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 judge's 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 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 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 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."
Questions
1. Auditors are required to assess fraud risks as part of their ethical and professional responsibilities. What characteristics of Nortel might have caused it to be identified as a high-risk audit? Use the fraud triangle in answering this question.
2. In the Ontario Superior Court ruling, Justice Marrocco "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." Morrocco added he was "not satisfied beyond a reasonable doubt" that the trio [i.e., Dunn, Beatty, and Gollogly] had ‘deliberately misrepresented' financial results. Review the accounting manipulations in the case and answer the following questions:
a. What types of "financial shenanigans" were used by the trio to manipulate earnings?
b. Do you agree with the decision of Judge Morrocco in not holding the trio legally liable? Why or why not?
3. Trust is an essential element in the relationship between the external auditor and top management. Evaluate the actions taken by the top officers with respect to their relationship with the Deloitte & Touche auditors, their fiduciary responsibilities as the head of Nortel and corporate governance in general.