Behind the Nortel ruling

When the music finally stopped at Nortel Networks, three senior executives were left without chairs — 0r anywhere else to hide.

When companies as big as the once-mighty corporate juggernaut fail, it’s always a good idea to have something — or someone — to throw to the angry mob. And that’s the role that fell to former CEO Frank Dunn and top financial executives, Douglas Beatty and Michael Gollogly.

The three have now been acquitted of fraud charges — specifically that they tinkered with Nortel’s accounting reserves to trigger bonus payments and stock options that benefitted them. The judge hearing the case ruled that proving criminal intent ultimately wasn’t possible.

What still needs to be put on trial, however, is the enduring practice of managing earnings and the widespread collusion that allows it to continue. Because on a grander-than-usual scale, that’s what the Nortel executives were doing.

Still, like any drug, the short-term rush outweighs the long-term price of addiction. “Managing” results creates both the culture and the opportunities for abuse that can become lethal once dependence has been established. And there’s an awfully fine line between managing earnings and cooking the books.

Like so many others, over 20 years Nortel had fallen into the practice of providing quarterly earnings “guidance” and then manipulating or smoothing financial results to attain the targets. The demands of the very shareholders who are now cursing the company are what drove it.

As the investment business community has increasingly emphasized the metric short-term financial results, the pressure to provide and meet those expectations has also increased. The proliferation of arbitrageurs, speculators and hedge funds — and their tremendous power to move markets — entrenched the practice further.

Those who deal with sophisticated derivatives and other financially engineered products favour earnings guidance because any discrepancy between actual and forecast results provides them with lucrative trading opportunities.

When earnings are ahead of the stated target, they can be eased through “restructuring expenses.” When earnings are below it, they can be bolstered from reserves set up in high-earning years.

Earnings can also be “managed” further through judiciously paced, “accretive” acquisitions of other businesses. In the 1990s, Jack Welch, the legendary former CEO of General Electric, turned this type of earnings management into an art form.

A study released last July by four prominent business school professors revealed that about half of earnings quality is determined by innate factors beyond the control of managers. About 20 per cent of firms manage earnings to misrepresent their economic performance. For such companies, 10 per cent of the typical earnings per share number is managed.

This is certainly nothing new.