##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q þ
    
    Quarterly Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
 For the Quarterly Period Ended March 31, 2005 OR o
    
    Transition Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
 For the Transition Period From ___________ to ___________ Commission file number: 000-30758 Nortel Networks Limited  Canada
    
    62-12-62580(State
or other jurisdiction of
incorporation or organization)
    
    (I.R.S. Employer Identification No.)8200 Dixie Road, Suite 100Brampton, Ontario, Canada
    
    L6T 5P6(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number including area code (905) 863-0000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to filing requirements for the past 90 days. Yes ü          No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Act). Yes ü          No Indicate the number of shares outstanding of each of the issuers classes of common stock, as at
May 16, 2005. 1,460,978,638 shares of common stock without nominal or par value




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TABLE OF CONTENTS PART I
FINANCIAL INFORMATION PAGEITEM 1.
    
    Consolidated Financial Statements (unaudited)
    
    5ITEM 2.
    
    Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    45ITEM 3.
    
    Quantitative and Qualitative Disclosures About
Market Risk
    
    105ITEM 4.
    
    Controls and Procedures
    
    105PART II
OTHER INFORMATIONITEM 1.
    
    Legal Proceedings
    
    112ITEM 5.
    
    Other Information
    
    112ITEM 6.
    
    Exhibits
    
    113SIGNATURES
    
    
    
    114
  2




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All dollar amounts in this document are in United States dollars unless otherwise stated. NORTEL, NORTEL (Logo), NORTEL NETWORKS the Modified GLOBEMARK, NT, and > THIS IS THE WAY >
THIS IS NORTEL (designmark) are trademarks of Nortel Networks. MOODYS is a trademark of Moodys Investor Services, Inc. NYSE is a trademark of the New York Stock Exchange, Inc. SAP is a trademark of SAP AG. S&P and STANDARD & POORS are trademarks of The McGraw-Hill Companies, Inc. All other trademarks are the property of the respective owners. 3




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PART I
FINANCIAL INFORMATION PAGEITEM 1.
    
    Consolidated Financial Statements (Unaudited)
    
    5ITEM 2.
    
    Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    45ITEM 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    105ITEM 4.
    
    Controls and Procedures
    
    105
 4




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NORTEL NETWORKS LIMITED

Consolidated Statements of Operations (unaudited) Three months ended March 31,(millions of U.S. dollars)
    
    2005
    
    
    2004Revenues
    
    $
    2,536
    
    
    $
    2,444Cost of revenues
    
    
    1,477
    
    
    
    1,372Gross profit
    
    
    1,059
    
    
    
    1,072Selling, general and administrative expense
    
    
    570
    
    
    
    538Research and development expense
    
    
    471
    
    
    
    466Amortization of intangibles
    
    
    2
    
    
    
    3Special charges
    
    
    21
    
    
    
    7(Gain) loss on sale of businesses and assets
    
    
    1
    
    
    
    Operating earnings (loss)
    
    
    (6
    )
    
    
    58Other income (expense)  net
    
    
    47
    
    
    
    88Interest expenseLong-term debt
    
    
    (29
    )
    
    
    (24
    )Other
    
    
    (2
    )
    
    
    (8
    )Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net earnings (loss) of associated companies
    
    
    10
    
    
    
    114Income tax benefit (expense)
    
    
    (15
    )
    
    
    9(5
    )
    
    
    123Minority interests  net of tax
    
    
    (5
    )
    
    
    (6
    )Equity in net earnings (loss) of associated companies  net of tax
    
    
    1
    
    
    
    (1
    )Net earnings (loss) from continuing operations
    
    
    (9
    )
    
    
    116Net earnings (loss) from discontinued operations  net of tax
    
    
    2
    
    
    
    1Net earnings (loss)
    
    
    (7
    )
    
    
    117Dividends on preferred shares
    
    
    9
    
    
    
    9Net earnings (loss) applicable to common shares
    
    $
    (16
    )
    
    $
    108
 The accompanying notes are an integral part of these consolidated financial statements 5




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NORTEL NETWORKS LIMITED
Consolidated Balance Sheets (unaudited) March 31,
    
    
    December 31,(millions of U.S. dollars, except for share amounts)
    
    2005
    
    
    2004ASSETSCurrent assetsCash and cash equivalents
    
    $
    3,390
    
    
    $
    3,607Restricted cash and cash equivalents
    
    
    81
    
    
    
    80Accounts receivable  net
    
    
    3,039
    
    
    
    2,800Inventories  net
    
    
    1,316
    
    
    
    1,414Deferred income taxes  net
    
    
    248
    
    
    
    255Other current assets
    
    
    423
    
    
    
    355Total current assets
    
    
    8,497
    
    
    
    8,511Investments
    
    
    148
    
    
    
    159Plant and equipment  net
    
    
    1,591
    
    
    
    1,646Goodwill
    
    
    2,080
    
    
    
    2,123Intangible assets  net
    
    
    75
    
    
    
    78Deferred income taxes  net
    
    
    3,706
    
    
    
    3,736Other assets
    
    
    671
    
    
    
    691Total assets
    
    $
    16,768
    
    
    $
    16,944LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilitiesTrade and other accounts payable
    
    $
    980
    
    
    $
    995Payroll and benefit-related liabilities
    
    
    459
    
    
    
    512Contractual liabilities
    
    
    505
    
    
    
    568Restructuring liabilities
    
    
    152
    
    
    
    254Other accrued liabilities
    
    
    2,855
    
    
    
    2,788Long-term debt due within one year
    
    
    1,290
    
    
    
    15Total current liabilities
    
    
    6,241
    
    
    
    5,132Long-term debt
    
    
    771
    
    
    
    2,062Deferred income taxes  net
    
    
    143
    
    
    
    143Other liabilities
    
    
    3,464
    
    
    
    3,189Total liabilities
    
    
    10,619
    
    
    
    10,526Minority interests in subsidiary companies
    
    
    93
    
    
    
    94Guarantees, commitments and contingencies (notes 10, 11 and 16)SHAREHOLDERS EQUITYPreferred shares, without par value  Authorized shares: unlimited;Issued and outstanding shares: 30,000,000 as of March 31, 2005
and 30,000,000 as of December 31, 2004
    
    
    536
    
    
    
    536Common shares, without par value  Authorized shares: unlimited;Issued and outstanding shares: 1,460,978,638 as of March 31, 2005
and 1,460,978,638 as of December 31, 2004
    
    
    1,211
    
    
    
    1,211Additional paid-in capital
    
    
    22,126
    
    
    
    22,107Accumulated deficit
    
    
    (17,008
    )
    
    
    (16,992
    )Accumulated other comprehensive income (loss)
    
    
    (809
    )
    
    
    (538
    )Total shareholders equity
    
    
    6,056
    
    
    
    6,324Total liabilities and shareholders equity
    
    $
    16,768
    
    
    $
    16,944
 The accompanying notes are an integral part of these consolidated financial statements 6




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NORTEL NETWORKS LIMITED
Consolidated Statements of Cash Flows (unaudited) Three months ended March 31,(millions of U.S. dollars)
    
    2005
    
    
    2004Cash flows from (used in) operating activitiesNet earnings (loss) from continuing operations
    
    $
    (9
    )
    
    $
    116Adjustments to reconcile net earnings (loss) from continuing operations to
net cash from (used in)operating activities, net of effects from acquisitions
and divestitures of businesses:Amortization and depreciation
    
    
    82
    
    
    
    90Equity in net (earnings) loss of associated companies  net of tax
    
    
    (1
    )
    
    
    1Stock option compensation
    
    
    19
    
    
    
    15Deferred income taxes
    
    
    8
    
    
    
    (4
    )Other liabilities
    
    
    78
    
    
    
    60(Gain) loss on sale or write down of investments, businesses and assets
    
    
    6
    
    
    
    (33
    )Other  net
    
    
    (118
    )
    
    
    18Change in operating assets and liabilities
    
    
    (289
    )
    
    
    (571
    )Net cash from (used in) operating activities of continuing operations
    
    
    (224
    )
    
    
    (308
    )Cash flows from (used in) investing activitiesExpenditures for plant and equipment
    
    
    (54
    )
    
    
    (43
    )Proceeds on disposals of plant and equipment
    
    
    
    
    
    
    5Acquisitions of investments and businesses  net of cash acquired
    
    
    (2
    )
    
    
    (3
    )Proceeds on sale of investments and businesses
    
    
    83
    
    
    
    55Net cash from (used in) investing activities of continuing operations
    
    
    27
    
    
    
    14Cash flows from (used in) financing activitiesDividends paid
    
    
    (14
    )
    
    
    (9
    )Increase in notes payable
    
    
    20
    
    
    
    10Decrease in notes payable
    
    
    (26
    )
    
    
    (13
    )Repayments of long-term debt
    
    
    
    
    
    
    (97
    )Repayments of capital leases payable
    
    
    (1
    )
    
    
    (3
    )Net cash from (used in) financing activities of continuing operations
    
    
    (21
    )
    
    
    (112
    )Effect of foreign exchange rate changes on cash and cash equivalents
    
    
    (35
    )
    
    
    13Net cash from (used in) continuing operations
    
    
    (253
    )
    
    
    (393
    )Net cash from (used in) operating activities of discontinued operations
    
    
    36
    
    
    
    (3
    )Net decrease in cash and cash equivalents
    
    
    (217
    )
    
    
    (396
    )Cash and cash equivalents at beginning of period
    
    
    3,607
    
    
    
    3,928Cash and cash equivalents at end of period
    
    $
    3,390
    
    
    $
    3,532
 See note 3 for supplemental cash flow information.
 The accompanying notes are an integral part of these consolidated financial statements 7




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NORTEL NETWORKS LIMITED
Notes to Consolidated Financial Statements (unaudited)
(millions of U.S. dollars, unless otherwise stated)  1.
    
    Significant accounting policies  Basis of presentation  The unaudited consolidated financial statements of Nortel Networks Limited (Nortel) have
been prepared in accordance with accounting principles generally accepted in the United States
(U.S.) (GAAP) and the rules and regulations of the U.S. Securities and Exchange Commission
(the SEC) for the preparation of interim financial information. They do not include all
information and notes required by U.S. GAAP in the preparation of annual consolidated financial
statements. The accounting policies used in the preparation of the unaudited consolidated
financial statements are the same as those described in Nortels audited consolidated financial
statements prepared in accordance with U.S. GAAP for the year ended December 31, 2004. Although
Nortel is headquartered in Canada, the unaudited consolidated financial statements are expressed
in U.S. dollars as the greater part of the financial results and net assets of Nortel are
denominated in U.S. dollars.Nortel makes estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities as of the date of the
consolidated financial statements and the reported amounts of revenues and expenses during the
reporting period. Actual results may differ from those estimates. Estimates are used when
accounting for items and matters such as revenue recognition and accruals for losses on
contracts, allowances for uncollectible accounts receivable and customer financing, receivables
sales, inventory obsolescence, product warranty, amortization, asset valuations, impairment
assessments, employee benefits including pensions, taxes and related valuation allowance,
restructuring and other provisions, stock-based compensation and contingencies.Nortel believes all adjustments necessary for a fair statement of the results for the periods
presented have been made and all such adjustments were of a normal recurring nature. The
financial results for the three months ended March 31, 2005 are not necessarily indicative of
financial results for the full year. The unaudited consolidated financial statements should be
read in conjunction with Nortels Annual Report on Form 10-K for the year ended December 31,
2004 filed with the SEC (Nortels 2004 Annual Report).  Comparative figures  Certain 2004 figures in the unaudited consolidated financial statements have been
reclassified to conform to the 2005 presentation.  Recent accounting pronouncements  (a)
    
    In March 2004, the Emerging Issues Task Force (EITF) reached consensus on Issue No.
03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments (EITF 03-1). EITF 03-1 provides guidance on determining when an investment
is considered impaired, whether that impairment is other than temporary and the measurement
of an impairment loss. EITF 03-1 is applicable to marketable debt and equity securities
within the scope of Statement of Financial Accounting Standards (SFAS) No. 115,
Accounting for Certain Investments in Debt and Equity Securities (SFAS 115), and SFAS
No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, and
equity securities that are not subject to the scope of SFAS 115 and not accounted for under
the equity method of accounting. In September 2004, the Financial Accounting Standards
Board (FASB) issued FASB Staff Position (FSP) EITF 03-1-1, Effective Date of
Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment
and Its Application to Certain Investments, which delays the effective date for the
measurement and recognition criteria contained in EITF 03-1 until final application
guidance is issued. The delay does not suspend the requirement to recognize
other-than-temporary impairments as required by existing authoritative literature. The
adoption of EITF 03-1 is not expected to have a material impact on Nortels results of
operations and financial condition.(b)
    
    In November 2004, the FASB issued SFAS No. 151, Inventory Costs (SFAS 151). SFAS
151 requires that abnormal amounts of idle facility expense, freight, handling costs and
wasted material (spoilage) be recognized as current period charges rather than capitalized
as a component of inventory costs. In addition, SFAS 151 requires allocation of fixed
production overheads to inventory based on the normal capacity of the production
facilities. This statement is effective for inventory costs incurred in fiscal periods
beginning after June 15, 2005. The guidance should be applied prospectively. Nortel is currently assessing the impact of SFAS 151 on its
results of operations and financial condition. 8




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(c)
    
    In December 2004, the FASB issued SFAS No. 123 (Revised 2004), Share-Based Payment
(SFAS 123R), which requires all share-based payments to employees, including grants of
employee stock options, to be recognized as compensation expense in the consolidated
financial statements based on their fair values. SFAS 123R also modifies certain
measurement and expense recognition provisions of SFAS No. 123, Accounting for Stock-Based
Compensation (SFAS 123), that will impact Nortel, including the requirement to estimate
employee forfeitures each period when recognizing compensation expense, and requiring that
the initial and subsequent measurement of the cost of liability-based awards each period be
based on the fair value (instead of the intrinsic value) of the award. This statement is
effective for Nortel as of January 1, 2006. Nortel previously elected to expense employee
stock-based compensation using the fair value method prospectively for all awards granted
or modified on or after January 1, 2003 in accordance with SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure  an Amendment of FASB Statement No.
123 (SFAS 148). Nortel is currently assessing the impact of SFAS 123R on its results of
operations and financial condition, as well as the impact of SEC Staff Accounting Bulletin
107, Share-Based Payment (SAB 107). SAB 107 was issued by the SEC in March 2005, and
provides supplemental SFAS 123R application guidance based on the views of the SEC.(d)
    
    In March 2005, the FASB issued FSP No. 46(R)-5, Implicit Variable Interests under FASB
Interpretation No. (FIN) 46 (revised December 2003), Consolidation of Variable Interest
Entities (FSP FIN 46R-5). FSP FIN 46R-5 provides guidance for a reporting enterprise on
whether it holds an implicit variable interest in Variable Interest Entities (VIEs) or
potential VIEs when specific conditions exist. This FSP is effective in the first period
beginning after March 3, 2005 in accordance with the transition provisions of FIN 46
(Revised 2003), Consolidation of Variable Interest Entities  an Interpretation of
Accounting Research Bulletin No. 51 (FIN 46R). Nortel has determined that the adoption
of FSP FIN 46R-5 will not have an impact on its results of operations and financial
condition.  2.
    
    Accounting changes  (a)
    
    Accounting for Certain Financial Instruments with Characteristics of both Liabilities
and Equity  In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity (SFAS 150). SFAS 150
clarifies the accounting for certain financial instruments with characteristics of both
liabilities and equity, including mandatorily redeemable non-controlling interests, and
requires that those instruments be classified as liabilities on the balance sheets.
Previously, many of those financial instruments were classified as equity. SFAS 150 is
effective for financial instruments entered into or modified after May 31, 2003 and
otherwise is effective at the beginning of the first interim period beginning after June 15,
2003. In November 2003, the FASB issued FSP FAS 150-3, Effective Date, Disclosures, and
Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities
and Certain Mandatorily Redeemable Non-controlling Interests under FASB Statement No. 150,
Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and
Equity (FSP FAS 150-3), which deferred indefinitely the effective date for applying the
specific provisions within SFAS 150 related to the classification and measurement of
mandatorily redeemable non-controlling interests.Nortel continues to consolidate two enterprises with limited lives. Upon liquidation in
2024, the net assets of these entities will be distributed to the owners based on their
relative interests at that time. The minority interests included in the consolidated
balance sheets related to these entities were a total of $49 and $50 as of March 31, 2005
and December 31, 2004, respectively. Nortel has not yet determined the fair value of these
minority interests as of March 31, 2005. The adoption of SFAS 150, as amended by FSP FAS
150-3, did not have a material impact on Nortels results of operations and financial
condition. 9




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3.
    
    Consolidated financial statement details  The following consolidated financial statement details are presented for each of the three
months ended March 31, 2005 and 2004 for the consolidated statements of operations, as of March
31, 2005 and December 31, 2004 for the consolidated balance sheets and for each of the three
months ended March 31, 2005 and 2004 for the consolidated statements of cash flows.  Consolidated statements of operations  Other income (expense)  net: Three months ended March 31,2005
    
    
    2004Interest income
    
    $
    14
    
    
    $
    15Gain (loss) on sale or write down of investments
    
    
    (5
    )
    
    
    33Currency exchange gains (losses)
    
    
    26
    
    
    
    1Other  net
    
    
    12
    
    
    
    39Other income (expense)  net
    
    $
    47
    
    
    $
    88
  Hedge ineffectiveness and the discontinuance of cash flow hedges and fair value hedges that
were accounted for in accordance with SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities (SFAS 133) had no material impact on the net earnings (loss) for the three
months ended March 31, 2005 and 2004 and were reported within other income (expense)  net in
the consolidated statements of operations.  Consolidated balance sheets  Accounts receivable  net: March 31,
    
    
    December 31,2005
    
    
    2004Trade receivables
    
    $
    2,241
    
    
    $
    2,259Notes receivable
    
    
    198
    
    
    
    42Contracts in process
    
    
    707
    
    
    
    6083,146
    
    
    
    2,909Less: provision for doubtful accounts
    
    
    (107
    )
    
    
    (109
    )Accounts receivable  net
    
    $
    3,039
    
    
    $
    2,800
  Inventories  net: March 31,
    
    
    December 31,2005
    
    
    2004Raw materials
    
    $
    915
    
    
    $
    935Work in process
    
    
    64
    
    
    
    125Finished goods
    
    
    1,802
    
    
    
    1,8632,781
    
    
    
    2,923Less: provision for inventory
    
    
    (1,087
    )
    
    
    (1,141
    )Inventories  net
    
    
    1,694
    
    
    
    1,782Less: long-term inventory (a)
    
    
    (378
    )
    
    
    (368
    )Current inventories  net
    
    $
    1,316
    
    
    $
    1,414
 (a)
    
    Long-term portion of inventory related to deferred costs discussed below which is
included in other assets.  Finished goods inventory includes certain direct and incremental costs associated with
arrangements where title and risk of loss was transferred to the customer but revenue
was deferred due to other revenue recognition criteria not being met. As of March 31, 2005 and
December 31, 2004, these deferred costs totaled $799 and $829, respectively. 10




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Other current assets: March 31,
    
    
    December 31,2005
    
    
    2004Prepaid expenses
    
    $
    199
    
    
    $
    175Income taxes recoverable
    
    
    34
    
    
    
    38Current assets of discontinued operations (a)
    
    
    13
    
    
    
    14Other
    
    
    177
    
    
    
    128Other current assets
    
    $
    423
    
    
    $
    355
 (a)
    
    Includes accounts receivable of $2 and $3 and inventories of $57 and $58 as of March
31, 2005 and December 31, 2004, respectively, which were fully provided for.  Plant and equipment  net: March 31,
    
    
    December 31,2005
    
    
    2004Cost:Land
    
    $
    56
    
    
    $
    63Buildings
    
    
    1,331
    
    
    
    1,514Machinery and equipment
    
    
    2,560
    
    
    
    2,4813,947
    
    
    
    4,058Less accumulated depreciation:Buildings
    
    
    (436
    )
    
    
    (502
    )Machinery and equipment
    
    
    (1,920
    )
    
    
    (1,910
    )(2,356
    )
    
    
    (2,412
    )Plant and equipment  net (a)
    
    $
    1,591
    
    
    $
    1,646
 (a)
    
    Included assets held for sale with a carrying value of $43 and $29 as of March 31,
2005 and December 31, 2004, respectively, related to owned facilities that were being
actively marketed. These assets were written down to their estimated fair values less
costs to sell. The write downs were included in special charges. Nortel expects to
dispose of all of these facilities during 2005.  Goodwill:The following table outlines goodwill by reportable segment: Carrier
    
    
    
    
    
    
    GSM andPacket
    
    
    CDMA
    
    
    UMTS
    
    
    EnterpriseNetworks
    
    
    Networks
    
    
    Networks
    
    
    Networks
    
    
    TotalBalance  net as of December 31, 2004
    
    $
    528
    
    
    $
    28
    
    
    $
    9
    
    
    $
    1,558
    
    
    $
    2,123Changes:Disposal
    
    
    (37
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (37
    )Foreign exchange
    
    
    (3
    )
    
    
    (1
    )
    
    
    
    
    
    
    (2
    )
    
    
    (6
    )Balance  net as of March 31, 2005
    
    $
    488
    
    
    $
    27
    
    
    $
    9
    
    
    $
    1,556
    
    
    $
    2,080
  Due to the change in operating segments and reporting segments as described in note 4, a
triggering event occurred requiring a goodwill impairment test in the first quarter of 2005 in
accordance with SFAS No. 142, Goodwill and Other Intangible Assets. Nortel performed this test
and concluded that there was no impairment. 11




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Intangible assets  net: March 31,
    
    
    December 31,2005
    
    
    2004Other intangible assets (a)
    
    $
    35
    
    
    $
    38Pension intangible assets
    
    
    40
    
    
    
    40Intangible assets  net
    
    $
    75
    
    
    $
    78
 (a)
    
    Other intangible assets are being amortized over a ten year period ending in 2013,
based on their expected pattern of benefit to future periods using estimates of
undiscounted cash flows. The amortization expense is denominated in a foreign currency and
may fluctuate due to changes in foreign exchange rates.  Other accrued liabilities: March 31,
    
    
    December 31,2005
    
    
    2004Outsourcing and selling, general and administrative related provisions
    
    $
    323
    
    
    $
    321Customer deposits
    
    
    39
    
    
    
    28Product related provisions
    
    
    53
    
    
    
    57Warranty provisions (note 10)
    
    
    254
    
    
    
    271Deferred revenue
    
    
    1,225
    
    
    
    1,210Miscellaneous taxes
    
    
    48
    
    
    
    52Income taxes payable
    
    
    93
    
    
    
    110Current liabilities of discontinued operations
    
    
    2
    
    
    
    Interest payable
    
    
    27
    
    
    
    40Advance billings in excess of revenues recognized to date on contracts
    
    
    624
    
    
    
    581Other
    
    
    167
    
    
    
    118Other accrued liabilities
    
    $
    2,855
    
    
    $
    2,788
  Other liabilities: March 31,
    
    
    December 31,2005
    
    
    2004Pension, post-employment and post-retirement benefit liabilities
    
    $
    2,269
    
    
    $
    2,208Restructuring liabilities (note 5)
    
    
    199
    
    
    
    209Deferred revenue
    
    
    506
    
    
    
    509Other long-term provisions
    
    
    490
    
    
    
    263Other liabilities
    
    $
    3,464
    
    
    $
    3,189
  Consolidated statements of cash flows  Change in operating assets and liabilities: Three months ended March 31,2005
    
    
    2004Restricted cash and cash equivalents
    
    $
    1
    
    
    $
    1Accounts receivable  net
    
    
    (255
    )
    
    
    58Inventories  net
    
    
    39
    
    
    
    (54
    )Income taxes
    
    
    (18
    )
    
    
    (23
    )Restructuring liabilities
    
    
    (128
    )
    
    
    (84
    )Accounts payable, payroll and contractual liabilities
    
    
    (64
    )
    
    
    (435
    )Other operating assets and liabilities
    
    
    136
    
    
    
    (34
    )Change in operating assets and liabilities
    
    $
    (289
    )
    
    $
    (571
    )
 12




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##### Table of Contents



Interest and taxes paid (recovered): Three months ended March 31,2005
    
    
    2004Cash interest paid
    
    $
    45
    
    
    $
    37Cash taxes
paid (recovered)  net
    
    $
    14
    
    
    $
    8
  4.
    
    Segment information  General description  During 2004, Nortels operations were organized and represented by four operating segments,
which were also its reportable segments: Wireless Networks, Enterprise Networks, Wireline
Networks, and Optical Networks. Effective October 1, 2004, Nortel established a new streamlined
organizational structure that included, among other things, combining the businesses represented
by its four operating segments at that time into two business organizations: (i) Carrier
Networks and Global Operations and (ii) Enterprise Networks.The two business organizations include four operating segments. Nortels Carrier Networks and
Global Operations organization is comprised of the following operating segments: (a) Carrier
Packet Networks, which is substantially an amalgamation of Nortels previous Wireline Networks
and Optical Networks operating segments; (b) Code Division Multiple Access (CDMA) Networks,
which previously represented a portion of the Wireless Networks operating segment; (c) Global
System for Mobile communications (GSM) and Universal Mobile Telecommunications Systems
(UMTS) Networks, which also previously represented a portion of the Wireless Networks
operating segment. The Enterprise Networks operating segment remains substantially
unchanged and is a separate operating segment.Although certain structural changes were made to reflect the reorganization effective October 1,
2004, Nortel did not meet the criteria to change its reportable segments under SFAS No. 131,
Disclosures about Segments of an Enterprise and Related Information (SFAS 131), for the 2004
fiscal year. Nortels operating results on a segmented basis for the new business organizations
were not available for review by the chief operating decision maker (CODM) during the 2004
fiscal year, as a significant amount of Nortels finance resources were allocated to the
restatement activity that was completed during January 2005. Commencing in the first quarter of
2005, Nortel met the criteria under SFAS 131 to change its reportable segments to reflect the
four operating segments of the two business organizations established effective October 1, 2004.
Nortels four reportable segments and other business activities are described below:  
    
    Carrier Packet Networks provides: (i) circuit and packet voice solutions, (ii)
data networking and security solutions and (iii) optical long-haul and metropolitan optical
network solutions. Together, these solutions provide or transport data, voice and
multimedia communications solutions to Nortels service provider customers that operate
wireline networks. These service provider customers include local and long distance
telephone companies, wireless service providers, cable operators and other communication
service providers.
    
    CDMA Networks provides communication network solutions that incorporate CDMA and Time
Division Multiple Access (TDMA) network solutions to enable Nortels wireless service
provider customers to offer their customers, the subscribers for wireless communication
services, the ability to be mobile while they send and receive voice and data
communications using wireless devices, such as cellular telephones, personal digital
assistants and other
computing and communications devices.
    
    GSM and UMTS Networks also provides communication network solutions to Nortels wireless
service provider customers; however, these solutions incorporate GSM and UMTS network
solutions.
    
    Enterprise Networks provides: (i) circuit and packet voice solutions and (ii)
data networking and security solutions which provide data, voice and multimedia
communications solutions to Nortels enterprise customers. Nortels Enterprise Networks
customers consist of a broad range of enterprise customers around the world, including
large businesses and their branch offices, small businesses and home offices, as well as
government agencies, educational and other institutions and utility organizations. 13




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##### Table of Contents




    
    Other represents miscellaneous business activities and corporate functions. None of
these activities meet the quantitative criteria to be disclosed separately as reportable
segments. Costs associated with shared services and other corporate costs are allocated to
the segments based on usage determined generally by headcount. Costs not allocated to the
segments are primarily related to Nortels corporate compliance and other non-operational
activities and are included in Other.  Nortels vice-chairman and chief executive officer (the CEO) has been identified as the CODM
in assessing the performance of the segments and the allocation of resources to the segments.
The CEO relies on the information derived directly from Nortels management reporting system.
The primary financial measure used by the CEO in assessing performance and allocating resources
to the segments is management earnings (loss) before income taxes (Management EBT), a measure
that includes the cost of revenues and selling, general and administrative (SG&A) expense,
research and development (R&D) expense, interest expense, other income (expense)  net,
minority interests  net of tax and equity in net earnings (loss) of associated companies  net
of tax. The CEO does not review asset information on a segmented basis in order to assess
performance and allocate resources. The accounting policies of the reportable segments are the
same as those applied to the consolidated financial statements.  Segments  The following tables set forth information by segment for each of the three months ended: March 31,
    
    
    March 31,2005
    
    
    2004RevenuesCarrier Packet Networks
    
    $
    664
    
    
    $
    683CDMA Networks
    
    
    535
    
    
    
    569GSM and UMTS Networks
    
    
    788
    
    
    
    656Enterprise Networks
    
    
    547
    
    
    
    534Other
    
    
    2
    
    
    
    2Total
    
    $
    2,536
    
    
    $
    2,444Management EBTCarrier Packet Networks
    
    $
    (30
    )
    
    $
    (59
    )CDMA Networks
    
    
    168
    
    
    
    224GSM and UMTS Networks
    
    
    53
    
    
    
    1Enterprise Networks
    
    
    32
    
    
    
    25Other
    
    
    (193
    )
    
    
    (74
    )Total
    
    
    30
    
    
    
    117Amortization of intangibles
    
    
    (2
    )
    
    
    (3
    )Special charges
    
    
    (21
    )
    
    
    (7
    )Gain (loss) on sale of businesses and assets
    
    
    (1
    )
    
    
    Income tax benefit (expense)
    
    
    (15
    )
    
    
    9Net earnings (loss) from continuing operations
    
    $
    (9
    )
    
    $
    116
 14




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##### Table of Contents



5.
    
    Special charges  During 2001, Nortel implemented a work plan to streamline operations and activities around
core markets and leadership strategies in light of the significant downturn in both the
telecommunications industry and the economic environment, and capital market trends impacting
operations and expected future growth rates (the 2001 Restructuring Plan).In addition, activities were initiated in 2003 to exit certain leased facilities and leases for
assets no longer used across all segments. The liabilities associated with these activities
were measured at fair value and recognized under SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities (SFAS 146).In 2004 and 2005, Nortels focus is on managing each of its businesses based on financial
performance, the market and customer priorities. In the third quarter of 2004, Nortel announced
a strategic plan that includes a work plan involving focused workforce reductions, including a
voluntary retirement program, of approximately 3,250 employees, real estate optimization and
other cost containment actions such as reductions in information services costs, outsourced
services and other discretionary spending across all segments, but primarily in Carrier Packet
Networks (the 2004 Restructuring Plan). Nortel estimates charges to earnings associated with
the 2004 Restructuring Plan in the aggregate of approximately $450 comprised of approximately
$220 with respect to the workforce reductions and approximately $230 with respect to the real
estate actions. No additional special charges are expected to be recorded with respect to the other cost
containment actions. Approximately $160 of the aggregate charges were incurred in 2004 with
the remainder expected to be incurred in 2005.During the three months ended March 31, 2005, Nortel continued to implement these restructuring
work plans. Changes in the provisions related to special charges recorded from January 1, 2005 to March 31, 2005 were as follows: Contractsettlement
    
    
    Plant andWorkforce
    
    
    and lease
    
    
    equipmentreduction
    
    
    costs
    
    
    write downs
    
    
    Total2001 Restructuring PlanProvision balance as of December 31, 2004 (a)
    
    $
    15
    
    
    $
    326
    
    
    $
    
    
    
    $
    341Revisions to prior accruals
    
    
    (3
    )
    
    
    
    
    
    
    (1
    )
    
    
    (4
    )Cash drawdowns
    
    
    (2
    )
    
    
    (40
    )
    
    
    
    
    
    
    (42
    )Foreign exchange and other adjustments
    
    
    (1
    )
    
    
    (4
    )
    
    
    1
    
    
    
    (4
    )Provision balance as of March 31, 2005
    
    $
    9
    
    
    $
    282
    
    
    $
    
    
    
    $
    2912004 Restructuring PlanProvision balance as of December 31, 2004 (a)
    
    $
    122
    
    
    $
    
    
    
    $
    
    
    
    $
    122Other special charges
    
    
    18
    
    
    
    8
    
    
    
    1
    
    
    
    27Revisions to prior accruals
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    (2
    )Cash drawdowns
    
    
    (86
    )
    
    
    
    
    
    
    
    
    
    
    (86
    )Foreign exchange and other adjustments
    
    
    
    
    
    
    
    
    
    
    (1
    )
    
    
    (1
    )Provision balance as of March 31, 2005
    
    $
    52
    
    
    $
    8
    
    
    $
    
    
    
    $
    60Total provision balance as of March 31, 2005 (a)
    
    $
    61
    
    
    $
    290
    
    
    $
    
    
    
    $
    351
 (a)
    
    As of March 31, 2005 and December 31, 2004, the short-term provision balance was $152
and $254, respectively, and the long-term provision balance was $199 and $209,
respectively. 15




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##### Table of Contents



Regular full-time (RFT) employee notifications resulting in special charges for both
restructuring plans were as follows: Employees (approximate)Direct(a)
    
    
    Indirect(b)
    
    
    TotalRFT employee
notifications for
the three months
ended March 31,
2005
    
    
    20
    
    
    
    220
    
    
    
    240
 (a)
    
    Direct employees included employees performing manufacturing, assembly, testing and
inspection activities associated with the production of Nortels products.(b)
    
    Indirect employees included employees performing manufacturing, management, sales,
marketing, research and development and administrative activities.  2001 Restructuring Plan  Three months ended March 31, 2005During the three months ended March 31, 2005, Nortel recorded revisions of $4 related to prior
accruals.The workforce reduction provision balance was drawn down by cash payments of $2 during the three
months ended March 31, 2005. The remaining provision is expected to be substantially drawn down
by the end of 2005.No new contract settlement and lease costs were incurred during the period. During the three
months ended March 31, 2005, the provision balance for contract settlement and lease costs was
drawn down by cash payments of $40. The remaining provision, net of approximately $241 in
estimated sublease income, is expected to be substantially drawn down by the end of 2013.Three months ended March 31, 2004During the three months ended March 31, 2004, Nortel recorded special charges of $7, which
included revisions of $1 related to prior accruals.Workforce reduction charges of $6 were related to severance and benefit costs associated with
approximately 80 employees notified of termination during the three months ended March 31, 2004
which related entirely to Carrier Packet Networks. During the three months ended March 31,
2004, the workforce reduction provision balance was drawn down by cash payments of $27.No new contract settlement and lease costs were incurred during the period. Revisions to prior
accruals for contract settlement and lease costs of $1 were identified for the three months
ended March 31, 2004. During the three months ended March 31, 2004, the provision balance for
contract settlement and lease costs was drawn down by cash payments of $57.In 2003, Nortel initiated activities to exit certain leased facilities and leases for assets no
longer used, across all segments. The costs associated with these planned activities have been
valued using the estimated fair value method prescribed under SFAS 146. The table below
summarizes the total costs estimated to be incurred as a result of these activities, which have
met the criteria described in SFAS 146, the balance of these accrued expenses as of March 31,
2005 and the movement in the accrual for the three months ended March 31, 2005. These costs are
included in the provision balance above as of March 31, 2005. 16




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##### Table of Contents



PaymentsCosts
    
    
    made
    
    
    Adjustmentsduring the
    
    
    during the
    
    
    during theAccrued
    
    
    three months
    
    
    three months
    
    
    three months
    
    
    Accruedbalance as of
    
    
    ended
    
    
    ended
    
    
    ended
    
    
    balance as ofDecember 31, 2004
    
    
    March 31, 2005
    
    
    March 31, 2005
    
    
    March 31, 2005
    
    
    March 31, 2005Lease costs (a)
    
    $
    31
    
    
    $
    
    
    
    $
    (1
    )
    
    $
    3
    
    
    $
    33
 (a)
    
    Total estimated costs, net of estimated sublease income, associated with these accruals
are $69, of which $19 was drawn down by cash payments of $21 and offset by non-cash
adjustments of $2 prior to January 1, 2005.  Special charges  by segmentThe following table outlines special charges incurred by segment for the three months ended
March 31: Contractsettlement
    
    
    Plant andWorkforce
    
    
    and lease
    
    
    equipmentreduction
    
    
    costs
    
    
    write downs
    
    
    Total2001 Restructuring PlanCarrier Packet Networks
    
    $
    (1
    )
    
    $
    
    
    
    $
    (1
    )
    
    $
    (2
    )CDMA Networks
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    GSM and UMTS Networks
    
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    (1
    )Enterprise Networks
    
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    (1
    )Total special charges for the three months
ended March 31, 2005
    
    $
    (3
    )
    
    $
    
    
    
    $
    (1
    )
    
    $
    (4
    )Carrier Packet Networks
    
    $
    6
    
    
    $
    1
    
    
    $
    
    
    
    $
    7Total special charges for the three months
ended March 31, 2004
    
    $
    6
    
    
    $
    1
    
    
    $
    
    
    
    $
    7
  As described in the definition of Management EBT in note 4, segment Management EBT does not
include special charges. A significant portion of Nortels provisions for workforce reductions
and contract settlement and lease costs is associated with shared services. These costs have
been allocated to the segments in the table above based generally on headcount.  2004 Restructuring Plan  Three months ended March 31, 2005During the three months ended March 31, 2005, Nortel recorded special charges of $25, which
included revisions of $2 related to prior accruals.Workforce reduction charges of $16, net of revisions to prior accruals of $2, were related to
severance and benefit costs associated with approximately 240 employees notified of termination
during the three months ended March 31, 2005. The workforce reduction provision balance was
drawn down by cash payments of $86 during the three months ended March 31, 2005. The workforce
reduction was primarily in the U.S., Canada and EMEA and extended across all segments. The
remaining provision is expected to be substantially drawn down by the end of 2005.Contract settlement and lease costs of $8 consisted of negotiated settlements to cancel or
renegotiate contracts and net lease charges related to leased facilities (comprised of office
space) and leased furniture that were identified as no longer
required primarily in the U.S. and in the Enterprise Networks
segment.
These lease costs, net of anticipated sublease income, included costs
relating to non-cancelable lease terms from
the date leased facilities ceased to be used and termination penalties. This provision is
expected to be substantially drawn down by the end of 2016. 17




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##### Table of Contents



Special charges  by segmentThe following table outlines special charges incurred by segment for the three months ended
March 31, 2005: Contractsettlement
    
    
    Plant andWorkforce
    
    
    and lease
    
    
    equipmentreduction
    
    
    costs
    
    
    write downs
    
    
    Total2004 Restructuring PlanCarrier Packet Networks
    
    $
    9
    
    
    $
    1
    
    
    $
    1
    
    
    $
    11CDMA Networks
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    1GSM and UMTS Networks
    
    
    3
    
    
    
    
    
    
    
    
    
    
    
    3Enterprise Networks
    
    
    3
    
    
    
    7
    
    
    
    
    
    
    
    10Total special charges for the three months
ended March 31, 2005
    
    $
    16
    
    
    $
    8
    
    
    $
    1
    
    
    $
    25
  6.
    
    Income taxes  During the three months ended March 31, 2005, Nortel recorded a tax expense of $15 on
earnings from continuing operations before income taxes, minority interests and equity in net
earnings (loss) of associated companies of $10. Nortel recorded a tax expense against the
earnings of certain taxable entities and recorded additional valuation allowances against the
tax benefit of current period losses of other entities. The tax expense of $15 is primarily
related to the drawdown of Nortels deferred tax assets and current tax provisions in certain
taxable jurisdictions and various corporate minimum and other taxes, partially offset by the
recognition of R&D related incentives.During the three months ended March 31, 2004, Nortel recorded a tax benefit of $9 on earnings
from continuing operations before income taxes, minority interests and equity in net earnings
(loss) of associated companies of $114. Nortel recorded a tax expense against the earnings of
certain taxable entities and recorded additional valuation allowances against the tax benefit of
current period losses of other entities. The tax benefit of $9 resulted from the settlement of
certain tax audits partially offset by the drawdown of Nortels deferred tax assets and current
income tax provisions in certain taxable jurisdictions and various corporate minimum related
income taxes.As of March 31, 2005, Nortels deferred income tax assets, excluding discontinued operations,
were $3,811. The most significant components of the gross deferred income tax assets are the tax
benefit of loss carryforwards and investment tax credits and temporary differences related to
certain liabilities (primarily provisions, pensions and other post retirement obligations). The
majority of the carryforward amounts do not begin to expire until 2017.The deferred income tax assets are net of a valuation allowance of $3,376. The valuation
allowance of $3,376 was recorded in accordance with SFAS No. 109, Accounting for Income Taxes,
which requires that a valuation allowance be established when it is more likely than not that
some portion or all of a companys deferred tax assets will not be realized. The valuation
allowance was determined based on an assessment of the positive and
negative evidence of the recoverability of deferred tax assets, which
included the carryforward periods attributable to the significant tax assets, Nortels history
of generating taxable income in its material jurisdictions, and Nortels cumulative loss
position. Primarily as a result of the losses realized in 2001 and 2002, Nortel determined that
it is more likely than not that a portion of its deferred income tax assets will not be
realized. Accordingly, a valuation allowance has been recorded against a portion of the assets.
However, due to the fact that the majority of the carryforward amounts do not expire in the near
future, Nortels extended history of profitability in its material tax jurisdictions, exclusive
of the 2001 and 2002 losses, and Nortels future projections of profitability, Nortel
determined that it is more likely than not that the remaining portion of its deferred income tax
assets recorded as of March 31, 2005 will be realized.Nortel is subject to ongoing examinations by certain tax authorities of the jurisdictions in
which it operates. Nortel regularly assesses the status of these examinations and the potential
for adverse outcomes to determine the adequacy of the provision for income and other taxes.
Nortel believes that it has adequately provided for tax adjustments that are probable as a
result of any ongoing or future examinations. 18




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##### Table of Contents



7.
    
    Employee benefit plans  Nortel maintains various retirement programs covering substantially all of its employees,
consisting of defined benefit, defined contribution and investment plans.Nortel has four kinds of capital accumulation and retirement programs: balanced capital
accumulation and retirement programs (the Balanced Program) and investor capital accumulation
and retirement programs (the Investor Program) available to substantially all of its North
American employees; flexible benefits plan, which includes a group personal
pension plan (the Flexible Benefits Plan), available to substantially all of its employees in
the United Kingdom (U.K.); and traditional capital accumulation and retirement programs that
include defined benefit pension plans (the Traditional Program) which are closed to
new entrants in the U.K. and portions of which are closed to new entrants in the U.S. and
Canada. Although these four kinds of programs represent Nortels major retirement programs and
may be available to employees in combination and/or as options within a program, Nortel also has
smaller pension plan arrangements in other countries.Nortel also provides other benefits, including post-retirement benefits and post-employment
benefits. Employees in the Traditional Program are eligible for their existing Company
sponsored post-retirement benefits or a modified version of these benefits, depending on age or
years of service. Employees in the Balanced Program are eligible for post-retirement benefits
at reduced Company contribution levels, while employees in the Investor Program have access to
post-retirement benefits by purchasing a Nortel-sponsored retiree health care plan at their own
cost.The following details the net pension expense, all related to continuing operations, for the
defined benefit plans for the three months ended: March 31,
    
    
    March 31,2005
    
    
    2004Pension expense:Service cost
    
    $
    35
    
    
    $
    30Interest cost
    
    
    116
    
    
    
    104Expected return on plan assets
    
    
    (109
    )
    
    
    (102
    )Amortization of prior service cost
    
    
    1
    
    
    
    1Amortization of net losses (gains)
    
    
    23
    
    
    
    19Curtailment loss (gain)
    
    
    1
    
    
    
    Net pension expense
    
    $
    67
    
    
    $
    52
  The following details the net cost components, all related to continuing operations, of
post-retirement benefits other than pensions for the three months ended: March 31,
    
    
    March 31,2005
    
    
    2004Post-retirement benefit cost:Service cost
    
    $
    2
    
    
    $
    3Interest cost
    
    
    10
    
    
    
    10Expected return on plan assets
    
    
    (1
    )
    
    
    Amortization of prior service cost
    
    
    (1
    )
    
    
    (1
    )Amortization of net losses (gains)
    
    
    
    
    
    
    1Net post-retirement benefit cost
    
    $
    10
    
    
    $
    13
  During the three months ended March 31, 2005, contributions of $69 were made to the defined
benefit plans and $7 to the post-retirement benefit plans. Nortel expects to contribute an
additional $23 in 2005 to the defined benefit pension plans for a total contribution of $92, and
an additional $22 in 2005 to the post-retirement benefit plans for a total contribution of $29. 19




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8.
    
    Divestitures and change in investments  Divestitures  Manufacturing operationsOn June 29, 2004, Nortel announced an agreement with Flextronics International Ltd.
(Flextronics), regarding the divestiture of substantially all of Nortels remaining
manufacturing operations, including product integration, testing and repair operations carried
out in Calgary and Montreal, Canada and Campinas, Brazil, as well as certain activities related
to these locations, including the management of the supply chain, related suppliers and
third-party logistics. In Europe, Flextronics has made an offer to purchase similar Nortel
operations at Monkstown, Northern Ireland and Chateaudun, France, subject to the completion of
the required information and consultation process.Under the terms of the agreement and offer, Flextronics will also acquire Nortels global repair
services, as well as certain design assets in Ottawa, Canada and Monkstown related to hardware
and embedded software design, and related product verification for certain established optical
products.Nortel and Flextronics have entered into a four year supply agreement for manufacturing services
(whereby Flextronics will manage approximately $2,500 of Nortels annual cost of revenues) and a
three year supply agreement for design services. The portion of the transaction related to the
optical design activities in Ottawa and Monkstown was completed on November 1, 2004. On
February 8, 2005, Nortel announced the completion of the portion of the transaction related to
the manufacturing activities in Montreal. Nortel previously reported that the portion of the
transaction related to the manufacturing activities in Calgary was expected to close in the
second quarter of 2005 and that the balance of the transaction was expected to close on separate
dates occurring during the first half of 2005. Nortel and Flextronics are currently discussing
the timing of the closing of the balance of the transaction in order to optimize the business
transition between the companies. As a result of these discussions, it is now expected that the
balance of the transaction, relating to the manufacturing operations in Chateaudun, Calgary and
Monkstown, will close by the end of the first quarter of 2006. As a result, Nortel and
Flextronics intend to enter into an amendment agreement to extend the term of the original
agreement and offer to reflect this updated schedule. These transactions are subject to
customary conditions and regulatory approvals.The successful completion of the agreement and offer with Flextronics will result in the
transfer of approximately 2,500 employees from Nortel to Flextronics. As of the first quarter
of 2005, Nortel has transferred approximately 1,040 of its employees to Flextronics. Nortel
expects to receive cash proceeds ranging from approximately $675 to $725, which will be
allocated to each separate closing. Nortel previously announced that the estimated cash
proceeds would be received substantially in 2005. Nortel and Flextronics are currently
discussing the timing of the cash payments based on the expected change to the original
schedule. Such payments will be subject to a number of adjustments, including potential
post-closing date asset valuations and potential post-closing indemnity payments. Nortel is expecting proceeds on the sale of this business to exceed the net book value of the
assets transferred (including goodwill and foreign currency translation adjustments) and the direct
and incremental costs of the transaction (including transition, potential severance, pension
adjustments, information technology and real estate costs). The resulting net gain on sale of this
business will be recognized once substantially all of the risks and other incidents of ownership
have been transferred.As of March 31, 2005 Nortel has received net cash of approximately $85, transferred approximately
$193 of inventory and equipment to Flextronics relating to the closing of the optical design
activities in Ottawa and Monkstown and the manufacturing activities in Montreal and recorded deferred charges of approximately $108 and deferred
income of approximately $250. As Flextronics has the ability to exercise rights to sell back
to Nortel certain inventory and equipment after the expiration of a specified period (up to fifteen
months) following each respective closing date, Nortel has retained these assets on its balance
sheet to the extent they have not been consumed as part of ongoing operations as at March 31, 2005.
Nortel does not expect that such rights will be exercised with respect to any material amount of
inventory and/or equipment. 20




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Change in investments  On February 3, 2004, Nortel sold approximately 7 million common shares of Entrust Inc.
(Entrust) for cash consideration of $33, and recorded a gain of $18 in other income (expense)
  net. As a result of this transaction, Nortel no longer holds any equity interest in Entrust.During March 2004, Nortel sold 1.8 million shares of Arris Group, Inc. (Arris Group) for cash
consideration of $17, which resulted in a gain of $13, which was recorded in other income
(expense)  net. Following this transaction, Nortel owned 3.2 million Arris Group common shares
or 4.2 percent of Arris Group outstanding common shares.  Other  On January 20, 2005, Nortel signed a Joint Venture Framework Agreement with China Putian
Corporation to establish a joint venture for R&D, manufacture and sale of third generation (3G)
mobile telecommunications equipment and products to customers in China. Nortel expects to have
a definitive joint venture agreement by June 30, 2005. Nortel anticipates that it will own 49%
of the joint venture and China Putian will own 51%.On January 23, 2005, Nortel signed a non-binding
Memorandum of Understanding with LG Electronics, Inc.
to establish a joint venture for providing high quality, leading edge telecommunications
equipment and networking solutions to Korea and other markets globally. The proposed joint
venture is subject to negotiation of final terms and execution of a definitive agreement.
Nortel expects to complete this transaction in the second half of 2005. In the proposed joint
venture, Nortel anticipates that it will have an ownership interest of 50% plus one share.  9.
    
    Long-term debt, credit and support facilities  As a result of the delay in the filing of Nortels and Nortel Networks Corporations
(NNC) 2003 Annual Reports on Form 10-K for the year ended December 31, 2003 (the 2003 Annual
Reports), 2004 Quarterly Reports on Form 10-Q for the first, second and third quarters of 2004
(the 2004 Quarterly Reports) and 2004 Annual Reports on Form 10-K for the year ended December
31, 2004 (the 2004 Annual Reports, and together with the
2003 Annual Reports and the 2004 Quarterly
Reports, the Reports), Nortel and NNC were not in compliance with their obligations to deliver
their respective SEC filings to the trustees under Nortels and NNCs public debt indentures as
of March 31, 2005. Approximately $1,800 of notes of Nortel (or its subsidiaries) and $1,800 of
convertible debt securities of NNC were outstanding under such indentures as of March 31, 2005.These delays did not result in the automatic event of default and acceleration of the long-term
debt of Nortel or NNC and such default and acceleration could not have occurred unless notice of
such non-compliance from holders of not less than 25% of the outstanding principal amount of any
relevant series of debt securities were provided to Nortel or NNC, as applicable, and Nortel or
NNC, as applicable, failed to deliver the relevant report within 90 days after such notice was
provided, all in accordance with the terms of the indentures. While such notice could have been
given at any time after March 30, 2004 as a result of the delayed filing of the Reports, neither
Nortel nor NNC received a notice as of March 31, 2005. See note 17 for additional information
relating to the delayed filings.Approximately $1,275 of the 6.125% Notes are due in February 2006, and have been reclassified
from long-term debt to current liabilities. Nortel expects to have sufficient cash to meet this
future obligation.  Support facility  On February 14, 2003, Nortel entered into an agreement with Export Development Canada (EDC)
regarding arrangements to provide for support, on a secured basis, of certain performance
related obligations arising out of normal course business activities for the benefit of Nortel
(the EDC Support Facility). On December 10, 2004, Nortel and EDC amended the terms of the EDC
Support Facility by extending the termination date of the EDC Support Facility to December 31,
2006 from December 31, 2005.On February 14, 2003, Nortels obligations under the EDC Support Facility became secured on an
equal and ratable basis under the security agreements entered into by Nortel and various of its
subsidiaries that pledged substantially all of the assets of Nortel in favor of the banks under
the Nortel and Nortel Networks Inc. (NNI) $750 April 2000 five year credit facilities (the
Five Year Facilities) and the holders of Nortel and NNCs public debt securities. This
security became effective in favor of the banks and the public debt holders on April 4, 2002.
For additional information relating to the security agreements, see note 19. 21




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##### Table of Contents



The EDC Support Facility provides up to $750 in support, all on an uncommitted basis as of March
31, 2005. As of March 31, 2005, there was approximately $213 of outstanding support utilized
under the EDC Support Facility, approximately $145 of which was outstanding under the revolving
small bond sub-facility.The delayed filing of the Reports with the SEC, the trustees under Nortels and NNCs public
debt indentures and EDC gave EDC the right to (i) terminate its commitments under the EDC
Support Facility, relating to certain of Nortels performance related obligations arising out of
normal course business activities, and (ii) exercise certain rights against the collateral
pledged under related security agreements or require Nortel to cash collateralize all existing
support.Throughout 2004 and into 2005, Nortel obtained waivers from EDC with respect to these matters to
permit continued access to the EDC Support Facility in accordance with its terms while Nortel
and NNC worked to complete their filing obligations. The waivers also applied to certain
related breaches under the EDC Support Facility relating to the delayed filings and the
restatements and revisions to Nortels and NNCs prior financial results (the Related
Breaches). In connection with such waivers, EDC reclassified the previously committed $300
revolving small bond sub-facility of the EDC Support Facility as uncommitted support during the
applicable waiver period. The $300 revolving small bond sub-facility will not become committed
support until all delayed filings have been filed with the SEC, the trustees under Nortels and
NNCs public debt indentures and EDC and Nortel obtains a permanent waiver of the Related
Breaches.On January 14, 2005 and February 15, 2005, Nortel obtained waivers from EDC of certain defaults
and the Related Breaches by Nortel under the EDC Support Facility relating to the delayed
filings of Nortels and NNCs financial reports. Both of these waivers expired and on March 15,
2005, Nortel obtained a new waiver from EDC (the March Waiver).The March Waiver remained in effect until the earliest of certain events including the date on
which Nortel and NNC filed their respective Quarterly Reports on Form 10-Q for the third quarter
of 2004 and the 2004 Annual Reports, or April 30, 2005. As previously announced, Nortel and NNC
have filed the 2004 Quarterly Reports and the 2004 Annual Reports. See note 17 for additional
information relating to the delayed filings.  10.
    
    Guarantees  Nortel has entered into agreements that contain features which meet the definition of a
guarantee under FASB Interpretation No. 45, Guarantors Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness of Others  an Interpretation of
FASB Statements No. 5, 57 and 107 and Rescission of FASB Interpretation No. 34 (FIN 45). FIN
45 defines a guarantee as a contract that contingently requires Nortel to make payments (either
in cash, financial instruments, other assets, common shares of Nortel Networks Corporation or
through the provision of services) to a third party based on changes in an underlying economic
characteristic (such as interest rates or market value) that is related to an asset, a liability
or an equity security of the guaranteed party or a third partys failure to perform under a
specified agreement. A description of the major types of Nortels outstanding guarantees as of
March 31, 2005 is provided below:  (a)
    
    Business sale and business combination agreements  In connection with agreements for the sale of portions of its business, including
certain discontinued operations, Nortel has typically retained the liabilities of a business
which relate to events occurring prior to its sale, such as tax, environmental, litigation
and employment matters. Nortel generally indemnifies the purchaser of a Nortel business in
the event that a third party asserts a claim against the purchaser that relates to a
liability retained by Nortel. Some of these types of guarantees have indefinite terms while
others have specific terms extending to June 2008.Nortel also entered into guarantees related to the escrow of shares in business combinations
in prior periods. These types of agreements generally include indemnities that require
Nortel to indemnify counterparties for loss incurred from litigation that may be suffered by
counterparties arising under such agreements. These types of indemnities apply over a
specified period of time from the date of the business combinations and do not provide for
any limit on the maximum potential amount.Nortel is unable to estimate the maximum potential liability for these types of
indemnification guarantees as the business sale agreements generally do not specify a
maximum amount and the amounts are dependent upon the outcome of future contingent events,
the nature and likelihood of which cannot be determined. 22




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##### Table of Contents



Historically, Nortel has not made any significant indemnification payments under such
agreements and no significant liability has been accrued in the consolidated financial
statements with respect to the obligations associated with these guarantees.In conjunction with the sale of a subsidiary to a third party, Nortel guaranteed to the
purchaser that specified annual volume levels would be achieved by the business sold over a
ten year period ending December 31, 2007. The maximum amount that Nortel may be required to
pay under the volume guarantee as of March 31, 2005 is $9. A liability of $8 has been
accrued in the consolidated financial statements with respect to the obligation associated
with this guarantee as of March 31, 2005.  (b)
    
    Intellectual property indemnification obligations  Nortel has periodically entered into agreements with customers and suppliers that
include limited intellectual property indemnification obligations that are customary in the
industry. These types of guarantees typically have indefinite terms and generally require
Nortel to compensate the other party for certain damages and costs incurred as a result of
third party intellectual property claims arising from these transactions.The nature of the intellectual property indemnification obligations generally prevents
Nortel from making a reasonable estimate of the maximum potential amount it could be
required to pay to its customers and suppliers. Historically, Nortel has not made any
significant indemnification payments under such agreements. A liability of $6 has been
accrued in the consolidated financial statements with respect to the obligations associated
with these guarantees as of March 31, 2005.  (c)
    
    Lease agreements  Nortel has entered into agreements with its lessors that guarantee the lease payments
of certain assignees of its facilities to lessors. Generally, these lease agreements relate
to facilities Nortel vacated prior to the end of the term of its lease. These lease
agreements require Nortel to make lease payments throughout the lease term if the assignee
fails to make scheduled payments. Most of these lease agreements also require Nortel to pay
for facility restoration costs at the end of the lease term if the assignee fails to do so.
These lease agreements have expiration dates through June 2015. The maximum amount that
Nortel may be required to pay under these types of agreements is $46 as of March 31, 2005.
Nortel generally has the ability to attempt to recover such lease payments from the
defaulting party through rights of subrogation.Historically, Nortel has not made any significant payments under these types of guarantees
and no significant liability has been accrued in the consolidated financial statements with
respect to the obligations associated with these guarantees.  (d)
    
    Third party debt agreements  Nortel has guaranteed the debt of certain customers. These third party debt agreements
require Nortel to make debt payments throughout the term of the related debt instrument if
the customer fails to make scheduled debt payments. These third party debt agreements have
expiration dates extending to May 2012. The maximum amount that Nortel may be required to
pay under these types of debt agreements is $7 as of March 31, 2005. Under most such
arrangements, the Nortel guarantee is secured, usually by the assets being purchased or
financed. No liability has been accrued in the consolidated financial statements with
respect to the obligations associated with these financial guarantees as of March 31, 2005.Nortel is a full and unconditional guarantor of NNCs $1,800 4.25% Convertible Senior Notes
(Senior Notes) due September 1, 2008, in the event that NNC does not make payments for the
principal, premium, if any, interest and other amounts, if any, as they are due. The
maximum amount that Nortel may be required to pay under this guarantee is $1,800 plus the
premium, if any, and interest. No amount has been accrued in the consolidated financial
statements with respect to the obligation associated with this guarantee.  (e)
    
    Indemnification of banks and agents under EDC Support Facility and security agreements  Nortel has agreed to indemnify EDC under the EDC Support Facility against any legal
action brought against EDC that relates to the provision of support under the EDC Support
Facility. Nortel has also agreed to indemnify the collateral agent under the security
agreements against any legal action brought against the collateral
agent in connection with the collateral pledged under the security 23




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##### Table of Contents



agreements. These
indemnifications generally apply to issues that arise during the term of the credit and
support facilities, or for as long as the security agreements remain in effect (see notes 9
and 17).Nortel is unable to estimate the maximum potential liability for these types of
indemnification guarantees as the agreements typically do not specify a maximum amount and
the amounts are dependent upon the outcome of future contingent events, the nature and
likelihood of which cannot be determined at this time.Historically, Nortel has not made any significant indemnification payments under such
agreements and no significant liability has been accrued in the consolidated financial
statements with respect to the obligations associated with these indemnification guarantees.Nortel has agreed to indemnify certain of its counterparties in certain receivables
securitization transactions. The indemnifications provided to counterparties in these types
of transactions may require Nortel to compensate counterparties for costs incurred as a
result of changes in laws and regulations (including tax legislation) or in the
interpretations of such laws and regulations, or as a result of regulatory penalties that
may be suffered by the counterparty as a consequence of the transaction. Certain
receivables securitization transactions include indemnifications requiring the repurchase of
the receivables if the particular transaction becomes invalid. As of March 31, 2005, Nortel
had approximately $205 of securitized receivables which were subject to repurchase under
this provision, in which case Nortel would assume all rights to collect such receivables.
The indemnification provisions generally expire upon expiration of the securitization
agreements, which extend through 2006, or collection of the receivable amounts by the
counterparty.Nortel is generally unable to estimate the maximum potential liability for these types of
indemnification guarantees as certain agreements do not specify a maximum amount and the
amounts are dependent upon the outcome of future contingent events, the nature and
likelihood of which cannot be determined at this time.Historically, Nortel has not made any significant indemnification payments or receivable
repurchases under such agreements and no significant liability has been accrued in the
consolidated financial statements with respect to the obligations associated with these
guarantees.  (f)
    
    Other indemnification agreements  Nortel has also entered into other agreements that provide indemnifications to
counterparties in certain transactions including investment banking agreements, guarantees
related to the administration of capital trust accounts, guarantees related to the
administration of employee benefit plans, indentures for its outstanding public debt and
asset sale agreements (other than the business sale agreements noted above). These
indemnification agreements generally require Nortel to indemnify the counterparties for
costs incurred as a result of changes in laws and regulations (including tax legislation) or
in the interpretations of such laws and regulations and/or as a result of losses from
litigation that may be suffered by the counterparties arising from the transactions. These
types of indemnification agreements normally extend over an unspecified period of time from
the date of the transaction and do not typically provide for any limit on the maximum
potential payment amount.The nature of such agreements prevents Nortel from making a reasonable estimate of the
maximum potential amount it could be required to pay to its counterparties. The
difficulties in assessing the amount of liability result primarily from the unpredictability
of future changes in laws, the inability to determine how laws apply to counterparties and
the lack of limitations on the potential liability.Historically, Nortel has not made any significant indemnification payments under such
agreements and no significant liability has been accrued in the consolidated financial
statements with respect to the obligations associated with these guarantees. 24




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Product warranties  The following summarizes the accrual for product warranties that was recorded as part of
other accrued liabilities in the consolidated balance sheet as of March 31, 2005: Balance as of December 31, 2004
    
    $
    271Payments
    
    
    (56
    )Warranties issued
    
    
    42Revisions
    
    
    (3
    )Balance as of March 31, 2005
    
    $
    254
  11.
    
    Commitments  Bid, performance related and other bonds  Nortel has entered into bid, performance related and other bonds associated with various
contracts. Bid bonds generally have a term of less than twelve months, depending on the length
of the bid period for the applicable contract. Other bonds primarily relate to warranty,
rental, real estate and customs contracts. Performance related and other bonds generally have a
term of twelve months and are typically renewed, as required, over the term of the applicable
contract. The various contracts to which these bonds apply generally have terms ranging from
two to five years. Any potential payments which might become due under these bonds would be
related to Nortels non-performance under the applicable contract. Historically, Nortel has not
had to make material payments under these types of bonds and does not anticipate that any
material payments will be required in the future. The following table sets forth the maximum
potential amount of future payments under bid, performance related and other bonds, net of the
corresponding restricted cash and cash equivalents, as of the following dates: March 31,
    
    
    December 31,2005
    
    
    2004Bid and performance related bonds(a)
    
    $
    265
    
    
    $
    362Other bonds (b)
    
    
    44
    
    
    
    68Total bid, performance related and other bonds
    
    $
    309
    
    
    $
    430
 (a)
    
    Net of restricted cash and cash equivalent amounts of $38 and $36 as of March
31, 2005 and December 31, 2004, respectively.(b)
    
    Net of restricted cash and cash equivalent amounts of $35 and $28 as of March
31, 2005 and December 31, 2004, respectively.  Venture capital financing  Nortel has entered into agreements with selected venture capital firms where the venture
capital firms make and manage investments in start-ups and emerging enterprises. The agreements
require Nortel to fund requests for additional capital up to its commitments when and if
requests for additional capital are solicited by the venture capital firm. Nortel had remaining
commitments, if requested, of $15 as of March 31, 2005. These commitments expire at various
dates through 2012. 25




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##### Table of Contents



12.
    
    Financing arrangements  Customer financing  Pursuant to certain financing agreements, Nortel is committed to provide future financing
in connection with purchases of Nortels products and services. Commitments to extend future
financing generally have conditions for funding, fixed expiration or termination dates and
specific interest rates and purposes. Nortel attempts to limit its financing credit risk by
utilizing an internal credit committee that monitors the credit exposure of Nortel.The following table sets forth customer financing related information and commitments, excluding
discontinued operations, as of the following dates: March 31,
    
    
    December 31,2005
    
    
    2004Drawn and outstanding  gross
    
    $
    56
    
    
    $
    118Provisions for doubtful accounts
    
    
    (39
    )
    
    
    (38
    )Drawn and outstanding  net(a)
    
    
    17
    
    
    
    80Undrawn commitments
    
    
    64
    
    
    
    69Total customer financing
    
    $
    81
    
    
    $
    149
 (a)
    
    Included short-term and long-term amounts. Short-term and long-term amounts were
included in accounts receivable  net and other assets, respectively, in the consolidated
balance sheets.  During the three months ended March 31, 2005 and 2004, net customer financing bad debt
expense as a result of settlements and adjustments to other existing provisions was not
significant.During the three months ended March 31, 2005 and 2004, Nortel entered into certain agreements to
restructure and/or settle various customer financing and related receivables, including rights
to accrued interest. As a result of these transactions, Nortel received cash consideration of
approximately $110 ($36 of the proceeds was included in discontinued operations) and $15 to
settle outstanding receivables with a net carrying value of $100 ($33 of the net carrying value
was included in discontinued operations) and $14, respectively.During the three months ended March 31, 2005 and 2004, Nortel reduced undrawn customer financing
commitments by $5 and $114, respectively, as a result of the expiration or cancellation of
commitments and changing customer business plans. As of March 31, 2005, all undrawn commitments
were available for funding under the terms of the financing agreements.  Consolidation of variable interest entities  Certain lease financing transactions of Nortel were structured through single transaction
VIEs that did not have sufficient equity at risk as defined in FIN 46R. Effective July 1, 2003,
Nortel prospectively began consolidating two VIEs for which Nortel was considered the primary
beneficiary following the guidance of FIN 46, Consolidation of Variable Interest Entities  an
interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements
(FIN 46), on the basis that Nortel retained certain risks associated with guaranteeing
recovery of the unamortized principal balance of the VIEs debt, which represented the majority
of the risks associated with the respective VIEs activities. The amount of the guarantees will
be adjusted over time as the underlying debt matures. During the three months ended March 31,
2004, the debt related to one of the VIEs was extinguished, and as a result, consolidation of
this VIE was no longer required. As of March 31, 2005, Nortels consolidated balance sheet
included $94 of long-term debt and $93 of plant and equipment  net related to the remaining
VIE. These amounts represented both the collateral and maximum exposure to loss as a result of
Nortels involvement with the VIE.As of March 31, 2005, Nortel did not have any variable interests related to transfers of
financial assets. Nortel has other financial interests and contractual arrangements which would
meet the definition of a variable interest under FIN 46R, including investments in other
companies and joint ventures, customer financing arrangements, and guarantees and
indemnification arrangements. As of March 31, 2005, none of these interests or arrangements
were considered significant variable interests and, therefore, did not meet the requirements for
consolidation or disclosure under FIN 46R. 26




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13.
    
    Stock-based compensation plans  On March 10, 2004, Nortel announced, among other things, that it was likely that Nortel
would need to revise certain previously announced results and restate previously filed financial
results for one or more earlier periods. As a result of Nortels March 10, 2004 announcement,
Nortel suspended as of March 10, 2004: the purchase of Nortel Networks Corporation common
 shares under the stock purchase plans for eligible employees in eligible countries, and a stock
purchase plan for eligible unionized employees in Canada (collectively, the ESPPs); the
exercise of outstanding options granted under the Nortel Networks Corporation 2000 Stock Option
Plan (the 2000 Plan); Nortel Networks Corporation 1986 Stock Option Plan As Amended and
Restated (the 1986 Plan), and the grant of any additional options under those plans, or the
exercise of outstanding options granted under employee stock option plans previously assumed by
Nortel in connection with mergers and acquisitions; and the purchase of units in a Nortel stock
fund or purchase of Nortel Networks Corporation common shares under Nortels defined
contribution and investment plans, until such time, at the earliest, that Nortel and NNC are in
compliance with U.S. and Canadian regulatory securities filing requirements.Effective January 1, 2003, Nortel elected to adopt the fair value based method for measurement
and recognition of all stock-based compensation prospectively for all awards granted, modified,
or settled on or after January 1, 2003 in
accordance with SFAS 148. Prior to January 1, 2003, Nortel, as permitted under SFAS 123, applied
the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees, and related interpretations in accounting for its employee
stock-based compensation plans.The fair value at grant date of stock options is estimated using the Black-Scholes-Merton
option-pricing model. Compensation expense is recognized on a straight-line basis over the
stock option vesting period. Adjustments to compensation expense due to not meeting employment
vesting requirements are accounted for in the period when they occur.Pro forma disclosureHad Nortel applied the fair value method to all stock-based compensation awards in all periods,
reported net earnings (loss) applicable to common shares would have been adjusted to
the pro forma amounts indicated below for the three months ended: March 31,
    
    
    March 31,2005
    
    
    2004Net earnings (loss) applicable to common shares  as reported
    
    $
    (16
    )
    
    $
    108Stock-based compensation  reported
    
    
    18
    
    
    
    58Stock-based compensation  pro forma (a)
    
    
    (25
    )
    
    
    (73
    )Net earnings (loss) applicable to common shares  pro forma
    
    $
    (23
    )
    
    $
    93
 (a)
    
    Stock-based compensation  pro forma expense was net of tax of nil in each period.  The following table presents stock-based compensation recorded for the three months ended: March 31,
    
    
    March 31,2005
    
    
    2004Stock-based compensation:Stock option expense
    
    $
    19
    
    
    $
    15Employer portion of ESPPs(a)
    
    
    
    
    
    
    Restricted Stock Units expense (a)
    
    
    
    
    
    
    41Deferred Stock Units expense(a)
    
    
    (1
    )
    
    
    2Total stock-based compensation reported  net of tax
    
    $
    18
    
    
    $
    58
 (a)
    
    Compensation related to employer portion of ESPPs, Restricted Stock Units (RSUs) and
Deferred Stock Units (DSUs) was net of tax of nil in each period. 27




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During the three months ended March 31, 2004, approximately 38 million stock options were
granted. No stock options were granted during the three months ended March 31, 2005. The
following weighted-average assumptions were used in computing the fair value of stock options
for purposes of expense recognition and pro forma disclosures, as applicable, for the three
months ended: March 31,2004Black-Scholes weighted-average assumptionsExpected dividend yield
    
    
    0.00
    %Expected volatility
    
    
    94.47
    %Risk-free interest rate
    
    
    2.96
    %Expected option life in years
    
    
    4Weighted-average stock option fair value
per option granted
    
    $
    5.21
  14.
    
    Comprehensive income (loss)  The following are the components of comprehensive income (loss), net of tax, for each of
the three months ended: March 31,
    
    
    March 31,2005
    
    
    2004Net earnings (loss)
    
    $
    (7
    )
    
    $
    117Other comprehensive income (loss) adjustments:Change in foreign currency translation adjustment(a)
    
    
    (258
    )
    
    
    (4
    )Unrealized gain (loss) on investments  net (b)
    
    
    (7
    )
    
    
    (19
    )Minimum pension liability adjustment  net
    
    
    2
    
    
    
    1Unrealized derivative gain (loss) on cash flow hedges  net (c)
    
    
    (8
    )
    
    
    (6
    )Comprehensive income (loss)
    
    $
    (278
    )
    
    $
    89
 (a)
    
    The change in the foreign currency translation adjustment was not adjusted for income
taxes since it related to indefinite term investments in non-U.S. subsidiaries. The change
in foreign currency translation adjustment includes $187 released due to a divestiture in the
first quarter of 2005.(b)
    
    Certain securities deemed available-for-sale by Nortel were measured at fair value.
Unrealized holding gains (losses) related to these securities were excluded from net
earnings (loss) and were included in accumulated other comprehensive income (loss) until
realized. Unrealized gain (loss) on investments was net of tax of nil and nil for the
three months ended March 31, 2005 and 2004, respectively.(c)
    
    During the three months ended March 31, 2005 and 2004, net derivative gains of $8 and
$3, respectively, were reclassified to other income (expense)  net. Nortel estimates that
$9 of net derivative gains (losses) included in accumulated other comprehensive loss will
be reclassified into net earnings (loss) within the next 12 months.  15.
    
    Related party transactions  In the ordinary course of business, Nortel engages in transactions with certain of its
equity-owned investees that are under or are subject to Nortels significant influence and with
joint ventures of NNC and with NNC and directly owned subsidiaries of NNC. These transactions
are sales and purchases of goods and services under usual trade terms and are measured at their
exchange amounts.Balances with related parties were as follows: March 31,
    
    
    December 31,2005
    
    
    2004Consolidated balance sheetsOwing from NNC
    
    $
    131
    
    
    $
    134Owing from NNC subsidiaries
    
    
    128
    
    
    
    114Other related parties (a)
    
    
    
    
    
    
    (5
    )Related party receivables
    
    $
    259
    
    
    $
    243
 (a)
    
    Nortel purchases certain inventory for its Carrier Packet Networks business from
Bookham, Inc. (Bookham), a related party due to Nortels equity interest in Bookham.
Nortel has certain notes receivable due from Bookham with a carrying amount of $19 and $20
as of March 31, 2005 and December 31, 2004, respectively. 28




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Bookham is a sole supplier of key optical components to Nortels optical networks solutions
in its Carrier Packet Networks segment. During the three months ended March 31, 2005 and 2004,
Nortels aggregate purchases from Bookham were $4 and $19, respectively. As of March 31, 2005
and December 31, 2004, accounts payable to Bookham were nil and $5, respectively.On December 2, 2004, Nortel and Bookham entered into a restructuring agreement which, among
other changes, extended the maturity date of a senior secured note (the Series B Note) by one
year from November 8, 2005 to November 8, 2006, and eliminated the conversion feature of a
senior unsecured note (the Series A Note). Bookham also agreed to secure the Series A Note,
provide additional collateral for the Series A Note and the Series B Note, and provide Nortel
with other debt protection covenants.In February 2005, Nortel agreed to waive until November 6, 2006 the requirement under the Series
A Note and Series B Note for Bookham to maintain a minimum cash balance. In May 2005, Nortel
entered into an amendment to adjust the prepayment provisions of
these notes and received additional collateral for these notes. In May 2005, Nortel entered into an amendment to its
supply agreement with Bookham to include for a twelve month period price increases for certain
products, and acceleration of certain planned purchase orders and invoice payment terms. These
May 2005 amendments were agreed to by Nortel to provide Bookham with financial
flexibility to continue the supply of optical components for Nortels Carrier Packet Networks
products.  16.
    
    Contingencies  Subsequent to the February 15, 2001 announcement in
which NNC provided revised guidance
for financial performance for the 2001 fiscal year and the first
quarter of 2001, NNC and
certain of its then current officers and directors were named as defendants in more than
twenty-five purported class action lawsuits. These lawsuits in the U.S. District Courts for the
Eastern District of New York, for the Southern District of New York and for the District of New
Jersey and in courts in the provinces of Ontario, Quebec and British Columbia in Canada, on behalf of
shareholders who acquired Nortel Networks Corporation securities as early as October 24, 2000
and as late as February 15, 2001, allege, among other things, violations of U.S. federal and
Canadian provincial securities laws. These matters also have been the subject of review by
Canadian and U.S. securities regulatory authorities. On May 11, 2001, the defendants filed
motions to dismiss and/or stay in connection with the three proceedings in Quebec primarily
based on the factual allegations lacking substantial connection to Quebec and the inclusion of
shareholders resident in Quebec in the class claimed in the Ontario lawsuit. The plaintiffs in
two of these proceedings in Quebec obtained court approval for discontinuances of their
proceedings on January 17, 2002. The motion to dismiss and/or stay the third proceeding was
heard on November 6, 2001 and the court deferred any determination on the motion to the judge
who will hear the application for authorization to commence a class proceeding. On December 6,
2001, the defendants filed a motion seeking leave to appeal that decision. The motion for leave
to appeal was dismissed on March 11, 2002. On October 16, 2001, an order in the Southern
District of New York was filed consolidating twenty-five of the related U.S. class action
lawsuits into a single case, appointing class plaintiffs and counsel for such plaintiffs. The
plaintiffs served a consolidated amended complaint on January 18, 2002. On December 17, 2001,
the defendants in the British Columbia action served notice of a motion requesting the court to
decline jurisdiction and to stay all proceedings on the grounds that British Columbia is an
inappropriate forum. The motion has been adjourned at the plaintiffs request to a future date
to be set by the parties.A class action lawsuit against NNC was also filed in the U.S. District Court for the Southern
District of New York on behalf of shareholders who acquired the securities of JDS Uniphase
Corporation (JDS) between January 18, 2001 and February 15, 2001, alleging violations of the
same U.S. federal securities laws as the above-noted lawsuits.On April 1, 2002, NNC filed a motion to dismiss both the above consolidated U.S. shareholder
class action and the above JDS shareholder class action complaints on the grounds that they
failed to state a cause of action under U.S. federal securities laws. With respect to the JDS
shareholder class action complaint, NNC also moved to dismiss on the separate basis that JDS
shareholders lacked standing to sue NNC. On January 3, 2003, the District Court granted the
motion to dismiss the JDS shareholder class action complaint and denied the motion to dismiss
the consolidated U.S. class action complaint. Plaintiffs appealed the dismissal of the JDS
shareholder class action complaint. On November 19, 2003, oral argument was held before the
U.S. Court of Appeals for the Second Circuit on the JDS shareholders appeal of the dismissal of
their complaint. On May 19, 2004, the Second Circuit issued an opinion affirming the dismissal
of the JDS shareholder class action complaint and on July 14, 2004 the Second Circuit denied
plaintiffs motion for rehearing. On October 12, 2004, the plaintiffs filed a petition for writ
of certiorari in the U.S. Supreme Court. On November 12, 2004, the defendants filed Brief for
the Respondents in Opposition, and on November 22, 2004, the plaintiffs filed Reply to Brief in
Opposition. On January 10, 2005, the U.S. Supreme Court denied the petition for writ of
certiorari. With respect to the consolidated U.S. shareholder class action, the plaintiffs
served a motion for class certification on March 21, 2003. On May 30, 2003, the defendants
served an 29




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opposition to the motion for class certification. Plaintiffs reply was served on
August 1, 2003. The District Court held oral arguments on September 3, 2003 and issued an order
granting class certification on September 5, 2003. On September 23, 2003, the defendants filed
a motion in the Second Circuit for permission to appeal the class certification decision. The
plaintiffs opposition to the motion was filed on October 2, 2003. On November 24, 2003, the
Second Circuit denied the motion. On March 10, 2004, the District Court approved the form of
notice to the class which was published and mailed.On July 17, 2002, a new purported class action lawsuit (the Ontario Claim) was filed in the
Ontario Superior Court of Justice, Commercial List, naming NNC, certain of its current and
former officers and directors and its auditors as defendants. The factual allegations in the
Ontario Claim are substantially similar to the allegations in the consolidated amended complaint
filed in the U.S. District Court described above. The Ontario Claim is on behalf of all
Canadian
residents who purchased Nortel Networks Corporation securities (including options on Nortel
Networks Corporation securities) between October 24, 2000 and February 15, 2001. The plaintiffs
claim damages of Canadian $5,000, plus punitive damages in the amount of Canadian $1,000,
prejudgment and postjudgment interest and costs of the action. On September 23, 2003, the Court
issued an order allowing the plaintiffs to proceed to amend the Ontario Claim and requiring that
the plaintiffs serve class certification materials by December 15, 2003. On September 24, 2003,
the plaintiffs filed a notice of discontinuance of the original action filed in Ontario. On
December 12, 2003, plaintiffs counsel requested an extension of time to January 21, 2004 to
deliver class certification materials. On January 21, 2004, plaintiffs counsel advised the
Court that the two representative plaintiffs in the action no longer wished to proceed, but
counsel was prepared to deliver draft certification materials pending the replacement of the
representative plaintiffs. On February 19, 2004, the plaintiffs counsel advised the Court of a
potential new representative plaintiff. On February 26, 2004, the defendants requested the
Court to direct the plaintiffs counsel to bring a motion to permit the withdrawal of the
current representative plaintiffs and to substitute the proposed representative plaintiff. On
June 8, 2004, the Court signed an order allowing a Second Fresh as Amended Statement of Claim
that substituted one new representative plaintiff, but did not change the substance of the prior
claim.A purported class action lawsuit was filed in the U.S. District Court for the Middle District of
Tennessee on December 21, 2001, on behalf of participants and beneficiaries of the Nortel
Long-Term Investment Plan (the Plan) at any time during the period of March 7, 2000 through
the filing date and who made or maintained Plan investments in Nortel Networks Corporation
common shares, under the Employee Retirement Income Security Act (ERISA) for Plan-wide relief
and alleging, among other things, material misrepresentations and omissions to induce Plan
participants to continue to invest in and maintain investments in Nortel Networks Corporation
common shares in the Plan. A second purported class action lawsuit, on behalf of the Plan and
Plan participants for whose individual accounts the Plan purchased Nortel Networks Corporation
common shares during the period from October 27, 2000 to February 15, 2001 and making similar
allegations, was filed in the same court on March 12, 2002. A third purported class action
lawsuit, on behalf of persons who are or were Plan participants or beneficiaries at any time
since March 1, 1999 to the filing date and making similar allegations, was filed in the same
court on March 21, 2002. The first and second purported class action lawsuits were consolidated
by a new purported class action complaint, filed on May 15, 2002 in the same court and making
similar allegations, on behalf of Plan participants and beneficiaries who directed the Plan to
purchase or hold shares of certain funds, which held primarily Nortel Networks Corporation
common shares, during the period from March 7, 2000 through December 21, 2001. On September 24,
2002, plaintiffs in the consolidated action filed a motion to consolidate all the actions and to
transfer them to the U.S. District Court for the Southern District of New York. The plaintiffs
then filed a motion to withdraw the pending motion to consolidate and transfer. The withdrawal
was granted by the District Court on December 30, 2002. A fourth purported class action
lawsuit, on behalf of the Plan and Plan participants for whose individual accounts the Plan held
Nortel Networks Corporation common shares during the period from March 7, 2000 through March 31,
2001 and making similar allegations, was filed in the U.S. District Court for the Southern
District of New York on March 12, 2003. On March 18, 2003, plaintiffs in the fourth purported
class action filed a motion with the Judicial Panel on Multidistrict Litigation to transfer all
the actions to the U.S. District Court for the Southern District of New York for coordinated or
consolidated proceedings pursuant to 28 U.S.C. section 1407. On June 24, 2003, the Judicial
Panel on Multidistrict Litigation issued a transfer order transferring the Southern District of
New York action to the U.S. District Court for the Middle District of Tennessee (the
Consolidated ERISA Action). On September 12, 2003, the plaintiffs in all the actions filed a
consolidated class action complaint. On October 28, 2003, the defendants filed a motion to
dismiss the complaint and a motion to stay discovery pending disposition of the motion to
dismiss. On March 30, 2004, the plaintiffs filed a motion for certification of a class
consisting of participants in, or beneficiaries of, the Plan who held
shares of the NNC Stock
Fund during the period from March 7, 2000 through March 31, 2001. On April 27, 2004, the Court
granted the defendants motion to stay discovery pending resolution of defendants motion to
dismiss. On June 15, 2004, the plaintiffs filed a First Amended Consolidated Class Action
Complaint that added additional current and former officers and employees as defendants and
expanded the purported class period to extend from March 7, 2000 through to June 15, 2004. 30




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Subsequent to the March 10, 2004 announcement in which
NNC indicated it was likely that it
would need to revise its previously announced unaudited results for the year ended December 31,
2003, and the results reported in certain of its quarterly reports for 2003, and to restate its
previously filed financial results for one or more earlier periods,
NNC and certain of its
then current and former officers and directors were named as defendants in 27 purported class
action lawsuits. These lawsuits in the U.S. District Court for the Southern District of New
York on behalf of shareholders who acquired Nortel Networks Corporation securities as early as
February 16, 2001 and as late as May 15, 2004, allege, among other things, violations of U.S.
federal securities laws. These matters are also the subject of investigations by Canadian and
U.S. securities regulatory and criminal investigative authorities. On June 30, 2004, the Court
signed Orders consolidating the 27 class actions and appointing lead plaintiffs and lead
counsel. The plaintiffs filed a consolidated class action complaint on September 10, 2004,
alleging a class period of April 24, 2003 through and
including April 27, 2004. On November 5, 2004, Nortel Networks Corporation and the Audit
Committee Defendants filed a motion to dismiss the consolidated class action complaint. On
January 18, 2005, the lead plaintiffs, NNC and the Audit Committee Defendants reached an
agreement in which NNC would withdraw its motion to dismiss and plaintiffs would dismiss
Count II of the complaint which asserts a claim against the Audit Committee Defendants. On May
13, 2005, the plaintiffs filed a motion for class certification.On April 5, 2004, NNC announced that the SEC had issued a formal order of investigation in
connection with NNCs previous restatement of its financial results for certain periods, as
announced in October 2003, and NNCs announcements in March 2004 regarding the likely need to
revise certain previously announced results and restate previously filed financial results for
one or more periods. The matter had been the subject of an informal SEC inquiry. On April 13,
2004, NNC announced that it had received a letter from the staff of the Ontario Securities
Commission (OSC) advising that there is an OSC Enforcement Staff investigation into the same
matters that are the subject of the SEC investigation.On May 14, 2004, NNC announced that it had received a federal grand jury subpoena for the
production of certain documents, including financial statements and corporate, personnel and
accounting records, in connection with an ongoing criminal investigation being conducted by the
U.S. Attorneys Office for the Northern District of Texas, Dallas Division.On May 18, 2004, a purported class action lawsuit was filed in the U.S. District Court for the
Middle District of Tennessee on behalf of individuals who were participants and beneficiaries of
the Plan at any time during the period of December 23, 2003 through the filing date and who made
or maintained Plan investments in Nortel Networks Corporation common shares, under the ERISA for
Plan-wide relief and alleging, among other things, breaches of fiduciary duty. On September 3,
2004, the Court signed a stipulated order consolidating this action with the Consolidated ERISA
Action described above. On June 16, 2004, a second purported class action lawsuit, on behalf of
the Plan and Plan participants for whose individual accounts the Plan purchased Nortel Networks
Corporation common shares during the period from October 24, 2000 to June 16, 2004, and making
similar allegations, was filed in the U.S. District Court for the Southern District of New York.
On August 6, 2004, the Judicial Panel on Multidistrict Litigation issued a conditional transfer
order to transfer this action to the U.S. District Court for the Middle District of Tennessee
for coordinated or consolidated proceedings pursuant to 28 U.S.C. section 1407 with the
Consolidated ERISA Action described above. On August 20, 2004, plaintiffs filed a notice of
opposition to the conditional transfer order with the Judicial Panel. On December 6, 2004, the
Judicial Panel denied the opposition and ordered the action transferred to the U.S. District
Court for the Middle District of Tennessee for coordinated or consolidated proceedings with the
Consolidated ERISA Action described above. On January 3, 2005, this action was received in the
U.S. District Court for the Middle District of Tennessee and consolidated with the Consolidated
ERISA Action described above.On July 28, 2004, Nortel and NNC, and certain directors and officers, and certain former
directors and officers, of Nortel and NNC, were named as defendants in a purported class
proceeding in the Ontario Superior Court of Justice on behalf of shareholders who acquired
Nortel Networks Corporation securities as early as November 12, 2002 and as late as July 28,
2004. This lawsuit alleges, among other things, breaches of trust and fiduciary duty,
oppressive conduct and misappropriation of corporate assets and trust property in respect of the
payment of cash bonuses to executives, officers and employees in 2003
and 2004 under the NNC
Return to Profitability bonus program and seeks damages of Canadian $250 and an order under the
Canada Business Corporations Act directing that an investigation be made respecting these bonus
payments.On July 30, 2004, a shareholders derivative complaint was filed in the U.S. District Court for
the Southern District of New York against certain directors and officers, and certain former
directors and officers, of NNC alleging, among other things, breach of fiduciary duties owed
to NNC during the period from 2000 to 2003 including by causing NNC to engage in unlawful
conduct or failing to prevent such 31




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conduct; causing NNC to issue false statements; and
violating the law. On February 14, 2005, the defendants filed motions to dismiss the derivative
complaint. On April 29, 2005, the plaintiffs filed an opposition to the motions to dismiss.On August 16, 2004, NNC received a letter from the Integrated Market Enforcement Team of the
Royal Canadian Mounted Police (RCMP) advising NNC that the RCMP would be commencing a
criminal investigation into Nortel and NNCs financial accounting situation.On February 16, 2005, a motion for authorization to institute a class action on behalf of
residents of Québec, who purchased NNC securities between January 29, 2004 and March 15,
2004, was filed in the Québec Superior Court naming NNC as a defendant. The motion alleges
that NNC made misrepresentations about 2003 financial results.On March 9, 2005, Nortel and NNC, and certain of its current and former officers and directors
and its auditors were named as defendants in a purported class action proceeding filed in the
Ontario Superior Court of Justice, Commercial List, on behalf of all Canadian residents who
purchased Nortel Networks Corporation securities from April 24, 2003 to April 27, 2004. This
lawsuit alleges, among other things, negligence, misrepresentations, oppressive conduct, insider
trading and violations of Canadian corporation and competition laws in connection with NNCs
2003 financial results and seeks damages of Canadian $3,000, plus punitive damages in the amount
of Canadian $1,000, prejudgment and postjudgment interest and costs of the action.Except as otherwise described herein, in each of the matters described above, the plaintiffs are
seeking an unspecified amount of monetary damages.Nortel is also a defendant in various other suits, claims, proceedings and investigations which
arise in the normal course of business.Nortel and NNC are unable to ascertain the ultimate aggregate amount of monetary liability or financial
impact to Nortel of the above matters which, unless otherwise specified, seek damages from the
defendants of material or indeterminate amounts or could result in fines and penalties. Nortel
cannot determine whether these actions, suits, claims and proceedings will, individually or
collectively, have a material adverse effect on the business, results of operations, financial
condition and liquidity of Nortel and NNC. Nortel or NNC, as
applicable, and any named directors and officers of Nortel or NNC, as
applicable, intend
to vigorously defend these actions, suits, claims and proceedings.
Nortel and NNC will continue to
cooperate fully with all authorities in connection with the regulatory and criminal
investigations.  Environmental matters  Nortels operations are subject to a wide range of environmental laws in various
jurisdictions around the world. Nortel seeks to operate its business in compliance with such
laws. In 2004, Nortel became subject to new European product content laws and product takeback
and recycling requirements that will require full compliance by 2006. It is expected that these
laws will require Nortel to incur additional compliance costs. Although costs relating to
environmental matters have not resulted in a material adverse effect on the business, results of
operations, financial condition and liquidity in the past, there can be no assurance that Nortel
will not be required to incur such costs in the future. Nortel has a corporate environmental
management system standard and an environmental program to promote such compliance. Moreover,
Nortel has a periodic, risk-based, integrated environment, health and safety audit program.Nortels environmental program focuses its activities on design for the environment, supply
chain and packaging reduction issues. Nortel works with its suppliers and other external groups
to encourage the sharing of non-proprietary information on environmental research.Nortel is exposed to liabilities and compliance costs arising from its past and current
generation, management and disposal of hazardous substances and wastes. As of March 31, 2005,
the accruals on the consolidated balance sheet for environmental matters were $30. Based on
information available as of March 31, 2005, management believes that the existing accruals are
sufficient to satisfy probable and reasonably estimable environmental liabilities related to
known environmental matters. Any additional liabilities that may result from these matters, and
any additional liabilities that may result in connection with other locations currently under
investigation, are not expected to have a material adverse effect on the business, results of
operations, financial condition and liquidity of Nortel. 32




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Nortel has remedial activities under way at 12 sites which are either currently or previously
owned or occupied facilities. An estimate of Nortels anticipated remediation costs associated
with all such sites, to the extent probable and reasonably estimable, is included in the
environmental accruals referred to above in an approximate amount of $30.Nortel is also listed as a potentially responsible party under the U.S. Comprehensive
Environmental Response, Compensation and Liability Act (CERCLA) at six Superfund sites in the
U.S. An estimate of Nortels share of the anticipated remediation costs associated with such
Superfund sites is expected to be de minimis and is included in the environmental accruals of
$30 referred to above.Liability under CERCLA may be imposed on a joint and several basis, without regard to the extent
of Nortels involvement. In addition, the accuracy of Nortels estimate of environmental
liability is affected by several uncertainties such as additional requirements which may be
identified in connection with remedial activities, the complexity and
evolution of environmental laws and regulations, and the identification of presently unknown
remediation requirements. Consequently, Nortels liability could be greater than its current
estimate.  Other  In August 2004, Nortel entered into a contract with Bharat Sanchar Nigram Limited (BSNL)
to establish a wireless network in India for total expected revenues
of approximately $500 to be recognized substantially in 2005. This
resulted in a project loss of approximately $160 in 2004. Nortel expects to record an
additional loss of approximately $20 substantially in the second quarter of 2005 as a result of
additional orders received in that period. The losses on this contract are primarily driven by
the pricing pressures as a result of the competitive nature of Indias telecom market and also
Nortels start up costs to become a significant GSM vendor in this market.In addition to the orders under the existing contract, BSNL may increase the amounts purchased
under the contract up to an additional 50% of the existing contract level to allow for business
expansion. Nortel expects that there is the potential for further product losses, which will be
determined by the product mix and magnitude of additional orders.  17.
    
    Subsequent events  EDC Support Facility  On April 14, 2005, Nortel and NNC announced that the
filing of Nortels and NNCs Quarterly Reports on
Form 10-Q for the first quarter of 2005 (the 2005 First
Quarter Reports) were
expected to be delayed and that, if necessary, Nortel intended to seek a new waiver from EDC in
connection with such delay.On April 29, 2005, Nortel obtained a new waiver from EDC (the April Waiver) of certain
defaults and related breaches by Nortel under the EDC Support Facility. The April Waiver
remains in effect until the earliest of certain events including the date on which Nortel and
NNC have filed the 2004 Annual Reports and the 2005 First Quarter Reports, or May 31, 2005.On May 31, 2005, Nortel obtained a permanent waiver from EDC (the Permanent Waiver) of certain
defaults and the Related Breaches by Nortel under the EDC Support Facility. With the filing of
the 2005 First Quarter Reports and the Permanent Waiver, Nortel will be in compliance with its
obligations under the EDC Support Facility.As of May 16, 2005, there was approximately $228 of outstanding support utilized under the EDC
Support Facility, approximately $160 of which was outstanding under the small bond sub-facility.  Debt securities  As a result of the delay in filing the Reports and the 2005 First Quarter Reports, Nortel
and NNC were not in compliance with their obligations to deliver their respective SEC filings to
relevant parties under Nortels and NNCs public debt indentures.With the filing of the 2005 First Quarter Reports with the SEC and the delivery of the 2005
First Quarter Reports to the trustees under Nortels and NNCs public debt indentures, Nortel
and NNC will be in compliance with their delivery obligations under the public debt indentures. 33




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Stock exchanges  As a result of the delay in filing the Reports and the 2005 First Quarter Reports, Nortel
was in breach of the continued listing requirements of the New York Stock Exchange (NYSE) and
Toronto Stock Exchange (TSX). With the filing and delivery of the 2005 First Quarter Reports,
Nortel will be in compliance with the continued listing requirements of the NYSE and TSX.  Other  On April 26, 2005, Nortel announced that NNI, a wholly owned subsidiary of Nortel, had
entered into an agreement with PEC Solutions, Inc. (PEC) providing for the acquisition of all
of the outstanding shares of PEC for $15.50 per share in cash, or approximately $448 (net of
cash acquired), plus transaction costs and expenses. The acquisition
is subject to certain conditions, including the successful completion of a tender offer and
regulatory approvals. Nortel currently expects to complete the acquisition during the second
quarter of 2005.On May 20, 2005, Nortel announced the signing of an agreement with International Business
Machines (IBM), designed to support customized products across a range of market segments.
Nortel will establish a Nortel-IBM Joint Development Center to collaborate on the design and
development of new products and services.  18.
    
    Reconciliation from U.S. GAAP to Canadian GAAP  New Canadian regulations allow issuers that are required to file reports with the SEC, upon
meeting certain conditions, to satisfy their Canadian continuous disclosure obligations by using
financial statements prepared in accordance with U.S. GAAP. Accordingly, for fiscal 2005 and
2004, Nortel is including in the notes to its consolidated financial statements a reconciliation
highlighting the material differences between its financial statements prepared in accordance
with U.S. GAAP as compared to financial statements prepared in accordance with accounting
principles generally accepted in Canada (Canadian GAAP). Subsequent to 2005, no further
reconciliation will be required under current Canadian regulations. Prior to 2004, Nortel
prepared financial statements (with accompanying notes) and Managements Discussion and Analysis
  Canadian Supplement in accordance with Canadian GAAP and Canadian securities regulations, all
of which were presented as a separate report and filed with the relevant Canadian securities
regulators in compliance with its Canadian continuous disclosure obligations.The consolidated financial statements of Nortel have been prepared in accordance with U.S. GAAP
and the accounting rules and regulations of the SEC which differ in certain material respects
from those principles and practices that Nortel would have followed had its consolidated
financial statements been prepared in accordance with Canadian GAAP. The following is a
reconciliation of the net earnings (loss) between U.S. GAAP and Canadian GAAP for the three
months ended March 31, 2005 and 2004 and accumulated deficit as of March 31, 2005 and 2004: March 31,
    
    
    March 31,2005
    
    
    2004Net earnings (loss)U.S. GAAP
    
    $
    (7
    )
    
    $
    117Derivative accounting (b) ((h)(i))
    
    
    (4
    )
    
    
    26Other
    
    
    2
    
    
    
    4Canadian GAAP
    
    $
    (9
    )
    
    $
    147Accumulated deficitBalance at the beginning of the period
    
    $
    (18,558
    )
    
    $
    (18,656
    )Net earnings (loss)
    
    
    (9
    )
    
    
    147Dividends on preferred shares
    
    
    (9
    )
    
    
    (9
    )Deficit at the end of the period
    
    $
    (18,576
    )
    
    $
    (18,518
    )
 34




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##### Table of Contents



The following details the material differences between U.S. GAAP and Canadian GAAP for
balance sheet information as of March 31, 2005 and December 31, 2004: March 31, 2005
    
    
    December 31, 2004U.S.
    
    
    
    
    
    
    Canadian
    
    
    U.S.
    
    
    
    
    
    
    CanadianGAAP
    
    
    Adjustments
    
    
    GAAP
    
    
    GAAP
    
    
    Adjustments
    
    
    GAAPASSETSCurrent assets (f)
    
    $
    8,497
    
    
    $
    6
    
    
    $
    8,503
    
    
    $
    8,511
    
    
    $
    5
    
    
    $
    8,516Investments (c) (f)
    
    
    148
    
    
    
    (10
    )
    
    
    138
    
    
    
    159
    
    
    
    (16
    )
    
    
    143Plant and equipment  net
    
    
    1,591
    
    
    
    (4
    )
    
    
    1,587
    
    
    
    1,646
    
    
    
    (1
    )
    
    
    1,645Goodwill (a)
    
    
    2,080
    
    
    
    (910
    )
    
    
    1,170
    
    
    
    2,123
    
    
    
    (910
    )
    
    
    1,213Intangible assets  net (g)
    
    
    75
    
    
    
    (40
    )
    
    
    35
    
    
    
    78
    
    
    
    (40
    )
    
    
    38Deferred income taxes  net (g)
    
    
    3,706
    
    
    
    (215
    )
    
    
    3,491
    
    
    
    3,736
    
    
    
    (220
    )
    
    
    3,516Other assets (b) (g)
    
    
    671
    
    
    
    20
    
    
    
    691
    
    
    
    691
    
    
    
    (20
    )
    
    
    671Total assets
    
    $
    16,768
    
    
    $
    (1,153
    )
    
    $
    15,615
    
    
    $
    16,944
    
    
    $
    (1,202
    )
    
    $
    15,742LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities (f)
    
    $
    6,241
    
    
    $
    4
    
    
    $
    6,245
    
    
    $
    5,132
    
    
    $
    (42
    )
    
    $
    5,090Long-term debt (b)
    
    
    771
    
    
    
    (16
    )
    
    
    755
    
    
    
    2,062
    
    
    
    (26
    )
    
    
    2,036Deferred income taxes  net (g)
    
    
    143
    
    
    
    13
    
    
    
    156
    
    
    
    143
    
    
    
    14
    
    
    
    157Other liabilities (b) (g)
    
    
    3,464
    
    
    
    (1,364
    )
    
    
    2,100
    
    
    
    3,189
    
    
    
    (1,362
    )
    
    
    1,827Total liabilities
    
    
    10,619
    
    
    
    (1,363
    )
    
    
    9,256
    
    
    
    10,526
    
    
    
    (1,416
    )
    
    
    9,110Minority interests in subsidiary companies
    
    
    93
    
    
    
    
    
    
    
    93
    
    
    
    94
    
    
    
    
    
    
    
    94Total shareholders equity(b) (c) (f) (g)
    
    
    6,056
    
    
    
    210
    
    
    
    6,266
    
    
    
    6,324
    
    
    
    214
    
    
    
    6,538Total liabilities and shareholders equity
    
    $
    16,768
    
    
    $
    (1,153
    )
    
    $
    15,615
    
    
    $
    16,944
    
    
    $
    (1,202
    )
    
    $
    15,742
  There were no material differences between U.S. GAAP and Canadian GAAP affecting statements
of cash flows for the three months ended March 31, 2005 and 2004.The significant differences between U.S. GAAP and Canadian GAAP that impact the consolidated
financial statements of Nortel include the following:  (a)
    
    Business combinations  All of Nortels business combinations have been accounted for using the purchase
method. Until June 30, 2001, under Canadian GAAP, when common share consideration was
involved, the purchase price of Nortels acquisitions was determined based on the average
trading price per Nortel Networks Corporation common share for a reasonable period before
and after the date the transaction was closed. Under U.S. GAAP, when common share
consideration was involved, the purchase price of the acquisitions was determined based on
the average price per Nortel Networks Corporation common share for a reasonable period
before and after the date the acquisition was announced or the date on which the exchange
ratio became fixed. After June 30, 2001, treatment under Canadian GAAP was the same as
under U.S. GAAP for measurement of share consideration. As a result of the difference
between Canadian GAAP and U.S. GAAP until June 30, 2001, the value of purchase price
consideration assigned to acquisitions may have varied significantly depending on the length
of time between the announcement date and the closing date of the transaction and the
volatility of Nortel Networks Corporation common share price within that time frame.Stock options assumed on acquisitions were recorded at fair value for acquisitions on or
after July 1, 2000 under U.S. GAAP, and for acquisitions on or after July 1, 2001 under
Canadian GAAP. Beginning with acquisitions completed subsequent to July 1, 2000, U.S. GAAP
requires an allocation of a portion of the purchase price to deferred compensation related
to the intrinsic value of unvested options held by employees of the companies acquired. The
deferred compensation is amortized to net earnings (loss) based on the remaining vesting
period of the option awards. With the adoption of The Canadian Institute of Chartered
Accountants (CICA) Handbook Section 3870, Stock-based Compensation and Other Stock-based
Payments, on January 1, 2002, unearned compensation is recorded on unvested options held by
employees of acquired companies. Previously, there was no requirement to record deferred
compensation in respect of such unvested options under Canadian GAAP. Nortel has not
completed any acquisitions subsequent to January 1, 2002. The difference in accounting for
options assumed or issued to the value ascribed under U.S. GAAP, as part of acquisitions
discussed above, can result in a different balance being ascribed to goodwill under U.S.
GAAP. 35




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The potential differences in the initial measurement of goodwill in business combinations
under Canadian GAAP and U.S. GAAP may result in a difference in the amount of any subsequent
goodwill impairment charge. Effective January 1, 2002, under both U.S. GAAP and Canadian
GAAP, the method used in accounting for goodwill changed from an amortization method to an
impairment only method, thereby eliminating any impact on net earnings (loss) due to the
amortization of different amounts of goodwill during these periods.  (b)
    
    Derivative accounting  Under U.S. GAAP, effective January 1, 2001, Nortel adopted SFAS 133, which was
subsequently amended by SFAS No. 138, Accounting for Certain Derivative Instruments and
Certain Hedging Activities  an Amendment of SFAS No. 133, and SFAS No. 149, Amendment of
Statement 133 on Derivative Instruments and Hedging Activities. Under Canadian GAAP, gains
and losses on derivatives that are designated as hedges and that manage the underlying risks
of anticipated transactions are not recorded until the underlying hedged item is recorded in
net earnings (loss) and hedge ineffectiveness is not recorded until settlement. Under U.S.
GAAP, the accounting for changes in the fair value of a derivative depends on the intended
use of the derivative and the resulting designation. For fair value hedges, changes in the
fair value of the derivative and of the hedged item attributable to the hedged risk are
reported in net earnings (loss) from continuing operations immediately. For cash flow
hedges, the effective portion of the gains or losses is reported as a component of other
comprehensive income (loss) and the ineffective portion is reported in net earnings (loss)
from continuing operations immediately. Foreign currency hedges can be either fair value
hedges or cash flow hedges and are accounted for accordingly.Under U.S. GAAP, an embedded derivative is accounted for at fair value separate from the
host contract when certain specified conditions are met. Under Canadian GAAP, embedded
derivatives are not accounted for separately from the host contract.  (c)
    
    Investments  Under U.S. GAAP, certain investment securities deemed available-for-sale by Nortel are
re-measured to fair value each period, with unrealized holding gains (losses) included in
other comprehensive income (loss) until realized. Under Canadian GAAP, these investments
are recorded at historical cost unless a loss that is considered other than temporary
occurs.  (d)
    
    Other financial statement presentation differences  Under Canadian GAAP, global investment tax credits are required to be deducted from R&D
expense while under U.S. GAAP, these amounts are deducted from the income tax benefit
(expense). The impact of this difference in the three months ended March 31, 2005 and 2004
of $9 and $11, respectively, was to increase or decrease net earnings (loss) from continuing
operations before income taxes, non-controlling interests and equity in net loss of
associated companies under Canadian GAAP, with a corresponding increase or decrease in
income tax benefit (expense).  (e)
    
    Other  Under U.S. GAAP, translation adjustments for self-sustaining subsidiaries are reported
as a component of other comprehensive income (loss), whereas, under Canadian GAAP, these
translation adjustments are classified as foreign currency translation adjustment, also a
component of shareholders equity.  (f)
    
    Joint ventures  Nortel has a number of joint ventures with other parties. Under U.S. GAAP, investments
in joint ventures are accounted for under the equity method, whereas, under Canadian GAAP,
the proportionate consolidation method is used. The difference in accounting does not
impact net earnings (loss), but does impact certain other consolidated financial statement
items. 36




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(g)
    
    Pension and other post-retirement benefits  Under U.S. GAAP, a minimum pension liability adjustment must be recognized in the
amount of the excess of the unfunded accumulated benefit obligation over the recorded
pension benefit liability. An offsetting intangible pension asset is recorded equal to the
unrecognized prior service costs, with any difference recorded in accumulated other
comprehensive loss. No such adjustments are required under Canadian GAAP.  (h)
    
    Accounting changes  (i)
    
    Derivative accountingEffective January 1, 2004, Nortel adopted CICA Accounting Guideline (AcG) 13, Hedging
Relationships (AcG-13), which establishes specific criteria for derivatives to qualify
for hedge accounting. Nortel had been previously applying these criteria under U.S.
GAAP. Therefore, there was no impact on adoption of AcG-13.Concurrent with the adoption of AcG-13, Nortel also adopted the CICAs Emerging Issues
Committee (EIC) 128, Accounting for Trading, Speculative or Non-Hedging Derivative
Financial Instruments (EIC 128), which requires that certain freestanding derivative
instruments that give rise to a financial asset or liability, and do not qualify for
hedge accounting under AcG-13, be recognized on the balance sheet and measured at fair
value, with changes in fair value recognized in earnings (loss) in each period. As a
result of the adoption of EIC 128, certain warrants, which had been previously recorded
at cost under Canadian GAAP, are required to be recorded at fair value consistent with
U.S. GAAP. The impact of this accounting change, which has been recorded prospectively
as at January 1, 2004, was an increase to investments and other income of $23 for the
three months ended March 31, 2004.(ii)
    
    Determining whether an arrangement contains a leaseIn December 2004, the EIC issued abstract 150, Determining Whether an Arrangement
Contains a Lease (EIC 150). EIC 150 provides guidance on how to determine whether an
arrangement contains a lease that is within the scope of CICA Handbook Section 3065,
Leases. The guidance in EIC 150 is based on whether the arrangement conveys to the
purchaser the right to use a tangible asset, and is effective for Nortel for arrangements
entered into or modified after January 1, 2005. Equivalent guidance in U.S. GAAP has
already been adopted by Nortel. The adoption of EIC 150 did not have any material impact
on Nortels results of operations and financial condition.(iii)
    
    Financial Instruments  Presentation and DisclosureIn January 2004, the CICA issued amendments to CICA Handbook Section 3860, Financial
Instruments  Presentation and Disclosure (Section 3860), to require obligations that
must or can be settled at the issuers option, by a variable number of the issuers own
equity instruments to be presented as liabilities. Thus, securities issued by an
enterprise that give the issuer unrestricted rights to settle the principal amount in
cash or in the equivalent value of its own equity instruments will no longer be presented
as equity. The amendments to Section 3860 are applicable to Nortel beginning January 1,
2005 on a retroactive basis. The adoption of the amendments to Section 3860 did not have
any material impact on Nortels results of operations and financial condition.  (i)
    
    Recently issued accounting pronouncements  (i)
    
    In January 2005, the EIC issued amended abstract 144, Accounting by a customer
(including a reseller) for certain consideration received from a
vendor. The
amendment is effective retroactively for periods commencing on or after February 15,
2005. The amendment requires companies to recognize the benefit of non-discretionary
rebates for achieving specified cumulative purchasing levels as a reduction of the cost
of purchases over the relevant period, provided the rebate is probable and reasonably
estimable. Otherwise, the rebates would be recognized as purchasing milestones are
achieved. Nortel does not expect
the adoption of the new amendment will have a material impact on its results of operations or financial
condition. 37




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(ii)
    
    In January 2005, the CICA issued Section 3855,
Financial Instruments 
Recognition and Measurement, Section 1530, Comprehensive Income, and Section 3865,
Hedges. The new standards will be effective for interim and annual financial
statements commencing in 2007. Earlier adoption is permitted. Most significantly for
Nortel under Canadian GAAP, the new standards will introduce comprehensive income to
Canadian GAAP, a concept Nortel has been following under U.S. GAAP. Foreign exchange
gains and losses on the translation of the financial statements of self-sustaining
subsidiaries previously recorded in a separate section of shareholders equity will be
presented in comprehensive income. Also, mark-to-market adjustments on available for
sale investments will be recorded in comprehensive income. Derivative financial
instruments will be recorded in the balance sheet at fair value and the changes in fair
value of derivatives designated as cash flow hedges will be reported in comprehensive
income.  19.
    
    Supplemental consolidating financial information  As of March 31, 2005, and as a result of Nortels credit ratings, various liens, pledges
and guarantees were effective under security agreements entered into by Nortel and various of
its subsidiaries (see note 9).The security agreements were originally entered into in connection with the $1,510 December 2001
364-day credit facilities (which expired on December 13, 2002). The security became effective
April 4, 2002, following Moodys Investors Service, Inc. (Moodys) downgrade of Nortels
senior long-term debt rating to below investment grade, in respect of the then existing credit
facilities including the Five Year Facilities. Consequently, on April 4, 2002 and in accordance
with the negative pledge covenants in the indentures for all Nortels outstanding public debt
securities, all such public debt securities became, under the terms of the security agreements,
secured equally and ratably with the obligations under Nortels and NNIs then existing credit
facilities. Nortels obligations under the EDC Support Facility became secured on an equal and
ratable basis under the security agreements on February 14, 2003.As a result of Nortel terminating the Five Year Facilities, certain foreign security agreements
entered into by Nortel and various of its subsidiaries under which shares of certain
subsidiaries of Nortel incorporated outside of the U.S. and Canada were pledged in favor of the
banks under the Five Year Facilities, EDC and the holders of Nortels and NNCs outstanding
public debt securities also terminated in accordance with their terms. In addition, guarantees
by certain subsidiaries of Nortel incorporated outside of the U.S. and Canada terminated in
accordance with their terms. As of March 31, 2005, the security agreements pledge substantially
all of the assets of Nortel located in the U.S. and Canada and those of most of its U.S. and
Canadian subsidiaries, including the shares of certain of Nortels U.S. and Canadian
subsidiaries, in favor of EDC and the holders of Nortels and NNCs outstanding public debt
securities (see note 9). In addition, certain of Nortels wholly owned subsidiaries, including
NNI, most of Nortels Canadian subsidiaries, Nortel Networks (Asia) Limited, Nortel Networks
(Ireland) Limited and Nortel Networks U.K. Limited, have guaranteed Nortels obligations under
the EDC Support Facility and Nortels and NNCs outstanding public debt securities (the
Guarantor Subsidiaries). Non-guarantor subsidiaries (the Non-Guarantor Subsidiaries)
represented either wholly owned subsidiaries of Nortel whose shares were pledged, or were the
remaining subsidiaries of Nortel which did not provide liens, pledges or guarantees.If Nortels senior long-term debt rating by Moodys returns to Baa2 (with a stable outlook) and
its rating by Standard & Poors returns to BBB (with a stable outlook), the security and
guarantees will be released in full. If the EDC Support Facility is terminated, or expires, the
security and guarantees will also be released in full. Nortel may provide EDC with cash
collateral in an amount equal to the total amount of its outstanding obligations and undrawn
commitments and expenses under the EDC Support Facility (or any other alternative collateral or
arrangements acceptable to EDC) in lieu of the security provided under the security agreements.
Accordingly, if the EDC Support Facility is secured by cash or other alternate collateral or
arrangements acceptable to EDC, the security and guarantees will also be released in full.The following supplemental consolidating financial data illustrates, in separate columns, the
composition (as described below) of Nortel Networks Limited, the Guarantor Subsidiaries, the
Non-Guarantor Subsidiaries, eliminations and the consolidated total for the three months ended
March 31, 2005 and 2004 and as of March 31, 2005 and December 31, 2004, respectively.Investments in subsidiaries are accounted for using the equity method for purposes of the
supplemental consolidating financial data. Net earnings (loss) of subsidiaries are therefore
reflected in the investment account and net earnings (loss). The principal elimination entries
eliminate investments in subsidiaries and intercompany balances and transactions. The financial
data may not necessarily be indicative of the results of operations or financial position had
the subsidiaries been operating as independent entities. 38




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##### Table of Contents



Supplemental Consolidating Statements of Operations for the three months ended March 31, 2005: Nortel
    
    
    
    
    
    
    Non-Networks
    
    
    Guarantor
    
    
    Guarantor(millions of U.S. dollars)
    
    Limited
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    TotalRevenues
    
    $
    514
    
    
    $
    1,620
    
    
    $
    1,026
    
    
    $
    (624
    )
    
    $
    2,536Cost of revenues
    
    
    390
    
    
    
    965
    
    
    
    746
    
    
    
    (624
    )
    
    
    1,477Gross profit
    
    
    124
    
    
    
    655
    
    
    
    280
    
    
    
    
    
    
    
    1,059Selling, general and administrative expense
    
    
    138
    
    
    
    318
    
    
    
    114
    
    
    
    
    
    
    
    570Research and development expense
    
    
    37
    
    
    
    363
    
    
    
    71
    
    
    
    
    
    
    
    471Amortization of intangibles
    
    
    
    
    
    
    
    
    
    
    2
    
    
    
    
    
    
    
    2Special charges
    
    
    5
    
    
    
    9
    
    
    
    7
    
    
    
    
    
    
    
    21(Gain) loss on sale of businesses and assets
    
    
    
    
    
    
    2
    
    
    
    (1
    )
    
    
    
    
    
    
    1Operating earnings (loss)
    
    
    (56
    )
    
    
    (37
    )
    
    
    87
    
    
    
    
    
    
    
    (6
    )Other income (expense)  net
    
    
    21
    
    
    
    19
    
    
    
    7
    
    
    
    
    
    
    
    47Interest expenseLong-term debt
    
    
    (19
    )
    
    
    (3
    )
    
    
    (7
    )
    
    
    
    
    
    
    (29
    )Other
    
    
    (2
    )
    
    
    (12
    )
    
    
    12
    
    
    
    
    
    
    
    (2
    )Earnings (loss) from continuing operations before
income taxes, minority interests and equity in
net earnings (loss) of associated companies
    
    
    (56
    )
    
    
    (33
    )
    
    
    99
    
    
    
    
    
    
    
    10Income tax benefit (expense)
    
    
    (2
    )
    
    
    (12
    )
    
    
    (1
    )
    
    
    
    
    
    
    (15
    )(58
    )
    
    
    (45
    )
    
    
    98
    
    
    
    
    
    
    
    (5
    )Minority interests  net of tax
    
    
    
    
    
    
    
    
    
    
    (5
    )
    
    
    
    
    
    
    (5
    )Equity in net earnings (loss) of associated companies net of tax
    
    
    49
    
    
    
    100
    
    
    
    14
    
    
    
    (162
    )
    
    
    1Net earnings (loss) from continuing operations
    
    
    (9
    )
    
    
    55
    
    
    
    107
    
    
    
    (162
    )
    
    
    (9
    )Net earnings (loss) from discontinued operations net of tax
    
    
    2
    
    
    
    1
    
    
    
    
    
    
    
    (1
    )
    
    
    2Net earnings (loss)
    
    
    (7
    )
    
    
    56
    
    
    
    107
    
    
    
    (163
    )
    
    
    (7
    )Dividends on preferred shares
    
    
    9
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9Net earnings (loss) applicable to common shares
    
    $
    (16
    )
    
    $
    56
    
    
    $
    107
    
    
    $
    (163
    )
    
    $
    (16
    )
 39




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##### Table of Contents



Supplemental Consolidating Statements of Operations for the three months ended March 31, 2004: Nortel
    
    
    
    
    
    
    Non-Networks
    
    
    Guarantor
    
    
    Guarantor(millions of U.S. dollars)
    
    Limited
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    TotalRevenues
    
    $
    898
    
    
    $
    1,678
    
    
    $
    902
    
    
    $
    (1,034
    )
    
    $
    2,444Cost of revenues
    
    
    487
    
    
    
    1,188
    
    
    
    731
    
    
    
    (1,034
    )
    
    
    1,372Gross profit
    
    
    411
    
    
    
    490
    
    
    
    171
    
    
    
    
    
    
    
    1,072Selling, general and administrative expense
    
    
    104
    
    
    
    330
    
    
    
    104
    
    
    
    
    
    
    
    538Research and development expense
    
    
    194
    
    
    
    201
    
    
    
    71
    
    
    
    
    
    
    
    466Amortization of intangibles
    
    
    
    
    
    
    
    
    
    
    3
    
    
    
    
    
    
    
    3Special charges
    
    
    3
    
    
    
    
    
    
    
    4
    
    
    
    
    
    
    
    7(Gain) loss on sale of businesses and assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Operating earnings (loss)
    
    
    110
    
    
    
    (41
    )
    
    
    (11
    )
    
    
    
    
    
    
    58Other income (expense)  net
    
    
    33
    
    
    
    60
    
    
    
    (5
    )
    
    
    
    
    
    
    88Interest expenseLong-term debt
    
    
    (16
    )
    
    
    (1
    )
    
    
    (7
    )
    
    
    
    
    
    
    (24
    )Other
    
    
    
    
    
    
    (20
    )
    
    
    12
    
    
    
    
    
    
    
    (8
    )Earnings (loss) from continuing operations before
income taxes, minority interests and equity in
net earnings (loss) of associated companies
    
    
    127
    
    
    
    (2
    )
    
    
    (11
    )
    
    
    
    
    
    
    114Income tax benefit (expense)
    
    
    37
    
    
    
    (25
    )
    
    
    (3
    )
    
    
    
    
    
    
    9164
    
    
    
    (27
    )
    
    
    (14
    )
    
    
    
    
    
    
    123Minority interests  net of tax
    
    
    
    
    
    
    
    
    
    
    (6
    )
    
    
    
    
    
    
    (6
    )Equity in net earnings (loss) of associated companies net of tax
    
    
    (48
    )
    
    
    (113
    )
    
    
    2
    
    
    
    158
    
    
    
    (1
    )Net earnings (loss) from continuing operations
    
    
    116
    
    
    
    (140
    )
    
    
    (18
    )
    
    
    158
    
    
    
    116Net earnings (loss) from discontinued operations net of tax
    
    
    1
    
    
    
    1
    
    
    
    
    
    
    
    (1
    )
    
    
    1Net earnings (loss)
    
    
    117
    
    
    
    (139
    )
    
    
    (18
    )
    
    
    157
    
    
    
    117Dividends on preferred shares
    
    
    9
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9Net earnings (loss) applicable to common shares
    
    $
    108
    
    
    $
    (139
    )
    
    $
    (18
    )
    
    $
    157
    
    
    $
    108
 40




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##### Table of Contents



Supplemental Consolidating Balance Sheets as of March 31, 2005: Nortel
    
    
    
    
    
    
    Non-Networks
    
    
    Guarantor
    
    
    Guarantor(millions of U.S. dollars)
    
    Limited
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    TotalASSETSCurrent assetsCash and cash equivalents
    
    $
    (7
    )
    
    $
    2,175
    
    
    $
    1,222
    
    
    $
    
    
    
    $
    3,390Restricted cash and cash equivalents
    
    
    45
    
    
    
    27
    
    
    
    9
    
    
    
    
    
    
    
    81Accounts receivable  net
    
    
    702
    
    
    
    1,308
    
    
    
    770
    
    
    
    
    
    
    
    2,780Intercompany/related party accounts receivable
    
    
    486
    
    
    
    864
    
    
    
    693
    
    
    
    (1,784
    )
    
    
    259Inventories  net
    
    
    215
    
    
    
    669
    
    
    
    432
    
    
    
    
    
    
    
    1,316Deferred income taxes  net
    
    
    45
    
    
    
    202
    
    
    
    1
    
    
    
    
    
    
    
    248Other current assets
    
    
    60
    
    
    
    183
    
    
    
    180
    
    
    
    
    
    
    
    423Total current assets
    
    
    1,546
    
    
    
    5,428
    
    
    
    3,307
    
    
    
    (1,784
    )
    
    
    8,497Investments
    
    
    2,228
    
    
    
    (6,992
    )
    
    
    529
    
    
    
    4,383
    
    
    
    148Intercompany advances
    
    
    354
    
    
    
    1,490
    
    
    
    2,068
    
    
    
    (3,912
    )
    
    
    Plant and equipment  net
    
    
    464
    
    
    
    752
    
    
    
    375
    
    
    
    
    
    
    
    1,591Goodwill
    
    
    (9
    )
    
    
    1,917
    
    
    
    172
    
    
    
    
    
    
    
    2,080Intangible assets  net
    
    
    36
    
    
    
    2
    
    
    
    37
    
    
    
    
    
    
    
    75Deferred income taxes  net
    
    
    1,817
    
    
    
    1,801
    
    
    
    88
    
    
    
    
    
    
    
    3,706Other assets
    
    
    43
    
    
    
    291
    
    
    
    337
    
    
    
    
    
    
    
    671Total assets
    
    $
    6,479
    
    
    $
    4,689
    
    
    $
    6,913
    
    
    $
    (1,313
    )
    
    $
    16,768LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilitiesTrade and other accounts payable
    
    $
    512
    
    
    $
    449
    
    
    $
    19
    
    
    $
    
    
    
    $
    980Intercompany/related party accounts payable
    
    
    (3,513
    )
    
    
    3,584
    
    
    
    1,713
    
    
    
    (1,784
    )
    
    
    Payroll and benefit-related liabilities
    
    
    66
    
    
    
    268
    
    
    
    125
    
    
    
    
    
    
    
    459Contractual liabilities
    
    
    126
    
    
    
    195
    
    
    
    184
    
    
    
    
    
    
    
    505Restructuring liabilities
    
    
    17
    
    
    
    111
    
    
    
    24
    
    
    
    
    
    
    
    152Other accrued liabilities
    
    
    418
    
    
    
    1,736
    
    
    
    701
    
    
    
    
    
    
    
    2,855Long-term debt due within one year
    
    
    1,287
    
    
    
    12
    
    
    
    (9
    )
    
    
    
    
    
    
    1,290Total current liabilities
    
    
    (1,087
    )
    
    
    6,355
    
    
    
    2,757
    
    
    
    (1,784
    )
    
    
    6,241Long-term debt
    
    
    235
    
    
    
    118
    
    
    
    418
    
    
    
    
    
    
    
    771Deferred income taxes  net
    
    
    
    
    
    
    108
    
    
    
    35
    
    
    
    
    
    
    
    143Other liabilities
    
    
    1,275
    
    
    
    1,961
    
    
    
    228
    
    
    
    
    
    
    
    3,464Intercompany advances
    
    
    
    
    
    
    297
    
    
    
    3,615
    
    
    
    (3,912
    )
    
    
    Total liabilities
    
    
    423
    
    
    
    8,839
    
    
    
    7,053
    
    
    
    (5,696
    )
    
    
    10,619Minority interests in subsidiary companies
    
    
    
    
    
    
    
    
    
    
    93
    
    
    
    
    
    
    
    93SHAREHOLDERS EQUITYPreferred shares
    
    
    536
    
    
    
    237
    
    
    
    1
    
    
    
    (238
    )
    
    
    536Common shares
    
    
    1,211
    
    
    
    5,416
    
    
    
    1,626
    
    
    
    (7,042
    )
    
    
    1,211Additional paid-in capital
    
    
    22,126
    
    
    
    787
    
    
    
    4,247
    
    
    
    (5,034
    )
    
    
    22,126Accumulated deficit
    
    
    (17,008
    )
    
    
    (11,146
    )
    
    
    (6,299
    )
    
    
    17,445
    
    
    
    (17,008
    )Accumulated other comprehensive income (loss)
    
    
    (809
    )
    
    
    556
    
    
    
    192
    
    
    
    (748
    )
    
    
    (809
    )Total shareholders equity
    
    
    6,056
    
    
    
    (4,150
    )
    
    
    (233
    )
    
    
    4,383
    
    
    
    6,056Total liabilities and shareholders equity
    
    $
    6,479
    
    
    $
    4,689
    
    
    $
    6,913
    
    
    $
    (1,313
    )
    
    $
    16,768
 41




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##### Table of Contents



Supplemental Consolidating Balance Sheets as of December 31, 2004: Nortel
    
    
    
    
    
    
    Non-Networks
    
    
    Guarantor
    
    
    Guarantor(millions of U.S. dollars)
    
    Limited
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    TotalASSETSCurrent assetsCash and cash equivalents
    
    $
    (2
    )
    
    $
    2,414
    
    
    $
    1,195
    
    
    $
    
    
    
    $
    3,607Restricted cash and cash equivalents
    
    
    52
    
    
    
    20
    
    
    
    8
    
    
    
    
    
    
    
    80Accounts receivable  net
    
    
    476
    
    
    
    1,244
    
    
    
    831
    
    
    
    
    
    
    
    2,551Intercompany/related party accounts receivable
    
    
    541
    
    
    
    1,135
    
    
    
    776
    
    
    
    (2,203
    )
    
    
    249Inventories  net
    
    
    298
    
    
    
    608
    
    
    
    508
    
    
    
    
    
    
    
    1,414Deferred income taxes  net
    
    
    45
    
    
    
    211
    
    
    
    (1
    )
    
    
    
    
    
    
    255Other current assets
    
    
    33
    
    
    
    166
    
    
    
    156
    
    
    
    
    
    
    
    355Total current assets
    
    
    1,443
    
    
    
    5,798
    
    
    
    3,473
    
    
    
    (2,203
    )
    
    
    8,511Investments
    
    
    2,222
    
    
    
    (6,772
    )
    
    
    508
    
    
    
    4,201
    
    
    
    159Intercompany advances
    
    
    346
    
    
    
    1,102
    
    
    
    2,066
    
    
    
    (3,514
    )
    
    
    Plant and equipment  net
    
    
    480
    
    
    
    771
    
    
    
    395
    
    
    
    
    
    
    
    1,646Goodwill
    
    
    
    
    
    
    1,946
    
    
    
    177
    
    
    
    
    
    
    
    2,123Intangible assets  net
    
    
    37
    
    
    
    1
    
    
    
    40
    
    
    
    
    
    
    
    78Deferred income taxes  net
    
    
    1,824
    
    
    
    1,814
    
    
    
    98
    
    
    
    
    
    
    
    3,736Other assets
    
    
    80
    
    
    
    288
    
    
    
    323
    
    
    
    
    
    
    
    691Total assets
    
    $
    6,432
    
    
    $
    4,948
    
    
    $
    7,080
    
    
    $
    (1,516
    )
    
    $
    16,944LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilitiesTrade and other accounts payable
    
    $
    486
    
    
    $
    391
    
    
    $
    118
    
    
    $
    
    
    
    $
    995Intercompany/related party accounts payable
    
    
    (3,561
    )
    
    
    3,626
    
    
    
    2,138
    
    
    
    (2,203
    )
    
    
    Payroll and benefit-related liabilities
    
    
    68
    
    
    
    306
    
    
    
    138
    
    
    
    
    
    
    
    512Contractual liabilities
    
    
    175
    
    
    
    218
    
    
    
    175
    
    
    
    
    
    
    
    568Restructuring liabilities
    
    
    32
    
    
    
    184
    
    
    
    38
    
    
    
    
    
    
    
    254Other accrued liabilities
    
    
    380
    
    
    
    1,642
    
    
    
    766
    
    
    
    
    
    
    
    2,788Long-term debt due within one year
    
    
    13
    
    
    
    12
    
    
    
    (10
    )
    
    
    
    
    
    
    15Total current liabilities
    
    
    (2,407
    )
    
    
    6,379
    
    
    
    3,363
    
    
    
    (2,203
    )
    
    
    5,132Long-term debt
    
    
    1,520
    
    
    
    120
    
    
    
    422
    
    
    
    
    
    
    
    2,062Deferred income taxes  net
    
    
    
    
    
    
    108
    
    
    
    35
    
    
    
    
    
    
    
    143Other liabilities
    
    
    995
    
    
    
    1,928
    
    
    
    266
    
    
    
    
    
    
    
    3,189Intercompany advances
    
    
    
    
    
    
    297
    
    
    
    3,217
    
    
    
    (3,514
    )
    
    
    Total liabilities
    
    
    108
    
    
    
    8,832
    
    
    
    7,303
    
    
    
    (5,717
    )
    
    
    10,526Minority interests in subsidiary companies
    
    
    
    
    
    
    
    
    
    
    94
    
    
    
    
    
    
    
    94SHAREHOLDERS EQUITYPreferred shares
    
    
    536
    
    
    
    237
    
    
    
    
    
    
    
    (237
    )
    
    
    536Common shares
    
    
    1,211
    
    
    
    5,417
    
    
    
    1,622
    
    
    
    (7,039
    )
    
    
    1,211Additional paid-in capital
    
    
    22,107
    
    
    
    775
    
    
    
    4,243
    
    
    
    (5,018
    )
    
    
    22,107Accumulated deficit
    
    
    (16,992
    )
    
    
    (10,931
    )
    
    
    (6,450
    )
    
    
    17,381
    
    
    
    (16,992
    )Accumulated other comprehensive income (loss)
    
    
    (538
    )
    
    
    618
    
    
    
    268
    
    
    
    (886
    )
    
    
    (538
    )Total shareholders equity
    
    
    6,324
    
    
    
    (3,884
    )
    
    
    (317
    )
    
    
    4,201
    
    
    
    6,324Total liabilities and shareholders equity
    
    $
    6,432
    
    
    $
    4,948
    
    
    $
    7,080
    
    
    $
    (1,516
    )
    
    $
    16,944
 42




---



##### Table of Contents



Supplemental Consolidating Statements of Cash Flows for the three months ended March 31, 2005: Nortel
    
    
    
    
    
    
    Non-Networks
    
    
    Guarantor
    
    
    Guarantor(millions of U.S. dollars)
    
    Limited
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    TotalCash flows from (used in) operating activitiesNet earnings (loss) from continuing operations
    
    $
    (9
    )
    
    $
    55
    
    
    $
    107
    
    
    $
    (162
    )
    
    $
    (9
    )Adjustments to reconcile net earnings (loss)
from continuing operations to net cash from
(used in) operating activities, net of effects
from acquisitions and divestitures of businesses:Amortization and depreciation
    
    
    12
    
    
    
    46
    
    
    
    24
    
    
    
    
    
    
    
    82Equity in
net earnings (loss) of associated companies  net of
tax
    
    
    (49
    )
    
    
    (100
    )
    
    
    (14
    )
    
    
    162
    
    
    
    (1
    )Stock option compensation
    
    
    4
    
    
    
    11
    
    
    
    4
    
    
    
    
    
    
    
    19Deferred income taxes
    
    
    
    
    
    
    11
    
    
    
    (3
    )
    
    
    
    
    
    
    8Other liabilities
    
    
    25
    
    
    
    50
    
    
    
    3
    
    
    
    
    
    
    
    78(Gain) loss
on sale or write down of
investments, businesses and assets
    
    
    
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    6Other  net
    
    
    (156
    )
    
    
    77
    
    
    
    (39
    )
    
    
    
    
    
    
    (118
    )Change in operating assets and liabilities
    
    
    (34
    )
    
    
    (157
    )
    
    
    (98
    )
    
    
    
    
    
    
    (289
    )Intercompany/related party activity
    
    
    129
    
    
    
    (211
    )
    
    
    82
    
    
    
    
    
    
    
    Net cash from (used in) operating activities
of continuing operations
    
    
    (78
    )
    
    
    (212
    )
    
    
    66
    
    
    
    
    
    
    
    (224
    )Cash flows from (used in) investing activitiesExpenditures for plant and equipment
    
    
    (9
    )
    
    
    (30
    )
    
    
    (15
    )
    
    
    
    
    
    
    (54
    )Proceeds on disposals of plant and equipment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Acquisitions
of investments and businesses  net of cash acquired
    
    
    
    
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    (2
    )Proceeds on sale of investments and businesses
    
    
    76
    
    
    
    7
    
    
    
    
    
    
    
    
    
    
    
    83Net cash from (used in) investing activities
of continuing operations
    
    
    67
    
    
    
    (25
    )
    
    
    (15
    )
    
    
    
    
    
    
    27Cash flows from (used in) financing activitiesDividends paid
    
    
    (9
    )
    
    
    
    
    
    
    (5
    )
    
    
    
    
    
    
    (14
    )Increase in notes payable
    
    
    
    
    
    
    
    
    
    
    20
    
    
    
    
    
    
    
    20Decrease in notes payable
    
    
    
    
    
    
    
    
    
    
    (26
    )
    
    
    
    
    
    
    (26
    )Repayments of long-term debt
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Repayments of capital leases payable
    
    
    2
    
    
    
    (2
    )
    
    
    (1
    )
    
    
    
    
    
    
    (1
    )Net cash from (used in) financing activities
of continuing operations
    
    
    (7
    )
    
    
    (2
    )
    
    
    (12
    )
    
    
    
    
    
    
    (21
    )Effect of foreign exchange rate changes
on cash and cash equivalents
    
    
    
    
    
    
    (23
    )
    
    
    (12
    )
    
    
    
    
    
    
    (35
    )Net cash from (used in) continuing operations
    
    
    (18
    )
    
    
    (262
    )
    
    
    27
    
    
    
    
    
    
    
    (253
    )Net cash from (used in) operating activities
of discontinued operations
    
    
    13
    
    
    
    23
    
    
    
    
    
    
    
    
    
    
    
    36Net increase (decrease) in cash and cash equivalents
    
    
    (5
    )
    
    
    (239
    )
    
    
    27
    
    
    
    
    
    
    
    (217
    )Cash and cash equivalents at beginning of period
    
    
    (2
    )
    
    
    2,414
    
    
    
    1,195
    
    
    
    
    
    
    
    3,607Cash and cash equivalents at end of period
    
    $
    (7
    )
    
    $
    2,175
    
    
    $
    1,222
    
    
    $
    
    
    
    $
    3,390
 43




---



##### Table of Contents



Supplemental Consolidating Statements of Cash Flows for the three months ended March 31, 2004: Nortel
    
    
    
    
    
    
    Non-Networks
    
    
    Guarantor
    
    
    Guarantor(millions of U.S. dollars)
    
    Limited
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    TotalCash flows from (used in) operating activitiesNet earnings (loss) from continuing operations
    
    $
    116
    
    
    $
    (140
    )
    
    $
    (18
    )
    
    $
    158
    
    
    $
    116Adjustments to reconcile net earnings (loss)
from continuing operations to net cash from
(used in) operating activities, net of effects
from acquisitions and divestitures of businesses:Amortization and depreciation
    
    
    10
    
    
    
    44
    
    
    
    36
    
    
    
    
    
    
    
    90Equity in net earnings (loss) of
associated companies  net of tax
    
    
    48
    
    
    
    113
    
    
    
    (2
    )
    
    
    (158
    )
    
    
    1Stock option compensation
    
    
    2
    
    
    
    11
    
    
    
    2
    
    
    
    
    
    
    
    15Deferred income taxes
    
    
    (1
    )
    
    
    (1
    )
    
    
    (2
    )
    
    
    
    
    
    
    (4
    )Other liabilities
    
    
    20
    
    
    
    30
    
    
    
    10
    
    
    
    
    
    
    
    60(Gain) loss
on sale or write down of
investments, businesses and assets
    
    
    
    
    
    
    (35
    )
    
    
    2
    
    
    
    
    
    
    
    (33
    )Other  net
    
    
    (16
    )
    
    
    (5
    )
    
    
    39
    
    
    
    
    
    
    
    18Change in operating assets and liabilities
    
    
    (239
    )
    
    
    (242
    )
    
    
    (90
    )
    
    
    
    
    
    
    (571
    )Intercompany/related party activity
    
    
    100
    
    
    
    16
    
    
    
    (116
    )
    
    
    
    
    
    
    Net cash from (used in) operating activities
of continuing operations
    
    
    40
    
    
    
    (209
    )
    
    
    (139
    )
    
    
    
    
    
    
    (308
    )Cash flows from (used in) investing activitiesExpenditures for plant and equipment
    
    
    (8
    )
    
    
    (31
    )
    
    
    (4
    )
    
    
    
    
    
    
    (43
    )Proceeds on disposals of plant and equipment
    
    
    4
    
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    5Acquisitions
of investments and businesses 
net of cash acquired
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    (3
    )Proceeds on sale of investments and businesses
    
    
    
    
    
    
    55
    
    
    
    
    
    
    
    
    
    
    
    55Net cash from (used in) investing activities
of continuing operations
    
    
    (4
    )
    
    
    22
    
    
    
    (4
    )
    
    
    
    
    
    
    14Cash flows from (used in) financing activitiesDividends paid
    
    
    (9
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9
    )Increase in notes payable
    
    
    
    
    
    
    
    
    
    
    10
    
    
    
    
    
    
    
    10Decrease in notes payable
    
    
    
    
    
    
    
    
    
    
    (13
    )
    
    
    
    
    
    
    (13
    )Repayments of long-term debt
    
    
    
    
    
    
    (85
    )
    
    
    (12
    )
    
    
    
    
    
    
    (97
    )Repayments of capital leases payable
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    (3
    )Net cash from (used in) financing activities
of continuing operations
    
    
    (9
    )
    
    
    (88
    )
    
    
    (15
    )
    
    
    
    
    
    
    (112
    )Effect of foreign exchange rate changes
on cash and cash equivalents
    
    
    
    
    
    
    12
    
    
    
    1
    
    
    
    
    
    
    
    13Net cash from (used in) continuing operations
    
    
    27
    
    
    
    (263
    )
    
    
    (157
    )
    
    
    
    
    
    
    (393
    )Net cash from (used in) operating activities
of discontinued operations
    
    
    4
    
    
    
    (7
    )
    
    
    
    
    
    
    
    
    
    
    (3
    )Net increase (decrease) in cash and cash equivalents
    
    
    31
    
    
    
    (270
    )
    
    
    (157
    )
    
    
    
    
    
    
    (396
    )Cash and cash equivalents at beginning of period
    
    
    (8
    )
    
    
    2,963
    
    
    
    973
    
    
    
    
    
    
    
    3,928Cash and cash equivalents at end of period
    
    $
    23
    
    
    $
    2,693
    
    
    $
    816
    
    
    $
    
    
    
    $
    3,532
 44




---



##### Table of Contents



ITEM 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations  Table of Contents Business overview
    
    
    47Our business
    
    
    47Our segments
    
    
    47Our strategy and outlook
    
    
    48Strategy
    
    
    48Financial targets
    
    
    492005 Outlook
    
    
    49Evolution of our supply chain strategy
    
    
    50Developments in 2005
    
    
    51First quarter 2005 consolidated results summary
    
    
    51Significant business developments
    
    
    52Acquisitions
    
    
    52Joint ventures
    
    
    52Optical components operations
    
    
    52Bharat Sanchar Nigram Limited contract
    
    
    52Nortel Audit Committee Independent Review; restatements; related matters
    
    
    53Restatements and Independent Review
    
    
    53Revenue Independent Review
    
    
    53Material weaknesses in internal control over financial
reporting
    
    
    54EDC Support Facility
    
    
    54Debt securities
    
    
    55Regulatory actions and pending litigation
    
    
    55Stock-based
compensation plans
    
    
    55Results of operations  continuing operations
    
    
    56Consolidated information
    
    
    56Revenues
    
    
    56Geographic revenues
    
    
    56Gross profit and gross margin
    
    
    58Operating expenses
    
    
    59Selling, general and administrative expense
    
    
    59Research and development expense
    
    
    59Special charges
    
    
    60Other income (expense)  net
    
    
    63Interest expense
    
    
    63Income tax benefit (expense)
    
    
    63Net earnings (loss) from continuing operations
    
    
    64Segment information
    
    
    64Carrier Packet Networks
    
    
    65CDMA Networks
    
    
    67GSM and UMTS Networks
    
    
    68Enterprise Networks
    
    
    69Other
    
    
    70Liquidity and capital resources
    
    
    70Cash flows
    
    
    71Operating activities
    
    
    71Investing activities
    
    
    74Financing activities
    
    
    74Uses of liquidity
    
    
    74Contractual cash obligations
    
    
    75
 45




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Customer financing
    
    
    75Acquisitions
    
    
    75Sources of liquidity
    
    
    76Credit facilities
    
    
    76Available support facility
    
    
    76Shelf registration statement and base shelf prospectus
    
    
    77Credit ratings
    
    
    78Off-balance sheet arrangements
    
    
    78Bid, performance related and other bonds
    
    
    78Receivables securitization transactions
    
    
    79Application of critical accounting policies and estimates
    
    
    79Provisions for doubtful accounts
    
    
    79Provisions for inventory
    
    
    80Provisions for product warranties
    
    
    81Tax asset valuation
    
    
    81Goodwill valuation
    
    
    82Special charges
    
    
    82Accounting changes and recent accounting pronouncements
    
    
    82Accounting changes
    
    
    82Recent accounting pronouncements
    
    
    83Canadian supplement
    
    
    83Accounting changes
    
    
    84Outstanding share data
    
    
    84Market risk
    
    
    84Equity price risk
    
    
    85Environmental matters
    
    
    85Legal proceedings
    
    
    85Risk factors/forward looking statements
    
    
    86Risks relating to our restatements and related matters
    
    
    86Risks relating to our business
    
    
    93
 46




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Managements Discussion and Analysis of Financial Condition and Results of Operations You should read this Managements Discussion and Analysis of Financial Condition and Results
of Operation, or MD&A, in combination with the accompanying unaudited consolidated financial
statements prepared in accordance with accounting principles generally accepted in the United
States, or U.S. GAAP. A number of our and Nortel Networks Corporations past filings with the
United States Securities and Exchange Commission, or SEC, remain subject to ongoing review by the
SECs Division of Corporation Finance. Ongoing SEC review may require us to amend this Quarterly
Report onForm 10-Qor our other public filings further. See Risk factors/forward looking
statements. This section contains forward looking statements and should be read in conjunction with the risk
factors described below under Risk factors/forward looking statements. All dollar amounts in
this MD&A are in millions of United States, or U.S., dollars unless otherwise stated. Where we say we, us, our or Nortel, we mean Nortel Networks Limited or Nortel Networks
Limited and its subsidiaries, as applicable, and where we refer to the industry, we mean the
telecommunications industry. Business overview Our business Nortel is a recognized leader in delivering communications capabilities that enhance the human
experience, ignite and power global commerce, and secure and protect the worlds most critical
information. Serving both service provider and enterprise customers, we deliver innovative
technology solutions encompassing end-to-end broadband, Voice over Internet Protocol, or VoIP,
multimedia services and applications, and wireless broadband solutions designed to help people
solve the worlds greatest challenges. Our networking solutions consist of hardware, software and
services. Our business consists of the design, development, manufacture, assembly, marketing,
sale, licensing, installation, servicing and support of these networking solutions. A substantial
portion of our business has a technology focus and is dedicated to making strategic investments in
research and development, or R&D. This focus forms a core strength and is a factor that we believe
differentiates us from many of our competitors. We believe our acknowledged strength is strong
customer loyalty as a result of providing value to our customers through high reliability networks,
a commitment to ongoing support and an evolution of solutions as technology advancements in the
products are made. We are the principal direct operating subsidiary of Nortel Networks Corporation, or NNC. NNC holds
all of our outstanding common shares but none of our outstanding preferred shares. NNCs common
shares are publicly traded on the New York Stock Exchange, or NYSE, and Toronto Stock Exchange, or
TSX under the symbol NT. Our cumulative Redeemable Class A Preferred Shares Series 5 and
Non-cumulative Redeemable Class A Preferred Shares Series 7 are traded on the TSX under the symbols
NTL.PR.F and NTL.PR.G, respectively. Acquisitions involving any share consideration are completed
by NNC, while acquisitions involving only cash consideration are generally completed by Nortel. Our segments During 2004, our operations were organized and represented by four operating segments which
were also our reportable segments: Wireless Networks, Enterprise Networks, Wireline Networks, and
Optical Networks. Effective October 1, 2004, we established a new streamlined organizational
structure that included, among other things, combining the businesses represented by our four
operating segments at that time into two business organizations: (i) Carrier Networks and Global
Operations and (ii) Enterprise Networks. Our two business organizations include four operating segments. Our Carrier Networks and Global
Operations organization is comprised of the following operating segments: (a) Carrier Packet
Networks, which is substantially an amalgamation of our previous Wireline Networks and Optical
Networks operating segments; (b) Code Division Multiple Access, or CDMA, Networks, which previously
represented a portion of our Wireless Networks operating segment; and (c) Global System for Mobile
communications, or GSM, and Universal Mobile Telecommunications Systems, or UMTS, Networks which
also previously represented a portion of our Wireless Networks operating segment. Our Enterprise
Networks operating segment remains substantially unchanged and is a separate operating segment. 47




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Although certain structural changes were made to reflect the reorganization effective October 1,
2004, we did not meet the criteria to change our reportable segments under Statement of Financial
Accounting Standards, or SFAS, No. 131, Disclosures about Segments of an Enterprise and Related
Information, or SFAS 131, for the 2004 fiscal year. Our operating results on a segmented basis
for the new business organizations were not available for review by our chief operating decision
maker during the 2004 fiscal year, as a significant amount of our finance resources were allocated
to the restatement activity that was completed during January 2005. Commencing in the first
quarter of 2005, we met the criteria under SFAS 131 to change our reportable segments to reflect
the four operating segments of the two business organizations established effective October 1,
2004. These four reportable segments and other business activities are described below:  
    
    Carrier Packet Networks provides: (i) circuit and packet voice solutions, (ii)
data networking and security solutions and (iii) optical long-haul and metropolitan optical
network solutions. Together, these solutions provide or transport data, voice and
multimedia communications solutions to our service provider customers that operate wireline
networks. These service provider customers include local and long distance telephone
companies, wireless service providers, cable operators and other communication service
providers.
    
    CDMA Networks provides communication network solutions that incorporate CDMA and Time
Division Multiple Access, or TDMA, network solutions to enable our wireless service
provider customers to offer their customers, the subscribers for wireless communication
services, the ability to be mobile while they send and receive voice and data
communications using wireless devices, such as cellular telephones, personal digital
assistants and other computing and communications devices.
    
    GSM and UMTS Networks also provides communication network solutions to our wireless
service provider customers; however, these solutions incorporate GSM and UMTS network
solutions.
    
    Enterprise Networks provides: (i) circuit and packet voice solutions and (ii) data
networking and security solutions which provide data, voice and multimedia communications
solutions to our enterprise customers. Our Enterprise Networks customers consist of a
broad range of enterprise customers around the world, including large businesses and their
branch offices, small businesses and home offices, as well as government agencies,
educational and other institutions and utility organizations.
    
    Other represents miscellaneous business activities and corporate functions. None of
these activities meet the quantitative criteria to be disclosed separately as reportable
segments. Costs associated with shared services and other corporate costs are allocated to
the segments based on usage determined generally by headcount. Costs not allocated to the
segments are primarily related to our corporate compliance and other non-operational
activities and are included in other. Our vice chairman and chief executive officer, or CEO, has been identified as our chief operating
decision maker in assessing the performance of the segments and the allocation of resources to the
segments. The CEO relies on the information derived directly from our management reporting system.
The primary financial measure used by the CEO in assessing performance and allocating resources to
the segments is management earnings (loss) before income taxes, or Management EBT. This measure
includes the cost of revenues, selling, general and administrative, or SG&A, expense, R&D expense,
interest expense, other income (expense)  net, minority interests  net of tax and equity in net
earnings (loss) of associated companies  net of tax. The CEO does not review asset information on
a segmented basis in order to assess performance and allocate resources. See Segment information
 General description in note 4 of the accompanying unaudited consolidated financial statements. Our strategy and outlook Strategy We are driving our business forward on a platform of integrity with a focus on cash, costs and
revenues as strategic goals. We remain committed to our business strategy of technology and
solutions evolution in helping our customers transform their networks and implement new
applications and services to drive improved productivity, reduced costs and revenue growth. The principal components of our strategic plan, first announced in August 2004, are:  
    
    a commitment to best corporate practices and ethical conduct;
    
    a streamlined organizational structure to reflect alignment with carrier converged networks;
    
    an increased focus on the enterprise market and customers;
    
    optimized R&D programs for highly secure, available and reliable converged networks;
    
    a focus on partnerships, new markets and acquisitions; 48




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
    
    a focus on overall marketing strategy;
    
    the strategic review of embedded services to assess opportunities in the professional services business; and
    
    a distinct focus on government and defense customers. Our strategic plan also includes a work plan involving focused workforce reductions, including a
voluntary retirement program, of approximately 3,250 employees, real estate optimization and other
cost containment actions such as reductions in information services costs, outsourced services and
other discretionary spending, or the 2004 Restructuring Plan. Our workforce actions are focused to
disproportionately protect customer and sales facing roles as well as continue our focus on new
innovative solutions. We anticipate cost savings of approximately $500 in 2005 related to this
work plan, partially offset by planned investments in certain strategic areas such as the finance
organization. For further information related to our work plan, see
Results of operations 
continuing operations  Operating expenses  Special charges. Other key strategic initiatives include our finance transformation project which will include,
among other things, implementing a new information technology program (SAP) to provide an
integrated global financial system; our supply chain evolution strategy with Flextronics
International Ltd., or Flextronics; planned new joint ventures in Asia Pacific; and improvements in
the effectiveness of our strategic alliances. Financial targets Our financial targets focus on cash, costs and revenue. We expect to achieve targeted
improvements in cash flow from operations by driving improved earnings performance and working
capital management. We measure working capital performance through the use of various metrics, and
in particular, we are focused on improvements in accounts receivable performance and levels of
inventory (see Liquidity and capital resources  Cash flows). We have also set targets for cost reductions that include reducing our operating expenditures,
which is our combined SG&A and R&D spending, as a percentage of revenue. We are also focused on
maximizing cost effectiveness as we continue to experience pricing pressures for many of our
products. We have implemented a variety of programs to drive lower costs including our work plan
involving focused workforce reductions. Our model of outsourced manufacturing, including our
agreement with Flextronics, is important to maximizing our long-term cost effectiveness. As a global supplier in the communications equipment market, one of the keys to our long-term
success is revenue growth. In addition to efficiently providing global sales and support and
product development, it is important that we maintain or gain market share for us to be viewed by
our customers as a long-term, innovative networking solutions supplier. We are focusing on
government, security and services to drive revenue growth as evidenced by our April 26, 2005
announcement of our planned acquisition of PEC Solutions, Inc., or PEC. In addition to our focus on cash, costs and revenue, we also monitor performance in the following
areas: status with our key customers on a global basis; the achievement of expected milestones of
our key R&D projects; and the achievement of our key strategic initiatives. In an effort to ensure
we are creating value for our customers and maintaining strong relationships with those customers,
we monitor our project implementation, customer service levels and the status of key contracts. We
also conduct regular customer satisfaction and loyalty surveys to monitor customer relationships.
With respect to our R&D projects, we measure content, quality and timeliness versus project plans. 2005 Outlook We expect continued consolidation of certain service providers, particularly in the U.S. for
the remainder of 2005. We expect this trend to result in a net reduction in customer spending as
these service providers focus on improving the efficiency of their combined networks rather than
network expansion. Competition in the industry remains strong and our traditional large
competitors, newer competitors, particularly from China, and certain smaller niche competitors
continue to increase their market share and create pricing and margin pressures. We and our
competitors remain focused on certain key factors such as customer relationships, installed
networks, innovative and reliable products, services and price. In 2005, we are focusing on regions and networking solutions that we believe will be areas of
potential growth and importance to our customers. On a regional basis, we see potential
significant growth opportunities in emerging markets such as China and India. Evidence of our
focus on these emerging market opportunities includes our contract with Bharat Sanchar Nigram
Limited, or BSNL, to establish a wireless network in India, our investment in Sasken Communication
Technologies Ltd. of India to develop new software and deploy our networking equipment and our
planned joint venture with China Putian Corporation. Globally, we believe security and reliability
for service provider networks are increasingly important to governments, defense interests and enterprises around the world. 49




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In 2005, we expect our Management EBT to increase as compared to 2004 primarily due to expected
higher revenues, the impact of cost savings generated by our work plan, and lower costs resulting
from the substantial completion of our restatement activities. We expect that the increase will be
partially offset by increased investment costs in certain parts of the business and accruals for
expected employee bonuses for 2005 that were not incurred in 2004. The expected increase in
Management EBT is also expected to be partially offset by increased special charges in 2005
compared to 2004 associated with our work plan and an expected absence of gain on sale of
businesses and assets and income tax recoveries that were included in our 2004 results. For the remainder of 2005, we expect continued growth in revenues compared to 2004 and gross
margins in the range of 40 to 44 percent of revenue. We expect operating expenses as a percent of
revenue to be approximately 35 percent by the end of 2005 primarily driven by benefits from our
previously announced restructuring work plan and lower costs resulting from the substantial
completion of our restatement activities and expected higher revenues. Evolution of our supply chain strategy On June 29, 2004, we announced an agreement with Flextronics regarding the divestiture of
substantially all of our remaining manufacturing operations, including product integration, testing
and repair operations carried out in Calgary and Montreal, Canada and Campinas, Brazil, as well as
certain activities related to these locations, including the management of the supply chain,
related suppliers, and third-party logistics. In Europe, Flextronics has made an offer to purchase
similar operations at our Monkstown, Northern Ireland and Chateaudun, France locations, subject to
the completion of the required information and consultation process. Under the terms of the agreement and offer, Flextronics will also acquire our global repair
services, as well as certain design assets in Ottawa, Canada and Monkstown related to hardware and
embedded software design, and related product verification for certain established optical
products. We have entered into a four year supply agreement with Flextronics for manufacturing services
(whereby Flextronics will manage approximately $2,500 of our annual cost of revenues) and a three
year supply agreement for design services. The transfer of the optical design operations and
related assets in Ottawa and Monkstown closed in the fourth quarter of 2004. In the first quarter
of 2005, we completed the portion of the transaction related to the manufacturing activities in
Montreal. We previously reported that the portion of the transaction related to the manufacturing
activities in Calgary was expected to close in the second quarter of 2005 and that the balance of
the transaction was expected to close on separate dates occurring during the first half of 2005. We
and Flextronics are currently discussing the timing of the closing of the balance of the
transaction in order to optimize the business transition between the companies. As a result of
these discussions, it is now expected that the balance of the transaction, relating to the
manufacturing operations in Chateaudun, Calgary and Monkstown, will close by the end of the first
quarter of 2006. As a result, we and Flextronics intend to enter into an amendment agreement to
extend the term of the original agreement and offer to reflect this updated schedule. These
transactions are subject to customary conditions and regulatory approvals. The successful completion of the agreement and offer with Flextronics will result in the transfer
of approximately 2,500 of our employees to Flextronics. As of the first quarter of 2005, we have
transferred approximately 1,040 of our employees to Flextronics. We expect to receive cash
proceeds ranging from approximately $675 to $725, which will be allocated to each separate closing.
We previously announced that the estimated cash proceeds would be received substantially in 2005.
We and Flextronics are currently discussing the timing of the cash payments based on the expected
change to the original schedule. Such payments will be subject to a number of adjustments,
including potential post-closing date asset valuations and potential post-closing indemnity
payments. We are expecting proceeds on the sale of this business to exceed the net book value of the assets
transferred (including goodwill and foreign currency translation adjustments) and the direct and
incremental costs of the transaction (including transition, potential severance, pension
adjustments, information technology and real estate costs). The resulting net gain on sale of this
business will be recognized once substantially all of the risks and other incidents of ownership
have been transferred. As of March 31, 2005 we
have received net cash of approximately $85, transferred
approximately $193
of inventory and equipment to Flextronics relating to the closing of the optical design activities
in Ottawa and Monkstown and the manufacturing activities in Montreal and recorded deferred charges of approximately $108 and deferred
income of approximately $250. As Flextronics has the ability to exercise rights to sell back to us certain
inventory and equipment after the expiration of a specified period (up to fifteen months) following
each respective closing date, we have retained these assets on our balance sheet to the extent they
have not been consumed as part of ongoing operations as at March 31, 2005. We do not expect that
such rights will be exercised with respect to any material amount of inventory and/or equipment. 50




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Developments in 2005 First quarter 2005 consolidated results summary Summary of unaudited consolidated statements of operations data for the three months ended: March 31,
    
    
    % of
    
    
    March 31,
    
    
    % of(millions of U.S. dollars)
    
    2005
    
    
    revenues
    
    
    2004
    
    
    revenuesRevenues
    
    $
    2,536
    
    
    
    
    
    
    $
    2,444Gross profit
    
    
    1,059
    
    
    
    41.8
    
    
    
    1,072
    
    
    
    43.9Selling, general and administrative expense
    
    
    570
    
    
    
    22.5
    
    
    
    538
    
    
    
    22.0Research and development expense
    
    
    471
    
    
    
    18.6
    
    
    
    466
    
    
    
    19.1Amortization of intangibles
    
    
    2
    
    
    
    0.1
    
    
    
    3
    
    
    
    0.1Special charges
    
    
    21
    
    
    
    0.9
    
    
    
    7
    
    
    
    0.3(Gain) loss on sale of businesses and assets
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    Operating earnings (loss)
    
    
    (6
    )
    
    
    (0.3
    )
    
    
    58
    
    
    
    2.4Other income (expense)  net
    
    
    47
    
    
    
    1.8
    
    
    
    88
    
    
    
    3.6Interest expenseLong-term debt
    
    
    (29
    )
    
    
    (1.1
    )
    
    
    (24
    )
    
    
    (1.0
    )Other
    
    
    (2
    )
    
    
    
    
    
    
    (8
    )
    
    
    (0.3
    )Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net earnings (loss) of associated companies
    
    
    10
    
    
    
    0.4
    
    
    
    114
    
    
    
    4.7Income tax benefit (expense)
    
    
    (15
    )
    
    
    (0.6
    )
    
    
    9
    
    
    
    0.3(5
    )
    
    
    (0.2
    )
    
    
    123
    
    
    
    5.0Minority interests  net of tax
    
    
    (5
    )
    
    
    (0.2
    )
    
    
    (6
    )
    
    
    (0.2
    )Equity in net earnings (loss) of associated companies  net of tax
    
    
    1
    
    
    
    0.1
    
    
    
    (1
    )
    
    
    Net earnings (loss) from continuing operations
    
    
    (9
    )
    
    
    (0.3
    )
    
    
    116
    
    
    
    4.8Net earnings (loss) from discontinued operations  net of tax
    
    
    2
    
    
    
    
    
    
    
    1
    
    
    
    Net earnings (loss)
    
    $
    (7
    )
    
    
    (0.3
    )
    
    $
    117
    
    
    
    4.8
 Our consolidated revenues increased 4% in the first quarter of 2005 compared to the same
period in 2004 primarily due to a substantial increase in GSM and UMTS Networks. GSM and UMTS
Networks revenues increased 20% primarily due to revenue recognized in Asia Pacific on our BSNL
contract in the first quarter of 2005 and in EMEA and CALA due in part to expansion and enhancement
of existing networks by our service provider customers. For further information related to the
BSNL contract, see Significant business developments  Bharat Sanchar Nigram Limited contract. Our gross margin as a
percentage
of revenues decreased by 2.1 percentage points to 41.8% in the first
quarter of 2005 compared to 43.9% in the same period in 2004. The decrease was primarily due to
pricing pressures on certain of our products due to increased competition, unfavorable product mix
and unfavorable impact related to a wireless network contract with BSNL. This was partially offset
by continued improvements in our cost structure, overall higher sales volumes and lower inventory
and warranty provisions. SG&A expense as a
percentage of revenues increased by 0.5 percentage points to 22.5% in the first
quarter of 2005 compared to 22.0% in the same period in 2004 primarily due to increased costs
related to our restatement and related activities, unfavorable foreign exchange rate fluctuation
impacts associated with the strengthening of the Canadian dollar, euro and British pound against
the U.S. dollar and bad debt expense. This was partially offset by a decrease in our stock based
compensation primarily related to a payout under our restricted stock unit, or RSU, program in the
first quarter of 2004 that was not repeated in the first quarter of 2005 as the RSU program was
terminated and cost savings associated with our 2004 Restructuring Plan. 51




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R&D expense as a
percentage of revenues decreased by 0.5 percentage points to 18.6% in the first
quarter of 2005 compared to 19.1% in the first quarter of 2004 primarily due to the savings
associated with our 2004 Restructuring Plan partially offset by increased investments in certain
product areas and unfavorable foreign exchange impacts associated with the strengthening of the
Canadian dollar, euro and British pound against the U.S. dollar. Special charges increased substantially in the first quarter of 2005 compared to the same period of
2004 due to activities associated with the implementation of our 2004 Restructuring Plan. For
further information related to our 2004 work plan, see Results of operations  continuing
operations  Operating expenses  Special charges. We reported a net loss of $7 in the first quarter of 2005 compared to net earnings of $117 in the
same period of 2004 primarily due to the factors discussed above. Significant business developments Acquisitions On April 26, 2005, we
announced that Nortel Networks Inc., a wholly owned subsidiary of ours,
had entered into an agreement with PEC providing for the acquisition of all of the outstanding
shares of PEC for $15.50 per share in cash, or approximately $448 (net of cash acquired), plus transaction costs and expenses. The acquisition is subject to certain conditions,
including the successful completion of a tender offer and regulatory approvals. We currently
expect to complete the acquisition during the second quarter of 2005. Joint ventures On January 20, 2005, we signed a Joint Venture Framework Agreement with China Putian
Corporation to establish a joint venture for R&D, manufacture and sale of third generation, or 3G,
mobile telecommunications equipment and products to customers in China. We expect to enter into a
definitive joint venture agreement by June 30, 2005. We anticipate that we will own 49% of the
joint venture and China Putian will own 51%. On January 23, 2005, we signed a non-binding Memorandum of Understanding with LG Electronics, Inc.
to establish a joint venture for providing high quality, leading edge telecommunications equipment
and networking solutions to Korea and other markets globally. The proposed joint venture is
subject to negotiation of final terms and execution of a definitive agreement. We expect to
complete this transaction in the second half of 2005. In the proposed joint venture, we anticipate
that we will have an ownership interest of 50% plus one share. On May 20, 2005, we signed an agreement with International Business Machines Corporation, or IBM,
designed to support customized products across a range of market segments. As the first step in
this relationship, we plan to establish a Nortel-IBM Joint Development Center to collaborate on the
design and development of new products and services. We believe that this agreement with IBM is an
important component of our strategy to increase R&D collaboration while reducing our R&D expenses
and to introduce products while serving a broad range of customers more rapidly. Optical components operations On December 2, 2004, we entered into a restructuring agreement with Bookham Technology plc, or
Bookham, a sole supplier of key optical components for our optical networks solutions in our
Carrier Packet Networks segment. In February 2005, we agreed to waive until November 6, 2006,
minimum cash balance requirements under certain Bookham notes and in May 2005, we adjusted
the prepayment provisions of these notes and received additional collateral for these notes. In
May 2005, we amended our supply agreement with Bookham to provide Bookham with financial
flexibility to continue the supply of optical components for our optical networks solutions. See
Related party transactions in note 15 of the accompanying unaudited consolidated financial statements. Bharat Sanchar Nigram Limited contract In August 2004, we entered into a contract with BSNL to establish a wireless network in India
for total expected revenues of
approximately $500 to be recognized substantially in 2005. This resulted in a project loss of approximately $160 in 2004. We expect to record an additional loss of approximately $20 substantially in the second
quarter of 2005 as a result of additional orders expected to be received in that period. The
losses on this contract are primarily driven by the pricing pressures as a result of the
competitive nature of Indias telecommunications market 52




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and also our start up costs to become a
significant GSM vendor in this market. We believe that the revenue volumes driven by this contract
will create cost reduction benefits for our overall GSM business. In addition to the orders under the existing contract, BSNL may increase the amounts purchased
under the contract up to an additional 50% of the existing contract level to allow for business
expansion. We expect that there is the potential for further losses, which will be determined by
the product mix and magnitude of additional orders. Nortel Audit Committee Independent Review; restatements; related matters Restatements and Independent Review In May 2003, we commenced certain balance sheet reviews at the direction of certain members of
former management that led to a comprehensive review and analysis of our assets and liabilities, or
the Comprehensive Review, which resulted in the restatement (effected in December 2003) of our
consolidated financial statements for the years ended December 31, 2002, 2001 and 2000 and for the
quarters ended March 31, 2003 and June 30, 2003, or the First Restatement. In late October 2003,
the Audit Committees of our and NNCs Board of Directors, or the Audit Committee, initiated an
independent review of the facts and circumstances leading to the First Restatement, or the
Independent Review, and engaged the law firm now known as Wilmer Cutler Pickering Hale & Dorr LLP,
or WCPHD, to advise it in connection with the Independent Review. The Audit Committee sought to
gain a full understanding of the events that caused significant excess liabilities to be maintained
on the balance sheet that needed to be restated, and to recommend that our Board of Directors
adopt, and direct management to implement, necessary remedial measures to address personnel,
controls, compliance and discipline. In January 2005, the Audit Committee reported the findings of
the Independent Review, or the Independent Review Summary, together with its recommendations for
governing principles for remedial measures that were developed for the Audit Committee by WCPHD.
Each of our and NNCs Board of Directors has adopted these recommendations in their entirety and
directed our management to develop a detailed plan and timetable for their implementation, and will
monitor their implementation. As the Independent Review progressed, the Audit Committee directed new corporate management to
examine in depth the concerns identified by WCPHD regarding provisioning activity and to review
certain provision releases. That examination, and other errors identified by management, led to the
restatement of our financial statements for the years ended December 31, 2002 and 2001 and the
quarters ended March 31, 2003 and 2002, June 30, 2003 and 2002 and September 30, 2003 and 2002, or
the Second Restatement, and our revision of previously announced unaudited results for the year
ended December 31, 2003. The need for the Second Restatement resulted in delays in filing of our
and NNCs 2003 Annual Reports on Form 10-K for the year ended December 31, 2003, or the 2003 Annual
Reports, our and NNCs 2004 Annual Reports on Form 10-K for the year ended December 31, 2004, or
the 2004 Annual Reports, our and NNCs Quarterly Reports on Form 10-Q for the first, second and
third quarters of 2004, or the 2004 Quarterly Reports, and our and NNCs Quarterly Reports on Form
10-Q for the first quarter of 2005, or the 2005 First Quarter Reports, beyond the SECs required
filing dates. We refer to the 2003 Annual Reports, the 2004 Annual Reports, the 2004 Quarterly
Reports and the 2005 First Quarter Reports together as the Reports. Revenue Independent Review Over the course of the Second Restatement process, management identified certain accounting
practices that it determined should be adjusted as part of the Second Restatement. In particular,
management identified certain errors related to revenue recognition and undertook a process of
revenue reviews. In light of the resulting adjustments to revenues previously reported, the Audit
Committee is reviewing the facts and circumstances leading to the restatement of these revenues for
specific transactions identified in the Second Restatement. The review has a particular emphasis
on the underlying conduct that led to the initial recognition of these revenues. The Audit
Committee is seeking a full understanding of the historic events that required the revenues for
these specific transactions to be restated and will consider any appropriate additional remedial
measures, including those involving internal controls and processes. The Audit Committee has
engaged WCPHD to advise it in connection with this review, or the Revenue Independent Review. 53




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Material weaknesses in internal control over financial reporting As described in Item 9A of the 2004 Annual Report, two material weaknesses in our internal
control over financial reporting were identified at the time of the First Restatement. Over the
course of the Second Restatement process, we and our independent auditors, Deloitte & Touche LLP,
or Deloitte, identified a number of additional material weaknesses in our internal control over
financial reporting. On January 10, 2005, Deloitte confirmed to the Audit Committee these material
weaknesses, listed below:  
    
    lack of compliance with written Nortel procedures for monitoring and adjusting balances
related to certain accruals and provisions, including restructuring charges and contract
and customer accruals;
    
    lack of compliance with Nortel procedures for appropriately applying applicable GAAP to
the initial recording of certain liabilities including those described in SFAS No. 5,
Accounting for Contingencies, or SFAS No. 5, and to foreign currency translation as
described in SFAS No. 52, Foreign Currency Translation, or SFAS No. 52;
    
    lack of sufficient personnel with appropriate knowledge, experience and training in
U.S. GAAP and lack of sufficient analysis and documentation of the application of U.S.
GAAP to transactions, including but not limited to revenue transactions;
    
    lack of a clear organization and accountability structure within the accounting
function, including insufficient review and supervision, combined with financial reporting
systems that are not integrated and which require extensive manual interventions;
    
    lack of sufficient awareness of, and timely and appropriate remediation of, internal
control issues by Nortel personnel; and
    
    an inappropriate tone at the top, which contributed to the lack of a strong control
environment; as reported in the Independent Review Summary included in the 2003 Annual
Reports, there was a Management tone at the top that conveyed the strong leadership
message that earnings targets could be met through application of accounting practices
that finance managers knew or ought to have known were not in compliance with U.S. GAAP
and that questioning these practices was not acceptable. Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, or SOX 404, management assessed the
effectiveness of our internal control over financial reporting as at December 31, 2004, using the
criteria issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO,
in Internal Control-Integrated Framework. Based on that assessment, management determined that the
first five of the six material weaknesses listed above continued to exist as at December 31, 2004
and therefore concluded that, as at December 31, 2004, we did not maintain effective internal
control over financial reporting based on the COSO criteria. Our independent auditors issued an
attestation report with respect to that assessment and conclusion, which is included in Item 8 of
the 2004 Annual Report. Management also determined, based on that assessment, that the sixth material weakness, relating to
an inappropriate tone at the top, was eliminated as at December 31, 2004 as a result of certain
modifications to our internal control over financial reporting, remedial measures and other
actions. The first five of these six material weaknesses remain unremedied. We continue to identify,
develop and implement remedial measures to address these material weaknesses in our internal
control over financial reporting. See Item 9A of the 2004 Annual Report, the Controls and Procedures section of this report and
Risk factors/forward looking statements  Risks related to our restatements and related matters. EDC Support Facility The delayed filing of the Reports with the SEC, the trustees under our and NNCs public debt
indentures and Export Development Canada, or EDC, gave EDC the right to (i) terminate its
commitments under the $750 EDC support facility, or the EDC Support Facility, relating to certain
of our performance related obligations arising out of normal course business activities, and (ii)
exercise certain rights against the collateral pledged under related security agreements or require
us to cash collateralize all existing support. Throughout 2004 and into 2005, we obtained waivers from EDC with respect to these matters to permit
continued access to the EDC Support Facility in accordance with its terms while we and NNC worked
to complete our filing obligations. The waivers also applied to certain related breaches under the
EDC Support Facility relating to the delayed filings and the restatements and revisions to our and
NNCs prior financial results, or the Related Breaches. In connection with such waivers, EDC reclassified the previously committed $300 revolving small bond 54




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sub-facility of the
EDC Support Facility as uncommitted support during the applicable waiver period. The $300
revolving small bond sub-facility will not become committed support until all delayed filings have
been filed with the SEC, the trustees under our and NNCs public debt indentures and EDC and we
obtain a permanent waiver of the Related Breaches. On May 31, 2005, we obtained a permanent waiver from EDC, or the Permanent Waiver, of certain
defaults and the Related Breaches by us under the EDC Support Facility. With the filing and
delivery to the trustees of the 2005 First Quarter Reports and the Permanent Waiver, we will be in
compliance with its obligations under the EDC Support Facility and the $300 revolving small bond sub-facility will be reclassified as committed support. As of May 16, 2005, there was approximately $228 of outstanding support utilized under the EDC
Support Facility, approximately $160 of which was outstanding under the small bond sub-facility.
See Liquidity and capital resources  Sources of liquidity
 Available support facility and Risk
factors/forward looking statements. Debt securities As a result of the delay in filing the Reports, we and NNC were not in compliance with our
obligations to deliver our respective SEC filings to the trustees under our and NNCs public debt
indentures. With the filing of the 2005 First Quarter Reports with the SEC and the delivery of the
2005 First Quarter Reports to the trustees under our and NNCs public debt indentures, we and NNC
will be in compliance with our delivery obligations under the public debt indentures. Regulatory actions and pending litigation We are under investigation by the SEC and the Ontario Securities Commission, or OSC,
Enforcement Staff. In addition, Nortel has received a U.S. federal grand jury subpoena for the
production of certain documents sought in connection with an ongoing criminal investigation being
conducted by the U.S. Attorneys Office for the Northern District of Texas, Dallas Division.
Further, the Integrated Market Enforcement Team of the Royal Canadian Mounted Police, or RCMP, has
advised us that it would be commencing a criminal investigation into our financial accounting
situation. We will continue to cooperate fully with all authorities in connection with these
investigations and reviews. See Legal proceedings and Risk factors/forward looking statements. In addition, numerous class action complaints have been filed against us and NNC, including class
action complaints under the Employee Retirement Income Security Act, or ERISA. In addition, a
derivative action complaint has been filed against Nortel. These pending civil litigation actions
and regulatory and criminal investigations are significant and if decided against us, could
materially adversely affect our results of operations, financial condition and liquidity by
requiring us to pay substantial judgments, settlements, fines or other penalties. See Liquidity
and capital resources, Legal proceedings and Risk factors/forward looking statements. On May 31, 2004, the OSC issued a final order prohibiting all trading by our directors, officers
and certain current and former employees in the securities of Nortel Networks Corporation and
Nortel Networks Limited. This order will remain in effect until two full business days following
the receipt by the OSC of all filings required to be made by us and NNC pursuant to Ontario
securities laws. Because such filings would require amendments to our and NNCs previous filings
for each of the quarterly periods of 2003 and for earlier periods including 2002 and 2001, which we
do not believe to be feasible for the same reasons mentioned in Item 9A of our 2004 Annual Reports
with respect to the restatement of 2000 selected financial data, we and NNC plan to apply to the
OSC to have this order revoked now that we and NNC have become current with our financial reporting obligations
for the first quarter of 2005 under Ontario securities laws. The OSC may, in its discretion, revoke the order where in
its opinion to do so would not be prejudicial to the public interest. As a result of our delay in filing the Reports, we were in breach of the continued listing
requirements of the NYSE and TSX. With the filing and delivery of the 2005 First Quarter Reports,
we and NNC will be in compliance with the continued listing requirements of the NYSE and TSX. See
Risk factors/forward looking statements. Stock-based compensation plans As a result of our March 10, 2004 announcement that we and NNC would need to delay the filing
of our 2003 Annual Reports, we suspended as of March 10, 2004: the purchase of Nortel Networks
Corporation common shares under the stock purchase plans for eligible employees in eligible
countries that facilitate the acquisition of Nortel Networks Corporation common shares; the
exercise of outstanding options granted under the Nortel Networks Corporation 2000 Stock Option
Plan, or the 2000 Plan, or Nortel Networks Corporation 1986 Stock Option Plan as amended and
restated, or the 1986 Plan, or the grant of any additional options under those plans, or the exercise
of outstanding options granted 55




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under employee stock option plans previously assumed by us in connection with mergers and
acquisitions; and the purchase of units in a Nortel stock fund or purchase of Nortel Networks
Corporation common shares under our defined contribution and investments plans, until such time as,
at the earliest, that we and NNC are in compliance with U.S. and Canadian regulatory securities
filing requirements. We intend to lift the suspension of these plans as soon as practicable. Results of operations  continuing operations Consolidated information Revenues The following chart summarizes our recent quarterly revenues: (BAR CHART) Geographic revenues The following table summarizes our geographic revenues based on the location of the customer: For the three months ended March 31,2005
    
    
    2004
    
    
    $ Change
    
    
    % ChangeUnited States
    
    $
    1,146
    
    
    $
    1,217
    
    
    $
    (71
    )
    
    
    (6
    )EMEA(a)
    
    
    722
    
    
    
    596
    
    
    
    126
    
    
    
    21Canada
    
    
    114
    
    
    
    154
    
    
    
    (40
    )
    
    
    (26
    )Asia Pacific
    
    
    402
    
    
    
    347
    
    
    
    55
    
    
    
    16CALA(b)
    
    
    152
    
    
    
    130
    
    
    
    22
    
    
    
    17Consolidated
    
    $
    2,536
    
    
    $
    2,444
    
    
    $
    92
    
    
    
    4
 (a)
    
    The Europe, Middle East and Africa region, or EMEA.(b)
    
    The Caribbean and Latin America region, or CALA.
 Q1 2005 vs. Q1 2004 Our consolidated revenues increased 4% in the first quarter of 2005 compared to the same
period in 2004 primarily due to a substantial increase in GSM and UMTS Networks. Carrier Packet Networks revenues decreased 3% primarily due to a substantial decline in our
traditional circuit switching products revenues. This substantial decline was primarily due to
continued reductions in capital expenditures by our U.S., Canada and EMEA service provider
customers and a reduction in spending on our mature products in all regions. The substantial
decline in traditional circuit switching product revenues was partially offset by the substantial
increase in revenues related to our packet voice solutions in the U.S., Canada and EMEA regions as
customers continue to transition to these next-generation products from our traditional circuit
switching products. However, the amount of decline of our traditional circuit switching revenues
is higher than the growth in our next generation carrier packet technologies. In addition, overall
Carrier Packet Networks revenues decreased due in part to pricing pressures driven by increased
competition. CDMA Networks revenues decreased 6% primarily due to a substantial decline in Asia Pacific due to
the completion of certain customer 56




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network deployments during the first half of 2004. This was
partially offset by new contracts with certain customers and other customers expanding their
existing networks to meet increased subscriber demand primarily in the U.S. and Canada. GSM and UMTS Networks
revenues increased 20% primarily due to revenue recognized in Asia Pacific on
our BSNL contract in the first quarter of 2005. For further information related to the BSNL
contract, see Developments in 2005  Significant business developments  Bharat Sanchar Nigram
Limited contract. In addition, revenues in EMEA and CALA increased substantially due in part to
customers expanding their existing networks to meet increased subscriber demand or enhancing their
networks to support more sophisticated communication services. Enterprise Networks revenues increased 2% primarily due to a substantial increase in revenues
associated with our Internet Protocol, or IP, telephony solutions as customers continued to migrate
towards converged packet voice solutions from our traditional circuit switching products. In
addition, data networking and security revenues increased primarily due to growth from improved
market penetration of certain new data products partially offset by a decline in our legacy routing
portfolio revenues and associated declines in new service contracts and service contract renewals
and pricing pressures driven by increased competition. Q1 2005 vs. Q4 2004 Our consolidated revenues decreased 3% in the first quarter of 2005 compared to the fourth
quarter of 2004 primarily due to declines in revenue across all segments with the exception of a
significant increase in GSM and UMTS Networks. Carrier Packet Networks revenues decreased 3% primarily due to a significant decline in our
traditional circuit switching products revenues. This significant decline was primarily due to
continued reductions in capital expenditures by our EMEA, U.S. and Canada service provider
customers and a reduction in spending on our mature products in all regions. The significant
decline in traditional circuit switching product revenues was partially offset by a slight increase
in revenues related to our packet voice solutions in the U.S. as customers continue to transition
to these next-generation products from our traditional circuit switching products. In addition,
overall Carrier Packet Networks revenues decreased due in part to pricing pressures driven by
increased competition. CDMA Networks revenues decreased 13% primarily due to typically higher seasonal volumes in the
fourth quarter in the U.S. and Canada. GSM and UMTS Networks
revenues increased 18% primarily due to increased revenue recognized in Asia
Pacific on our BSNL contract in the first quarter of 2005. For further information related to the
BSNL contract, see Developments in 2005  Significant business developments  Bharat Sanchar Nigram
Limited contract. In addition, revenues in EMEA increased substantially due in part to customers
expanding their existing networks to meet increased subscriber demand or enhancing their networks
to support more sophisticated communication services. Enterprise Networks revenues decreased 16% primarily due to typically higher seasonal volumes in
the fourth quarter in EMEA, Asia Pacific and CALA regions. 2005 Based on current customer orders in emerging markets, particularly in Asia Pacific and CALA
and increased deployments of VoIP and next generation wireless technologies, including UMTS, we
believe that we are well positioned to grow our revenues in 2005. For 2005, we expect overall continued revenue growth over 2004 primarily due to:  
    
    continued growth in our voice over packet technologies and our 3G wireless technologies;
however, the timing of when service provider customers will deploy packet-based
technologies on a wider scale is still unclear;
    
    build-out of the BSNL contract in the Asia Pacific region. For further information
related to the BSNL contract, see Developments in 2005  Significant business developments
  Bharat Sanchar Nigram Limited contract;
    
    expansion and enhancement of existing networks by our customers due to subscriber growth and competitive pressures;
    
    anticipated growth in our Enterprise Networks business, particularly in our converged networks products; 57




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
    
    a focus by our customers on new technologies that create opportunities to optimize
existing networks while limiting capital expenditures and operating costs;
    
    expected continued growth in metro optical and carrier VoIP; and
    
    expected focus on new product areas, such as Wireless Local Area Networks, or WLAN, and carrier routing. Revenue growth generated from spending by our customers in the above areas of our business is
expected to be partially offset by revenue declines from:  
    
    customers limiting their investment in mature technologies as they focus on maximizing
return on invested capital;
    
    pricing pressures on sales of certain of our products as a result of increased
competition, particularly from low cost suppliers;
    
    consolidation of service providers which may reduce overall spending on
telecommunications equipment, including to date in our GSM and UMTS Networks segment; and
    
    the impact of our financial restatement activities and the internal restructuring and
realignment programs that were initiated in August 2004. For additional information, see
Developments in 2005  Nortel Audit Committee Independent Review; restatements; related
matters. While customer support generally remains strong, we believe that these
activities will continue to have an adverse impact on business performance in 2005. See Risk factors/forward looking statements for other factors that may affect our revenues.
While we have seen encouraging indicators in certain parts of the market, we can provide no
assurance that the growth areas that have begun to emerge will continue in the future. Gross profit and gross margin For the three months ended March 31,2005
    
    
    2004
    
    
    $ Change
    
    
    % ChangeGross profit
    
    $
    1,059
    
    
    $
    1,072
    
    
    $
    (13
    )
    
    
    (1
    )Gross margin
    
    
    41.8
    %
    
    
    43.9
    %
    
    

    (2.1 pts
    )
 Gross profit decreased $13 (while gross margin, which is gross profit calculated as a percent
of revenues, decreased 2.1 percentage points) in the first quarter of 2005 compared to the first
quarter of 2004 primarily due to:  
    
    a decrease of approximately $178 primarily as a result of (i) pricing
pressures on certain of our products due to increased competition for service provider and
enterprise customers; and (ii) unfavorable product mix associated with increased sales of
our next generation products which typically have lower gross margins in the early stages
of product evolution; and
    
    a decrease of approximately $5 related to a contract in India with BSNL and its adverse
impact on our overall gross margin mix. For further information
related to the BSNL contract, see Developments in 2005  Significant business developments
  Bharat Sanchar Nigram Limited contract; partially offset by
    
    an estimated increase of approximately $80 due to continued improvements in
our cost structure primarily as a result of lower material pricing;
    
    an increase of approximately $50 due to overall higher sales volumes; and
    
    an increase of approximately $40 primarily due to recoveries in inventory
provisions due to sale of inventory and lower warranty costs as a result of improved
product quality. While we cannot predict the extent to which changes in product mix and pricing pressures will
continue to impact our gross margin, we continue to see the effects of improvements in our product
costs primarily due to favorable supplier pricing. Considering the impacts of our strategic plan
described under Business overview  Our strategy and outlook and the higher costs associated with
initial customer deployments in emerging markets, we expect that gross margin will continue to
trend in the range of 40% to 44% of revenue for the full year 2005. See Risk factors/forward
looking statements for factors that may affect our gross margins. For a discussion of our gross
margins by segment, see Management EBT under Segment information. 58




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Operating expenses Selling, general and administrative expense For the three months ended March 31,2005
    
    
    2004
    
    
    $ Change
    
    
    % ChangeSG&A expense
    
    $
    570
    
    
    $
    538
    
    
    $
    32
    
    
    
    6As % of revenues
    
    
    22.5
    %
    
    
    22.0
    %

    0.5 pts
 SG&A expense increased
$32 and increased from 22.0% to 22.5% as a percentage of revenues in
the first quarter of 2005 compared to the first quarter of 2004 primarily due to:  
    
    costs related to our restatement and related activities of approximately $32
in the first quarter of 2005 compared to approximately $6 in the first quarter of 2004;
    
    increased investments in our finance organization;
    
    significant unfavorable foreign exchange impacts associated with the
strengthening of the Canadian dollar, euro and British pound against the U.S. dollar; and
    
    an increase in bad debt expense; partially offset by
    
    a decrease of approximately $41 in our stock based compensation primarily
related to a payout under our RSU program in the first quarter of 2004 that was not
repeated in the first quarter of 2005 as the RSU program was terminated; and
    
    cost savings associated with our 2004 Restructuring Plan. For a discussion of our SG&A expense by segment, see Management EBT under Segment information. Research and development expense For the three months ended March 31,2005
    
    
    2004
    
    
    $ Change
    
    
    % ChangeR&D expense
    
    $
    471
    
    
    $
    466
    
    
    $
    5
    
    
    
    1As % of revenues
    
    
    18.6
    %
    
    
    19.1
    %
    
    
    (0.5 pts
    )
 R&D expense increased by $5 in the first quarter of 2005 compared to the first quarter of 2004
primarily due to increased investments in certain product areas, unfavorable foreign exchange
impacts associated with the strengthening of the Canadian dollar, euro and British pound against
the U.S. dollar, partially offset primarily by the savings associated with our 2004 Restructuring
Plan. Our continued strategic investments in R&D are aligned with technology leadership in anticipated
growth areas. In the first quarter of 2005, we maintained a technology focus and commitment to
invest in new innovative solutions where we believed we would achieve the greatest future benefit
from this investment. Our R&D expense as a percentage of our consolidated revenues declined by 0.6
percentage points in the first quarter of 2005 compared to the first quarter of 2004. We expect to continue to manage R&D expense according to the requirements of our business,
allocating resources and investment where customer demand dictates, and reducing resources and
investment where opportunities for improved efficiencies present themselves. Our R&D efforts are
currently focused on secure and reliable converged networks including:  
    
    packetization of voice and multimedia IP telephony solutions services;
    
    services edge capability to realize simplification of customer network
operations and broadband access technologies, including wireless and wireline; and
    
    enhanced network security to ensure the level of reliability and performance
that has traditionally existed in carrier networks. We expect that our R&D expense as a percentage of revenue in 2005 will be lower than 2004 as we
seek to achieve ongoing cost reductions in R&D as part of our 2004 Restructuring Plan. For a
discussion of our R&D expense by segment, see Management EBT under Segment information. 59




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We expect operating expenses (both SG&A expense and R&D expense combined) as a percent of revenue
to be approximately 35 percent by the end of 2005 primarily driven by benefits from our previously
announced restructuring work plan and reductions in restatement, accounting and reporting costs.
See Business overview  Our strategy and outlook. Special charges During 2001, we implemented a work plan to streamline operations and activities around core
markets and leadership strategies in light of the significant downturn in both the
telecommunications industry and the economic environment, and capital market trends impacting
operations and expected future growth rates, or the 2001 Restructuring Plan. In addition, we initiated activities in 2003 to exit certain leased facilities and leases for
assets no longer used across all segments. In 2004 and 2005, our focus is on managing each of our businesses based on financial performance,
the market and customer priorities. Our 2004 Restructuring Plan includes a work plan involving
focused workforce reductions, including a voluntary retirement program, of approximately 3,250
employees, real estate optimization and other cost containment actions such as reductions in
information services costs, outsourced services and other discretionary spending across all
segments but primarily in Carrier Packet Networks. Approximately 73% of employee actions related
to the focused workforce reduction were completed by the end of the first quarter of 2005,
including approximately 62% who were notified of termination or acceptance of voluntary retirement,
with the remainder comprised of voluntary attrition of employees who were not replaced. The
remainder of employee actions is expected to be completed by June 30, 2005. This workforce
reduction is in addition to the workforce reduction that will result from our agreement with
Flextronics. For more information on our agreement with Flextronics,
see Business Overview  Evolution of our supply chain strategy. We expect the real estate actions to be completed by the
end of 2005. We estimate charges to earnings associated with the 2004 Restructuring Plan in the aggregate of
approximately $450 comprised of approximately $220 with respect to the workforce reductions and
approximately $230 with respect to the real estate actions. No charges are expected to be recorded
with respect to the other cost containment actions. We incurred aggregate charges of $160 in 2004
with the remainder expected to be incurred in 2005. The associated cash costs of the 2004 Restructuring Plan of approximately $430 are expected to be
split approximately equally between the workforce reductions and real estate actions.
Approximately 10% of these cash costs were incurred in 2004 and approximately 40% are expected to
be incurred in 2005. The remaining 50% of the cash costs relate to the real estate actions and are
expected to be incurred in 2006 through to 2022 for ongoing lease costs related to impacted real
estate facilities. In addition to the above, we also expect to incur capital cash costs of
approximately $50 in 2005 for facility improvements related to the real estate actions. In the first quarter of 2005, we realized costs savings of approximately $93 related to the 2004
Restructuring Plan primarily due to reductions to cost of revenues, SG&A expense and R&D expense of
approximately 20%, 40% and 40% as a percentage of the realized cost savings, respectively, across
all segments but primarily in Carrier Packet Networks. For the remainder of 2005, we expect
additional cost savings of approximately $400 to be substantially realized in the results of
operations in the second half of 2005, which we expect will be partially offset by the costs
associated with new hires added throughout 2005. We anticipate that the remainder of the cost
savings will be consistent with the level of cost savings experienced in the first quarter of 2005
in terms of the impact to cost of revenues, SG&A expense and R&D expense and our segments. We
expect that this work plan will primarily be funded with cash from operations. 60




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During the three months ended March 31, 2005, we continued to implement these restructuring work
plans. Changes in the provisions related to special charges recorded from January 1, 2005 to March 31, 2005 were as follows: Contract
    
    
    Plant andWorkforce
    
    
    Settlement and
    
    
    equipmentreduction
    
    
    lease costs
    
    
    write downs
    
    
    Total2001 Restructuring PlanProvision balance as of December 31, 2004(a)
    
    $
    15
    
    
    $
    326
    
    
    $
    
    
    
    $
    341Revisions to prior accruals
    
    
    (3
    )
    
    
    
    
    
    
    (1
    )
    
    
    (4
    )Cash drawdowns
    
    
    (2
    )
    
    
    (40
    )
    
    
    
    
    
    
    (42
    )Foreign exchange and other adjustments
    
    
    (1
    )
    
    
    (4
    )
    
    
    1
    
    
    
    (4
    )Provision balance as of March 31, 2005
    
    $
    9
    
    
    $
    282
    
    
    $
    
    
    
    $
    2912004 Restructuring PlanProvision balance as of December 31, 2004 (a)
    
    $
    122
    
    
    $
    
    
    
    $
    
    
    
    $
    122Other special charges
    
    
    18
    
    
    
    8
    
    
    
    1
    
    
    
    27Revisions to prior accruals
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    (2
    )Cash drawdowns
    
    
    (86
    )
    
    
    
    
    
    
    
    
    
    
    (86
    )Foreign exchange and other adjustments
    
    
    
    
    
    
    
    
    
    
    (1
    )
    
    
    (1
    )Provision balance as of March 31, 2005
    
    $
    52
    
    
    $
    8
    
    
    $
    
    
    
    $
    60Provision balance as of March 31, 2005 (a)
    
    $
    61
    
    
    $
    290
    
    
    $
    
    
    
    $
    351
 (a)
    
    As of March 31, 2005 and December 31, 2004, the short-term provision balance was $152 and
$254, respectively, and the long-term provision balance was $199 and $209, respectively.
 2001 Restructuring Plan Three months ended March 31, 2005 During the three months ended March 31, 2005, we recorded revisions of $4 related to prior
accruals. During the three months ended March 31, 2005, the workforce reduction provision balance was drawn
down by cash payments of $2. The remaining provision is expected to be substantially drawn down by
the end of 2005. No new contract settlement and lease costs were incurred during the period. During the three months
ended March 31, 2005, the provision balance for contract settlement and lease costs was drawn down
by cash payments of $40. The remaining provision, net of approximately $241 in estimated sublease
income, is expected to be substantially drawn down by the end of 2013. Three months ended March 31, 2004 During the three months ended March 31, 2004, we recorded special charges of $7, which
included revisions of $1 related to prior accruals. Workforce reduction charges of $6 were related to severance and benefit costs associated with
approximately 80 employees notified of termination during the three months ended March 31, 2004
which related entirely to Carrier Packet Networks. During the three months ended March 31, 2004,
the workforce reduction provision balance was drawn down by cash payments of $27. No new contract settlement and lease costs were incurred during the period. Revisions to prior
accruals for contract settlement and lease costs of $1 were identified for the three months ended
March 31, 2004. During the three months ended March 31, 2004, the provision balance for contract
settlement and lease costs was drawn down by cash payments of $57. 61




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Special charges  by segment The following table outlines special charges incurred by segment for the three months ended
March 31: Contract
    
    
    Plant andWorkforce
    
    
    settlement and
    
    
    equipmentreduction
    
    
    lease costs
    
    
    write downs
    
    
    Total2001 Restructuring PlanCarrier Packet Networks
    
    $
    (1
    )
    
    $
    
    
    
    $
    (1
    )
    
    $
    (2
    )CDMA Networks
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    GSM and UMTS Networks
    
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    (1
    )Enterprise Networks
    
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    (1
    )Special charges for the three months
ended March 31, 2005
    
    $
    (3
    )
    
    $
    
    
    
    $
    (1
    )
    
    $
    (4
    )Carrier Packet Networks
    
    $
    6
    
    
    $
    1
    
    
    $
    
    
    
    $
    7Special charges for the three months
ended March 31, 2004
    
    $
    6
    
    
    $
    1
    
    
    $
    
    
    
    $
    7
 The definition of segment Management EBT does not include special charges. A significant
portion of our provisions for workforce reductions and contract settlement and lease costs is
associated with shared services. These costs have been allocated to the segments in the table above
based generally on headcount. 2004 Restructuring Plan Three months ended March 31, 2005 During the three months ended March 31, 2005, we recorded special charges of $25, which
included revisions of $2 related to prior accruals. Workforce reduction charges of $16, net of revisions to prior accruals of $2, were related to severance and benefit costs associated with
approximately 240 employees notified of termination during the three months ended March 31, 2005.
During the three months ended March 31, 2005, the workforce reduction provision balance was drawn
down by cash payments of $86. The workforce reduction was primarily in the U.S., Canada and EMEA
and extended across all segments. The remaining provision is expected to be substantially drawn
down by the end of 2005. Contract settlement and lease costs of $8 consisted of negotiated settlements to cancel or
renegotiate contracts and net lease charges related to leased facilities (comprised of office
space) and leased furniture that were identified as no longer required primarily in the U.S. and in the Enterprise Networks segment. These
lease costs, net of anticipated sublease income, included costs relating to non-cancelable lease
terms from the date leased facilities ceased to be used and termination penalties. This provision is expected to be substantially drawn down by the end of 2016. Special charges  by segment The following table outlines 2004 Restructuring Plan special charges incurred by segment for
the three months ended March 31, 2005: Contractsettlement
    
    
    Plant andWorkforce
    
    
    and lease
    
    
    equipmentreduction
    
    
    costs
    
    
    write downs
    
    
    Total2004 Restructuring PlanCarrier Packet Networks
    
    $
    9
    
    
    $
    1
    
    
    $
    1
    
    
    $
    11CDMA Networks
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    1GSM and UMTS Networks
    
    
    3
    
    
    
    
    
    
    
    
    
    
    
    3Enterprise Networks
    
    
    3
    
    
    
    7
    
    
    
    
    
    
    
    10Special charges for the three months
ended March 31, 2005
    
    $
    16
    
    
    $
    8
    
    
    $
    1
    
    
    $
    25
 62




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For additional information related to our restructuring activities, see Special charges in
note 5 of the accompanying unaudited consolidated financial statements. Other income (expense)  net The components of other income (expense)  net were as follows: For the three months ended March 31,2005
    
    
    2004Interest income
    
    $
    14
    
    
    $
    15Gain (loss) on sale or write down of investments
    
    
    (5
    )
    
    
    33Currency exchange gains (losses)
    
    
    26
    
    
    
    1Other  net
    
    
    12
    
    
    
    39Other income (expense)  net
    
    $
    47
    
    
    $
    88
 In the first quarter of 2005, other income (expense)  net was $47, which primarily included:  
    
    foreign exchange gains of $26 primarily related to day-to-day transactional activities;
    
    a gain of $10 resulting from a restructured customer financing arrangement; and
    
    dividend income of $9 on our short-term investments; partially offset by
    
    losses of $5 related to changes in fair value of derivative financial
instruments that did not meet the criteria for hedge accounting. In the first quarter of 2004, other income (expense)  net was $88, which primarily included:  
    
    a gain of $23 related to prepaid equity forward purchase contracts that were
entered into in connection with the issuance of restricted stock units;
    
    a gain of $18 related to the sale of our remaining 7 million common shares of Entrust Inc., or Entrust;
    
    a gain of $13 related to the sale of Arris Group, Inc., or Arris Group, shares; and
    
    dividend income of $5 on our short-term investments. Interest expense Interest expense was $31 in the first quarter of 2005 compared to $32 in the first quarter of
2004. We expect that the quarterly interest expense for the remainder of 2005 will remain at a level
similar to 2004. Income tax benefit (expense) During the three months ended March 31, 2005, we recorded a tax expense of $15 on pre-tax
earnings of $10 from continuing operations before minority interests and equity in net earnings
(loss) of associated companies. We recorded a tax expense against the earnings of certain taxable
entities and recorded additional valuation allowances against the tax benefit of current period
losses of other entities. The tax expense related primarily to the drawdown of our deferred tax
assets and current tax provisions in certain taxable jurisdictions and various corporate minimum
and other taxes, partially offset by the recognition of R&D related incentives. In the first quarter of 2004, we recorded a tax benefit of $9 on pre-tax earnings of $114 from
continuing operations before minority interests and equity in net earnings (loss) of associated
companies. This tax benefit resulted from the settlement of certain tax audits partially offset by
the drawdown of our deferred tax assets and current income tax provisions in certain taxable
jurisdictions and various corporate minimum related income taxes. As of March 31, 2005, we have substantial loss carryforwards and valuation allowances in our
significant tax jurisdictions. These loss carryforwards will serve to minimize our future cash
income related taxes. We will continue to assess the valuation allowance recorded against our
deferred tax assets on a quarterly basis. The valuation allowance is in accordance with SFAS No.
109, Accounting for Income Taxes, which requires that a tax valuation allowance be established
when it is more likely than not that some portion or all of a companys deferred tax assets will
not be realized. Given the magnitude of our valuation allowance, future adjustments to this
valuation allowance based on actual 63




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results could result in a significant adjustment to our
effective tax rate. For additional information, see Application of critical accounting policies
and estimates  Tax asset valuation. Net earnings (loss) from continuing operations As a result of the items discussed above under Results of operations  continuing
operations, net loss from continuing operations was $9 in the first quarter of 2005. This amount
represented a decline of $125 compared to our net earnings from continuing operations of $116 in
the first quarter of 2004. Segment information The following tables set forth revenues, segment Management EBT and its reconciliation to net
earnings (loss) from continuing operations by segment: For the three months ended March 31,2005
    
    
    2004
    
    
    $ Change
    
    
    % ChangeRevenuesCarrier Packet Networks
    
    $
    664
    
    
    $
    683
    
    
    $
    (19
    )
    
    
    (3
    )CDMA Networks
    
    
    535
    
    
    
    569
    
    
    
    (34
    )
    
    
    (6
    )GSM and UMTS Networks
    
    
    788
    
    
    
    656
    
    
    
    132
    
    
    
    20Enterprise Networks
    
    
    547
    
    
    
    534
    
    
    
    13
    
    
    
    2Other(a)
    
    
    2
    
    
    
    2
    
    
    
    
    
    
    
    Total revenues
    
    $
    2,536
    
    
    $
    2,444
    
    
    $
    92
    
    
    
    4Segment Management EBTCarrier Packet Networks
    
    $
    (30
    )
    
    $
    (59
    )
    
    $
    29
    
    
    
    49CDMA Networks
    
    
    168
    
    
    
    224
    
    
    
    (56
    )
    
    
    (25
    )GSM and UMTS Networks
    
    
    53
    
    
    
    1
    
    
    
    52
    
    
    
    5,200Enterprise Networks
    
    
    32
    
    
    
    25
    
    
    
    7
    
    
    
    28Other(a)
    
    
    (193
    )
    
    
    (74
    )
    
    
    (119
    )
    
    
    (161
    )Total segment Management EBT
    
    
    30
    
    
    
    117
    
    
    
    (87
    )
    
    
    (74
    )Amortization of intangibles
    
    
    (2
    )
    
    
    (3
    )
    
    
    1
    
    
    
    33Special charges
    
    
    (21
    )
    
    
    (7
    )
    
    
    (14
    )
    
    
    (200
    )Gain (loss) on sale of businesses and assets
    
    
    (1
    )
    
    
    
    
    
    
    (1
    )
    
    
    Income tax benefit (expense)
    
    
    (15
    )
    
    
    9
    
    
    
    (24
    )
    
    
    (267
    )Net earnings (loss) from continuing operations
    
    $
    (9
    )
    
    $
    116
    
    
    $
    (125
    )
    
    
    (108
    )
 (a)
    
    Other represented miscellaneous business activities and corporate functions.
 64




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Management EBT is a measure that includes the cost of revenues, SG&A
expense, R&D expense, interest expense, other income (expense)  net, minority interests  net of
tax and equity in net loss of associated companies  net of tax. The following table sets forth the positive (negative) contribution to segment Management EBT by
each of its components: For the three months ended March 31, 2005 compared to March 31, 2004Gross Profit
    
    
    SG&A
    
    
    R&D
    
    
    Other items(b)
    
    
    Total $ changeCarrier Packet Networks
    
    $
    13
    
    
    $
    8
    
    
    $
    11
    
    
    $
    (3
    )
    
    $
    29CDMA Networks
    
    
    (62
    )
    
    
    2
    
    
    
    
    
    
    
    4
    
    
    
    (56
    )GSM and UMTS Networks
    
    
    46
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    52Enterprise Networks
    
    
    15
    
    
    
    (9
    )
    
    
    (3
    )
    
    
    4
    
    
    
    7Other(a)
    
    
    (25
    )
    
    
    (39
    )
    
    
    (13
    )
    
    
    (42
    )
    
    
    (119
    )Total Change
    
    $
    (13
    )
    
    $
    (32
    )
    
    $
    (5
    )
    
    $
    (37
    )
    
    $
    (87
    )
 (a)
    
    Other represented miscellaneous business activities and corporate functions.(b)
    
    Other items is comprised of interest expense, other income (expense)  net, minority
interests  net of tax and equity in net loss of associated companies  net of tax.
 Carrier Packet Networks Revenues The following chart summarizes recent quarterly revenues for Carrier Packet Networks: (BAR CHART) Q1 2005 vs. Q1 2004 Carrier Packet Networks revenues decreased 3% in the first quarter of 2005 compared to the
same period in 2004. Revenues from the traditional circuit switching products declined substantially primarily due to
continued reductions in capital expenditures by our U.S., Canada and EMEA service provider
customers and a reduction in spending on our mature products in all regions. The substantial
decline in traditional circuit switching product revenues was partially offset by the substantial
increase in revenues related to our packet voice solutions in the U.S., Canada and EMEA regions as
customers continue to transition to these next-generation products from our traditional circuit
switching products. However, the amount of decline of our traditional circuit switching revenues
is higher than the growth in our next generation carrier packet technologies. Revenues from the data networking and security portion of this segment increased primarily due to
new contracts with certain customers and other customers expanding their existing networks to meet
increased subscriber demand or enhancing their networks to support more sophisticated communication
services in the U.S., Canada and EMEA. Revenues in the optical networking portion of this segment increased primarily due to new contracts
with certain service provider customers and other customers expanding their existing networks in
the Asia Pacific region. In addition, we recognized revenues, which had previously been deferred
in prior periods, as a result of the final acceptance of a customer contract in the first quarter
of 2005. This increase was partially offset by a reduction due to shipping delays to our customers
in the U.S. and Canada as a result of the completion of a portion of the 65




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Flextronics transaction
relating to manufacturing facilities in Montreal in the first quarter of 2005. In addition,
customers continued to focus on maximizing return on invested capital by increasing the capacity
utilization rates and efficiency of existing networks. In addition, overall Carrier Packet Networks revenues decreased due in part to pricing pressures
driven by increased competition. Management EBT Management EBT for the Carrier Packet Networks segment increased by $29 in the first quarter of
2005 compared to the first quarter of 2004 primarily as a result of the items discussed below. Q1 2005 vs. Q1 2004 Carrier Packet Networks gross margin increased by approximately 3.0 percentage points (while
gross profit increased $13) primarily due to:  
    
    continued improvements in our cost structure primarily as a result of lower material pricing;
    
    recovery in inventory provision due to sale of inventory that was previously fully provided for; and
    
    lower warranty costs; partially offset by
    
    unfavorable product mix associated with increased sales of our next generation
products which typically have lower gross margins in the early stages of product evolution;
and
    
    continued pricing pressures on certain of our products due to increased
competition. Carrier Packet Networks SG&A expense decreased $8 primarily due to:  
    
    the continued impact of our workforce reductions across all regions and
associated reductions in other related costs such as information services and real estate;
partially offset by
    
    unfavorable foreign exchange rate impacts associated with the strengthening of
the Canadian dollar against the U.S. dollar; and
    
    increased bad debt expense. Carrier Packet Networks R&D expense decreased $11 primarily due to:  
    
    the continued impact of our workforce reductions that targeted a level of R&D
expense that was more representative of the volume of our business; partially offset by
    
    unfavorable foreign exchange rate impacts associated with the strengthening of
the Canadian dollar against the U.S. dollar. 66




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CDMA Networks Revenues The following chart summarizes recent quarterly revenues for CDMA Networks: (BAR CHART) Q1 2005 vs. Q1 2004 CDMA Networks revenues decreased 6% in the first quarter of 2005 compared to the same period
in 2004 primarily due to a substantial decline in Asia Pacific due to the completion of certain
customer network deployments during the first half of 2004. This was partially offset by new
contracts with certain customers and other customers expanding their existing networks to meet
increased subscriber demand primarily in the U.S. and Canada. Management EBT Management EBT for the CDMA Networks segment decreased by $56 in the first quarter of 2005 compared
to the first quarter of 2004 primarily as a result of the items discussed below. Q1 2005 vs. Q1 2004 CDMA Networks gross margin decreased by approximately 7.6 percentage points (while gross
profit decreased $62) primarily due to:  
    
    unfavorable product mix associated with increased sales of our next generation
products which typically have lower gross margins in the early stages of product evolution;
    
    pricing pressures on certain of our products due to increased competition for
service provider customers; and
    
    lower sales volumes of network expansion products and software upgrades that
typically have higher margins; partially offset by
    
    continued improvements in our cost structure primarily as a result of lower
material pricing. CDMA Networks SG&A expense decreased $2 primarily due to the ongoing focus on efficiencies and cost
reduction activities. CDMA Networks R&D expense was essentially flat primarily due to:  
    
    unfavorable foreign exchange rate impacts associated with the strengthening of
the Canadian dollar and euro against the U.S. dollar, largely offset by
    
    reduced spending due to project timing and completions. 67




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GSM and UMTS Networks The following chart summarizes recent quarterly revenues for GSM and UMTS Networks: (BAR CHART) Revenues Q1 2005 vs. Q1 2004 GSM and UMTS Networks revenues increased 20% in the first quarter of 2005 compared to the same
period in 2004. Revenues from GSM networks solutions increased substantially primarily due to revenue recognized in
Asia Pacific on our BSNL contract in the first quarter of 2005. For further information related to
the BSNL contract, see Developments in 2005  Significant business developments  Bharat Sanchar
Nigram Limited contract. In addition, revenues increased substantially in EMEA and CALA due in
part to customers expanding their existing networks to meet increased subscriber demand or
enhancing their networks to support more sophisticated communication services. Revenues from UMTS networks solutions were essentially flat. This was primarily due to increased
subscriber demand, new contracts with certain service provider customers and other customers
expanding their existing networks and the continued transition to this next generation technology,
offset by a loss of a contract due to industry consolidation of certain of our service provider customers, primarily in the U.S. Management EBT Management EBT for the GSM and UMTS Networks segment increased by $52 in the first quarter of 2005
compared to the first quarter of 2004 as a result of the items discussed below. Q1 2005 vs. Q1 2004 GSM and UMTS Networks gross margin increased by approximately 0.2 percentage points (while
gross profit increased $46) primarily due to:  
    
    overall higher sales volumes; and
    
    continued improvements in our cost structure primarily as a result of lower material pricing; partially offset by
    
    loss of approximately $5 related to our contract in India with BSNL; and
    
    pricing pressures on certain of our products due to increased competition for service provider customers. GSM and UMTS Networks SG&A expense decreased $6 primarily due to:  
    
    lower net trade and customer financing receivable expense; and
    
    decreases in employee related expenses; partially offset by
    
    unfavorable foreign exchange rate impacts associated with the strengthening of the euro against the U.S. dollar. GSM and UMTS Networks R&D expense was essentially flat primarily due to: 68




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
    
    unfavorable foreign exchange rate impacts associated with the strengthening of
the euro and Canadian dollar against the U.S. dollar;
    
    continued investment in the development of new UMTS products; and
    
    acceleration of programs to increase the feature content in our GSM product offering; largely offset by
    
    the impact of our workforce reductions across all regions and associated
reductions in other related costs such as information services and real estate. Enterprise Networks The following chart summarizes recent quarterly revenues for Enterprise Networks: (BAR CHART) Revenues Q1 2005 vs. Q1 2004 Enterprise Networks revenues increased approximately 2% in the first quarter of 2005 compared
to the same period in 2004 primarily due to a slight increase in the circuit and packet voice
portion and the data networking and security portion of this segment. Revenues from the circuit and packet voice portion of this segment increased slightly primarily due
to a substantial increase in revenues associated with our IP telephony solutions as customers
continued to migrate towards converged packet voice solutions from our traditional circuit
switching products. Revenues associated with the data networking and security portion of this segment increased
slightly primarily due to growth from improved market penetration of certain new data products.
This increase was partially offset by a decline in revenues associated with our legacy routing
portfolio and associated declines in new service contracts and service contract renewals. In
addition, we experienced a decline in revenue from certain of our data networking products
primarily due to pricing pressures driven by increased competition. Management EBT Management EBT for the Enterprise Networks segment increased by $7 in the first quarter of 2005
compared to the first quarter of 2004 primarily as a result of the items discussed below. Q1 2005 vs. Q1 2004 Enterprise Networks gross margin increased by approximately 1.7 percentage points (while gross
profit increased $15) primarily due to:  
    
    higher sales volumes of software upgrades that typically have higher margins; and
    
    continued improvements in our cost structure primarily as a result of lower material pricing; partially offset by
    
    pricing pressures on certain of our products due to increased competition for enterprise customers. Enterprise Networks SG&A expense increased $9 primarily due to: 69




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
    
    increases in sales and marketing expenses;
    
    an increase in bad debt expense;
    
    unfavorable foreign exchange rate impacts associated with the strengthening of
the euro against the U.S. dollar; and
    
    increases in employee related expenses; partially offset by
    
    the continued impact of our workforce reductions.Enterprise Networks R&D expense increased $3 primarily
due to:
    
    acceleration of R&D programs related to IP technologies; partially offset by
    
    effectively prioritizing investment in data products and increased outsourcing activity. Other Management EBT Other Management EBT decreased by $119 in the first quarter of 2005 compared to the first
quarter of 2004 primarily as a result of the items discussed below. Q1 2005 vs. Q1 2004 Other segment SG&A expense increased $39 primarily due to:  
    
    costs associated with our restatement activities and additional investment in our finance organization; and
    
    unfavorable foreign exchange rate impacts associated with the strengthening of the
Canadian dollar and euro against the U.S. dollar; partially offset by
    
    a decrease in stock based compensation in the first quarter of 2005 due to the RSU
expense that was incurred in the first quarter of 2004 and not repeated in 2005 as the
program was terminated in 2004. Other segment R&D expense increased by $13 primarily due to unfavorable foreign exchange rate
impacts associated with the strengthening of the Canadian dollar and euro against the U.S. dollar
partially offset by savings associated with our 2004 Restructuring Plan. Other segment other items expense increased by $42 primarily due to:  
    
    losses related to the sale of investments in the first quarter of 2005 compared to gains
in the first quarter of 2004 primarily related to the sale of shares in Arris Group and
Entrust; and
    
    losses related to changes in fair value of derivative financial instruments that do not
meet the criteria for hedge accounting compared to a gain in the first quarter of 2004;
partially offset by
    
    foreign exchange gains of $25 primarily related to day-to-day transactional activities. Liquidity and capital resources In the first quarter of 2005, we continued to maintain our strong liquidity position. As of
March 31, 2005, we had cash and cash equivalents excluding restricted cash, or cash, of $3,390
compared to $3,607 as of December 31, 2004 primarily due to cash outflow from operations of $224
which included cash payments for restructuring of $128 and payments of approximately $55 to our supplemental
pension funding, partially offset by cash proceeds from the sale of certain customer financing notes receivable of $110 ($36 of which is included in discontinued operations). 70




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Cash flows The following table summarizes our cash flows by activity and cash on hand as of March 31: 2005
    
    
    2004Net cash from (used in) operating activities of continuing operations
    
    $
    (224
    )
    
    $
    (308
    )Net cash from (used in) investing activities of continuing operations
    
    
    27
    
    
    
    14Net cash from (used in) financing activities of continuing operations
    
    
    (21
    )
    
    
    (112
    )Effect of foreign exchange rate changes on cash and cash equivalents
    
    
    (35
    )
    
    
    13Net cash from (used in) continuing operations
    
    
    (253
    )
    
    
    (393
    )Net cash from (used in) discontinued operations
    
    
    36
    
    
    
    (3
    )Net increase (decrease) in cash and cash equivalents
    
    
    (217
    )
    
    
    (396
    )Cash and cash equivalents at beginning of period
    
    
    3,607
    
    
    
    3,928Cash and cash equivalents at end of period
    
    $
    3,390
    
    
    $
    3,532
 Operating activities In the first quarter of 2005, our cash flows used in operating activities were $224 due to a
net loss from continuing operations of $9, plus net adjustments of $74 for non-cash and other
items less $289 related to the change in our operating assets and liabilities. In the first quarter of 2004, our cash flows used in operating activities were $308 due to net
earnings from continuing operations of $116, plus net adjustments of $147 for non-cash and other
items, less an adjustment of $571 related to the net change in our operating assets and
liabilities. Changes in operating assets and liabilities In the first quarter of 2005,
the use of cash of $289 relating to the change in our operating
assets and liabilities was primarily due to a $223 reduction in cash flows associated with our working capital performance as discussed
further below under Working capital metrics, restructuring outflows, supplemental pension funding
and other changes in operating assets and liabilities partially offset by collection of long-term
or customer financing receivables. In the first quarter of 2005, we received cash proceeds of approximately $74 from the sale of
certain customer financing notes receivable. We had cash outflows for restructuring activities of $128 primarily related to our
2004 Restructuring Plan and approximately $55 in supplemental pension funding. Other changes in other operating assets and liabilities included the following:  
    
    income tax payments of $14 in the first quarter of 2005 compared to $8 in the first
quarter of 2004 primarily due to an increase in income in certain taxable jurisdictions;
and
    
    an increase of $57 in cash from other changes in operating assets and liabilities
primarily due to an increase in long-term provisions which was primarily a result
of a deferred gain associated with the transition of certain manufacturing facilities to
Flextronics, partially offset by a reduction in liabilities, including the project loss associated with
BSNL. In the first quarter of 2004, the use of cash of $571 relating to the change in our operating
assets and liabilities was primarily due to restructuring outflows and other changes in assets and
liabilities partially offset by collection of long-term or customer financing receivables. Other
significant operating items included payments of approximately $280 in the first quarter of 2004
associated with our employee bonus plan and restricted stock unit program based on 2003
performance. We do not expect additional significant proceeds from customer financing receivables for the
remainder of 2005. We expect cash outflows of approximately $280 in 2005 related to both our
2001 Restructuring Plan and 2004 Restructuring Plan. Our pension funding in 2005 is expected to be
$92. We do not expect to have significant payments related to our employee bonus program in 2005
based on 2004 performance and our 2003 RSU program has been terminated. 71




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##### Table of Contents



Working capital metrics Working capital for each segment is primarily managed by our regional finance organization which
manages accounts receivable performance and by our global operations organization which manages
inventory and accounts payable. The $223 reduction in cash flows associated with our working
capital performance in the first quarter of 2005 was due to an increase in accounts
receivable of $255 and a decrease in accounts payable of $7, partially offset by a
reduction in inventories of $39, as further described below. Accounts receivable  net Days sales outstanding in accounts receivables, or DSO, measures the average number of days our
accounts receivables are outstanding. DSO is a metric that approximates the measure of the average
number of days from when we recognize revenue until we collect cash from our customers. The following table shows our quarterly DSO (a): (BAR CHART) (a)
    
    DSO for each quarter is calculated by dividing the quarter end accounts receivable-net
balance by revenues for the quarter, in each case as determined in accordance with GAAP, and
multiplying by 90 days.
 DSO increased as of March 31, 2005 compared to March 31, 2004 primarily due to:  
    
    an increase of approximately 7 days due to a note receivable that resulted from the
transfer of one of our manufacturing facilities to Flextronics, which did not have a
corresponding revenue impact;
    
    reduced accounts receivable securitizations; and
    
    increased GSM/UMTS Networks revenues from a large number of contracts involving
progress billings, with significant portions of collections occurring upon project
completion; partially offset by
    
    a reduced focus on collection activities, particularly in the first quarter of 2004,
due to our restatement activities. In 2005, we will continue to focus on improving our collections process. Offsetting this expected
improvement is an expected increase in the number of contracts involving progress billings and the
impact of the Flextronics payments and the associated notes receivable. We expect to experience
fluctuations in collections performance in individual quarters. 72




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Inventories  net Net inventory days, or NID, is a metric that approximates the average number of days from
procurement to sale of our product. The following table shows our quarterly NID (a): (BAR CHART) (a)
    
    NID for each quarter is calculated by dividing the average of the current quarter and prior
quarter inventories  net by the cost of revenues for the quarter, in each case as determined in
accordance with U.S. GAAP, and multiplying by 90 days. Finished goods inventory includes certain
direct and incremental costs associated with arrangements where title and risk of loss was
transferred to the customer but revenue was deferred due to other revenue recognition criteria not
being met. As of March 31, 2005 and March 31, 2004, these deferred costs totaled $799 and $407,
respectively.
 NID increased as of March 31, 2005 compared to March 31, 2004 primarily due to the increased
deferred costs associated with deferred revenues as described in note (a) of the table above and an
increase in inventory to meet new contract requirements, particularly in Asia Pacific for wireless
projects, including BSNL. In 2005, we expect that NID will fluctuate from quarter to quarter due in part to the fluctuations
in deferred costs associated with deferred revenues and will normally be highest in the third
quarter as inventory is held to support sales in the fourth quarter, which is typically our
strongest quarter of the year in terms of revenues. Inventory management continues to be an area of focus as we balance the need to maintain strategic
inventory levels to ensure competitive delivery performance to our customers against the risk of
inventory obsolescence due to rapidly changing technology and customer spending requirements. Days of purchases outstanding in accounts payable Days of purchases outstanding in accounts payable, or DPO, is a metric that approximates the
average number of days from when we receive purchased goods and services until we pay our
suppliers. The following table shows the quarterly DPO (a): (BAR CHART) (a)
    
    DPO for each quarter is calculated by dividing the quarter end trade and other accounts
payable by the cost of revenues for the quarter, in each case, as determined in accordance with
GAAP, and multiplying by 90 days.
 DPO increased to 59 days as of March 31, 2005 from 53 days as of March 31, 2004 as we placed
additional focus on establishing competitive payment terms with our suppliers and improving the
processing of payments to match payment terms. DPO will normally be highest in the third quarter and lowest
in the fourth quarter due to the impact of purchasing inventory in the third quarter to support sales
in the fourth quarter, which is generally our strongest quarter of the year in terms of revenue. However, the lower DPO in the third and the higher DPO in the fourth quarter
of 2004 did not reflect this trend primarily due 73




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to the impact of the project loss related to the BSNL project and
the deferred cost increases in the fourth quarter as described above. DPO was also slightly higher
in the first quarter of 2005 compared to the first quarter of 2004 due to the impact of the BSNL
project. While we will continue our focus on managing our DPO, we expect that DPO will continue to fluctuate
on a quarter by quarter basis. However, we expect DPO to be highest in the third quarter and
lowest in the fourth quarter due to the impact of purchasing inventory in the third quarter to
support sales in the fourth quarter, which is generally our strongest quarter of the year in terms
of revenue. Investing activities For the three months ended March 31, 2005, cash flows from investing activities were $27 and
were primarily due to proceeds of $83 including $76 related to the transfer of certain
manufacturing assets to Flextronics and $7 from the sale of certain investments and businesses
which we no longer considered strategic. These amounts were partially offset by $54 in plant and
equipment expenditures and $2 associated with acquisitions of certain investments and businesses. For the three months ended March 31, 2004, cash flows from investing activities were $14 and were
primarily due to proceeds of $55 from the sale of certain investments and businesses which we no
longer considered strategic including $17 related to the sale of the common shares of Arris Group
and $33 related to the sale of the common shares of Entrust. We also recorded proceeds of $5
primarily from the sale of plant and equipment in the U.S. These amounts were partially offset by
$43 in plant and equipment expenditures and $3 associated with acquisitions of certain investments
and businesses. Financing activities For the three months ended March 31, 2005, cash flows used in financing activities were $21
and were primarily due to dividends of $14 primarily paid by us related to our outstanding preferred shares
and a reduction of our notes payable by a net of $6. For the three months ended March 31, 2004, cash flows used in financing activities were $112 and
were primarily due to $97 used to reduce our long-term debt, a reduction of our notes payable by a
net of $3, a repayment of capital leases payable of $3 and dividends of $9 paid by us related to
our outstanding preferred shares. The reduction of our long-term debt was primarily due to the
extinguishment of debt of $87 related to the purchase of land and two buildings in the U.S. In the first quarter of 2005, our cash decreased $35 due to unfavorable effects of changes in
foreign exchange rates. Approximately $32 of the unfavorable impact was the result of unfavorable changes in the euro and
the British pound against the U.S. dollar. In the first quarter of 2004, our cash increased $13 due to favorable effects of changes in foreign
exchange rates. The increase was primarily a result of favorable changes in the British pound of
approximately $20 partially offset by unfavorable changes in the euro of approximately $7. In the first quarter of 2005, cash flows from our discontinued operations were $36 compared to net
cash used of $3 in the first quarter of 2004, primarily due to the collection of a customer
financing receivable. Uses of liquidity As of March 31, 2005, our cash requirements for the next 12 months are primarily expected to
fund operations, including our investments in R&D and the following items:  
    
    debt service, including repayment of our debt of $1,275 due in February 2006;
    
    our planned acquisition of PEC for an estimated $448, net of cash acquired;
    
    costs relating to workforce reduction and other restructuring activities;
    
    capital expenditures;
    
    investments in certain businesses, including planned joint ventures in Asia Pacific;
    
    pension and post-retirement benefits; and
    
    costs in relation to the restatement activities, matters related to the
Revenue Independent Review and other related matters, including regulatory and other legal
proceedings. 74




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We believe that we have sufficient cash to repay our debt of $1,275 due in February 2006. However,
we continue to routinely monitor the capital markets for opportunities to improve our capital
structure and financial flexibility. We are subject to significant pending civil litigation actions and regulatory and criminal
investigations which could materially adversely affect our results of operations, financial
condition and liquidity by requiring us to pay substantial judgments, settlements, fines or other
penalties. See Risk factors/forward looking statements. Also, from time to time, we may purchase our outstanding debt securities and/or convertible notes
in privately negotiated or open market transactions, by tender offer or otherwise, in compliance
with applicable laws. As well, we expect to be required to fund some portion of our aggregate
undrawn customer financing commitments as further described below. Contractual cash obligations Our contractual cash obligations for long-term debt, purchase obligations, operating leases,
outsourcing contracts, obligations under special charges, pension, post-retirement and
post-employment obligations and other long-term liabilities reflected on the balance sheet remained
substantially unchanged as of March 31, 2005 from the amounts disclosed as of December 31, 2004 in
our 2004 Annual Report. Customer financing Generally, customer financing arrangements may include financing with deferred payment terms
in connection with the sale of our products and services, as well as funding for non-product costs
associated with network installation and integration of our products and services. We may also
provide funding to our customers for working capital purposes and equity financing. The following
table provides information related to our customer financing commitments, excluding our
discontinued operations as of: March 31,
    
    
    December 31,2005
    
    
    2004Drawn and outstanding  gross
    
    $
    56
    
    
    $
    118Provisions for doubtful accounts
    
    
    (39
    )
    
    
    (38
    )Drawn and outstanding  net(a)
    
    
    17
    
    
    
    80Undrawn commitments
    
    
    64
    
    
    
    69Total customer financing
    
    $
    81
    
    
    $
    149
 (a)
    
    Included short-term and long-term amounts. Short-term and long-term amounts were included in
accounts receivable  net and other assets, respectively, in the unaudited consolidated balance sheets.
 During the three months ended March 31, 2005 and 2004, we entered into certain agreements to
restructure and/or settle various customer financing and related receivables including rights to
accrued interest. As a result of these transactions, we received cash consideration of
approximately $110 ($36 of the proceeds was included in discontinued operations) and $15, to settle
outstanding receivables with a net carrying value of $100 ($33 of the net carrying value was
included in discontinued operations) and $14, respectively. During the three months ended March 31, 2005 and 2004, we reduced undrawn customer financing
commitments by $5 and $114, respectively, as a result of the expiration or cancellation of
commitments and changing customer business plans. As of March 31, 2005, all undrawn commitments
were available for funding under the terms of the financing agreements. Acquisitions On April 26, 2005, we announced that Nortel Networks Inc., a wholly owned subsidiary of ours,
had entered into an agreement with PEC, providing for the acquisition of all of the outstanding
shares of PEC for $15.50 per share in cash, or approximately $448 (net of cash acquired), plus
transaction costs and expenses. The acquisition is subject to certain conditions, including the
successful completion of a tender offer and regulatory approvals. We currently expect to complete
the acquisition during the second quarter of 2005. 75




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Sources of liquidity As of March 31, 2005, we had cash of $3,390, excluding $81 of restricted cash and cash
equivalents. We believe this cash will be sufficient to fund the changes to our business model in
accordance with our strategic plan (see Business overview  Our strategy and outlook), fund our
investments and meet our customer commitments for at least the next 12 months. However, if capital
spending by service providers and other customers changes from what we currently expect, we may be
required to adjust our current business model. As a result, our revenues and cash flows may be
materially lower than we expect and we may be required to further reduce our investments or take
other measures in order to meet our cash requirements. In the future, we may seek additional funds
from liquidity generating transactions and other sources of external financing. We continue to
routinely monitor the capital markets for opportunities to improve our capital structure and
financial flexibility. Our ability and willingness to access the capital markets is based on many
factors including market conditions and overall financial objectives. Currently, our ability is
limited due to the impact of the delay in filing the Reports and the findings of the Independent Review and related matters. We cannot provide any assurance that our net cash
requirements will be as we currently expect, that we will continue to have access to the EDC
Support Facility when and as needed or that liquidity generating transactions or financings will be
available to us on acceptable terms. In addition, we have not assumed the need to make any
payments in respect of judgments, settlements, fines or other penalties in connection with our
pending civil litigation or investigations related to the First Restatement and Second Restatement,
which could have a material adverse effect on our financial condition or liquidity, other than
anticipated professional fees and expenses. See Risk factors/forward looking statements. As of the first quarter of 2005, we have received proceeds of approximately $85 relating to the
Flextronics transaction. We expect to receive an additional portion of the total expected net
proceeds of $675 to $725 from the Flextronics transaction which is expected to be partially offset
by cash outflows attributable to direct transaction costs and other costs associated with the
transaction. In 2005, we expect the contribution to cash flow from investments and customer
financing asset sales to be substantially lower. The sale of a customer financing receivable for
cash consideration of $110 in the first quarter of 2005 is expected to be the only significant
customer financing asset sale in 2005. Although we do not have any significant debt repayments
planned in 2005, we have a $1,275 debt due in February 2006. We believe that we have sufficient
cash to repay this debt; however, we continue to routinely monitor the capital markets for
opportunities to improve our capital structure and financial flexibility. Credit facilities As of March 31, 2005, we had no material credit facilities in place. Available support facility On February 14, 2003, we entered into the EDC Support Facility. As of March 31, 2005, the
facility provided for up to $750 in support including:  
    
    $300 of uncommitted revolving support for performance bonds or similar instruments,
of which $145 was outstanding;
    
    $150 of uncommitted support for receivables sales and/or securitizations, of which
none was utilized; and
    
    $300 of uncommitted support for performance bonds and/or receivables sales and/or
securitizations, of which $68 was outstanding. For additional information relating to the EDC Support Facility subsequent to March 31, 2005 and
waivers obtained in connection with certain defaults arising under the EDC Support Facility from
the delay in filing the Reports, see Developments in 2005  Nortel Audit Committee Independent
Review; restatements; related matters  EDC Support Facility and Risk factors/forward looking
statements. The EDC Support Facility provides that EDC may suspend its obligation to issue us any additional
support if events occur that would have a material adverse effect on our business, financial
position or results of operation. The EDC Support Facility will expire on December 31, 2006. The EDC Support Facility does not materially restrict our ability to sell any of our assets
(subject to certain maximum amounts) or to purchase or pre-pay any of its currently outstanding
debt. The EDC Support Facility can be suspended or terminated if our senior long-term debt rating
by Moodys Investors Service, or Moodys, has been downgraded to less than B3 or if our debt rating
by Standard & Poors, or S&P, has been downgraded to less than B-. 76




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As of March 31, 2005, our obligations under the EDC Support Facility were secured on an equal and
ratable basis under the security agreements entered into by us and various of our subsidiaries that
pledged substantially all of our and NNCs subsidiaries assets in favor of the holders of our
public debt securities and the holders of NNCs 4.25% Convertible Senior Notes. As of March 31,
2005, the security provided under the security agreements was comprised of:  
    
    pledges of substantially all of our assets and those of most of our U.S. and
Canadian subsidiaries; and
    
    guarantees by certain of our wholly owned subsidiaries organized in the U.S.,
Canada, England, Ireland and Hong Kong. If our senior long-term debt rating by Moodys returns to Baa2 (with a stable outlook) and its
rating by S&P returns to BBB (with a stable outlook), the security and guarantees will be released
in full. If the EDC Support Facility is terminated, or expires, the security and guarantees will
also be released in full. We may provide EDC with cash collateral in an amount equal to the total
amount of its outstanding obligations and undrawn commitments and expenses under this facility (or
any other alternative collateral or arrangements acceptable to EDC) in lieu of the security
provided under the security agreements. Accordingly, if the EDC Support Facility is secured by
cash or other alternate collateral or arrangements acceptable to EDC, the security and guarantees
will also be released in full. For information related to our outstanding public debt, see Long-term debt, credit and support
facilities in note 9 of the accompanying unaudited consolidated financial statements. For
additional financial information related to the security pledged, those subsidiaries providing
guarantees as of March 31, 2005, see Supplemental consolidating financial information in note 19
of the accompanying unaudited consolidated financial statements. For information related to our
debt ratings, see Credit ratings below. See Risk factors/forward looking statements for
factors that may affect our ability to comply with covenants and conditions in our EDC Support
Facility in the future. Shelf registration statement and base shelf prospectus In 2002, we and NNC filed a shelf registration statement with the SEC on May 13, 2002 and a
base shelf prospectus with the applicable securities regulatory authorities in Canada, to qualify the potential sale of up to
$2,500 of various types of securities in the U.S. and/or Canada. The qualifying securities include
common shares, preferred shares, debt securities, warrants to purchase equity or debt securities,
share purchase contracts and share purchase or equity units (subject to certain approvals). As of
March 31, 2005, approximately $1,700 under the shelf registration statement and base shelf
prospectus had been utilized. As of June 6, 2004, the Canadian base shelf prospectus expired. As
a result of the delayed filing of the Reports, we and NNC continue to be unable to use, in its
current form as a short-form shelf registration statement, the remaining approximately $800 of
capacity for various types of securities under our SEC shelf registration statement. We will again
become eligible for short-form shelf registration with the SEC after we have completed timely
filings of our financial reports for twelve consecutive months. For the same reasons, NNC is also
unable to permit holders of its prepaid forward purchase contracts to exercise certain early
settlement rights and receive Nortel Networks Corporation common shares in advance of the
otherwise applicable August 15, 2005 settlement date. These rights would again become exercisable
upon the effectiveness of a registration statement (or a post-effective amendment to the shelf
registration statement) filed with the SEC (with respect to the Nortel Networks Corporation common
shares to be delivered) that contains a related current prospectus. Under the terms of the
Purchase Contract and Unit Agreement which governs the purchase contracts, NNC has agreed to use
commercially reasonable efforts to have, in effect, a registration statement covering the Nortel
Networks Corporation common shares to be delivered and to provide a prospectus in connection
therewith. We do not believe that we will be able, through the use of commercially reasonable
efforts, to have an effective long form registration statement relating to the exercise of certain
early settlement rights by holders of our prepaid forward purchase contracts on file with the SEC
in advance of August 15, 2005. Accordingly, holders continue not to be able to exercise these
rights in advance of the otherwise applicable settlement date of August 15, 2005. See Risk
factors/forward looking statements. 77




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Credit ratings Rating on long-term debt
    
    
    Rating onissued or guaranteed by
    
    
    preferred sharesNortel Networks
    
    
    issued byLimited/Nortel Networks
    
    
    Nortel NetworksRating agency
    
    Corporation
    
    
    Limited
    
    
    Last changeStandard & Poors Ratings Service
    
    
    B-
    
    

    CCC-
    
    
    April 28, 2004Moodys Investors Service, Inc.
    
    
    B3
    
    
    Caa3
    
    
    November 1, 2002
 On April 28, 2004, S&P downgraded its ratings on us, including our long-term corporate credit
rating from B to B and our preferred
shares rating from CCC to CCC. At the same time, it
revised its outlook to developing from negative. Moodys outlook changed to review for potential
downgrade from uncertain on April 28, 2004. There can be no assurance that our credit ratings will
not be lowered or that these ratings agencies will not issue adverse commentaries, potentially
resulting in higher financing costs and reduced access to capital markets or alternative financing
arrangements. A reduction in our credit ratings may also affect our ability, and the cost, to
securitize receivables, obtain bid, performance related and other bonds, access the EDC Support
Facility and/or enter into normal course derivative or hedging transactions. Off-balance sheet arrangements Bid, performance related and other bonds We have entered into bid, performance related and other bonds in connection with various
contracts. Bid bonds generally have a term of less than twelve months, depending on the length of
the bid period for the applicable contract. Performance related and other bonds generally have a
term of twelve months and are typically renewed, as required, over the term of the applicable
contract. The various contracts to which these bonds apply generally have terms ranging from two
to five years. Any potential payments which might become due under these bonds would be related to
our non-performance under the applicable contract. Historically, we have not had to make material
payments and we do not anticipate that we will be required to make material payments under these
types of bonds. The following table provides information related to these types of bonds as of: March 31,
    
    
    December 31,2005
    
    
    2004Bid and performance related bonds (a)
    
    $
    265
    
    
    $
    362Other bonds (b)
    
    
    44
    
    
    
    68Total bid, performance related and other bonds
    
    $
    309
    
    
    $
    430
 (a)
    
    Net of restricted cash and cash equivalents amounts of $38 and $36 as of March 31, 2005 and
December 31, 2004, respectively.(b)
    
    Net of restricted cash and cash equivalents amounts of $35 and $28 as of March 31, 2005 and
December 31, 2004, respectively.
 The criteria under which bid, performance related and other bonds can be obtained changed due
to the industry environment primarily in 2002 and 2001. During that timeframe, in addition to the
payment of higher fees, we experienced significant cash collateral requirements in connection with
obtaining new bid, performance related and other bonds. Given that the EDC Support Facility is
used to support bid and performance bonds with varying terms, including those with at least 365 day
terms, we will likely need to increase our use of cash collateral to support these obligations
beginning on January 1, 2006 absent a further extension of the facility. 78




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Any bid or performance related bonds with terms that extend beyond December 31, 2006 are currently
not eligible for the support provided by this facility. See Liquidity and capital
resources  Sources of liquidity  Available support facility for additional information on the EDC
Support Facility and the security agreements and see Developments in 2005  Nortel Audit Committee
Independent Review; restatements; related matters  EDC Support Facility for developments in
connection with the EDC Support Facility subsequent to March 31, 2005. Receivables securitization transactions We have agreed to indemnify some of our counterparties in certain receivables securitization
transactions. The indemnifications provided to counterparties in these types of transactions may
require us to compensate counterparties for costs incurred as a result of changes in laws and
regulations (including tax legislation) or in the interpretations of such laws and regulations, or
as a result of regulatory penalties that may be suffered by the counterparty as a consequence of
the transaction. Certain receivables securitization transactions include indemnifications
requiring the repurchase of the receivables if the particular transaction becomes invalid. As of
March 31, 2005, we had approximately $205 of securitized receivables which were subject to
repurchase under this provision, in which case, we would assume all rights to collect such
receivables. The indemnification provisions generally expire upon expiration of the securitization
agreements, which extend through 2005, or collection of the receivable amount by the counterparty.
We are generally unable to estimate the maximum potential liability for all of these types of
indemnification guarantees as certain agreements do not specify a maximum amount and the amounts
are dependent upon the outcome of future contingent events, the nature and likelihood of which
cannot be determined at this time. Historically, we have not made any significant indemnification
payments or receivable repurchases under these agreements and no significant liability has been
accrued in the accompanying unaudited consolidated financial statements with respect to the
obligation associated with these guarantees. Application of critical accounting policies and estimates Our accompanying unaudited consolidated financial statements are based on the selection and
application of accounting policies generally accepted in the U.S., which require us to make
significant estimates and assumptions. We believe that the following accounting policies and
estimates may involve a higher degree of judgment and complexity in their application and represent
our critical accounting policies and estimates: revenue recognition, provisions for doubtful
accounts, provisions for inventory, provisions for product warranties, income taxes, goodwill
valuation, pension and post-retirement benefits, special charges and other contingencies. In general, any changes in estimates or assumptions relating to revenue recognition, provisions for
doubtful accounts, provisions for inventory and other contingencies (excluding legal contingencies)
are directly reflected in the results of our reportable operating segments. Changes in estimates or
assumptions pertaining to our tax asset valuations, our pension and post-retirement benefits and
our legal contingencies are generally not reflected in our reportable operating segments, but are reflected on a consolidated basis. We have discussed the application of these critical accounting policies and estimates with the
Audit Committee of our Board of Directors. We have not identified any changes to the nature of our critical accounting policies and estimates
as described in our 2004 Annual Report other than the material changes in the recorded balances and
other updates noted below. For further information related to our critical accounting policies and
estimates, see our 2004 Annual Report. Provisions for doubtful accounts In establishing the appropriate provisions for trade, notes and long-term receivables due from
customers, we make assumptions with respect to their future collectibility. Our assumptions are
based on an individual assessment of a customers credit quality as well as subjective factors and
trends, including the aging of receivable balances. Generally, these individual credit assessments
occur prior to the inception of the credit exposure and at regular reviews during the life of the
exposure and consider:  
    
    a customers ability to meet and sustain its financial commitments;
    
    a customers current and projected financial condition;
    
    the positive or negative effects of the current and projected industry outlook; and
    
    the economy in general. 79




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Once we consider all of these individual factors, we make a determination as to the probability of
default. An appropriate provision is then made, which takes into consideration the severity of the
likely loss on the outstanding receivable balance based on our experience in collecting these
amounts. In addition to these individual assessments, in general, outstanding trade accounts
receivable amounts for which recovery is not expected that are greater than 365 days are fully
provisioned for and amounts greater than 180 days are 50% provisioned for. The following table summarizes our accounts receivable and long-term receivable balances and
related reserves of our continuing operations as of: March 31,
    
    
    December 31,2005
    
    
    2004Gross accounts receivable
    
    $
    3,146
    
    
    $
    2,909Provision for doubtful accounts
    
    
    (107
    )
    
    
    (109
    )Accounts receivable  net
    
    $
    3,039
    
    
    $
    2,800Accounts receivable provision as a percentage of gross accounts receivables
    
    
    3
    %
    
    
    4
    %Gross long-term receivables
    
    $
    96
    
    
    $
    159Provision for doubtful accounts
    
    
    (66
    )
    
    
    (65
    )Net long-term receivables
    
    $
    30
    
    
    $
    94Long-term receivable provision as a percentage of gross long-term receivables
    
    
    69
    %
    
    
    41
    %
 Provisions for inventory Management must make estimates about the future customer demand for our products when
establishing the appropriate provisions for inventory. When making these estimates, we consider general economic conditions and growth prospects within
our customers ultimate marketplace, and the market acceptance of our current and pending products.
These judgments must be made in the context of our customers shifting technology needs and changes
in the geographic mix of our customers. With respect to our provisioning policy, in general, we fully reserve for surplus inventory in excess of our 365 day
demand forecast or that we deem to be obsolete. Generally, our inventory provisions have an inverse
relationship with the projected demand for our products. For example, our provisions usually
increase as projected demand decreases due to adverse changes in the conditions mentioned above. We
have experienced significant changes in required provisions in recent periods due to changes in
strategic direction, such as discontinuances of product lines, as well as declining market
conditions. A misinterpretation or misunderstanding of any of these conditions could result in
inventory losses in excess of the provisions determined to be appropriate as of the balance sheet
date. The following table summarizes our inventory balances and other related reserves of our continuing
operations as of: March 31,
    
    
    December 31,2005
    
    
    2004Gross inventory
    
    $
    2,781
    
    
    $
    2,923Inventory provisions
    
    
    (1,087
    )
    
    
    (1,141
    )Inventories  net (a)
    
    $
    1,694
    
    
    $
    1,782Inventory provisions as a percentage of gross inventory
    
    
    39
    %
    
    
    39
    %
 (a)
    
    Includes long-term portion of inventory related to the deferred costs which is included in
other assets.
 As of March 31, 2005, our inventory provisions as a percentage of gross inventory were 39%.
We have recorded inventory provisions related to continuing operations of $1,087 as of March 31, 2005
and $1,141 as of December 31, 2004. Inventory provisions decreased due to $6 as a result of
foreign exchange fluctuations, reclassifications and other adjustments, $32 of scrapped inventory
and $33 of reductions due to sale of inventory offset by $17 of additional inventory provisions.
In the future, we may be required to make significant adjustments to these provisions for the sale
and/or disposition of inventory that was provided for in prior periods. 80




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Provisions for product warranties Provisions are recorded for estimated costs related to warranties given to customers on our
products to cover defects. These provisions are calculated based on historical return rates as
well as on estimates which take into consideration the historical material replacement costs and
the associated labor costs to correct the product defect. Known product defects are specifically
provided for as we become aware of such defects. Revisions are made when actual experience differs
materially from historical experience. These provisions for product warranties are part of the
cost of revenues and are accrued when the products are sold. They represent the best possible
estimate, at the time the sale is made, of the expenses to be incurred under the warranty granted.
Warranty terms generally range from one to six years from the date of sale depending upon the
product. We accrue for warranty costs as part of our cost of revenues based on associated material costs and
technical support labor costs. Material cost is estimated based primarily upon historical trends
in the volume of product returns within the warranty period and the cost to repair or replace the
product. Technical support labor cost is estimated based primarily upon historical trends in the
rate of customer warranty claims and projected claims within the warranty period. The following table summarizes the accrual for product warranties that was recorded as part of
other accrued liabilities in the unaudited consolidated balance sheets as of: March 31,2005Balance as of December 31, 2004
    
    $
    271Payments
    
    
    (56
    )Warranties issued
    
    
    42Revisions
    
    
    (3
    )Balance as of March 31, 2005
    
    $
    254
 We engage in extensive product quality programs and processes, including actively monitoring
and evaluating the quality of our component suppliers. Our estimated warranty obligation is based
upon warranty terms, ongoing product failure rates, historical material replacement costs and the
associated labor to correct the product defect. If actual product failure rates, material
replacement costs, service or labor costs differ from our estimates, revisions to the estimated
warranty provision would be required. If we experience an increase in warranty claims compared
with our historical experience, or if the cost of servicing warranty claims is greater than the
expectations on which the accrual is based, our gross margin could be negatively affected. Tax asset valuation Our net deferred tax assets balance, excluding discontinued operations, was $3,811 at March
31, 2005 and $3,848 at December 31, 2004. The $37 decrease was primarily due to the impact of
foreign exchange effects related primarily to the British pound and a drawdown of deferred tax
assets in profitable jurisdictions. We currently have deferred tax assets resulting from net
operating loss carryforwards, tax credit carryforwards and deductible temporary differences, all of
which are available to reduce future taxes payable in our significant tax jurisdictions.
Generally, our loss carryforward periods range from seven years to an indefinite period. As a
result, we do not expect that a significant portion of these carryforwards will expire in the near
future. We assess the realization of these deferred tax assets quarterly to determine whether an income tax
valuation allowance is required. Based on available evidence, both positive and negative, we
determine whether it is more likely than not that all or a portion of the remaining net deferred
tax assets will be realized. The main factors that we consider include:  
    
    cumulative losses in recent years;
    
    history of loss carryforwards and other tax assets expiring;
    
    the carryforward period associated with the deferred tax assets;
    
    the nature of the income that can be used to realize the deferred tax assets;
    
    our net earnings (loss); and
    
    future earnings potential determined through the use of internal forecasts. 81




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In evaluating the positive and negative evidence, the weight given to each type of evidence must be
proportionate to the extent to which it can be objectively verified. If it is our belief that it
is more likely than not that some portion of these assets will not be realized, an income tax
valuation allowance is recorded. Primarily as a result of losses realized in 2001 and 2002, we concluded that it was more likely
than not that a portion of our deferred tax assets would not be realized. Accordingly, an income
tax valuation allowance has been recorded against these deferred income tax assets. However, due
to the fact that the majority of the carryforwards do not expire in the near future, our extended
history of earnings in our material tax jurisdictions exclusive of 2001 and 2002, and our future
expectations of earnings, we concluded that it is more likely than not that the remaining net
deferred income tax asset recorded as of March 31, 2005 will be realized. In the first quarter of 2005, our gross income tax valuation allowances decreased to $3,376 as of
March 31, 2005 compared to $3,395 as of December 31, 2004. The decrease was primarily due to the
impacts of foreign exchange offset by additional valuation allowances against current period losses
in certain jurisdictions. We assessed positive evidence including forecasts of future taxable
income to support realization of the net deferred tax assets, and negative evidence including our
cumulative loss position, and concluded that the valuation allowances as of March 31, 2005 were
appropriate. We continue to review all available positive and negative evidence on a jurisdictional basis and
our valuation allowance may need to be adjusted in the future as a result of this ongoing review.
Given the magnitude of our valuation allowance, future adjustments to this allowance based on
actual results could result in a significant adjustment to our net earnings. Goodwill valuation The carrying value of goodwill was $2,080 as of March 31, 2005 and $2,123 as of December 31,
2004. The decrease primarily relates to the divestiture of our manufacturing operations to
Flextronics and foreign exchange fluctuations associated with the minority interests in our French and German operations. Due to the change in our operating segments and reporting units as described in Business
overview  Our segments, a triggering event occurred requiring a goodwill impairment test in the quarter in
accordance with SFAS No. 142, Goodwill and other Intangible Assets. We performed this test and
concluded that there was no impairment. Special charges At each reporting date, we evaluate our accruals related to workforce reduction charges,
contract settlement and lease costs and plant and equipment write downs to ensure that these
accruals are still appropriate. As of March 31, 2005, we had $61 in accruals related to workforce
reduction charges and $290 in accruals related to contract settlement and lease costs, which
included significant estimates, primarily related to sublease income over the lease terms and other
costs for vacated properties. In certain instances, we may determine that these accruals are no
longer required because of efficiencies in carrying out our restructuring work plan. Adjustments
to workforce reduction accruals may also be required when employees previously identified for
separation do not receive severance payments because they are no longer employed by Nortel or were
redeployed due to circumstances not foreseen when the original plan was initiated. In these cases,
we reverse any related accrual to earnings when it is determined it is no longer required.
Alternatively, in certain circumstances, we may determine that certain accruals are insufficient as
new events occur or as additional information is obtained. In these cases, we would increase the
applicable existing accrual with the offset recorded against earnings. Increases or decreases to
the accruals for changes in estimates are classified within special charges in the statement of
operations. Accounting changes and recent accounting pronouncements Accounting changes Our consolidated financial statements are based on the selection and application of accounting
policies, generally accepted in the U.S. For more information related to the accounting policies
that we adopted as a result of new accounting standards, see Accounting changes in note 2 of the
accompanying unaudited consolidated financial statements. The following summarizes the accounting
change that we have adopted:  
    
    Accounting for certain financial instruments with characteristics of both liabilities
and equity  the adoption of SFAS No. 150, Accounting for Certain Financial Instruments
with Characteristics of both Liabilities and Equity in 2003 did not have a material
impact on our results of operations and financial condition. 82




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Recent accounting pronouncements In March 2004, the EITF reached consensus on Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments, or EITF 03-1. EITF
03-1 provides guidance on determining when an investment is considered impaired, whether that
impairment is other than temporary and the measurement of an impairment loss. EITF 03-1 is
applicable to marketable debt and equity securities within the scope of SFAS No. 115, Accounting
for Certain Investments in Debt and Equity Securities, or SFAS 115, and SFAS No. 124, Accounting
for Certain Investments Held by Not-for-Profit Organizations, and equity securities that are not
subject to the scope of SFAS 115 and not accounted for under the equity method of accounting. In
September 2004, the FASB issued FASB Staff Position, or FSP, EITF 03-1-1, Effective Date of
Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments, which delays the effective date for the measurement and
recognition criteria contained in EITF 03-1 until final application guidance is issued. The delay
does not suspend the requirement to recognize other-than-temporary impairments as required by
existing authoritative literature. The adoption of EITF 03-1 is not expected to have a material
impact on our results of operations and financial condition. In November 2004, the FASB issued SFAS No. 151, Inventory Costs, or SFAS 151. SFAS 151 requires
that abnormal amounts of idle facility expense, freight, handling costs, and wasted material
(spoilage) be recognized as current period charges rather than capitalized as a component of
inventory costs. In addition, SFAS 151 requires allocation of fixed production overheads to
inventory be based on the normal capacity of the production facilities. This statement is
effective for inventory costs incurred in fiscal periods beginning after June 15, 2005. The
guidance should be applied prospectively. We are currently assessing the impact of SFAS 151 on our
results of operations and financial condition. In December 2004, the FASB issued SFAS No. 123 (Revised 2004), Share-Based Payment, or SFAS 123R,
which requires all share-based payments to employees, including grants of employee stock options,
to be recognized as compensation expense in the unaudited consolidated financial statements based on their
fair values. SFAS 123R also modifies certain measurement and expense recognition provisions of
SFAS 123, that will impact us, including the requirement to estimate employee forfeitures each
period when recognizing compensation expense, and requiring that the initial and subsequent
measurement of the cost of liability-based awards each period be based on the fair value
(instead of the intrinsic value) of the award. This statement is effective for us as of January 1,
2006. We had previously elected to expense employee stock-based compensation using the fair value
method prospectively for all awards granted or modified on or after January 1, 2003 in accordance
with SFAS 148. We are currently assessing the impact of SFAS 123R on our results of operations and
financial condition. In March 2005, the FASB
issued FSP No. 46(R)-5, Implicit Variable Interests under FASB
Interpretation No., or FIN, 46 (Revised December 2003), Consolidation of Variable Interest
Entities, or FSP FIN 46R-5. FSP FIN 46R-5 provides guidance for a reporting enterprise on whether
we hold an implicit variable interest in Variable Interest Entities, or VIEs, or potential VIEs
when specific conditions exist. This FSP is effective in the first period beginning after March 3,
2005 in accordance with the transition provisions of FIN 46 (Revised 2003), Consolidation of
Variable Interest Entities  an Interpretation of Accounting Research Bulletin No. 51, or FIN 46R.
We have determined the adoption of FSP FIN 46R-5 will not have an impact on our results of
operations and financial condition. Canadian supplement New Canadian securities regulations and, as of March 8, 2005, amendments to the regulations
under the Canada Business Corporations Act, allow issuers that are required to file reports with
the SEC, upon meeting certain conditions, to satisfy their Canadian continuous disclosure
obligations by using financial statements prepared in accordance with U.S. GAAP. We have provided
the following supplemental information to highlight the significant differences that would have
resulted in the MD&A had it been prepared using Canadian GAAP information. The principal continuing reconciling differences that affect consolidated net earnings (loss) under
Canadian GAAP are accounting for derivatives and goodwill impairment arising from historical
differences in carrying value. We adopted new Canadian accounting standards for asset retirement
obligations and for derivatives in 2004 that are substantially consistent with
U.S. GAAP. Other historical differences between
U.S. GAAP and Canadian GAAP were primarily due to facts and
circumstances related to prior years that are not expected to affect future earnings (loss) under Canadian GAAP, including business
combinations. 83




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See note 18 of the accompanying unaudited consolidated financial statements for a reconciliation
from U.S. GAAP to Canadian GAAP, including a description of the material differences affecting our
unaudited consolidated statements of operations and unaudited consolidated balance sheets. There were no
significant differences affecting the unaudited consolidated statements of cash flows. Accounting changes Under Canadian GAAP, we adopted the following accounting changes as more fully described in
note 18(h) of the accompanying unaudited consolidated financial statements:  
    
    Derivative accounting  Effective January 1, 2004, we adopted Accounting Guideline 13,
Hedging Relationships, or AcG-13, which establishes specific criteria for derivatives to
qualify for hedge accounting. We had been previously applying these criteria under U.S.
GAAP; therefore, there was no impact on adoption of AcG-13. Concurrent with the adoption
of AcG-13, we also adopted the Canadian Institute of Chartered Accountants, or CICAs,
Emerging Issues Committee, or EIC, 128, Accounting for Trading, Speculative or Non-Hedging
Derivative Financial Instruments, or EIC 128. As a result of the adoption of EIC 128,
certain warrants, which had been previously recorded at cost under Canadian GAAP, are
required to be recorded at fair value consistent with U.S. GAAP. The impact of this
accounting change, which has been recorded prospectively as at January 1, 2004, was an
increase to investments and other income of $23 for the three months ended March 31, 2004.
    
    Determining whether an arrangement contains a lease  In December 2004, the EIC issued
abstract 150, Determining Whether an Arrangement Contains a Lease, or EIC 150. EIC 150
provides guidance on how to determine whether an arrangement contains a lease that is
within the scope of CICA Handbook Section 3065,
Leases. The guidance in EIC 150 is based on whether the arrangement conveys to the
purchaser the right to use a tangible asset, and is effective for us for arrangements
entered into or modified after January 1, 2005. We have already adopted equivalent guidance
under U.S. GAAP. The adoption of EIC 150 did not have any material impact on our results of
operations or financial condition.
    
    Financial Instruments  Presentation and Disclosure  In January 2004, the CICA issued
amendments to CICA Handbook Section 3860, Financial Instruments  Presentation and
Disclosure (Section 3860), to require obligations that must be or may be settled, at the issuers
option, by a variable number of the issuers own equity instruments to be presented as
liabilities. Thus, securities issued by an enterprise that give the issuer unrestricted
rights to settle the principal amount in cash or in the equivalent value of its own equity
instruments will no longer be presented as equity. The amendments to Section 3860 are
applicable to us beginning January 1, 2005 on a retroactive basis. The adoption of the
amendments to Section 3860 did not have any material impact on our results of operations
and financial condition. Outstanding share data As of May 16, 2005, Nortel Networks Limited had 1,460,978,638 outstanding common shares. Market risk Market risk represents the risk of loss that may impact our unaudited consolidated financial statements
through adverse changes in financial market prices and rates. Our market risk exposure results
primarily from fluctuations in interest rates and foreign exchange rates. To manage the risk from
these fluctuations, we enter into various derivative-hedging transactions that we have authorized
under our policies and procedures. We maintain risk management control systems to monitor market
risks and counterparty risks. These systems rely on analytical techniques including both
sensitivity analysis and value-at-risk estimations. We do not hold or issue financial instruments
for trading purposes. We manage foreign exchange exposures using forward and option contracts to hedge sale and purchase
commitments. Our most significant foreign exchange exposures are in the Canadian dollar, the
British pound and the euro. We enter into U.S. to Canadian dollar forward and option contracts
intended to hedge the U.S. to Canadian dollar exposure on future revenues and expenditure streams.
In accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, we
recognize the gains and losses on the effective portion of these contracts in earnings when the
hedged transaction occurs. Any ineffective portion of these contracts is recognized in earnings
immediately. 84




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We expect to continue to expand our business globally and, as such, expect that an increasing
proportion of our business may be denominated in currencies other than U.S. dollars. As a result,
fluctuations in foreign currencies may have a material impact on our business, results of
operations and financial condition. We try to minimize the impact of such currency fluctuations
through our ongoing commercial practices and by attempting to hedge our major currency exposures.
In attempting to manage this foreign exchange risk, we identify operations and transactions that
may have exposure based upon the excess or deficiency of foreign currency receipts over foreign
currency expenditures. Given our exposure to international markets, we regularly monitor all of
our material foreign currency exposures. However, if significant foreign exchange losses are
experienced, they could have a material adverse effect on our business, results of operations and
financial condition. A portion of our long-term debt is subject to changes in fair value resulting from changes in
market interest rates. We have hedged a portion of this exposure to interest rate volatility using
fixed for floating interest rate swaps. The change in fair value of the swaps are recognized in
earnings with offsetting amounts related to the change in the fair value of the hedged debt
attributable to interest rate changes. Any ineffective portion of the swaps is recognized in
income immediately. We record net settlements on these swap instruments as adjustments to interest
expense. Historically, we have managed interest rate exposures, as they relate to interest expense, using a
diversified portfolio of fixed and floating rate instruments denominated in several major
currencies. We use sensitivity analysis to measure our interest rate risk. The sensitivity
analysis includes cash, our outstanding floating rate long-term debt and any outstanding
instruments that convert fixed rate long-term debt to floating rate. Equity price risk The values of our equity investments in several publicly traded companies are subject to
market price volatility. These investments are generally in companies in the technology industry sector and are classified as
available for sale. We typically do not attempt to reduce or eliminate the market exposure on
these investment securities. We also hold certain derivative instruments or warrants that are
subject to market price volatility because their value is based on the common share price of a
publicly traded company. These derivative instruments are generally acquired through business
acquisitions or divestitures. In addition, derivative instruments may also be purchased to hedge
exposure to certain compensation obligations that vary based on future Nortel Networks Corporation
common share prices. We do not hold equity securities or derivative instruments for trading
purposes. Environmental matters We are subject to numerous environmental protection laws and regulations in various
jurisdictions around the world, primarily due to our manufacturing operations. As a result, we are
exposed to liabilities and compliance costs arising from our past and current generation,
management and disposition of hazardous substances and wastes. We have remedial activities under way at twelve of our facilities which are either currently
occupied or were previously owned or occupied. We have also been listed as a potentially
responsible party at six Superfund sites in the U.S. An estimate of our anticipated remediation
costs associated with all such facilities and sites, to the extent probable and reasonably
estimable, is included in our environmental accruals in an approximate amount of $30. For a discussion of Environmental matters, see Contingencies in note 16 of the accompanying
unaudited consolidated financial statements. Legal proceedings Nortel and/or certain of our directors and officers have been named as defendants in various
class action lawsuits. We are unable to determine the ultimate aggregate amount of monetary
liability or financial impact to us in these legal matters, which unless otherwise specified, seek
damages from the defendants of material or indeterminate amounts. We are also a defendant in
various other suits, claims, proceedings and investigations which are in the normal course of
business. We cannot determine whether these matters will, individually or collectively, have a
material adverse effect on our business, results of operations, financial condition and liquidity.
We, and any of our named directors or officers, intend to vigorously defend these actions, suits,
claims, proceedings and investigations. We are also subject to significant pending civil
litigation and ongoing regulatory and criminal investigations in the U.S. and Canada which could
require us to pay substantial judgments, settlements, fines or other penalties. For additional
information related to our legal proceedings, see Contingencies in note 16 of the 85




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accompanying
unaudited consolidated financial statements, the Legal Proceedings section of this report and Risk
factors/forward looking statements. Risk factors/forward looking statements You should carefully consider the risks described below before investing in our securities.
The risks described below are not the only ones facing us. Additional risks not currently known to
us or that we currently believe are immaterial may also impair our business, results of operations,
financial condition and liquidity. Unless required by applicable securities laws, we do not have
any intention or obligation to publicly update or revise any forward looking statements, whether as
a result of new information, future events or otherwise. Certain statements in this Quarterly Report onForm 10-Qcontain words such as could, expects,
may, anticipates, believes, intends, estimates, plans, envisions, seeks and other
similar language and are considered forward looking statements. These statements are based on our
current expectations, estimates, forecasts and projections about the operating environment,
economies and markets in which we operate. In addition, other written or oral statements which are
considered forward looking may be made by us or others on our behalf. These statements are subject
to important risks, uncertainties and assumptions, which are difficult to predict and the actual
outcome may be materially different. In particular, the risks described below could cause actual
events to differ materially from those contemplated in forward looking statements. Risks relating to our restatements and related matters Our two restatements of our consolidated financial statements and related events have had, and
will continue to have, a material adverse effect on us. In May 2003, we commenced certain balance sheet reviews at the direction of certain members of
former management that led to the Comprehensive Review, which resulted in the First Restatement.
In late October 2003, the Audit Committee initiated the Independent Review and engaged WCPHD to
advise it in connection with the Independent Review. The Audit Committee sought to gain a full
understanding of the events that caused significant excess liabilities to be maintained on the
balance sheet that needed to be restated, and to recommend that our Board of Directors adopt, and
direct management to implement, necessary remedial measures to address personnel, controls,
compliance and discipline. As the Independent Review progressed, the Audit Committee directed new
corporate management to examine in depth the concerns identified by WCPHD regarding provisioning
activity and to review certain provision releases. That examination, and other errors identified by
management, led to the Second Restatement and our revision of previously announced unaudited
results for the year ended December 31, 2003. The need for the Second Restatement resulted in
delays in filing the Reports. Over the course of the Second Restatement process, management identified certain accounting
practices that it determined should be adjusted as part of the Second Restatement. In particular,
management identified certain errors related to revenue recognition and undertook a process of
revenue reviews. In light of the resulting adjustments to revenues previously reported, the Audit
Committee has determined to review the facts and circumstances leading to the restatement of these
revenues for specific transactions identified in the Second Restatement. The review has a
particular emphasis on the underlying conduct that led to the initial recognition of these
revenues. The Audit Committee is seeking a full understanding of the historic events that required
the revenues for these specific transactions to be restated and will consider any appropriate
additional remedial measures, including those involving internal controls and processes. The Audit
Committee has engaged WCPHD to advise it in connection with this review. For more information on the Comprehensive Review, Independent Review, First Restatement, Second
Restatement and Revenue Independent Review, see the MD&A section of this report and Item 9A of
the 2003 Annual Report and 2004 Annual Report. As a result of these events, we have become subject to the following key risks, each of which is
described in more detail below. Each of these risks could have a material adverse effect on our
business, results of operations, financial condition and liquidity.  
    
    We are subject to ongoing regulatory and criminal investigations in the
U.S. and Canada, which could require us to pay substantial fines or other penalties.
    
    We are subject to significant pending civil litigation, which if decided
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could require us to pay substantial judgments,
settlements or other penalties and could result in the potential dilution of our common
 shares.
    
    Material adverse legal judgments, fines, penalties or settlements could
have a material adverse effect on our business, results of operations, financial
condition and liquidity, which could be very significant.
    
    We cannot predict the outcome of the Revenue Independent Review being
undertaken by our Audit Committee.
    
    We and our independent auditors have identified a number of material
weaknesses related to our internal control over financial reporting and concluded that
our internal control over financial reporting is ineffective, which could continue to
impact our ability to report our results of operations and financial condition
accurately and in a timely manner.
    
    The governing principles of the Independent Review particularly as they
relate to remedial measures may take time to implement.
    
    The delayed filing of the Reports and related matters caused us to breach
our public debt indentures. In addition, the delay in filing the Reports and related
matters resulted in a breach of our obligations under the EDC Support Facility and
caused us to seek waivers from EDC under the EDC Support Facility. Any future delays
in filing our periodic reports could cause us to similarly breach our public debt
indentures and our obligations under the EDC Support Facility and seek waivers from EDC
under the EDC Support Facility. In such circumstances, it is possible that the holders
of our public debt would seek to accelerate the maturity of
that debt and EDC would not grant us further waivers.
    
    Our credit ratings have been downgraded, we are currently unable to access
in its current form our shelf registration statement filed with the SEC and we
terminated the Five Year Facilities, each of which may affect our liquidity.
    
    The delay in filing of the Reports caused us to be in breach of the
continued listing requirements of the NYSE and TSX. Any future breach of the continued
listing requirements of the NYSE and TSX could cause the NYSE and/or the TSX to
commence suspension or delisting procedures in respect of Nortel Networks Corporations
common shares or other of our or NNCs listed securities.
    
    Continuing negative publicity has and may adversely affect our business.
    
    We may not be able to attract or retain the personnel necessary to achieve our business objectives.
    
    Ongoing SEC review may require us to amend our public disclosures further. We are subject to ongoing regulatory and criminal investigations in the U.S. and Canada, which
could require us to pay substantial fines or other penalties. We are under investigation by the SEC and the OSC. On April 5, 2004, we announced that the SEC had
issued a formal order of investigation in connection with our previous restatement of financial
results for certain periods and our announcements in March 2004 regarding the likely need to revise
certain previously announced results and restate previously filed financial results for one or more
earlier periods. On April 13, 2004, we announced that we had received a letter from the staff of the OSC advising us
of an OSC Enforcement Staff investigation into the same matters that are the subject of the SEC
investigation. We have also received a U.S. federal grand jury subpoena for the production of certain documents
sought in connection with an ongoing criminal investigation being conducted by the U.S. Attorneys
Office for the Northern District of Texas, Dallas Division. Further, on August 16, 2004, we
received a letter from the Integrated Market Enforcement Team of the RCMP advising us that it would
be commencing a criminal investigation into our financial accounting situation. Our senior management and Board of Directors have been required to devote significant time to these
investigations and related matters. We cannot predict when these investigations will be completed,
nor can we predict what the results of these investigations may be. Expenses incurred in
connection with these investigations (which include substantial fees of lawyers and other
professional advisors and potential obligations to indemnify officers and directors who may be
parties to such actions) could adversely affect our cash position. We may be required to pay
material fines, consent to injunctions on future conduct or suffer other penalties, each of which
could have a material adverse effect on our business, results of operations, financial condition
and liquidity. The investigations may adversely affect our ability to obtain, and/or increase the
cost of obtaining, directors and officers liability insurance and/or other types  of insurance,
which could have a material 87




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adverse affect on our business, results of operations and financial
condition. In addition, the findings and outcomes of the Independent Review, the Revenue
Independent Review and the regulatory and criminal investigations may affect the course of the
civil litigation pending against us, which are more fully described below. The effects and results of these or other investigations may have a material adverse effect on our
business, results of operations, financial condition and liquidity. We are subject to significant pending civil litigation, which if decided against us or as a result
of settlement, could require us to pay substantial judgments, settlements or other penalties and
could potentially result in the dilution of our common shares. In addition to being subject to litigation in the ordinary course of business, we are currently,
and may in the future be, subject to class actions, other securities litigation and other actions
arising in relation to our accounting restatements. Subsequent to NNCs March 10, 2004
announcement of the likely need for the Second Restatement, numerous class action complaints,
including ERISA class action complaints and a derivative action complaint, have been filed against
Nortel and certain current and former officers and directors. We expect that this litigation will be time consuming, expensive and distracting from the conduct
of our daily business. The adverse resolution of any specific lawsuit could have a material adverse
effect on our ability to favorably resolve other
lawsuits and on our financial condition and liquidity. We are unable at this time to estimate what
our ultimate liability in these matters may be, and it is possible that we will be required to pay
substantial judgments, settlements or other penalties and incur expenses that could have a material
adverse effect on our business, results of operations, financial condition and liquidity, and such
effects could be very significant. Expenses incurred in connection with these matters (which
include substantial fees of lawyers and other professional advisors and potential obligations to
indemnify officers and directors who may be parties to such actions) could adversely affect our
cash position. Material adverse legal judgments, fines, penalties or settlements could have a material adverse
effect on our business, results of operations, financial condition and liquidity, which could be
very significant. We estimate that as of March 31, 2005 our available cash and our cash flow from operations will be
adequate to fund our operations and service our debt for at least the next twelve months. In making
this estimate, we have not assumed the need to make any payments in connection with our pending
civil litigation or investigations related to the First Restatement and Second Restatement, other
than our anticipated professional fees and expenses. We believe that we have sufficient cash to
repay our debt of $1,275 relating to our 6.125% notes due February 2006. However, we continue to
routinely monitor the capital markets for opportunities to improve our capital structure and
financial flexibility. We can provide no assurances that any capital markets transactions will be
completed on favorable terms, or at all. Any material adverse legal judgments, fines, penalties or
settlements arising from the pending civil litigation and investigations could require additional
funding which may not be available on commercially reasonable terms, or at all. This could have a
material adverse effect on our business, results of operations, financial condition and liquidity,
including by:  
    
    requiring us to dedicate a substantial portion of our cash and/or cash flow from
operations to payments of such judgments, fines, penalties or settlements, thereby reducing
the availability of our cash and/or cash flow to fund working capital, capital
expenditures, R&D efforts and other general corporate purposes, including debt reduction;
    
    making it more difficult for us to satisfy our payment obligations with respect to our outstanding indebtedness;
    
    increasing the difficulty and/or cost to us of refinancing our indebtedness;
    
    increasing our vulnerability to general adverse economic and industry conditions;
    
    limiting our flexibility in planning for, or reacting to, changes in our businesses and
the industries in which we operate;
    
    making it more difficult for us to make acquisitions and investments;
    
    limiting our ability to obtain, and/or increase the cost of obtaining, directors and
officers liability insurance and/or other types of insurance; and 88




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
    
    restricting our ability to introduce new technologies and products and/or exploit
business opportunities. We cannot predict the outcome of the Revenue Independent Review being undertaken by our Audit
Committee. As more fully discussed in
Developments in 2005  Nortel Audit Committee Independent Review;
restatements; related matters and the Controls and Procedures section of this report, our Audit
Committee initiated the Revenue Independent Review to achieve a full understanding of the historic
events that required revenues for certain specific transactions to be restated. The Revenue
Independent Review has a particular emphasis on the underlying conduct that led to the initial
recognition of these revenues. The review will also consider any appropriate additional remedial
measures, including those involving internal controls and processes. The Audit Committee has
engaged WCPHD to advise it in connection with this review. We cannot predict the outcome of the
Revenue Independent Review. We and our independent auditors have identified a number of material weaknesses related to our
internal control over financial reporting, five of which remain unremedied, and concluded that our internal control over financial
reporting was ineffective as at December 31, 2004, which could continue to impact our ability to report
our results of operations and financial condition accurately and in a timely manner. Two material weaknesses in our internal control over financial reporting were identified at the
time of the First Restatement. Over the course of Second Restatement, we and Deloitte identified a number of additional material
weaknesses in our internal control over financial reporting. Deloitte confirmed to the Audit
Committee these material weaknesses, listed below, on January 10, 2005:  
    
    lack of compliance with written Nortel procedures for monitoring and adjusting balances
related to certain accruals and provisions, including restructuring charges and contract
and customer accruals;
    
    lack of compliance with Nortel procedures for applying applicable GAAP to the initial
recording of certain liabilities, including those described in SFAS No. 5, and to foreign
currency translation as described in SFAS No. 52;
    
    lack of sufficient personnel with appropriate knowledge, experience and training in
U.S. GAAP and lack of sufficient analysis and documentation of the application of U.S.
GAAP to transactions, including, but not limited to, revenue transactions;
    
    lack of a clear organization and accountability structure within the accounting
function, including insufficient review and supervision, combined with financial reporting
systems that are not integrated and which require extensive manual interventions;
    
    lack of sufficient awareness of, and timely and appropriate remediation of, internal
control issues by Nortel personnel; and
    
    an inappropriate tone at the top, which contributed to the lack of a strong control
environment; as reported in the Independent Review Summary set forth in Item 9A of the
2003 Annual Reports; there was a Management tone at the top that conveyed the strong
leadership message that earnings targets could be met through application of accounting
practices that finance managers knew or ought to have known were not in compliance with
U.S. GAAP and that questioning these practices was not acceptable. Our management assessed the effectiveness of our internal control over financial reporting as at
December 31, 2004 pursuant to SOX 404 and the related SEC rules and concluded that our internal
control over financial reporting was not effective as at December 31, 2004. Specifically, they
concluded that the first five of these six material weaknesses continue to exist and existed as at
December 31, 2004. Deloitte has also assessed the effectiveness of our internal control over
financial reporting as at December 31, 2004 and has also concluded that our internal control over
financial reporting was not effective as at December 31, 2004. The first five of these six material weaknesses remain unremedied. We continue to identify, develop
and implement remedial measures to address these material weaknesses. These material weaknesses,
if not fully addressed, could result in accounting errors such as those underlying the restatements
of our consolidated financial statements more fully discussed in Item 9A of the 2003 Annual Report
and the 2004 Annual Report. While our Board of Directors has approved the adoption of all of the
recommendations for remedial measures contained in the Summary of Findings and of Recommended
Remedial Measures of the Independent Review in the Controls and Procedures section of our 2003
Annual Report on Form 10-K, and our management has adopted a number of measures to strengthen our
internal control over financial reporting and address the material weaknesses identified above, we
may be unable to address such material weaknesses in a timely manner, which could adversely impact
the accuracy and timeliness of future reports and filings we make with the SEC and OSC. While we are implementing steps to ensure the effectiveness of our internal control over financial
reporting, failure to restore the effectiveness of our internal control over financial reporting
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accurately and could have a material adverse effect on our business, results of operations,
financial condition and liquidity. The governing principles of the Independent Review particularly as they relate to remedial measures
may take time to implement. As a result of the Independent Review, a number of significant remedial steps have been identified
as necessary to improve our process and procedures. These remedial steps may take time to
implement. In addition, the process of implementing the governing principles of the Independent
Review may be time consuming for our senior management and disrupt our business. The delayed filing of the Reports and related matters caused us to breach our public debt
indentures. In addition, the delay in filing the Reports and related matters resulted in a breach
of our obligations under the EDC Support Facility and caused us to seek waivers from EDC under the
EDC Support Facility. Any future delays in filing our periodic reports could cause us to similarly
breach our public debt indentures and our obligations under the EDC Support Facility and seek
waivers from EDC under the EDC Support Facility. In such circumstances, it is possible that the
holders of our public debt would seek to accelerate the maturity of that debt and EDC would not
grant us further waivers. As a result of the delayed filing of the Reports, we and NNC
breached our obligations to deliver
the Reports to the trustees under our and NNCs public debt indentures. With the filing of the
2005 First Quarter Reports with the SEC and the delivery of the 2005 First Quarter Reports to the
trustees under our and NNCs public debt indentures, we and NNC will be in compliance with our
delivery obligations under the public debt indentures. The delayed filings did not result in an automatic event of default and acceleration of the
outstanding long-term debt and such default and acceleration could not have occurred unless notice
of such non-compliance from holders of not less than 25% of the outstanding principal amount of any
relevant series of debt securities was provided to us or NNC, as applicable, and we or NNC, as
applicable, failed to deliver the relevant report within 90 days after such notice was provided,
all in accordance with the terms of the indentures. While such notice could have been given at any
time after March 30, 2004 as a result of the delayed filings of the Reports, neither we nor NNC has
received a notice. As a result of the delayed filing of our Reports and the Related Breaches, we were also required to
seek waivers from EDC under the EDC Support Facility. On May 31, 2005, we obtained the Permanent Waiver of the Related Breaches by us under the EDC Support
Facility. With the filing of the 2005 First Quarter Reports and the Permanent Waiver, we will be
in compliance with its obligations under the EDC Support Facility. Any future delay in the filing of our periodic reports with the SEC would similarly result in a
breach of our public debt indentures and require us to seek additional waivers from EDC under the
EDC Support Facility, which could reduce our access to the EDC Support Facility and may adversely
affect our liquidity. In such circumstances, it is possible that the holders of our public debt
would seek to accelerate the maturity of that debt and that EDC would not grant an additional
waiver or that the terms of such a waiver would be unfavorable. Our credit ratings have been downgraded, we are currently unable to access in its current form our
shelf registration statement filed with the SEC and we terminated the Five Year Facilities, each of
which may adversely affect our liquidity. On April 28, 2004, S&P downgraded its ratings of us, including our long-term corporate credit
rating from B to B- and our preferred share rating from CCC to CCC-. At the same time, it
revised its outlook to developing from negative. Moodys current long-term debt rating for us is
B3 and its preferred share rating is Caa3. On April 28, 2004, Moodys changed its outlook to
potential downgrade from uncertain. These ratings are below investment grade. Our credit ratings
could be lowered or rating agencies could issue adverse commentaries in the future, which could
have a material adverse effect on our business, results of operations, financial condition and
liquidity. These ratings and our current credit condition affect, among other things, our ability
to raise debt, access the commercial paper market (which is currently closed to us), engage in
alternative financing arrangements, obtain bank financings and affect our ability, and the cost to
securitize receivables, obtain customer bid, performance-related and other bonds and contracts,
access the EDC Support Facility and/or enter into normal course derivative or hedging transactions
and also affect the price of our stock. As a result of a ratings downgrade in 2002, security agreements became effective under which
substantially all of our assets located in the U.S. and Canada and those of most of our U.S. and
Canadian subsidiaries, including the shares of certain of our U.S. and Canadian subsidiaries, were
pledged. In addition, certain of our wholly owned subsidiaries have guaranteed our obligations
under the EDC Support Facility and our and NNCs outstanding debt securities. These agreements
will continue to secure the EDC Support Facility and our and NNCs outstanding public debt until
the EDC Support Facility expires, alternative collateral is provided, or our public debt ratings
return to at least BBB (with a 90




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stable outlook) by S&P and Baa2 (stable outlook) by Moodys. The
continued existence of these security arrangements may adversely affect our ability to incur
additional debt or obtain alternative financing arrangements. In addition, EDC is not obligated to
make any support available under the EDC Support Facility if our senior long-term rating by Moodys
is downgraded to less than B3 or if its debt rating by S&P is downgraded to less than B-. In addition, in April 2004, we terminated the Five Year Facilities. Absent this termination, the
banks would have been permitted, upon 30 days notice, to terminate their commitments under the
Five Year Facilities as a result of our failure to file our 2003 Annual Report on Form 10-K by
April 29, 2004. Although the Five Year Facilities were undrawn at termination, this termination
may adversely affect our liquidity. Further, as a result of the delayed filing of the Reports, we and NNC continue to be unable to use,
in its current form as a short-form shelf registration statement, the remaining approximately $800
of capacity for various types of securities under our SEC shelf registration statement. We will
again become eligible for short-form shelf registration with the SEC after we have completed timely
filings of our financial reports for twelve consecutive months. As a result, our ability to access
the capital markets is constrained, which may adversely affect our liquidity. The delay in filing the Reports caused us to be in breach of the continued listing requirements of
the NYSE and TSX. Any future breach of the continued listing requirements of the NYSE or TSX could
cause the NYSE and/or the TSX to commence suspension or delisting procedures in respect of Nortel
Networks Corporation common shares or other of our or NNCs listed securities. As a result of the delay in filing the Reports, we were in breach of the continued listing
requirements of the NYSE and TSX. With the filing and delivery of the 2005 First Quarter Reports,
we will be in compliance with the continued listing requirements of the NYSE and TSX. However, any
future breach of the continued listing requirements could cause the NYSE or TSX to commence
suspension or delisting procedures in respect of our or NNCs listed securities. The commencement
of any suspension or delisting procedures by either exchange remains, at all times, at the
discretion of such exchange and would be publicly announced by the exchange. If a suspension or delisting were to occur, there would be significantly less liquidity in the
suspended or delisted securities. In addition, our ability to raise additional necessary capital
through equity or debt financing, and attract and retain personnel by means of equity compensation,
would be greatly impaired. Furthermore, with respect to any suspended or delisted securities, we
would expect decreases in institutional and other investor demand, analyst coverage, market making
activity and information available concerning trading prices and volume, and fewer broker-dealers
would be willing to execute trades with respect to such securities. A suspension or delisting would
likely decrease the attractiveness of Nortel Networks Corporation common shares or other listed
securities of Nortel Networks Corporation and us to investors and cause the trading volume of
Nortel Networks Corporation common shares or other listed securities of Nortel Networks Corporation
and us to decline, which could result in a decline in the market price of such securities. Continuing negative publicity may adversely affect our business. As a result of the First Restatement and Second Restatement, we have been the subject of continuing
negative publicity. This negative publicity has contributed to significant declines in the prices
of our publicly traded securities. This negative publicity has and may have an effect on the terms
under which some customers and suppliers are willing to continue to do business with us and could
affect our financial performance or financial condition. We also believe that many of our
employees are operating under stressful conditions, which reduce morale and could lead to increased
employee turnover. Continuing negative publicity could have a material adverse effect on our
business and the market price of our publicly traded securities. As a result of the delay in the filing of the 2004 Annual Reports (containing our audited
consolidated financial statements for the year ended December 31, 2004), we were required to apply
to the Ontario Superior Court of Justice for an order permitting the postponement of our 2004
Annual Shareholders Meeting, or the Meeting. The Ontario Superior Court of Justice granted that
order, which permitted us to extend the time for calling the Meeting to a date not later than June
30, 2005. The order permitted us to comply with a specific SEC rule which requires us, in our
circumstances, to provide to shareholders our 2004 audited financial statements either prior to or
concurrently with the mailing of proxy materials for the Meeting. The postponement has, among other
things, contributed to the continuing negative publicity related to us, which may adversely affect
our business and the market price of our publicly traded securities. 91




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We may not be able to attract or retain the personnel necessary to achieve our business objectives. Competition for certain key positions and specialized technical personnel in the high-technology
industry remains strong. Our future success depends in part on our continued ability to hire,
assimilate in a timely manner and retain qualified personnel, particularly in key senior management
positions and in our key areas of potential growth. An important factor in attracting and
retaining qualified employees is our ability to provide employees with the opportunity to
participate in the potential growth of our business through programs such as stock option plans,
restricted stock unit plans and employee investment and share purchase plans. The scope and value
of these programs will be adversely affected by the volatility or negative performance of the
market price for Nortel Networks Corporations common shares. In connection with the delay in filing our 2003 Annual Reports, as of March 10, 2004, NNC suspended
the purchase of Nortel Networks Corporation common shares under the stock purchase plans for
eligible employees in eligible countries that facilitate the acquisition of Nortel Networks
Corporation common shares; the exercise of outstanding options granted under the 2000 Plan or the 1986 Plan, or the grant of any additional options under those plans, or the
exercise of outstanding options granted under employee stock option plans previously assumed by us
in connection with mergers and acquisitions; and the purchase of units in Nortels stock fund or
purchase of Nortel Networks Corporation common shares under our defined contribution and
investments plans until such time as, at the earliest, we are in compliance with U.S. and Canadian
regulatory securities filing requirements. On May 31, 2004, the OSC issued a final order
prohibiting all trading by our directors, officers and certain current and former employees in
Nortel Networks Corporations securities and those of NNC. Now that we and NNC have become current
with our financial reporting obligations for the first quarter of 2005 under Ontario securities laws, we and NNC plan to apply to the
OSC to have this order revoked. Such revocation will be at the discretion of the OSC.
Accordingly, our ability to provide employees with the opportunity to participate in Nortel stock
option plans, restricted stock unit plans and employee investment and share purchase plans has been
adversely affected and certain employees have not been able to trade in NNC securities. The
current suspension of these programs and OSC trading order, and any future suspension or OSC order,
may have a material adverse effect on our ability to hire, assimilate in a timely manner and retain
qualified personnel. In addition, in 2004 we terminated for cause our former president and chief executive officer,
former chief financial officer, former controller and seven additional individuals with significant
responsibilities for financial reporting. We have also commenced litigation against our former
president and chief executive officer, former chief financial officer and former controller,
seeking the return of payments made to them under our bonus plan in 2003. In August and September
2004, as part of our new strategic plan, we announced an anticipated workforce reduction of
approximately 3,250 employees. Approximately 73% of employee actions related to the focused
workforce reduction were completed by March 31, 2005, including approximately 62% that were
notified of termination or acceptance of voluntary retirement, with the remainder comprised of
voluntary attrition of employees that were not replaced. The remainder of employee actions is
expected to be completed by June 30, 2005. In addition, in 2001, 2002 and 2003, we implemented a
company-wide restructuring plan, which included a reduction of approximately two-thirds of our
workforce over the three-year period. We may find it more difficult to attract or retain qualified employees because of our recent
significant workforce reductions, business performance, management changes, restatement activities
and resulting negative publicity and the resulting impacts on our incentive programs and incentive
compensation plans. If we have not properly sized our workforce and retained those employees with
the appropriate skills, our ability to compete effectively may be adversely affected. We are also
more dependent on those employees we have retained, as many have taken on increased
responsibilities due to workforce reductions. If we are not successful in attracting, recruiting
or retaining qualified employees, including members of senior management, we may not have the
personnel necessary to achieve our business objectives, including the implementation of our
remedial measures. Ongoing SEC review may require us to amend our public disclosures further. We have received comments on our periodic filings from the staff of the SECs Division of
Corporation Finance. As part of this comment process, we may receive further comments from the
staff of the SEC relating to this Quarterly Report on Form 10-Q and our other periodic filings. As
a result, we may be required by the SEC to amend this Form 10-Q or other reports filed with the SEC
in order to make adjustments or additional disclosures. 92




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Risks relating to our business We continue to restructure our business to respond to industry and market conditions. The
assumptions underlying our restructuring efforts may prove to be inaccurate and we may have to
restructure our business again in the future. We continue to restructure our business to realign resources and achieve desired cost savings in an
increasingly competitive market. Our new strategic plan includes an anticipated further workforce
reduction of approximately 3,250 employees. We have based our restructuring efforts on certain
assumptions regarding the cost structure of our business. Our current assumptions may or may not
be correct and as a result, we may determine that further restructuring in the future will be
needed. Our restructuring efforts may not be sufficient for us to achieve improved results and
meet the changes in industry and market conditions, including increased competition. In
particular, we face increased competition from low cost competitors such as Huawei Technologies
Co., Ltd. and ZTE Corporation. We must manage the potentially higher growth areas of our business,
as well as the non-core areas, in order for us to achieve improved results. We have made, and will continue to make, judgments as to whether we should further reduce our
workforce or exit, or dispose of, certain businesses. These workforce reductions may impair our
ability to achieve our current or future business objectives. Costs incurred in connection with
restructuring efforts may be higher than estimated. Any decision by management to further limit
investment or exit, or dispose of, businesses may result in the recording of additional charges.
As a result, the costs actually incurred in connection with the restructuring efforts may be higher
than originally planned and may not lead to the anticipated cost savings and/or improved results. As part of our review of restructured businesses, we look at the recoverability of their tangible
and intangible assets. Future market conditions may trigger further write downs of these assets
due to uncertainties in:  
    
    the estimates and assumptions used in asset valuations, which are based on our
forecasts of future business performance; and
    
    accounting estimates related to the useful life and recoverability of the net
book value of these assets, including inventory, goodwill, net deferred taxes and other
intangible assets. We will continue to review our restructuring work plan based on our ongoing assessment of the
industry and the business environment. Our operating results have historically been subject to yearly and quarterly fluctuations and are
expected to continue to fluctuate. Our operating results have historically been, and are expected to continue to be, subject to
quarterly and yearly fluctuations as a result of a number of factors. These factors include:  
    
    our ability to execute our strategic plan, including the planned workforce
reductions, without negatively impacting our relationships with our customers, the delivery
of products based on new and developing technologies at competitive prices, the
effectiveness of our internal processes and organizations and the retention of qualified
personnel;
    
    our ability to focus on the day-to-day operation of our business while
implementing improvements in our internal controls and procedures, including our accounting
systems, and addressing the civil litigation actions and investigations related to our
restatements;
    
    our ability to successfully implement programs to stimulate customer spending
by anticipating and offering the kinds of products and services customers will require in
the future to increase the efficiency and profitability of their networks;
    
    our ability to successfully complete programs on a timely basis to reduce our
cost structure, including fixed costs, to streamline our operations and to reduce product
costs;
    
    our ability to successfully manage our manufacturing operations, which are
substantially outsourced to contract manufacturers;
    
    our ability to successfully comply with increased and complex regulations;
    
    our ability to focus our business on what we believe to be potentially higher
growth, higher margin businesses and to dispose of or exit non-core businesses;
    
    increased price and product competition in the networking industry, including
from low cost competitors; 93




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
    
    our ability to compete with low cost competitors, including those offering
attractive customer financing arrangements;
    
    the inherent uncertainties of using forecasts, estimates and assumptions for
asset valuations and in determining the amounts of accrued liabilities, provisions and
other items in our unaudited consolidated financial statements;
    
    the impact of changes in global capital markets and interest rates on our pension plan assets and obligations;
    
    fluctuations in our gross margins;
    
    the development, introduction and market acceptance of new technologies, and
integrated networking solutions, as well as the adoption of new networking standards;
    
    the overall trend toward industry consolidation and rationalization among our
customers, competitors and suppliers;
    
    our ability to make investments, including acquisitions, to strengthen our business;
    
    the ability of our customers and suppliers to obtain financing to fund capital expenditures;
    
    variations in sales channels, product costs and the mix of products sold;
    
    the size and timing of customer orders and shipments;
    
    our ability to obtain payment from customers on a timely basis;
    
    our ability to continue to obtain customer performance bonds and contracts;
    
    our ability to maintain appropriate inventory levels;
    
    the impact of acquired businesses and technologies;
    
    our ability to fund and sustain our research and development activities;
    
    the impact of our product development schedules, product quality variances,
manufacturing capacity and lead times required to produce our products; and
    
    the impact of higher insurance premiums and deductibles and greater
limitations on insurance coverage. Our decision to adopt fair value accounting for employee stock options on a prospective basis as of
January 1, 2003 has caused us to record an expense over the stock option vesting period, based on
the fair value at the date the options are granted, and could have a significant negative effect on
our reported results. Additionally, we are required to perform goodwill impairment tests on an annual basis and between
annual tests in certain circumstances, to value our deferred tax assets and to partially accrue
unfunded pension liabilities, each of which may result in a negative effect on our reported
results. We enter into agreements that may require us to make certain indemnification payments to third
parties in the event of certain changes in an underlying economic characteristic related to assets,
liabilities or equity securities of such third parties. The occurrence of events that may cause us
to become liable to make an indemnification payment is not within our control and an obligation to
make a significant indemnification payment under such agreements could have a significant negative
effect on our reported results. As a consequence, operating results for a particular future period are difficult to predict, and
therefore, prior results are not necessarily indicative of results to be expected in future
periods. Any of the foregoing factors, or any other factors described herein, could have a
material adverse effect on our business, results of operations and financial condition. Global economic conditions and other trends and factors affecting the telecommunications industry
are beyond our control and may result in reduced demand and pricing pressure on our products. There are trends and factors affecting the industry that are beyond our control and may affect our
operations. These trends and factors include:  
    
    adverse changes in the public and private equity and debt markets and our
ability, as well as the ability of our customers and suppliers, to obtain financing or to
fund working capital and capital expenditures;
    
    adverse changes in the credit quality of our customers and suppliers;
    
    adverse changes in the market conditions in our industry and the specific markets for our products;
    
    the trend towards the sale of converged networking solutions, which could lead
to reduced capital spending on multiple networks by our customers;
    
    visibility to, and the actual size and timing of, capital expenditures by our customers;
    
    inventory practices, including the timing of product and service deployment, of our customers;
    
    the amount of network capacity and the network capacity utilization rates of
our customers, and the amount of 94




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sharing and/or acquisition of new and/or existing network
capacity by our customers;
    
    policies of our customers regarding utilization of single or multiple vendors
for the products they purchase;
    
    the overall trend toward industry consolidation and rationalization among our
customers, competitors and suppliers;
    
    conditions in the broader market for communications products, including data
networking products and computerized information access equipment and services;
    
    increased price competition, particularly from low cost competitors;
    
    changes in legislation or accounting rules and governmental and environmental
regulation or intervention affecting communications or data networking;
    
    computer viruses, break-ins and similar disruptions from unauthorized
tampering with our computer systems; and
    
    acts of war or terrorism that could lead to disruptions in general global
economic activity, changes in logistics and security arrangements and reduced customer
demand for our products and services. Cautious capital spending in our industry has affected, and could affect, demand for, or pricing
pressures on, our products. Our gross margins may decline, which would reduce our operating results. Our gross margins may be negatively affected as a result of a number of factors, including:  
    
    increased price competition, particularly from low cost competitors;
    
    increased industry consolidation among our customers, which may lead to
decreased demand for, and downward pricing pressure on the prices of, our products;
    
    changes in product and geographic mix;
    
    customer and contract settlement costs;
    
    higher product, material or labor costs;
    
    increased inventory provisions or contract and customer settlement costs;
    
    warranty costs;
    
    obsolescence charges;
    
    loss of cost savings on future inventory purchases as a result of high inventory levels;
    
    introduction of new products and costs of entering new markets;
    
    increased levels of customer services;
    
    changes in distribution channels;
    
    excess capacity or excess fixed assets;
    
    accruals for employee incentive bonuses;
    
    further restructuring costs; and
    
    costs related to our restatements, including the possibility of substantial
fines, settlements and/or damages or other penalties, and/or remedial actions. Lower than expected gross margins would negatively affect our operating results. Cash flow fluctuations may affect our ability to fund our working capital requirements or achieve
our business objectives in a timely manner. Additional sources of funds may not be available or
may not be available on acceptable terms. Our working capital requirements and cash flows historically have been, and are expected to
continue to be, subject to quarterly and yearly fluctuations, depending on such factors as timing
and size of capital expenditures and debt repayments, levels of sales, timing of deliveries and
collection of receivables, inventory levels, customer payment terms, customer financing obligations
and supplier terms and conditions. In addition, if the industry or our current condition
deteriorates, notwithstanding the EDC Support Facility, an increased portion of our cash and cash
equivalents may be restricted as cash collateral for customer performance bonds and contracts. As
of March 31, 2005, we believe our cash on hand will be sufficient to fund our current business
model, manage our investments and meet our customer commitments for at least the next 12 months.
In making this estimate, we have not made provision for any material payments in connection with
our pending civil litigation actions and investigations related to the First Restatement and Second
Restatement, other than our anticipated professional fees and expenses. We believe that we have
sufficient cash to repay our debt of $1,275 relating to our 6.125% notes due February 2006.
However, we continue to routinely monitor the capital markets for opportunities to improve our
capital structure and financial flexibility. We can provide no assurances that any capital markets
transactions will be completed on favorable terms, or at all. Any material adverse legal
judgments, fines, penalties or 95




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settlements arising from these pending civil litigation actions and
investigations could require additional funding which may not be available on commercially
reasonable terms, or at all. This could have a material adverse effect on our liquidity, which
could be very significant. In addition, a greater than expected slow down in capital spending by service providers and other
customers may require us to adjust our current business model. As a result, our revenues and cash
flows may be materially lower than we expect and we may be required to further reduce our capital
expenditures and investments or take other measures in order to meet our cash requirements. We may seek additional funds from liquidity-generating transactions and other sources of external
financing (which may include a variety of debt, convertible debt and/or equity financings). We
cannot provide any assurance that our net cash requirements will be as we currently expect, that we
will continue to have access to the EDC Support Facility when and as needed, or that
liquidity-generating transactions or financings will be available to us on acceptable terms or at
all. Our inability to manage cash flow fluctuations resulting from the above factors and the
potential reduction, expiry or termination of the EDC Support Facility could have a material
adverse effect on our ability to fund our working capital requirements from operating cash flows
and other sources of liquidity or to achieve our business objectives in a timely manner. We may be materially and adversely affected by cautious capital spending by our customers.
Increased consolidation among our customers and the loss of customers in certain markets could have
a material adverse effect on our business, results of operations and financial condition. Continued cautiousness in capital spending by service providers and other customers may affect our
revenues more than we currently expect. Our revenues and operating results have been and may
continue to be materially and adversely affected by the continued cautiousness in capital spending
by our customers. We have focused on the larger customers in certain markets, which provide a
substantial portion of our revenues. Increased industry consolidation among our customers may lead
to downward pressure on the prices of our products, or reduced spending, a loss, reduction or delay
in business from one or more of these customers. Such increased industry consolidation among our
customers, reduced spending, a loss, reduction or delay in business from one or more of these
customers, or a failure to achieve a significant market share with these customers, could have a
material adverse effect on our business, results of operations, financial condition and liquidity. Our business may be materially and adversely affected by our high level of debt. In order to finance our business, we have incurred significant levels of debt compared to
historical levels, and we may need to obtain additional sources of funding, which may include debt
or convertible debt financing, in the future. A high level of debt, arduous or restrictive terms
and conditions related to accessing certain sources of funding, failure to meet the covenants in
the EDC Support Facility and any significant reduction in, or access to, such facility, poor
business performance or lower than expected cash inflows could materially and adversely affect our
ability to fund the operation of our business. Other effects of a high level of debt include the following:  
    
    we may have difficulty borrowing money in the future or accessing other sources of funding;
    
    a high debt level may affect our ability to refinance our existing debt,
including the $1,275 of debt relating to our 6.125% Notes due February 2006 should we
decide to do so;
    
    we may need to use a large portion of our cash flow from operations to pay
principal and interest on our indebtedness, which would reduce the amount of cash available
to finance our operations and other business activities;
    
    a high debt level, arduous or restrictive terms and conditions, or lower than
expected cash flows would make us more vulnerable to economic downturns and adverse
developments in our business; and
    
    if operating cash flows are not sufficient to meet our operating expenses,
capital expenditures and debt service requirements as they become due, we may be required,
in order to meet our debt service obligations, to delay or reduce capital expenditures or
the introduction of new products, sell assets and/or forego business opportunities
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An increased portion of our cash and cash equivalents may be restricted as cash collateral if we
are unable to secure alternative support for certain obligations arising out of our normal course
business activities. The EDC Support Facility may not provide all the support we require for certain of our obligations
arising out of our normal course of business activities. As of May 16, 2005, there was
approximately $228 of outstanding support utilized under the EDC Support Facility, approximately
$160 of which was outstanding under the small bond sub-facility. In addition, bid and performance
related bonds with terms that extend beyond December 31, 2006, which, absent any early termination
of the EDC Support Facility, is the expiry date of this facility, are currently not eligible for
the support provided by the EDC Support Facility. Given that the EDC Support Facility is used to
support bid and performance bonds with varying terms, including those with at least 365 days, we
may need to increase our use of cash collateral to support these obligations beginning on January
1, 2006 absent a further extension of the facility. Unless EDC agrees to extend the facility or
agrees to provide support outside the scope of the facility, we may be required to provide cash
collateral to support these obligations. We cannot provide any assurance that we will reach an
agreement with EDC on these matters. Under the terms of the waiver letter with EDC dated March 29,
2004, EDC may also suspend its obligation to issue us any additional support if events occur that
have a material adverse effect on our business, financial position or results of operations. If we
do not have access to sufficient support under the EDC Support Facility, and if we are unable to
secure alternative support, an increased portion of our cash and cash equivalents may be restricted
as cash collateral, which could adversely affect our ability to fund some of our normal course
business activities, capital expenditures, R&D projects and our ability to borrow in the future. An inability of our subsidiaries to provide us with funding in sufficient amounts could adversely
affect our ability to meet our obligations. We may at times depend primarily on loans, dividends or other forms of financing from our
subsidiaries to meet our obligations to pay interest and principal on outstanding public debt and
to pay corporate expenses. If our subsidiaries are unable to pay dividends or provide us with
loans or other forms of financing in sufficient amounts, it could adversely affect our ability to
meet our obligations. We may need to make larger contributions to our defined benefit plans in the future. We currently maintain various defined benefit plans in North America and the U.K. which cover
various categories of employees and retirees, which represent our major retirement plans. In
addition, we have smaller retirement plans in other countries. Our obligations to make
contributions to fund benefit obligations under these plans are based on actuarial valuations,
which themselves are based on certain assumptions about the long-term operation of the plans,
including employee turnover and retirement rates, the performance of the financial markets and
interest rates. If experience differs from the assumptions, the amounts we are obligated to
contribute to the plans may increase. In particular, the performance of the financial markets is
difficult to predict, particularly in periods of high volatility in the equity markets. If the
financial markets perform lower than the assumptions, we may have to make larger contributions in
the future than we would otherwise have to make and expenses related to defined benefit plans could
increase. Similarly, changes in interest rates can impact our contribution requirements. In a low
interest rate environment, the likelihood of required contributions in the future increases. If
interest rates are lower in the future than we assume they will be, then we would probably be
required to make larger contributions than we would otherwise have to make. In addition, the 2004 decision of the Supreme Court of Canada in Monsanto Canada Inc. v.
Superintendent of Financial Services has caused companies in Canada that sponsor defined benefit
plans, including us, to review certain of our past activities that may have triggered partial
wind-ups of such plans to determine whether a distribution of plan surplus, if any, should have
occurred at the time of any triggering event. Although the full impact of the decision remains
unclear and we have not yet made any determination regarding our plans, if it is determined that a
distribution of plan surplus should have occurred at the time of any triggering event, we may be
required to make a distribution out of our plan assets, which may lead to an increase in the amount
of future contributions that we are required to make. If market conditions deteriorate or future results of operations are less than expected, an
additional valuation allowance may be required for all or a portion of our deferred tax assets. We currently have deferred tax assets, which may be used to reduce taxable income in the future.
We assess the realization of these deferred tax assets quarterly, and if we determine that it is
more likely than not that some portion of these assets will not be realized, an income tax
valuation allowance is recorded. If market conditions deteriorate or future results of operations
are less than expected, future assessments may result in a determination that it is more likely
than not that some or all of our net deferred tax assets are not realizable. As a result, we may
need to establish an additional valuation allowance for all or a portion of our net deferred tax
assets, which may have a material adverse effect on our business, results of operations and
financial condition. 97




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Our performance may be materially and adversely affected if our expectations regarding market
demand for particular products prove to be wrong. We expect that data communications traffic will grow at a faster rate than the growth expected for
voice traffic and that the use of the Internet will continue to increase. We expect the growth of
data traffic and the use of the Internet will significantly impact traditional voice networks, both
wireline and wireless. We believe that this will create market discontinuities, which will make
traditional voice network products and services less effective as they were not designed for data
traffic. We believe that these market discontinuities in turn will lead to the convergence of data
and voice through upgrades of traditional voice networks to transport large volumes of data traffic
or through the construction of new networks designed to transport both voice and data traffic.
Either approach would require significant capital expenditures by service providers. We also
believe that such developments will give rise to the demand for IP optimized networking solutions,
and third generation, or 3G, wireless networks. We cannot be sure what the rate of this convergence of voice and data networks will be, due to the
dynamic and rapidly evolving nature of the communications business, the technology involved and the
availability of capital. Consequently, market discontinuities and the resulting demand for
IP-optimized networking solutions or 3G wireless networks may not continue. Alternatively, the pace of that development may be slower than currently anticipated.
On a regional basis, growth of our revenues from sales of our networking solutions in emerging
markets, such as China and India, may be less than we anticipate if current customer orders are not
indicative of future sales, strong growth in our UMTS technology does not occur, build-out of the
BSNL contract is slower than we expect, or those emerging markets experience slower growth or fewer
deployments of VoIP and wireless data networks than we anticipate. The market may also develop in
an unforeseen direction. Certain events, including the commercial availability and actual
implementation of new technologies, including 3G networks, or the evolution of other technologies,
may occur, which would affect the extent or timing of anticipated market demand, or increase demand
for products based on other technologies, or reduce the demand for IP-optimized networking
solutions or 3G wireless networks. Any such change in demand may reduce purchases of our
networking solutions by our customers, require increased expenditures to develop and market
different technologies, or provide market opportunities for our competitors. Our performance may
also be materially and adversely affected by a lack of growth in the rate of data traffic, a
reduction in the use of the Internet or a reduction in the demand for IP-optimized networking
solutions or 3G wireless networks in the future, and slower than anticipated revenue growth from
our network solutions such as WLAN and carrier routing. We also cannot be sure that the metro optical portion of our Carrier Packet Networks business will
continue to represent as large of a percentage of our overall Carrier Packet Networks revenues as
we expect, or that our current growth in carrier VoIP will continue, or that the continued decline
in sales of our traditional circuit switching solutions will not decline more rapidly than we
anticipate, any or all of which may materially and adversely affect our results of operations and
financial condition. We have made, and may continue to make, strategic acquisitions. If we are not successful in
operating or integrating these acquisitions, our business, results of operations and financial
condition may be materially and adversely affected. In the past, we acquired companies that we believed would enhance the expansion of our business and
products. We may make selective opportunistic acquisitions of companies or businesses with
resources and product or service offerings capable of providing us with additional product and/or
market strengths. Acquisitions involve significant risks and uncertainties, including:  
    
    the industry may develop in a different direction than anticipated and the
technologies we acquire may not prove to be those we need;
    
    the future valuations of acquired businesses may decrease from the market
price we paid for these acquisitions;
    
    the revenues of acquired businesses may not offset increased operating
expenses associated with these acquisitions;
    
    potential difficulties in completing in-process research and development
projects and delivering high quality products to our customers;
    
    potential difficulties in integrating new products, software, businesses and
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
    
    our customers or customers of the acquired businesses may defer purchase
decisions as they evaluate the impact of the acquisitions on our future product strategy;
    
    potential loss of key employees of the acquired businesses;
    
    diversion of the attention of our senior management from the operation of our daily business;
    
    entering new markets in which we have limited experience and where competitors
may have a stronger market presence;
    
    the potential adverse effect on our cash position as a result of all or a
portion of an acquisition purchase price being paid in cash; and
    
    potential assumption of liabilities. Our inability to successfully operate and integrate newly acquired businesses appropriately,
effectively and in a timely manner could have a material adverse effect on our ability to take
advantage of further growth in demand for IP-optimized network solutions and other advances in
technology, as well as on our revenues, gross margins and expenses. Acquisitions are inherently risky, and no assurance can be given that our previous or future
acquisitions will be successful and will not materially adversely affect our business, operating
results, or financial condition. Failure to manage and successfully integrate acquisitions could
materially harm our business and operating results. We operate in highly dynamic and volatile industries characterized by rapidly changing
technologies, evolving industry standards, frequent new product introductions and short product
life cycles. The markets for our products are characterized by rapidly changing technologies, evolving industry
standards, frequent new product introductions and short product life cycles. Our success depends,
in substantial part, on the timely and successful introduction of high quality new products and
upgrades, as well as cost reductions on current products to address the operational speed,
bandwidth, efficiency and cost requirements of our customers. Our success will also depend on our
ability to comply with emerging industry standards, to operate with products of other suppliers, to
integrate, simplify and reduce the number of software programs used in our portfolio of products,
to address emerging market trends, to provide our customers with new revenue-generating
opportunities and to compete with technological and product developments carried out by others.
The development of new, technologically advanced products, including IP-optimized networking
solutions, software products and 3G wireless networks, is a complex and uncertain process requiring
high levels of innovation, as well as the accurate anticipation of technological and market trends.
Investments in this development may result in our expenses growing at a faster rate than our
revenues, particularly since the initial investment to bring a product to market may be high. We
may not be successful in targeting new market opportunities, in developing and commercializing new
products in a timely manner or in achieving market acceptance for our new products. The success of new or enhanced products, including IP-optimized networking solutions and 3G
wireless networks, depends on a number of other factors, including the timely introduction of those
products, market acceptance of new technologies and industry standards, the quality and robustness
of new or enhanced products, competing product offerings, the pricing and marketing of those
products and the availability of funding for those networks. Products and technologies developed
by our competitors may render our products obsolete. Hackers may attempt to disrupt or exploit our
customers use of our technologies. If we fail to respond in a timely and effective manner to
unanticipated changes in one or more of the technologies affecting telecommunications and data
networking or our new products or product enhancements fail to achieve market acceptance, our
ability to compete effectively in our industry, and our sales, market share and customer
relationships could be materially and adversely affected. In addition, unanticipated changes in market demand for products based on a specific technology,
particularly lower than anticipated, or delays in, demand for IP-optimized networking solutions,
particularly long-haul and metro optical networking solutions, or 3G wireless networks, could have
a material adverse effect on our business, results of operations and financial condition if we fail
to respond to those changes in a timely and effective manner. We face significant competition and may not be able to maintain our market share and may suffer
from competitive pricing practices. We operate in a highly volatile industry that is characterized by industry rationalization and
consolidation, vigorous competition for market share and rapid technological development.
Competition is heightened in periods of slow overall market growth. These factors could result in
aggressive pricing practices and growing competition from smaller niche companies, established
competitors, as well as well-capitalized computer systems and communications companies, which, in turn,
could separately or together with consolidation in the industry have
a material adverse
effect on our gross margins. 99




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Since some of the markets in which we compete are characterized by the potential for rapid growth
and, in certain cases, low barriers to entry and rapid technological changes, smaller, specialized
companies and start-up ventures are now, or may in the future become, principal competitors. We
may also face competition from the resale of used telecommunications equipment, including our own
on occasion, by failed, downsized or consolidated high technology enterprises and
telecommunications service providers. In addition, we face the risk that certain of our
competitors may enter into additional business combinations, accelerate product development, or
engage in aggressive price reductions or other competitive practices, which make them more powerful
or aggressive competitors. We expect that we will face additional competition from existing competitors and from a number of
companies that have entered or may enter our existing and future markets. In particular, we
currently, and may in the future, face increased competition from low cost competitors such as
Huawei Technologies Co., Ltd. and ZTE Corporation. Some of our current and potential competitors
have greater marketing, technical and financial resources, including access to capital markets
and/or the ability to provide customer financing in connection with the sale of products. Many of
our current and potential competitors have also established, or may in the future establish,
relationships with our current and potential customers. Other competitive factors include the
ability to provide new technologies and products, end-to-end networking solutions, and new product
features, such as security, as well as conformance to industry standards. Increased competition
could result in price reductions, negatively affecting our operating results, reducing profit
margins and could potentially lead to a loss of market share. We face certain barriers in our efforts to expand internationally. We intend to continue to pursue international and emerging market growth opportunities. In many
international markets, long-standing relationships between potential customers and their local
suppliers and protective regulations, including local content requirements and type approvals,
create barriers to entry. In addition, pursuing international opportunities may require
significant investments for an extended period before returns on such investments, if any, are
realized and such investments may result in expenses growing at a faster rate than revenues.
Furthermore, those projects and investments could be adversely affected by:  
    
    reversals or delays in the opening of foreign markets to new competitors;
    
    trade protection measures;
    
    exchange controls;
    
    currency fluctuations;
    
    investment policies;
    
    restrictions on repatriation of cash;
    
    nationalization of local industry;
    
    economic, social and political risks;
    
    taxation;
    
    interest rates;
    
    challenges in staffing and managing international opportunities;
    
    other factors, depending on the country involved; and
    
    acts of war or terrorism. Difficulties in foreign financial markets and economies and of foreign financial institutions,
particularly in emerging markets, could adversely affect demand from customers in the affected
countries. An inability to maintain or expand our business in international and emerging markets
could have a material adverse effect on our business, results of operations and financial
condition. Fluctuations in foreign currency exchange rates could negatively impact our business, results of
operations and financial condition. As an increasing proportion of our business may be denominated in currencies other than U.S.
dollars, fluctuations in foreign currency exchange rates may have an adverse impact on our
business, results of operations and financial condition. Our primary currency exposures are to
Canadian dollars, British pounds and the euro. These exposures may change over time as we change
the geographic mix of our global business and as our business practices evolve. For instance, if
we increase our presence in emerging markets, we may see an increase in our 100




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exposure to emerging
market currencies, for example, the Indian rupee. These currencies may be affected by
internal factors and external developments in other countries. Also, our ability to enter into
normal course derivative or hedging transactions in the future may be impacted by our current
credit condition. We cannot predict whether foreign exchange losses will be incurred in the
future, and significant foreign exchange rate fluctuations may have a material adverse effect on
our business, results of operations and financial condition. If we fail to protect our intellectual property rights, or if we are subject to adverse judgments
or settlements arising out of disputes regarding intellectual property rights, our business,
results of operations and financial condition could be materially and adversely affected. Our industry is subject to uncertainty over adoption of industry standards and protection of
intellectual property rights. Our success is dependent on our proprietary technology, for the
protection of which we rely on patent, copyright, trademark and trade secret laws. Our business is
global and the level of protection of our proprietary technology provided by those laws varies by
jurisdiction. Our issued patents may be challenged, invalidated or circumvented, and our rights
under issued patents may not provide us with competitive advantages. Patents may not be issued
from pending applications, and claims in patents issued in the future may not be sufficiently broad
to protect our proprietary technology. In addition, claims of intellectual property infringement
or trade secret misappropriation may be asserted against us or our customers in connection with
their use of our products and the outcome of any of those claims may be uncertain. An unfavorable
outcome in such a claim could require us to cease offering for sale the products that are the
subject of such a claim, pay substantial monetary damages to a third party and/or make ongoing royalty payments to a third party. In addition, any
defense of claims of intellectual property infringement or trade secret misappropriation may
require extensive participation by senior management and/or other key employees and may reduce
their time and ability to focus on other aspects of our business. A failure by us to react to
changing industry standards, the lack of broadly-accepted industry standards, successful claims of
intellectual property infringement or other intellectual property claims against us or our
customers, or a failure by us to protect our proprietary technology could have a material adverse
effect on our business, results of operations and financial condition. In addition, if others
infringe on our intellectual property rights, we may not be able to successfully contest such
challenges. Rationalization and consolidation in the industry may lead to increased competition and harm our
business. The industry has experienced consolidation and rationalization and we expect this trend to
continue. There have been adverse changes in the public and private equity and debt markets for
industry participants which have affected their ability to obtain financing or to fund capital
expenditures. Some operators have experienced financial difficulty and have, or may, file for
bankruptcy protection or be acquired by other operators. Other operators may merge and we and one
or more of our competitors may each supply products to the companies that have merged or will
merge. This rationalization and/or consolidation could result in our dependence on a smaller
number of customers, purchasing decision delays by the merged companies and/or our playing a lesser
role, or no longer playing a role, in the supply of communications products to the merged companies
and downward pressure on pricing of our products. This rationalization and/or consolidation,
including the acquisition by Cingular Wireless of AT&T Wireless, could also cause increased
competition among our customers and pressure on the pricing of their products and services, which
could cause further financial difficulties for our customers. A rationalization of industry
participants could also increase the supply of used communications products for resale, resulting
in increased competition and pressure on the pricing for our new products. In addition,
telecommunications equipment suppliers may enter into business combinations, or may be acquired by
or sell a substantial portion of their assets to other competitors, resulting in accelerated
product development, increased financial strength, or a broader base of customers, creating even
more powerful or aggressive competitors. We may also see rationalization among equipment/component
suppliers. The business failures of operators, competitors or suppliers may cause uncertainty
among investors and in the industry generally and harm our business. Changes in regulation of the Internet and/or other aspects of the industry may affect the manner in
which we conduct our business and may materially and adversely affect our business, results of
operations and financial condition. Investment decisions of our customers could be affected by regulation of the Internet or other
aspects of the industry in any country where we operate. We could also be materially and adversely
affected by an increase in competition among equipment suppliers or by reduced capital spending by
our customers, as a result of a change in the regulation of the industry. If a jurisdiction in
which we operate adopts measures which affect the regulation of the Internet and/or other aspects
of the industry, we could experience both decreased demand for our products and increased costs of
selling such products. Changes in laws or regulations governing the Internet, Internet commerce
and/or other aspects of the industry could have a material adverse effect on our business, results
of operations and financial condition. 101




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In the U.S., on February 20, 2003, the Federal Communications Commission, or FCC, announced a
decision in its triennial review proceeding of the agencys rules regarding unbundled network
elements, or UNE. The text of the FCCs order and reasons for the decision were released on August
21, 2003. The uncertainty surrounding the impact of the FCCs decision, judicial review of the
decision, the adoption of interim rules, and the subsequent adoption of new unbundling rules with
an effective date of March 11, 2005 is affecting, and may continue to affect, the decisions of
certain of our U.S.-based service provider customers regarding investment in their
telecommunications infrastructure. These UNE rules and/or material changes in other
country-specific telecommunications or other regulations may affect capital spending by certain of
our service provider customers, which could have a material adverse effect on our business, results
of operations and financial condition. In Europe, we are subject to new product content laws and product takeback and recycling
requirements that will require full compliance by 2006. We expect that these laws will require us
to incur additional compliance costs. Although compliance costs relating to environmental matters
have not resulted in a material adverse effect on our business, results of operations and financial
condition in the past, they may result in a material adverse effect in the future. Industry concerns could continue and increase our exposure to our customers credit risk and the
risk that our customers will not be able to fulfill their payment obligations to us under customer
financing arrangements. The competitive environment in which we operate has required us in the past to provide significant
amounts of medium-term and long-term customer financing. Customer financing arrangements may include financing in
connection with the sale of our products and services, funding for certain non-product and service
costs associated with network installation and integration of our products and services, financing
for working capital and equity financing. While we have significantly reduced our customer
financing exposure, we expect we may continue in the future to provide customer financing to
customers in areas that are strategic to our core business activity. We expect to continue to hold most current and future customer financing obligations for longer
periods prior to any possible placement with third-party lenders, due to, among other factors,
recent economic uncertainty in various countries, adverse capital market conditions, our current
credit condition, adverse changes in the credit quality of our customers and reduced demand for
telecommunications financing in capital and bank markets. In addition, risks generally associated
with customer financing, including the risks associated with new technologies, new network
construction, market demand and competition, customer business plan viability and funding risks,
may require us to hold certain customer financing obligations over a longer term. We may not be
able to place any of our current or future customer financing obligations with third-party lenders
on acceptable terms. Certain customers have been experiencing financial difficulties and have failed to meet their
financial obligations. As a result, we have incurred charges for increased provisions related to
certain trade and customer financing receivables. If there are further increases in the failure of
our customers to meet their customer financing and receivables obligations to us or if the
assumptions underlying the amount of provisions we have taken with respect to customer financing
and receivables obligations do not reflect actual future financial conditions and customer payment
levels, we could incur losses in excess of our provisions, which could have a material adverse
effect on our cash flow and operating results. Negative developments associated with our supply contracts and contract manufacturing agreements
including in our Carrier Packet Networks segment as a result of using a sole supplier for key
optical components of our Carrier Packet Networks solutions may materially and adversely affect our
business, results of operations, financial condition and supply relationships. We have entered into supply contracts with customers to provide products and services, which in
some cases involve new technologies currently being developed, or which we have not yet
commercially deployed, or which require us to build networks. Some of these supply contracts
contain delivery and installation timetables, performance criteria and other contractual
obligations which, if not met, could result in our having to pay substantial penalties or
liquidated damages and/or the termination of the supply contract. Unexpected developments in these
supply contracts could have a material adverse effect on our revenues, cash flows and relationships
with our customers. In particular, we currently rely on a sole supplier, Bookham, for key optical components of the
optical networks portion of our Carrier Packet Networks solutions and our supply of such components
used in our solutions could be materially adversely affected by adverse developments in the supply
arrangement with that supplier. In February 2005, we agreed to waive for a period of time
Bookhams obligation to maintain a minimum cash balance under certain secured and unsecured notes
and in May 2005 we entered into an agreement to adjust the prepayment provisions under these
notes and an amendment to our supply
agreement with Bookham to provide certain product price increases and 102




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accelerated purchase orders
and invoice payment terms. The inability of such supplier to meet its contractual obligations
under our supply arrangements and of us to make alternative arrangements could have a material
adverse effect on our revenues, cash flows and relationships with our customers. Our ability to meet customer demand is, in part, dependent on us obtaining timely and adequate
component parts and products from suppliers, contract manufacturers, and internal manufacturing
capacity. As part of the transformation of our supply chain from a vertically integrated
manufacturing model to a virtually integrated model, we have outsourced, or are in the process of
outsourcing, substantially all of our manufacturing capacity to contract manufacturers, including
an agreement with Flextronics announced on June 29, 2004 regarding the divestiture of certain of
our manufacturing operations and related activities. The transfer to Flextronics of our optical
design operations and related assets in Ottawa, Canada and Monkstown, Northern Ireland was
completed in the fourth quarter of 2004. In the first quarter of 2005, we completed the portion of
the transaction relating to our manufacturing activities in Montreal, Canada. We and Flextronics
are currently discussing the timing of the closing of the balance of the remaining transaction in
order to optimize the business transition between the companies. As a result of these discussions,
it is now expected that the balance of the transaction relating to the manufacturing operations in
Chateaudun, Calgary and Monkstown will close by the end of the first quarter of 2006. As a result,
we and Flextronics intend to enter into an amendment agreement to extend the term of the original
agreement and offer to reflect this updated schedule. These transitions are subject to customary
conditions and regulatory approvals. Upon the completion of the divestiture, a significant portion
of our supply chain will be concentrated with Flextronics. We work closely with our suppliers and
contract manufacturers to address quality issues and to meet increases in customer demand, when needed, and we also manage our internal manufacturing capacity, quality, and inventory levels
as required. However, we may encounter shortages or interruptions in the supply of quality
components and/or products in the future. In addition, our component suppliers and contract
manufacturers have experienced, and may continue to experience, a consolidation in the industry and
financial difficulties, both of which may result in fewer sources of components or products and
greater exposure to the financial stability of our suppliers. A reduction or interruption in
component supply or external manufacturing capacity, a significant increase in the price of one or
more components, or excessive inventory levels could materially and negatively affect our gross
margins and our operating results and could materially damage customer relationships. There is no assurance that we will be able to complete, on a timely basis or otherwise, the
remaining portion of the transaction with Flextronics, which could materially and negatively impact
our cash flows and operating results and impede achievement of our strategic goal to improve our
business efficiency and operating cost performance. Many of our current and planned products are highly complex and may contain defects or errors that
are detected only after deployment in telecommunications networks, which could harm our reputation
and adversely affect our business, results of operations and financial condition. Our products are highly complex, and some of them can be fully tested only when deployed in
telecommunications networks or with other equipment. From time to time, our products have
contained undetected defects, errors or failures. The occurrence of any defects, errors or
failures could result in cancellation of orders, product returns, diversion of our resources, legal
actions by our customers or our customers end users and other losses to us or to our customers or
end users. Any of these occurrences could also result in the loss of or delay in market acceptance
of our products and loss of sales, which would harm our business and adversely affect our business,
results of operations and financial condition. Our business may suffer if our strategic alliances are not successful. We have entered into a number of strategic alliances with suppliers, developers and members in our
industry to facilitate product compatibility, encourage adoption of industry standards or to offer
complementary product or service offerings to meet customer needs. In some cases, the companies
with which we have strategic alliances also compete against us in some of our business areas. If a
member of a strategic alliance fails to perform its obligations, if the relationship fails to
develop as expected or if the relationship is terminated, we could experience delays in product
availability or impairment of our relationships with our customers. In addition to the investigations and litigation arising out of our restatements, we are also
subject to numerous class actions and other lawsuits as well as lawsuits in the ordinary course of
business. In addition to the investigations and litigation arising out of our restatements, we are currently
a defendant in numerous class actions and other lawsuits, including lawsuits initiated on behalf of
holders of Nortel Networks Corporation common shares, which seek damages of material and
indeterminate amounts, as well as lawsuits in the ordinary course of our business. In the future,
we may be subject to similar litigation. The defense of these lawsuits may divert our managements
attention, and we may incur significant expenses in defending these lawsuits (including 103




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substantial
fees of lawyers and other professional advisors and potential obligations to indemnify officers and
directors who may be parties to such actions). In addition, we may be required to pay judgments or
settlements that could have a material adverse effect on our results of operations, financial
condition and liquidity. 104




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ITEM 3.
    Quantitative and Qualitative Disclosures About Market Risk Market risk represents the risk of loss that may impact the consolidated financial statements
of Nortel due to adverse changes in financial market prices and rates. Nortels market risk
exposure is primarily a result of fluctuations in interest rates and foreign exchange rates.
Disclosure of market risk is contained in Market Risk in the MD&A section of this report and in
our 2004 Annual Report filed with the SEC on May 2, 2005. 
  ITEM 4.
    Controls and Procedures Management Conclusions Concerning Disclosure Controls and Procedures We carried out an evaluation under the supervision and with the participation of management,
including the current CEO and current CFO (William A. Owens and Peter W. Currie, respectively),
pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, of the effectiveness of our
disclosure controls and procedures as at March 31, 2005 (the end of the period covered by this
report) and as at May 31, 2005. The CEO and CFO were appointed to such positions as at April 28,
2004 and February 14, 2005, respectively. In making this evaluation, the CEO and CFO considered, among other matters:  
    
    the Second Restatement and the revisions to our preliminary unaudited results for the
year ended December 31, 2003;
    
    the findings of the Independent Review summarized in the Summary of Findings and of
Recommended Remedial Measures of the Independent Review, submitted to the Audit Committee
in January 2005 by WCPHD and Huron Consulting Services LLC, or the Independent Review
Summary, included in Item 9A of our 2003 Annual Report;
    
    the terminations for cause of our former president and chief executive officer, former
chief financial officer, former controller and seven additional senior finance employees
during the course of the Independent Review and the reasons therefor as described in the
Independent Review Summary;
    
    the material weaknesses in our internal control over financial reporting that we and our
external auditor, Deloitte, have identified (as more fully described below);
    
    the measures we have identified, developed and begun to implement, beginning in November
2003, to remedy those material weaknesses (as more fully described below);
    
    managements assessment of our internal control over financial reporting and conclusion
that our internal control over financial reporting was not effective as at December 31,
2004, and Deloittes attestation report with respect to that assessment and conclusion,
each pursuant to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002,
included in Item 8 and Item 9A of our 2004 Annual Report; and
    
    the decision of the Audit Committee to undertake the Revenue Independent Review (as more
fully described below). Based on this evaluation, the CEO and CFO have concluded that our disclosure controls and
procedures as at March 31, 2005 and as at May 31, 2005 were not effective to provide reasonable
assurance that information required to be disclosed in the reports we file and submit under the
Exchange Act is recorded, processed, summarized and reported as and when required. In light of this conclusion and as part of the extensive work undertaken in connection with the
Second Restatement, the preparation of our 2004 Annual Report and this report, we have applied
compensating procedures and processes as necessary to ensure the reliability of our financial
reporting. Accordingly, management believes, based on its knowledge, that (i) this report does not
contain any untrue statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which they were made, not misleading with
respect to the period covered by this report and (ii) the financial statements, and other financial
information included in this report, fairly present in all material respects our financial
condition, results of operations and cash flows as at, and for, the periods presented in this
report. 105




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* * * * * * Material Weaknesses in Internal Control Over Financial Reporting Our internal control over financial reporting is designed to provide reasonable assurance regarding
the reliability of financial reporting and the preparation of financial statements for external
purposes in accordance with applicable GAAP. Our internal control over financial reporting should
include those policies and procedures that:  
    
    pertain to the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of our assets;
    
    provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with applicable GAAP, and that receipts
and expenditures are being made only in accordance with authorizations of management and
the Board of Directors; and
    
    provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use or disposition of our assets that could have a material effect on the
financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or
detect misstatements. Also, projections of any evaluation of effectiveness to future periods are
subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate. As previously disclosed in Item 9A of our 2004 Annual Report, management, including the current CEO
and current CFO, assessed the effectiveness of our internal control over financial reporting as at
December 31, 2004 and concluded that five material weaknesses in our internal control over
financial reporting existed as at December 31, 2004. These material weaknesses, which remain unremedied, are:  
    
    lack of compliance with written Nortel procedures for monitoring and adjusting balances
related to certain accruals and provisions, including restructuring charges and contract
and customer accruals;
    
    lack of compliance with Nortel procedures for appropriately applying applicable GAAP to
the initial recording of certain liabilities, including those described in SFAS No. 5, and
to foreign currency translation as described in SFAS No. 52;
    
    lack of sufficient personnel with appropriate knowledge, experience and training in U.S.
GAAP and lack of sufficient analysis and documentation of the application of U.S. GAAP to
transactions, including, but not limited to, revenue transactions;
    
    lack of a clear organization and accountability structure within the accounting
function, including insufficient review and supervision, combined with financial reporting
systems that are not integrated and which require extensive manual interventions; and
    
    lack of sufficient awareness of, and timely and appropriate remediation of, internal
control issues by Nortel personnel. As used above, the term material weakness means a significant deficiency (within the meaning of
Public Company Accounting Oversight Board Auditing Standard No. 2), or a combination of significant
deficiencies, that results in there being more than a remote likelihood that a material
misstatement of our annual or interim financial statements will not be prevented or detected on a
timely basis by employees in the normal course of their assigned functions. 106




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For additional information with respect to the material weaknesses and other deficiencies
identified at the time of the First Restatement and the Second Restatement, as well as certain
additional background information regarding the First Restatement and the Second Restatement, see
Item 9A of our 2003 Annual Report and 2004 Annual Report, note 3 to the audited consolidated
financial statements accompanying our 2003 Annual Report and  Developments in 2004 
Restatements in the MD&A section of our 2003 Annual Report. * * * * * * Changes in Internal Control Over Financial Reporting and Remedial Measures We continue to identify, develop and begin to implement remedial measures to strengthen our
internal control over financial reporting and address the material weaknesses in our internal
control over financial reporting. At the recommendation of the Audit Committee, the Board of
Directors adopted all of the recommendations for remedial measures contained in the Independent
Review Summary. The governing principles of the recommendations developed by WCPHD and provided to
the Audit Committee were the following:  
    
    establishing standards of conduct to be enforced through appropriate discipline;
    
    infusing strong technical skills and experience into the finance organization;
    
    requiring comprehensive, on-going training on increasingly complex accounting standards;
    
    strengthening and improving internal controls and processes;
    
    establishing a compliance program throughout the Company which is appropriately staffed and funded;
    
    requiring management to provide clear and concise information, in a timely manner, to
the Board of Directors to facilitate its decision-making; and
    
    implementing an information technology platform that improves the reliability of
financial reporting and reduces the opportunities for manipulation of results. See the Independent Review Summary for further information concerning these governing principles as
they translate into recommendations regarding three categories  people, processes and technology. The Board of Directors has directed management to develop a detailed plan and timetable for the
implementation of these recommendations and will monitor their implementation. Management has
begun to address certain of these recommendations as set forth in more detail below and is also in
the process of reviewing its other remedial measures in light of these recommendations. We have identified, developed and begun to implement a number of measures to strengthen our
internal control over financial reporting and address the material weaknesses identified above, as
discussed below. These measures are in the process of being reviewed in light of the
recommendations of the Independent Review, and certain of these measures may be modified or
superseded as managements plan progresses, or as a result of the Revenue Independent Review.  
    
    Appointment of New Senior Leadership with High Ethical and Moral Standards.  
    
    In April 2004, we terminated for cause our former president and chief
executive officer, former chief financial officer and former controller (the
former chief financial officer and former controller having been placed on paid
leaves of absence in March 2004), and in August 2004, we terminated for cause
seven additional senior finance employees with 107




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significant responsibilities for our financial reporting as a whole or for their
respective business units and geographic regions.
    
    We appointed new senior leadership with high ethical and moral standards:
In April 2004, we appointed a new permanent CEO, and in March 2004, we
appointed an interim CFO and Controller, who each became permanent in April
2004. Since then we appointed a new CFO, Peter Currie, in February 2005, and a
new controller, Paul W. Karr, in May 2005, both more fully described below.  
    
    Emphasis by New Senior Management of Honesty and Ethical Behavior.  
    
    In August 2004, we adopted a new strategic plan that includes a renewed
commitment to best corporate practices and ethical conduct, including the
establishment of the office of a chief ethics and compliance officer, which has
now been filled with the permanent appointment of Susan E. Shepard, effective
February 21, 2005.  
    
    Emphasis on Reliable and Transparent Financial Reporting.  
    
    Over the course of and subsequent to the Second Restatement process, our
current CEO, William A. Owens, our CFO through the Second Restatement process,
William R. Kerr, and starting February 14, 2005, our current CFO, Peter Currie,
have communicated to employees the importance of the Second Restatement process
and the ongoing need for reliable and transparent financial reporting and
ethical conduct. Those communications included formal presentations as part of
our annual executive conference in November 2004. Additionally, our CFO
through the Second Restatement process and our current CFO have encouraged
finance personnel to bring matters of concern to managements attention without
fear of retribution.
    
    Beginning in July 2004, we have emphasized the importance of internal
control over financial reporting throughout the organization, including through
numerous education sessions, to various levels of management.
    
    Beginning in September 2004, we implemented mandatory training procedures
for senior management with respect to our internal back-up certification
process, with an emphasis on the accountability of senior management both for
their individual areas of responsibility and for the business as a whole as
members of the senior leadership team.
    
    Beginning in 2004, we implemented a process to increase visibility to
management after the close of a financial period of potential adjustments to
the financial statements.  
    
    Alignment of Leadership Compensation with Financial Accountability.  
    
    In June 2004, management recommended, the joint leadership resources
committee recommended and the Board of Directors subsequently approved the
inclusion of financial accountability as a key qualitative factor in the
individual leadership performance objectives for determination of incentive
cash awards under our annual incentive plan.
    
    In January 2005, we received notification from certain senior executives
that they would as a matter of corporate leadership and integrity pay an amount
equal to their Return to Profitability bonuses, conveying their deep
disappointment over the circumstances that led to the Second Restatement and
their determination to make it clear to employees, investors and others that
such activities are unacceptable to them.  
    
    Extended Balance Sheet Reviews. In March 2005, we implemented extended and
enhanced balance sheet review procedures for financial periods beginning with the third
quarter of 2004, as follows: 108




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
    
    We have scheduled regular balance sheet reviews across all segments and
major statutory entities in advance of our periodic report filings; and
    
    We clarified accountability within Nortel for review of significant balance
sheet accounts and required specific focus on accounts involving significant
estimates and judgments.  
    
    Finance Department Organizational Structure. We announced, and have begun to
implement, plans to transform our finance organization, which include a renewed commitment
to transparency, accuracy, accountability and competency as fundamental goals. Measures we
have begun to implement include:  
    
    In the first quarter of 2004, we began to enhance our global technical
accounting group and established global revenue governance and global finance
governance teams.
    
    In March 2004, we began hiring additional full-time finance personnel (with
a focus on qualified accounting professionals) as part of an initiative
introduced by the CFO at that time, William R. Kerr, and the controller at that
time, MaryAnne E. Pahapill. This initiative is aimed at both strengthening the
finance organizations technical skills and experience, including at a senior
level, and addressing employee attrition.
    
    In May 2005, we appointed Paul W. Karr, an experienced financial and
accounting executive and an expert in U.S. GAAP, as controller.
    
    We established a global corporate finance Sarbanes-Oxley compliance group
beginning in the third quarter of 2004.
    
    We engaged Accenture, a global management consulting and technology services
firm, in the third quarter of 2004 to assess the finance organizations
structure, processes and systems. The assessment was completed in February
2005. We appointed a global finance transformation leader in the first quarter
of 2005 and expect to begin the detailed design phase of our finance
transformation project in the later portion of the second quarter of 2005. We
expect the implementation of this project will continue into 2007 and will
include, among other things, implementing an information technology platform
(SAP) to provide an integrated global financial system.
    
    In connection with our assessment of internal control over financial
reporting pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we began
to modify or enhance existing processes and implement new control activities,
including improved levels of documentation, and enhanced monitoring and
supervision of processes such as reconciliation of account balances and
compliance with internal policies.  
    
    Training Initiatives.  
    
    We re-established our formal training group in the second quarter of 2004
(led by the global finance governance team described above) to implement
ongoing training programs for finance personnel globally to strengthen the
finance organizations technical skills and experience. The groups focus
includes training with respect to SFAS No. 5; accounting for hedging and
derivatives; revenue recognition, accruals and provisions; and SFAS No. 52.
    
    In the first quarter of 2005, the global revenue governance team provided
additional training sessions for finance personnel including more in-depth
focus on revenue recognition guidelines and U.S. GAAP. 109




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
    
    Internal Audit.  
    
    In the first quarter of 2004, we modified the mandate of our internal audit
function to place a greater emphasis on the adequacy of, and compliance with,
procedures relating to internal control over financial reporting.
    
    In October 2004, we engaged outside consultants to conduct a strategic
performance review of the internal audit function. The objective of this
review is to ensure that internal audit meets professional internal audit
standards and moves towards audit best practices. The strategic review has
been completed and management has begun to implement certain of the
recommendations of the review.  
    
    Manual Journal Entry Processes.  
    
    We developed new procedures related to manual journal entries, which focus
on approvals, more stringent documentation processes and reduction of user
access to manual journal entry functions. We continue to work towards
achieving full implementation of these procedures. The above mentioned changes in internal control over financial reporting materially affected our
internal control over financial reporting, and these changes and expected changes as a result of
remedial measures to be developed and implemented are reasonably likely to materially affect and
strengthen our internal control over financial reporting in the future. We intend to continue to
make ongoing assessments of our internal controls and procedures periodically and as a result of
the recommendations of the Independent Review and any additional recommendations of the Revenue
Independent Review (as more fully described below). In the period covered by this
report the following changes occurred in our internal control over
financial reporting that materially affected, or are reasonably likely to materially affect, our
control over financial reporting:  
    
    The appointment of our current CFO, the appointment of a permanent chief ethics
and compliance officer, the notifications by senior executives related to the
Return to Profitability bonuses, the implementation of extended and enhanced
balance sheet review procedures, the appointment of a global finance transformation
leader, and the additional training sessions held by the global revenue governance
team for finance personnel, all of which are more fully described above.
    
    Concurrent with and arising from the completion of the portion of the
Flextronics transaction related to the manufacturing activities in Montreal, Canada
in the first quarter of 2005, as described in greater detail under Business Overview 
Evolution of our supply chain strategy in the MD&A section of this report, or the Montreal Closing, we expanded and implemented upgrades
to the existing enterprise resource planning system, or ERP System. These changes
were required to support the accounting and supply chain processes related to the
transfer of these manufacturing operations, including migration of related accounts
payable functions at certain of our other locations, to the ERP System. As
described in Employee relations in Item 1 of our 2004 Annual Report,
approximately 910 employees from various business support functions located in
Montreal were transferred in connection with the completion of the Montreal
Closing. * * * * * * Revenue Independent Review As more fully described in Item 9A of our 2003 Annual Report and 2004 Annual Report, over the
course of the Second Restatement process, management identified certain accounting practices that
it determined should be adjusted as part of the Second Restatement. In particular, management
identified certain errors related to revenue recognition and undertook a process of revenue
reviews. In light of the resulting 110




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adjustments to
previously reported revenues, the Audit Committee has determined to review the facts and
circumstances leading to the restatement of these revenues for specific transactions identified in
the Second Restatement. The Revenue Independent Review has a particular emphasis on the underlying
conduct that led to the initial recognition of these revenues. The Audit Committee is seeking a
full understanding of the historic events that required the revenues for these specific
transactions to be restated and will consider any appropriate additional remedial measures,
including those involving internal controls and processes. The Audit Committee has engaged WCPHD
to advise it in connection with the Revenue Independent Review. 111




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PART II OTHER INFORMATION 
  ITEM 1.
    Legal Proceedings The following includes updated information relating to certain of our material legal
proceedings as previously reported in our 2004 Annual Report. Subsequent to the
March 10, 2004 announcement in which Nortel Networks
Corporation, or NNC, indicated it was likely that it would
need to revise its previously announced unaudited results for the year ended December 31, 2003, and
the results reported in certain of its quarterly reports for 2003, and to restate its previously
filed financial results for one or more earlier periods, NNC and certain of its then current and
former officers and directors were named as defendants in 27 purported class action lawsuits.
These lawsuits in the U.S. District Court for the Southern District of New York on behalf of
shareholders who acquired Nortel Networks Corporation securities as early as February 16, 2001 and
as late as May 15, 2004, allege, among other things, violations of U.S. federal securities laws.
These matters are also the subject of investigations by Canadian and U.S. securities regulatory and
criminal investigative authorities. On June 30, 2004, the Court signed orders consolidating the 27
class actions and appointing lead plaintiffs and lead counsel. The plaintiffs filed a consolidated
class action complaint on September 10, 2004, alleging a class period of April 24, 2003 through and
including April 27, 2004. On November 5, 2004, Nortel Networks Corporation and the Audit Committee
Defendants filed a motion to dismiss the consolidated class action complaint. On January 18, 2005,
the lead plaintiffs, NNC and the Audit Committee Defendants reached
an agreement in which NNC
would withdraw its motion to dismiss and plaintiffs would dismiss Count II of the complaint which
asserts a claim against the Audit Committee Defendants. On May 13, 2005, plaintiff filed a motion
for class certification. On July 30, 2004, a shareholders derivative complaint was filed in the U.S. District Court for the
Southern District of New York against certain directors and officers, and certain former directors
and officers, of NNC
 alleging, among other things, breach of fiduciary duties owed to NNC
during the period from 2000 to 2003 including by causing NNC to engage in unlawful conduct or
failing to prevent such conduct; causing NNC to issue false statements; and violating the law.
On February 14, 2005, the defendants filed motions to dismiss the derivative complaint. On April
29, 2005, the plaintiffs filed an opposition to the motions to dismiss. Except as noted above, there have been no material developments in our material legal proceedings.
For additional discussion of our material legal proceedings, see Contingencies in note 16 of the
accompanying unaudited consolidated financial statements and Risk Factors/forward looking
statements in the MD&A section of this report. 
  ITEM 5.
    Other Information On April 26, 2005, Nortel Networks Inc. (NNI), a wholly owned subsidiary of Nortel Networks
Limited, entered into a merger agreement with PEC Solutions, Inc. (PEC), providing for the
acquisition of all of the outstanding shares of PEC for $15.50 per share in cash, or approximately
$448 (net of cash acquired), plus transaction costs and expenses. The merger
agreement provides for NNI to acquire PEC in a two-step transaction in which a cash tender offer
will be made for all outstanding shares of PEC common stock at a price of $15.50 per share,
followed by a merger in which the holders of the remaining outstanding shares of PEC common stock
will also receive $15.50 per share in cash, without interest. The consummation of the transaction
is subject to certain conditions, including the tender of a specified number of shares of PEC,
receipt of regulatory approvals, and other customary conditions. We currently expect to complete
the acquisition during the second quarter of 2005. 112




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ITEM 6.
    Exhibits Exhibit No.
    
    Description10.1*
    
    
    Letter, dated January 10, 2005, to Mr. Lynton (Red) Wilson, the Chairman of the Board of
Nortel Networks Corporation, from the indicated members of Nortels core executive leadership
team (filed as Exhibit 10.1 to Nortel Network Limiteds Current Report on Form 8-K dated
January 11, 2005).10.2
    
    
    Peter Currie, Executive Vice-President and Chief Financial Officer Employment Letter dated
January 20, 2005.10.3
    
    
    Second Amending Agreement to the Asset Purchase Agreement effective February 7, 2005 among
Nortel Networks Limited, Flextronics Telecom Systems Ltd. and Flextronics International Ltd.10.4
    
    
    Amendment No. 1 to the Master Repair Services Agreement effective February 8, 2005 between
Nortel Networks Limited and Flextronics Telecom Systems Ltd.10.5
    
    
    Amendment No. 1 to the Master Contract Logistics Services Agreement effective February 8,
2005 between Nortel Networks Limited and Flextronics Telecom Systems Ltd.10.6
    
    
    Gary Daichendt, President and Chief Operating Officer Employment Letter dated March 2, 2005.10.7*
    
    
    Master Facility Agreement dated as of February 13, 2003, and amended July 10, 2003, between
Nortel Networks Limited and Export Development Canada, and as further amended by letter
agreements dated March 29, 2004, May 28, 2004, August 20, 2004, September 29, 2004, December
10, 2004, October 29, 2004, November 19, 2004, December 10, 2004, January 14, 2005, February
15, 2005 and March 15, 2005 (filed as Exhibit 99.2 to Nortel Networks Limiteds Current Report
on Form 8-K dated March 16, 2005).10.8
    
    
    Summary statement of terms of the additional special pension benefits for the Vice-Chairman
and Chief Executive Officer approved by the Joint Leadership Resources Committee of the Board
of Directors of Nortel Networks Corporation and Nortel Networks Limited and the Independent
members of the Board of Directors of Nortel Networks Corporation and Nortel Networks Limited
on March 22, 2005.10.9
    
    
    Agreement and Plan of Merger dated as of April 25, 2005, by and among Nortel Networks Inc.,
PS Merger Sub, Inc. and PEC Solutions, Inc. (filed as Exhibit 99(d)(1) to Nortel Networks Inc.
Current Report on Form SC TO-T dated May 3, 2005).31.1
    
    
    Certification of the Vice-Chairman and Chief Executive Officer pursuant to 18 U.S.C. Section
1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    
    Certification of the Executive Vice-President and Chief Financial Officer pursuant to 18
U.S.C. Section 1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32
    
    
    Certification of the Vice-Chairman and Chief Executive Officer and Executive Vice-President
and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
   *
    
    Incorporated by reference.
 113




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NORTEL NETWORKS LIMITED
(Registrant) Chief Financial Officer
    
    Chief Accounting Officer/s/ PETER W. CURRIE
    
    /s/ PAUL W. KARRPETER W. CURRIE
Executive Vice-President
and Chief Financial Officer
    
    PAUL W. KARR
Controller
 Dated: May 31, 2005 114