Financial reporting: between a rock and a hard place?

Nortel. The word is never used in a positive way in Canada. Nortel Networks Corp. was one of the most dramatic corporate failures in the country. While Nortel’s collapse and failure occurred over a decade ago (in 2000), remnants of the scandal still remain, including recent stories in national newspapers (see Jan 30/12 and Feb 14/12). While there were some obvious business factors that precipitated the company’s failure (including a collapse of the entire high-tech sector), poor and fraudulent accounting practices were clearly in play. The specifics of the fraud are still being investigated but a few things are clear and impact students taking an accounting course.

  1. Management probably had financial reporting incentives that differed from those of other stakeholders—particularly shareholders. In the recent news about Nortel it seems clear that management was keen to receive bonuses that were triggered or affected by the profitability of the firm. It appears that those incentive contracts were based on some non-GAAP (i.e., unofficial) profit number. Instead of reporting the GAAP-compliant profit (which was negative), management decided it would be “better” to artificially inflate the financial statements to show a profit so they wouldn’t look as greedy for taking their bonuses. That makes some sense—how happy would you be if your boss took a bonus but everyone else got nothing? Of course, that doesn’t make it right, it just makes it logical. Another option available to management would have been to properly disclose the negative GAAP net income and not take their bonuses. Financial incentives are strange beasts and can create odd logical-but-unethical behaviour.
  2. Financial reporting involves a lot—a LOT—of flexibility and judgment. This doesn’t make accounting good or bad, it just is. If users of financial statements are unaware of this flexibility, they may use financial statements improperly. If we think about the most common financial statement metric discussed, net income, many readers might feel that it must be an accurate number. More experienced financial statement users are aware that net income is simply the sum of a bunch of estimates and, therefore, an estimate itself.In addition, the two main building blocks of financial statements, assets and liabilities, are future oriented. That is, the value of an asset or a liability requires some estimation of what will occur in the future. Nortel obviously used this flexibility to its advantage for many years. As a future user of financial statements, you need to read them with a fair degree of skepticism. It’s not that they’re wrong, but they’re definitely not perfectly correct. Nortel is a reminder of this aspect of financial statements.

The collapse of Nortel is a high-profile reminder of some underlying characteristics of financial statements—they are prepared by people with extensive insider information and potentially odd incentives, and they contain a ton of estimation. Nortel’s fall contains many other interesting lessons, and we may revisit it over the next while as the Nortel investigation continues. If you have any questions or comments on Nortel or on the concepts discussed above, please leave a comment below.

Note: this blog was originally posted on my site hosted by Pearson Education (http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

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