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.
Nortel explained that these changes followed from Statements of Position issued by the AICPA ( Nortel followed U. S. GAAP), which required that revenue from longer- term contracts involving “ multiple deliverables,” such as hardware, software, and services, should be deferred until delivery.
As a result, Nortel reduced its originally reported earnings for the first nine months of 2005 by $ 95 million, and for 2004 by $ 279 million.
On the same day, Nortel announced an estimated, unaudited, net loss from 2005 continuing operations of $ 2.421 billion. In addition to the reduction due to revenue deferral, this loss included an expense of $ 2.474 billion to settle shareholder litigation resulting from previous accounting restatements (see Problem 12). On March 10, 2006, Nortel’s share price on the S& P TSX 500 Composite index fell 11 cents in heavy trading to C$ 3.50, for a return of - 3.05% for the day. On the same day, the S& P TSX Composite index rose 68.28 points to 11,833.61, for a return of 0.58%. According to Reuters’s website, Nortel’s beta on the S& P TSX at this time was 1.96. The risk- free interest rate R f was 4.5%, or 0.0001 per day.
a. Evaluate the change in relevance and reliability of Nortel’s 2005 revised financial statements, resulting from its revenue deferral.
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 S& P TSX Composite index, for March 10, 2006. Do you feel that the abnormal return arose from the news of the revenue deferral or from the $ 2.474 billion shareholder litigation expense, or both? Explain.