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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 statements. The goal was to present the company in a positive light so that investors would buy (hold) Nortel stock, thereby inflating the stock price. Although Nortel was an international company, the listing of its securities on U.S. stock exchanges subjected it to all SEC regulations, along with the requirement to register its financial statements with the SEC and prepare them in 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, Nortels losses mounted to $27.3 billion by 2001, resulting in the termination of two-thirds of its workforce.

The Nortel fraud primarily involved four members of Nortels senior management as follows: CEO Frank Dunn, CFO Douglas Beatty, controller Michael Gollogly, and assistant controller Maryanne Pahapill. At the time of the audit, Dunn was a certified management accountant, while Beatty, Gollogly, and Pahapill were chartered accountants in Canada.

Accounting Irregularities

On March 12, 2007, the SEC alleged the following in a complaint against Nortel:1

In late 2000, Beatty and Pahapill implemented changes to Nortels revenue recognition policies that violated U.S. GAAP, specifically to pull forward revenue to meet publicly announced revenue targets. These actions improperly boosted Nortels 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.

In November 2002, Dunn, Beatty, and Gollogly learned that Nortel was carrying over $300 million in excess reserves. The three did not release these excess reserves into income as required under U.S. GAAP. Instead, they concealed their existence and maintained them for later use. Further, Beatty, Dunn, and Gollogly directed the establishment of yet another $151 million in unnecessary reserves during the 2002 year-end closing process to avoid posting a profit and paying bonuses earlier than Dunn had predicted publicly. These reserve manipulations erased Nortels pro forma profit for the fourth quarter of 2002 and caused it to report a loss instead.2

In the first and second quarters of 2003, Dunn, Beatty, and Gollogly directed the release of at least $490 million of excess reserves specifically to boost earnings, fabricate profits, and pay bonuses. These efforts turned Nortels 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 Nortels 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.

During the second half of 2003, Dunn and Beatty repeatedly misled investors as to why Nortel was conducting a purportedly comprehensive review of its assets and liabilities, which resulted in Nortels restatement of approximately $948 million in liabilities in November 2003. Dunn and Beatty falsely represented to the public that the restatement was caused solely by internal control mistakes. In reality, Nortels first restatement was necessitated by the intentional improper handling of reserves, which occurred throughout Nortel for several years, and the first restatement effort was sharply limited to avoid uncovering Dunn, Beatty, and Golloglys earnings management activities.

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 issuers assets.

Dunn and Beatty were separately charged with violations of the officer certification provisions instituted by SOX under Section 302. The commission sought a permanent injunction, civil monetary penalties, officer and director bars, and disgorgement with prejudgment interest against all four defendants.

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 Nortels revenue recognition policies to accelerate revenues as needed to meet Nortels quarterly and annual revenue guidance, and to hide the worsening condition of Nortels business. Techniques used to accomplish this goal include:

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 Nortels warehouses and offsite storage locations. Revenues could not be recognized for this inventory because U.S. GAAP revenue recognition rules generally require goods to be delivered to the buyer before revenue can be recognized. This inventory grew, in part, because orders were slowing and, in June 2000, Nortel had banned bill-and-hold transactions from its sales and accounting practices. The company reinstituted bill-and-hold sales when it became clear that it fell short of earnings guidance. In all, Nortel accelerated into 2000 more than $1 billion in revenues through its improper use of bill-and-hold transactions.

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 business was suffering from the same widespread economic downturn that affected the entire telecommunications industry. As Nortels business plummeted throughout the remainder of 2001, the company reacted by implementing a restructuring that, among other things, reduced its workforce by two-thirds and resulted in a significant write-down of assets.

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 manipulated the companys reserves to manage Nortels publicly reported earnings, create the false appearance that his leadership and business acumen was responsible for Nortels profitability, and pay bonuses to these three defendants and other Nortel executives.

Releasing reserves into income. From at least July 2002 through June 2003, Dunn, Beatty, and Gollogly released excess reserves to meet Dunns unrealistic and overly aggressive earnings targets. When Nortel internally (and unexpectedly) determined that it would return to profitability in the fourth quarter of 2002, the reserves were used to reduce earnings for the quarter, avoid reporting a profit earlier than Dunn had publicly predicted, and create a stockpile of reserves that could be (and were) released in the future as necessary to meet Dunns prediction of profitability by the second quarter of 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 basis. Because their actions drew the attention of Nortels outside auditors, they made only a portion of the planned reserve releases. This allowed Nortel to report nearly break-even results (though not actual profit) and to show internally that the company had again reached profitability on a pro forma basis necessary to pay bonuses.

Siemens Reserve

During the fraud trial, former Nortel accountant Susan Shaw testified about one of the most controversial accounting provisions on the companys 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.

Nortel had created an accounting reserve on its books at the time the Siemens lawsuit was filed to provide for a settlement in the case, but it was alleged that a portion of the provision was arbitrarily left on Nortels books long after the lawsuit was resolved in the fourth quarter of 2001. It became part of a group of extra head office, non-operating reserves that allegedly was reversed arbitrarilyand with no appropriate business triggerto push the company into a profit in 2003 and earn return to profitability bonuses for executives.

The $4-million remaining Siemens provision was initially booked to be reversed into income in the first quarter of 2003, but then withdrawn, allegedly because it was not needed to push the 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 companys 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 cross-examination, Porter showed Shaw a working document recovered from the files of Nortels external auditors at Deloitte & Touche, showing the auditor reviewed Nortels justifications for keeping the Siemens reserve on the books until that time and for reversing it in the second quarter of 2003. Deloittes notes showed the auditor reviewed Nortels detailed rationale for the reserve and concluded its release in the second quarter was reasonable.3

The company said it was holding on to the reserve because the settlement with Siemens had been rancorous and Nortel wanted to be sure there would be no further claims made after the lawsuit was settled and $32 million was paid to Siemens in two installments in late 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. 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.

However, the amount became part of a broad restatement of reserves announced at Nortel at the end of 2003. The company noted in the restatement that the Siemens reserve should have been reversed in the fourth quarter of 2001 when the lawsuit was settled.

Role of Auditors and Audit Committee

In late October 2000, as a first step toward reintroducing bill-and-hold transactions into Nortels sales and accounting practices, Nortels 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?4

On November 2, 2000, Deloitte presented Nortel with a set of charts that, among other things, explained the US GAAP criteria for revenues to be recognized prior to delivery (including additional factors to consider for a bill-and-hold transaction) and also provided an example of a customer request for a bill-and-hold sale that would support the assertion that Nortel should recognize revenue prior to delivery.

Nortels earnings management scheme began to unravel at the end of the second quarter of 2003. On the morning of July 24, 2003, the same day on which Nortel issued its second Quarter 2003 earnings release, Deloitte informed Nortels audit committee that it had found a reportable condition with respect to weaknesses in Nortels accounting for the establishment and disposition of reserves. Deloitte went on to explain that, in response to its concerns, Nortels management had undertaken a project to gather support and determine proper resolution of certain provision balances. Management, in fact, had undertaken this project because the auditor required adequate audit evidence for the upcoming year-end 2003 audit. Nortel concealed its auditors concerns from the public, instead disclosing the comprehensive review.

Shortly after Nortels announced restatement, the audit committee commenced an independent investigation and hired outside counsel to help it gain a full understanding of the events that caused significant excess liabilities to be maintained on the balance sheet that needed to be restated, as well as to recommend any necessary remedial measures. The investigation uncovered evidence that Dunn, Beatty, and Gollogly and certain other financial managers were responsible for Nortels improper use of reserves in the second half of 2002 and first half of 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 in misstated revenues and at least another $746 million in liabilities. All of the financial statement effects of the defendants two accounting fraud schemes were corrected as of this date, but there remained lingering effects from the defendants internal control and other nonfraud violations.

Nortel also disclosed the findings to date of the audit committees independent review, which concluded, among other things, that Dunn, Beatty, and Gollogly were responsible for Nortels improper use of reserves in the second half of 2002 and first half of 2003. The second restatement, however, did not reveal that Nortels top executives had also engaged in revenue recognition 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 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 Nortels independent auditor by making materially false and misleading statements and omissions in connection with the quarterly reviews and annual audits of the financial statements that were materially misstated. Among other things, each of the defendants submitted management representation letters to the auditors that concealed the fraud and made false statements, which included that the affected quarterly and annual financial statements were presented in conformity with U.S. GAAP and that they had no knowledge of any fraud that could have a material effect on the financial statements. Dunn, Beatty, and Gollogly also submitted a false management representation letter in connection with Nortels first restatement, and Pahapill likewise made false management representations in connection with Nortels second restatement.

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 SECs charges, agreed to settle the commissions action by consenting to be enjoined permanently from violating the antifraud, reporting, books and records, and internal control provisions of the federal securities laws and by paying a $35 million civil penalty, which the commission placed in a Fair Fund5 for distribution to affected shareholders.6 Nortel also agreed to report periodically to the commissions staff on its progress in implementing remedial measures and resolving an outstanding material weakness over its revenue recognition procedures.

On January 14, 2009, Nortel filed for protection from creditors in the United States, Canada, and the United Kingdom in order to restructure its debt and financial obligations. In June, the company announced that it no longer planned to continue operations and that it would sell off all of its business units. Nortels CDMA wireless business and long-term evolutionary access technology (LTE) were sold to Ericsson, and Avaya purchased its Enterprise business unit.

The final indignity for Nortel came on June 25, 2009, when Nortels stock price dropped to 18.5 a share, down from a high of $124.50 in 2000. Nortels 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 giants stock valuation once accounted for a third of its value.

Postscript

The three former top executives of Nortel Networks Corp. were found not guilty of fraud on January 14, 2013. In the court ruling, Justice Frank Marrocco of the Ontario Superior Court found that the accounting manipulations that caused the company to restate its earnings for 2002 and 2003 did not cross the line into criminal behavior.

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.

The decision underlines that management still has a duty to prepare financial statements that present fairly the financial position and results of the company according to a forensic accountant, Charles Smedmor, who followed the case. Nothing in the judges decision 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 Nortels auditors from Deloitte & Touche. Judge Marrocco accepted these arguments, noting many times in his ruling that bookkeeping decisions were reviewed and approved by auditors and were disclosed adequately to investors in press releases or notes added to the financial statements.

Nonetheless, the judge also said that he believed that the accused were attempting to manage Nortels financial results in both the fourth quarter of 2002 and in 2003, but he added he was not satisfied that the changes resulted in material misrepresentations. He said that except for $80 million of reserves released in the first quarter of 2003, the rest of the use of reserves was within the normal course of business. Judge Marrocco said the $80 million release, while clearly unsupportable and later reversed during a restatement of Nortels books, was disclosed properly in Nortels financial statements at the time and was not a material amount. He 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 Nortels books in 2003 and 2005 were probably unnecessary in hindsight, although he said he understood why they were done in the context of the time. He said the original statements were arguably correct within a threshold of what was material for a company of that size.

Darren Henderson, an accounting professor at the Richard Ivey School of Business at the University of Western Ontario, said that a guilty verdict would have raised the bar for management to justify their accounting judgments. But the acquittal makes it clear that management manipulation of financial statements is very difficult to prove beyond a reasonable doubt in a court of law, he said.

It is clear that setting up reserves or provisions is still subject to management discretion, Henderson said. The message . . . is that it is okay to use accounting judgments to achieve desired outcomes, [such as] a certain earnings target.

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1U.S. District Court for the Southern District of New York, U.S. Securities and Exchange Commission v. Frank A. Dunn, Douglas C. Beatty, Michael J. Gollogly, and Maryanne E. Pahapill, Civil Action No. 07-CV-2058, www.sec.gov/litigation/complaints/ 2007/comp20036.pdf .

2Pro forma means literally as a matter of form. Companies sometimes report income to the public and financial analysts that may not be calculated in accordance with GAAP. For example, a company might report pro forma earnings that exclude depreciation expense, amortization expense, and nonrecurring expenses such as restructuring costs. In general, pro forma earnings are reported in an effort to put a more positive spin on a companys operations. Unfortunately, there are no accounting rules on just how pro forma should be calculated, so comparability is difficult at best, and investors may be misled as a result.

3Janet McFarland, Nortel Accounting Reserve Reversal Deemed Reasonable, The Globe and Mail, September 6, 2012, Available at:http://www.theglobeandmail.com/globe-investor/nortel-accounting-reserve-reversal-deemed-reasonable-by-auditors-court-told/article4171550/.

4U.S. SEC v. Nortel Networks Corporation and Nortel Networks Limited, Civil Action No. 07-CV-8851, October 15, 2007, Available at:https://www.sec.gov/litigation/complaints/2007/comp20333.pdf

5A Fair Fund is a fund established by the SEC to distribute disgorgements (returns of wrongful profits) and penalties (fines) to defrauded investors. Fair Funds hold money recovered from a specific SEC case. The commission chooses how to distribute the money to defrauded investors, and when completed, the fund terminates.

6Theresa Tedesco and Jamie Sturgeon, Nortel: Cautionary Tale of a Former Canadian Titan,Financial Post, June 27, 2009.

QUESTIONS:

1. 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 Nortels auditors from Deloitte & Touche. Judge Marrocco accepted these arguments. Marrocco added he was not satisfied 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 Marroccos decision was justified? Explain.

2. Does it appear from the facts of the case that the Deloitte auditors met their ethical and professional responsibilities in the audit of Nortels financial statements?