On March 10, 2006, Nortel Networks Corp. announced that it would delay filing its 2005 financial reports with the SEC. The delay arose because Nortel and its auditors decided that certain revenue recognized in prior periods should have been deferred. The estimated deferral of revenue previously recognized in the first nine months of 2005 totaled

$162 million U.S., reducing 2005 earnings from continuing operations by $95 million. For 2004 and prior years, the corresponding amounts were deferral of $704 million of previously recognized revenue and a reduction of prior years’ earnings of $279 million.

Nortel explained that these changes follow from Statements of Position issued by the AICPA (Nortel follows U.S. GAAP), which require that revenue from longer-term contracts involving “multiple deliverables,” such as hardware, software, and services, should be deferred until delivery.

On the same day, Nortel announced an estimated, unaudited, net loss from 2005 continuing operations of $2.421 billion. This loss included an expense of $2.474 billion to settle shareholder litigation resulting from previous accounting restatements (see Theory in Practice11.

1).

On March 10, 2006, Nortel’s share price on the TSX composite index fell 11 cents in heavy trading to $3.50 Can., for a return of3.

05% for the day. On the same day, the TSX composite index rose68.

28 points to 11,833.61, for a return of0.

58%. According to Reuters’ web site, Nortel's beta on the TSX at this time was1.

96. The risk-free interest rate R; was4.

5%, or0.

0001 per day.

Required

a. Evaluate the effect of Nortel's revenue deferral on the relevance and reliability of its 2005 financial statements.

b. What earnings management pattern did Nortel appear to be following for 2005? Why?

c. Calculate the abnormal return on Nortel's shares, relative to the return on the TSX, for March 10, 2006. Do you feel that the abnormal return arose primarily from the news of the revenue deferral or from the $2.474 billion shareholder litigation expense?

Explain.

Hint: According to the market model and CAPM, a Re = Bi).

d. Nortel included the $2.474 billion shareholder litigation expense as part of continuing operations, rather than as an extraordinary item. Do you agree? Explain.