Whenever corporate financial malfeasance is alleged, the question always arises: Where were the auditors? The answer may help determine the fates of Frank Dunn, Douglas Beatty and Michael Gollogly, three former senior Nortel Networks executives now on trial in downtown Toronto before the Ontario Superior Court.
Nortel was once Canada’s technology champion. After the tech bust of the early 2000s, it racked up significant losses and dramatically reduced its workforce. In 2003, the company began reporting profits. But those results were subsequently restated twice, a fiasco that contributed to the defendants’ dismissals and ultimately led to the men facing two counts of fraud each. The Crown contends they orchestrated Nortel’s illusory 2003 profits through liberal use of what’s known as “cookie jar” reserves, allowing them to collect significant bonuses. Each man denies the charges, which have not been proven.
The Crown’s focus on the cookie jar puzzles some observers. After all, it’s just one of a large number of abuses alleged to have occurred at Nortel during the 1990s and 2000s. For example, the company was often accused of recognizing revenues prematurely or inappropriately. It was also criticized for ignoring certain costs in its financial statements, a practice that allowed bonuses to be awarded to management during the frequent periods in which the company lost money. The Nortel saga “involves way more than just earnings management,” says Ramy Elitzur, a professor at the Rotman School of Management. He says U.S. prosecutors would probably have pursued other alleged manipulations as well. Forensic accountant Al Rosen is similarly mystified. This way, he says, the Crown is “either going to hit a home run or they’re going to strike out. There’s no in-between.”
The narrow focus may help the Crown simplify its case, but it’s also risky. Public companies are required to make balance sheet provisions for anticipated liabilities that are both probable and reasonably estimable. For example, a company might decide to wrap up an underperforming division, and make a provision for expected costs from severance, closing offices and other matters. Or perhaps its legal team thinks they’ll have to pay to settle a lawsuit.
The trick is that if things turn out better than expected—the restructuring proves less expensive than predicted, or the lawsuit gets settled on favourable terms—the company can release the reserves into earnings, providing a one-time boost to financial results. Unscrupulous executives discovered they could set aside reserves in good periods by making overly conservative assumptions. In a bad quarter, they could find spurious reasons to release those reserves and—voila!—losses could become profits. In the U.S., multinationals like Dell, Microsoft and Xerox have admitted to or settled charges involving cookie-jar reserves.
Accounting rules govern how long reserves can be held on the balance sheet and under what circumstances they should be released. Those rules have become more specific over time as regulators sought to curtail cookie-jar accounting. But in practice, “there’s always a lot of judgment involved in these estimates,” says Sandra Peters of the CFA Institute in New York. “Not only when you take them and how you establish them, but how you measure them.” Proving the accused wilfully stepped outside these ill-defined boundaries could be tough.
It’s clear the defence will lean heavily on the involvement of Nortel’s accountants, Deloitte & Touche. Within moments of beginning his opening address, lawyer David Porter (acting for Dunn) declared that “in virtually every respect, the relevant accounting judgments and decisions of Nortel’s finance personnel were known by [Deloitte], reviewed in detail by them at the time, and…considered appropriate and reasonable.” If the defence can establish clear and open communication between Nortel and Deloitte about its reserves, that would weigh against any inference of fraud. The trial is expected to continue for many months to come.