Nortel's misdeeds can be categorized into two groups. The first set of activities dealt with revenue recognition issues beginning in 2000. Specifically, the firm used bill and hold transactions to magnify its revenues. For the most part, generally accepted accounting principles require inventory to be delivered to the customer before the corporation can recognize the revenues. There are some exceptions, and bill and hold transactions may be an exception.

Bill and hold transactions are governed by Staff Accounting Bulletin No. 101, and they must meet several guidelines in order for the revenues to be considered realized. They are:

1. The risks of ownership must have passed to the buyer;
2. The customer must have made a fixed commitment to purchase the goods, preferably in written documentation;
3. The buyer, not the seller, must request that the transaction be on a bill and hold basis. The buyer must have a substantial business purpose for ordering the goods on a bill and hold basis;
4. There must be a fixed schedule for delivery of the goods. The date for delivery must be reasonable and must be consistent with the buyer's business purpose (e.g., storage periods are customary in the industry);
5. The seller must not have retained any specific performance obligations such that the earning process is not complete;
6. The ordered goods must have been segregated from the seller's inventory and not be subject to being used to fill other orders; and
7. The equipment [product] must be complete and ready for shipment.

The SEC pointed out two major deficiencies in Nortel's accounting for these transactions, both violations of the third criterion. The bill and hold transactions under questions were requested by Nortel and not by its customers. Additionally, the customers of Nortel did not have any particular reason for having bill and hold transactions; there was no business purpose for them.

The second accounting scheme involved reserves (liabilities). When more reported income was not necessary to achieve manager bonuses, no later than 2002, Nortel started accruing a number of items, recognizing the expenses and the current liabilities. Later, when they desired greater income, the managers released the reserves by reducing current debts when incurring various costs instead of recognizing them as expenses. Of course, this does not meet the spirit of SFAS No. 5, which states that probably liabilities are to be measured at how much is expected to be paid.

The SEC relates these antics with the compensation schemes of Nortel. In particular, not only did Nortel managers manipulate revenues and expenses to obtain the bonuses, but they were careful not to exceed the thresholds by very much. In this way, managers were able to save revenues and incomes for the proverbial rainy day and collect bonuses whether the business climate rained or shined.

Nortel paid $35 million in fines for these behaviors (Litigation Release No. 20333). I wonder why the SEC fines corporations since the innocent stockholders are the ones who pay these fines.

Three top managers of Nortel settled with the SEC (Litigation Release No. 20546). These three individuals were vice presidents of the business units involved in the accounting schemes. They paid fines, disgorgement, and interest to the tune of $143,481 to $163,031 each. I wonder whether these fines are sufficiently high to be a disincentive to other managers.

The SEC's litigation against five other former executives of Nortel is ongoing (Litigation Release Nos. 20036 and 20546). They include the former CEO and controller. Let's hope they receive justice from the court system.

Finally, I think the SEC should promote these settlements better. The accounting scandals were so much in the news a few years before; it seems their resolutions should also receive some public attention. How else will the public know that the miscreants have actually been singled out and dealt with? Besides, if the public ignores the problem of accounting scandals, it will re-motivate some of today's managers to use accounting for their own purposes. We need to keep these schemes and their proper resolutions in mind, lest we forget the loss of billions of dollars in wealth because of the accounting antics of yesteryear.

Relevant SEC documents:

• Litigation Release No. 20546 (April 30, 2008): http://www.sec.gov/litigation/litreleases/2008/lr20546.htm 
• Litigation Release No. 20333 (October 15, 2007): http://www.sec.gov/litigation/litreleases/2007/lr20333.htm 
• Complaint filed in U.S. District Court, U.S. SEC v. Nortel Networks Corporation and Nortel Networks Limited (October 15, 2007): http://www.sec.gov/litigation/complaints/2007/comp20036.pdf 
• Litigation Release No. 20275 (September 12, 2007): http://www.sec.gov/litigation/litreleases/2007/lr20275.htm 
• Litigation Release No. 20036 (March 12, 2007): http://www.sec.gov/litigation/litreleases/2007/lr20036.htm 
• Staff Accounting Bulletin 101, Revenue Recognition in Financial Statements (December 3, 1999): http://www.sec.gov/interps/account/sab101.htm

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

Return to The Accounting Cycle

J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.