunn introduced a radical restructuring process which witnessed a diminution of more than 50 percent of Nortel’s workforce to 45,000 in 2001 and a further decline of 10,000 in 2002. Due to these cost savings, Nortel posted a profit of US$ 54 million in the first quarter of the financial year of 2003. During the second quarter of 2003 also, profits were reported.

However, during the third quarter of 2003, when Nortel reported profits, restatements impacting Nortel’s financial statements of 2000, 2001, and 2002 were also published.

In October 2003, Nortel stated that it was going to restate its financial results to the tune of $900 million of liabilities reported in its previous year June 30, 2003, ending balance sheet mainly due to overall in-house evaluation of these financial commitments through its ‘Maiden Revised Statement.’ According to Nortel, the major impacts of this revised statement would be a diminution in earlier covered aggregate losses for the financial year from 2000 to 2002 and a swell in shareholder’s net assets and equity, which was announced earlier on its balance sheet.

Nortel continually missed filing deadlines throughout 2004. The 2003 financial statements were finally issued only on January 10, 2005, which is 12 months after the year-end. Nortel’s reported revenues in 2003 were US$424 million, which is down from the US$732 million reported earlier. The cost of the financial restatement and review was over US$100 million. About 600 Nortel employees worked full-time on the restatement in addition to the work of Wilmer Cutler.

Since it was declared in October 2003 that a restatement was necessary, Nortel held more than eighty audit committee and board of director’s meetings. A section titled ‘Major Deficiencies in In-house Checks over Reporting of Financial Identified During the Second Restatement was included in the MD&A section of Norton’s annual report 2004. The above report recommended that Nortel Management must address the following six identified material weaknesses:

  1. There has been short of conformity with spelled Nortel procedures for supervising and aligning balances associated with some provisions and accruals, including charges for restructuring and customer accruals and contract;
  2. There has been short of compliance with Nortel procedures for properly pertaining appropriate GAAP to the preliminary accounting of some liabilities, together with those elaborated in foreign currency translation as described in SFAS No. 52 and SFAS No. 5 ;
  3. There has been short of adequate evaluation and documentation of the application of U.S. GAAP to financial transactions, including, but not restricted to, revenue;
  4. There has been obvious accountability and organizational structure within the accounting occupation, including insufficient supervision and review, blended with financial coverage systems that are not structured and, which necessitate widespread manual interferences;
  5. There has been short of comprehension of, and appropriate and timely redressal of, internal control issues by Nortel employees;
  6. An improper ‘tenor at the top’, which bestowed to the short of a sturdy control environment. (SEC, 2007).

Due to restatements, concerns were raised for the delay in publishing in Nortel financial reports and the substantial bonus paid to Nortel executives. This prompted the Audit Committee of Nortel to order an independent review (IR) of Nortel’s financial status.

The audit committee of Nortel wished to benefit from complete comprehension of the incidents that stimulated considerable surplus financial obligations to be reported on the balance sheet that required be restating and making recommendations to employ required corrective initiatives to handle controls, compliances related to employees, and regulation.

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The Internal Review spotlighted the economic image of the Company at the period that decision was taken, and proceedings were initiated as regards to provision made. The Second Restatement mirrored the major transformations to financial outcomes and the restated financial outcomes diverge from the past outcomes that caused the background for this investigation.

In the financial year 2002, Nortel was about to attain profits and these exercises were perused to conform to enforce globally unaudited earnings before tax objectives.

The individual provisions were comparatively small when compared to the dollar value and the total sum of the provisos made the variance between a reported loss and a profit, on a draft basis, in the 2002 last financial quarter and the published profit.

The findings of IR ended in a further restatement of the financial statements of Nortel and the termination of ten senior executives including CEO, CFO, and financial controller. All the ousted executives were asked to repay the bonuses received from the company. A dozen senior executives were also asked to recoup the company with the bonus amount paid, and they were not terminated. (Brooks and Dunn, 2009 p.304).

It was alleged that Nortel was engaged in manipulating earnings to camouflage its losses and to make a false representation as if the company is making profits and this is mainly intended to meet Wall Street’s expectations.

In the restatement process, Nortel had to go back to 1999 and reduce its sales numbers by an aggregate of $3.4 billion. Since Nortel is a Canadian company, it paid a huge amount as a fine in Canada and also accepted to pay about $2.5 billion to settle shareholder’s disputes associated with the accounting scandal. (Coenen, 2007).

The main reasons for the accounting scandal in Nortel are as follows:

  • The top management of Nortel did not want to accept the realistic view of the financial position of the company and encouraged the finance managers of the company to use improper accounting practices to inflate the profits of the company.
  • Tone at the top that expressed a communication that earning goals had to be achieved through whatever exercises essential and that no employee would be allowed to question such practices;
  • Within Nortel’s finance area, there is a need for technical accounting expertise;
  • Ineffective or fragile internal controls;
  • Lack of clear accountability and responsibility due to the existence of complex corporate structure.
  • Lack of transparency due to lack of integration between business units.
  • Ineffective or weak internal controls offered either no check or little on inaccurate financial reporting.
  • The existence of a complex ‘matrix’ structure resulted in the absence of obvious accountability and responsibility by business regions and segments. (Brooks and Dunn, 2009 p.307).
  • The absence of integration between corporate management and the business units paves to a lack of precision as regards provisioning activity to attain internal EBT ( Earnings Before Tax ) goals.
  • Nortel reported heavy financial losses both in 2001 and 2002 and reduced its employee’s strength by nearly two-thirds. The remaining skeleton structure employees were asked to espouse additional duties with no pay increase. Thus, the concomitant downsizing of the workforce and operations and the company’s downturn resulted in the loss of documentation and a diminution in the financial discipline. It was stressed that these factors were mainly responsible for noteworthy excess reporting in the balance sheet as of June 30, 2003, which culminated in the First Restatement.
  • When Frank Dunn became CEO in 2001, he made his finance department people achieve internal EBT goals, which were not in compliance with U.S. GAAP.
  • At the instruction of erstwhile CFO Doug Beatty, in the third quarter of 2002, a company-wide evaluation of accrued liabilities on Nortel’s balance sheet was initiated in early August 2002. The CFO learned that such evaluation resulted in about $303M in provisions, which were no longer needed and were available for discharge. (Brooks and Dunn, 2009 p.308).
  • CFO and other financial staff were well aware that if any excess provision is retained on the balance sheet then it would cause the company’s financial statements to be erroneous and that US GAAP requires either that provisions are released during that period and properly divulged or there should be a restatement of financial of that prior period. However, the Nortel finance department released that excess provision or excess accruals into income over the subsequent several financial quarters in contravention of US GAAP provisions by failing to fine-tune Nortel’s financial statements to report for the significant excess accrued liabilities.
  • During the first quarter of 2003, when Nortel declared publicly that it anticipated attaining Pro-forma profitability in the second quarter of 2003, Dunn unleashed his strategy and road maps to achieve the targets set by him. (Brooks and Dunn, 2009 p.308).
  • These road maps unraveled that the internal EBT goals for the quarter could only be achieved through the release of the excess provisions in the balance sheet that was short of an accounting trigger in the quarter. Then, excess provisions were identified at each division level, which is called ‘hard’ provisions. Then, it was identified that which ‘hard’ provision would be released to plug the gap and to meet the internal EBIT targets. Thus Nortel could post a profit of $361M by releasing the ‘hard ‘provisions during the first quarter of 2003 even though business was running at a loss.
  • It is to be observed that US GAAP does not authorize such a release without proper justifications of excess provisions in the income statements.
  • When presenting the Pro-forma results for the quarter to the audit committee, the financial controller of Nortel wrongly represented that the major portions of these releases were non-recurring, one-time, and in conformity with U.S GAAP.
  • CFO failed to inform both the board of directors and the audit committee that the release of excess’ hard’ provisions was needed to attain profitability and to cook up for the gap in operational results.
  • They have not informed either the board or the audit committee that such release is made with an ulterior motive of covering the cost of bonus payments to key executives.
  • Thus, the provisions of US GAAP have been infringed mainly to turn a loss for the quarter into a profit. Further, excess ‘hard’ provisions have been retained on the balance sheet to be employed when required in a later financial quarter.
  • Top executives of Nortel rather supplied cooked-up figures to the Board and the audit committee and based on the representation made b the Nortel top management, they approved the quarterly results and the issuance of bonus to top executives. (Brooks and Dunn, 2009 p.308).

Nortel accounting scandal has taught us the following lessons:

  • Establishing a sound ‘tone at the top ‘mainly through efficient procedures, policies, and complete knowledge and pledge to fiduciary accountability, duty, and accuracy, especially in financial reporting.
  • There should be a continuing education on U.S GAAP for both accounting and finance department staff.
  • A strict warning should be given to both the accounting and finance departments that Norton would never tolerate any failure to follow the U.S GAAP guidelines. (SEC, 2007).
  • Future recruitment for the finance and accounting department should be from an external source that too with those qualified persons with acumen accounting and reporting expertise and skills and has established record of ethical and integrity demeanor, especially in top finance positions.
  • The by-passed ‘technical accounting group ‘in Nortel should be bolstered and strengthened.
  • Nortel’s Code of Conduct of 1998 was regarded as being the primary edge. Despite the code of conduct, Nortel’s financial statements were still misrepresented with the cognition and help of many finance bank trust department employees throughout the organization internationally. How was this feasible? Why there was no whistleblower during this period?
  • US$50 million of bonus paid to management appears to be comparatively negligible, given the 3.2 billion shares outstanding. Why did it create such anxiety?
  • What would be the responsibilities and role of the Chief Ethics and Compliance Officer of Nortel? What would be a suitable reporting arrangement and why?
  • Fraud risk associated with each engagement is to be assessed by the audit team as per section 5135 of the CICA Assurance handbook. Why risk audit has not been carried over in the Nortel for the last several years?
  • There are material weaknesses in Nortel’s control systems, especially in management controls and internal accounting controls as agreed by both Nortel’s auditors and management, how would it be feasible for an auditor to certify an unprofessional opinion on a global company about assets of US$17 billion and with income of US$10 billion?
  • Companies are required to report the costs associated with downsizing while witnessing an uncertain future. Why provisions recorded are for estimated future costs instead of reporting the actual costs only as and when incurred? For auditors, what hurdles do such estimates cause? Only because of these provisions, Nortel was able to indulge in accounting scandal thereby using these provisions to inflate its quarter revenues to match Wall Street’s expectations. (SEC, 2007).

Reporting problems and analyzing them using accounting theory

Moral Hazard

This happens due to the separation of control of the business and the ownership. Management may function in bad faith to derive an advantage to enhance their interest to the detriment of investors as the actions of the top management cannot be watched by the shareholders. To avoid such moral hazards, the company has to construct a mechanism to assess the performance of management and should make them accountable for their deeds. In this regard, net income can be used as an indicator for the assessment of the performance of a company and the competence and quality of top management.

Net income should serve as a yardstick for deciding the executive compensation. In Nortel, CFO and other financial staff were well aware that if any excess provision is retained on the balance sheet then it would cause the company’s financial statements to be erroneous and that US GAAP requires either that provisions are released during that period and properly divulged or there should be a restatement of financial of that prior period. However, the Nortel finance department released that excess provision or excess accruals into income over the subsequent several financial quarters in contravention of US GAAP provisions by failing to fine-tune Nortel’s financial statements to report for the significant excess accrued liabilities. Thus, Nortel’s top executives practiced unethical activities, which resulted in moral hazardous.

Reliability

A company’s information is dependable if it is verifiable. For instance, identical results might have been achieved if similar measurements are employed and if financial results are presented on a realistic representation of what materialized. Further, it should be neutral and should be reasonably free from bias. Moreover, it should have tradeoff qualities. It should have a tradeoff between the timeliness of financial information and the reliability of the information. It should focus on the requirements of the users of financial statements. Nortel continually missed filing deadlines throughout 2004. The 2003 financial statements were finally issued only on January 10, 2005, which is 12 months after the year-end. This demonstrates that it lacks reliability.

Relevance

A company’s financial information can be said to be relevant if it supports the following:

  • A company’s financial information should have a predictive value, and it should cause a change. It should have a feedback value, and it should be timely.
  • A company’s financial information should be relevant in the sense that financial information should be reported or published on time. Missing of filling deadlines corroborates that Nortel lacks relevance.

Earnings management

Corporate strategies for earnings management will adhere to either one or more of the three following strategies.

  • Select from the supple of choices available within GAAP.
  • To bank on the subjective forecasts and application preferences available within the choices and
  • To use asset purchases and disposals and the time duration for reporting them.

It is to be noted that all references made within GAAP will be tantamount to earnings management, whereas preferences made outside GAAP will be construed as fraud. A court is a competent authority to decide whether certain management reporting actions that are initiated outside the limits of GAAP are earnings management or fraud. (Riahi-Belkaoui, p.461). There has been short of compliance with Nortel procedures for properly pertaining appropriate GAAP to the preliminary accounting of some liabilities, together with those elaborated in foreign currency translation as described in SFAS No. 52 and SFAS No. 5. This corroborates the fact that Nortel engaged in fraud.

Executive compensation

Net income should act as input to executive compensation, which will be acting as motivation for management to perform. Executive compensation should be offered to mirror positive management stewardship. Some companies reward their top executives for losses in the risk-bearing ingredient of compensation, say by backdating options. This may minimize the risk of losing such compensation but may also amount to securities fraud as corroborated by the current probes by the SEC against US companies. (Marnet, 2008, p.19). Net income should serve as a yardstick for deciding the executive compensation. In Nortel, CFO and other financial staff were well aware that if any excess provision is retained on the balance sheet, then it would cause the company’s financial statements to be erroneous.

Conclusion

Adding more fuel to fire, in a copyright infringement case against telecommunications retailer Platinum Networks Nortel was awarded $47.4 million in punitive damages in 2006. Further, Nortel reached agreements with investor lawsuits in the United States and Canada where the comprehensive settlement compelled Nortel to issue over 600 million common shares and to disburse the U.S. $575 million in cash.

Nortel picked up the erstwhile Motorola top-executive Mike Zafirovski as its CEO to turn around the company in 2005.

The Board of Nortel has reposed much confidence in Zafirovski, its new CEO, who assisted to turn around Motorola Inc.’s mobile business as he’s had some knowledge in putting companies back on track.

Nortel may be functioning successfully if there has been no accounting scandal.

Lack of internal controls, failure to adhere to US-GAAP provisions, failure to foresee the risk and to implement risk mitigation strategies are the main reasons for Nortel’s turmoil and Nortel had to censure itself for these developments. The charges are serious and hence Canadian government has not come forward to rescue Nortel with any bailout packages.

Nortel’s episode highlights that business is having both economic and social commitments to society. Further, the government and the business are both having major parts to play in the contemporary economy, and integrity and ethics are most indispensable not only to personal fulfillment but also to the success of any business.

No doubt, accounting scandal blending with a destabilized market with cut-throat competition has caused the Nortel to push to a premature state of decline.

References

Brooks, Leonard J & Dunn Paul. (2009). Business & Professional Ethics for Directors, Executives and Accountants. New York: Cengage Learning.

Coenen Tracy. (2007). SEC Suit Against Nortel Highlights Accounting Fraud Schemes. Web.

Marnet Oliver. (2008). Behaviour and Rationality in Corporate Governance. New York: Routledge.

Riahi-Blkaoui, Ahmed. (2004). Accounting Theory. New York: Cengage Learning.

Scott, William R. (2008). Financial Accounting Theory, 5th Canadian New York: Pearson Publishing.

sec. (2007). SEC v. Nortel Networks Corporation. Web.

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