The flameout that occurred in the global telecom industry between 2000 and 2002 didn't just result in the obliteration of a staggering amount of market value (both real and fictitious) in the equivalent of an eye-blink. It also required an industry that had been expanding at light speed to suddenly slam on its brakes and throw itself into reverse without even stopping in neutral. Almost overnight, companies that had been handing out hefty bonuses to new hires began giving people money not to take the jobs they'd been offered.
As demand for telecom equipment dried up and warehouses began to fill with unwanted products, companies such as Nortel Networks and Lucent started writing off inventories and slashing their staff levels as fast as they could, trying to get their costs in line with their rapidly disappearing revenue. For a glimpse of how manic and uncontrollable this process was, have a look at Nortel's restatement of results for the past three years.
The telecom equipment maker said several weeks ago that it was going to restate its results for 2000, 2001, 2002 and the first half of 2003, as a result of errors that were made in the way it accounted for revenue gains, product-related liabilities, tax deferrals and several other issues. Nortel said at the time that this would reduce its liabilities during that period by about $900-million (U.S.), would reduce its revenue for those years by about $92-million and would also cut the company's losses.
After making the announcement, Nortel's shares sold off sharply, closing down more than 6 per cent on fairly heavy volume. In an environment where companies such as WorldCom and Global Crossing have had to restate their financial results by a substantial amount — in WorldCom's case, admitting that it overstated its cash flow by $3.8-billion — it's not surprising that investors reacted negatively to Nortel's news. But was it justified, or was it an overreaction by jittery investors?
The release Nortel put out Wednesday gave the final amounts for its restatement, which wound up reducing liabilities by $952-million, cutting revenue by $122-million and boosting profit almost $500-million. So how does a company misstate its financial results by that much? And were these simply honest accounting mistakes, or is there more to it than that? (The company said on Wednesday that its audit committee is conducting an independent review into the need for the restatement).
While the markets may be hypersensitive to any suggestion of accounting trickery — and who can blame them — Nortel's restatement looks fairly benign. Contrary to popular perception, accounting is not a science like physics or chemistry, which is what makes it so easy for companies to fool investors in the first place. At every stage of a company's business, assumptions are made about sales, expenses, tax treatment, and so on — assumptions that can turn out to be wrong.
It appears that some of Nortel's assumptions over the past three years were too optimistic (which is why $122-million in revenue got booked when it shouldn't have) and others were far too pessimistic, which is why liabilities have been reduced by almost $1-billion and profit boosted by half a billion. In terms of revenue, according to an analysis by Merrill Lynch, Nortel misstated revenue by $99-million related to certain contracts, while about $23-million worth of "calculation errors" were made related to sales in the Caribbean and Latin America.
When it comes to liabilities, $425-million related to customer accounts was recorded in error, meaning some that were written off as "bad debts" actually didn't turn out to be so bad after all. Another $342-million came from calculation errors on restructuring charges — severance payments, depreciation on assets that were written down, etc. — and $185-million was not supported by appropriate documentation. The company also benefited from $158-million in income tax adjustments related to the valuation of certain assets, and $167-million in foreign currency translation adjustments.
One thing to remember is that all these figures apply to a more than three-year period, at a company where annual revenue during those years went to less than $10-billion from $30-billion, where staffing levels went to about 35,000 from more than 95,000, and where goodwill and other expenses were written off to the tune of more than $30-billion in 2001 and 2002. When you're handing out severance packages to 60,000 people in half a dozen countries, it's not all that surprising you might be off by a few million. In the scope of Nortel's downsizing, those kinds of numbers are a virtual rounding error.
Most of the analysts who follow the company were untroubled by the restatement, which Steve Kamman of CIBC World Markets said was designed to "tidy up the historical record." Ehud Gelblum of J.P. Morgan said the "previous lack of internal control is troubling," but that it doesn't change his current view of Nortel. More than anything else, what the restatement emphasizes is just how difficult it was for even the company itself to get a handle on the speed with which its business model was disintegrating, and that in most cases — for obvious reasons, given their previous optimistic forecasts — Nortel decided to err on the side of pessimism.
© The Globe and Mail
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