Ethical Obligations and Decision Making in Accounting, 4/e 1
Case 7-1 Nortel Networks
Canada-based Nortel Networks was one of the largest telecommunications equipment companies
in the world prior to its filing for bankruptcy protection on January 14, 2009, in the United
States, Canada, and Europe. The company had been subjected to several financial reporting
investigations by U.S. and Canadian securities agencies in 2004. The accounting irregularities
centered on premature revenue recognition and hidden cash reserves used to manipulate financial
accordance with U.S. GAAP.
The company had gambled by investing heavily in Code Division Multiple Access (CDMA)
wireless cellular technology during the 1990s in an attempt to gain access to the growing
European and Asian markets. However, many wireless carriers in the aforementioned markets
opted for rival Global System Mobile (GSM) wireless technology instead. Coupled with a
worldwide economic slowdown in the technology sector, Nortel’s losses mounted to $27.3
billion by 2001, resulting in the termination of two-thirds of its workforce.
Accounting Irregularities
On March 12, 2007, the SEC alleged the following in a complaint against Nortel:
• In late 2000, Beatty and Pahapill implemented changes to Nortel’s revenue recognition
policies that violated U.S. GAAP, specifically to pull forward revenue to meet publicly
announced revenue targets. These actions improperly boosted Nortel’s fourth quarter and
fiscal 2000 revenue by over $1 billion, while at the same time allowing the company to
meet, but not exceed, market expectations. However, because their efforts pulled in more
revenue than needed to meet those targets, Dunn, Beatty, and Pahapill selectively
reversed certain revenue entries during the 2000 year-end closing process.
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and pay bonuses. These efforts turned Nortel’s first-quarter 2003 loss into a reported
profit under U.S. GAAP, which allowed Dunn to claim that he had brought Nortel to
profitability a quarter ahead of schedule. In the second quarter of 2003, their efforts
largely erased Nortel’s quarterly loss and generated a pro forma profit. In both quarters,
Nortel posted sufficient earnings to pay tens of millions of dollars in so-called return to
profitability bonuses, largely to a select group of senior managers.
The complaint charged Dunn, Beatty, Gollogly, and Pahapill with violating and/or aiding and
abetting violations of the antifraud, reporting, and books and records requirements. In addition,
they were charged with violating the Securities Exchange Act Section 13(b)(2)(B) that requires
issuers to devise and maintain a system of internal accounting controls sufficient to provide
reasonable assurances that, among other things, transactions are recorded as necessary to permit
the preparation of financial statements in conformity with U.S. GAAP and to maintain
accountability for the issuer’s assets.
Specifics of Earnings Management Techniques
From the third quarter of 2000 through the first quarter of 2001, when Nortel reported its
financial results for year-end 2000, Dunn, Beatty, and Pahapill altered Nortel’s revenue
recognition policies to accelerate revenues as needed to meet Nortel’s quarterly and annual
revenue guidance, and to hide the worsening condition of Nortel’s business. Techniques used to
accomplish this goal include:
1. Reinstituting bill-and-hold transactions. The company tried to find a solution for the
hundreds of millions of dollars in inventory that was sitting in Nortel’s warehouses and
offsite storage locations. Revenues could not be recognized for this inventory because
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2. Restructuring business-asset write-downs. Beginning in February 2001, Nortel suffered
serious losses when it finally lowered its earnings guidance to account for the fact that its
3. Creating reserves. In relation to writing down the assets, Nortel established reserves that
were used to manage earnings. Assisted by defendants Beatty and Gollogly, Dunn
4. Releasing reserves into income. From at least July 2002 through June 2003, Dunn,
Beatty, and Gollogly released excess reserves to meet Dunn’s unrealistic and overly
2003. When 2003 turned out to be rockier than expected, Dunn, Beatty, and Gollogly
orchestrated the release of excess reserves to cause Nortel to report a profit in the first
quarter of 2003, a quarter earlier than the public expected, and to pay defendants and
others substantial bonuses that were awarded for achieving profitability on a pro forma
Siemens Reserve
During the fraud trial, former Nortel accountant Susan Shaw testified about one of the most
controversial accounting provisions on the company’s books, relating to a 2001 lawsuit filed
against Nortel by Siemens AG. It was long-standing practice across Nortel to establish reserves
on a “worst case” basis, which meant at an amount equal to the maximum possible exposure.
company into a profitable position in the quarter. It was then booked to be used in the second
quarter, and became the only head office non-operating reserve used in the quarter.
The contention was that the Siemens reserve was used in that quarter because Nortel needed
almost exactly $4 million more income to reach the payout trigger for the company’s restricted
share unit plan at that time. However, lawyer David Porter argued the Siemens amount was
triggered in the second quarter because that is when the company believed it was no longer
needed and should appropriately be reversed.
In its working notes, Deloitte recorded that Nortel felt it was “prudent” to keep the $4 million on
the books until mid-2002. Shaw testified she felt the reserve was being reversed on schedule with
the plan to keep it in place for the first two quarters of the year. Porter asked Shaw whether the
auditors were satisfied at the time there was an appropriate triggering event to use the reserve in
the second quarter of 2002, and she replied there was one.
Role of Auditors and Audit Committee
In late October 2000, as a first step toward reintroducing bill-and-hold transactions into Nortel’s
sales and accounting practices, Nortel’s then controller and assistant controller asked Deloitte to
explain, among other things, (1) “[u]nder what circumstances can revenue be recognized on
product (merchandise) that has not been shipped to the end customer?” and (2) whether
merchandise accounting can be used to recognized revenues “when installation is imminent” or
“when installation is considered to be a minor portion of the contract”?
2003.
In March 2004, Nortel suspended Beatty and Gollogly and announced that it would “likely” need
to revise and restate previously filed financial results further. Dunn, Beatty, and Gollogly were
terminated for cause in April 2004.
On January 11, 2005, Nortel issued a second restatement that restated approximately $3.4 billion
first time that its restated revenues in part had resulted from management fraud, stating that “in
an effort to meet internal and external targets, the senior corporate finance management team . . .
changed the accounting policies of the 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’s independent auditor by making
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The defendants’ scheme resulted in Nortel issuing materially false and misleading quarterly and
annual financial statements and related disclosures for at least the financial reporting periods
ending December 31, 2000, through December 31, 2003, and in all subsequent filings made with
the SEC that incorporated those financial statements and related disclosures by reference.
On October 15, 2007, Nortel, without admitting or denying the SEC’s charges, agreed to settle
18.5¢ a share, down from a high of $124.50 in 2000. Nortel’s battered and bruised stock was
finally delisted from the S&P/TSX composite index, a stock index for the Canadian equity
market, ending a colossal collapse on an exchange on which the Canadian telecommunications
giant’s stock valuation once accounted for a third of its value.
Postscript
diminished that duty.”
During the trial, lawyers for the accused said that the men believed that the accounting decisions
they made were appropriate at the time, and that the accounting treatment was approved by
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Nortel’s auditors from Deloitte & Touche. Judge Marrocco accepted these arguments, noting
concluded that Beatty and Dunn “were prepared to go to considerable lengths” to use reserves to
improve the bottom line in the second quarter of 2003, but he said the decision was reversed
before the financial statements were completed because Gollogly challenged it.
In a surprising twist, Judge Marrocco also suggested the two devastating restatements of Nortel’s
books in 2003 and 2005 were probably unnecessary in hindsight, although he said he understood
Questions
1. Discuss Nortel’s accounting for the following transactions and why they were not in
conformity with GAAP:
o Revenue recognition
o Reserve accounting
o Accounting for contingent liabilities
Revenue Recognition
Accelerated revenue into an earlier period by pulling forward revenue to the last quarter of 2000
to meet market expectations. This violates GAAP because specific criteria must be met during a
period to justify revenue recognition. It lines up with Schilit’s Shenanigan #1.
Reserve Accounting
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Accounting for Contingent Liabilities
Siemens filed a lawsuit against Nortel in 2001. Nortel set up a reserve for the worst case scenario
that reflected maximum possible loss. This had the effect of creating another cookie jar reserve
since the overstated amount could be brought back into income at a later date thereby misleading
2. The following two statements are made in the case:
o Accounting experts said the case is sure to be closely watched by others in the
business community for the message it sends about where the line lies
between fraud and the acceptable use of discretion in accounting.
o Darren Henderson opined that “The message . . . is that it is okay to use
accounting judgments to achieve desired outcomes, [such as] a certain
earnings target.”
Evaluate these statements from the perspectives of representational faithfulness and
fair presentation of the financial results reported by Nortel.
The Nortel results were skewed because of the use of reserves and the manipulation of revenue
to manage earnings in a way that met management’s goals rather than to faithfully represent the
true economic substance of the transactions. Management’s decision making was motivated by
the desire to achieve expected outcomes and not to fairly represent the results of operations and
financial position.
3. During the trial, lawyers for the accused said that the men believed that the
accounting decisions they made were appropriate at the time, and that the
accounting treatment was approved by Nortel’s auditors from Deloitte & Touche.
Judge Marrocco accepted these arguments. Marrocco added he was “not satisfied
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beyond a reasonable doubt” that the trio [i.e., Dunn, Beatty, and Gollogly] had
“deliberately misrepresented” financial results. Given the facts of the case do you
believe Judge Marrocco’s decision was justified? Explain.
The trio lied and committed fraud. They manipulated the accounting records to meet market
expectations. In addition to the cookie-jar effect, the manipulations were motivated by delaying
bonuses until a later period when they had been projected to be paid by management. Perhaps the
judge went easy on management because their decisions did not seem to be motivated by a desire
to drive the stock price up and trade on insider information, two motivations that clearly establish
culpability. Judge Marrocco may not have fully understood the GAAP problems in setting up
and altering reserve amounts over time.
4. Does it appear from the facts of the case that the Deloitte auditors met their ethical
and professional responsibilities in the audit of Nortel’s financial statements?
Nortel had invested heavily in the Code Division Multiple Access (CDMA) wireless cellular
technologies in the 1990s. However, by the later 1990s and early 2000s, it was clear the industry
standard would be the rival Global System Mobile (GSM). There was a worldwide economic
slowdown in the technology sector. Those two indicators should have warned the auditors that
Nortel might be experiencing losses or pressures to make market expectations; one of the signs
of a high-risk audit. The announcement in October 2003 that Nortel would restate its financials
for FY 2000, FY 2001, and FY 2002 were additional signs of high-risk audit.
Top management had the opportunity to commit fraud and the internal controls seemed
nonexistent or overridden. The fact that the company was investigated by the SEC over an
extensive period of time should have raised red flags for the auditors. The fact that they were lied
to about management in a number of ways does not excuse auditors’ failure to spot the red flags
and follow up aggressively.
The auditors did not meet their ethical and professional responsibilities to exercise due care with
the appropriate level of skepticism and independently verify recorded accrued reserves. They
failed to spot the indicators of fraud. Looking at some of the facts in the case, the questions
posed by the controller about revenue recognition should have raised alarm bells about
management’s true intentions. The facts of the case provide the following information.