Thinking about the 2013 acquittal of the three Nortel executives on fraud charges. As summarized by Howard Solomon:
(Justice) Marrocco emphasized that his decision is based on evidence heard and documents presented in his courtroom only and that the criminal charges had to be proven beyond a reasonable doubt…
Marrocco concluded that during the period the trial was concerned, Nortel’s accrued liabilities were estimated at the high end of valuations – in other words, the judge said, Nortel executives, staff and auditors “wanted to account for every possible risk.”
One of the risks of Nortel’s condition was that excess accrued liability balances would find their way onto the company’s balance sheet, Marrocco said, (and) that’s what happened.
Ultimately Nortel had to re-state $900 million in excess liabilities in 2003 and 2004 from previous financial results, he said.
That re-statement meant $900 million in expenses didn’t have to be paid, and therefore shareholders’ equity was increased by that amount.
However he found no criminal fault. The threshold of measuring the value of the accrued liabilities was lowered when the restatements were made, he said, and also factored in errors in revenue recognition – or, as he wrote in his full decision, a difference of opinion…
What is being said is that when management overestimates liabilities for expenses, during the course of putting together financial statements at the end of a particular period, management also has overestimated the expenses in that period. Higher expenses mean lower income. When, in the following period, management realizes that it has overestimated the liabilities for expenses in the following period, the overestimation must be adjusted downwards, which results in less expenses the following period, and increased income accordingly. An example would be estimated liabilities for warranty costs, made at the end of one period. One doesn’t know how right or how wrong one is until warranty claims are made in the following period. The very nature of an accrued liability, which is an estimate, involves later actual results varying from what was estimated. In terms of the accounting burden of proof in order to estimate the liability…balance of probabilities? How, if at all, in such circumstances, could the act of estimation become an become an act of fraud?
In the judgement, it is stated that Nortel management used higher than 50 plus 1% to estimate the original liability, and then used a “lower threshold” to reverse it. Some might argue that the circumstances are more the reverse. A “conservative” accounting treatment errs on the side of anticipating all losses, within an acceptable range of probability, with the floor being 50 plus 1%. When one reverses such accruals, it is because one has greater certainty, based on actual results. The threshold is therefore higher, not lower.
Or so one tries to convey the accounting logic, more obtusely than preferred…