Continued from part 1
In part 1 we reviewed the basics for accounting for liabilities. Nortel uses the term “reserve” instead of liabilities, but the same principles hold true. Nortel is currently under legal discussions about their accounting for reserves. If you haven’t read Part 1 and want a quick review of what liabilties are and how to account for them, read that first.
So Nortel has gone ahead and set up these reserves and now wants to reverse them. The reversing entry will definitely increase income (again, see Part 1 for the reasons). Nortel executives argue that the liability no longer exists and therefore the reserve must be reversed. The auditors aren’t so sure that the liability has been fully settled and would prefer to leave the liability on the balance sheet. Leaving the liability there would have no effect on net income.
It possible that the Nortel execs are telling the truth or maybe they are trying to manipulate net income. These types of financial reporting decisions are never transparent and the small shareholder is always at an information disadvantage. Perhaps you are starting to see the potential conflict of interest – Nortel execs had plenty of motivation for wanting to improperly reverse the reserves. I’m not saying that what they did was wrong, the courts will decide that. I am saying that they had lots of incentive for doing the wrong thing.
What incentives? Well after Nortel profitability fell dramatically in the early 2000’s, the board of directors introduced a new bonus plan referred to as “The Return to Profitability”. Seems like a good idea. Nortel needed management to bear down and focus on making sure that the company turned the corner to being a profitable business again. Providing incentives to management for successfully accomplishing that seems like common sense. The problem with so many of these bonus plans is that they focus on accounting profitability as a pseudo-measurement of true, economic profitability. That too makes sense – economic profitability is rarely known, accounting profitability when done properly is a reasonable (but not perfect) proxy.
But, and this is a big BUT … accounting profitability is subject to manipulation or massaging. And when you have the ability to earn a substantial bonus, you definitely have incentive to mess around with the accounting. I’m sure there are very ethical people out there that would never fall into that trap but history has shown that many people choose the dark side when faced with this issue.
Rewind to 2002-2003: Nortel exec’s are sitting around wishing they could get their bonuses when they look at the financial statements and see these reserves (liabilities) sitting on the balance sheet. They think to themselves, “hey, if we reverse those we can quickly increase net income, triggering the bonuses”. The auditors disagree or at least try to disagree but the reserves get reversed, net income gets an upward pop, bonuses get triggered, executives spend lavishly.
Bad accounting? Sure, but it is just one more example of well-intentioned incentive plans back firing. When you create bonus plans and incentives for managers, be careful that you eliminate or reduce their motivation to improperly trigger those bonuses. That’s not easy to do but the downside of not carefully developing the bonus plan and monitoring the accounting process is, well – Nortel. You don’t want that.
What’s the lesson here: financial reporting is not perfect; use financial statements carefully!
Note: this blog was originally posted on my site hosted by Pearson Education (http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)