Although I wrote about Nortel a few posts ago, it really is the never-ending financial reporting story in Canada. A recent Globe and Mail article outlines the argument (no, that’s too strong… ‘discussion’) that occurred between Nortel executives and their auditors, Deloitte & Touche. The issue at the core of the article and current legal discussions involves when Nortel should have undone some of their “reserves.” This is a complex topic for anyone that hasn’t completed a few accounting courses. I doubt that 5% of the people on the street have a grasp of what went on at Nortel. At the risk of over-simplifying, let me try to explain it here.
The reserves they refer to in the article are actually liabilities, which would be sitting there on the balance sheet as credit balances. The term “reserve” has a slightly different meaning under different GAAP, so lets clear that up now. Under IFRS (Conceptual Framework, para 4.20), reserves are actually an equity item and mean something different than what we’re discussing here. Nortel reported under US GAAP (despite being a Canadian company). In US GAAP, “reserves” refer to liabilities with uncertain timing or uncertain amounts. Under IFRS, these are called “provisions” (IAS 37).
Getting back to the stuff in the recent news—what Nortel referred to as “reserves” were liabilities. Nortel execs and the auditors were arguing about when to remove those credit balances from the balance sheet. These reserves are no different than regular liabilities. Nortel believed that they owed someone some amount of money or future service. There are essentially two options when dealing with these types of liabilities: 1) Nortel could have settled the liability by paying the other party or providing the expected service (this is the normal course of action), or 2) Nortel could have decided it was no longer responsible for settling the liability and removed the credit balance from its balance sheet. Let’s quickly walk through examples of each of these options.
Assume that Nortel offers a customer a special warranty to fix a specific piece of equipment if it breaks in the next three years. This warranty meets the definition of a liability. Therefore, on the date of the sale Nortel books a special warranty liability related to the piece of equipment. The journal entry on the sale date should be:
Dr Warranty Expense $X
Cr Special Warranty Liability $X
This would reduce net income immediately and create a liability.
Case 1: Over the next three years, the equipment breaks and requires service. Nortel provides the service and parts necessary. Assuming that Nortel pays cash for the workers and parts, the journal entry on the date of the repair would be:
Dr Special Warranty Liability $Y
Cr Cash $Y
This would have no impact on net income.
Case 2: Over the next three years, the equipment performs flawlessly and requires no warranty service. At the end of the three years, Nortel would still have that original Special Warranty Liability on its balance sheet for $X, but since the warranty will have expired it would no longer owe anything and wouldn’t have a true liability. Therefore, it should reverse the liability:
Dr Special Warranty Liability $X
Cr Warranty Expense** $X
Note that this journal entry actually increases net income at the end of the third year. What Nortel is in trouble for is Case 2, reversing the liability (“reserve”) at a potentially inappropriate time. Notice the substantial difference between Case 1 and Case 2: the first does NOT impact net income, the second does. If Nortel wanted to inflate its income, reversing a liability would definitely accomplish that. In some cases, reversing the liability is completely justified. The question is, did Nortel have the proper justification? In the next part, we’ll look at the reserve leading up to the time Nortel reversed it and examine some potential incentives that Nortel had to artificially increase net income.
** While it may seem unusual or wrong to credit (Cr) an expense account it is acceptable. It is unlikely that the Cr to Warranty Expense would create a negative expense. Since there would have been other Dr entries to that same account during the year, the Cr only reduces the expense rather than making it negative.
Note: this blog was originally posted on my site hosted by Pearson Education (http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)