1. 1 NORTEL CASE STUDY Prepared by: Shahnam Taheri Financial Analyst shahnamtaheri@gmail.com July 2012 Introduction In last decade, we have seen many large companies end up in collapse or bankruptcy and have watched some of high senior managers, because of fraudulent behavior, have gone to jail. The biggest fraudulent and financial scandals in Canadian corporate history and one of the biggest in the world is Nortel Network Corp case. The Securities and Exchange Commission (SEC) of USA and Royal Canadian Mounted Police (RCMP) have charged four former executives of Nortel Network Corp. with engaging in accounting fraud by manipulating financial statements and cooking the books of company. The companys former officers have been accused of manipulating accounting reserves in 2002 and 2003 to push Nortel to profitability and by falsely showing their management performance high, they created bonuses for themselves. This paper discusses a brief history of Nortel and special concerns about material misstatement in that company due to fraud and illegal acts and tries to analyze what risk factors and conditions created the possibility for fraudulent financial reporting at Nortel. At the end we will discuss about the ways to prevent or at least reduce the possibilities of fraudulent accounting and illegal activities which may happen in such companies like Nortel in future.

2. 2 1- Brief History of Nortel Since its 1895 founding as Northern Electric and Manufacturing, supplying telecommunications equipment for Canadas fledgling telephone system, Nortel has grown to become a global leader in delivering communications capabilities that enhance the human experience, power global commerce, and secure and protect the worlds most critical information. (http://www.nortel-canada.com/about/history).In 1985, following industry deregulation, Bell Canada Enterprises (BCE) was formed as the parent company to Bell Canada and Northern Telecom. In 2000, BCE spun out Nortel, distributing its holdings of Nortel to its shareholders. Bell-Northern Research was gradually absorbed into Nortel, as it first acquired a majority share in BNR, and eventually acquired the entire company. In the late 1990s, stock market speculators, hoping that Nortel would reap increasingly lucrative profits from the sale of fiber optic network gear, began pushing up the company's share price to unheard-of levels despite the company's repeated failure to turn a profit. Under the leadership of CEO John Roth, sales of optical equipment had been robust in the late 1990s, but the market was soon saturated. When the speculative telecom bubble of the late 1990s reached its pinnacle late in the year 2000, Nortel was to become one of the most spectacular casualties. At its height, Nortel accounted for more than a third of the total valuation of all the companies listed on the Toronto Stock Exchange (TSX), employing 94,500 worldwide, with 25,900 in Canada alone. Nortel's market capitalization fell from C$398 billion in September 2000 to less than C$5 billion in August 2002, as Nortel's stock price plunged from C$124 to C$0.47. When Nortel's stock crashed, it took with it a wide swath of Canadian investors and pension funds and left 60,000 Nortel employees unemployed. Roth was criticized after it was revealed that he cashed in his own stock options for a personal gain of C$135 million in 2000 alone. CEO John Roth retired in 2001. His planned successor and chief operating officer, Clarence Chandra, already on sick leave due to complications following his 1997 stabbing in Singapore, decided to quit, however. Chief financial officer Frank Dunn was eventually chosen as Roth's permanent replacement. (http://en.wikipedia.org/wiki/Nortel) 3. 3 2- Nature of fraud and accounting rules In April 26, 2004, Nortel fired its CEO, CFO, and Controller. The SEC had been looking into Nortels use of reserve accounts and trying to determine if Nortel released those reserves back in to earnings for legitimate reasons. Speculation suggests that Nortel Problems may have arisen as employees sought ways to participate in a bonus program tied in to Nortel 2003 turnaround after years of heavy losses. Known within the company as the return to profitability bonus program, Nortel paid out $300 million in employee bonuses, with approximately $80 million paid to senior executives. Management was too aggressive with accounting accruals in order to show profitability and receive bonuses. (April 2004, Wall street Journal pp.A3, A6) .Here, the reserves are actually liabilities (special warranty liabilities).Nortel believed they owed some one some amount of money for future service. When warranty is an integral and inseparable part of sale, the accrual-based expense warranty method is used.(P.749, Kieso) The journal entry on the sale date should be: Dr. Warranty expense $X Cr. Warranty Liability $X This would reduce net income and create a liability. Unfortunately according to an article of Globe and mail,no one including Nortel controller or external auditors from Deloitte & Touch had told the companys use of accounting reserves in the first quarter 2003 was bad What the senior managers directed through manipulating this journal entry as below: Dr. Warranty Liability $X Cr. Warranty expenses $X By this journal entry the warranty expenses reduced at the end of the fourth quarter of 2003 and therefore increased the net income. 4. 4 Charges (against ex-Nortel executives) include two counts of fraud affecting a public market(it cost companys shareholders billions of dollars) affecting capital market, two counts of falsifying books and documents and three counts of issuing a materially wrong prospectus(Toronto Star) 3- Risks factors and conditions for illegal financial accounting reporting Three conditions are generally present when material misstatements due to Fraud Occur (P.83.Messier) (a) Management or other employees have an incentive or are under pressure that provides a reason to commit fraud. This was happened for top management of Nortel. Frank Dunn, the chief executive of Nortel Networks Corp., pledged in 2002 to end giant telecom equipment makers years of red ink. At the start 2003, the company was no closer to that goal. In January, Nortels executives told its board that the company would lose $112 million in the years first quarter.( P.A.1,Wall Street Journal (b) Circumstances exist that provide an opportunity for a fraud to be carried out. When looking at some of recent large-scale frauds such as WorldCom, management override around the journal entry process was the key contributing factors. (p.16, Lanza) Financial statement fraud at Nortel like most of fraudulent cases involved its senior management override internal control. Frank Dunn, the ex- Nortel CEO and Douglas Beatty and controller Michael Gollogly initiate improper journal entries which were done on late night. By using false journal entries, they could manipulate to remove accounting reserves from balance sheet to reduce expenses and showing profits in income statement. Delloite-Touche, the external auditors, on that time they didnt investigate about all journal entries which should be detected. (c) Some individuals possess an attitude, character, or set of ethical values that allow them to knowingly and intentionally commit a dishonest act. Egocentric motivation and seeking bonuses drove Nortels senior manager to prepare fraudulent financial statements to gain both bonuses and prestige for themselves. 5. 5 Mr. Dunn landed as Nortels CFO in1999 after more than 20 years working his way up through the finance department. Subordinates were fearful to his temper; they often began conversation with the phrase, Frank wants Mr. Dunn mantra was that he would turn Nortel to the black.(pA.1, Wall Street Journal). 3-How to prevent financial statement fraud There are different ways to prevent the risk of management of fraud. To Extract Journal entries to general ledger accounts know to be problematic (p.17, Lanza) To track any issues identified in internal control reviews. For unusual day that journal entry happens on weekends, holidays or late night. Auditors should be proactive in journal entry testing in IT environment especially large numbers and qualitative. Formation an independent committee of auditors that only report to the board could be another way to prevent fraud. Some companies have ethics officers to serve (facilitates) financial and other work pressures( p.733, Smieliauskas) 4- Conclusion The Nortel case was one of the waves of financial scandals in the last decade that led the collapse, company bankruptcy, and losing million dollars of shareholders, pension funders in Canada and USA. Fraudulent financial reporting often arises in difficult time of companies history like cash shortage, falling stock prices and fear of losing management positions and bonuses. Nortel case and other cases show audit procedures to detect fraudulent financial reporting are not effective as is believed. Detecting journal entries by person name, time of the day, materiality, in IT environment, whistle blower hotline, independent internal control committees and reviewing the relation between bonuses of managers with profitability could be prevent fraud and training managers. At the time being for the only way for managers to be in their positions and get large bonuses in companies with low profits or 6. 6 large losses, is to cook their books. We must refuse this game at the beginning. Auditors must also try to their jobs properly so that capital market system works smoothly. Improving corporate governance with persons who have personal integrity and competence and check and balance them constantly could be prevent them for fraudulent behavior Clear organization and responsibility structure within financial and accounting department, a with a systemized and strong control and reporting system could eliminate any weakness for potential fraud actions in companies. Effective monitoring and regulatory are essential if we want capital markets work efficiently without any crisis in future. 7. 7 REFERENCES Berube, Gerard, An anniversary for Nortel:2005,/www.camagazine.com/archives/print-magazine21153,6/11/2012 Brown Ken and Mark Heinzl: 2004,Reversing the Charges: Nortel Board Finds Accounting Behind 03 Profits, How to Empty the Cookie Jar, Wall Street Journal. Cormier, Denis and Michael Magnan: 2005,From Accounting to Foreaccounting John Molson School of Business, Concordia University. Croket, Roger O.:2004,Nortels Numbers: A No-ShowAgain, Business Week Online;9/3/2004,pN.PAG,0p Doyle Simon: 2005,Meet the man who told you so, The Ottawa Citizen, Section E, Business Kieso, Weygandt, Warfield, Young and Wieck: 2005,Intermediate Accounting Volume Two, Seventh Canadian Edition, John Wiley & Sons Canada, Ltd. 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