Question: In April 2004 Nortel Networks Corp announced that it had

In April 2004, Nortel Networks Corp. announced that it had fired its CEO, Chief Financial Officer, and Controller. Its share price, over $ 11 prior to the announcement, fell to Can. $ 5.26. The company later announced that several more senior managers were also fired.
The events leading to these dismissals had their roots in the collapse of the technology boom in the early 2000s. This left many of Nortel’s customers and subsidiary companies in financial distress. Conservative provisions were recorded by Nortel in 2001 and 2002 to provide for costs of contract cancellations, bad debts, layoffs, and plant closures. By mid- 2002, about $ 5 billion of such provisions were on Nortel’s balance sheet.
These provisions, together with reduced business activity following the collapse of the technology boom, resulted in Nortel reporting a series of losses totalling about $ 34 billion for 2000– 2002 incl. As part of its attempts to stem these losses, Nortel instituted a system of “ return to profitability” executive bonuses, which would be paid if quarterly pro- forma profits ( Section 7.11.2 ) were earned. If one quarter was profitable, 20% of bonus would be paid, an additional 40% would be paid if the next quarter was profitable, and the final 40% paid if four consecutive quarters were profitable.
In the fourth quarter, 2002, it appeared that pro- forma earnings (but not GAAP earn-ings) for the quarter were going to be positive, which would trigger bonus payments. However, additional provisions were recorded by Nortel to ensure that pro- forma earnings were negative. These provisions were reversed in 2003, and Nortel reported positive pro-forma income in the first two quarters of 2003. Consequently, most employees received cash bonuses, including the CEO, who received $ 3.6 million.
However, the company issued restated 2000– 2003 GAAP results in December 2003 in response to regulators’ concerns, writing off some $ 900 million of excess reserves. These writeoffs were carried back to restate 2000– 2002 earnings upward. However, earnings for the first two quarters of 2003 were revised downward to GAAP losses of $ 146 and $ 128 million, respectively, compared with an originally stated first quarter GAAP 2003 loss of $ 16 million and a second quarter profit of $ 40 million. This revision supported concerns expressed in the previous paragraph that management engaged in earnings management to enable bonus payments.
In February 2006, Nortel agreed to a US$ 2.7 billion settlement of two class- action lawsuits resulting from this incident. In March 2007, the SEC began civil proceedings against several former executives. These were settled with a payment of $ 35 million. In May 2007, Nortel agreed to pay $ 1 million to the Ontario Securities Commission to meet the costs of the Commission’s investigation into this incident. No penalty was paid, although the company formally agreed that its 2002 and 2003 financial statements were not in compliance with GAAP.
In 2008, the three officers were charged with fraud in an Ontario court for deliberately misreporting Nortel’s financial statements during 2000– 2004. The prosecution claimed that the original financial statements and their 2003 revisions were materially misrepresented. Testimony at the trial, as reported in financial media, suggested that a reason for recording extra reserves in fourth quarter 2002 was that management felt paying executive bonuses when reported GAAP earnings for the quarter were negative would attract criticism. Also, management felt that a single pro- forma profitable quarter following huge losses would be ignored by a skeptical market. However, the prosecution claimed that the real motivation was that reversal of these 2002 reserves would enable Nortel to report successive profitable pro- forma quarters and pay greater bonuses in 2003.
In January 2013, the three executives were acquitted of fraud charges. Reasons for acquittal included immateriality of $ 900 million of reserve misstatements in relation to the $ 34 billion of losses Nortel had reported. Also, the judge concluded that since conservatism was well established in accounting practice, the overstatements of the original reserves (which enabled the subsequent management of excess reserves and earnings) were not fraudulent.
However, these events were part of a series of accounting misstatements, resulting in loss of investor confidence (see also Problem 14). This contributed to Nortel’s filing for bankruptcy protection in 2009. The company has now sold its assets and is in the process of winding up.

a. Which earnings management policy did Nortel appear to be using in its fourth quarter 2002? Why? Which policy did it appear to be using in the first two quarters of 2003? Why?
b. Outline accounting theory that supports the judge’s conclusion that conservatism is a well- accepted accounting practice.
c. Discuss the possible impacts on manager effort of the Nortel compensation plan’s tying of bonuses to a return to pro- forma profitability.
d. Assuming that the conservative special item accruals recorded by Nortel during 2000– 2002 were justified by pessimistic economic conditions at the time, why was Nortel’s senior management dismissed in 2004?
e. Given revisions to the reporting of special items under FASB and IASB GAAP ( Section 11.6.1 ), could these events have happened if the special item revisions standards had been in effect during 2000– 2003? Explain.

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