Pattern of failure

February 12, 2013 | Last updated on February 12, 2013
4 min read

The courts of Canada made it clear you’re on your own when it comes to protecting yourself from accounting chicanery.

Last month, three Nortel executives were found not guilty of cooking the books back in 2003 when the company reported an unexpected reversal of red ink. The Crown alleged the men had used loose accounting to orchestrate fake income and trigger millions in performance bonuses.

According to the judgment, however, the now-official word is the phony income and ensuing executive bonuses were just a happy accident, and not the product of some nefarious scheme.

Nobody disputes the income was fake, since it was later restated. But, as the defence’s story goes, Nortel was crumbling inward at the time — accounting personnel had been slashed, and all hands were scrambling to keep it together.

No smoking gun

Even from the early days of the trial, which started in January 2012, there were rumblings the prosecution’s case was weak, and they were in for a tough slog to prove their argument of accounting conspiracy and fraud.

There were no smoking-gun emails, and the defence did a good job deflecting the motive angle. The judge accepted the executives were likely to receive their bonuses anyway, and would not have risked taking deliberate, illegal means to get them earlier than expected.

And that’s where the case seems to have fallen apart — according to the ruling, it wasn’t fraud, but rather accounting missteps and weak rules that produced the fake profits and subsequent bonuses. Compare this decision to the one in the Royal Group Technologies case rendered in late 2010. In that case, company executives privately purchased a land parcel north of Toronto, and flipped it the same day to public shareholders for a $6.5-million profit.

The transaction was not disclosed to investors. The judge ruled no fraud took place and the executives were acquitted.

Lack of robust requirements

Both the Nortel and Royal Group cases are the flagship prosecutions of the now-foundering Integrated Market Enforcement Teams, which were supposed to steer Canada into financial accountability.

Instead, rather than act as a safety net for investors, recent court decisions have been doing more to identify just how weak investor defences are.

The fall of Canada’s tech darling

At its height, Nortel employed more than 90,000 workers worldwide and was worth nearly $300 billion. During the technology boom in 1999-2000, Nortel was one of Canada’s most valuable companies, with its shares peaking at $124.50.

In the years that followed the accounting scandal, the company’s shares nosedived to penny-stock status amid falling sales, large debts, and a gamut of legal issues.

In 2009, Nortel filed for bankruptcy in North America and Europe, shedding thousands of jobs. Since then, it has sold its remaining businesses piecemeal to various buyers for more than US$7.8 billion, one of the largest asset sales in Canadian history.

—Canadian Press

In the Royal Group case, there were no rules that prevented executives from conducting the transaction, nor was it required the deal be disclosed to investors. If anything failed to deter the questionable behaviour, it was not the failed prosecution of the case after the fact, but rather the lack of robust accounting and auditing requirements in the first place.

The judge in the Nortel case reaffirmed that belief in writing by saying, “When estimating and recording accrued expenses/liabilities, considerable discretion is accorded to management and, correspondingly, considerable judgment is required.”

He further pointed to inconsistencies between Nortel’s internal accounting policies and U.S. generally accepted accounting principles. He noted for decades Nortel had a culture in place that sought conservatism in estimating liabilities, whereas more recent guidance from the SEC had indicated liabilities should reflect the low end (and not the high side) of estimated ranges.

Accounting policies are notoriously weak in major areas, especially on the topic of general liability reserves. Further, they were even weaker between 1999 and 2003, and regulators (including the SEC) had only recently started to clamp down on potential abuse of general reserves.

By that time, the judge ruled, Nortel was in a state of chaos, and his belief is the executives were far too preoccupied with keeping the company afloat to bother tinkering with accounting accruals to trigger performance bonuses. But in cases where management is ostensibly over-tasked, there are supposed to be other safety nets in place.

The big question is what happened to the auditors? Their ranks were not slashed to the extent of Nortel’s internal accountants.

The decision

In his decision, the judge seems to give the auditors and management free passes, saying the “enormous losses” meant they were “quite reasonably concentrating on doing all things necessary to make sure that Nortel had sufficient cash reserves to survive.”

With this exoneration, auditors will likely do little to step up their games. The take-aways from the Nortel case are:

1. Accounting rules are vague, and by no means cover extensive contingencies or offer adequate guidance. Management has considerable judgment in applying them, and investors should exercise considerable judgment in trusting the resulting financial statements.

2. Auditing rules are weak. The 100-year-old relationship between Nortel and its auditors could not have done much to induce a culture of skepticism.

3. Courts are an avenue of last resort. They won’t fix situations where weak stewardship has failed investors.

The best advice is to avoid questionable situations from the start. Nortel was rife with warning signs before the accounting scandal and collapse. So investors need to trust their own judgment.

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada.