Accounting principles: use and abuse

“Only when the tide goes out do you discover who’s been swimming

naked” (Warren Buffett)

The background on Nortel

• In 1990s Nortel equipment carried 75% of North American internet traffic

• By 1998 Nortel had 73,000 employees and revenues of US$22 bn

• Tech meltdown of 2000 – shares crash, falling from $124.50 to under $1.00

• Restructuring followed, heads rolled, jobs were slashed in an attempt to recover

The new bonus plan

• Stock based compensation plans were “out of the money” leading to morale issues

• New bonus plan designed to motivate staff– to pay out on return to profitability (“RTP

plan”)– Design principles: “pay for the behaviour

you want”; “you get what you measure”• Q1 2003 net Earnings of $54m triggered

bonus payments of US$50m under the RTP plan

Take 5 minutes for this

• In Q1 2003 the executive team at Nortel released reserves and accruals previously set aside for restructuring-related costs of $361m

• Using Q1 2003 financial statements for Nortel, show the effect of releasing those reserves and accruals in an earlier period (for the purposes of this illustration only – March 31, 2002)

• What would net earnings have been for Q1 2003?

Conclusion of Independent Review

It was concluded by Wilmer Cutler and reported to the Special Committee that Dunn drove senior management to achieve Earnings Before Taxes (EBT) targets through the use of provisions not in accordance with GAAP. They noted that judgment is required to set provisions, but in Nortel’s case the judgment was stretched ‘to create a flexible tool to achieve EBT targets’

Fraud? Let the courts decide…

• TV coverage of fraud trial outcome• Bonus marks to the first student to point

out the journalist’s (common) error

The story of Livent

Live theatre giant • 1989 Myron Gotlieb

and Garth Drabinsky bought from Cineplex Odeon

• Acquired rights to Andrew Lloyd Weber’s Phantom of the Opera

• Got listed on TSE (now TSX)

• Great shows, boom times for live theatre

The Phantom of the Opera

Success leads to failure

• Despite– Blockbusters like Joseph and the Amazing

Technicolour Dreamcoat, Show Boat, Ragtime– North American successes from Vancouver to

Toronto to Broadway – this company is hot!• 1997 the company reports a loss of $44.1m• It becomes clear that the drama is not

confined to the stage alone at Livent!

Exercise: In your groups:

• Nominate a scribe and a spokesperson• Restate the December 31, 1997 financial

statements of Livent to correct the errors on the following slides:

Livent accounting irregularities

• Corporate sponsorships for logo placement in the amount of $4m have been reported as revenue in the income statement in 1997 but are attributable to shows to be run in 1998 and subsequent years

• Preproduction costs in the amount of $7m have been reported as an asset on the balance sheet in 1997 but these costs relate to shows that were performed in 1997 and prior years

Livent restated

Livent problems – the timeline

• 1998 company sold (to Michael Ovitz)• Financial irregularities discovered• Bankruptcy protection sought in November

1998• Drabinsky and Gotlieb convicted of fraud 2009• Drabinsky goes to jail for 5 years, Gotlieb for 4

– (released on day parole 2013 and 2012 respectively)

• Deloitte (auditor) ordered to pay damages of $85m in a landmark case (April 2014)

Another one, not unlike Livent

Worldcom and fixed asset accounting

Basic rule:Assets are outlays that have a future benefit. Expenses are outlays that have no future benefit, all benefit is used up in the current period.

Worldcom video

Time for one more

Enron was a case that included undisclosed debts – debts that were carried in entities that did not form part of Enron’s financial reports.

That couldn’t happen today, and surely not in Canada?

Off balance sheet activities…let’s look at a recent example

The Ornge Story and the question of Entity Definition