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Nortel decision won’t discourage accounting games

The acquittal of Nortel senior executives, many will argue, has all but granted a free legal pass to any company that wants to massage its financial reports to present better numbers to an unknowing public. The decision does nothing to discourage a company from moving a few things around to turn a loss into a profit or meet a guidance target. With the Nortel verdict as precedent, an awful lot of accounting games may now have a stamp of legal legitimacy.

The case against the failed technology company's top brass is a particularly meaningful one precisely because it wasn't that strong. Unlike the Canadian corporate fraud case to which it is most often compared – that of Livent – the evidence was much thinner that any of Nortel's senior executives had knowingly changed financial numbers with the specific intent to deceive the investing public.

It was, in essence, a trial on how far companies can stretch "earnings management," a euphemistic term for using accounting gimmicks to change the bottom line in financial statements. The crown's argument was that Nortel's bosses systematically created pools of accounting reserves as a "cookie jar" that they could dip into to satisfy a craving for profits whenever it was convenient (particularly for executive bonus payments). The defence countered that everything Nortel did with these discretionary pools of money was entirely within the scope of acceptable accounting practices (even though others might argue that this involved more liberal assumptions and interpretations than many accountants would prefer).

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In corporate accounting, it has long been understood (to the chagrin of many investors) that there are myriad ways to skin a company's financial cat – and some companies might be prone to push the bounds of accounting creativity to carve good numbers out of not-so-good ones. Investors might roll their eyes when the numbers come out, question aloud the "quality" of the earnings (another euphemistic term, for separating genuine financial achievements from performance-enhancing accounting), even translate that skepticism into a discount on the stock value. But otherwise, there was little they could do but sit back and take it.

The Nortel case offered a glimmer of hope that the courts would see such cynically systematic earnings management as fraud. However, while Ontario Superior Court Justice Frank Marrocco expressed questions during the trial about the propriety of such accounting practices, in the end he couldn't establish that these acts were fraudulent in and of themselves. (And there simply wasn't sufficient evidence to establish that the executives charged – former CEO Frank Dunn, former CFO Douglas Beatty and former controller Michael Gollogly – had criminal intent behind their earnings wizardry.)

Certainly, some less scrupulous company executives will see this acquittal as a green light to continue using every trick in the book to bend their profit statements into whatever shape they like.

It's more than just unfair to investors. Such financial-statement gamesmanship weaken the quality of earnings reporting throughout the market, and this precedent will make future corporate accounting-fraud cases even harder to convict in the future. The happy win for Nortel's former bosses is an unhappy loss of a big opportunity for investors across the land.

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