Nortel Financial Shenanigans & how They Manipulated Earnings Discussion

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 manipu- late 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 secu- rities 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 tech- nology 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 technol- ogy 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. The Nortel fraud primarily involved four members of Nortel’s 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:’ 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. 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 manipula- tions erased Nortel’s pro forma profit for the fourth quarter of 2002 and caused it to report a loss instead.? ‘U.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, leases/2007/Lr20036.htm. 2 Pro 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 depreci- ation 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 company’s 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. • 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 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. 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 Nortel’s 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, Nortel’s 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 Gollogly’s 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 issuer’s 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 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 dol- lars in inventory that was sitting in Nortel’s warehouses and offsite storage locations. Revenues could not be rec- ognized 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 acceler- ated into 2000 more than $1 billion in revenues through its improper use of bill-and-hold transactions. 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 business was suffering from the same wide- spread economic downturn that affected the entire telecommunications industry. As Nortel’s business plum- meted 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. 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 manipulated the company’s reserves to manage Nortel’s publicly reported earnings, create the false appearance that his leadership and business acumen was responsible for Nortel’s profitability, and pay bonuses these three defendants and other Nortel executives. 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 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 the future as necessary to meet Dunn’s 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 atten- tion of Nortel’s side auditors, they made only a portion of the planned reserve releases. Thi 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. 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 account- ing 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 recognize revenues “when installation is imminent” or “when installation is considered to be a minor portion of the contract.”-3 On November 2, 2000, Deloitte presented Nortel with a set of charts that, among other things, explained the U.S. 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. Nortel’s 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 Nortel’s audit committee that it had found a “reportable condition with respect to weaknesses in Nortel’s account- ing for the establishment and disposition of reserves. Deloitte went on to explain that, in response to its concerns, Nortel’s management had undertaken a project to gather support and determine proper resolution of certain pro- vision 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 auditor’s concerns from the public, instead disclosing the comprehensive review. Shortly after Nortel’s 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 mea- sures. The investigation uncovered evidence that Dunn, Beatty, and Gollogly and certain other financial managers were responsible for Nortel’s 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 rev- enues 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 committee’s independent review, which concluded, among other things, that Dunn, Beatty, and Gollogly were responsible for Nortel’s improper use of reserves in the second half of 2002 and first half of 2003. The second restatement, however, did not reveal that Nortel’s 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 U.S. SEC. Nortel Networks Corporation and Nortel Networks Limited, Civil Action No. 07-CV-8851, October 15, 2007. Available at: 20333.pdf. 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 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 Nortel’s first restatement, and Pahapill likewise made false management representations in connection with Nortel’s second restatement. The defendants’ scheme resulted 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 the commission’s 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 com- mission placed in a Fair Funde for distribution to affected shareholders. Nortel also agreed to report periodically to the commission’s 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. Nortel’s 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 Nortel’s stock price dropped to 18.54 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 com- posite 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 During testimony about the fraud at Nortel on June 13, 2012, the lead Deloitte auditor on the Nortel engagement, Don Hathway, suggested that CEO Frank Dunn “did not understand the role of the external auditors from Deloitte & Touche as they probed issues related to the company’s accounting in 2003. Hathway told the Toronto fraud trial of Dunn and two other former Nortel executives that, after almost a year of working daily with Nortel staff at the company’s head office, he concluded that neither management nor the board’s audit committee understood his role. Hathway was assigned to head the Nortel audit team in January 2003 and said he and Deloitte audit partner John Cawthorne quickly found themselves being pressured by Dunn to help Nortel find strategies to deal with its account ing issues. “He had lectured John Cawthorne and I on more than one occasion about the need to be creative and come up with solutions … It indicated to me that he did not understand our role as independent auditors.” A 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. Theresa Tedesco and Jamie Sturgeon, “Nortel: Cautionary Tale of a Former Canadian Titan,” Financial Post, June 27, 2009 “Janet McFarland, Nortelexecutives didn’tunderstand’auditorwasindependent:testimony, The Globeand Mai, June 13, 2012, https:// article42563691 Hathway said the relationship with the Nortel board’s audit committee, led by former bank executive John Cleghorn, also grew strained and needed to be “reset” by late 2003. “The audit committee seemed more interested in getting things done by a certain schedule than they did getting them done right,” Hathway testified. “I was surprised by that, because my view of their function was to oversee the integrity of the financial reporting process.” He said he was criticized by Cleghorn for taking too long to review issues related to the press release announcing first-quarter financial results in 2003 and was “severely criticized” for expressing reservations about offering an assurance on the company’s third-quarter financial statements that year. Hathway testified he felt Nortel had a “macho” culture and that many of its senior executives had never worked anywhere else, so “hadn’t seen how other companies do things. I think that type of culture was problematic,” he said. By November 2003, Hathway was removed as lead audit partner on the engagement after spending his brief tenure rais- ing red flags about Nortel’s use of accounting reserves in 2003. He instead became a senior technical adviser to the audit team. He said his supervisor told him he was being replaced because he didn’t communicate with the audit committee.” Hathway said he first discovered in the summer of 2003–just six months after being assigned to lead the Nortel audit-that senior executives at the company were unhappy with his work. At the time, Hathway was pressing the company to launch a comprehensive review of the accounting reserves it was carrying on its balance sheet-a review that later led to a controversial restatement of the company’s books in the fall of 2003. Hathway testified that he was shown the results of Deloitte client-survey interviews conducted in July 2003,with Mr. Beatty and Mr. Gollogly. In the interview summary, Gollogly reportedly complained that Deloitte’s two new lead audit partners-Hathway and Cawthorne-were “night and day” compared with Deloitte partners previously assigned to Nortel and were “turning the audit on its head. Gollogly described Hathway and Cawthorne as ‘inflexi- ble,” the interview summary said, and not in ‘solution mode.” 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. During the trial, lawyers for the accused said that the men believed that the accounting decisions they made were appropriate the time, and that the accounting treatment was approved by Nortel’s 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 Nortel’s 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 Nortel’s books, was disclosed properly in Nortel’s financial statements at the time and was not a material amount. He concluded that Beatty and Dunn “were prepared to 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 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 com- pany of that size. Questions 1. Describe each of the financial shenanigans used by Nortel and how they manipulated earnings. 2. What were the motivating factors that led to the fraud at Nortel? How should the auditors have considered these factors and the culture at Nortel in its risk assessment? 454 Chapter 7 Earnings Management 3. Assume you had to prepare an assessment of internal control over financial reporting at Nortel, what would your conclusion be and why? 4. Does it appear from the facts of the case that the Deloitte auditors met their ethical and professional responsi- bilities in the audit of Nortel’s financial statements? Be specific.

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