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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, 2004 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(Exact name of registrant as specified in its charter) 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           No ü 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
January 21, 2005 1,460,978,638 without nominal or par value




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EXPLANATORY NOTE Nortel Networks Limited previously announced the need to restate its consolidated financial
statements for the years ended December 31, 2002 and 2001 and each of its first three quarterly
periods for 2003. The unaudited consolidated statements of operations and cash flows for the three months ended March
31, 2003, including the applicable notes, contained in this Quarterly Report on Form 10-Q, have
been restated. A number of Nortel Networks past filings with the United States Securities and Exchange Commission
remain subject to ongoing review by the United States Securities and Exchange Commissions Division
of Corporation Finance. In addition, the Second Restatement involved the restatement of Nortel
Networks consolidated financial statements for 2001 and 2002 and the first, second and third
quarters of 2003. Amendments to Nortel Networks prior filings with the United States Securities
and Exchange Commission would be required in order for Nortel Networks to be in full compliance
with Nortel Networks reporting obligation under the Securities Exchange Act of 1934. However,
Nortel Networks does not believe that it will be feasible to amend Nortel Networks Annual Report on
Form 10-K/A for the year ended December 31, 2002, or 2002 Form 10-K/A and our 2003 Quarterly
Reports due to, among other factors, identified material weaknesses in Nortel Networks internal
control over financial reporting, the significant turnover in Nortel Networks finance personnel,
changes in accounting systems, documentation weaknesses, a likely inability to obtain third party
corroboration in certain cases due to the substantial industry adjustment in recent years and the
passage of time generally. In addition, disclosure in the 2002 Form
10-K/A and 2003 Form 10-Qs would in large part repeat the disclosure contained in our 2003 Annual
Report on Form 10-K and this report and expected to be contained in
our other 2004 Form 10-Qs. Accordingly, Nortel Networks does not plan to amend
our 2002 Form 10-K/A and 2003 Form 10-Qs. Nortel Networks
believes that it has included in our 2003
Annual Report on Form 10-K and in this report all information needed for current investor understanding. Ongoing
United States Securities and Exchange Commission review may require Nortel Networks to amend this
Quarterly Report on Form 10-Q or Nortel Networks other public filings. For a description of the restatements, see Restatement in note 2 of the unaudited consolidated
financial statements and Item 2 Managements Discussion and Analysis of Financial Condition and
Results of Operations  Developments in 2004  Nortel Networks Audit Committee Independent Review;
restatements; related matters contained in this Quarterly Report on Form 10-Q. 1




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TABLE OF CONTENTS PART I
FINANCIAL INFORMATION  
 PAGEITEM 1.
    
    Consolidated Financial Statements (unaudited)
    
    3ITEM 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    56ITEM 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    115ITEM 4.
    
    Controls and Procedures
    
    115PART II
OTHER INFORMATIONITEM 1.
    
    Legal Proceedings
    
    128ITEM 6.
    
    Exhibits and Reports on Form 8-K
    
    129SIGNATURES
    
    133EX-10.3EX-31.1EX-31.2EX-32
  All dollar amounts in this document are in United States dollars unless otherwise stated. NORTEL, NORTEL NETWORKS,
NORTEL NETWORKS LOGO, NT, the GLOBEMARK and SUCCESSION are trademarks of Nortel Networks. MOODYS is a trademark of Moodys Investor Services, Inc. RCMP is a trademark of the Royal Canadian Mounted Police. S&P and STANDARD & POORS are trademarks of The McGraw-Hill Companies, Inc. Any other company or product
names may be trademarks of their respective companies. 2




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PART I
FINANCIAL INFORMATION PAGEITEM 1.
    
    Consolidated Financial Statements (unaudited)
    
    4ITEM 2.
    
    Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    56ITEM 3.
    
    Quantitative and Qualitative Disclosures About
Market Risk
    
    115ITEM 4.
    
    Controls and Procedures
    
    115
 3




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NORTEL NETWORKS LIMITED
Consolidated Statements of Operations (unaudited) March 31,
    
    
    March 31,(millions of U.S. dollars)
    
    2004
    
    
    2003As restated *Revenues
    
    $
    2,444
    
    
    $
    2,295Cost of revenues
    
    
    1,372
    
    
    
    1,388Gross profit
    
    
    1,072
    
    
    
    907Selling, general and administrative expense
    
    
    538
    
    
    
    490Research and development expense
    
    
    466
    
    
    
    477Amortization of acquired technology and other
    
    
    3
    
    
    
    Deferred stock option compensation
    
    
    
    
    
    
    Special charges
    
    
    7
    
    
    
    140(Gain) loss on sale of businesses and assets
    
    
    
    
    
    
    (1
    )Operating earnings (loss)
    
    
    58
    
    
    
    (199
    )Other income (expense)  net
    
    
    88
    
    
    
    95Interest expenseLong-term debt
    
    
    (24
    )
    
    
    (25
    )Other
    
    
    (8
    )
    
    
    (8
    )Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net loss of associated companies
    
    
    114
    
    
    
    (137
    )Income tax (expense) benefit
    
    
    9
    
    
    
    3123
    
    
    
    (134
    )Minority interests  net of tax
    
    
    (6
    )
    
    
    (17
    )Equity in net loss of associated companies  net of tax
    
    
    (1
    )
    
    
    (22
    )Net earnings (loss) from continuing operations
    
    
    116
    
    
    
    (173
    )Net earnings (loss) from discontinued operations  net of tax
    
    
    1
    
    
    
    133Net earnings (loss) before cumulative effect of accounting change
    
    
    117
    
    
    
    (40
    )Cumulative effect of accounting change  net of tax
    
    
    
    
    
    
    (12
    )Net earnings (loss)
    
    
    117
    
    
    
    (52
    )Dividends on preferred shares
    
    
    9
    
    
    
    8Net earnings (loss) applicable to common shares
    
    $
    108
    
    
    $
    (60
    )
 *
    
    See note 2
 The accompanying notes are an integral part of these consolidated financial statements 4




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NORTEL NETWORKS LIMITED
Consolidated Balance Sheets (unaudited) March 31,
    
    
    December 31,(millions of U.S. dollars)
    
    2004
    
    
    2003ASSETSCurrent assetsCash and cash equivalents
    
    $
    3,532
    
    
    $
    3,928Restricted cash and cash equivalents
    
    
    62
    
    
    
    63Accounts receivable  net
    
    
    2,584
    
    
    
    2,659Inventories  net
    
    
    1,246
    
    
    
    1,190Income taxes recoverable
    
    
    85
    
    
    
    90Deferred income taxes  net
    
    
    400
    
    
    
    369Other current assets
    
    
    313
    
    
    
    314Total current assets
    
    
    8,222
    
    
    
    8,613Investments
    
    
    217
    
    
    
    244Plant and equipment  net
    
    
    1,596
    
    
    
    1,654Goodwill
    
    
    2,123
    
    
    
    2,125Intangible assets  net
    
    
    82
    
    
    
    86Deferred income taxes  net
    
    
    3,336
    
    
    
    3,397Other assets
    
    
    349
    
    
    
    337Total assets
    
    $
    15,925
    
    
    $
    16,456LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilitiesNotes payable
    
    $
    13
    
    
    $
    17Trade and other accounts payable
    
    
    819
    
    
    
    860Payroll and benefit-related liabilities
    
    
    523
    
    
    
    764Contractual liabilities
    
    
    486
    
    
    
    529Restructuring
    
    
    161
    
    
    
    205Other accrued liabilities
    
    
    2,316
    
    
    
    2,467Long-term debt due within one year
    
    
    23
    
    
    
    119Total current liabilities
    
    
    4,341
    
    
    
    4,961Long-term debt
    
    
    2,083
    
    
    
    2,091Deferred income taxes  net
    
    
    168
    
    
    
    190Other liabilities
    
    
    2,961
    
    
    
    2,944Total liabilities
    
    
    9,553
    
    
    
    10,186Minority interests in subsidiary companies
    
    
    86
    
    
    
    80Commitments and contingencies (notes 13 and 18)SHAREHOLDERS EQUITYPreferred shares, without par value  Authorized shares: unlimited;
Issued and outstanding shares: 30,000,000 at March 31, 2004 and December 31, 2003
    
    
    536
    
    
    
    536Common shares, without par value  Authorized shares: unlimited;
Issued and outstanding shares: 1,460,978,638 at March 31, 2004 and December 31, 2003
    
    
    1,211
    
    
    
    1,211Additional paid-in capital
    
    
    22,047
    
    
    
    22,031Accumulated deficit
    
    
    (16,958
    )
    
    
    (17,066
    )Accumulated other comprehensive loss
    
    
    (550
    )
    
    
    (522
    )Total shareholders equity
    
    
    6,286
    
    
    
    6,190Total liabilities and shareholders equity
    
    $
    15,925
    
    
    $
    16,456
 The accompanying notes are an integral part of these consolidated financial statements 5




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NORTEL NETWORKS LIMITED
Consolidated Statements of Cash Flows (unaudited) March 31,
    
    
    March 31,(millions of U.S. dollars)
    
    2004
    
    
    2003As restated *Cash flows from (used in) operating activitiesNet earnings (loss) from continuing operations
    
    $
    116
    
    
    $
    (173
    )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
    
    
    90
    
    
    
    114Non-cash portion of special charges and related asset write downs
    
    
    
    
    
    
    18Equity in net loss of associated companies
    
    
    1
    
    
    
    22Stock option compensation
    
    
    15
    
    
    
    4Deferred income taxes
    
    
    (4
    )
    
    
    13Other liabilities
    
    
    60
    
    
    
    12(Gain) loss on repurchases of outstanding debt securities
    
    
    
    
    
    
    (4
    )(Gain) loss on sale or write down of investments and businesses
    
    
    (33
    )
    
    
    6Other  net
    
    
    (145
    )
    
    
    (153
    )Change in operating assets and liabilities
    
    
    (408
    )
    
    
    4Net cash from (used in) operating activities of continuing operations
    
    
    (308
    )
    
    
    (137
    )Cash flows from (used in) investing activitiesExpenditures for plant and equipment
    
    
    (43
    )
    
    
    (22
    )Proceeds on disposals of plant and equipment
    
    
    5
    
    
    
    6Acquisitions of investments and businesses  net of cash acquired
    
    
    (3
    )
    
    
    (2
    )Proceeds on sale of investments and businesses
    
    
    55
    
    
    
    7Net cash from (used in) investing activities of continuing operations
    
    
    14
    
    
    
    (11
    )Cash flows from (used in) financing activitiesDividends on preferred shares
    
    
    (9
    )
    
    
    (8
    )Increase (decrease) in notes payable  net
    
    
    (3
    )
    
    
    (13
    )Repayments of long-term debt
    
    
    (97
    )
    
    
    (43
    )Repayments of capital leases payable
    
    
    (3
    )
    
    
    (3
    )Net cash from (used in) financing activities of continuing operations
    
    
    (112
    )
    
    
    (67
    )Effect of foreign exchange rate changes on cash and cash equivalents
    
    
    13
    
    
    
    18Net cash from (used in) continuing operations
    
    
    (393
    )
    
    
    (197
    )Net cash from (used in) discontinued operations
    
    
    (3
    )
    
    
    301Net increase (decrease) in cash and cash equivalents
    
    
    (396
    )
    
    
    104Cash and cash equivalents at beginning of period
    
    
    3,928
    
    
    
    3,742Cash and cash equivalents at end of period
    
    $
    3,532
    
    
    $
    3,846
 *
    
    See note 2
 The accompanying notes are an integral part of these consolidated financial statements 6




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NORTEL NETWORKS LIMITED Notes to Consolidated Financial Statements (unaudited)
(millions of U.S. dollars, unless otherwise stated)
  1.
    
    Significant accounting policiesBasis of presentation  The unaudited consolidated financial statements of Nortel Networks Limited (Nortel
Networks) 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 Networks
audited consolidated financial statements prepared in accordance with U.S. GAAP for the year
ended December 31, 2003. Although Nortel Networks 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 Networks are
denominated in U.S. dollars.As described in note 2, the unaudited consolidated statements of operations and cash flows for
the three months ended March 31, 2003, including the applicable notes, were restated.Nortel Networks 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, 2004 are not necessarily indicative
of financial results for the full year. The unaudited consolidated financial statements should
be read in conjunction with Nortel Networks Annual Report on Form 10-K for the year ended
December 31, 2003 filed with the SEC (Nortel Networks 2003 Annual Report).  Comparative figures  Certain 2003 figures in the unaudited consolidated financial statements have been
reclassified to conform to the 2004 presentation and certain 2003 figures have been restated as
set out in note 2.  Recent accounting pronouncements  (a)
    
    On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act
of 2003 (the MPDIM Act) was signed into law in the U.S. The MPDIM Act introduced a
prescription drug benefit under Medicare (specifically, Medicare Part D) as well as a
federal subsidy to sponsors of retiree health care benefit plans that provide a benefit
that is at least actuarially equivalent to Medicare Part D. As permitted by Financial
Accounting Standards Board (FASB) Staff Position (FSP) Financial Accounting Standard
(FAS) 106-1, Accounting and Disclosure Requirements Related to the Medicare Prescription
Drug, Improvement and Modernization Act of 2003, Nortel Networks chose to make the
one-time deferral election which remained in effect for its plans in the U.S. until the
earlier of the issuance of specific authoritative guidance by the FASB on how to account
for the federal subsidy to be provided to plan sponsors under the MPDIM Act or the
remeasurement of plan assets and obligations subsequent to January 31, 2004. Therefore,
Nortel Networks post-retirement benefit obligation as of March 31, 2004 and net
post-retirement benefit cost for the three months ended March 31, 2004 did not reflect the
effects of the MPDIM Act on the plans. On May 19, 2004, FSP FAS 106-2, Accounting and
Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and
Modernization Act of 2003 (FSP FAS 106-2) was issued by the FASB to provide guidance
relating to the prescription drug subsidy provided by the MPDIM Act. Nortel Networks
expects to have portions of its post-retirement benefit plans qualify as actuarially
equivalent to the benefit provided under the MPDIM Act, for which it expects to receive
federal subsidies. Nortel Networks expects that other portions of the plans will not be
actuarially equivalent. The financial impact of the federal subsidies was determined by
remeasuring Nortel Networks retiree life and medical obligation as of January 1, 2004, as
provided under the retroactive application provision of FSP FAS 106-2. The effective date
of FSP FAS 106-2 is the first annual or interim period beginning after June 15, 2004, with
earlier adoption encouraged. Nortel Networks adopted FSP FAS 106-2 for the three-month
period ended June 30, 2004. As a result of adoption, the accumulated post-retirement
benefit obligation decreased by $31. Net periodic post-retirement benefit costs are
expected to decrease by $2 for the remainder of 2004 as a result of the subsidy. 7




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(b)
    
    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 FASB issued 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
Networks results of operations and financial position.  2.
    
    RestatementFirst Restatement  In May 2003, Nortel Networks commenced certain balance sheet reviews at the direction of certain
members of former management that led to a comprehensive review and analysis of its assets and
liabilities (the Comprehensive Review), which resulted in the restatement (effected in
December 2003) of its 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 (the First
Restatement).The Comprehensive Review purported to (i) identify balance sheet accounts that, as of June 30,
2003, were not supportable and required adjustment; (ii) determine whether such adjustments
related to the third quarter of 2003 or prior periods; and (iii) document certain account
balances in accordance with Nortel Networks accounting policies and procedures. The
Comprehensive Review was supplemented by additional procedures carried out between July 2003 and
November 2003 to quantify the effects of potential adjustments in the relevant periods and
review the appropriateness of releases of certain contractual liability and other related
provisions (also called accruals, reserves or accrued liabilities) in the six fiscal quarters
ending with the fiscal quarter ended June 30, 2003 and formed the basis for the adjustments made
to the financial statements in the First Restatement.On December 23, 2003, Nortel Networks filed with the SEC an amended Annual Report on Form 10-K/A
for the year ended December 31, 2002 (the 2002 Form 10-K/A) and amended Quarterly Reports on
Form 10-Q/A for the first and second quarters of 2003 (the 2003 Form 10-Q/As) reflecting the
First Restatement. As disclosed in those reports, the net effect of the First Restatement
adjustments was a reduction in accumulated deficit of $486, $171 and $32 as of December 31,
2002, 2001 and 2000, respectively.  Second Restatement  In late October 2003, the Audit Committee of Nortel
Networks and Nortel Networks Corporation (NNC) Boards of Directors (the
Audit Committee) initiated an independent review of the facts and circumstances leading to the
First Restatement (the Independent Review) and engaged the law firm now known as Wilmer Cutler
Pickering Hale & Dorr LLP (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 the Board adopt, and direct management to implement, necessary remedial measures to address
personnel, controls, compliance and discipline. The Independent Review focused initially on
events relating to the establishment and release of contractual liability and other related
provisions in the second half of 2002 and the first half of 2003, including the involvement of
senior corporate leadership. As the Independent Review evolved, its focus broadened to include
specific provisioning activities in each of the business units and geographic regions. In light
of concerns raised in the initial phase of the Independent Review, the Audit Committee expanded
the review to include provisioning activities in the third and fourth quarters of 2003.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
provision releases in each of the four quarters of 2003, down to a low threshold. That
examination, and other errors identified by management, led to the 5




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restatement of Nortel Networks consolidated 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 (the Second Restatement).Over the course of the Second Restatement process, management also 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. This review will have a particular emphasis on the underlying conduct that led to
the initial recognition of these revenues.Other accounting practices that management examined and adjusted as part of the Second
Restatement included, among other things, the following:  
    
    Nortel Networks foreign exchange accounting as part of managements plan to
address an identified material weakness related to foreign currency translation;
    
    intercompany balances that did not eliminate upon consolidation and related provisions;
    
    special charges relating to inventory impairment, contract settlement costs and other charges; and
    
    the accounting treatment of certain elements of discontinued operations.  Due to, among other factors, significant turnover in Nortel Networks finance personnel, changes
in accounting systems, documentation weaknesses and identified material weaknesses in internal
control over financial reporting, the Second Restatement involved hundreds of Nortel Networks
finance personnel and a number of outside consultants and advisors. The process required the
review and verification of a substantial number of documents and communications and related
accounting entries over multiple fiscal periods. In addition, the review of accruals and
provisions and the application of accounting literature to certain matters in the Second
Restatement, including revenue recognition, foreign exchange, special charges and discontinued
operations, was complicated by the passage of time, lack of availability of supporting records
and the turnover of finance personnel. As a result of this complexity, estimates and
assumptions that impact both the quantum of the various recorded adjustments and the fiscal
period to which they were attributed were required in the determination of certain of the Second
Restatement adjustments. Nortel Networks believes the procedures followed in determining such
estimates were appropriate and reasonable using the best available information.The following tables present the impact of the Second Restatement adjustments on Nortel Networks
previously reported consolidated statements of operations and a summary of the adjustments from
the Second Restatement for the three months ended March 31, 2003. The Second Restatement
adjustments related primarily to the following items, each of which reflect a number of related
adjustments that have been aggregated for disclosure purposes, and are described in the
paragraphs following the tables below:  
    
    Revenues and cost of revenues;
    
    Foreign exchange;
    
    Intercompany balances;
    
    Special charges;
    
    Other;
    
    Reclassifications; and
    
    Discontinued operations. 6




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Consolidated Statement of Operations for the three months ended March 31, 2003: As previouslyreported
    
    
    Adjustments
    
    
    As restatedRevenues
    
    $
    2,376
    
    
    $
    (81
    )
    
    $
    2,295Cost of revenues
    
    
    1,324
    
    
    
    64
    
    
    
    1,388Gross profit
    
    
    1,052
    
    
    
    (145
    )
    
    
    907Selling, general and administrative expense
    
    
    513
    
    
    
    (23
    )
    
    
    490Research and development expense
    
    
    502
    
    
    
    (25
    )
    
    
    477Special charges
    
    
    111
    
    
    
    29
    
    
    
    140(Gain) Loss on sale of businesses and assets
    
    
    (4
    )
    
    
    3
    
    
    
    (1
    )Operating earnings (loss)
    
    
    (70
    )
    
    
    (129
    )
    
    
    (199
    )Other income  net
    
    
    5
    
    
    
    90
    
    
    
    95Interest expenseLong-term debt
    
    
    (23
    )
    
    
    (2
    )
    
    
    (25
    )Other
    
    
    (7
    )
    
    
    (1
    )
    
    
    (8
    )Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net loss of associated companies
    
    
    (95
    )
    
    
    (42
    )
    
    
    (137
    )Income tax (expense) benefit
    
    
    (6
    )
    
    
    9
    
    
    
    3(101
    )
    
    
    (33
    )
    
    
    (134
    )Minority interests  net of tax
    
    
    8
    
    
    
    (25
    )
    
    
    (17
    )Equity in net loss of associated companies  net of tax
    
    
    (10
    )
    
    
    (12
    )
    
    
    (22
    )Net earnings (loss) from continuing operations
    
    
    (103
    )
    
    
    (70
    )
    
    
    (173
    )Net earnings (loss) from discontinued operations  net of tax
    
    
    164
    
    
    
    (31
    )
    
    
    133Net earnings (loss) before cumulative effect of accounting change
    
    
    61
    
    
    
    (101
    )
    
    
    (40
    )Cumulative effect of accounting change  net of tax
    
    
    (8
    )
    
    
    (4
    )
    
    
    (12
    )Net earnings (loss)
    
    
    53
    
    
    
    (105
    )
    
    
    (52
    )Dividends on preferred shares
    
    
    5
    
    
    
    3
    
    
    
    8Net earnings (loss) applicable to common shares
    
    $
    48
    
    
    $
    (108
    )
    
    $
    (60
    )
 7




---



##### Table of Contents



Summary of Restatement Adjustments for the three months ended March 31, 2003: Revenuesand cost
    
    
    
    
    
    
    Inter-
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Dis-of
    
    
    Foreign
    
    
    company
    
    
    Special
    
    
    
    
    
    
    Reclassifi-
    
    
    continued
    
    
    Totalrevenues
    
    
    exchange
    
    
    balances
    
    
    charges
    
    
    Other
    
    
    cations
    
    
    operations
    
    
    adjustmentsRevenues
    
    $
    (81
    )
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    (81
    )Cost of revenues
    
    
    27
    
    
    
    11
    
    
    
    7
    
    
    
    
    
    
    
    9
    
    
    
    10
    
    
    
    
    
    
    
    64Gross profit
    
    
    (108
    )
    
    
    (11
    )
    
    
    (7
    )
    
    
    
    
    
    
    (9
    )
    
    
    (10
    )
    
    
    
    
    
    
    (145
    )Selling, general and administrative expense
    
    
    
    
    
    
    
    
    
    
    1
    
    
    
    
    
    
    
    (32
    )
    
    
    8
    
    
    
    
    
    
    
    (23
    )Research and development expense
    
    
    
    
    
    
    
    
    
    
    (1
    )
    
    
    
    
    
    
    (19
    )
    
    
    (5
    )
    
    
    
    
    
    
    (25
    )Special charges
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    29
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    29(Gain) loss on sale of businesses and assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3
    
    
    
    
    
    
    
    3Other income (expense)  net
    
    
    
    
    
    
    101
    
    
    
    1
    
    
    
    
    
    
    
    (16
    )
    
    
    15
    
    
    
    (11
    )
    
    
    90Interest expense  long term debt
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    (2
    )Interest expense  other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    (1
    )Income tax benefit (expense)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9
    
    
    
    
    
    
    
    
    
    
    
    9Minority interests  net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (26
    )
    
    
    1
    
    
    
    
    
    
    
    (25
    )Equity in net loss of associated
companies  net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (12
    )
    
    
    
    
    
    
    
    
    
    
    (12
    )Net earnings (loss) from
discontinued operations  net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (31
    )
    
    
    (31
    )Cumulative effect of accounting
change  net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4
    )
    
    
    
    
    
    
    
    
    
    
    (4
    )Total restatement adjustments
    
    $
    (108
    )
    
    $
    90
    
    
    $
    (6
    )
    
    $
    (29
    )
    
    $
    (10
    )
    
    $
    
    
    
    $
    (42
    )
    
    $
    (105
    )
  The effect of the Second Restatement adjustments on the consolidated balance sheet as of
March 31, 2003 is shown following the discussion below.  Revenues and cost of revenues  Revenues and cost of revenues were impacted by various errors related to revenue
recognition, corrections to foreign exchange accounting, intercompany related items and other
adjustments, including financial statement reclassifications. These items are further described
below. The net impact to revenues of the adjustments was a decrease of $81 for the three months
ended March 31, 2003. The net impact to cost of revenues related to these revenue adjustments,
and the other corrections was an increase of $64 for the three months ended March 31, 2003. The
following table summarizes the revenue recognition adjustments and other adjustments to revenues
and cost of revenues, which decreased gross profit by $145 in the three months ended March 31,
2003: 8




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##### Table of Contents



Cost ofRevenues
    
    
    revenuesRevenue recognition adjustments:Application
of SAB 101 or SOP 97-2 (a)Title and delivery
    
    $
    35
    
    
    $
    9Undelivered elements and liquidated damages
    
    
    (17
    )
    
    
    28Application
of SOP 81-1 (b)
    
    
    (18
    )
    
    
    31Other revenue recognition adjustments
    
    
    (81
    )
    
    
    (41
    )Increase (decrease) associated with revenue recognition
    
    
    (81
    )
    
    
    27Other adjustments:Foreign exchange
    
    
    
    
    
    
    11Intercompany
    
    
    
    
    
    
    7Other
    
    
    
    
    
    
    9Reclassifications
    
    
    
    
    
    
    10Increase (decrease) to revenues and cost of revenues
    
    $
    (81
    )
    
    $
    64
 (a)
    
    Staff Accounting Bulletin (SAB) 101, Revenue Recognition in Financial Statements
(SAB 101); Statement of Position (SOP) 97-2, Software Revenue Recognition (SOP
97-2).(b)
    
    SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type
Contracts (SOP 81-1).
  Application of SAB 101 or SOP 97-2Title and deliveryRevenues were recognized on certain sales (primarily prior to 2001) for which it was
subsequently determined that the criteria for revenue recognition under SAB 101 or SOP 97-2, as
applicable, had not been met, including arrangements in which legal title or risk of loss on
products did not transfer to the buyer until full payment was received, and arrangements where
delivery had not occurred. Revenues and related cost of revenues for these agreements should
have been deferred until title or risk of loss had passed and all criteria for revenue
recognition had been met. Therefore, adjustments were made to defer revenues and related cost
of revenues from the periods in which they were originally recorded and to recognize them in the
periods in which all revenue recognition criteria were met.Undelivered elements and liquidated damagesIn certain multiple element arrangements, total arrangement fees were recognized as revenue at
the time of delivery of software or hardware, but prior to the delivery of future contractual or
implicit post-contract support (PCS) or other services. Revenues should have been allocated
to these future deliverables based on their fair value and recognized ratably over the PCS
period or as the future obligations were performed. As well, in certain circumstances where the
criteria to treat delivered software and hardware elements and undelivered PCS services as
separate accounting units were not met, the entire arrangement fee should have been recognized
over the PCS period. Adjustments were made to appropriately allocate revenue among the
accounting units and recognize the allocated revenue in accordance with the applicable revenue
recognition guidance.Revenues were also recognized for certain contracts that involved undelivered elements as a
result of product development delays. The lack of relative fair value for the undelivered
element meant that revenues and cost of revenues for all products delivered should have been
deferred until the undelivered element was delivered. As originally recorded, revenues were
recognized upon delivery of an alternative product and costs were accrued for the undelivered
element. To correct for these items, related cost provisions were reversed and revenues and
associated cost of revenues were recognized in the appropriate periods when all elements had
been delivered.Revenues were recognized on certain contracts with potential liquidated damages arising
primarily from network outages, shipment delays or product development delays on undelivered
elements. Generally, revenues and related cost of revenues should have been deferred up to the
maximum potential liquidated damages until the damages had been incurred or there was no longer
a possibility of incurring such damages. Specific contracts, primarily in the Asia region, had
the potential for liquidated damages plus right of return privileges if such damages exceeded
contractually defined thresholds due to a product development delay (undelivered element).
Revenues for all products delivered should have been deferred until the undelivered element was
delivered. 12




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##### Table of Contents





| |  | After delivery of the undelivered element, and in light of a lack of a reasonable
and reliable history of comparable product returns on which to base a returns allowance,
revenues should have been deferred until the right of return had lapsed or until expected
returns could be reasonably estimated. After the right of return had lapsed or reasonable
estimates of expected returns could be made, revenues should have continued to be deferred up to
the amount of the maximum potential liquidated damages until either the earlier of when the
damages were incurred, or there was no longer the possibility of incurring any damages. As
originally recorded, cost provisions were recorded for the amount of the estimated damages
and/or cost of product replacement. To correct these items, related cost provisions were
reversed and revenues and associated cost of revenues were recognized in the appropriate
periods.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  | Application of SOP 81-1                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| |  | Adjustments were required to the application of percentage-of-completion accounting for certain
long-term construction contracts. In the Europe, Middle East and Africa (EMEA) region,
revenues and costs of revenues were not recognized using an appropriate measure of progress
towards completion. An input method should have been used based on actual costs incurred and
known/projected margin estimates at the time. This error was corrected, as well as other
application errors that were identified across all regions.                                                                                                                                                                                                                                                                                                                                                                                                      
|
| |  | Other revenue recognition adjustments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|
| |  | Other adjustments primarily included corrections related to an overstatement of revenues and cost of
revenues as a result of two specific transactions recorded in the first quarter of 2003
which should have been recorded in 2002. In addition, other revenue
recognition adjustments were made which related to
a specific contract in the Caribbean and Latin American (CALA) region, other errors related to
non-cash incentives and concessions provided to customers and other calculation errors.                                                                                                                                                                                                                                                                                                                                                                                                                                



| |  | Foreign exchange
| |  | ----------------



| |  | As part of the plan to address a material weakness reported in Nortel Networks Quarterly
Report on Form 10-Q for the period ended September 30, 2003, a review of foreign exchange
accounting was undertaken. The net impact was a decrease to pre-tax loss of $90 for the three
months ended March 31, 2003. The following presents the impact of these restatement adjustments
on the consolidated statements of operations for the three months ended March 31, 2003, which
are described below:
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Gross profitOther errors
    
    $
    (11
    )Total decrease to gross profit
    
    $
    (11
    )Other incomeFunctional currency designation
    
    $
    62Intercompany transaction designation
    
    
    (19
    )Revaluation errors related to discontinued operations
    
    
    30Other errors
    
    
    28Total increase to other income
    
    $
    101Total decrease to pre-tax loss
    
    $
    90




| |  | Functional currency designation
| |  | -------------------------------



| |  | The determination of the functional currency for certain entities was re-examined, based on
the guidance under SFAS No. 52, Foreign Currency Translation (SFAS 52). As a result, Nortel
Networks identified four instances in which the functional currency designation of an entity was
incorrect. These revisions resulted in increases or decreases to other income (expense)  net.
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Intercompany transaction designation
| |  | ------------------------------------



| |  | Nortel Networks identified two instances of incorrect treatment of significant foreign
currency translation gains and losses arising from intercompany positions. Under SFAS 52,
intercompany foreign currency transactions that were long-term in nature should have been
recorded in accumulated other comprehensive loss on the balance sheet
when translated rather than recorded as a transactional gain
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

13



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##### Table of Contents



or loss in the statement of operations. The net impact of
the adjustments was an increase or decrease to other income (expense)  net, with an offset to
accumulated other comprehensive loss.  Revaluation errors related to discontinued operations  Errors were identified in the revaluation of certain foreign denominated customer financing
provisions within discontinued operations, the correction of which increased other income and
decreased net earnings from discontinued operations.  Other errors  Other errors identified were related to translation of foreign denominated intercompany
transactions, revaluation of certain foreign denominated intercompany transactions and
accounting for mark-to-market adjustments for foreign exchange contracts as required under SFAS
No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133).  Intercompany balances  Historically, Nortel Networks had certain intercompany balances that did not eliminate upon
consolidation (out-of-balance positions), and provisions had been recorded accordingly. As
part of the Second Restatement, Nortel Networks reviewed these provisions and determined that
they should not have been recorded. Adjustments were recorded in the appropriate periods to
reverse these provisions and to correct the significant out-of-balance positions. The
adjustments to reverse the provisions affected the second quarter of 2003 and periods prior to
2000. The net impact of the adjustments to correct the significant out-of-balance positions was
an increase of $6 to pre-tax loss for the three months ended March 31, 2003.  Special charges  As part of the Second Restatement, the components of special charges were re-examined and
an increase to special charges of $29 for the three months ended March 31, 2003 was recorded.
Adjustments for restructuring were recorded to special charges related to contract settlement
costs, including real estate related items, severance and fringe benefit related costs and plant
and equipment impairment costs. Nortel Networks determined that these items were either
recorded in special charges in error or, although correctly recorded when originally recognized,
were not adjusted in the appropriate subsequent periods for changes in estimates and/or
assumptions. The following presents the impact of these other adjustments on special charges
for the three months ended March 31, 2003: Contract settlement costs
    
    $
    (3
    )Plant and equipment impairment costs
    
    
    29Severance and fringe benefit related costs
    
    
    3Total increase to special charges
    
    $
    29
  Other  Other adjustments were primarily to correct certain accruals, provisions or other
transactions which were either initially recorded incorrectly in prior periods, or not properly
released or adjusted for changes in estimates and/or assumptions in the appropriate subsequent
periods. The components of these adjustments for the three months ended March 31, 2003 are
described below. 14




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##### Table of Contents



Other adjustmentsCost of revenues
    
    $
    (9
    )Selling, general and administrative expense
    
    
    32Research and development expense
    
    
    19Other income (expense)  net
    
    
    (16
    )Interest expense
    
    
    (3
    )Income tax benefit (expense)
    
    
    9Minority interests  net of tax
    
    
    (26
    )Equity in net loss of associated companies  net of tax
    
    
    (12
    )Cumulative effect of accounting change  net of tax
    
    
    (4
    )Net decrease to net earnings
    
    $
    (10
    )
  Cost of revenuesFor the three months ended March 31, 2003, the increase to cost of revenues of $9 was comprised
primarily of an increase of approximately $11 for warranty costs, approximately $11 for customer
and contract related accruals and approximately $6 related to other accruals, partially offset
by a decrease of approximately $19 to reflect an adjustment to the
timing of employee bonus related accruals, including as a result of
the applicable performance metrics for the bonus awards not having
been met in the period in which the bonuses were originally awarded
as a result of the Second Restatement.Selling, general and administrative expenseFor the three months ended March 31, 2003, the decrease of $32 to selling, general and
administrative expense was comprised primarily of reductions of
approximately $39 to reflect adjustments to the
timing of employee bonus related accruals and a decrease of approximately $24
related to bad debt expense, partially offset by $12 related to contract amendments and
settlements with certain service providers and approximately $19 related to other accruals.Research and development expenseFor the three months ended March 31, 2003, the decrease of $19 in research and development
expense was primarily the result of a decrease of approximately $26  to reflect an adjustment to the
timing of employee bonus related accruals, including as a result of
the applicable performance metrics for the bonus awards not having
been met in the period in which the bonuses were originally awarded
as a result of the Second Restatement and approximately $13 to correctly treat certain
software repair costs as warranty costs, partially offset by an increase of approximately $20
related to various research and development projects and other accruals.Other income (expense)  netFor the three months ended March 31, 2003, the increase
of $16 in other expense was primarily the
result of an increase of approximately $31 related to sales and use tax provisions and
adjustments of approximately $15 related to sales of receivables and customer financing,
partially offset by decreases of approximately $16 from corrections to the timing of the
recognition of the impairment of certain investments and approximately $15 for unused customer
credits originally recognized as a reduction to customer revenues in this period.Interest expenseFor the three months ended March 31, 2003, the increase to interest expense of $3 was primarily
the result of a $4 increase related to long-term debt for corrections to accounting for certain
sale-leaseback transactions, partially offset by a $2 decrease from adjustments to the timing of the recognition of costs associated with sales
of receivables and customer financing.Income taxes, minority interests and equity in net loss of associated companies  net of taxIncome tax benefit and minority interests were also adjusted as part of the Second Restatement.
The adjustment to income tax benefit was an increase of $9 for the three months ended March 31,
2003 primarily related to investment tax credits and taxes attributable to preferred share
dividends. The adjustment to minority interests as a result of the Second Restatement
adjustments was a decrease of $26 for the three months ended March 31, 2003. 15




---



##### Table of Contents



As part of the Second Restatement, equity in net loss of associated companies  net of tax was
adjusted to reflect the final reported losses of the associated companies for the period rather
than the estimates that were used when originally recorded. The adjustment resulted in an
increase to net loss of $12 for the three months ended March 31, 2003.  Reclassifications  As a result of the restatement process, various presentation inconsistencies were
identified. Adjustments were made to appropriately reflect certain items in the consolidated
statements of operations. The reclassifications were made for royalty expense, (gain) loss on
sale of businesses and assets, and other items including certain functional spending and
specific expenses. The amounts that were reclassified for the three months ended March 31, 2003
are detailed below: Royalty
    
    
    Disposalexpense
    
    
    of assets
    
    
    Other
    
    
    TotalCost of revenues
    
    $
    13
    
    
    $
    
    
    
    $
    (3
    )
    
    $
    10Selling, general and administrative expense
    
    
    
    
    
    
    
    
    
    
    8
    
    
    
    8Research and development expense
    
    
    
    
    
    
    
    
    
    
    (5
    )
    
    
    (5
    )(Gain) loss on sale of businesses and assets
    
    
    
    
    
    
    3
    
    
    
    
    
    
    
    3Other expense
    
    
    (13
    )
    
    
    (3
    )
    
    
    1
    
    
    
    (15
    )Minority interests  net of tax
    
    
    
    
    
    
    
    
    
    
    (1
    )
    
    
    (1
    )Net impact of reclassifications
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
  Discontinued operationsAs a result of the restatement process, the initial provision for loss on disposal of the
access solutions discontinued operations recorded in June 2001, and the subsequent activity
during 2001 through 2004 were re-examined. Nortel Networks concluded that the net loss on
disposal of operations recognized in the second quarter of 2001 was overstated. In addition,
other adjustments were necessary to correct certain items that were either initially recorded
incorrectly, or not properly released or adjusted for changes in estimates in the appropriate
periods subsequent to the second quarter of 2001. The net impact of the adjustments was a $31
decrease to the previously reported net earnings from discontinued operations  net of tax for
the three months ended March 31, 2003.The adjustments consisted primarily of a decrease of approximately $90 resulting from the
elimination of a gain on redemption of an investment interest due to the reversal in an earlier
period of a full valuation allowance that had been recorded against the investment interest when
acquired, a decrease of approximately $30 related to the revaluation of certain foreign
denominated customer financing provisions, partially offset by an increase of $37 for
corrections to accrued liabilities, a net increase of $33 from adjustments to contingent
liabilities and approximately $11 related to a gain on settlement of a sales representation
agreement which had previously been recorded in continuing operations.Balance sheetThe following table presents the impact of the Second Restatement adjustments on Nortel
Networks previously reported consolidated balance sheet as of March 31, 2003. The impact on
inventories  net and various liabilities, including deferred revenue, was primarily due to the
adjustments to revenues and cost of revenues described above. The adjustments to plant and
equipment  net and long-term debt primarily related to corrections to the accounting for
certain sale-leaseback transactions. In addition, there were reclassifications resulting from the
restatement adjustments and to conform to the 2003 presentation in the consolidated balance
sheet. 16




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##### Table of Contents



Consolidated Balance Sheet as of March 31, 2003 As previouslyreported
    
    
    Adjustments
    
    
    As restatedASSETSCurrent assetsCash and cash equivalents
    
    $
    3,845
    
    
    $
    1
    
    
    $
    3,846Restricted cash and cash equivalents
    
    
    227
    
    
    
    
    
    
    
    227Accounts receivable  net
    
    
    2,131
    
    
    
    (37
    )
    
    
    2,094Inventories  net
    
    
    885
    
    
    
    560
    
    
    
    1,445Income taxes recoverable
    
    
    60
    
    
    
    43
    
    
    
    103Deferred income taxes  net
    
    
    784
    
    
    
    
    
    
    
    784Other current assets
    
    
    421
    
    
    
    (35
    )
    
    
    386Total current assets
    
    
    8,353
    
    
    
    532
    
    
    
    8,885Investments
    
    
    200
    
    
    
    43
    
    
    
    243Plant and equipment  net
    
    
    1,435
    
    
    
    217
    
    
    
    1,652Goodwill
    
    
    2,021
    
    
    
    (2
    )
    
    
    2,019Intangible assets  net
    
    
    43
    
    
    
    
    
    
    
    43Deferred income taxes  net
    
    
    2,863
    
    
    
    27
    
    
    
    2,890Other assets
    
    
    750
    
    
    
    (102
    )
    
    
    648Total assets
    
    $
    15,665
    
    
    $
    715
    
    
    $
    16,380LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilitiesNotes payable
    
    $
    12
    
    
    $
    34
    
    
    $
    46Trade and other accounts payable
    
    
    776
    
    
    
    (74
    )
    
    
    702Payroll and benefit-related liabilities
    
    
    650
    
    
    
    (58
    )
    
    
    592Contractual liabilities
    
    
    1,122
    
    
    
    (242
    )
    
    
    880Restructuring
    
    
    433
    
    
    
    (44
    )
    
    
    389Other accrued liabilities
    
    
    2,616
    
    
    
    269
    
    
    
    2,885Long-term debt due within one year
    
    
    234
    
    
    
    10
    
    
    
    244Total current liabilities
    
    
    5,843
    
    
    
    (105
    )
    
    
    5,738Long-term debt
    
    
    1,894
    
    
    
    212
    
    
    
    2,106Deferred income taxes  net
    
    
    431
    
    
    
    (7
    )
    
    
    424Other liabilities
    
    
    2,397
    
    
    
    401
    
    
    
    2,798Total liabilities
    
    
    10,565
    
    
    
    501
    
    
    
    11,066Minority interests in subsidiary companies
    
    
    114
    
    
    
    (10
    )
    
    
    104SHAREHOLDERS EQUITYPreferred shares
    
    
    536
    
    
    
    
    
    
    
    536Common shares
    
    
    1,211
    
    
    
    
    
    
    
    1,211Additional paid-in capital
    
    
    22,005
    
    
    
    4
    
    
    
    22,009Accumulated deficit
    
    
    (17,559
    )
    
    
    (134
    )
    
    
    (17,693
    )Accumulated other comprehensive loss
    
    
    (1,207
    )
    
    
    354
    
    
    
    (853
    )Total shareholders equity
    
    
    4,986
    
    
    
    224
    
    
    
    5,210Total liabilities and shareholders equity
    
    $
    15,665
    
    
    $
    715
    
    
    $
    16,380
  3.
    
    Accounting changes(a)
    
    Stock-based compensationEffective January 1, 2003, Nortel Networks elected to expense employee stock-based
compensation using the fair value based 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. Prior to January 1, 2003, Nortel Networks, as permitted by SFAS No. 123, Accounting
for 17




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Stock-Based Compensation, 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 option-pricing
model. Compensation expense is recognized on a straight line basis over the vesting period
of the award.Had Nortel Networks applied the fair value based method to all stock-based awards in all
periods, reported net earnings (loss) and earnings (loss) per common share would have been
adjusted to the pro forma amounts indicated below for each of the three months ended: March 31,
    
    
    March 31,2004
    
    
    2003Net earnings (loss) applicable to common shares  reported
    
    $
    108
    
    
    $
    (60
    )Stock-based compensation  reported(a)
    
    
    58
    
    
    
    6Stock-based compensation  pro forma(b)
    
    
    (73
    )
    
    
    (113
    )Net earnings (loss) applicable to common shares  pro forma
    
    $
    93
    
    
    $
    (167
    )
 (a)
    
    Stock-based compensation  reported, included for the three months ended March 31, 2004 and 2003:i.
    
    
    Stock option expense of $15 and $4, respectively, which was net of tax of nil in
each period;ii.
    
    
    Employer portion of stock purchase plan contributions expense of nil and $1, respectively, which was net of tax of nil in each period;iii.
    
    
    Restricted stock units expense of $41 and nil, respectively, which was net of tax of nil in each period; andiv.
    
    
    Deferred stock units expense of $2 and $1, respectively, which was net of tax of nil in each period.(b)
    
    Stock-based compensation  pro forma was net of tax of nil in each period.
  The following weighted-average assumptions were used in computing the fair value of
stock options for each of the three months ended: March 31,
    
    
    March 31,2004
    
    
    2003Black-Scholes weighted-average assumptionsExpected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %Expected volatility
    
    
    94.47
    %
    
    
    92.48
    %Risk-free interest rate
    
    
    2.96
    %
    
    
    2.82
    %Expected option life in years
    
    
    4
    
    
    
    4Weighted-average stock option fair value per option granted
    
    $
    5.21
    
    
    $
    1.56
  (b)
    
    Asset retirement obligationsIn June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement
Obligations (SFAS 143), which applies to certain obligations associated with the
retirement of tangible long-lived assets. SFAS 143 requires that a liability be initially
recognized for the estimated fair value of the obligation when it is incurred. The
associated asset retirement cost is capitalized as part of the carrying amount of the
long-lived asset and depreciated over the remaining life of the underlying asset and the
associated liability is accreted to the estimated fair value of the obligation at the
settlement date through periodic accretion charges to net earnings (loss). When the
obligation is settled, any difference between the final cost and the recorded amount is
recognized as income or loss on settlement. Effective January 1, 2003, Nortel Networks
adopted the initial recognition and measurement provisions of SFAS 143 and identified
certain asset retirement obligations to remediate leased premises and buildings and
equipment situated on leased land. The adoption of SFAS 143 resulted in an increase to net
loss of $12 (net of tax of nil) which has been reported as a cumulative effect of accounting
change  net of tax, an increase in plant and equipment  net of $4 and an asset retirement obligation liability of $16 as of January 1, 2003. The
adoption of SFAS 143 did not have a material impact on depreciation and accretion expense or
basic and diluted earnings (loss) per share.(c)
    
    Accounting for certain financial instruments with characteristics of both liabilities
and equityIn 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 18




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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. The adoption of SFAS 150, as amended by
FSP FAS 150-3, did not have a material impact on Nortel Networks results of operations and
financial condition.As of December 31, 2003 and March 31, 2004, Nortel Networks continued 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 interest included in the consolidated balance sheet related to these entities as of
March 31, 2004 was $50. Nortel Networks has not yet determined the fair value of this
minority interest as of March 31, 2004.  4.
    
    Consolidated financial statement detailsThe following consolidated financial statement details are presented as of March
31, 2004 and December 31, 2003 for the consolidated balance sheets and for each of the three
months ended March 31, 2004 and 2003 for the consolidated statements of cash flows.Consolidated balance sheetsAccounts receivable  net: March 31,
    
    
    December 31,2004
    
    
    2003Trade receivables
    
    $
    2,143
    
    
    $
    2,271Contracts in process
    
    
    625
    
    
    
    5822,768
    
    
    
    2,853Less: provision for doubtful accounts
    
    
    (184
    )
    
    
    (194
    )Accounts receivable  net
    
    $
    2,584
    
    
    $
    2,659
  Inventories  net: March 31,
    
    
    December 31,2004
    
    
    2003Raw materials
    
    $
    183
    
    
    $
    249Work in process
    
    
    256
    
    
    
    221Finished goods
    
    
    807
    
    
    
    720Inventories  net(a)
    
    $
    1,246
    
    
    $
    1,190
 (a)
    
    Net of inventory provisions of $1,027 and $ 1,226 as of March 31, 2004 and December 31,
2003, respectively. Other reserves for claims related to contract manufacturers and
suppliers of $86 and $120 as of March 31, 2004 and December 31, 2003, respectively, were
included in other accrued liabilities. These accruals were related to cancellation charges, contracted-for
inventory in excess of future demand and the settlement of certain other claims.
 19




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##### Table of Contents



Other current assets: March 31,
    
    
    December 31,2004
    
    
    2003Prepaid expenses
    
    $
    201
    
    
    $
    176Current assets of discontinued operations(a)
    
    
    29
    
    
    
    28Other
    
    
    83
    
    
    
    110Other current assets
    
    $
    313
    
    
    $
    314
 (a)
    
    See note 17 for additional information.
  Plant and equipment  net: March 31,
    
    
    December 31,2004
    
    
    2003Cost:Land
    
    $
    62
    
    
    $
    63Buildings
    
    
    1,464
    
    
    
    1,483Machinery and equipment
    
    
    2,634
    
    
    
    2,7054,160
    
    
    
    4,251Less accumulated depreciation:Buildings
    
    
    (462
    )
    
    
    (457
    )Machinery and equipment
    
    
    (2,102
    )
    
    
    (2,140
    )(2,564
    )
    
    
    (2,597
    )Plant and equipment  net(a)(b)(c)
    
    $
    1,596
    
    
    $
    1,654
 (a)
    
    Included assets held for sale with a carrying value of $26 and $30 as of March 31, 2004
and December 31, 2003, respectively, related to owned facilities that were being actively
marketed. These assets were written down in previous periods to their estimated fair
values less costs to sell. The write downs were included in special charges. Nortel
Networks expects to dispose of all of these facilities by mid-2005.(b)
    
    Included variable interest entity assets consolidated prospectively, as required by
FASB Interpretation No. 46 (Revised 2003), Consolidation
of Variable Interest Entities  an Interpretation of Accounting Research Bulletin No. 51 (FIN 46R), of $93 and $183 as of
March 31, 2004 and December 31, 2003, respectively.(c)
    
    Included embedded leases recorded prospectively, as required by EITF 01-8, Determining
Whether an Arrangement Contains a Lease, of $2 and $2 as of March 31, 2004 and December
31, 2003, respectively.
  Goodwill:The following table outlines goodwill by reportable segment: Wireless
    
    
    Enterprise
    
    
    Wireline
    
    
    OpticalNetworks
    
    
    Networks
    
    
    Networks
    
    
    Networks
    
    
    Other
    
    
    TotalBalance  net as of December 31, 2003
    
    $
    35
    
    
    $
    1,555
    
    
    $
    526
    
    
    $
    9
    
    
    $
    
    
    
    $
    2,125Change:Foreign exchange
    
    
    
    
    
    
    (1
    )
    
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    (2
    )Balance  net as of March 31, 2004
    
    $
    35
    
    
    $
    1,554
    
    
    $
    525
    
    
    $
    9
    
    
    $
    
    
    
    $
    2,123
  Intangible assets  net: March 31,
    
    
    December 31,2004
    
    
    2003Other intangible assets(a)
    
    $
    42
    
    
    $
    45Pension intangible assets(b)
    
    
    40
    
    
    
    41Intangible assets  net
    
    $
    82
    
    
    $
    86
 (a)
    
    Other intangible assets are being amortized over a ten year period ending in 2013. The
amortization expense is denominated in a foreign currency and may fluctuate due to changes
in foreign exchange rates. Other intangible assets are amortized over their expected
pattern of benefit to future periods using estimates of undiscounted cash flows.
 20




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(b)
    
    Pension intangible assets were recorded as required by SFAS No. 87, Employers
Accounting for Pensions. Amounts are not amortized but are adjusted as part of the annual
minimum pension liability assessment.
  Other accrued liabilities: March 31,
    
    
    December 31,2004
    
    
    2003Outsourcing and selling, general and administrative related
    
    $
    294
    
    
    $
    298Customer deposits
    
    
    38
    
    
    
    73Product related
    
    
    86
    
    
    
    120Warranty
    
    
    350
    
    
    
    382Deferred income
    
    
    838
    
    
    
    761Miscellaneous taxes
    
    
    26
    
    
    
    75Income taxes payable
    
    
    103
    
    
    
    110Current liabilities of discontinued operations
    
    
    4
    
    
    
    6Interest payable
    
    
    23
    
    
    
    37Advance billings in excess of revenues recognized on long term contracts
    
    
    454
    
    
    
    509Other
    
    
    100
    
    
    
    96Other accrued liabilities
    
    $
    2,316
    
    
    $
    2,467
  Other liabilities: March 31,
    
    
    December 31,2004
    
    
    2003Pension, post-employment and post-retirement benefits liability
    
    $
    2,022
    
    
    $
    1,973Long-term provisions
    
    
    939
    
    
    
    971Other liabilities
    
    $
    2,961
    
    
    $
    2,944
  Consolidated statements of cash flowsChange in operating assets and liabilities: March 31,
    
    
    March 31,2004
    
    
    2003Restricted cash and cash equivalents
    
    $
    1
    
    
    $
    20Accounts receivable
    
    
    58
    
    
    
    182Inventories
    
    
    (54
    )
    
    
    92Income taxes
    
    
    (23
    )
    
    
    (5
    )Restructuring
    
    
    (84
    )
    
    
    (190
    )Accounts payable and accrued liabilities
    
    
    (435
    )
    
    
    (167
    )Other operating assets and liabilities
    
    
    129
    
    
    
    72Change in operating assets and liabilities
    
    $
    (408
    )
    
    $
    4
  Interest and taxes paid: March 31,
    
    
    March 31,2004
    
    
    2003Cash interest paid
    
    $
    37
    
    
    $
    43Cash taxes paid  net
    
    $
    8
    
    
    $
    21
 21




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##### Table of Contents



5.
    
    Segment informationGeneral descriptionDuring 2003 and up to September 30, 2004, Nortel Networks operations were organized around four
reportable segments consisting of Wireless Networks, Enterprise Networks, Wireline Networks and
Optical Networks. Wireless Networks included network access and core networking products for
voice and data communications that span second and third generation wireless technologies and
most major global standards for mobile networks and related professional services. Enterprise
Networks included circuit and packet voice solutions, data networking and security solutions and
the related professional services used by enterprise customers. Wireline Networks included
circuit and packet voice solutions, data networking and security solutions and the related
professional services used by service provider customers. Optical Networks included
metropolitan, regional and long-haul optical transport and switching solutions and managed
broadband services and related professional services for both service provider and enterprise
customers.Other represented miscellaneous business activities and corporate functions. None of these
activities meet the quantitative criteria to be disclosed as reportable segments. As described
in note 17, Nortel Networks access solutions operations were discontinued during the year ended
December 31, 2001. These operations were previously included as a separate business activity
within other. The data below excludes amounts related to the access solutions operations.Effective October 1, 2004, a new streamlined organizational structure was established that
involved, among other things, combining the businesses of Nortel Networks four segments into two
business organizations: (i) Carrier Networks and Global Operations, and (ii) Enterprise
Networks. Nortel Networks is reviewing the impact of these changes on its reportable segments.Nortel Networks president and chief executive officer (the CEO) has been identified as the
chief operating decision maker in assessing the performance of the segments and the allocation
of resources to the segments. Each reportable segment is managed separately with each segment
manager reporting directly to the CEO. The CEO relies on the information derived directly from
the Nortel Networks management reporting system. In 2003, Nortel Networks reported that the
primary financial measure used by the former chief operating decision maker in assessing
performance and allocating resources to the segments was contribution margin, a measure that was
comprised of gross profit less selling, general and administrative expense. In April 2004,
Nortel Networks and NNCs boards of directors appointed a new CEO. Commencing in the second
quarter of 2004, 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 contribution
margin, research and development (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. As a result of the change in Nortel Networks primary
financial measure used to assess the performance of the segments during the period in which
Nortel Networks financial reports as described in note 19 have been delayed, and because both
contribution margin and Management EBT were available to the former chief operating decision
maker during the first quarter of 2004, Nortel Networks has determined that it is appropriate to
disclose both contribution margin and Management EBT for the periods presented.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 Networks corporate compliance and other non-operational activities
and are included in other. In addition, 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. 22




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##### Table of Contents



SegmentsThe following tables set forth information by segment for each of the three months ended
March 31: March 31,
    
    
    March 31,2004
    
    
    2003RevenuesWireless Networks
    
    $
    1,225
    
    
    $
    869Enterprise Networks
    
    
    534
    
    
    
    585Wireline Networks
    
    
    439
    
    
    
    515Optical Networks
    
    
    245
    
    
    
    317Other
    
    
    1
    
    
    
    9Total
    
    $
    2,444
    
    
    $
    2,295Contribution marginWireless Networks
    
    $
    448
    
    
    $
    272Enterprise Networks
    
    
    82
    
    
    
    107Wireline Networks
    
    
    111
    
    
    
    129Optical Networks
    
    
    2
    
    
    
    2Other
    
    
    (109
    )
    
    
    (93
    )Total
    
    $
    534
    
    
    $
    417Management EBTWireless Networks
    
    $
    221
    
    
    $
    50Enterprise Networks
    
    
    25
    
    
    
    46Wireline Networks
    
    
    (5
    )
    
    
    38Optical Networks
    
    
    (53
    )
    
    
    (52
    )Other
    
    
    (71
    )
    
    
    (119
    )Total
    
    
    117
    
    
    
    (37
    )Amortization of acquired technology
    
    
    (3
    )
    
    
    Deferred stock option compensation
    
    
    
    
    
    
    Special charges
    
    
    (7
    )
    
    
    (140
    )Gain (loss) on sale of businesses and assets
    
    
    
    
    
    
    1Income tax benefit (expense)
    
    
    9
    
    
    
    3Net earnings (loss) from continuing operations
    
    $
    116
    
    
    $
    (173
    )
 23




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6.
    
    Special chargesDuring the three months ended March 31, 2004, Nortel Networks continued to implement its
restructuring work plans initiated in 2001 and 2003. Special charges recorded from January 1,
2004 to March 31, 2004 were as follows: ContractsettlementWorkforce
    
    
    and leasereduction
    
    
    costs
    
    
    TotalProvision balance as of December 31, 2003(a)
    
    $
    64
    
    
    $
    455
    
    
    $
    519Other special charges
    
    
    6
    
    
    
    
    
    
    
    6Revisions to prior accruals
    
    
    
    
    
    
    1
    
    
    
    1Cash drawdowns
    
    
    (27
    )
    
    
    (57
    )
    
    
    (84
    )Non-cash drawdowns
    
    
    
    
    
    
    
    
    
    
    Foreign exchange and other adjustments
    
    
    
    
    
    
    7
    
    
    
    7Provision balance as of March 31, 2004(a)
    
    $
    43
    
    
    $
    406
    
    
    $
    449
 (a)
    
    As of March 31, 2004 and December 31, 2003, the short-term provision balance was $161
and $205, respectively, and the long-term provision balance was $288 and $314,
respectively, which was included in long-term provisions, as a component of other
liabilities.
  Regular full-time (RFT) employee notifications included in special charges were as
follows: Employees (approximate)Direct(a)
    
    
    Indirect(b)
    
    
    TotalRFT employee notifications for the three months ended March 31, 2004
    
    
    40
    
    
    
    40
    
    
    
    80
 (a)
    
    Direct employees included employees performing manufacturing, assembly, test and
inspection activities associated with the production of Nortel Networks products.(b)
    
    Indirect employees included employees performing manufacturing, management, sales,
marketing, research and development and administrative activities.
  Three months ended March 31, 2004During the three months ended March 31, 2004, Nortel Networks 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 Optical Networks. During the three months ended March 31, 2004, the
workforce reduction provision balance was drawn down by cash payments of $27. The remaining
provision is expected to be substantially drawn down by the end of 2004.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. The remaining
provision, net of approximately $313 in estimated sublease income, is expected to be
substantially drawn down by the end of 2013.In 2003, Nortel Networks 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 No. 146,
Accounting for Costs Associated with Exit or Disposal Activities (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, 2004 and the movement in the accrual for the three months ended March 31, 2004. These costs
are included in the provision balance above as of March 31, 2004. 24




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Costs
    
    
    Payments made
    
    
    Adjustmentsduring the
    
    
    during the
    
    
    during theAccrued
    
    
    three months
    
    
    three months
    
    
    three months
    
    
    Accruedbalance as of
    
    
    ended
    
    
    ended
    
    
    ended
    
    
    balance as ofDecember 31, 2003
    
    
    March 31, 2004
    
    
    March 31, 2004
    
    
    March 31, 2004
    
    
    March 31, 2004Lease costs(a)
    
    $
    36
    
    
    $
    
    
    
    $
    (3
    )
    
    $
    
    
    
    $
    33
 (a)
    
    Total estimated costs, net of estimated sublease income, associated with these accruals
are $62, of which $14 was drawn down by cash payments of $8 and non-cash adjustments of $6
prior to January 1, 2004.
  Three months ended March 31, 2003For the three months ended March 31, 2003, Nortel Networks recorded total special charges
of $140, which was net of revisions of $3 related to prior accruals.Workforce reduction charges of $72 were related to severance and benefit costs associated with
approximately 800 employees notified of termination, which extended across all segments.
Offsetting these charges were revisions of $24, which were primarily related to termination
benefits where actual costs were lower than the estimated amounts across all segments.Contract settlement and lease costs of $43 consisted of net lease charges related to leased
facilities (comprised of office, warehouse and manufacturing space) and leased furniture that
were newly identified as no longer being used and which were valued using the estimated fair
value method prescribed under SFAS 146. These costs extended across all segments. In addition
to these charges were revisions of $31 resulting primarily from changes in estimates for
sublease income and costs to vacate certain properties, across all segments.Plant and equipment charges of $28 were related to current period write downs to fair value less
costs to sell for various leasehold improvements and excess Optical Networks equipment.
Offsetting these charges were revisions of $10 to prior write downs of assets held for sale
related primarily to adjustments to original plans or estimated amounts for certain facility
closures.7.
    
    Income taxesDuring the three months ended March 31, 2004, Nortel Networks recorded a tax benefit of $9
on earnings from continuing operations before income taxes, minority interests and equity in net
loss of associated companies of $114.During the three months ended March 31, 2003, Nortel Networks recorded a tax benefit of $3 on
loss from continuing operations before income taxes, minority interests and equity in net loss
of associated companies of $137.As of March 31, 2004, Nortel Networks net deferred tax assets, excluding discontinued
operations, were $3,568, reflecting temporary differences between the financial reporting and
tax treatment of certain current assets and liabilities and non-current assets and liabilities,
in addition to the tax benefit of net operating and capital loss carryforwards and tax credit
carryforwards. These carryforwards expire at various dates beginning in 2004. The valuation
allowance was recorded in accordance with SFAS No. 109, Accounting for Income Taxes, which
requires that tax valuation allowances 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
allowances were attributed to an assessment of positive and negative evidence, including
forecasts of future taxable income to support realization for the net deferred tax assets and
Nortel Networks cumulative consolidated loss position.8.
    
    Employee benefit plansNortel Networks maintains various retirement programs covering substantially all of its
employees, consisting of defined benefit, defined contribution and investment plans.Nortel Networks 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
U.K.; and traditional capital accumulation and retirement programs that include 25




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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 Networks major retirement programs and may be
available to employees in combination and/or as options within a program, Nortel Networks also
has smaller pension plan arrangements in other countries.Nortel Networks 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 Networks-sponsored retiree health care
plan at their own cost.The following details the net pension expense for the defined benefit plans for the three months
ended March 31: March 31,
    
    
    March 31,2004
    
    
    2003Pension expense:Service cost
    
    $
    30
    
    
    $
    29Interest cost
    
    
    104
    
    
    
    101Expected return on plan assets
    
    
    (102
    )
    
    
    (103
    )Amortization of prior service cost
    
    
    1
    
    
    
    2Amortization of net losses (gains)
    
    
    19
    
    
    
    11Settlement losses (gains)
    
    
    
    
    
    
    2Net pension expense
    
    $
    52
    
    
    $
    42
  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,
    
    
    March 31,2004
    
    
    2003Post-retirement benefit cost:Service cost
    
    $
    3
    
    
    $
    2Interest cost
    
    
    10
    
    
    
    10Amortization of prior service cost
    
    
    (1
    )
    
    
    (1
    )Amortization of net losses (gains)
    
    
    1
    
    
    
    (1
    )Net post-retirement benefit cost
    
    $
    13
    
    
    $
    10
  During the three months ended March 31, 2004, contributions of $18 were made to the defined
benefit plans and $8 to the post-retirement benefit plans. Nortel Networks contributed an
additional $197 in 2004 to the defined benefit plans for a total contribution of $215, which
excluded $78 of deferred contributions for 2004 which were made in 2003, and an additional $22
in 2004 to the post-retirement benefit plans for a total contribution of $30.9.
    
    DivestituresOn February 3, 2004, Nortel Networks 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 Networks no longer holds any equity
interest in Entrust.During March 2004, Nortel Networks 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 Networks owned 3.2 million Arris
Group common shares or 4.2 percent of Arris Group outstanding common shares (see note 17). 26




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10.
    
    Long-term debt, credit and support facilities  Long-term debtAs a result of the delay in the filing of Nortel Networks 2003 Annual Report and the annual
report on Form 10-K for the year ended December 31, 2003 of
Nortel Networks parent corporation, NNC (the NNC 2003 Annual Report, and together with the Nortel
Networks 2003 Annual Report, the 2003 Annual Reports), Nortel Networks and NNC were not in
compliance with their obligations to deliver their respective SEC filings to the trustees under
Nortel Networks and NNCs public debt indentures. Approximately $1,800 of notes of Nortel
Networks (or its subsidiaries) and $1,800 of convertible debt securities of NNC were outstanding
under such indentures as of March 31, 2004. The delay did not result in an automatic event of
default and acceleration of the long-term debt of Nortel Networks or NNC and such default and
acceleration could not occur unless notice of such non-compliance was provided to Nortel
Networks or NNC, as applicable, and Nortel Networks or NNC, as applicable, failed to file and
deliver the relevant report within 90 days after such notice was provided, all in accordance
with the terms of the indentures. Neither Nortel Networks nor NNC received any such notice by
March 31, 2004. For additional information, see note 19.During the three months ended March 31, 2004, Nortel Networks purchased land and two buildings
for $87 that were previously leased by Nortel Networks, through a single transaction variable
interest entity that was consolidated under the provisions of FIN 46R. As a result, Nortel
Networks extinguished a debt of $87.During the three months ended March 31, 2003, Nortel Networks purchased a portion of its 6.125 %
Notes due February 15, 2006 with a face value of $39. The transaction resulted in a gain of $4
which was included in the consolidated statement of operations within other income (expense) -
net for the three months ended March 31, 2003.Credit facilitiesAs of March 31, 2004 and December 31, 2003, Nortel Networks had total unused committed
credit facilities of $750 under the Nortel Networks and Nortel Networks Inc. (NNI) $750 April
2000 five year credit facilities (the Five Year Facilities). For additional information, see
note 19.Support facilityOn February 14, 2003, Nortel Networks 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 Networks (the EDC Support Facility). Nortel Networks obligations under the EDC
Support Facility also became secured on an equal and ratable basis under the security agreements
entered into by Nortel Networks and various of its subsidiaries that pledged substantially all
of the assets of Nortel Networks in favor of the banks under the Five Year Facilities and the
holders of Nortel Networks and NNCs public debt securities. This security became effective in
favor of the banks and the public debt holders on April 4, 2002 (see note 21). On July 10,
2003, Nortel Networks and EDC amended the terms of the EDC Support Facility by extending the
termination date of the facility to December 31, 2005 from June 30, 2004 and on December 10,
2004, Nortel Networks and EDC amended the terms of the EDC Support Facility by extending the
termination date of the facility to December 31, 2006 from December 31, 2005 (for additional
information relating to the EDC Support Facility, the Five Year Facilities and the related
security agreements, see notes 19 and 21).On March 10, 2004, NNC announced that the filing of the 2003 Annual Reports with the SEC would
be delayed. On March 15, 2004, NNC announced that the filing of the 2003 Annual Reports with
the SEC would extend beyond March 30, 2004 and that would result in EDC having the right to
terminate its commitments under the EDC Support Facility and to exercise certain rights against
the collateral under the related security agreements (see note 21). Nortel Networks obtained a
waiver from EDC on March 29, 2004 of certain defaults under the EDC Support Facility related to
the delay in filing the 2003 Annual Reports with the SEC, the trustees under Nortel Networks and
NNCs public trust indentures and EDC and to permit continued access to the EDC Support Facility
in accordance with its terms while Nortel Networks and NNC completed their filing obligations.
The waiver also applied to certain related breaches under the EDC Support Facility relating to
the delayed filings and the planned restatements and revisions to Nortel Networks and NNCs
prior financial results (the Related Breaches). The waiver was to remain in effect until the
earliest of certain events or May 29, 2004. On March 29, 2004, Nortel Networks and EDC also
amended the EDC Support Facility to provide that EDC may also suspend its obligation to issue
Nortel Networks any additional support if events occur that have a material adverse effect on
Nortel Networks business, financial position or results of operations
and that such amendment
would survive the waiver period. For additional information relating to the 27




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EDC Support
Facility, the waiver and the related security agreements, see notes 19 and 21.As of March 31, 2004, the EDC Support Facility provided for up to $750 in support including $300
of committed revolving support for performance bonds or similar instruments, of which $188 was
utilized, $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 $183 was utilized (see note 19).11.
    
    Financial instruments and hedging activitiesOn January 27, 2003, various cross currency coupon swaps (notional amount of Canadian $350)
were terminated. There was no impact to net earnings (loss) on termination as these instruments
were not designated as hedges and changes in fair value were previously accounted for in the
consolidated statements of operations.Hedge ineffectiveness and the discontinuance of cash flow hedges and fair value hedges that were
accounted for in accordance with SFAS 133 had no material impact on the net earnings (loss) for
the three months ended March 31, 2004 and 2003 and were reported within other income (expense) -
net in the consolidated statements of operations.12.
    
    GuaranteesNortel Networks has entered into agreements that contain features which meet the definition
of a guarantee under FIN 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 Networks 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 Networks outstanding guarantees
as of March 31, 2004 is provided below:  (a)
    
    Business sale and business combination agreementsIn connection with agreements for the sale of portions of its business, including
certain discontinued operations, Nortel Networks 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 Networks generally indemnifies the purchaser of a
Nortel Networks business in the event that a third party asserts a claim against the
purchaser that relates to a liability retained by Nortel Networks. Some of these types of
guarantees have indefinite terms while others have specific terms extending to June 2008.Nortel Networks 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 Networks 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 Networks 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.Historically, Nortel Networks 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 Networks 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 Networks
may be required to pay under the volume guarantee as of March 31, 2004 is $8. A liability
of $6 has been accrued in the consolidated financial statements with respect to the
obligation associated with this guarantee as of March 31, 2004. 28




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(b)
    
    Intellectual property indemnification obligationsNortel Networks 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 Networks 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 Networks from making a reasonable estimate of the maximum potential amount it could
be required to pay to its customers and suppliers. Historically, Nortel Networks 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, 2004.(c)
    
    Lease agreementsNortel Networks 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 Networks vacated prior to the end of the term of its
lease. These lease agreements require Nortel Networks to make lease payments throughout the
lease term if the assignee fails to make scheduled payments. Most of these lease agreements
also require Nortel Networks 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 Networks may be required to pay under these types
of agreements is $55 as of March 31, 2004. Nortel Networks generally has the ability to
attempt to recover such lease payments from the defaulting party through rights of
subrogation.Historically, Nortel Networks 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)
    
    Debt agreementsNortel Networks has guaranteed the debt of certain customers. These third party debt
agreements require Nortel Networks 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
Networks may be required to pay under these types of debt agreements is $8 as of March 31,
2004. Under most such arrangements, the Nortel Networks guarantee is secured, usually by
the assets being purchased or financed. A liability of $7 has been accrued in the
consolidated financial statements with respect to the obligations associated with these
financial guarantees as of March 31, 2004.Nortel Networks 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 Networks 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 credit facilities, EDC Support Facility and
security agreementsAs of March 31, 2004, Nortel Networks had agreed to indemnify the banks and agents
under its credit facilities against costs or losses resulting from changes in laws and
regulations which would increase the banks costs or reduce their return and from any legal
action brought against the banks or agents related to the use of loan proceeds. Nortel
Networks has also 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 Networks 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 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 10
and 19). 29




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Nortel Networks 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 Networks 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 Networks has agreed to indemnify its counterparties in receivables securitization
transactions. The indemnifications provided to counterparties in these types of
transactions may require Nortel Networks 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, 2004, Nortel
Networks had approximately $261 of securitized receivables which were subject to repurchase
under this provision, in which case Nortel Networks 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
amounts by the counterparty.Nortel Networks is 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, Nortel Networks 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 agreementsNortel Networks 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 Networks 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 Networks 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 Networks 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.  Product warrantiesThe 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, 2004: 30




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Balance as of December 31, 2003
    
    $
    382Payments
    
    
    (77
    )Warranties issued
    
    
    50Revisions
    
    
    (5
    )Balance as of March 31, 2004
    
    $
    350
  13.
    
    CommitmentsBid, performance related and other bondsNortel Networks 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. 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 Networks non-performance under the applicable contract.
Historically, Nortel Networks 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 periods: March 31,
    
    
    December 31,2004
    
    
    2003Bid and performance related bonds(a)
    
    $
    412
    
    
    $
    427Other bonds(b)
    
    
    55
    
    
    
    53Total bid, performance related and other bonds
    
    $
    467
    
    
    $
    480
 (a)
    
    Net of restricted cash and cash equivalent amounts of $13 and $14 as of March 31, 2004
and December 31, 2003, respectively.(b)
    
    Net of restricted cash and cash equivalent amounts of $30 and $31 as of March 31, 2004
and December 31, 2003, respectively.
  Customer financingPursuant to certain financing agreements, Nortel Networks is committed to provide future
financing in connection with purchases of Nortel Networks 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 Networks attempts to limit its financing
credit risk by utilizing an internal credit committee that monitors the credit exposure of
Nortel Networks. The following table sets forth customer financing related information and
commitments, excluding discontinued operations, as of the following periods: March 31,
    
    
    December 31,2004
    
    
    2003Drawn and outstanding  gross
    
    $
    381
    
    
    $
    401Provisions for doubtful accounts
    
    
    (278
    )
    
    
    (281
    )Drawn and outstanding  net(a)
    
    
    103
    
    
    
    120Undrawn commitments(b)
    
    
    66
    
    
    
    180Total customer financing
    
    $
    169
    
    
    $
    300
 (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.(b)
    
    On January 8, 2004, Nortel Networks negotiated an agreement with a certain customer and
reduced Nortel Networks aggregate undrawn customer financing commitments from $180 to $69.
  During the three months ended March 31, 2004 and 2003, Nortel Networks recorded net
customer financing bad debt expense of nil and $1, respectively.During the three months ended March 31, 2004 and 2003, Nortel Networks entered into certain
agreements to restructure and/or settle various customer financing and related receivables. As
a result of these transactions, Nortel Networks 31




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received cash consideration of approximately $15
and $9, respectively, to settle outstanding receivables with a net carrying value of $14 and $3,
respectively.During the three months ended March 31, 2004 and 2003, Nortel Networks reduced undrawn customer
financing commitments by $114 and $148, respectively, as a result of the expiration or
cancellation of commitments and changing customer business plans. As of March 31, 2004, all
undrawn commitments were available for funding under the terms of the financing agreements.Venture capital financingNortel Networks 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 Networks 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
Networks had remaining commitments, if requested, of $21 and $24 as of March 31, 2004 and
December 31, 2003, respectively. These commitments expire at various dates through 2012.14.
    
    Restricted cash and cash equivalentsAs of March 31, 2004 and December 31, 2003, approximately $62 and $63, respectively, of
cash and cash equivalents was restricted as collateral for certain bid, performance related and
other bonds as well as for certain normal course of business transactions. The cash and cash
equivalents collateral was in addition to the payment of fees and was required as a result of
the general economic and industry environment and Nortel Networks credit ratings.15.
    
    Stock-based compensation plansAs a result of NNCs March 10, 2004 announcements, as described in note 19, Nortel Networks
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 at a discount; the exercise of
outstanding options granted under the Nortel Networks Corporation 2000 Stock Option Plan or
Nortel Networks Corporation 1986 Stock Option Plan As Amended and Restated, 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 Nortel Networks or NNC in connection with
mergers and acquisitions; and the purchase of units in a NNC stock fund or purchase of Nortel
Networks Corporation common shares under Nortel Networks defined contribution and investment
plans, until such time, at the earliest, that Nortel Networks and NNC are in compliance with
U.S. and Canadian regulatory securities filing requirements.16.
    
    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 31,2004
    
    
    2003Net earnings (loss)
    
    $
    117
    
    
    $
    (52
    )Other comprehensive income (loss) adjustments:Change in foreign currency translation adjustment(a)
    
    
    (4
    )
    
    
    74Unrealized gain (loss) on investments  net(b)
    
    
    (19
    )
    
    
    1Minimum pension liability adjustment  net
    
    
    1
    
    
    
    Unrealized derivative gain (loss) on cash flow hedges  net(c)
    
    
    (6
    )
    
    
    13Comprehensive income (loss)
    
    $
    89
    
    
    $
    36
 (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.(b)
    
    Certain securities deemed available-for-sale by Nortel Networks 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 loss until
realized. Unrealized gain (loss) on investments was net of tax of nil and $5 for the three
months ended March 31, 2004 and 2003, respectively.(c)
    
    During the three months ended March 31, 2004 and 2003, net derivative gains of $3 and
$2, respectively, were reclassified to other income (expense)  net. Nortel Networks
estimates that $6 of net derivative gains (losses) included in accumulated other
comprehensive loss will be reclassified into net earnings (loss) within the next 12 months.
 32




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17.
    
    Discontinued operationsDuring the year ended December 31, 2003, Nortel Networks substantially completed the wind
down of its access solutions operations. During the three months ended March 31, 2004, there
was no change to the initial disposal strategy or intent to exit the business which was approved
by the Nortel Networks Board of Directors on June 14, 2001.The following unaudited consolidated financial results for discontinued operations are presented
as of March 31, 2004 and December 31, 2003 for the consolidated balance sheets and for each of
the three months ended March 31, 2004 and 2003, for the consolidated statements of operations
and consolidated statements of cash flows:Consolidated statements of operations: March 31,
    
    
    March 31,2004
    
    
    2003Revenues
    
    $
    1
    
    
    $
    4Net earnings from discontinued operations  net of tax(a)
    
    $
    1
    
    
    $
    133
 (a)
    
    Net earnings from discontinued operations was net of applicable income tax of nil and
$8 for the three months ended March 31, 2004 and 2003, respectively.
  Consolidated balance sheets: March 31,
    
    
    December 31,2004
    
    
    2003Deferred income taxes
    
    $
    25
    
    
    $
    26Other current assets
    
    
    4
    
    
    
    2Total current assets of discontinued operations(a)(b)
    
    
    29
    
    
    
    28Other long-term assets(b)(c)
    
    
    4
    
    
    
    4Total assets of discontinued operations
    
    $
    33
    
    
    $
    32Current liabilities(b)(d)
    
    $
    4
    
    
    $
    6Long-term liabilities(b)
    
    
    1
    
    
    
    1Total liabilities of discontinued operations
    
    $
    5
    
    
    $
    7
 (a)
    
    Included accounts receivable of nil, which was net of provisions of $2 and $5, as of
March 31, 2004 and December 31, 2003, respectively. Included inventories of nil and nil,
which was net of provisions of $74 and $75, as of March 31, 2004 and December 31, 2003,
respectively.(b)
    
    Current assets, other long-term assets, current liabilities and long-term liabilities
of discontinued operations were included in other current assets, other assets, other
accrued liabilities and other liabilities, respectively, on the consolidated balance
sheets.(c)
    
    Included customer financing receivables of $4 and $4, which was net of provisions of
$55 and $55, as of March 31, 2004 and December 31, 2003.(d)
    
    Consisted of future contractual obligations and estimated liabilities of $4 and $6 as
of March 31, 2004 and December 31, 2003, respectively.
  Consolidated statements of cash flows: March 31,
    
    
    March 31,2004
    
    
    2003Cash flows from (used in) discontinued operationsOperating activities
    
    $
    (3
    )
    
    $
    60Investing activities
    
    
    
    
    
    
    241Net cash from (used in) discontinued operations
    
    $
    (3
    )
    
    $
    301
  Activity during the three months ended March 31, 2003Nortel Networks recorded net earnings from discontinued operations  net of tax, of $133
for the three months ended March 31, 2003. The significant items included in net earnings are
summarized below. 33




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On March 24, 2003, Nortel Networks sold 8 million common shares of Arris Group back to Arris
Group for cash consideration of $28 pursuant to a March 11, 2003 agreement, which resulted in a
gain of $12. Following this transaction, Nortel Networks interest in Arris Group was reduced to
18.8 percent, and it ceased equity accounting for the investment. As a result, Nortel Networks
now classifies its remaining ownership interest in Arris Group as an available-for-sale
investment within continuing operations. Nortel Networks continues to dispose of its interest
in Arris Group and the gain or loss on the sale of shares subsequent to the first quarter of
2003 has been included in other income (expense)  net (see note 9).On March 18, 2003, Nortel Networks assigned its subordinated redeemable preferred interest in
Arris Interactive, L.L.C. (Arris Interactive) to ANTEC Corporation, an Arris Group company,
for cash consideration of $88. As a result of this transaction, Nortel Networks recorded a loss
of $2. Also in connection with the March 2003 transactions, Nortel Networks received $11 upon
settlement of a sales representation agreement with Arris Group and recorded a gain of $11.On March 20, 2003, Nortel Networks entered into an agreement with a customer to restructure
approximately $465 of trade and customer financing receivables owed to Nortel Networks, the
majority of which was previously provisioned. As a result of the restructuring agreement,
Nortel Networks received consideration including cash of $125, notes receivable and an ownership
interest which have been fully provided for and the mutual release of all other claims between
the parties. A gain of $66 was recorded as a result of the transaction. In addition to the
restructuring agreement, a five year equipment and services supply agreement was entered into
requiring customer payment terms of either cash in advance or guarantee by letters of credit in
favor of Nortel Networks.18.
    
    ContingenciesSubsequent 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 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
Second Circuit on the JDS shareholders appeal of the dismissal of their 34




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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 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
Networks 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 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 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 35




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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.On March 4, 1997, Bay Networks, Inc. (Bay Networks), a company acquired on August 31, 1998,
announced that shareholders had filed two separate lawsuits in the U.S. District Court for the
Northern District of California (the Federal Court) and the California Superior Court, County
of Santa Clara (the California Court), against Bay Networks and ten of Bay Networks then
current and former officers and directors purportedly on behalf of a class of shareholders who
purchased Bay Networks common shares during the period of May 1, 1995 through October 14, 1996.
On August 17, 2000, the Federal Court granted the defendants motion to dismiss the federal
complaint. On August 1, 2001, the U.S. Court of Appeals for the Ninth Circuit denied the
plaintiffs appeal of that decision. On April 18, 1997, a second lawsuit was filed in the
California Court, purportedly on behalf of a class of shareholders who acquired Bay Networks
common shares pursuant to the registration statement and prospectus that became effective on
November 15, 1995. The two actions in the California Court were consolidated in April 1998;
however, the California Court denied the plaintiffs motion for class certification. In January
2000, the California Court of Appeal rejected the plaintiffs appeal of the decision. A
petition for review was filed with the California Supreme Court by the plaintiffs and was
denied. In February 2000, new plaintiffs who allege to have been shareholders of Bay Networks
during the relevant periods, filed a motion for intervention in the California Court seeking to
become the representatives of a class of shareholders. The motion was granted on June 8, 2001
and the new plaintiffs filed their complaint-in-intervention on an individual and purported
class representative basis alleging misrepresentations made in connection with the purchase and
sale of securities of Bay Networks in violation of California statutory and common law. On March
11, 2002, the California Court granted the defendants motion to strike the class allegations.
The plaintiffs were permitted to proceed on their individual claims. The intervenor-plaintiffs
appealed the dismissal of their class allegations. On July 25, 2003, the California Court of
Appeal reversed the trial courts dismissal of the intervenor-plaintiffs class allegations. On
September 3, 2003, the defendants filed a petition for review with the California Supreme Court
seeking permission to appeal the Court of Appeal decision. On October 22, 2003, the California
Supreme Court denied, without opinion, the defendants petition for review. On December 22,
2003, the plaintiffs served their motion for certification of a class of purchasers of Bay
Networks common shares from July 25, 1995 through to October 14, 1996. Hearing of the
plaintiffs motion for class certification was held on May 4, 2004. On July 27, 2004, the Court
entered an Amended Order Denying Motion of Intervenor Plaintiffs for Class Certification and
Setting Further Hearing. On August 9, 2004, the intervenor-plaintiffs obtained Court approval to dismiss their claims and this action and, on September 30,
2004, the Court entered dismissal with prejudice of the entire action of all parties and all
causes of action.Subsequent to the March 10, 2004 announcement in which NNC indicated it was likely that it and
Nortel Networks would need to revise their previously announced unaudited results for the year
ended December 31, 2003, and the results reported in certain of their quarterly reports for
2003, and to restate their 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
(see note 19). 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, Nortel Networks Corporation, and the Audit Committee Defendants
reached an agreement in which Nortel Networks 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 18, 2004, a purported class action lawsuit was filed in the U.S. District Court for the
Middle District of Tennessee on behalf of 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 36




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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 July 28, 2004, Nortel Networks and NNC, and certain directors and officers, and certain
former directors and officers, of Nortel Networks 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 conduct; causing NNC to issue false statements; and violating the
law.Except as otherwise described herein, in each of the matters described above, the plaintiffs are
seeking an unspecified amount of monetary damages.Nortel Networks is also a defendant in various other suits, claims, proceedings and
investigations which arise in the normal course of business.Nortel Networks is unable to ascertain the ultimate aggregate amount of monetary liability or
financial impact to Nortel Networks 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 Networks 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 Networks.
Nortel Networks or NNC, as applicable, and any named directors and officers of Nortel Networks
or NNC, as applicable, intend to vigorously defend these actions, suits, claims and proceedings. 37




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Environmental mattersNortel Networks operations are subject to a wide range of environmental laws in various
jurisdictions around the world. Nortel Networks seeks to operate its business in compliance with
such laws. In 2004, Nortel Networks expects to become 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 Networks 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 Networks will not be required to incur such costs in the
future. Nortel Networks has a corporate environmental management system standard and an
environmental program to promote such compliance. Moreover, Nortel Networks has a periodic,
risk-based, integrated environment, health and safety audit program.Nortel Networks environmental program focuses its activities on design for the environment,
supply chain and packaging reduction issues. Nortel Networks works with its suppliers and other
external groups to encourage the sharing of non-proprietary information on environmental
research.Nortel Networks 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, 2004,
the accruals on the consolidated balance sheet for environmental matters were $31. Based on
information available as of March 31, 2004, management believes that the existing accruals are
sufficient to satisfy probable and reasonably estimable environmental liabilities related to
known environmental matters. Any additional liability 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 Networks.Nortel Networks has remedial activities under way at 12 sites which are either currently or
previously owned or occupied facilities. An estimate of Nortel Networks 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 $31.Nortel Networks is also listed as a potentially responsible party (PRP) under the U.S.
Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) at six Superfund
sites in the U.S. An estimate of Nortel Networks 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 $31 referred to above.Liability under CERCLA may be imposed on a joint and several basis, without regard to the extent
of Nortel Networks involvement. In addition, the accuracy of Nortel Networks 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 Networks liability could be greater than its current
estimate.19.
    
    Subsequent eventsNortel Networks Audit Committee Independent Review; restatements; related mattersAs previously announced by NNC in October 2003, in late October 2003 the Nortel Networks
Audit Committee initiated the Independent Review of the facts and circumstances leading to the
First Restatement and engaged WCPHD to advise it in connection with the Independent Review.On March 10, 2004, NNC announced that as a result of the work done to date in connection with
the Independent Review, it was re-examining the establishment, timing of, support for and
release to income of certain accruals and provisions in prior periods. Further, it was likely
that NNC and Nortel Networks would need to revise their previously announced unaudited results
for the year ended December 31, 2003, and the results reported in certain of their quarterly
reports for 2003, and to restate their previously filed financial results for one or more
earlier periods. NNC announced on March 15, 2004 that the filing of the 2003 Annual Reports
would be delayed beyond March 30, 2004.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 38




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previously filed financial results for one or more earlier 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 April 28, 2004, NNC announced that the Independent Review was extended to include the second
half of 2003 and it was determined that the previously announced unaudited results for the year
ended December 31, 2003 needed to be revised and that the financial results reported in each of
NNCs and Nortel Networks quarterly periods of 2003 and for earlier periods including 2002 and
2001 needed to be restated. NNC also announced that it and Nortel Networks were not expected to
timely file their first quarter 2004 financial statements and, in accordance with Canadian
securities regulations, their 2003 Canadian GAAP audited financial statements and Annual
Information Form.In April 2004, Nortel Networks terminated for cause its former president and chief executive
officer, former chief financial officer and former controller and, in August 2004, seven
additional senior finance employees with significant responsibilities for Nortel Networks
financial reporting as a whole or for their respective business units and geographic regions in
August 2004.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, prepared during the period from January 1, 2000 to the date of the subpoena.
The materials sought are pertinent to an ongoing criminal investigation being conducted by the
U.S. Attorneys Office for the Northern District of Texas, Dallas Division.On May 17, 2004, NNC announced that the OSC had issued a temporary order that prohibits all
trading by directors, officers and certain current and former employees in the securities of
Nortel Networks and NNC, which temporary order was replaced with a final order issued on May 31,
2004. The final order remains in effect until two full business days following the receipt by
the OSC of all filings required to be made by Nortel Networks and NNC pursuant to Ontario
securities laws.On June 29, 2004, NNC announced that Nortel Networks and NNC did not expect to timely file
financial statements for the second quarter of 2004 and related periodic reports in accordance
with U.S. and Canadian securities laws.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 NNCs financial accounting situation.On August 19, 2004, Nortel Networks announced a new streamlined organizational structure,
effective October 1, 2004, that involved, among other things, combining the businesses of Nortel
Networks four segments into two business organizations: (i) Carrier Networks and Global
Operations, and (ii) Enterprise Networks. Further, a focused workforce reduction of
approximately 3,250 employees was announced. In addition, the Audit Committee anticipated that
there would be work done, in addition to that portion of the inquiry
which affected Nortel
Networks and NNCs ability to finalize their 2003 audited financial statements, in connection
with its Independent Review, on remedial measures, internal controls and improvements to
processes.On October 27, 2004, NNC announced that Nortel Networks and NNC did not expect to file their
third quarter 2004 financial statements, and the related periodic reports, by the required
deadlines in November 2004 in compliance with certain U.S. and Canadian securities regulations.Nortel Networks has terminated for cause 10 individuals, including its former president and
chief executive officer, its former chief financial officer and its former controller. Nortel
Networks has demanded repayment by the individuals terminated for cause of payments made under
Nortel Networks bonus plans in respect of 2003.Subsequent to the March 10, 2004 announcement, numerous class action complaints, including ERISA
class action complaints, have been filed against Nortel Networks and NNC in the U.S. and Canada.
In addition, a derivative action complaint has been filed against NNC. Nortel Networks and NNC
are subject to significant pending civil litigation which, if decided against Nortel Networks
and NNC, could result in substantial damages or other penalties which, in turn, could have a
material adverse effect on the business, results of operations, financial condition and
liquidity of Nortel Networks (see note 18). 39




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In January 2005, the Audit Committee reported the findings of the Independent Review, together
with its recommendations for governing principles for remedial measures that were developed for
the Audit Committee by WCPHD. Each of Nortel Networks and NNCs Boards of Directors has adopted
those recommendations in their entirety and directed management to develop a detailed plan and
timetable for their implementation, and will monitor their implementation.Also in January 2005, the Nortel Networks Audit Committee determined to review the facts and
circumstances leading to the restatement of certain revenues for specific transactions
identified in the Second Restatement. This review will have a particular emphasis on the
underlying conduct that led to the initial recognition of these revenues. The Audit Committee
will develop any appropriate additional remedial measures, and has engaged WCPHD to advise it in
connection with such review.EDC Support FacilityOn May 28, 2004, Nortel Networks obtained a new waiver from EDC of certain defaults under
the EDC Support Facility related to the delay in filing the 2003 Annual Reports and Nortel
Networks and NNCs quarterly reports on Form 10-Q for the three months ended March 31, 2004 (the
First Quarter Reports) and the Related Breaches, which waiver was to remain in effect until
the earliest of certain events or August 30, 2004. This waiver reclassified the previously
committed $300 revolving small bond sub-facility of the EDC Support Facility as uncommitted
support.A further waiver was obtained from EDC effective August 20, 2004 (the August Waiver) related
to the delay in filing the 2003 Annual Reports, the First Quarter Reports and Nortel Networks
and NNCs quarterly reports on Form 10-Q for the three months ended June 30, 2004 (the Second
Quarter Reports) and the Related Breaches, which waiver was to remain in effect until the
earliest of certain events or September 30, 2004.On September 29, 2004, Nortel Networks obtained a new waiver from EDC (the September Waiver)
which replaced the August Waiver on substantially the same terms as provided in the August
Waiver except that the September Waiver was to remain in effect until the earliest of certain
events or October 31, 2004.On October 29, 2004, Nortel Networks obtained a new waiver from EDC (the October Waiver) which
replaced the September Waiver on substantially the same terms as the September Waiver except
that the October Waiver remained in effect until the earliest of certain events or November 19,
2004.A further waiver was obtained from EDC effective November 19, 2004 (the November Waiver)
related to the delay in filing the 2003 Annual Reports, the First Quarter Reports, the Second
Quarter Reports and Nortel Networks and NNCs quarterly reports on Form 10-Q for the three
months ended September 30, 2004 (the Third Quarter Reports, and together with the 2003 Annual
Reports, the First Quarter Reports and the Second Quarter Reports, the Reports, and the Third
Quarter Reports together with the First Quarter Reports and Second Quarter Reports, the
Quarterly Reports) and the Related Breaches, which waiver was to remain in effect until the
earliest of certain events or December 10, 2004.On December 10, 2004, Nortel Networks obtained a new waiver from EDC (the December Waiver)
which replaced the November Waiver on substantially the same terms as the November Waiver except
that: (i) the December Waiver included an amendment to the EDC Support Facility to extend the
termination date of the EDC Support Facility to December 31, 2006 from December 31, 2005; and
(ii) the December Waiver remains in effect until the earliest of certain events including the
date on which Nortel Networks and NNC have filed all of the Reports or January 15, 2005.On January 14, 2005, NNL obtained a new waiver from EDC (the January Waiver) which replaced
the December Waiver on substantially the same terms as the December Waiver except that the
January Waiver remains in effect until the earliest of certain events including the date on
which Nortel Networks and NNL have filed all of the Reports or February 15, 2005.If Nortel Networks and NNC do not file all of the Reports by February 15, 2005, EDC will have
the right on such date (absent a further waiver in relation to the delayed filings and the
Related Breaches) to: (i) terminate the EDC Support Facility; (ii) exercise certain rights
against collateral; or (iii) require Nortel Networks to cash collateralize all existing support.In addition, the Related Breaches will continue beyond the filing of the Reports. Accordingly,
EDC will have the right beginning on February 15, 2005 (absent a further waiver of the Related
Breaches) to terminate or suspend the EDC 40




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Support Facility and exercise certain other rights against collateral notwithstanding the filing
of the Reports. While Nortel Networks is seeking a permanent waiver from EDC in connection with
the Related Breaches, there can be no assurance that Nortel Networks will receive any waiver or
as to the terms of any such waiver. The $300 revolving small bond sub-facility will not become
committed support until all of the Reports have been filed with the SEC, the trustees under
Nortel Networks and NNCs public trust indentures and EDC and Nortel Networks obtains a
permanent waiver of the Related Breaches.Credit facilities and security agreementsOn April 28, 2004, Nortel Networks notified the banks under the Five Year Facilities that
it was terminating these facilities. Absent such termination, the banks would have been
permitted, upon 30 days notice, to terminate their commitments under the Five Year Facilities
as a result of Nortel Networks inability to file the Nortel Networks 2003 Annual Report by April
29, 2004. Upon termination, the Five Year Facilities were undrawn.As a result of the termination of the Five Year Facilities, certain foreign security agreements
entered into by Nortel Networks and various of its subsidiaries under which shares of certain
subsidiaries of Nortel Networks 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 Networks and
NNCs outstanding public debt securities also terminated in accordance with their terms (see
note 21). In addition, guarantees by certain subsidiaries of Nortel Networks incorporated
outside of the U.S. and Canada terminated in accordance with their terms. Security agreements
remain in place under which substantially all of the assets of Nortel Networks 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 Networks U.S. and Canadian subsidiaries, are pledged in favor of EDC and the
holders of Nortel Networks and NNCs outstanding public debt securities. In addition, the
guarantees by certain of Nortel Networks wholly owned subsidiaries, including NNI, most of
Nortel Networks Canadian subsidiaries, Nortel Networks (Asia) Limited, Nortel Networks (Ireland)
Limited and Nortel Networks U.K. Limited, of Nortel Networks obligations under the EDC Support
Facility and Nortel Networks and NNCs outstanding public debt securities remain in place.Debt securitiesAs a result of the delay in filing the Reports, Nortel Networks and NNC have not been in
compliance with their obligations to deliver their respective SEC filings to relevant parties
under Nortel Networks and NNCs public debt indentures. As of December 31, 2004, approximately
$1,800 of notes of Nortel Networks (or its subsidiaries) and $1,800 of convertible debt
securities of NNC were outstanding.These delays have not resulted in an automatic event of default and acceleration of the
outstanding long-term debt and such default and acceleration cannot occur unless notice of such
non-compliance from holders of 25% of the outstanding principal amount of any relevant debt
securities is provided to Nortel Networks or NNC, as applicable, and Nortel Networks or NNC, as
applicable, fail to file and deliver the relevant report within 90 days after such notice is
provided, all in accordance with the terms of the indentures. While such notice could have been
given at any time after March 30, 2004, neither Nortel Networks nor NNC has received a notice to
the date of this report.After filing the 2003 Annual Reports, the First Quarter
Reports and the Second Quarter Reports, as a result of the delay in
filing the Third Quarter Reports, Nortel Networks and NNC continue not
to be in compliance with their obligations under Nortel Networks and NNCs public debt
indentures as described above. If notice were given, Nortel Networks
believes that it is probable that it and NNC would file and deliver
the Third Quarter Reports within 90 days of the receipt of such
a notice. In the unlikely event that acceleration of Nortel Networks and
NNCs debt securities were to occur, Nortel Networks may be unable to meet its payment
obligations.Stock exchangesAs a result of the continued delay in filing the Quarterly Reports, Nortel Networks is in
breach of the continued listing requirements of the NYSE and the TSX. To date, neither the NYSE
nor the TSX has commenced any suspension or delisting procedures in respect of Nortel Networks
Corporation common shares or other of Nortel Networks 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.Directory and operator services businessOn August 2, 2004, Nortel Networks completed the contribution of certain assets and
liabilities of its directory and operator services (DOS) business to VoltDelta Resources LLC
(VoltDelta), a wholly owned subsidiary of Volt 41




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Information Sciences, Inc. (VIS), in return for a 24 percent interest in VoltDelta. After a
period of two years, Nortel Networks and VIS each have an option to cause Nortel Networks to
sell its VoltDelta shares to VIS for proceeds ranging from $25 to $70. As a result of this
transaction, approximately 160 Nortel Networks DOS employees in North America and Mexico joined
VoltDelta. Nortel Networks recorded a gain on sale of businesses and assets of approximately
$50 in the third quarter of 2004.Evolution of Nortel Networks supply chain strategyOn June 29, 2004, Nortel Networks announced an agreement with Flextronics International
Ltd. (Flextronics), regarding the divestiture of substantially all of Nortel Networks
remaining manufacturing operations, including product integration, testing and repair operations
carried out in Nortel Networks Systems Houses 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 the Nortel Networks Monkstown, Northern Ireland and
Chateaudun, France Systems Houses, subject to the completion of the required information and
consultation process.Under the terms of the agreement and offer, Flextronics will also acquire Nortel Networks global
repair services, as well as certain design assets in Ottawa and Monkstown related to hardware
and embedded software design, and related product verification for certain established optical
products.Nortel Networks and Flextronics have entered into a four year supply agreement for manufacturing
services (whereby Flextronics will manage approximately $2,500 of Nortel Networks annual cost of
sales) 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. The portions of the transaction related to the manufacturing activities in Montreal and
Calgary are expected to close in the first and second quarters of 2005, respectively. The
balance of the transaction is expected to close on separate dates occurring during the first
half of 2005. 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 Networks to Flextronics. Nortel Networks
expects to receive cash proceeds ranging from approximately $675 to $725, which will be
allocated to each separate closing and, with respect to each closing, will be paid on an
installment basis up to nine months thereafter. Such payments will be subject to a number of
adjustments, including potential post-closing date asset valuations and potential post-closing
indemnity payments. Flextronics also has the ability in certain cases to exercise rights to
sell back to Nortel Networks certain inventory and equipment after the expiration of a specified
period (of up to fifteen months) following each respective closing date. Nortel Networks does
not expect such rights to be exercised with respect to any material amount of inventory and/or
equipment. The cash proceeds estimate is comprised of approximately $475 to $525 for inventory
and equipment and $200 for intangible assets. The cash proceeds would be partially offset by
related estimated transaction costs (including transition, potential severance, and information
technology implementation and real estate costs) of approximately $200.As a result of the proposed sale of the Northern Ireland Systems House to Flextronics, Nortel
Networks has determined that it is probable that certain grants received from government
agencies related to employment achievement targets will have to be repaid. The ultimate
repayment amount, if any, cannot be determined at this time. The total grants received which
could be subject to repayment is approximately $35. No amount has been accrued in the
consolidated financial statements.OtherOn May 7, 2004, Nortel Networks received $80 in proceeds from the sale of certain assets in
connection with a customer contract settlement in Latin America. This resulted in a gain of
$78, which will be included in (gain) loss on sale of businesses and assets for the three months
ended June 30, 2004.In August 2004, Nortel Networks entered into a contract with Bharat Sanchar Nigram Limited to
establish a wireless network in India. Nortel Networks commitments to date for orders received
under this contract have resulted in an estimated project loss of approximately $150, which has
been recorded in the third quarter of 2004.On October 26, 2004, Nortel Networks entered into an agreement with Foundry Networks, Inc.
(Foundry) to settle outstanding patent infringement claims and counterclaims by the parties.
As part of the settlement, Nortel Networks granted Foundry a four year license 42




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under certain patents, and Foundry paid $35 to Nortel
Networks.On December 15 and 16, 2004, Nortel Networks sold certain notes receivable and convertible notes
receivable that had been received as a result of the restructuring of a customer financing
arrangement for cash proceeds of $116. The net carrying amount of the notes receivable and
convertible notes receivable was $56.On December 23, 2004, a customer financing arrangement was restructured. The notes receivable
that were restructured had a net carrying amount as of December 31, 2003 of $13, net of
provisions for doubtful accounts of $147 ($55 of the provision is included in discontinued
operations). Nortel Networks is currently assessing the value of the restructured notes
receivable and expects that an increase in value from the net carrying amount has occurred.On January 20, 2005, Nortel Networks 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
Networks expects to have a definitive joint venture agreement by June 30, 2005. Nortel Networks
anticipates that it will own 49% of the joint venture and China Putian will own 51%.On January 23, 2005, Nortel Networks signed a Memorandum of Understanding with LG Electronics 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 execution of a definitive agreement. Nortel Networks expects to complete this
transaction in the second quarter of 2005. In the proposed joint
venture, Nortel Networks anticipates that it will
have 50% plus one share.20.
    
    Reconciliation from U.S. GAAP to Canadian GAAPNew Canadian securities 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 interim periods in fiscal 2004 and 2005, Nortel Networks will include 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 interim reconciliation will be required under
current Canadian securities regulations. Prior to 2004, Nortel Networks prepared interim
financial statements (with accompanying notes) and Managements Discussion and Analysis -
Canadian Supplement in accordance with Canadian GAAP, 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 Networks 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 Networks 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, 2004 and 2003: March 31,
    
    
    March 31,2004
    
    
    2003As restated *Net earnings (loss)U. S. GAAP
    
    $
    117
    
    
    $
    (52
    )Derivative accounting(b)
    
    
    26
    
    
    
    (4
    )Cumulative effect of accounting change  net of tax(c)
    
    
    
    
    
    
    12Other
    
    
    4
    
    
    
    (19
    )Canadian GAAP
    
    $
    147
    
    
    $
    (63
    )
 *
    
    See note 20(i).
  There were no material differences between U.S. GAAP and Canadian GAAP affecting statements
of cash flows for the three months ended March 31, 2004 and 2003.The following details the material differences between U.S. GAAP and Canadian GAAP for balance
sheet information as of March 31, 2004 and December 31, 2003: 43




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March 31, 2004
    
    
    December 31, 2003U.S.
    
    
    
    
    
    
    Canadian
    
    
    U.S.
    
    
    
    
    
    
    CanadianGAAP
    
    
    Adjustments
    
    
    GAAP
    
    
    GAAP
    
    
    Adjustments
    
    
    GAAPASSETSCurrent assets(g)
    
    $
    8,222
    
    
    $
    7
    
    
    $
    8,229
    
    
    $
    8,613
    
    
    $
    4
    
    
    $
    8,617Investments(d)
    
    
    217
    
    
    
    (64
    )
    
    
    153
    
    
    
    244
    
    
    
    (105
    )
    
    
    139Plant and equipment  net
    
    
    1,596
    
    
    
    (3
    )
    
    
    1,593
    
    
    
    1,654
    
    
    
    (5
    )
    
    
    1,649Goodwill(a)
    
    
    2,123
    
    
    
    (910
    )
    
    
    1,213
    
    
    
    2,125
    
    
    
    (910
    )
    
    
    1,215Intangible assets  net(h)
    
    
    82
    
    
    
    (37
    )
    
    
    45
    
    
    
    86
    
    
    
    (41
    )
    
    
    45Deferred income taxes  net(h)
    
    
    3,336
    
    
    
    (202
    )
    
    
    3,134
    
    
    
    3,397
    
    
    
    (197
    )
    
    
    3,200Other assets(b)(h)
    
    
    349
    
    
    
    8
    
    
    
    357
    
    
    
    337
    
    
    
    24
    
    
    
    361Total assets
    
    $
    15,925
    
    
    $
    (1,201
    )
    
    $
    14,724
    
    
    $
    16,456
    
    
    $
    (1,230
    )
    
    $
    15,226LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities(f)(g)
    
    $
    4,341
    
    
    $
    6
    
    
    $
    4,347
    
    
    $
    4,961
    
    
    $
    5
    
    
    $
    4,966Long-term debt(b)
    
    
    2,083
    
    
    
    (53
    )
    
    
    2,030
    
    
    
    2,091
    
    
    
    (55
    )
    
    
    2,036Deferred income taxes  net(h)
    
    
    168
    
    
    
    13
    
    
    
    181
    
    
    
    190
    
    
    
    13
    
    
    
    203Other liabilities(b)(h)
    
    
    2,961
    
    
    
    (1,169
    )
    
    
    1,792
    
    
    
    2,944
    
    
    
    (1,155
    )
    
    
    1,789Total liabilities
    
    
    9,553
    
    
    
    (1,203
    )
    
    
    8,350
    
    
    
    10,186
    
    
    
    (1,192
    )
    
    
    8,994Minority interests in subsidiary companies
    
    
    86
    
    
    
    
    
    
    
    86
    
    
    
    80
    
    
    
    
    
    
    
    80Total
shareholders equity(d)(f)(h)
    
    
    6,286
    
    
    
    2
    
    
    
    6,288
    
    
    
    6,190
    
    
    
    (38
    )
    
    
    6,152Total liabilities and shareholders equity
    
    $
    15,925
    
    
    $
    (1,201
    )
    
    $
    14,724
    
    
    $
    16,456
    
    
    $
    (1,230
    )
    
    $
    15,226
  The significant differences between U.S. GAAP and Canadian GAAP that impact the
consolidated financial statements of Nortel Networks include the following:  (a)
    
    Business combinationsAll of Nortel Networks 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 Networks 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 Networks 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.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. 44




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Under Canadian GAAP, Nortel Networks is required to capitalize the value assigned to
in-process R&D and amortize the asset value over its estimated useful life. Under U.S.
GAAP, this value is written off immediately. The difference due to capitalization of
in-process R&D expense is included in other, in the above reconciliation of net earnings
(loss).(b)
    
    Derivative accountingUnder U.S. GAAP, effective January 1, 2001, Nortel Networks 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 fall into 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.Effective January 1, 2004, Nortel Networks adopted Accounting Guideline 13, Hedging
Relationships (AcG-13), which establishes specific criteria for derivatives to qualify
for hedge accounting. Nortel Networks 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 Networks 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 during the three months ended March 31, 2004.(c)
    
    Asset retirement obligationsUnder U.S. GAAP, Nortel Networks adopted SFAS 143 effective January 1, 2003, and
recorded a cumulative effect of accounting change, net of tax within net earnings (loss) on
the date of adoption. Nortel Networks adopted similar Canadian guidance, CICA Handbook
Section 3110, Asset Retirement Obligations, effective January 1, 2004, with retroactive
restatement of prior periods. Under Canadian GAAP, the cumulative effect of adoption as of
January 1, 2003 was recorded as an adjustment to opening accumulated deficit, as opposed to
an adjustment within net earnings (loss) under U.S. GAAP, resulting in a difference of $12. 45




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##### Table of Contents



(d)
    
    InvestmentsUnder U.S. GAAP, certain investment securities deemed available-for-sale by Nortel
Networks are remeasured 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.(e)
    
    Other financial statement presentation differencesUnder Canadian GAAP, global investment tax credits are required to be deducted from R&D
expense while under U.S. GAAP, these amounts are required to be deducted from the income tax
benefit (expense). The impact of this difference in the three months ended March 31, 2004
and 2003 of $11 and $9, 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).(f)
    
    OtherUnder U.S. GAAP, effective December 31, 2002, Nortel Networks adopted the disclosure
requirements of FIN 45. In addition, effective January 1, 2003, Nortel Networks adopted the
initial recognition and measurement provisions of FIN 45 that require a guarantor to
recognize, at the inception of certain types of guarantees, a liability for the estimated
fair value of the obligation undertaken in issuing the guarantee. The recognition
requirements of FIN 45 are applicable for certain guarantees issued or modified after
December 31, 2002. Under Canadian GAAP, there is no requirement to recognize a liability
for the estimated fair value of the obligation undertaken in issuing the guarantee.
However, a contingent loss that is likely to be incurred is recognized if it can be
reasonably estimated.Under U.S. GAAP, effective January 1, 2003, Nortel Networks adopted SFAS 146. SFAS 146
requires that costs associated with an exit or disposal activity be recognized when the
liability is incurred. Under Canadian GAAP, the Emerging Issues Committee (EIC) of the
CICA issued EIC 134, Accounting for Severance and Termination Benefits (EIC 134), and
EIC 135, Accounting for Costs Associated with Exit and Disposal Activities (Including Costs
Incurred in a Restructuring) (EIC 135), which harmonize the requirements with SFAS 146.
Effective March 31, 2003, Nortel Networks adopted EIC 134 and EIC 135.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.(g)
    
    Joint venturesNortel Networks 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.(h)
    
    Pension and other post-retirement benefitsUnder U.S. GAAP, a minimum additional pension liability 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.(i)
    
    RestatementAs described in note 2, Nortel Networks has restated its consolidated financial
statements for the years ended December 31, 2002 and 2001, and the quarters ended March 31,
June 30, and September 30, 2003. The following table presents the impact of the Second
Restatement adjustments on Nortel Networks previously reported
consolidated statement of operations for the three 46




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##### Table of Contents



months ended March 31, 2003 prepared in
accordance with Canadian GAAP: As previouslyreported
    
    
    Adjustments
    
    
    As restatedRevenues
    
    $
    2,376
    
    
    $
    (80
    )
    
    $
    2,296Cost of revenues
    
    
    1,323
    
    
    
    65
    
    
    
    1,388Gross profit
    
    
    1,053
    
    
    
    (145
    )
    
    
    908Selling, general and administrative expense
    
    
    509
    
    
    
    (17
    )
    
    
    492Research and development expense
    
    
    497
    
    
    
    (28
    )
    
    
    469Special charges
    
    
    115
    
    
    
    28
    
    
    
    143(Gain) loss on sale of businesses and assets
    
    
    (4
    )
    
    
    
    
    
    
    (4
    )Operating earnings (loss)
    
    
    (64
    )
    
    
    (128
    )
    
    
    (192
    )Other income (expense)  net
    
    
    (17
    )
    
    
    104
    
    
    
    87Interest expenseLong-term debt
    
    
    (23
    )
    
    
    (2
    )
    
    
    (25
    )Other
    
    
    (7
    )
    
    
    (1
    )
    
    
    (8
    )Earnings (loss) from continuing operations before income taxes,
non-controlling interests and equity in net loss of associated companies
    
    
    (111
    )
    
    
    (27
    )
    
    
    (138
    )Income tax (expense) benefit
    
    
    (22
    )
    
    
    3
    
    
    
    (19
    )(133
    )
    
    
    (24
    )
    
    
    (157
    )Non-controlling interests  net of tax
    
    
    8
    
    
    
    (25
    )
    
    
    (17
    )Equity in net (loss) of associated companies  net of tax
    
    
    (10
    )
    
    
    (12
    )
    
    
    (22
    )Net earnings (loss) from continuing operations
    
    
    (135
    )
    
    
    (61
    )
    
    
    (196
    )Net earnings (loss) from discontinued operations  net of tax
    
    
    164
    
    
    
    (31
    )
    
    
    133Net earnings (loss) before cumulative effect of accounting change
    
    
    29
    
    
    
    (92
    )
    
    
    (63
    )Cumulative effect of accounting change  net of tax
    
    
    
    
    
    
    
    
    
    
    Net earnings (loss)
    
    
    29
    
    
    
    (92
    )
    
    
    (63
    )Dividends on preferred shares
    
    
    5
    
    
    
    3
    
    
    
    8Net earnings (loss) applicable to common shares
    
    $
    24
    
    
    $
    (95
    )
    
    $
    (71
    )
  The impact of the Second Restatement adjustments for the three months ended March 31,
2003 was an increase to net loss prepared in accordance with Canadian GAAP and U.S. GAAP of
$92 and $105, respectively. The Second Restatement adjustments primarily related to the
following items, each of which reflect a number of related adjustments that have been
aggregated for disclosure purposes: revenues and cost of revenues; foreign exchange;
intercompany balances; special charges; other; reclassifications; and discontinued
operations. See note 2 for a description of these differences.The following table presents the impact of the Second Restatement adjustments on Nortel
Networks previously reported consolidated balance sheet prepared in accordance with Canadian
GAAP as of March 31, 2003: 47




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##### Table of Contents



As previouslyreported
    
    
    Adjustments
    
    
    As restatedASSETSCurrent assetsCash and cash equivalents
    
    $
    3,848
    
    
    $
    2
    
    
    $
    3,850Restricted cash and cash equivalents
    
    
    227
    
    
    
    
    
    
    
    227Accounts receivable  net
    
    
    2,138
    
    
    
    (43
    )
    
    
    2,095Inventories  net
    
    
    885
    
    
    
    560
    
    
    
    1,445Income taxes recoverable
    
    
    60
    
    
    
    43
    
    
    
    103Future income taxes  net
    
    
    784
    
    
    
    
    
    
    
    784Other current assets
    
    
    428
    
    
    
    (35
    )
    
    
    393Total current assets
    
    
    8,370
    
    
    
    527
    
    
    
    8,897Investments
    
    
    183
    
    
    
    28
    
    
    
    211Plant and equipment  net
    
    
    1,431
    
    
    
    216
    
    
    
    1,647Goodwill
    
    
    1,111
    
    
    
    (2
    )
    
    
    1,109Future income taxes  net
    
    
    2,713
    
    
    
    27
    
    
    
    2,740Other assets
    
    
    657
    
    
    
    (49
    )
    
    
    608Total assets
    
    $
    14,465
    
    
    $
    747
    
    
    $
    15,212LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilitiesNotes payable
    
    $
    12
    
    
    $
    34
    
    
    $
    46Trade and other accounts payable
    
    
    764
    
    
    
    (61
    )
    
    
    703Payroll and benefit-related liabilities
    
    
    650
    
    
    
    (58
    )
    
    
    592Contractual liabilities
    
    
    1,123
    
    
    
    (241
    )
    
    
    882Restructuring
    
    
    436
    
    
    
    (45
    )
    
    
    391Other accrued liabilities
    
    
    2,608
    
    
    
    277
    
    
    
    2,885Long-term debt due within one year
    
    
    234
    
    
    
    10
    
    
    
    244Total current liabilities
    
    
    5,827
    
    
    
    (84
    )
    
    
    5,743Long-term debt
    
    
    1,819
    
    
    
    221
    
    
    
    2,040Future income taxes  net
    
    
    430
    
    
    
    (7
    )
    
    
    423Other liabilities
    
    
    1,531
    
    
    
    392
    
    
    
    1,923Total liabilities
    
    
    9,607
    
    
    
    522
    
    
    
    10,129Non-controlling interests in subsidiary companies
    
    
    114
    
    
    
    (10
    )
    
    
    104SHAREHOLDERS EQUITYPreferred shares
    
    
    536
    
    
    
    
    
    
    
    536Common shares
    
    
    1,794
    
    
    
    
    
    
    
    1,794Contributed surplus
    
    
    22,148
    
    
    
    4
    
    
    
    22,152Deficit
    
    
    (19,166
    )
    
    
    (62
    )
    
    
    (19,228
    )Foreign currency translation adjustment
    
    
    (568
    )
    
    
    293
    
    
    
    (275
    )Total shareholders equity
    
    
    4,744
    
    
    
    235
    
    
    
    4,979Total liabilities and shareholders equity
    
    $
    14,465
    
    
    $
    747
    
    
    $
    15,212
  21.
    
    Supplemental consolidating financial informationAs of March 31, 2004, as a result of Nortel Networks credit ratings, various liens, pledges
and guarantees were effective under security agreements entered into by Nortel Networks and
various of its subsidiaries that pledged substantially all of the assets of Nortel Networks in
favor of the banks under the Five Year Facilities, EDC and the holders of Nortel Networks and
NNCs outstanding public debt securities, which debt securities represent substantially all of
NNCs consolidated long-term debt (see note 19).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 48




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##### Table of Contents



Investors Service, Inc. (Moodys) downgrade of Nortel
Networks 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 Networks and
NNC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
Networks and NNIs then existing credit facilities. Nortel Networks obligations under the EDC
Support Facility became secured on an equal and ratable basis under the security agreements on
February 14, 2003.As of March 31, 2004, the security provided under the security agreements was comprised of
pledges of substantially all of the assets of Nortel Networks and those of most of its U.S. and
Canadian subsidiaries and pledges of shares in certain of Nortel Networks other subsidiaries.
In addition, certain of Nortel Networks wholly owned subsidiaries guaranteed Nortel Networks
obligations under the credit and support facilities and outstanding public debt securities (the
Guarantor Subsidiaries). Non-guarantor subsidiaries (the Non-Guarantor Subsidiaries)
represented either wholly owned subsidiaries of Nortel Networks whose shares were pledged, or
were the remaining subsidiaries of Nortel Networks which did not provide liens, pledges or
guarantees (see note 19).If Nortel Networks 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 both the Five Year Facilities and the EDC
Support Facility are terminated, or expire, the security and guarantees will also be released in
full (see note 19). Nortel Networks 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 (see note 10). Accordingly, if the
EDC Support Facility is secured by cash or other alternate collateral or arrangements acceptable
to EDC and if the Five Year Facilities are terminated or expire, the security and guarantees
will also be released in full (see note 19 for additional information related to the Five Year
Facilities and the security agreements).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 as of March 31, 2004 and
December 31, 2003, and for the three months ended March 31, 2004 and 2003, respectively (see
note 19).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. 49




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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
    
    
    $
    1,797
    
    
    $
    772
    
    
    $
    (1,023
    )
    
    $
    2,444Cost of revenues
    
    
    487
    
    
    
    1,299
    
    
    
    609
    
    
    
    (1,023
    )
    
    
    1,372Gross profit
    
    
    411
    
    
    
    498
    
    
    
    163
    
    
    
    
    
    
    
    1,072Selling, general and administrative expense
    
    
    104
    
    
    
    364
    
    
    
    70
    
    
    
    
    
    
    
    538Research and development expense
    
    
    194
    
    
    
    205
    
    
    
    67
    
    
    
    
    
    
    
    466Amortization of acquired technology
    
    
    
    
    
    
    
    
    
    
    3
    
    
    
    
    
    
    
    3Special charges
    
    
    3
    
    
    
    1
    
    
    
    3
    
    
    
    
    
    
    
    7(Gain) loss on sale of businesses and assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Operating earnings (loss)
    
    
    110
    
    
    
    (72
    )
    
    
    20
    
    
    
    
    
    
    
    58Other income (expense)  net
    
    
    33
    
    
    
    58
    
    
    
    (3
    )
    
    
    
    
    
    
    88Interest expenseLong-term debt
    
    
    (16
    )
    
    
    (1
    )
    
    
    (7
    )
    
    
    
    
    
    
    (24
    )Other
    
    
    
    
    
    
    (22
    )
    
    
    14
    
    
    
    
    
    
    
    (8
    )Earnings (loss) from continuing operations before
income taxes, minority interests and equity in
net loss of associated companies
    
    
    127
    
    
    
    (37
    )
    
    
    24
    
    
    
    
    
    
    
    114Income tax benefit (expense)
    
    
    37
    
    
    
    (16
    )
    
    
    (12
    )
    
    
    
    
    
    
    9164
    
    
    
    (53
    )
    
    
    12
    
    
    
    
    
    
    
    123Minority interests  net of tax
    
    
    
    
    
    
    
    
    
    
    (6
    )
    
    
    
    
    
    
    (6
    )Equity in
net loss of associated companies  net of tax
    
    
    (48
    )
    
    
    (246
    )
    
    
    
    
    
    
    293
    
    
    
    (1
    )Net earnings (loss) from continuing operations
    
    
    116
    
    
    
    (299
    )
    
    
    6
    
    
    
    293
    
    
    
    116Net earnings
(loss) from discontinued operations  net of tax
    
    
    1
    
    
    
    1
    
    
    
    
    
    
    
    (1
    )
    
    
    1Net earnings (loss)
    
    
    117
    
    
    
    (298
    )
    
    
    6
    
    
    
    292
    
    
    
    117Dividends on preferred shares
    
    
    9
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9Net earnings (loss) applicable to common shares
    
    $
    108
    
    
    $
    (298
    )
    
    $
    6
    
    
    $
    292
    
    
    $
    108
 50




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Supplemental Consolidating Statements of Operations for the three months ended March 31, 2003: Nortel
    
    
    
    
    
    
    Non-Networks
    
    
    Guarantor
    
    
    Guarantor(millions of U.S. dollars)
    
    Limited
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    TotalRevenues
    
    $
    869
    
    
    $
    1,701
    
    
    $
    587
    
    
    $
    (862
    )
    
    $
    2,295Cost of revenues
    
    
    460
    
    
    
    1,395
    
    
    
    395
    
    
    
    (862
    )
    
    
    1,388Gross profit
    
    
    409
    
    
    
    306
    
    
    
    192
    
    
    
    
    
    
    
    907Selling, general and administrative expense
    
    
    147
    
    
    
    327
    
    
    
    16
    
    
    
    
    
    
    
    490Research and development expense
    
    
    193
    
    
    
    217
    
    
    
    67
    
    
    
    
    
    
    
    477Special charges
    
    
    32
    
    
    
    83
    
    
    
    25
    
    
    
    
    
    
    
    140(Gain) loss on sale of businesses and assets
    
    
    
    
    
    
    3
    
    
    
    (4
    )
    
    
    
    
    
    
    (1
    )Operating earnings (loss)
    
    
    37
    
    
    
    (324
    )
    
    
    88
    
    
    
    
    
    
    
    (199
    )Other income (expense)  net
    
    
    134
    
    
    
    (24
    )
    
    
    (15
    )
    
    
    
    
    
    
    95Interest expenseLong-term debt
    
    
    (18
    )
    
    
    
    
    
    
    (7
    )
    
    
    
    
    
    
    (25
    )Other
    
    
    (2
    )
    
    
    (16
    )
    
    
    10
    
    
    
    
    
    
    
    (8
    )Earnings (loss) from continuing operations before
income taxes, minority interests and equity in
net loss of associated companies
    
    
    151
    
    
    
    (364
    )
    
    
    76
    
    
    
    
    
    
    
    (137
    )Income tax benefit (expense)
    
    
    154
    
    
    
    (292
    )
    
    
    141
    
    
    
    
    
    
    
    3305
    
    
    
    (656
    )
    
    
    217
    
    
    
    
    
    
    
    (134
    )Minority interests  net of tax
    
    
    
    
    
    
    
    
    
    
    (17
    )
    
    
    
    
    
    
    (17
    )Equity in
net loss of associated companies  net of tax
    
    
    (486
    )
    
    
    337
    
    
    
    (8
    )
    
    
    135
    
    
    
    (22
    )Net earnings (loss) from continuing operations  net of tax
    
    
    (181
    )
    
    
    (319
    )
    
    
    192
    
    
    
    135
    
    
    
    (173
    )Net earnings (loss) from discontinued operations  net of tax
    
    
    133
    
    
    
    86
    
    
    
    
    
    
    
    (86
    )
    
    
    133Net earnings (loss) from continuing operations before cumulative
effect of accounting change  net of tax
    
    
    (48
    )
    
    
    (233
    )
    
    
    192
    
    
    
    49
    
    
    
    (40
    )Cumulative effect of accounting change  net of tax
    
    
    (4
    )
    
    
    (8
    )
    
    
    
    
    
    
    
    
    
    
    (12
    )Net earnings (loss)
    
    
    (52
    )
    
    
    (241
    )
    
    
    192
    
    
    
    49
    
    
    
    (52
    )Dividends on preferred shares
    
    
    8
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8Net earnings (loss) applicable to common shares
    
    $
    (60
    )
    
    $
    (241
    )
    
    $
    192
    
    
    $
    49
    
    
    $
    (60
    )
 51




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##### Table of Contents



Supplemental Consolidating Balance Sheets as of March 31, 2004: Nortel
    
    
    
    
    
    
    Non-Networks
    
    
    Guarantor
    
    
    Guarantor(millions of U.S. dollars)
    
    Limited
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    TotalASSETSCurrent assetsCash and cash equivalents
    
    $
    23
    
    
    $
    2,846
    
    
    $
    663
    
    
    $
    
    
    
    $
    3,532Restricted cash and cash equivalents
    
    
    25
    
    
    
    35
    
    
    
    2
    
    
    
    
    
    
    
    62Accounts receivable  net
    
    
    318
    
    
    
    1,474
    
    
    
    605
    
    
    
    
    
    
    
    2,397Intercompany/related party accounts receivable
    
    
    319
    
    
    
    1,038
    
    
    
    720
    
    
    
    (1,890
    )
    
    
    187Inventories  net
    
    
    301
    
    
    
    624
    
    
    
    321
    
    
    
    
    
    
    
    1,246Income taxes recoverable
    
    
    13
    
    
    
    57
    
    
    
    15
    
    
    
    
    
    
    
    85Deferred income taxes  net
    
    
    53
    
    
    
    347
    
    
    
    
    
    
    
    
    
    
    
    400Other current assets
    
    
    16
    
    
    
    205
    
    
    
    92
    
    
    
    
    
    
    
    313Total current assets
    
    
    1,068
    
    
    
    6,626
    
    
    
    2,418
    
    
    
    (1,890
    )
    
    
    8,222Investments
    
    
    1,956
    
    
    
    (7,900
    )
    
    
    279
    
    
    
    5,882
    
    
    
    217Intercompany advances
    
    
    257
    
    
    
    699
    
    
    
    1,878
    
    
    
    (2,834
    )
    
    
    Plant and equipment  net
    
    
    455
    
    
    
    792
    
    
    
    349
    
    
    
    
    
    
    
    1,596Goodwill
    
    
    
    
    
    
    1,962
    
    
    
    161
    
    
    
    
    
    
    
    2,123Intangible assets  net
    
    
    39
    
    
    
    1
    
    
    
    42
    
    
    
    
    
    
    
    82Deferred income taxes  net
    
    
    1,697
    
    
    
    1,575
    
    
    
    64
    
    
    
    
    
    
    
    3,336Other assets
    
    
    116
    
    
    
    60
    
    
    
    173
    
    
    
    
    
    
    
    349Total assets
    
    $
    5,588
    
    
    $
    3,815
    
    
    $
    5,364
    
    
    $
    1,158
    
    
    $
    15,925LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilitiesNotes payable
    
    $
    2
    
    
    $
    3
    
    
    $
    8
    
    
    $
    
    
    
    $
    13Trade and other accounts payable
    
    
    235
    
    
    
    506
    
    
    
    78
    
    
    
    
    
    
    
    819Intercompany/related party accounts payable
    
    
    (3,895
    )
    
    
    3,131
    
    
    
    2,654
    
    
    
    (1,890
    )
    
    
    Payroll and benefit-related liabilities
    
    
    100
    
    
    
    311
    
    
    
    112
    
    
    
    
    
    
    
    523Contractual liabilities
    
    
    31
    
    
    
    292
    
    
    
    163
    
    
    
    
    
    
    
    486Restructuring
    
    
    39
    
    
    
    103
    
    
    
    19
    
    
    
    
    
    
    
    161Other accrued liabilities
    
    
    311
    
    
    
    1,509
    
    
    
    496
    
    
    
    
    
    
    
    2,316Long-term debt due within one year
    
    
    11
    
    
    
    13
    
    
    
    (1
    )
    
    
    
    
    
    
    23Total current liabilities
    
    
    (3,166
    )
    
    
    5,868
    
    
    
    3,529
    
    
    
    (1,890
    )
    
    
    4,341Long-term debt
    
    
    1,546
    
    
    
    125
    
    
    
    412
    
    
    
    
    
    
    
    2,083Deferred income taxes  net
    
    
    1
    
    
    
    164
    
    
    
    3
    
    
    
    
    
    
    
    168Other liabilities
    
    
    920
    
    
    
    1,850
    
    
    
    191
    
    
    
    
    
    
    
    2,961Intercompany advances
    
    
    1
    
    
    
    297
    
    
    
    2,536
    
    
    
    (2,834
    )
    
    
    Total
liabilities
    
    
    (698
    )
    
    
    8,304
    
    
    
    6,671
    
    
    
    (4,724
    )
    
    
    9,553Minority interests in subsidiary companies
    
    
    
    
    
    
    
    
    
    
    86
    
    
    
    
    
    
    
    86SHAREHOLDERS EQUITYPreferred shares
    
    
    536
    
    
    
    237
    
    
    
    
    
    
    
    (237
    )
    
    
    536Common shares
    
    
    1,211
    
    
    
    6,091
    
    
    
    799
    
    
    
    (6,890
    )
    
    
    1,211Additional paid-in capital
    
    
    22,047
    
    
    
    1,091
    
    
    
    3,893
    
    
    
    (4,984
    )
    
    
    22,047Accumulated deficit
    
    
    (16,958
    )
    
    
    (12,919
    )
    
    
    (6,028
    )
    
    
    18,947
    
    
    
    (16,958
    )Accumulated other comprehensive income (loss)
    
    
    (550
    )
    
    
    1,011
    
    
    
    (57
    )
    
    
    (954
    )
    
    
    (550
    )Total shareholders equity
    
    
    6,286
    
    
    
    (4,489
    )
    
    
    (1,393
    )
    
    
    5,882
    
    
    
    6,286Total liabilities and shareholders equity
    
    $
    5,588
    
    
    $
    3,815
    
    
    $
    5,364
    
    
    $
    1,158
    
    
    $
    15,925
 52




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##### Table of Contents



Supplemental Consolidating Balance Sheets as of December 31, 2003: Nortel
    
    
    
    
    
    
    Non-Networks
    
    
    Guarantor
    
    
    Guarantor(millions of U.S. dollars)
    
    Limited
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    TotalASSETSCurrent assetsCash and cash equivalents
    
    $
    (8
    )
    
    $
    3,164
    
    
    $
    772
    
    
    $
    
    
    
    $
    3,928Restricted cash and cash equivalents
    
    
    25
    
    
    
    37
    
    
    
    1
    
    
    
    
    
    
    
    63Accounts receivable  net
    
    
    314
    
    
    
    1,671
    
    
    
    520
    
    
    
    
    
    
    
    2,505Intercompany/related party accounts receivable
    
    
    345
    
    
    
    1,053
    
    
    
    808
    
    
    
    (2,052
    )
    
    
    154Inventories  net
    
    
    302
    
    
    
    565
    
    
    
    323
    
    
    
    
    
    
    
    1,190Income taxes recoverable
    
    
    13
    
    
    
    52
    
    
    
    25
    
    
    
    
    
    
    
    90Deferred income taxes  net
    
    
    67
    
    
    
    302
    
    
    
    
    
    
    
    
    
    
    
    369Other current assets
    
    
    31
    
    
    
    178
    
    
    
    105
    
    
    
    
    
    
    
    314Total current assets
    
    
    1,089
    
    
    
    7,022
    
    
    
    2,554
    
    
    
    (2,052
    )
    
    
    8,613Investments
    
    
    1,995
    
    
    
    (7,568
    )
    
    
    285
    
    
    
    5,532
    
    
    
    244Intercompany advances
    
    
    166
    
    
    
    537
    
    
    
    1,855
    
    
    
    (2,558
    )
    
    
    Plant and equipment  net
    
    
    475
    
    
    
    817
    
    
    
    362
    
    
    
    
    
    
    
    1,654Goodwill
    
    
    
    
    
    
    1,962
    
    
    
    163
    
    
    
    
    
    
    
    2,125Intangible assets  net
    
    
    40
    
    
    
    1
    
    
    
    45
    
    
    
    
    
    
    
    86Deferred income taxes  net
    
    
    1,673
    
    
    
    1,655
    
    
    
    69
    
    
    
    
    
    
    
    3,397Other assets
    
    
    102
    
    
    
    60
    
    
    
    175
    
    
    
    
    
    
    
    337Total assets
    
    $
    5,540
    
    
    $
    4,486
    
    
    $
    5,508
    
    
    $
    922
    
    
    $
    16,456LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilitiesNotes payable
    
    $
    2
    
    
    $
    3
    
    
    $
    12
    
    
    $
    
    
    
    $
    17Trade and other accounts payable
    
    
    347
    
    
    
    406
    
    
    
    107
    
    
    
    
    
    
    
    860Intercompany/related party accounts payable
    
    
    (4,071
    )
    
    
    3,211
    
    
    
    2,912
    
    
    
    (2,052
    )
    
    
    Payroll and benefit-related liabilities
    
    
    137
    
    
    
    479
    
    
    
    148
    
    
    
    
    
    
    
    764Contractual liabilities
    
    
    26
    
    
    
    309
    
    
    
    194
    
    
    
    
    
    
    
    529Restructuring
    
    
    52
    
    
    
    138
    
    
    
    15
    
    
    
    
    
    
    
    205Other accrued liabilities
    
    
    356
    
    
    
    1,660
    
    
    
    451
    
    
    
    
    
    
    
    2,467Long-term debt due within one year
    
    
    11
    
    
    
    101
    
    
    
    7
    
    
    
    
    
    
    
    119Total current liabilities
    
    
    (3,140
    )
    
    
    6,307
    
    
    
    3,846
    
    
    
    (2,052
    )
    
    
    4,961Long-term debt
    
    
    1,549
    
    
    
    127
    
    
    
    415
    
    
    
    
    
    
    
    2,091Deferred income taxes  net
    
    
    
    
    
    
    173
    
    
    
    17
    
    
    
    
    
    
    
    190Other liabilities
    
    
    930
    
    
    
    1,811
    
    
    
    203
    
    
    
    
    
    
    
    2,944Intercompany advances
    
    
    11
    
    
    
    297
    
    
    
    2,250
    
    
    
    (2,558
    )
    
    
    Total
liabilities
    
    
    (650
    )
    
    
    8,715
    
    
    
    6,731
    
    
    
    (4,610
    )
    
    
    10,186Minority interests in subsidiary companies
    
    
    
    
    
    
    
    
    
    
    80
    
    
    
    
    
    
    
    80SHAREHOLDERS EQUITYPreferred shares
    
    
    536
    
    
    
    237
    
    
    
    
    
    
    
    (237
    )
    
    
    536Common shares
    
    
    1,211
    
    
    
    6,089
    
    
    
    799
    
    
    
    (6,888
    )
    
    
    1,211Additional paid-in capital
    
    
    22,031
    
    
    
    1,081
    
    
    
    3,891
    
    
    
    (4,972
    )
    
    
    22,031Accumulated deficit
    
    
    (17,066
    )
    
    
    (12,661
    )
    
    
    (5,972
    )
    
    
    18,633
    
    
    
    (17,066
    )Accumulated other comprehensive income (loss)
    
    
    (522
    )
    
    
    1,025
    
    
    
    (21
    )
    
    
    (1,004
    )
    
    
    (522
    )Total shareholders equity
    
    
    6,190
    
    
    
    (4,229
    )
    
    
    (1,303
    )
    
    
    5,532
    
    
    
    6,190Total liabilities and shareholders equity
    
    $
    5,540
    
    
    $
    4,486
    
    
    $
    5,508
    
    
    $
    922
    
    
    $
    16,456
 53




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##### 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
    
    
    $
    (299
    )
    
    $
    6
    
    
    $
    293
    
    
    $
    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
    
    
    
    47
    
    
    
    33
    
    
    
    
    
    
    
    90Non-cash portion of special charges
and related asset write downs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Equity in net loss of associated companies
    
    
    48
    
    
    
    246
    
    
    
    
    
    
    
    (293
    )
    
    
    1Current and deferred stock
option compensation
    
    
    2
    
    
    
    11
    
    
    
    2
    
    
    
    
    
    
    
    15Deferred income taxes
    
    
    (1
    )
    
    
    (1
    )
    
    
    (2
    )
    
    
    
    
    
    
    (4
    )Other liabilities
    
    
    20
    
    
    
    31
    
    
    
    9
    
    
    
    
    
    
    
    60(Gain) loss on repurchases of outstanding
debt securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (Gain) loss on sale or write-down of
investments and businesses
    
    
    
    
    
    
    (35
    )
    
    
    2
    
    
    
    
    
    
    
    (33
    )Other  net
    
    
    (17
    )
    
    
    (102
    )
    
    
    (26
    )
    
    
    
    
    
    
    (145
    )Change in operating assets and liabilities
    
    
    (238
    )
    
    
    (27
    )
    
    
    (143
    )
    
    
    
    
    
    
    (408
    )Intercompany/related party activity
    
    
    100
    
    
    
    (125
    )
    
    
    25
    
    
    
    
    
    
    
    Net cash from (used in) operating activities
of continuing operations
    
    
    40
    
    
    
    (254
    )
    
    
    (94
    )
    
    
    
    
    
    
    (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
    
    
    
    
    
    
    
    
    
    
    
    55Investments in subsidiaries
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net cash from (used in) investing activities
of continuing operations
    
    
    (4
    )
    
    
    22
    
    
    
    (4
    )
    
    
    
    
    
    
    14Cash flows from (used in) financing activitiesDividends on preferred shares
    
    
    (9
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9
    )Increase (decrease) in notes payable  net
    
    
    
    
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    (3
    )Repayments of long-term debt
    
    
    
    
    
    
    (87
    )
    
    
    (10
    )
    
    
    
    
    
    
    (97
    )Repayments of capital leases payable
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    (3
    )Net cash from (used in) financing activities
of continuing operations
    
    
    (9
    )
    
    
    (90
    )
    
    
    (13
    )
    
    
    
    
    
    
    (112
    )Effect of foreign exchange rate changes
on cash and cash equivalents
    
    
    
    
    
    
    11
    
    
    
    2
    
    
    
    
    
    
    
    13Net cash from (used in) continuing operations
    
    
    27
    
    
    
    (311
    )
    
    
    (109
    )
    
    
    
    
    
    
    (393
    )Net cash from (used in) discontinued operations
    
    
    4
    
    
    
    (7
    )
    
    
    
    
    
    
    
    
    
    
    (3
    )Net increase (decrease) in cash and
cash equivalents
    
    
    31
    
    
    
    (318
    )
    
    
    (109
    )
    
    
    
    
    
    
    (396
    )Cash and cash equivalents
at beginning of period
    
    
    (8
    )
    
    
    3,164
    
    
    
    772
    
    
    
    
    
    
    
    3,928Cash and cash equivalents
at end of period
    
    $
    23
    
    
    $
    2,846
    
    
    $
    663
    
    
    $
    
    
    
    $
    3,532
 54




---



##### Table of Contents



Supplemental Consolidating Statements of Cash Flows for the three months ended March 31, 2003: 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
    
    $
    (181
    )
    
    $
    (319
    )
    
    $
    192
    
    
    $
    135
    
    
    $
    (173
    )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
    
    
    26
    
    
    
    57
    
    
    
    31
    
    
    
    
    
    
    
    114Non-cash portion of special charges
and related asset write downs
    
    
    5
    
    
    
    13
    
    
    
    
    
    
    
    
    
    
    
    18Equity in net loss of associated companies
    
    
    486
    
    
    
    (337
    )
    
    
    8
    
    
    
    (135
    )
    
    
    22Current and deferred stock
option compensation
    
    
    1
    
    
    
    3
    
    
    
    
    
    
    
    
    
    
    
    4Deferred income taxes
    
    
    10
    
    
    
    (5
    )
    
    
    8
    
    
    
    
    
    
    
    13Other liabilities
    
    
    22
    
    
    
    (11
    )
    
    
    1
    
    
    
    
    
    
    
    12(Gain) loss on repurchases of outstanding
debt securities
    
    
    (4
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4
    )(Gain) loss on sale or write-down of
investments and businesses
    
    
    1
    
    
    
    5
    
    
    
    
    
    
    
    
    
    
    
    6Other  net
    
    
    54
    
    
    
    (173
    )
    
    
    (34
    )
    
    
    
    
    
    
    (153
    )Change in operating assets and liabilities
    
    
    (331
    )
    
    
    180
    
    
    
    155
    
    
    
    
    
    
    
    4Intercompany/related party activity
    
    
    (377
    )
    
    
    773
    
    
    
    (396
    )
    
    
    
    
    
    
    Net cash from (used in) operating activities
of continuing operations
    
    
    (288
    )
    
    
    186
    
    
    
    (35
    )
    
    
    
    
    
    
    (137
    )Cash flows from (used in) investing activitiesExpenditures for plant and equipment
    
    
    (5
    )
    
    
    (11
    )
    
    
    (6
    )
    
    
    
    
    
    
    (22
    )Proceeds on disposals of plant and equipment
    
    
    
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    6Acquisitions
of investments and businesses  net of cash acquired
    
    
    
    
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    (2
    )Proceeds on sale of investments and businesses
    
    
    1
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    7Investments in subsidiaries
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net cash from (used in) investing activities
of continuing operations
    
    
    (4
    )
    
    
    (1
    )
    
    
    (6
    )
    
    
    
    
    
    
    (11
    )Cash flows from (used in) financing activitiesDividends on preferred shares
    
    
    (8
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (8
    )Increase (decrease) in notes payable  net
    
    
    
    
    
    
    4
    
    
    
    (17
    )
    
    
    
    
    
    
    (13
    )Repayments of long-term debt
    
    
    (34
    )
    
    
    
    
    
    
    (9
    )
    
    
    
    
    
    
    (43
    )Repayments of capital leases payable
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    (3
    )Net cash from (used in) financing activities
of continuing operations
    
    
    (42
    )
    
    
    1
    
    
    
    (26
    )
    
    
    
    
    
    
    (67
    )Effect of foreign exchange rate changes
on cash and cash equivalents
    
    
    
    
    
    
    13
    
    
    
    5
    
    
    
    
    
    
    
    18Net cash from (used in) continuing operations
    
    
    (334
    )
    
    
    199
    
    
    
    (62
    )
    
    
    
    
    
    
    (197
    )Net cash from (used in) discontinued operations
    
    


    72
    
    
    
    229
    
    
    
    
    
    
    
    
    
    
    
    301Net increase (decrease) in cash and
cash equivalents
    
    
    (262
    )
    
    
    428
    
    
    
    (62
    )
    
    
    
    
    
    
    104Cash and cash equivalents
at beginning of period
    
    
    251
    
    
    
    2,392
    
    
    
    1,099
    
    
    
    
    
    
    
    3,742Cash and cash equivalents
at end of period
    
    $
    (11
    )
    
    $
    2,820
    
    
    $
    1,037
    
    
    $
    
    
    
    $
    3,846
 55




---



##### Table of Contents



ITEM  2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations  Table of Contents Business overview
    
    
    58Our business
    
    
    58Our segments
    
    
    58Our business environment
    
    
    59How we measure performance
    
    
    61Our strategic plan and outlook
    
    
    61Developments in 2004
    
    
    62First quarter consolidated results summary
    
    
    62Nortel Networks Audit Committee Independent Review; restatements; related matters
    
    
    63Comprehensive Review and First Restatement
    
    
    63Independent Review
    
    
    63Second Restatement
    
    
    63Material weaknesses in internal control over financial
reporting identified in Second Restatement
    
    
    66Revenue Independent Review
    
    
    67Personnel actions
    
    
    67EDC Support Facility
    
    
    67Credit facilities and security agreements
    
    
    68Debt securities
    
    
    68Shelf registration statement
    
    
    68Credit ratings
    
    
    68Regulatory actions and pending litigation
    
    
    69Stock-based compensation plans
    
    
    69Evolution of our supply chain strategy
    
    
    69Other business developments
    
    
    70Customer financing commitments
    
    
    70Sale of Entrust shares
    
    
    70Real estate
    
    
    70Customer contract settlement
    
    
    71Directory and operator services business
    
    
    71Bharat Sanchar Nigram Limited contract
    
    
    71Patent infringement settlement
    
    
    71Customer financing arrangements
    
    
    71Joint Ventures
    
    
    71Results of operations  continuing operations
    
    
    71Segment revenues
    
    
    71Geographic revenues
    
    
    72Consolidated revenues
    
    
    72Wireless Networks revenues
    
    
    74Enterprise Networks revenues
    
    
    75Wireline Networks revenues
    
    
    77Optical Networks revenues
    
    
    78Gross profit and gross margin
    
    
    79Segment gross profit and gross margin
    
    
    79Operating expenses
    
    
    80Selling, general and administrative expense
    
    
    80Segment selling, general and administrative expense
    
    
    81Research and development expense
    
    
    81Segment research and development expense
    
    
    82Segment contribution margin
    
    
    82Segment Management EBT
    
    
    83
 56




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##### Table of Contents



Special charges
    
    
    83Other income (expense)  net
    
    
    84Interest expense
    
    
    84Income tax benefit (expense)
    
    
    84Net earnings (loss) from continuing operations
    
    
    85Results of operations  discontinued operations
    
    
    85Liquidity and capital resources
    
    
    85Cash flows
    
    
    85Uses of liquidity
    
    
    87Contractual cash obligations
    
    
    87Customer financing
    
    
    87Discontinued operations
    
    
    88Sources of liquidity
    
    
    88Credit facilities
    
    
    88Available support facility
    
    
    89Shelf registration statement and base shelf prospectus
    
    
    89Credit ratings
    
    
    90Off-balance sheet arrangements
    
    
    90Bid, performance related and other bonds
    
    
    90Receivables securitization and certain lease financing transactions
    
    
    91Other indemnifications or guarantees
    
    
    92Application of critical accounting estimates
    
    
    92Provisions for doubtful accounts
    
    
    92Provisions for inventory
    
    
    93Tax asset valuation
    
    
    94Accounting changes and recent accounting pronouncements
    
    
    94Accounting changes
    
    
    94Recent accounting pronouncements
    
    
    95Canadian supplement
    
    
    95Market risk
    
    
    96Equity price risk
    
    
    96Legal proceedings
    
    
    97Risk factors/forward looking statements
    
    
    97Risks relating to our restatements and related matters
    
    
    97Risks relating to our business
    
    
    104
   57




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##### Table of Contents



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. As discussed herein, this MD&A gives effect to the Second Restatement as
described below in Developments in 2004  Nortel Networks Audit Committee Independent Review;
restatements; related matters and in Restatement in note 2 of the accompanying unaudited
consolidated financial statements. 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. In addition, the Second Restatement involved
the restatement of our consolidated financial statements for 2001 and 2002 and the first, second
and third quarters of 2003. Amendments to our prior filings with the SEC would be required in order
for us to be in full compliance with our reporting obligations under the Exchange Act. However, we
do not believe that it will be feasible to amend our Annual Report onForm 10-K/Afor the year
ended December 31, 2002, or 2002Form 10-K/A,and our 2003Form 10-Qs, due to, among other factors,
identified material weaknesses in our internal control over financial reporting, the significant
turnover in our finance personnel, changes in accounting systems, documentation weaknesses, a
likely inability to obtain third party corroboration in certain cases due to the substantial
industry adjustment in recent years and the passage of time generally. In addition, disclosure in
the 2002Form 10-K/Aand 2003Form 10-Qswould in large part repeat the disclosure contained in our
Annual Report onForm 10-Kfor the year ended December 31, 2003, or the 2003 Annual Report, and
this report and expected to be contained in the other 2004Form 10-Qs. Accordingly, we do not plan
to amend our 2002Form 10-K/Aand 2003Form 10-Qs. We believe that we have included in the 2003
Form 10-K and in this report all information needed for current investor understanding. 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 Networks, 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 Networks 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 IP, multimedia services and
applications, and wireless broadband solutions designed to help people solve the worlds greatest
challenges. 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 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 envision a networked society where people are able to connect and interact
with information and with each other instantly, simply and reliably, accessing data, voice and
multimedia communications services and sharing experiences anywhere, anytime. 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 segments During 2003 and up to September 30, 2004, our operations were organized into four reportable
segments as follows: 58




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##### Table of Contents




    
    Wireless Networks  Our Wireless Networks segment provides communications networks that
enable end-users 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. Our Wireless Networks customers are wireless service
providers, and their customers are the subscribers for wireless communications services.
    
    Enterprise Networks  Our Enterprise Networks segment provides data, voice and
multimedia communications solutions for 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.
    
    Wireline Networks  Our Wireline Networks segment addresses the demand by our service
provider customers for cost efficient data, voice and multimedia communications solutions.
We offer our Wireline Networks products and services to a wide range of wireline and
wireless service providers around the world. Our service provider customers include local
and long distance telephone companies, wireless service providers, cable operators and
other communication service providers. We also provide services to our data networking and
security customers which consist of system integrators that in turn build, operate and
manage networks for their customers, such as businesses, government agencies and utility
organizations.
    
    Optical Networks  Our Optical Networks segment solutions transport data, voice and
multimedia communications within and between cities, countries or continents by
transmitting communications signals in the form of light waves through fiber optic cables.
Our Optical Networks business is primarily focused on offering our optical networking
solutions to service providers around the world. The service provider customers for our
optical networking products include local and long-distance telephone companies, cable
operators, Internet service providers and other communications service providers. Effective October 1, 2004, we established a new streamlined organizational structure that included,
among other things, combining the businesses of our four segments into two business organizations:
(i) Carrier Networks and Global Operations, and (ii) Enterprise Networks. We are reviewing the
impact of these changes on our reportable segments under Statement of Financial Accounting
Standards, or SFAS, No. 131, Disclosures about segments of an enterprise and related information. Our business environment In 2001, we entered into an unprecedented period of business realignment in response to a
significant adjustment in the industry. Industry demand for networking equipment dramatically
declined in response to the industry adjustment, severe economic downturns in various regions
around the world and a tightening in global capital markets. We implemented a company-wide
restructuring plan to streamline our operations and activities around core markets and operations,
which included significant workforce reductions, global real estate closures and dispositions,
substantial write-downs of our capital assets, goodwill and other intangible assets and extensive
contract settlements with customers and suppliers around the world. As a result of these actions,
our workforce declined significantly from January 1, 2001 to December 31, 2003 and over the same
time period, we significantly reduced our facilities. In 2003, customer spending remained cautious
as a result of tightened capital markets mainly in the first half of 2003 and customers realigning
capital spending with their current levels of revenues and profits in order to maximize their
return on invested capital. We experienced continued industry adjustment and capital spending
restrictions by our service provider customers. Also, excess network capacity and competition
continued to exist in the industry which led to continued pricing pressures on the sale of certain
of our products. During the second half of 2003 and in 2004, we began to experience a period of relative industry
stability. Throughout the second half of 2003 and in 2004, we announced several new contracts
across all of our reportable segments, but primarily in our Wireless Networks segment, as certain
service provider customers began to expand and upgrade their existing networks. In 2004, however,
we continued to experience pricing pressures on sales of certain products across all of our
reportable segments primarily as a result of increased competition. As first announced on August 19, 2004, we have put in place a new strategic plan that recognizes
these industry dynamics and the evolution of the converged network (see Business overview  Our
strategic plan and outlook). In an increasingly cost-competitive environment, we are taking
steps that we believe will better position us to grow market share and improve our results and cash
generation. As part of our strategic plan, we also announced a focused workforce reduction of
approximately 3,250 employees. 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 59




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ended March 31, 2003 and June 30, 2003, or the First
Restatement. In late October 2003, the Audit Committees of our and NNCs Boards 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, 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 Boards 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. The Summary of Findings of Recommended Remedial Measures of the Independent
Review is set forth in full in Item 9A of our and NNCs 2003 Annual Reports on Form 10-K, or the
2003 Annual Reports. 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 (effected with the filing of the 2003 Annual Reports) 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 the 2003 Annual Reports and our and NNCs Quarterly
Reports on Form 10-Q for the first, second and third quarters of 2004, or the 2004 Quarterly
Reports, beyond the SECs required filing dates in 2004. We refer to the 2003 Annual Reports and
the 2004 Quarterly Reports together as 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. As described in more detail in the Controls and Procedures section of this
report, in light of the resulting adjustments to revenues previously reported in relevant periods,
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. This review will
have a particular emphasis on the underlying conduct that led to the initial recognition of these
revenues. The Audit Committee will seek 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. See Risk factors/forward
looking statements. Over the course of the Second Restatement process, we and our independent auditors identified a
number of material weaknesses in our internal control over financial reporting. Further, in
connection with the Independent Review, we terminated for cause our former president and chief
executive officer, former chief financial officer and former controller in April 2004 and seven
additional senior finance employees with significant responsibilities for our financial reporting
as a whole or for their respective business units and geographic areas in August 2004. We are
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. We are currently in a challenging transitional period in connection with the completion of our
restatement activity and as we implement the new strategic plan. We believe that our strategic plan
will enable us to build on our market leadership in developing the converged networks of the future
and improve business efficiency and operating cost performance in an increasingly competitive
market. On January 27, 2005, we announced the appointment of Peter Currie as our chief financial officer
effective February 14, 2005. Our current chief financial officer, William Kerr, will serve as a
senior advisor to our president and chief executive officer assisting Peter Currie in the
transition to his role and the ongoing transformation of our finance organization as well as
make a strategic contribution to plans for market expansion and growth. We further announced the
appointment of Karen Sledge as controller on an interim basis effective February 7, 2005. Our
current controller, MaryAnne Pahapill, has accepted a financial position outside Nortel Networks.
We have initiated a search process to fill the controller position permanently. 60




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How we measure performance Each reportable segment is allocated resources and assets based on whether projected customer
demand would support additional investment. We make adjustments to reduce resources and assets
within a reportable segment in response to market conditions or where opportunities for improved
efficiencies present themselves. Our president and chief executive officer, or CEO, has been identified as the chief operating
decision maker in assessing the performance of the segments and the allocation of resources to the
segments. Each reportable segment is managed separately with each segment manager reporting
directly to the CEO. The CEO relies on the information derived directly from our management
reporting system. In 2003, we reported that the primary financial measure used by the former chief
operating decision maker in assessing performance and allocating resources to the segments was
contribution margin, a measure that was comprised of gross profit less selling, general and
administrative expense, or SG&A. In April 2004, our and NNCs boards of directors appointed a new
CEO. Commencing in the second quarter of 2004, the primary financial measure used by our CEO in
assessing performance and allocating resources to the segments is management earnings (loss) before
income taxes, or Management EBT, a measure that includes contribution margin, R&D expense, interest
expense, other income (expense)  net, minority interest  net of tax and equity in net loss of
associated companies  net of tax. As a result of the change in the primary financial measure used
to assess the performance of our segments during the period in which the Reports have been delayed,
and because both contribution margin and Management EBT were available to the former chief
operating decision maker during 2003, we have determined that it is appropriate to disclose both
contribution margin and Management EBT for the periods presented. See
Segment information  General description in note 5 of the accompanying unaudited consolidated financial statements. From a liquidity perspective, we maintain strict controls over our sources and uses of cash. We
also focus on the liquidity and cash flows of our customers in an effort to minimize our credit
risk. We closely monitor our inventory levels, both in our manufacturing facilities as well as at
our contract manufacturers, in an effort to minimize our exposure to excess supply and subsequent
cash costs incurred as a result of excess capacity. Our strategic plan and outlook On August 19, 2004, we announced a new strategic plan intended to enable us to build on our
market leadership in developing the converged networks of the future and improve business
efficiency and operating cost performance in an increasingly competitive market. We provided
further details concerning the strategic plan on September 30, 2004 and December 14, 2004. It is
our intention to be optimally positioned to maximize strategic opportunities as they arise and
leverage our acknowledged strengths in high reliability networks and strong customer loyalty. We
continue to drive our business forward with a focus on costs, cash 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 the strategic plan are:  
    
    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 been filled
on an interim basis pending the permanent appointment of Susan E. Shepard, effective
February 21, 2005;
    
    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;
    
    the establishment of a chief strategy officer to drive partnerships, new markets and acquisitions;
    
    the establishment of a chief marketing officer to drive 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. 61




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Our strategic plan also includes a work plan involving focused workforce reductions of
approximately 3,250 employees, a voluntary retirement program, real estate optimization and other
cost containment actions such as reductions in information services costs, outsourced services and
other discretionary spending. Our workforce actions are focused to disproportionately protect
customer and sales facing roles as well as continue our focus on new innovative solutions.
Approximately 64% of employee actions related to the focused workforce reduction were completed by
the end of 2004, including approximately 55% 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 are expected to be completed by June 30, 2005. In
addition, however, the Company continues to hire in certain strategic areas such as investments in
the finance organization. These focused headcount reductions are intended to result in ongoing cost
reductions in R&D and SG&A expenses and cost of sales. These actions are subject to the completion
of required jurisdictional consultation and regulatory approvals. This workforce reduction is in
addition to the workforce reduction that will result from our agreement with Flextronics
International Ltd., or Flextronics (for more information, see Evolution of our supply chain
strategy). We expect the real estate actions to be completed by the end of 2005. We estimate charges to the income statement associated with our overall work 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. Approximately 25% of the aggregate income
statement charges were incurred in 2004 with the remainder expected to be incurred in 2005. The associated cash costs of the work 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 relates to the real estate actions and are expected 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. We anticipate cost savings from the implementation of the work plan of approximately $500 in 2005,
which is expected to increase on an annualized basis beyond 2005 as the full impact of the work
plan is realized. We expect that this work plan will primarily be funded with cash from
operations. We expect that our consolidated revenues in 2004 will be slightly lower compared with 2003. The
2003 consolidated revenues included revenues that were deferred from prior periods. We see growth
opportunities in emerging markets such as China and India. Further, we believe security and
reliability for service provider networks are increasingly important to governments, defense
interests and enterprises around the world. Developments in 2004 First quarter consolidated results summary In the first quarter of 2004, our consolidated revenues were $2,444 compared to $2,295 in the
first quarter of 2003, representing an increase of 6%. Revenues in Wireline Networks, Optical
Networks and Enterprise Networks decreased by 15%, 23% and 9%, respectively, while revenues in
Wireless Networks increased by 41%. Our gross margin increased to 44% in the first quarter of 2004 compared to 40% in the first quarter
of 2003, an improvement of 4 percentage points. SG&A expense increased 10% in the first quarter of
2004 compared to the first quarter of 2003 and R&D expense was relatively flat in the first quarter
of 2004 compared to the first quarter of 2003. The significant increase in SG&A expense was
primarily due to increased employee related expenses and unfavorable foreign exchange rate
fluctuations. R&D expense remained essentially flat due to the continued impact of our workforce
reductions partially offset by unfavorable foreign exchange impacts. We believe our levels of R&D
spending are commensurate with our technology focus and commitment to invest in next-generation
solutions. Special charges declined 95% in the first quarter of 2004 compared to the first quarter
of 2003, primarily as a result of our completion of a substantial portion of activities associated
with our restructuring work plan initiated in 2001. These activities included workforce
reductions, contract settlements and facility closures. Our discontinued operations contributed $1 of net earnings in the first quarter of 2004 compared to
$133 of net earnings in the first quarter of 2003 reflecting the continued wind-down activities of
our discontinued operations. 62




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We reported net earnings
before cumulative effect of accounting change of $117 in the first quarter
of 2004 compared to a net loss before cumulative effect of accounting change of $40 in the first
quarter of 2003. In the first quarter of 2004, our cash and cash equivalents, or cash, decreased $396 from $3,928 as
of December 31, 2003 to $3,532 as of March 31, 2004. The decrease was due to a decrease in cash of
$308 from operating activities, a decrease in cash of $112 from our financing activities and a
decrease in cash of $3 from our discontinued operations. These decreases in cash were partially
offset by an increase of $14 related to our investing activities and favorable foreign exchange
impacts of $13. Nortel Networks Audit Committee Independent Review; restatements; related matters  Comprehensive Review and First Restatement 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.
See notes 2 and 19 of the accompanying unaudited consolidated financial statements and the
Controls and Procedures section of this report. In connection with the Comprehensive Review, Deloitte & Touche LLP, or D&T, our independent
auditors, informed the Audit Committee on July 24, 2003 of a reportable condition that did not
constitute a material weakness in our internal control over financial reporting (throughout this
report, unless otherwise indicated, reportable condition and material weakness have the
meanings as formerly set forth under standards established by the American Institute of Certified
Public Accountants, or AICPA). Later, on November 18, 2003, as part of the communications by D&T
to the Audit Committee with respect to D&Ts interim audit procedures for the year ended December
31, 2003, D&T informed the Audit Committee that it had identified certain reportable conditions,
each of which constituted a material weakness in our internal control over financial reporting.
These material weaknesses identified in the First Restatement were also later identified in
connection with the Second Restatement together with certain additional material weaknesses in our
internal control over financial reporting, as described in greater detail in the Controls and
Procedures section of this report.  Independent Review In late October 2003, the Audit Committee initiated the Independent Review and engaged WCPHD
to advise it in connection with the Independent Review in order 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.
The Independent Review focused initially on events relating to the establishment and release of
contractual liability and other related provisions (also called accruals, reserves, or accrued
liabilities) in the second half of 2002 and the first half of 2003, including the involvement of
senior corporate leadership. As the Independent Review evolved, its focus broadened to include
specific provisioning activities in each of the business units and geographic regions. In light of
concerns raised in the initial phase of the Independent Review, the Audit Committee expanded the
review to include provisioning activities in the third and fourth quarters of 2003. As discussed more fully in the Controls and Procedures section of this report, the Independent
Review concluded that [i]n summary, former corporate management (now terminated for cause) and
former finance management (now terminated for cause) in the Companys finance organization
endorsed, and employees carried out, accounting practices relating to the recording and release of
provisions that were not in compliance with [U.S. GAAP] in at least four quarters, including the
third and fourth quarters of 2002 and the first and second quarters of 2003. In three of those
four quarters  when Nortel was at, or close to, break even  these practices were undertaken to
meet internally imposed . . . targets. While the dollar value of most of the individual provisions
was relatively small, the aggregate value of the provisions made the difference between a profit
and a reported loss, on a pro forma basis, in the fourth quarter of 2002 and the difference between
a loss and a reported profit, on a pro forma basis, in the first and second quarters of 2003.  Second Restatement 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
provision releases, down to a low threshold. That examination, and other errors identified by
management, led to the Second Restatement. 63




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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, resulting in adjustments to previously reported revenues during the periods 1998
through 2003. Other accounting practices that management examined and adjusted as part of the
Second Restatement included, among other things, the following:  
    
    intercompany balances that did not eliminate upon consolidation and related provisions;
    
    our foreign exchange accounting, as part of our plan to address an identified material
weakness related to foreign currency translation;
    
    special charges relating to inventory impairment, contract settlement costs and other charges; and
    
    the accounting treatment of certain elements of discontinued operations.  Quarter ended March 31, 2003 The following table presents the impact of the Second Restatement adjustments on our previously
reported consolidated statement of operations data for the three months ended March 31, 2003. The
Second Restatement adjustments related primarily to the following items, each of which reflect a
number of related adjustments that have been aggregated for disclosure purposes, and are described
in the paragraphs following the table below. See Restatement in note 2 of the accompanying
unaudited consolidated financial statements.  
    
    revenues and cost of revenues;
    
    foreign exchange;
    
    intercompany balances;
    
    special charges;
    
    other;
    
    reclassifications; and
    
    discontinued operations. Consolidated Statement of Operations data for the three months ended March 31, 2003 As previouslyreported
    
    
    Adjustments
    
    
    As restatedRevenues
    
    $
    2,376
    
    
    $
    (81
    )
    
    $
    2,295Gross profit
    
    
    1,052
    
    
    
    (145
    )
    
    
    907Operating earnings (loss)
    
    
    (70
    )
    
    
    (129
    )
    
    
    (199
    )Earnings (loss) from continuing operations before income taxes,
minority interests and equity in net loss of associated companies
    
    
    (95
    )
    
    
    (42
    )
    
    
    (137
    )Net earnings (loss) from continuing operations
    
    
    (103
    )
    
    
    (70
    )
    
    
    (173
    )Net earnings (loss) from discontinued operations  net of tax
    
    
    164
    
    
    
    (31
    )
    
    
    133Net earnings (loss)
    
    
    53
    
    
    
    (105
    )
    
    
    (52
    )Dividends on preferred shares
    
    
    5
    
    
    
    3
    
    
    
    8Net earnings (loss) applicable to common shares
    
    $
    48
    
    
    $
    (108
    )
    
    $
    (60
    )
 Revenues and cost of revenues Revenues and cost of revenues were impacted by various errors related to revenue recognition,
corrections to foreign exchange accounting, intercompany related items and other adjustments,
including financial statement reclassifications. The net impact to revenues of the adjustments was
a decrease of $81 for the three months ended March 31, 2003. The net impact to cost of revenues
related to these revenue adjustments, and the other corrections was an increase of $64 for the
three months ended March 31, 2003. The Second Restatement adjustments to revenues and cost of
revenues related primarily to the following items:  
    
    incorrect application of SEC Staff Accounting Bulletin, or SAB, No. 104, Revenue
Recognition (preceded by SAB 101), or SAB 104, or AICPA Statement of Position, or SOP,
97-2, Software Revenue Recognition, or SOP 97-2, the most significant of which related
to revenue that should have been deferred until title or risk of loss had passed, or
products had been delivered; 64




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
    
    incorrect application of SOP 81-1, Accounting for Performance of Construction-Type
and Certain Production-Type Contracts, or SOP 81-1, with respect to
percentage-of-completion accounting for certain long-term construction contracts; and
    
    various other adjustments primarily included corrections related to an overstatement of
revenues and cost of revenues as a result of two specific transactions recorded
in the first quarter of 2003 which should have been recorded in 2002. In addition, revenue
recognition adjustments were made which relate to a specific contract in the Caribbean and Latin
America, or CALA, region, other errors related to non-cash incentives and concessions
provided to customers and other calculation errors.  Foreign exchange As part of the plan to address a material weakness reported in our Quarterly Report on Form 10-Q
for the period ended September 30, 2003, a review of foreign exchange accounting was undertaken.
The net impact to pre-tax loss was a decrease of $90 for the three months ended March 31, 2003.
The significant items were as follows:  
    
    we re-examined the determination of the functional currency for certain entities
based on the guidance under SFAS No. 52, Foreign Currency Translation, or SFAS No.
52. As a result, we identified four instances in which the functional currency
designation of an entity was incorrect. These revisions resulted in increases or
decreases to other income (expense)  net;
    
    we identified two instances of incorrect treatment of significant intercompany
positions. The net impact of the adjustments was an increase or decrease to other
income (expense)  net, with an offset to accumulated other comprehensive loss;
    
    we identified errors in the revaluation of certain foreign denominated customer
financing provisions within discontinued operations, the correction of which increased
other income and decreased net earnings from discontinued operations; and
    
    we identified errors related to translation of foreign denominated intercompany
transactions, revaluation of certain foreign denominated intercompany transactions and
accounting for mark-to-market adjustments for foreign exchange contracts as required
under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, or
SFAS No. 133.  Intercompany balances Historically, we had certain intercompany balances that did not eliminate upon consolidation, or
out-of-balance positions, and provisions had been recorded accordingly. As part of the Second
Restatement, we reviewed these provisions and determined that they should not have been recorded.
We recorded adjustments in the appropriate periods to reverse these provisions and to correct the
significant out-of-balance positions. The adjustments to reverse the provisions affected the
second quarter of 2003 and periods prior to 2000. The net impact of these adjustments to correct
significant out-of-balance positions was an increase of $6 to pre-tax loss for the three months
ended March 31, 2003.  Special charges As part of the Second Restatement, we re-examined the components of special charges, and recorded
an increase to special charges of $29 for the three months ended March 31, 2003. We determined
that certain items were either recorded in special charges in error or, although correctly recorded
when originally recognized, were not adjusted in the appropriate subsequent periods for changes in
estimates and/or assumptions. These items related to contract settlement costs, including real
estate related items, severance and fringe benefit related costs and plant and equipment impairment
costs.  Other We recorded other adjustments primarily to correct certain accruals, provisions or other
transactions, which were either initially recorded incorrectly in prior periods, or not properly
released or adjusted for changes in estimates and/or assumptions in the appropriate subsequent
periods. The impact of these adjustments was an increase to pre-tax loss of $10 for the three
months ended March 31, 2003 and included tax and minority interests impacts of all Second
Restatement adjustments. 65




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The adjustment to income tax benefit was an increase of $9 for the three months ended March 31,
2003 primarily related to investment tax credits and taxes attributable to preferred share
dividends. The adjustment to minority interests as a result of the Second Restatement adjustments
was an decrease of $26 for the three months ended March 31, 2003.  Reclassifications As a result of the restatement process, various presentation inconsistencies were identified.
Adjustments were made to appropriately reflect certain items in the consolidated statement of
operations. The reclassifications were made for royalty expense, gain (loss) on sale of businesses
and assets and other items including
certain functional spending and specific expenses.  Discontinued operations As a result of the restatement process, we re-examined the initial provision for loss on disposal
of the access solutions discontinued operations recorded in June 2001, and the subsequent activity
during 2001 through 2004. We concluded that the net loss on disposal of operations recognized in
the second quarter of 2001 was overstated. In addition, other adjustments were necessary to
correct certain items that were either initially recorded incorrectly, or not properly released or
adjusted for changes in estimates in the appropriate periods subsequent to the second quarter of
2001. The net impact of the adjustments on net earnings from discontinued operations  net of tax
for the three months ended March 31, 2003 was a decrease of $31. The adjustments consisted primarily of a decrease of approximately $90 resulting from the
elimination of a gain on redemption of an investment interest due to the reversal in an earlier
period of a full valuation allowance that had been recorded against the investment interest when
acquired and a decrease of approximately $30 related to the revaluation of certain foreign
denominated customer financing provisions, partially offset by an
increase of $37 for corrections to accrued liabilities, a $33 net increase from adjustments
to contingent liabilities and approximately $11 related to a gain on settlement of a sales
representation agreement which had previously been recorded in continuing operations.  Material weaknesses in internal control over financial reporting identified in Second Restatement As described above and in the Controls and Procedures section of this 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 D&T identified a
number of additional material weaknesses in our internal control over financial reporting, as
further described in the Controls and Procedures section of this report. D&T confirmed to the
Audit Committee these material weaknesses, listed below, on January 10, 2005:  
    
    lack of compliance with written Nortel Networks 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 Networks 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;
    
    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 Networks 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 referred to in the Controls
and Procedures section of this report, 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. Upon completion of managements assessment of our internal control over financial reporting as of
December 31, 2004 pursuant to SOX 404, we currently expect to conclude that the first five of
these six material weaknesses continue to exist at December 31, 2004. We continue to identify,
develop and begin to implement remedial measures to address them, as described in the Controls and Procedures section of this 66




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report. See also notes 2 and 19 to the
accompanying unaudited consolidated financial statements.  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 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 will have a
particular emphasis on the underlying conduct that led to the initial recognition of these
revenues. The Audit Committee will seek 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.  Personnel actions In connection with the Independent Review, we have, among other actions, terminated for cause:  
    
    our former president and chief executive officer, former chief financial officer and
former controller in April 2004 (the former chief financial officer and former controller
having been placed on paid leaves of absence in March 2004); and
    
    seven additional senior finance employees with significant responsibilities for our
financial reporting as a whole or for their respective business units and geographic
regions in August 2004. Each of these former members of management had responsibility for their respective positions at the
time of the Comprehensive Review and First Restatement. The Board of Directors determined that
each of these individuals had significant responsibilities for our financial reporting as a whole,
or for their respective business units and geographic regions, and that each was aware, or ought to
have been aware, that our provisioning activity, described above, did not comply with U.S. GAAP.  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. We obtained waivers from EDC with respect to these
and related matters to permit continued access to the EDC Support Facility in accordance with its
terms while we complete our filing obligations with respect to the Reports. The current waiver
will expire on February 15, 2005. The waivers have also applied to certain additional 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 sub-facility of the
EDC Support Facility as uncommitted support during the waiver period. The $300 revolving small
bond facility will not become committed support until all of the Reports have been filed with the
SEC and we obtain a permanent waiver of the Related Breaches. If we and NNC have not filed all of the Reports by February 15, 2005, EDC will have
the right, on such date, (absent a further waiver in relation to the delayed filings and the
Related Breaches), to (i) terminate the EDC Support Facility and (ii) exercise certain rights
against collateral or require us to cash collaterize all existing support. In addition, the Related Breaches will continue beyond the filing of the Reports. Accordingly, EDC
will have the right (absent a further waiver of the Related Breaches) beginning on February 15,
2005 to terminate or suspend the EDC Support Facility or exercise certain rights against collateral
notwithstanding the filing of the Reports. While we are seeking a permanent waiver from EDC in
connection with the Related Breaches, there can be no assurance that we will receive any waiver or
as to the terms of any such waiver. 67




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As of January 21, 2005, approximately $292 of outstanding support under the EDC Support
Facility was outstanding, $208 of which was outstanding under the revolving small bond
sub-facility. See Available support facility and Risk factors/forward looking statements.  Credit facilities and security agreements On April 28, 2004, we terminated our and Nortel Networks Inc., or NNI, $750 April 2000 five
year credit facilities, or the Five Year Facilities. Absent such 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. Upon
termination, the Five Year Facilities were undrawn. As a result of the termination of the Five Year Facilities, certain foreign security agreements
entered into by us and various of our subsidiaries, under which shares of certain of our
subsidiaries 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 our and NNCs outstanding public debt securities,
also terminated in accordance with their terms (see note 19 of the accompanying unaudited
consolidated financial statements). In addition, the guarantees by certain subsidiaries
incorporated outside of the U.S. and Canada terminated in accordance with their terms. Security
agreements remain in place 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, are pledged in favor of EDC and the holders of our and NNCs
outstanding public debt securities. In addition, the guarantees by certain of our wholly owned
subsidiaries, including NNI, most of our Canadian subsidiaries, Nortel Networks (Asia) Limited,
Nortel Networks (Ireland) Limited and Nortel Networks U.K. Limited, of our obligations under the
EDC Support Facility and our and NNCs outstanding public debt securities, remain in place. See
Liquidity and capital resources.  Debt securities As a result of the delay in filing the Reports, we and NNC have not been in compliance with
our obligations to deliver the Reports to the trustees under our and NNCs public debt indentures.
As of December 31, 2004, approximately $1,800 of our notes (or our subsidiaries notes) and $1,800
of NNCs convertible debt securities were outstanding. These delays have not resulted in an automatic event of default and acceleration of the outstanding
long-term debt and such default and acceleration cannot occur unless notice by holders of at least
25% of the outstanding principal amount of any relevant series of debt securities of such
non-compliance is provided to us or NNC, as applicable, and we or NNC, as applicable, fail to file
and deliver the relevant Report within 90 days after such notice is provided, all in accordance
with the terms of the indentures. While such notice could have been given at any time after March
30, 2004, neither we nor NNC has received a notice to the date of
this report. After filing the 2003 Annual Reports and our and
NNCs Quarterly Reports on Form 10-Q for the first and second
quarters of 2004, as a result of the
delay in filing our and NNCs Quarterly Reports on Form 10-Q for
the third quarter of 2004, or the Third Quarter Reports, we and NNC
continue not to be in compliance with our
obligations under our and NNCs public debt indentures, as
described above. If notice were given, we believe that it is probable
that we would file and deliver the Third Quarter Reports within 90
days of receipt of such a notice. In the unlikely event that acceleration of our debt securities were to occur, we may be unable to meet our payment
obligations. As previously reported, based on publicly available information as of January 10, 2005, we have
reason to believe that more than 25% of the outstanding principal amount of the $150 of 7.875%
notes due June 2026 issued by one of our subsidiaries and guaranteed by us are held by one holder,
or a group of related holders. Other than with respect to that series of debt securities, based on
such publicly available information, neither we nor NNC are aware of any holder, or group of
related holders, that holds at least 25% of the outstanding principal amount of any relevant series
of debt securities. However, based on such publicly available information, we have reason to
believe that there is sufficient concentration among holders of the $150 of 7.40% notes due June
2006 issued by us that the acquisition of a relatively small additional amount of these notes by
certain holders could result in a holder or a group of related holders holding 25% or more of the
outstanding principal amount of these notes. See Liquidity and capital resources and Risk
factors/forward looking statements.  Shelf registration statement Owing to the delayed filing of the Reports, we are currently unable to use, in its current
form, the remaining approximately $800 of capacity under our shelf registration statement filed
with the SEC for various types of securities. See Liquidity and capital resources and Risk
factors/forward looking statements.  Credit ratings On April 28, 2004,
Standard & Poors, or S&P, downgraded its ratings on us, including our
long-term corporate credit 68




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ratings 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. On April 28, 2004, Moodys Investors Service,
Inc., or Moodys, changed its outlook to potential downgrade from uncertain. See Credit ratings
and Risk factors/forward looking statements.  Regulatory actions and pending litigation We are under investigation by the SEC and the Ontario Securities Commission, or OSC,
Enforcement Staff. In addition, Nortel Networks 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 us and NNC. 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. We and NNC continue to provide periodic updates to the NYSE and the TSX concerning our and
NNCs delay in filing certain of the Reports. The NYSE granted us and NNC an extension of up to
March 31, 2005 to file our 2003 Annual Reports, during which the Nortel Networks Corporation common
shares and our and NNCs other securities would remain listed on the NYSE, and we and NNC filed the
2003 Annual Reports in January 2005. To the date of this report, neither the NYSE nor the TSX has
commenced any suspension or delisting procedures in respect of Nortel Networks Corporation common
shares or other of our or NNCs listed securities. The commencement of any suspension or delisting
procedure by either exchange remains, at all times, at the discretion of such exchange, and would
be publicly announced by the exchange. See Risk factors/forward looking statements.  Stock-based compensation plans As a result of NNCs 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 under employee stock option plans previously assumed by us
in connection with mergers and acquisitions; and the purchase of units in a Nortel Networks 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. Evolution of our supply chain strategy Over the last five years, we have divested most of our manufacturing activities to Electronic
Manufacturing Services, or EMS, suppliers. 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 our Systems
Houses 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 Systems Houses, subject to the completion of
the required information and consultation process. 69




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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 sales) 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. The portions of the
transaction related to the manufacturing activities in Montreal and Calgary are expected to close
in the first and second quarters of 2005, respectively. The balance of the transaction is expected
to close on separate dates occurring during the first half of 2005. 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. We expect to receive cash proceeds ranging
from approximately $675 to $725, which will be allocated to each separate closing and, with respect
to each closing, will be paid on an installment basis up to nine months thereafter. Such payments
will be subject to a number of adjustments, including from potential post-closing date asset
valuations and potential post-closing indemnity payments. Flextronics also has the ability in
certain cases to exercise rights to sell back to us certain inventory and equipment after the
expiration of a specified period (of up to fifteen months) following each respective closing date.
We do not expect such rights to be exercised with respect to any material amount of inventory
and/or equipment. The cash proceeds estimate is comprised of approximately $475 to $525 for
inventory and equipment and $200 for intangible assets. The cash proceeds would be partially
offset by related estimated transaction costs (including transition, potential severance, and
information technology implementation and real estate costs) of approximately $200. We also announced that we plan to create Solutions Operations Centers in Calgary and Montreal and,
pending the completion of information and consultation processes in Europe, in Monkstown and
Chateaudun. These centers are expected to have overall responsibility for the strategic management
and control of our various supply chains, including all customer interfaces, customer service,
order management, quality assurance, product cost management, new product introduction, and network
solutions integration, testing and fulfillment. We believe that the use of an outsourced manufacturing model has enabled us to benefit from leading
manufacturing technologies, leverage existing resources from around the world, lower our cost of
sales, quickly adjust to fluctuations in market demand and decrease our investment in plant,
equipment and inventories. We continue to retain in-house all strategic management and overall
control responsibilities associated with our various supply chains, including all customer
interfaces, customer service, order management, quality assurance, product cost-management, new
product introduction, and network solutions integration, testing and fulfillment. Other business developments  Customer financing commitments During the three months ended March 31, 2004 and 2003, we reduced our undrawn customer
financing commitments by $114 and $148, respectively, primarily as a result of the expiration or
cancellation of commitments and changing customer business plans. As of March 31, 2004, all
undrawn commitments were available for funding under the terms of our financing agreements. For
additional information, see Customer financing.  Sale of Entrust shares On February 3, 2004, we sold approximately 7 million common shares of Entrust Inc., or
Entrust, for cash consideration of $33, resulting in a gain of $18. In connection with this
transaction, we no longer hold any equity interest in Entrust.  Real estate On March 1, 2004, we purchased land and two buildings for $87 that were previously leased by
us, which leases expired on February 28, 2004. As a result, we extinguished a debt of $87. 70




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Customer contract settlement On May 7, 2004, we received $80 in proceeds from the sale of certain assets in connection with
a customer contract settlement in Latin America. This resulted in a gain of $78, which will be
included in (gain) loss on sale of businesses and assets for the three months ended June 30, 2004.  Directory and operator services business On August 2, 2004, we completed the contribution of certain assets and liabilities of our
directory and operator services, or DOS, business to VoltDelta Resources LLC, or VoltDelta, a
wholly owned subsidiary of Volt Information Sciences, Inc., or VIS, in return for a 24% interest in
VoltDelta. After a period of two years, we and VIS each have an option to cause us to sell our
VoltDelta shares to VIS for proceeds ranging from $25 to $70. As a result of this transaction,
approximately 160 of our DOS employees in North America and Mexico joined VoltDelta. We recorded a
gain on sale of businesses and assets of approximately $50 in the third quarter of 2004.  Bharat Sanchar Nigram Limited contract In August 2004, we entered into a contract with Bharat Sanchar Nigram Limited to establish a
wireless network in India. Our commitments to date for orders received under this contract have
resulted in an estimated project loss of approximately $150, which has been recorded in the third
quarter of 2004.  Patent infringement settlement On October 26, 2004, we entered into an agreement with Foundry Networks, Inc., or Foundry, to
settle outstanding patent infringement claims and counterclaims by us and Foundry. As part of the
settlement, we granted Foundry a four year license under certain patents and Foundry paid $35 to
us.  Customer financing arrangements On December 15 and 16, 2004, we sold certain notes receivable and convertible notes receivable
that had been received as a result of the restructuring of a customer financing arrangement for
cash proceeds of $116. The net carrying amount of the notes receivable and convertible notes
receivable was $56. On December 23, 2004, a customer financing arrangement was restructured. The notes receivable that
were restructured had a net carrying amount as of December 31, 2003 of $13, net of provisions for
doubtful accounts of $147 ($55 of the provision is included in discontinued operations). We are
currently assessing the value of the restructured notes receivable and expect that an increase in
value from the net carrying amount has occurred.  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 (3G)
mobile telecommunications equipment and products to customers in China. We expect to have 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 Memorandum of Understanding with LG Electronics 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 execution
of a definitive agreement. We expect to complete this transaction in the second quarter of 2005.
We anticipate that we will own 50% plus one share of the joint venture. Results of operations  continuing operations Segment revenues The following table summarizes our revenues for the three months ended March 31, 2004 and
2003, respectively, by segment: 71




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For the three months ended March 31,2004
    
    
    2003
    
    
    $ Change
    
    
    % ChangeWireless Networks
    
    $
    1,225
    
    
    $
    869
    
    
    $
    356
    
    
    
    41Enterprise Networks
    
    
    534
    
    
    
    585
    
    
    
    (51
    )
    
    
    (9
    )Wireline Networks
    
    
    439
    
    
    
    515
    
    
    
    (76
    )
    
    
    (15
    )Optical Networks
    
    
    245
    
    
    
    317
    
    
    
    (72
    )
    
    
    (23
    )Other(a)
    
    
    1
    
    
    
    9
    
    
    
    (8
    )
    
    
    (89
    )Consolidated
    
    $
    2,444
    
    
    $
    2,295
    
    
    $
    149
    
    
    
    6
 (a)
    
    Other represented miscellaneous business activities and corporate functions.
 Geographic revenues The following table summarizes our geographic revenues based on the location of the customer: For the three months ended March 31,2004
    
    
    2003
    
    
    $ Change
    
    
    % ChangeUnited States
    
    $
    1,217
    
    
    $
    1,161
    
    
    $
    56
    
    
    
    5EMEA(a)
    
    
    596
    
    
    
    579
    
    
    
    17
    
    
    
    3Canada
    
    
    154
    
    
    
    131
    
    
    
    23
    
    
    
    18Asia Pacific
    
    
    347
    
    
    
    303
    
    
    
    44
    
    
    
    15CALA(b)
    
    
    130
    
    
    
    121
    
    
    
    9
    
    
    
    7Consolidated
    
    $
    2,444
    
    
    $
    2,295
    
    
    $
    149
    
    
    
    6
 (a)
    
    The Europe, Middle East and Africa region, or EMEA.(b)
    
    The Caribbean and Latin America region, or CALA.
 Consolidated revenues The following chart summarizes our recent quarterly revenues: (BAR CHART)  Q1 2004 vs. Q1 2003 Our consolidated revenues increased 6% in the first quarter of 2004 compared to the first
quarter of 2003. Revenues in Wireline Networks, Optical Networks and Enterprise Networks decreased
by 15%, 23% and 9%, respectively, while revenues in Wireless Networks increased by 41%. Wireless
Networks revenues increased substantially as a result of increased spending by our wireless service
provider customers on our Universal Mobile Telecommunications Systems, or UMTS, Global System for
Mobile Communications, or GSM, and Code Division Multiple Access, or CDMA, technologies. Our
Wireless Networks business benefited from 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. Declines in other segments were primarily due to continued
capital spending restrictions experienced by our wireline and optical service providers and pricing
and competitive pricing pressures on certain Enterprise Networks data networking products. 72




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Customer spending remained cautious, with many of our customers realigning capital spending with
their current levels of revenues and profits in order to maximize their return on invested capital.
Many customers continued to focus on conserving capital, decreasing their debt levels, reducing
costs and/or increasing the capacity utilization rates and efficiency of existing networks. Also,
excess network capacity and competition continued to exist in the industry which led to continued
pricing pressures on the sale of certain of our products. From a geographic perspective, the 6% increase in revenues in the first quarter of 2004 compared to
the first quarter of 2003 was primarily due to a:  
    
    5% increase in revenues in the U.S. primarily due to the upgrading of CDMA networks in
the region to higher data speeds and GSM network expansion that has been tied to increased
subscriber demand. The increase was partially offset by continued capital spending
restrictions experienced by wireline and optical service providers and pricing and
competitive pricing pressures on certain Enterprise Networks data networking products.
    
    15% increase in revenues in Asia Pacific primarily due to new GSM contracts
with certain service providers and CDMA network upgrades, which was partially offset by
increased competition and reductions in capital spending for Optical Networks products in
the region;
    
    18% increase in revenues in Canada primarily due to GSM contracts with certain
service providers in response to increased subscriber demand; and
    
    3% increase in revenues in EMEA primarily due to new GSM and UMTS contracts
with certain service providers which was partially offset by continued capital spending
restrictions experienced by wireline service providers and decreased product volumes
experienced with Enterprise Networks channel partners.  Q1 2004 vs. Q4 2003 Our consolidated revenues decreased 25% in the first quarter of 2004 compared to the fourth
quarter of 2003. The substantial declines in Enterprise Networks, Wireline Networks and Optical
Networks revenues and the significant decline in Wireless Networks revenues were due to typical
industry seasonality declines in all business segments, extended Wireline Networks product
acceptance timelines and decreased product volumes with Enterprise Networks channel partners.
Also, in the fourth quarter of 2003, we experienced an increase in revenues associated with our
traditional circuit switching and interactive voice response products primarily due to the release
of key software including Succession 3.0. The general availability of this software in the fourth
quarter of 2003 triggered the recognition of approximately $300 of associated revenues deferred
from prior periods. From a geographic perspective, the 25% decline in revenues in the first quarter of 2004 compared to
the fourth quarter of 2003 was primarily due to a:  
    
    37% decrease in revenues in the U.S. primarily due to seasonality typically
associated with the first quarter of our fiscal year, certain service provider customers
completing their network expansions, recognition of previously deferred revenue relating to
the general availability of Succession 3.0 in the fourth quarter of 2003 and declines in
traditional circuit switching volumes with certain of our large channel partners; and
    
    13% decrease in revenues in EMEA and 22% decrease in revenues in Canada
primarily due to seasonality; partially offset by
    
    10% increase in revenues in Asia Pacific primarily resulting from new service
provider contracts in the region.  2004 and 2005 We expect that our consolidated revenues in 2004 will be slightly lower compared with 2003.
The 2003 consolidated revenues included revenues that were deferred from prior periods. Although
we expect a slight decline of consolidated revenues in 2004 as compared to 2003, we saw growth in
several areas in 2004 primarily as a result of customers increasing their investments in:  
    
    voice over packet technologies;
    
    third generation wireless technologies; and
    
    expansion and enhancement of existing networks due to subscriber growth and competitive pressures. The period of relative industry stability that had characterized the second half of 2003 continued
into 2004. For 2005, we expect revenue growth over 2004 primarily due to continued growth in the
above areas. 73




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Spending in these areas of our business has been partially offset by customers limiting their
investment in mature technologies as they focus on maximizing return on investment capital. In
addition, we have continued to experience pricing pressures on sales of certain of our products as
a result of increased competition particularly from low cost suppliers. Further, while customer
support generally remains strong, we believe the ongoing restatement activities and the internal
restructuring and realignment programs initiated in August 2004 adversely impacted business
performance in 2004. Consolidated revenues for the third and fourth quarters of 2004 reflect certain of these trends,
with third quarter 2004 consolidated revenues lower than previously announced preliminary unaudited
consolidated revenues for the second quarter of 2004. Our fourth quarter is expected to be our
strongest quarter in 2004. Our quarterly results of operations will not necessarily be consistent
with our historical quarterly profile or indicative of our expected results in future quarters.
See Risk factors/forward looking statements for other factors that may affect our revenues. Wireless Networks revenues The following chart summarizes recent quarterly revenues for Wireless Networks: (BAR CHART)  Q1 2004 vs. Q1 2003 Wireless Networks revenues increased 41% in the first quarter of 2004 compared to the first
quarter of 2003 due to increased spending by our wireless service provider customers on our UMTS,
GSM and CDMA technologies. We benefited from 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. CDMA revenues increased substantially in the first quarter of 2004 compared to the first quarter of
2003 due to a significant increase in the U.S. and a substantial increase in Asia Pacific. In the
U.S. our customers expanded and upgraded their existing networks to accommodate higher data speeds.
In Asia Pacific, CDMA revenues increased substantially primarily due to new contracts with certain
service provider customers and other customers expanding their existing networks to meet increased
subscriber demand. These increases in revenues were partially offset by a substantial CDMA revenue
decline in EMEA primarily due to the completion of key customer network deployments during the
first quarter of 2003. Time Division Multiple Access, or TDMA, revenues declined substantially in the first quarter of
2004 compared to the first quarter of 2003 primarily due to the ongoing transition to newer
wireless technologies. The substantial decline was primarily due to customers in the U.S. and CALA
continuing to migrate from the mature TDMA technology to GSM and CDMA technologies. In the first
quarter of 2004, TDMA revenues accounted for approximately 2% of total Wireless Networks revenues
compared to 10% in the first quarter of 2003. GSM revenues increased substantially in the first quarter of 2004 compared to the first quarter of
2003. The substantial increase was due to substantial increased revenues across all regions
primarily related to accelerated network expansions with certain service providers expanding their
existing networks to meet increased subscriber demand and new contracts with certain service
providers. UMTS revenues increased substantially in the first quarter of 2004 compared to the first quarter of
2003 primarily due to the continued transition to this next generation technology in EMEA and the U.S. From a geographic perspective, the 41% increase in Wireless Networks revenues in the first quarter
of 2004 compared to the 74




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same period in 2003 was primarily due to a 28% increase in revenues in the
U.S., a 135% increase in revenues in Asia Pacific, a 41% increase in revenues in EMEA and a 113%
increase in revenues in Canada primarily due to new contracts with certain service provider
customers and other customers expanding or enhancing their existing networks to meet increased
subscriber demand and in the U.S., customers expanding and upgrading their existing networks to
accommodate higher data speeds.  Q1 2004 vs. Q4 2003 Wireless Networks revenues decreased 15% in the first quarter of 2004 compared to the fourth
quarter of 2003 due to substantial declines in CDMA and TDMA revenues and a significant reduction
in UTMS revenues and moderately lower GSM revenues. The substantial decline in CDMA revenues and
modest decline in GSM revenues were primarily due to seasonality typically associated with the
first quarter of our fiscal year as well as certain service provider customers completing their
network expansions in 2003. The substantial decline in TDMA revenues was primarily due to
customers in the U.S. continuing to migrate from the mature TDMA technology to GSM and CDMA
technologies. The significant reduction in UTMS revenues was mainly due to a slowdown in
deployment by certain service provider customers. From a geographic perspective, the 15% decrease in Wireless Networks revenues in the first quarter
of 2004 compared to the fourth quarter in 2003 was primarily due to a 25% decrease in revenues in
the U.S., 11% decline in EMEA and 12% decline in Canada, partially offset by a 31% increase in
revenues in Asia Pacific. The decreases in the U.S. and EMEA were mainly related to seasonality
typically associated with the first quarter of our fiscal year as well as certain service provider
customers completing their network expansions in the fourth quarter of 2003. The increase in Asia
Pacific was primarily due to new contracts with certain service provider customers.  2004 and 2005 During 2004, Wireless Networks revenues continued to be primarily generated by sales of CDMA
and GSM technologies. Also, revenues associated with our TDMA technology continued to decline in
2004 compared to 2003 due to the continued transition to newer wireless technologies. Regarding
our UMTS technology, revenues have grown compared to 2003 as a result of contracts announced in the
second half of 2003 and in 2004 and the continued transition to this next generation technology.
We expect a growing percentage of our Wireless Networks revenues to come from our UMTS technology.
While we have seen encouraging indicators in certain areas of the wireless market, we can provide
no assurance that these growth areas that have begun to emerge will continue in the future. Enterprise Networks revenues The following chart summarizes recent quarterly revenues for Enterprise Networks: (BAR CHART)  Q1 2004 vs. Q1 2003 Enterprise Networks revenues declined 9% in the first quarter of 2004 compared to the first
quarter of 2003 primarily due to a significant decline in the data networking and security portion
of this segment. Revenues from the circuit and packet voice portion of this segment remained essentially flat in the
first quarter of 2004 compared to the same period in 2003. We experienced a reduction in revenues associated with our
traditional circuit switching products primarily due to the continued evolution towards Internet
Protocol, or IP, telephony solutions. Revenue declines in our traditional circuit switching were
partially offset by a substantial increase in revenues associated with our IP telephony solutions
as customers continued to migrate towards converged packet voice solutions. 75




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Revenues associated with the data networking and security portion of this segment decreased
significantly in the first quarter of 2004 compared to the first quarter of 2003. The significant
decrease in revenues was primarily due to a decline in sales of our legacy routing portfolio and
associated declines in new service contracts and service contract renewals. We also experienced a
decline in revenue from certain of our data networking products primarily due to pricing pressures
driven by increased competition. These declines were partially offset by growth in revenues of
certain new data products. From a geographic perspective, the 9% decline in Enterprise Networks revenues in the first quarter
of 2004 compared to the first quarter of 2003 was primarily due to a:  
    
    7% decline in revenues in the U.S. primarily due to a decline in volume of our
traditional circuit switching products, pricing and competitive pressures on certain of our
data products and a reduction in the number of new service contracts and service contract
renewals;
    
    10% decline in revenues in EMEA primarily due to pricing and competitive
pressures on certain data networking products and continuing economic uncertainty in the
region; and
    
    19% decline in revenues in Asia Pacific primarily due to a reduction in our
traditional circuit switching products.  Q1 2004 vs. Q4 2003 Enterprise Networks revenues declined 43% in the first quarter of 2004 compared to the fourth
quarter of 2003 due to a substantial decline in the circuit and packet voice portion of this
segment and a decline in the data networking and security portion of this segment. Traditional
circuit switching product revenues declined substantially primarily due to the continued evolution
towards IP telephony solutions. In the fourth quarter of 2003, we experienced an increase in
revenues associated with our traditional circuit switching and interactive voice response products
primarily due to the release of key software including Succession 3.0. The general availability of
this software in the fourth quarter of 2003 triggered the recognition of approximately $300 of
associated revenues deferred from prior periods. Many of the software programs that caused the
deferrals ended in the fourth quarter of 2003 resulting in the release of the remaining deferral
during that period. Our legacy routing portfolio and associated new service contracts and
service contract renewals also decreased due to pricing and competitive pressures as well as
product constraints. Additionally, security products experienced unusually high seasonal volumes
in the fourth quarter of 2003, which were not repeated in the first quarter of 2004. From a geographic perspective, the 43% decline in Enterprise Networks revenues in the first quarter
of 2004 compared to the fourth quarter of 2003 was primarily due to a 60% decline in the U.S., a 9%
decline in EMEA and a 16% decline in Canada. The declines in the U.S. and Canada were primarily
due to declines in traditional circuit switching volumes with certain of our large U.S. channel
partners, pricing and competitive pressures on certain of our data products, reduction in the
number of new service contracts and service contract renewals and the recognition of previously
deferred revenues relating to the release of certain software including the general availability of
Succession 3.0 in the fourth quarter of 2003. The decline in revenue in EMEA was primarily due to
pricing and competitive pressures on certain data networking products and continuing economic
uncertainty in the region.  2004 and 2005 During 2004, our Enterprise Networks customers continued to increase the deployment of voice
over packet technologies in their communications networks. We expect that data, voice and
multimedia communications will continue to converge, and enterprises will look for ways to maximize
the effectiveness of their existing networks while reducing ongoing capital expenditures and
operating costs. Also, we anticipate that demand will continue to decline for our traditional
circuit switching products, however, it is difficult to determine the extent to which future
declines in demand will occur as a result of the migration to voice over packet technologies. In
2005, we are focused on increasing our market presence with enterprise customers. In particular,
we are focusing on leading enterprise customers with high performance networking needs. While we
have seen encouraging indicators in certain parts of the enterprise market, we can provide no
assurance that the growth areas that have begun to emerge will continue in the future. 76




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Wireline Networks revenues The following chart summarizes recent quarterly revenues for Wireline Networks: (BAR CHART)  Q1 2004 vs. Q1 2003 Wireline Networks revenues declined 15% in the first quarter of 2004 compared to the first
quarter of 2003 due to a decline in the circuit and packet voice portion of this segment and a
substantial decline in the data networking and security portion of this segment. Revenues from the circuit and packet voice portion of this segment decreased primarily due to a
significant decline in our traditional circuit switching product revenues primarily due to the
continued capital spending restrictions by service providers of these mature products and also
uncertainty related to the impact of the Federal Communications Commission , or FCC, decision
regarding the regulation of the availability of unbundled network elements, or UNEs, released on
August 21, 2003 and subsequent judicial review and FCC reconsideration of the decision. Revenues from the data networking and security portion of this segment decreased substantially in
the first quarter of 2004 compared to the first quarter of 2003 primarily due to substantial
declines in EMEA and the U.S. In these regions, we experienced a decline in demand for our mature
products primarily due to service providers continuing to reduce their capital expenditures in this
area. Additionally, pricing pressure has driven a portion of the revenue decline in these regions
as certain customer contracts were renegotiated in the period. From a geographic perspective, the 15% decline in Wireline Networks revenues in the first quarter
of 2004 compared to the first quarter of 2003 was primarily due to a:  
    
    23% decline in revenues in the U.S. primarily due to the continued decline in
legacy products in both circuit and packet voice and data networking and security;
    
    10% decline in revenues in EMEA primarily due to a decline in demand for our
mature data products; and
    
    7% decline in revenues in Asia Pacific due to low demand for both mature
circuit and next generation packet voice solutions; partially offset by
    
    56% increase in revenues in CALA primarily due to demand for both mature and
next generation packet voice solutions.  Q1 2004 vs. Q4 2003 Wireline Networks revenues declined 23% in the first quarter of 2004 compared to the fourth
quarter of 2003 due to substantial declines in the data networking and security portion of this
segment and the circuit and packet voice portion of this segment. These declines were primarily
due to incremental fourth quarter spending by certain service provider customers as well as the
seasonality factors that are traditionally associated with the first quarter of our fiscal year.
Also, packet voice product revenues declined sequentially due to typical high levels of fourth
quarter spending by our North American carrier customers. From a geographic perspective, the 23% decline in Wireline Networks revenues in the first quarter
of 2004 compared to the fourth quarter of 2003 was primarily due to a 27% decline in the U.S., a
15% decline in EMEA and a 41% decline in Canada. These declines were primarily due to the factors
mentioned above. 77




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2004 and 2005 In 2004, our service provider customers continued to increase the deployment of packet-based
technologies in their communications networks as they looked for ways to optimize their existing
networks and offer new revenue generating services while limiting capital expenditures and
operating costs. However, the timing of when service provider customers will deploy packet-based
technologies on a wider scale is still unclear. Further, it is difficult to determine the effect
the FCC decision regarding the regulation of the availability of UNEs and subsequent adoption on
December 15, 2004 of new unbundling rules in response to the remand by the U.S. Court of Appeals
for the D.C. Circuit will have on our business. The demand for our traditional circuit switching
products has continued to decline as certain service providers continued to reduce their capital
expenditures on these legacy technologies. While we have seen encouraging indicators in certain
areas of the wireline service provider market, we can provide no assurance that the growth areas
that have begun to emerge will continue in the future. Optical Networks revenues The following chart summarizes recent quarterly revenues for Optical Networks: (BAR CHART)  Q1 2004 vs. Q1 2003 Optical Networks revenues declined 23% in the first quarter of 2004 compared to the first
quarter of 2003 due to a substantial decline in the long-haul portion of this segment. Revenues in the long-haul portion of this segment declined significantly in CALA and declined
substantially across all other regions primarily due to capital spending restrictions as customers
completed their network expansions in 2003. Globally, service providers continued to focus on
maximizing return on invested capital by increasing the capacity utilization rates and efficiency
of existing networks. In addition, significant excess inventories continued to exist in this
portion of the segment which resulted in ongoing pricing pressures across all regions. Revenues in the metro optical portion of this segment increased significantly in the first quarter
of 2004 compared to the first quarter of 2003. The significant increase in revenues was primarily
due to a substantial increase in the U.S. primarily related to certain service provider customers
upgrading and expanding their regional networks. From a geographic perspective, the 23% decline in Optical Networks revenues in the first quarter of
2004 compared to the same period in 2003 was primarily due to a:  
    
    51% decline in revenues in Asia Pacific primarily due to increased competition and
reductions in capital spending for optical products; and
    
    24% decline in revenues in EMEA primarily related to the completion of certain
long-haul network build-outs and other one-time shipments to certain customers in the first
quarter of 2003.  Q1 2004 vs. Q4 2003 Optical Networks revenues declined 22% in the first quarter of 2004 compared to the fourth
quarter of 2003. The decline was primarily the result of a substantial decline in the long-haul
portion of this segment and a significant decline in the metro optical portion of this segment.
These declines were primarily due to certain one-time shipments in
the fourth quarter of 2003 that were not repeated in the first quarter of 2004. 78




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From a geographic perspective, the 22% decline in Optical Networks revenues in the first quarter of
2004 compared to the fourth quarter of 2003 was primarily due to a 31% decline in the U.S. and a
24% decline in EMEA. The declines in both regions were primarily due to one-time shipments to
certain customers in the fourth quarter of 2003 that were not repeated in the first quarter of
2003.  2004 and 2005 During 2004, our major customers in the optical long-haul portion of Optical Networks remained
focused on maximizing return on their invested capital by increasing the capacity utilization rates
and efficiency of existing networks. We expect that any additional capital spending by those
customers in the near term will be increasingly directed to opportunities that enhance customer
performance, revenue generation and cost reduction. We see an increase in demand for metro Dense Wavelength Division Multiplexing, or metro DWDM. This
increase is primarily due to new network deployments by certain customers and other customers
expanding their networks, driven by emerging applications such as Cable Video on Demand, all of
which have resulted in a need for low cost, high capacity connectivity between network sites. As a
result, we expect that the metro optical portion of this segment will continue to represent a
larger percentage of overall Optical Networks revenues. While we have seen encouraging indicators
in certain parts of the optical 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 31,2004
    
    
    2003
    
    
    $ Change
    
    
    % ChangeGross profit
    
    $
    1,072
    
    
    $
    907
    
    
    $
    165
    
    
    
    18Gross margin
    
    
    43.9
    %
    
    
    39.5
    %
    
    
    4.4
    %
 Gross margin improved 4.4 percentage points in the first quarter of 2004 compared to the first
quarter of 2003 primarily due to:  
    
    continued improvements in our cost structure primarily as a result of
favorable supplier pricing; partially offset by
    
    changes in product mix mainly related to decreased volumes of certain products with higher margins; and
    
    pricing pressures on certain of our products. While we cannot predict the extent to which changes in product mix and pricing pressures will
impact our gross margin, we continue to see the effects of improvements in our product costs
primarily due to favorable material pricing. Considering the impacts of our strategic plan
described under Business overview  Our strategic plan and outlook and the higher costs
associated with initial customer deployments in emerging markets, we expect that gross margin will
trend in the range of 40% to 44% through 2005. See Risk factors/forward looking statements for
factors that may affect our gross margins.  Segment gross profit and gross margin  Wireless Networks Wireless Networks gross margin improved by approximately 4.7 percentage points in the first quarter
of 2004 compared to the first quarter of 2003 primarily due to:  
    
    changes in product mix mainly related to increased volumes of certain products with higher margins;
    
    improvements in our product costs primarily as a result of favorable materials pricing; and
    
    improvements in other operations related costs; partially offset by
    
    reductions in the selling price of certain products as a
result of increased competition for service provider customers; and
    
    an increase in contract-related costs including customer trials. 79




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Enterprise Networks Enterprise Networks gross margin improved by approximately 0.2 percentage points in the first
quarter of 2004 compared to the first quarter of 2003 primarily due to:  
    
    improvements in our product costs primarily as a result of favorable material pricing; partially offset by
    
    reductions in the selling price of certain of our products in
2003 as a result of increased competition for enterprise customers.  Wireline Networks Wireline Networks gross margin improved by approximately 2.4 percentage points in the first quarter
of 2004 compared to the first quarter of 2003 primarily due to improvements in our cost structure
as a result of favorable supplier pricing and design improvements.  Optical Networks Optical Networks gross margin improved by approximately 2.1 percentage points in the first quarter
of 2004 compared to the first quarter of 2003 primarily due to:  
    
    changes in product mix mainly related to increased volumes in the metro optical portion of this segment; and
    
    reductions in operations related costs mainly in the U.S., Canada and EMEA. Operating expenses  Selling, general and administrative expense For the three months ended March 31,2004
    
    
    2003
    
    
    $ Change
    
    
    % ChangeSG&A expense
    
    $
    538
    
    
    $
    490
    
    
    $
    48
    
    
    
    10As % of revenues
    
    
    22.0
    %
    
    
    21.4
    %
    
    0.6
    pts
 SG&A expense increased
$48 in the first quarter of 2004 compared to the first quarter of 2003
primarily due to:  
    
    an increase in expense related to our stock-based compensation plans,
including restricted stock unit and stock option programs;
    
    significant unfavorable foreign exchange impacts associated with the Canadian
dollar, euro and British pound; and
    
    net trade and customer financing receivable recoveries of $2 in the first
quarter of 2004 compared to a recovery of $17 in the first quarter of 2003. Recoveries
were higher in 2003 as a result of favorable settlements related to the sale or
restructuring of various receivables and net recoveries on other trade and customer
financing receivables due to subsequent collections for amounts exceeding our original
estimates of net recovery; partially offset by
    
    the continued impact of our workforce reductions and associated reductions in
other related costs such as information services and real estate in the first quarter of
2003 that was not repeated in the first quarter of 2004. Overall in 2004, we expect increased SG&A expense compared to 2003 primarily as a result of net
trade and customer financing receivable recoveries of $179 that were included in our SG&A expense
in 2003 that are not expected to be repeated at the same levels in 2004, negative foreign exchange
impacts, increases in our stock-based compensation programs and costs of approximately $115 related
to our restatement activities. Although we expect increased SG&A expense in 2004 compared to 2003,
through the implementation of our strategic plan, we expect to reduce operating expenses (both SG&A
and R&D expense) to 35% of revenues or lower on an annualized basis in 2005. See Business
overview  Our strategic plan and outlook. 80




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Segment selling, general and administrative expense  Wireless Networks Wireless Networks SG&A expense increased substantially in the first quarter of 2004 compared to the
first quarter of 2003 primarily due to:  
    
    increases in employee related expenses and unfavorable foreign exchange rate impacts; and
    
    net trade and customer financing receivable recoveries in the first quarter of 2003 not repeated in 2004.  Enterprise Networks Enterprise Networks SG&A expense remained essentially flat in the first quarter of 2004 compared to
the first quarter of 2003 primarily due to:  
    
    the continued impact of our workforce reductions, primarily in the U.S. and
Canada, and associated reductions in other related costs such as information services and
real estate; partially offset by
    
    unfavorable foreign exchange rate impacts.  Wireline Networks Wireline Networks SG&A expense decreased modestly in the first quarter of 2004 compared to the
first quarter of 2003 primarily due to net trade receivable provisioning in the first quarter of
2003 not repeated in 2004.  Optical Networks Optical Networks SG&A expense decreased significantly in the first quarter of 2004 compared to the
first quarter of 2003 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.  Research and development expense For the three months ended March 31,2004
    
    
    2003
    
    
    $ Change
    
    
    % ChangeR&D expense
    
    $
    466
    
    
    $
    477
    
    
    $
    (11
    )
    
    
    (2
    )As % of revenues
    
    
    19.1
    %
    
    
    20.8
    %
    



    (1.7 pts
    )
 R&D expense was relatively flat in the first quarter of 2004 compared to the first quarter of
2003 primarily due to the continued impact of our workforce reductions partially offset by
unfavorable foreign exchange impacts. Our continued strategic investments in R&D are aligned with technology leadership in anticipated
growth areas. 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. As
a result, our R&D expense as a percentage of our consolidated revenues remained relatively flat at
19.1% in the first quarter of 2004 compared to 20.8% in the first quarter of 2003. 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 2004 will be similar to 2003 and 2005
will be lower than 81




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2004 as we seek to achieve ongoing cost reductions in R&D as part of our
strategic plan first announced in August 2004. See Business overview  Our strategic plan and
outlook.  Segment research and development expense  Wireless Networks Wireless Networks R&D expense increased slightly in the first quarter of 2004 compared to the first
quarter of 2003 primarily due to:  
    
    continued investment in the development of new CDMA products;
    
    acceleration of programs to increase the feature content in GSM product offerings; and
    
    unfavorable foreign exchange impacts associated with the Canadian dollar and euro.  Enterprise Networks Enterprise Networks R&D expense decreased slightly in the first quarter of 2004 compared to the
first quarter of 2003 primarily due to:  
    
    effectively prioritizing our investment in our data products and increased outsourcing activity; partially offset by
    
    unfavorable foreign exchange impacts associated with the Canadian dollar; and
    
    acceleration of IP portfolio R&D programs.  Wireline Networks Wireline Networks R&D expense increased in the first quarter of 2004 compared to the first quarter
of 2003 primarily due to:  
    
    continued investment in the development of new voice and data products;
    
    accelerated development of certain new products; and
    
    unfavorable foreign exchange rate impacts associated with the Canadian dollar.  Optical Networks Optical Networks R&D expense decreased substantially in the first quarter of 2004 compared to the
first quarter of 2003 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.  Segment contribution margin For the three months ended March 31,2004
    
    
    2003
    
    
    $ Change
    
    
    % ChangeWireless Networks
    
    $
    448
    
    
    $
    272
    
    
    $
    176
    
    
    
    65Enterprise Networks
    
    
    82
    
    
    
    107
    
    
    
    (25
    )
    
    
    (23
    )Wireline Networks
    
    
    111
    
    
    
    129
    
    
    
    (18
    )
    
    
    (14
    )Optical Networks
    
    
    2
    
    
    
    2
    
    
    
    
    
    
    
    Other
    
    
    (109
    )
    
    
    (93
    )
    
    
    (16
    )
    
    
    (17
    )Total
    
    $
    534
    
    
    $
    417
    
    
    $
    117
    
    
    
    28
 As a result of the gross margin and SG&A expense changes discussed above, our total segment
contribution margin improved by $117 in the first quarter of 2004 compared to the first quarter of
2003. See Segment information in note 5 of the accompanying unaudited consolidated financial statements. 82




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Segment Management EBT For the three months ended March 31,2004
    
    
    2003
    
    
    $ Change
    
    
    % ChangeWireless Networks
    
    $
    221
    
    
    $
    50
    
    
    $
    171
    
    
    
    342Enterprise Networks
    
    
    25
    
    
    
    46
    
    
    
    (21
    )
    
    
    (46
    )Wireline Networks
    
    
    (5
    )
    
    
    38
    
    
    
    (43
    )
    
    
    (113
    )Optical Networks
    
    
    (53
    )
    
    
    (52
    )
    
    
    (1
    )
    
    
    (2
    )Other
    
    
    (71
    )
    
    
    (119
    )
    
    
    48
    
    
    
    40Total
    
    $
    117
    
    
    $
    (37
    )
    
    $
    154
    
    
    
    416
 The changes in segment Management EBT are a result of the gross margin, SG&A expense and R&D
expense changes discussed above. See Segment information in note 5 of the accompanying unaudited
consolidated financial statements for a reconciliation of segment Management EBT to net earnings
(loss) from continuing operations.  Special charges During the three months ended March 31, 2004, we continued to implement our restructuring work
plan initiated in 2001. In addition, as described below, certain exit activities initiated in 2003
were continued. Special charges recorded from January 1, 2004 to March 31, 2004 were as follows: ContractsettlementWorkforce
    
    
    and leasereduction
    
    
    costs
    
    
    TotalProvision balance as of December 31, 2003(a)
    
    $
    64
    
    
    $
    455
    
    
    $
    519Other special charges
    
    
    6
    
    
    
    
    
    
    
    6Revisions to prior accruals
    
    
    
    
    
    
    1
    
    
    
    1Cash drawdowns
    
    
    (27
    )
    
    
    (57
    )
    
    
    (84
    )Non-cash drawdowns
    
    
    
    
    
    
    
    
    
    
    Foreign exchange and other adjustments
    
    
    
    
    
    
    7
    
    
    
    7Provision balance as of March 31, 2004 (a)
    
    $
    43
    
    
    $
    406
    
    
    $
    449
 (a)
    
    As of March 31, 2004 and December 31, 2003, the short-term provision balance was $161 and
$205, respectively, and the long-term provision balance was $288 and $314, respectively (which
was included in long-term provisions, as a component of other liabilities).
 We implemented our work plan to streamline our operations and activities around our core
markets and leadership strategies during 2001 in light of the significant downturn in both the
telecommunications industry and the economic environment, and capital market trends impacting our
operations and expected future growth rates. This work plan was adjusted during 2001, 2002 and
2003 to reflect the continued decline in the industry and economic environment, and in the capital
markets. In addition, we initiated activities in 2003 to exit certain leased facilities and leases
for assets no longer used across all segments. In the first quarter of 2004, we recorded special charges of $7, which included revisions of $1
related to prior accruals. Workforce reduction charges of $6 related to the cost of severance and benefits associated with
approximately 80 employees notified of termination during the three months ended March 31, 2004
which related entirely to Optical Networks. During the three months ended March 31, 2004, the
workforce reduction provision balance was drawn down by cash payments of $27. The remaining
provision is expected to be substantially drawn down by the end of 2004. No new contract settlement and lease costs were incurred during the period. Revisions to prior
accruals for contract settlement and lease cost estimates 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. The remaining
provision, net of approximately $313 in estimated sublease revenue,
is expected to be substantially drawn down by the end of 2013. 83




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On December 31, 2003, our workforce was 35,160. In 2004 and into 2005, our focus is on managing
each of our businesses based on financial performance, the market and customer priorities. In the
third quarter of 2004, we announced a strategic plan that includes a work plan involving focused
workforce reductions and a voluntary retirement program relating in the aggregate to 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. Expected cash
costs in connection with this work plan are approximately $430. See Business overview  Our
strategic plan and outlook. For additional information on expected future cash outflows related to special charges, see
Liquidity and capital resources  Uses of liquidity. For additional information related to our
restructuring activities, see Special charges in note 6 of the accompanying unaudited
consolidated financial statements. Other income (expense)  net In the first quarter of 2004, other income  net was $88, which primarily included:  
    
    a gain of $18 related to the sale of our remaining 7 million common shares of Entrust;
    
    interest income of $14 on our short-term investments;
    
    $23 related to the gain on prepaid equity forward purchase contracts that were
entered into in connection with the issuance of restricted stock units;
    
    dividend income of $5 on our short-term investments; and
    
    a gain of $13 related to the sale of Arris Group, Inc., or Arris Group,
 shares. For additional information on our investment in Arris Group see Results of
operations  discontinued operations. In the first quarter of 2003, other income  net was $95, which primarily included:  
    
    interest income of $15 on our short-term investments;
    
    foreign exchange gains of $92 primarily related to day-to-day transactional activities; and
    
    a payment of $25 received from a settlement related to intellectual property use; partially offset by
    
    adjustments to various sales tax reserves of $28. Interest expense Interest expense decreased $1 in the first quarter of 2004 compared to the first quarter of
2003 primarily due to a reduction in the outstanding balances of our notes payable and long-term
debt. Our quarterly interest expense in the first quarter of 2004 and the second quarter of 2004 was $32
and $28, respectively. We expect that the quarterly interest expense for the remainder of 2004 will
remain at similar levels. Income tax benefit (expense) 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 loss of associated companies.
This tax benefit resulted from the settlement of certain tax audits
partially offset by the draw down of our deferred tax assets and current income tax
provisions in certain taxable jurisdictions and various corporate minimum related income taxes. In the first quarter of 2003, we recorded a tax benefit of $3 on a pre-tax loss of $137 from
continuing operations before minority interests and equity in net loss of associated companies.
The income tax benefit was attributed to the utilization of a portion of the current periods
operating losses against the income earned in discontinued operations. As of March 31, 2004, 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. Our valuation
allowance is primarily attributed to ongoing industry concerns. Given the magnitude of our
valuation 84




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allowance, future adjustments to this allowance based on actual cash results could result
in a significant adjustment to our effective tax rate. For additional information, see
Application of critical accounting 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 earnings from continuing operations were $116 in the first quarter of 2004. This
amount represented an improvement of $289 compared to our net loss from continuing operations of
$173 in the first quarter of 2003. Results of operations  discontinued operations As of December 31, 2003, we had substantially completed the wind-down of our access solutions
operations. In the first quarter of 2004, there was almost no activity in discontinued operations and we
recorded net earnings from discontinued operations (net of tax) of $1. In the first quarter of 2003, we recorded $133 in net earnings from discontinued operations (net of
tax), primarily related to the following activity:  
    
    a gain of $12 on March 24, 2003 from the sale of 8 million common shares of Arris Group
back to Arris Group for cash consideration of $28 pursuant to a March 11, 2003 agreement.
In addition, on March 18, 2003, we assigned our membership interest in Arris Interactive
LLC, or Arris, to ANTEC Corporation, an Arris Group company, for cash consideration of
$88, resulting in a loss of $2. Also in connection with these transactions, we received
$11 upon the settlement of a sales representation agreement with Arris Group and recorded
a gain of $11. Following the March 2003 transactions, we reduced our interest in Arris
Group to 18.8 percent, and ceased equity accounting for the investment. As a result, we
reclassified our remaining ownership interest in Arris Group as an available-for-sale
investment within continuing operations effective in the second quarter of 2003. We
continue to dispose of our interest in Arris Group, and the gain or loss on the sale of
 shares subsequent to the first quarter of 2003 was included in other
income (expense)  net; and
    
    a gain of $66 in the first quarter of 2003 from the settlement of certain trade and
customer financing receivables, the majority of which was previously provisioned. For additional information, see Discontinued operations in note 17 of the accompanying unaudited
consolidated financial statements and Other income (expense)  net. Liquidity and capital resources Cash flows The following table summarizes our cash flows by activity and cash on hand as of March 31: 2004
    
    
    2003Net cash from (used in) operating activities of continuing operations
    
    $
    (308
    )
    
    $
    (137
    )Net cash from (used in) investing activities of continuing operations
    
    
    14
    
    
    
    (11
    )Net cash from (used in) financing activities of continuing operations
    
    
    (112
    )
    
    
    (67
    )Effect of foreign exchange rate changes on cash and cash equivalents
    
    
    13
    
    
    
    18Net cash from (used in) continuing operations
    
    
    (393
    )
    
    
    (197
    )Net cash from (used in) discontinued operations
    
    
    (3
    )
    
    
    301Net increase (decrease) in cash and cash equivalents
    
    
    (396
    )
    
    
    104Cash and cash equivalents at beginning of period
    
    
    3,928
    
    
    
    3,742Cash and cash equivalents at end of period
    
    $
    3,532
    
    
    $
    3,846
 85




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As of March 31, 2004, our primary source of liquidity was our cash. As of March 31, 2004, we
had cash of $3,532 excluding $62 of restricted cash and cash equivalents. We believe this cash
will be sufficient to fund the changes to our business model in accordance with the strategic plan
(see Business overview  Our strategic plan and outlook), manage 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 including those 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. In the first quarter of 2004, our cash flows used in operating activities were $308 due to net
earnings from continuing operations of $116, less net adjustments of $16 for non-cash and other
items, less an adjustment of $408 related to the net change in our operating assets and
liabilities. The net use of cash of $408 resulting from the change in our operating assets and
liabilities was primarily due to:  
    
    cash of $1 due to a decrease in restricted cash; and
    
    net cash of $58 from accounts receivable related primarily to an increase in collections
in the first quarter of 2004 as a result of the increase in revenues in the first quarter
of 2004 compared to the first quarter of 2003; more than offset by
    
    $54 primarily related to product shipments not exceeding additions to inventories during
the first quarter of 2004;
    
    use of cash of $23 related to income taxes;
    
    $84 in restructuring related cash outflows; and
    
    a net decrease of $306 related to accounts payable and accrued liabilities and other
operating assets and liabilities. The net decrease of $306 related to accounts payable and accrued liabilities and other operating
assets and liabilities was mainly a result of:  
    
    payments related to our employee bonus plans;
    
    payments related to our stock-based compensation plans, including restricted stock unit programs;
    
    payments of certain contract manufacturer and supplier accruals;
    
    settlement of certain obligations related to our internal information systems infrastructure;
    
    activities associated with our outsourcing contracts;
    
    reduction of certain customer contract settlement costs; and
    
    the proportionate decrease in these assets and liabilities as a result of the decline in the size of our business. As a result of previously incurred tax losses and tax credits, we do not expect that we will have
to make significant cash income tax payments in the foreseeable future. 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. 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 is primarily due to the extinguishment of debt of $87 related to
the purchase of land and two buildings in the U.S. 86




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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. Also in the first quarter of 2004, our discontinued operations used net cash of $3 related to the
continued wind down of our discontinued operations. Uses of liquidity As of March 31, 2004, our cash requirements for the next 12 months are primarily to fund:  
    
    operations;
    
    research and development;
    
    costs relating to workforce reduction and other restructuring activities;
    
    capital expenditures;
    
    debt service;
    
    pension and post-retirement benefits; and
    
    costs in relation to the restatement activities, matters related to the
Independent Review and other related matters, including regulatory and other legal
proceedings. In particular, we are subject to significant pending civil litigation actions and regulatory and
criminal investigations, which could materially adversely affect our financial condition and
liquidity by requiring us to pay substantial judgments, settlements, fines or other penalties. See
Risk factors/forward looking statements. Considerable effort and resources have been expended
on our restatement activities in 2004, including the dedicated effort of hundreds of employees and
numerous external consultants and advisors. The estimated costs of our restatement activities in
2004 are approximately $115, which amount is included in SG&A expense in our consolidated
statements of operations in the periods in which the costs are incurred. 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.  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, 2004 from the amounts disclosed as of December 31, 2003 in
our 2003 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 for working capital purposes and equity financing. The following table provides information related to our customer financing commitments, excluding our
discontinued operations as of: 87




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March 31,
    
    
    December 31,2004
    
    
    2003Drawn and outstanding  gross
    
    $
    381
    
    
    $
    401Provisions for doubtful accounts
    
    
    (278
    )
    
    
    (281
    )Drawn and outstanding  net(a)
    
    
    103
    
    
    
    120Undrawn commitments(b)
    
    
    66
    
    
    
    180Total customer financing
    
    $
    169
    
    
    $
    300
 (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.(b)
    
    On January 8, 2004, Nortel Networks negotiated an agreement with a certain customer and
reduced Nortel Networks aggregate undrawn customer financing
commitments from $180 to $69.
 In the first quarter of 2004, we entered into certain agreements to restructure and/or settle
various customer financing and related receivables. As a result of these transactions, we received
cash consideration of approximately $15 to settle outstanding receivables with a net carrying value
of approximately $14. During the first quarter of 2004 and 2003, we reduced undrawn customer financing commitments by
$114 and $148, respectively, as a result of the expiration or cancellation of commitments and
changing customer business plans. We continue to regularly assess the levels of our customer financing provisions based on a
loan-by-loan review to evaluate whether the terms of each loan reflect current market conditions.
We review the ability of our customers to meet their repayment obligations and determine our
provisions accordingly. Commitments to extend future financing generally have conditions for
funding, fixed expiration or termination dates and specific interest rates and purposes. We cannot
predict with certainty the extent to which our customers will satisfy the applicable conditions for
funding, and subsequently request funding, prior to the termination date of the commitments. We
are currently directly supporting most outstanding balances and expect to initially fund any future
commitments in the normal course of business from our working capital. We expect to fund
substantially all of our current remaining undrawn commitments in 2004 or 2005. However, we also
expect that we will be able to arrange for third party lenders to assume these obligations in the
same timeframe. At the end of the first quarter, all undrawn commitments were available for
funding under the terms of the financing agreements. Discontinued operations As of March 31, 2004, accruals related to our discontinued access solutions operations totaled
$4 and were related to future contractual obligations and estimated liabilities during the planned
period of disposition. The remaining accruals are expected to be substantially drawn down by cash
payments by the end of 2005. For additional information related to our discontinued operations, see Discontinued operations in
note 17 of the accompanying unaudited consolidated financial statements. Sources of liquidity  Credit facilities As of March 31, 2004, we had $750 in undrawn credit under the Five Year Facilities scheduled
to expire in April 2005. These credit facilities were entered into on April 12, 2000 by us and NNI
and permitted borrowings for general corporate purposes. The Five Year Facilities contained a
financial covenant requiring that our consolidated tangible net worth be not less than $1,888 at
any time. As of March 31, 2004, we were in compliance with this covenant and there were no amounts
drawn under the Five Year Facilities. On April 28, 2004, we notified the lenders under the Five
Year Facilities that we were terminating these facilities. Due to our failure to file our 2003
Annual Report on Form 10-K by April 29, 2004, the banks, under the Five Year Facilities, would have
otherwise been permitted to, upon 30 days notice, terminate their commitments under the Five Year
Facilities. Upon termination, we were in compliance with that financial covenant and the Five Year
Facilities were undrawn. For additional information relating to the Five Year Facilities and the
impact of the termination of these facilities under the related security agreements, see
Developments in 2004  Nortel Networks Audit Committee Independent Review; restatements; related matters  Credit facilities and security agreements and
Risk factors/forward looking statements. 88




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Available support facility On February 14, 2003, we entered into the EDC Support Facility. As of March 31, 2004, the
facility provided for up to $750 in support including:  
    
    $300 of committed revolving support for performance bonds or similar instruments, of which $188 was utilized;
    
    $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 $183 was utilized. For additional information related to the EDC Support Facility subsequent to March 31, 2004 and
waivers obtained in connection with certain defaults arising under the EDC Support Facility from
the delay in filing the Reports, see Developments in 2004  Nortel Networks Audit Committee
Independent Review; restatements; related matters  EDC Support Facility and Risk factors/forward looking statements. On March 29, 2004, we and EDC amended the EDC Support Facility to provide 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. As a result of an amendment on
December 10, 2004, the EDC Support Facility will expire on December 31, 2006. The EDC Support Facility does not materially restrict our ability to sell any of its 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, has been downgraded to less than B3 or if its debt rating by S&P has been downgraded to
less than B-. As of March 31, 2004, 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,
2004, 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;
    
    share pledges in certain of our other subsidiaries; and
    
    guarantees by certain of our wholly owned subsidiaries organized in 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 10 of the accompanying unaudited consolidated financial statements. For
additional financial information related to those subsidiaries providing guarantees as of March 31,
2004, see Supplemental consolidating financial information in note 21 of the accompanying
unaudited consolidated financial statements. For information related to the security pledged,
those subsidiaries providing guarantees and the impact of the termination of the Five Year
Facilities on the related security agreements, subsequent to March 31, 2004, see Developments in
2004  Nortel Networks Audit Committee Independent Review; restatements; related matters  Credit
facilities and security agreements. 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 and a base shelf
prospectus with the applicable securities regulatory authorities in Canada, to qualify for the
potential sale of up to $2,500 of various types of securities in the U.S. and/or Canada. The
qualifying securities include guaranteed debt securities of Nortel
Networks Limited. As of March 31, 2004, approximately $1,700 under the 89




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shelf registration statement and base shelf prospectus has
been utilized. As of June 6, 2004, the Canadian shelf registration expired. Owing to matters
described above in Developments in 2004  Nortel Networks Audit Committee Independent Review;
restatements; related matters with respect to the delayed filing of the Reports, we are currently
unable to utilize the remaining capacity under the SEC shelf registration statement in its current
form. For the same reasons, we are also unable to permit holders of our 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
will 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 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, we have agreed to
use commercially reasonable efforts to have, in effect, a registration statement covering the
common shares to be delivered and to provide a prospectus in connection therewith. Credit ratings Rating on long-termdebt issued orguaranteed byNortel Networks
    
    Rating on preferredLimited/Nortel
    
    shares issued byNetworks
    
    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 its long-term corporate credit
rating from B to B and its 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 31,2004
    
    
    2003Bid and performance related bonds (a)
    
    $
    412
    
    
    $
    427Other bonds (b)
    
    
    55
    
    
    
    53Total bid, performance related and other bonds
    
    $
    467
    
    
    $
    480
 (a)
    
    Net of restricted cash and cash equivalents of $13 as of March 31, 2004 and $14 as of
December 31, 2003.(b)
    
    Net of restricted cash and cash equivalents of $30 as of March 31, 2004 and $31 as of
December 31, 2003.
 The criteria under which bid, performance related and other bonds can be obtained changed due
to the industry environment 90




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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. The EDC Support Facility provides support for certain obligations under bid and performance related
bonds and has reduced the requirement to provide cash collateral to support these obligations. As
of March 31, 2004, the EDC Support Facility provided for up to $750 in support of which $300 was
committed revolving support for performance bonds of which $188 was utilized as of March 31, 2004.
The remainder was uncommitted support, subject to certain limitations, for performance bonds,
receivables sales and/or securitizations, of which $183 was utilized as of March 31, 2004. 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. In addition to the support facility with EDC,
our existing security agreements permit us to secure additional obligations under bid and
performance related bonds with the assets pledged under the security agreements and to provide cash
collateral as security for these types of bonds. See Available support facility for additional
information on the EDC Support Facility and the security agreements and see Developments in 2004 
Nortel Networks Audit Committee Independent Review; restatements; related matters  EDC Support
Facility for additional information in connection with amendments to the EDC Support Facility and
developments in connection with the EDC Support Facility and related security agreements subsequent
to March 31, 2004. Receivables securitization and certain lease financing transactions In January 2003, the Financial Accounting Standards Board, or FASB, issued FASB
Interpretation, or FIN, No. 46, Consolidation of Variable Interest Entities  an Interpretation of
Accounting Research Bulletin No. 51, Consolidated
Financial Statements, or FIN 46, and in
December 2003, the FASB issued a revision of FIN 46  FIN 46 (Revised 2003), or FIN 46R. FIN 46R
provides guidance with respect to the consolidation of variable interest entities, or VIEs. VIEs
are characterized as entities in which equity investors do not have a controlling financial
interest or there is not sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support. Reporting entities which have a variable
interest in such an entity and are deemed to be the primary beneficiary must consolidate the
variable interest entity. We have conducted certain receivable sales transactions either directly with financial institutions
or with multi-seller conduits. Under some of these agreements, we have continued as servicing
agent and/or have provided limited recourse. The fair value of these retained interests is based
on the market value of servicing the receivables and historical payment patterns, expected cash
flows and appropriate discount rates, as applicable. Where we have acted as the servicing agent,
we generally have not recorded an asset or liability related to servicing as the annual servicing
fees were equivalent to those that would have been paid to a third party servicing agent. Also, we
have not historically experienced significant credit losses with respect to receivables sold with
limited recourse. As of March 31, 2004, none of these
arrangements or interests met the requirements for consolidation
under FIN 46R. Additionally, we have agreed to indemnify our counterparties in 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, 2004, we had approximately $261 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. 91




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Other indemnifications or guarantees Through our normal course of business, we have also entered into other indemnifications or
guarantees that arise in various types of arrangements including:  
    
    business sale and business combination agreements;
    
    intellectual property indemnification obligations;
    
    lease agreements;
    
    third party debt agreements;
    
    indemnification of banks and agents under our credit and support facilities and security agreements; and
    
    other indemnification agreements. In the first quarter of 2004, we did not make any significant payments under any of these
indemnifications or guarantees. In certain cases, due to the nature of the agreement, we have not
been able to estimate our maximum potential loss or the maximum potential loss has not been
specified. For additional information, see Guarantees in note 12 of the accompanying unaudited
consolidated financial statements. Application of critical accounting 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 estimates may
involve a higher degree of judgment and complexity in their application and represent our critical
accounting estimates. The application of these estimates requires us to make subjective and
objective judgments. 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 estimates with the Audit Committee
of our Board of Directors. There have been no changes to our critical accounting estimates since December 31, 2003, other than
the material changes in the recorded balances and other updates noted below. For further
information related to our critical accounting estimates, see our 2003 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. 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 that are greater than 365 days are fully provisioned for and amounts greater
than 180 days are 50% provisioned for. In subsequent periods, we may be required to make
adjustments once further information becomes available or actual events occur. As a result, we may
incur significant adjustments to our provisions for trade, notes and long-term receivables. 92




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We recorded net receivable recoveries, related to continuing operations, of $2 in the first quarter
of 2004 and $16 in the first quarter of 2003. The receivable provisions recorded in the first
quarter of 2004 and the first quarter of 2003 primarily related to normal business activity. The following table summarizes our accounts receivable and long-term receivable balances and
related reserves of our continuing operations as of: March 31,
    
    
    December 31,2004
    
    
    2003Gross accounts receivable
    
    $
    2,768
    
    
    $
    2,853Provision for doubtful accounts
    
    
    (184
    )
    
    
    (194
    )Accounts receivable  net
    
    $
    2,584
    
    
    $
    2,659Accounts receivable provision as a percentage of gross accounts receivables
    
    
    7%
    
    
    
    7%Gross long-term receivables
    
    $
    383
    
    
    $
    386Provision for doubtful accounts
    
    
    (293
    )
    
    
    (297
    )Net long-term receivables
    
    $
    90
    
    
    $
    89Long-term receivable provision as a percentage of gross long-term receivables
    
    
    77
    %
    
    
    77
    %
 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. We recorded inventory provisions and other reserves related to our contract manufacturers and
suppliers of $1,027 as of March 31, 2004 and $1,226 as of December 31, 2003. The decrease
in inventory provisions and other reserves was primarily due to our inventory levels being better
aligned to customer demand. The following table summarizes our inventory balances and other
related reserves of our continuing operations as of: March 31,
    
    
    December 31,2004
    
    
    2003Gross inventory
    
    $
    2,273
    
    
    $
    2,416Inventory provisions
    
    
    (1,027
    )
    
    
    (1,226
    )Inventory  net
    
    $
    1,246
    
    
    $
    1,190Inventory provisions as a percentage of gross inventory
    
    
    45
    %
    
    
    51
    %Other reserves for claims related to our contract manufacturers and suppliers(a)
    
    $
    (86
    )
    
    $
    (120
    )
 (a)
    
    This amount was included in other accrued liabilities and related to cancellation charges,
contracted for inventory in excess of future demand and the settlement of certain other
claims.
 As of March 31, 2004, our inventory provisions as a percentage of gross inventory was 45%. In
the future, we may be required to make significant adjustments to these provisions for the sale
and/or disposition of inventory that was previously provided for. 93




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Customers continued to be cautious with their capital expenditures in 2004. As a result, we will
continue to closely monitor our inventory provisions to ensure that they appropriately reflect the
current market conditions. However, the inventory provisions we have recorded in the past may not
be reflective of those in future quarters. Tax asset valuation Our net deferred tax assets balance, excluding discontinued operations, was $3,568 as of March
31, 2004 and $3,576 as of December 31, 2003. The $8 decrease was primarily due to the drawdown of
deferred tax assets in certain jurisdictions and the impact of foreign exchange effects related
primarily to the Canadian dollar and the British pound. 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. 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. In the first quarter of 2004, our gross income tax valuation allowances increased to $3,178 as of
March 31, 2004 compared to $3,108 as of December 31, 2003. The increase was primarily due to
foreign exchange and other adjustments offset by a drawdown of the valuation allowance against a
portion of the current period earnings. 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,
2004 were appropriate. If market conditions deteriorate further or future results of operations are less than expected,
future assessments may result in a determination that some or all of the net deferred tax assets
are not realizable. As a result, we may need to establish an additional tax valuation allowance
for all or a portion of the net deferred tax assets, which may have a material adverse effect on
our business, results of operations and financial condition. Alternatively, if our future results
of operations are better than expected, these assessments may result in the reduction of our
valuation allowances. 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. Accounting changes and recent accounting pronouncements Accounting changes Our unaudited consolidated financial statements are based on the selection and application of
U.S. GAAP. For more information related to the accounting policies that we adopted as a result of
new accounting standards, see Accounting changes in note 3 of the accompanying unaudited
consolidated financial statements. There were no accounting changes in the three months ended
March 31, 2004. The following summarizes the accounting changes that we adopted in the three
months ended March 31, 2003: 94




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
    
    Stock-based compensation  we adopted SFAS No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure  an Amendment of FASB Statement No. 123
which amended the transitional provisions of SFAS No. 123, Accounting for Stock-based
Compensation for companies electing to recognize employee stock-based compensation
using the fair value based method. Effective January 1, 2003 we elected to expense
employee stock-based compensation using the fair value based method prospectively for
all awards granted, modified, or settled on or after January 1, 2003. The impact of
the adoption of the fair value based method for expense recognition of employee awards
resulted in $5 (net of tax of nil) of stock option expense for the three months ended
March 31, 2003.
    
    Asset retirement obligations  we adopted SFAS No. 143, Accounting for Asset
Retirement Obligations, or SFAS 143, which resulted in an increase to net loss of $12 (net of tax of nil) which has been reported as a cumulative effect of
accounting changes  net of tax, an increase in plant and equipment  net of $4 and an
asset retirement obligation liability of $16 as of January 1, 2003. The adoption of
SFAS 143 did not have a material impact on depreciation and accretion expense or basic
and diluted earnings (loss) per share. Recent accounting pronouncements On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of
2003, or the MPDIM Act, was signed into law in the U.S. The MPDIM Act introduced a prescription
drug benefit under Medicare (specifically, Medicare Part D) as well as a federal subsidy to
sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially
equivalent to Medicare Part D. As permitted by FASB Staff Position, or FSP, Financial Accounting
Standard, or FAS, 106-1, Accounting and Disclosure Requirements Related to the Medicare
Prescription Drug, Improvement and Modernization Act of 2003, we chose to make the one-time
deferral election which remained in effect for our plans in the U.S. until the earlier of the
issuance of specific authoritative guidance by the FASB on how to account for the federal subsidy
to be provided to plan sponsors under the MPDIM Act, or the remeasurement of plan assets and
obligations subsequent to January 31, 2004. Therefore, our post-retirement benefit obligation as
of December 31, 2003 and net post-retirement benefit cost for the year ended December 31, 2003 did
not reflect the effects of the MPDIM Act on the plans. On May 19, 2004, FSP FAS 106-2, Accounting
and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and
Modernization Act of 2003, or FSP FAS 106-2, was issued by the FASB to provide guidance relating
to the prescription drug subsidy provided by the MPDIM Act. We expect to have portions of our
post-retirement benefit plans qualify as actuarially equivalent to the benefit provided under the
MPDIM Act, for which it expects to receive federal subsidies. We expect that other portions of the
plans will not be actuarially equivalent. The financial impact of the federal subsidies was
determined by remeasuring our retiree life and medical obligation as of January 1, 2004, as
provided under the retroactive application provision of FSP FAS 106-2. The effective date of FSP
FAS 106-2 is the first annual or interim period beginning after June 15, 2004, with earlier
adoption encouraged. We adopted FSP FAS 106-2 for the three-month period ended June 30, 2004. As
a result of adoption, the accrued post-retirement benefit obligation decreased by $31. Net
periodic post-retirement benefit costs are expected to decrease by $2 for 2004, as a result of the
subsidy. In March 2004, the Emerging Issues Task Force, or 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 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 position. Canadian supplement New Canadian securities 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. 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. 95




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The principal continuing reconciling differences that affect consolidated net earnings (loss) under
Canadian GAAP are derivative accounting, financial instruments and goodwill impairment arising from
historical differences in carrying value. We adopted new Canadian accounting standards for asset
retirement obligations in 2004 and for stock option compensation in 2003 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. See note 20 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
consolidated statements of operations and consolidated balance sheets. There were no significant
differences affecting the consolidated statements of cash flows. 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. For a discussion of our accounting policies for derivative financial instruments, see Accounting
changes in note 3(c) of the accompanying unaudited consolidated financial statements. Additional
disclosure of our financial instruments is included in Financial instruments and hedging
activities in note 11 of the accompanying unaudited consolidated financial statements. 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, we recognize the gains and losses on the effective portion of
these contracts in income when the hedged transaction occurs. Any ineffective portion of these
contracts is recognized in income immediately. 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. We cannot predict whether we will incur foreign exchange
gains or losses in the future. 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 96




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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 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 $31. For a discussion of Environmental matters, see Contingencies in note 18 of the accompanying
unaudited consolidated financial statements. Legal proceedings Nortel Networks 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 18 of the
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. 97




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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 will have a
particular emphasis on the underlying conduct that led to the initial recognition of these
revenues. The Audit Committee will seek 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 and Controls and Procedures sections
of this 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
against us, could require us to pay substantial judgments, settlements or other
penalties.
    
    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, 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 our Reports and related matters caused us to breach
our public debt indentures and seek waivers from EDC under the EDC Support Facility,
which may affect our liquidity. The continuing delays in filing certain of our Reports
and related matters has resulted in a continuing breach of our public debt indentures
and our obligations under the EDC Support Facility. It is possible that the holders of
our public debt will seek to accelerate the maturity of that debt and EDC will not grant
us additional waivers.
    
    Our credit ratings have been downgraded, we are currently unable to access
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 certain of our Reports could cause the TSX and/or the
NYSE 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 may adversely affect our business and the
market price of our publicly traded securities. 98




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
    
    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, NNC announced that the SEC
had issued a formal order of investigation in connection with our and NNCs previous restatement of
financial results for certain periods 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 earlier periods. On April 13, 2004, NNC announced that it had received a letter from the staff of the OSC advising
of an OSC Enforcement Staff investigation into the same matters that are the subject of the SEC
investigation. NNC has 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, the Integrated Market
Enforcement Team of the RCMP has advised NNC 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 adverse affect on our business, results of operations and financial
condition. In addition, the findings and outcomes of the Independent Review and 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, could require
us to pay substantial judgments, settlements or other penalties. 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
us and NNC 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 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 cannot predict the outcome of the Revenue Independent Review being undertaken by our Audit
Committee. As discussed in greater detail in 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 will have a particular emphasis on the underlying conduct that led to the
initial recognition of these revenues. 99




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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. Material adverse legal judgments, fines, penalties or settlements could have a material adverse
effect on our financial condition and liquidity, which could be very significant. We estimate that 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 12 months. In making this estimate, we have
not assumed the need to make any payments in connection with our pending civil litigation or
investigations including those related to the First Restatement and Second Restatement, other than
our anticipated professional fees and expenses. 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
    
    restricting our ability to introduce new technologies and products and/or exploit
business opportunities. We and our independent auditors have identified a number of material weaknesses related to our
internal control over financial reporting, 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 D&T identified a
number of additional material weaknesses in our internal control over financial reporting. D&T
confirmed to the Audit Committee these material weaknesses, listed below, on January 10, 2005:  
    
    lack of compliance with written Nortel Networks 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 Networks 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 Networks personnel; and 100




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
    
    an inappropriate tone at the top, which contributed to the lack of a strong control
environment; as reported in the Independent Review Summary referred to in the Controls
and Procedures section of this report, 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. Upon completion of managements assessment of our internal control over financial reporting as of
December 31, 2004 pursuant to SOX 404, we currently expect to conclude that the first five of these
six material weaknesses continue to exist as of December 31, 2004, and we continue to identify,
develop and begin to implement remedial measures to address them. 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 Developments in 2004 -Nortel Networks
Audit Committee Independent Review; restatements; related matters in the MD&A and Controls and
Procedures section of this 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 referred to in the Controls and
Procedures section of this report, 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. In addition, starting with our fiscal year 2004 Annual Report on Form 10-K, we must comply with
Section 404(a) of the Sarbanes-Oxley Act of 2002, and the related SEC rules, which require
management to assess the effectiveness of our internal control over financial reporting annually
and to include in our Annual Report on Form 10-K a management report on that assessment, together
with an attestation by our independent registered public accounting firm. In light of the material
weaknesses identified in connection with the First Restatement and Second Restatement, our
management expects to conclude that our internal control over financial reporting as of December
31, 2004 is ineffective, and D&T has advised us that they expect their report on managements
assessment of internal control over financial reporting also to indicate that internal control over
financial reporting is ineffective. 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 could continue to impact our ability to report our financial
condition and results of operations 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 for 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 our Reports and related matters caused us to breach our public debt
indentures and seek waivers from EDC under the EDC Support Facility, which may affect our
liquidity. Continuing delays in filing certain of our Reports and related matters has resulted in a breach of our public debt indentures
and our obligations under the EDC Support Facility. It is possible that the holders of our public
debt will seek to accelerate the maturity of that debt and EDC will not grant us additional
waivers. As a result of the delayed filing of our Reports, we and NNC breached our obligations to deliver
the Reports to the trustees under our and NNCs public debt indentures. While continuing delays
in filing certain of our Reports will not result in an automatic event of default and acceleration
of the outstanding debt, if holders of 25% of the outstanding principal amount of any relevant
series of debt securities provide notice of this non-compliance and we or NNC, as applicable, fail
to file and deliver the relevant Report within 90 days after the notice is provided, then the
trustee under the indenture or the holders will have the right to accelerate the maturity of the
relevant series of debt securities. While such notice could have been given any time after March
30, 2004, neither we nor NNC has received a notice as of the date of this report. If the required
percentage of holders under one series of debt securities were to give such a notice and, after the
90 day cure period expired, were to accelerate the maturity of such series of debt securities, then
the principal amount of each other series of debt securities could, upon 10 days notice, be
accelerated without the lapse of an additional 90 day cure period. If an acceleration of our debt
securities were to occur, we may be unable to meet our payment obligations. As previously reported, based on publicly available information as of January 10, 2005, we have
reason to believe that more than 25% of the outstanding principal amount of the $150 of 7.875%
notes due June 2026 issued by one of our subsidiaries and guaranteed by us are held by one holder, or a
group of related holders. Other than with respect to that series of debt securities, based on such
publicly available information, 101




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neither we nor NNC are aware of any holder, or group of related
holders, that holds at least 25% of the outstanding principal amount of any relevant series of debt
securities. However, based on such publicly available information, we have reason to believe that
there is sufficient concentration among holders of the $150 of 7.40% notes due June 2006 issued by
us that the acquisition of a relatively small additional amount of these notes by certain holders
could result in a holder or a group of related holders holding 25% or more of the outstanding
principal amount of these notes. See Liquidity and capital resources. 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. Our continuing delays in filing certain of
our Reports will require us to seek an additional waiver from EDC. EDC may not grant an additional
waiver or the terms of such a waiver may be unfavorable. If we do not obtain an additional waiver
from EDC, EDC would have the right to terminate the EDC Support Facility, require cash collateral,
or exercise its rights against the collateral pledged under the related security agreements. In
addition, the Related Breaches will continue beyond the filing of the Reports. Accordingly, EDC
will have the right (absent a further waiver of the Related Breaches) to terminate or suspend the
EDC Support Facility notwithstanding the filing of the Reports beginning on February 15, 2005.
While we are seeking a permanent waiver from EDC in connection with the Related Breaches, there can
be no assurance that we will receive such waiver, or any waiver or as to the terms of any such
waiver. 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. Our credit ratings have been downgraded, we are currently unable to access our shelf registration
statement filed with the SEC and NNC 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 its long-term corporate credit
rating from B to B- and its 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, 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, alternative arrangements are made, or our public debt ratings
return to at least BBB (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, NNL 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, the delayed filing of the Reports has resulted in our inability to use, in its current
form, the remaining approximately $800 of capacity under our shelf registration statement filed
with the SEC for various types of securities. As a result, our ability to access the capital
markets is constrained, which may adversely affect our liquidity. The delay in filing certain of our Reports could cause the Toronto Stock Exchange and/or the New
York Stock Exchange to commence suspension or delisting procedures in respect of Nortel Networks
Limiteds common shares or other of our or NNCs listed securities. 102




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Although we have filed our and NNCs 2003 Annual Reports, the delayed filing of our 2004 Quarterly
Reports causes us to continue to be in breach of these listing requirements. Although each of the
NYSE and TSX has verbally confirmed that it has not commenced, nor has any intention of commencing,
any suspension or delisting procedures in respect of our and NNCs listed securities at the date of
this report, 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.
Pending the filing of our and NNCs 2003 Annual Reports, the NYSE had permitted our and NNCs
listed securities to continue to be traded on the exchange for the three month period ended March
31, 2005. In exercising the discretion relating to the grant of that additional three month period
and the continued listing of our and NNCs securities in light of the delayed filing of our 2004
Quarterly Reports, the NYSEs procedures provide that the NYSE would consider, among other things,
the likelihood of the relevant Reports being filed, the Companys and NNCs general financial
status and the frequency and detail of the Companys and NNCs ongoing disclosures to the market on
the status of such filings. 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 our common shares or other listed securities of Nortel
Network Limited and NNC to investors and cause the trading volume of
Nortel Networks Corporation common shares or other
listed securities of Nortel Network Limited and NNC 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 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 our 2003 Annual Report (containing our audited
consolidated financial statements for the year ended December 31, 2003), we were required to apply
to the Ontario Superior Court of Justice for an order permitting the postponement of our 2004
Annual Shareholders 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 December 31, 2004,
or such later date as the Court may permit. As a result of the continued delay in the filing of
our 2003 Annual Report, in October 2004 we announced that we intended to seek a further order
extending the time for calling the meeting to a date no later than March 31, 2005, which order the
Court granted on December 10, 2004. A further extension to a date no later than May 31, 2005 was
obtained from the Court on December 21, 2004 to permit us to comply with a specific SEC rule which
would require 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. This 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. 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 our 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 103




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us in connection with
mergers and acquisitions; and the purchase of units in Nortel Networks 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 our securities and
those of Nortel Networks Corporation. 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 law. Accordingly, our ability to provide employees with the opportunity to
participate in Nortel Networks 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 our and NNCs 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. In August and September 2004, as part of our new
strategic plan, we announced an anticipated workforce reduction of approximately 3,250 employees.
Approximately 64% of employee actions related to the focused workforce reduction were completed by
the end of 2004, including approximately 55% 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 are 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. However, we do not believe that it will be
feasible to amend our 2002 Form 10-K/A or 2003 Form 10-Qs due to, among other factors, the
identified material weaknesses in our internal control over financial reporting, the significant
turnover in our finance personnel, changes in accounting systems, documentation weaknesses, a
likely inability to obtain third party corroboration in certain cases due to the substantial industry adjustment in recent years and the passage of time generally. Amendments to our prior
filings would be required for us to be in full compliance with our Exchange Act reporting
obligations. 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
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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 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;
    
    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 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 continue to obtain customer performance bonds and contracts;
    
    our ability to maintain appropriate inventory levels;
    
    the impact of acquired businesses and technologies;
    
    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. 105




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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 that could
adversely affect the price of our publicly traded securities. 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 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 and could contribute to
volatility in the market price of our publicly traded securities. Our gross margins may be negatively affected as a result of a number of factors, including:  
    
    increased price competition, particularly from low cost competitors;
    
    changes in product and geographic mix; 106




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
    
    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 and could
contribute to volatility in the market price of our publicly traded securities. 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, 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. 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. Any material adverse legal judgments, fines, penalties or
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. The
loss of customers in certain markets could have a material adverse effect on our business, results
of operations and financial condition. We expect that our consolidated revenues in 2004 will be slightly lower compared to 2003. The 2003
consolidated revenues included revenues that were deferred from prior periods. 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. A reduction or delay in business from one or
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achieve a significant market share with these customers, could have a material adverse
effect on our business, results of operations and financial condition. 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 secure 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;
    
    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
including acquisitions, research and development projects or product design enhancements. 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. In particular, although this facility
provides for up to $750 in support, the $300 revolving small bond sub-facility will not become
committed support until all of the Reports are filed and we obtain a permanent waiver of the
Related Breaches. As of January 21, 2005, there was approximately $292 of outstanding support
utilized under the EDC Support Facility, approximately $208 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 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
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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. Our valuation allowance is primarily attributable to continued
uncertainty in the industry. 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. 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. 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. We have made, and may continue to make, strategic acquisitions. If we are not successful in
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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
operations in an efficient and effective manner;
    
    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; 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
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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 have a material adverse effect on our gross margins. 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. For a list of our principal competitors, see Competition in each of the business segment
descriptions in the Business section of this report. 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; 111




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
    
    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 exposure to emerging
market currencies, such as, 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. 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, 112




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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. In the U.S., on February 20, 2003, the FCC announced a decision in its triennial review proceeding
of the agencys rules regarding UNEs. 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 decision and
subsequent adoption on December 15, 2004 of new unbundling rules in response to the remand by the
U.S. Court of Appeals for the D.C. Circuit 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 expect to become 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
may materially and adversely affect our business, results of operations, financial condition and
supply relationships. 113




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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. 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 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. The
transfer of our manufacturing activities in Montreal, Canada is expected to be completed in the
first quarter of 2005. The balance of the divestiture is anticipated to close in the first half of
2005, subject to completion of the required information and consultation processes with the
relevant employee representatives. 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 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. 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. 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 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. 114




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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 Networks due to adverse changes in financial market prices and rates. Nortel Networks
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 Managements Discussion and
Analysis of Financial Condition and Results of Operations and in our Annual Report on Form 10-K for
the year ended December 31, 2003. 
  ITEM 4.
    
    Controls and Procedures In light of the relevance of the findings of the Independent Review to the matters addressed
in this Item 4, please see the Summary of Findings and of Recommended Remedial Measures of the
Independent Review, submitted to the Audit Committee by WCPHD and Huron Consulting Services LLC,
or the Independent Review Summary, included in Item 9A of our 2003 Annual Report. This Item 4
addresses, among other matters:  
    
    current managements conclusions concerning our disclosure controls and procedures as at
March 31, 2004 and January 31, 2005 and certain earlier dates (see Current Management
Conclusions Concerning Disclosure Controls and Procedures);
    
    information relating to the First Restatement, including a discussion of material
weaknesses in internal control over financial reporting identified at the time of the First
Restatement (see Additional Background  First Restatement);
    
    information relating to the Second Restatement, including a discussion of material
weaknesses in internal control over financial reporting identified over the course of the
Second Restatement (see Additional Background  Second Restatement);
    
    the determination of the Audit Committee to review the facts and circumstances leading
to the restatement of revenues, as part of the Second Restatement, for specific
transactions during the periods 1999 through 2002, with particular emphasis on the
underlying conduct that led to the initial recognition of these revenues, which we refer to
as the Revenue Independent Review (see Revenue Independent Review);
    
    the current status of our internal control over financial reporting and expectations as
to management conclusions and the independent auditor attestation required to be included
in our fiscal year 2004 Annual Report on Form 10-K, or the 2004 Form 10-K, pursuant to
Section 404 of the Sarbanes-Oxley Act (see Current Status of Material Weaknesses in
Internal Control Over Financial Reporting and Expectations as to Required Management
Conclusions and Independent Auditor Attestation Pursuant to Section 404 of the
Sarbanes-Oxley Act);
    
    remedial measures adopted by the Board of Directors pursuant to the recommendations of
WCPHD, and remedial measures identified, developed and begun to be implemented by our
current management, including pursuant to recommendations from D&T (see Remedial
Measures); and
    
    changes in internal control over financial reporting (see Remedial Measures).Current Management Conclusions Concerning Disclosure Controls and Procedures In January 2005, 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 William R. Kerr, respectively), pursuant to Rule 13a-15 under the Exchange
Act, of the effectiveness of our disclosure controls and procedures as at March 31, 2004 (the end
of the period covered by this report) and as at January 31, 2005. The CEO and CFO were appointed
to such positions as at April 28, 2004, with the CFO having served in such capacity on an interim
basis since March 15, 2004. 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 Independent Review Summary; 115




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
    
    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, D&T, 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);
    
    our omission of 1999 and 2000 selected financial data from our 2003 Annual Report, and
our decision not to amend our 2002 Form 10-K/A and our 2003 quarterly reports (as more
fully described below); 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, 2004 and January 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, 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. As discussed in our 2003 Annual Report, the Second Restatement and other matters listed above also
resulted in the re-evaluation, in January 2005, of the effectiveness of our disclosure controls and
procedures as at December 31, 2002, March 31, 2003, June 30, 2003 and September 30, 2003. Based on
these evaluations and in consideration of the Second Restatement and other matters listed above,
the CEO and CFO concluded that our disclosure controls and procedures, as at December 31, 2002,
March 31, 2003, June 30, 2003 and September 30, 2003, 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. These new conclusions are in contrast to conclusions reached as a result of previous evaluations
carried out under the supervision and with the participation of management, including the former
chief executive officer and former chief financial officer. In particular, these conclusions
differ from the conclusions stated in our 2002 Annual Report on Form 10-K and Quarterly Reports on
Form 10-Q for the quarters ended March 31, 2003 and June 30, 2003 that our disclosure controls and
procedures were so effective as at December 31, 2002, March 31, 2003 and June 30, 2003,
respectively. They also differ from the conclusions based upon the re-evaluations carried out in
December 2003 under the supervision and with the participation of management, including the former
president and chief executive officer and former chief financial officer, as stated in our amended
2002 Annual Report on Form 10-K/A, or the 2002 Form 10-K/A, and amended Quarterly Reports on Form
10-Q for the quarters ended March 31, 2003 and June 30, 2003, or the 2003 Form 10-Q/As, that our
disclosure controls and procedures were so effective as at December 31, 2002, March 31, 2003 and
June 30, 2003, respectively, after taking into account the First Restatement and the identification
of certain material weaknesses. These new conclusions also differ from the conclusions stated in
our Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 that our disclosure
controls and procedures were so effective as at September 30, 2003, after taking into account the
First Restatement and the identification of certain material weaknesses. * * * * * * 116




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Additional Background This section provides additional information with respect to the identified material weaknesses and
other deficiencies, as well as certain additional background information regarding the First
Restatement and the Second Restatement. In this report, unless otherwise indicated, the terms material weakness and reportable
condition have the meanings as formerly set forth under standards established by the AICPA, which
were applicable with respect to 2003. The AICPA then defined a (i) reportable condition as a
matter that comes to an auditors attention that represents a significant deficiency in the design
or operation of internal control that could adversely affect an entitys ability to initiate,
record, process and report financial data consistent with the assertions of management in the
financial statements and (ii) material weakness as a reportable condition in which the design or
operation of one or more of the internal control components does not reduce to a relatively low
level the risk that misstatements caused by error or fraud in amounts that would be material in
relation to the financial statements being audited may occur and not be detected within a timely
period by employees in the normal course of performing their assigned functions.  First Restatement  Overview 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.
Each of the former members of management terminated for cause had responsibility for their
respective positions at the time of the Comprehensive Review and First Restatement. As disclosed
in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2003, the Comprehensive Review
was initiated [I]n light of a period of unprecedented industry adjustment and subsequent
restructuring actions, including workforce reductions and asset write-downs . . . . The amounts
under review were recorded when our balance sheet and income statement were much larger.
Specifically, what would have been relatively minor amounts in prior periods may be considered to
be material to current periods. As noted in the Independent Review Summary, Nortel posted
significant losses in 2001 and 2002 and downsized its work force by nearly two-thirds. The
remaining employees were asked to undertake significant additional responsibilities with no
additional increase in pay and no bonuses. The Companys former senior corporate management
asserted, at the start of the inquiry, that the Companys downturn, and concomitant downsizing of
operations and workforce, led to a loss of documentation and a decline in financial discipline.
Those factors, in their view, were primarily responsible for the significant excess provisions on
the balance sheet as at June 30, 2003, which resulted in the First Restatement. While that
downturn surely played a part in the circumstances leading to the First Restatement, the root
causes ran far deeper. The root causes of the First Restatement, as identified in the Independent
Review, are more fully discussed in the Independent Review Summary. The Comprehensive Review purported to (i) identify balance sheet accounts that, as at June 30,
2003, were not supportable and required adjustment; (ii) determine whether such adjustments related
to the third quarter of 2003 or prior periods; and (iii) document certain account balances in
accordance with our accounting policies and procedures. The Comprehensive Review, as supplemented
by additional procedures carried out between July 2003 and November 2003 to quantify the effects of
potential adjustments in the relevant periods and review the appropriateness of releases of certain
contractual liability and other related provisions (also called accruals, reserves or accrued
liabilities) in the six fiscal quarters ending with the fiscal quarter ended June 30, 2003, formed
the basis for the adjustments made to the financial statements in the First Restatement. On December 23, 2003, we filed with the SEC the 2002 Form 10-K/A and the 2003 Form 10-Q/As
reflecting the First Restatement. As disclosed in those reports, the net effect of the First
Restatement adjustments was a reduction in accumulated deficit of
$486 million, $171 million and
$32 million as at December 31, 2002, 2001 and 2000, respectively. The following were the principal
adjustments of the First Restatement:  
    
    Approximately $924 million and $507 million of certain liabilities (primarily accruals
and provisions) carried on our previously reported consolidated balance sheet as at
December 31, 2002 and 2001, respectively, were released to income in prior periods.
    
    We determined to correct certain known errors previously not recorded because the amount
of the errors was not material to the consolidated financial statements. Specifically,
among other items, we made certain revenue adjustments to reflect revenue that should have
been deferred instead of recognized in a particular period. 117




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
    
    We made adjustments to correct errors related to deferred income tax assets and foreign
currency translation accounts and made reclassification adjustments within the consolidated
balance sheet to better reflect the underlying nature of certain items. These
reclassifications did not impact our net assets as at the end of any period.  Material Weaknesses and Other Deficiencies in Internal Control over Financial Reporting
Identified at the Time of the First Restatement In 2003, we, together with D&T, identified a number of deficiencies in our internal control over
financial reporting. On July 24, 2003, D&T first informed the Audit Committee that deficiencies in documentary support
for certain accruals and provisions on our balance sheet as at June 30, 2003 constituted a
reportable condition, but not a material weakness, in our internal control over financial
reporting. In particular, D&T concluded, in respect of this reportable condition that it was
unclear, due to the lack of documentation regarding support for certain provisions and accruals,
the passage of time and the turnover of personnel, as to what adjustments, if any, should have been
made in prior years. D&T noted that its assessment was based on such information as was available
at the date of its communication to the Audit Committee and the materiality of the underlying
amounts in the context of 2003 reported results. This conclusion was initially disclosed in our
Quarterly Report on Form 10-Q for the quarter ended June 30, 2003. On November 18, 2003, as part of the communications by D&T to the Audit Committee with respect to
D&Ts interim audit procedures for the year ended December 31, 2003, D&T informed the Audit
Committee that there were two reportable conditions, each of which constituted a material weakness
in our internal control over financial reporting. No other reportable conditions were communicated
by D&T to the Audit Committee at the time of the First Restatement. These reportable conditions
were as follows:  
    
    lack of compliance with established Nortel Networks procedures for monitoring and
adjusting balances related to certain accruals and provisions, including restructuring
charges; and
    
    lack of compliance with established Nortel Networks procedures for appropriately
applying U.S. 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. The foregoing material weaknesses contributed to the need for the First Restatement. Upon
completion of our assessment of our internal control over financial reporting as at December 31,
2004 pursuant to Section 404(a) of the Sarbanes-Oxley Act of 2002 and related SEC rules, or SOX
404, we currently expect to conclude that these material weaknesses continued to exist as at
December 31, 2004, and we continue to identify, develop and begin to implement remedial measures to
address them, as described below.  Second Restatement  Independent Review In late October 2003, the Audit Committee initiated the Independent Review in order to, as noted in
the Independent Review Summary, 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 the Board of Directors adopt, and direct management to implement, necessary remedial
measures to address personnel, controls, compliance and discipline. As noted in the Independent
Review Summary, [t]he [Independent Review] focused initially on events relating to the
establishment and release of contractual liability and other related provisions . . . in the second
half of 2002 and the first half of 2003, including the involvement of senior corporate leadership.
 . . . As the [Independent Review] evolved, its focus broadened to include specific provisioning
activities in each of the business units and geographic regions. In light of concerns raised in
the initial phase of the [Independent Review], the Audit Committee expanded the review to include
provisioning activities in the third and fourth quarters of 2003. As discussed more fully in the Independent Review Summary, the Independent Review concluded that
[i]n summary, former corporate management (now terminated for cause) and former finance management
(now terminated for cause) in the Companys finance organization endorsed, and employees carried
out, accounting practices relating to the recording and release of provisions that were not in
compliance with [U.S. GAAP] in at least four quarters, including the third and fourth quarters of
2002 and the first and second quarters of 2003. In three of those four quarters  when Nortel was
at, or close to, break even  these practices were undertaken to meet internally imposed pro-forma
earnings before taxes . . . targets. While the dollar value of most of
the individual provisions was relatively small, the aggregate value of
the 118




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provisions made the difference between a profit and a reported loss, on a pro forma basis, in
the fourth quarter of 2002 and the difference between a loss and a reported profit, on a pro forma
basis, in the first and second quarters of 2003.  Second Restatement Process As noted in the Independent Review Summary, [a]s 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 provision releases in each of the four quarters of
2003, down to a low threshold. That examination, and other errors identified by management, led to
[the Second Restatement]. . . . In addition to this examination of provisioning activity, management, including our new CFO,
undertook various initiatives aimed at ensuring the reliability and integrity of the audited
consolidated financial statements included in our 2003 Annual Report
and our unaudited consolidated financial statements included in this
report and our other 2004 Form 10-Qs. As part of these efforts, our new CFO
encouraged employees across our finance organization to raise any questions or concerns regarding
other potential accounting errors that should be reviewed for possible adjustment in the Second
Restatement. In addition, as management identified individual customer contracts and transactions
for re-examination of the establishment and release of provisions, management also undertook a
review of many of those contracts and transactions more generally to understand the broader nature
of the original accounting for the contract or transaction. This individual contract and
transaction review also identified additional accounting issues. As a result of these initiatives,
management, with the assistance of outside consultants, then undertook further detailed reviews of
our significant accounting policies, specific transactions and communications and other documents
relating to the identified issues. As a result, the Second Restatement included adjustments to
correct errors relating to a number of accounting issues other than provisioning. In particular, management identified various errors involving recognition of revenues. To
identify, assess and remedy these errors, management, assisted by outside consultants, reviewed a
substantial number of individual transactions as well as significant accounting policies across all
of our major product lines and geographical regions. As part of our review of individual
contracts, we analyzed the relevant contractual provisions (such as delivery and acceptance terms),
delivery and other data from our logistics systems, characteristics of the particular products and
customers and the manner in which revenue recognition policies were applied. We also utilized
databases within our accounting systems to identify additional contracts that might raise revenue
recognition issues. In light of the increasing magnitude of the total revenue adjustments
identified by the beginning of November 2004, the Board of Directors directed management to conduct
additional focused revenue reviews in selected periods in order to test the conclusions we had
reached and identify any potential additional revenue adjustments. Management has completed these
reviews. Overall in the Second Restatement, as a result of adjustments to correct errors related to revenue
recognition, we increased revenues by an aggregate of
$1,491 million in 2001 and $440 million in
2002. We also decreased previously reported revenues for the first
three quarters of 2003 by an aggregate of $55 million (including
a decrease of $81 million for the three months ended
March 31, 2003). Most
of these adjustments constituted the recognition of revenues that had previously been improperly
recognized in prior years and should have been deferred (often over a number of years). This also
had the effect of reducing previously reported revenues in 1998, 1999 and 2000 by approximately
$158 million, $388 million and $2,833 million,
respectively (adjusted from $355 million in 1999 and $2,866 million in 2000, as was reported in our 2003 Annual Reports). Of these adjustments identified in
the Second Restatement, approximately $1,200 million of revenues
has been deferred to the fourth quarter of 2003 and to years after
2003, while approximately $250 million of revenues was permanently reversed, as described below. In light of the total magnitude of these revenue adjustments, we present below an overview of the
principal revenue adjustments required in the Second Restatement to correct accounting errors
related to revenue recognition and the general circumstances that gave rise to them. In addition,
as described under Revenue Independent Review, 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 will have a particular
emphasis on the underlying conduct that led to the initial recognition of these revenues, and will
consider any appropriate additional remedial measures, including those involving internal controls
and processes.  
    
    Title and deliveryAn increase of
$1,624 million in 2001 and $211 million in 2002. An increase of $35 million in the three months ended March 31, 2003. Of this amount, we made
adjustments of approximately $870 million in 2001 and $200 million in 2002
to correct errors relating to passage of product title or risk of
loss. In the three months ended March 31, 2003, we increased
revenues by approximately $20 million. Both employee input and
our review of the broader original accounting treatment of certain 119




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individual contracts identified a specific customer contract as warranting re-examination of the
timing of revenue recognition relative to the timing of passage of product title. Following a
detailed review, we determined that revenues had been recorded erroneously before title had passed.
We also reviewed other similar contracts and determined that corrections were also required where
title or risk of loss had not passed. These corrections principally impacted North American
contracts in our Optical and Wireline businesses. Some of the adjustments related to title and risk of loss issues described above resulted in a
permanent reversal of revenues, rather than a deferral of revenues to later periods. In certain
cases, revenues were recognized in error in a particular period (before title had passed and the
criteria for revenue recognition had been met) and a bad debt expense was subsequently recorded due
to collectibility issues. In such cases, both entries were reversed. Following those corrections,
if title in fact never passed or the other criteria were never met, and the customer failed to pay,
the revenues were not recognized in subsequent periods but instead permanently reversed. We
permanently reversed a total of approximately $150 million of revenues in 2000 and $25 million in
2001 as a result of title and risk of loss adjustments. We also identified errors related to title and delivery issues in connection with arrangements
known as bill and hold transactions, in which revenue is recognized before actual delivery of the
product. Corrections of these errors resulted in the deferral of revenue into later periods, which
had the effect of a net increase to revenues of approximately
$760 million in 2001 and $10 million in
2002. In the first quarter of 2003, we increased revenues by approximately $15 million. Our scrutiny of this issue was similarly prompted by employee input. In this
situation, we determined that the relevant accounting policy had been incorrectly applied to a
number of contracts, and revenues were recognized where the relevant criteria had not been fully
met. In reviewing individual contracts, we examined, among other things: whether significant
product returns had occurred in later periods, the accounts receivable history, whether better
pricing was provided for the particular purchase order to incent a customer to enter into a bill
and hold arrangement, whether purchase orders were eventually placed by the customer and whether
third-party corroboration was available as to whether the arrangement was at the request of the
customer or Nortel Networks. As a result of our consideration of these factors, we deferred all
revenues associated with bill and hold arrangements to subsequent periods. We no longer recognize
revenue on bill and hold arrangements before delivery occurs and all other criteria of revenue
recognition are fully met.  
    
    Undelivered elements and liquidated damagesA decrease of $190 million in 2001 and
an increase of $45 million in 2002. A decrease of
$17 million in the three months ended March 31, 2003. Another area of review prompted by our review of the broader original accounting treatment of
certain individual contracts was related to certain optical product transactions where revenues
related to undelivered product elements were erroneously recognized. In these cases, revenues for
customer orders were recognized upon delivery of interim product solutions pending the availability
of the later generation optical product that the customer had ordered. In this circumstance,
revenues for the order should have been deferred until the undelivered element was delivered as we
did not have evidence supporting the fair value of the undelivered element. Accordingly, we
restated the recorded revenues, deferring recognition to subsequent periods, which had the effect
of a net decrease to revenues of approximately $40 million in 2001 and an increase to revenues of
approximately $190 million in 2002. In the first quarter of
2003, we increased revenues by approximately
$20 million. We also focused on accounting for software revenue recognition more generally, particularly in our
Optical business. In Fall 2004, we sought the views of the SECs Office of the Chief Accountant,
or OCA, on one issue with respect to our historical and continuing accounting treatment under U.S.
GAAP of revenues recognized on sales of certain optical products containing embedded software. We
advised the OCA that we believed our historical accounting treatment of these optical products was
appropriate, and we were fully supported in this conclusion by D&T. We, in consultation with D&T,
nevertheless decided to obtain the views of the OCA on our analysis and conclusions due to the
judgments involved in the applicable accounting analysis and the significant impact a different
conclusion could have had on our reported revenues (namely, the deferred recognition of substantial
revenues over a number of subsequent years). Following discussions with us, the OCA did not
approve or disapprove our accounting in this area, and we concluded that we would not make any
adjustments to our accounting treatment of the sales of these optical products as part of the
Second Restatement. We also considered revenue recognition policies related to post-contract support, or PCS, with
respect to all business lines, and identified certain Enterprise products that presented issues.
For these products, we recognized revenues at the time of delivery of the product but before
completion of PCS or other future services agreed to in the contract. Because in some cases we did
not have vendor specific objective evidence of fair value for those services (for example, where we
made available free software upgrades on our website), U.S. GAAP requires the revenues to be
recognized over the PCS period. Accordingly, we corrected this error and deferred the revenues to subsequent periods, 120




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resulting in a net decrease
to revenues of approximately $140 million in 2001 and
$155 million in 2002. In the first quarter of 2003, we decreased
revenues by approximately $40 million.  
    
    Fixed or determinable feesAn increase of $133 million in 2002 . As a result of our focus on accounting for software revenue recognition more generally as
described above, we identified a specific contract for which revenue for sales had been recognized
but the criteria for revenue recognition had not been met, including the criteria that contract
fees be either fixed or determinable. Accordingly, we corrected this error and deferred the
revenues to subsequent periods when customer payments became due and all criteria for revenue
recognition were met.  
    
    Reseller transactionsAn increase of $151 million in 2001. As a result of employee input, we determined that a certain reseller lacked economic substance
apart from Nortel Networks at the time of the relevant transaction. In such a case, we should have
deferred revenues and recognized them only upon the resellers sale of the products to an end
customer. Accordingly, we corrected this error and deferred the revenues to subsequent periods.  
    
    Reciprocal arrangementsA decrease of approximately $55 million in 2000 and $20
million in 2001 . In our review of a particular contract in connection with other issues described above, we
determined that it also involved a reciprocal arrangement with the customer. Instead of
recognizing the full amount of revenues we received on the sale of products or services, the
amounts we paid the customer under the reciprocal arrangement should have been treated as a
reduction of revenues. Through our review of a substantial number of individual contracts, as
noted above, we also identified a limited number of other reciprocal arrangements, which were
recorded as permanent reductions in revenue.  
    
    Application of SOP 81-1A decrease of approximately $40 million in 2001 and an
increase of approximately $80 million in 2002. A
decrease of $18 million in the first quarter of
2003. All of these adjustments relate solely to the application of
SOP 81-1 and not also to other revenue recognition items, as was
reported in our 2003 Annual Report. As we continued to review the application of our accounting policies, as well as specific
contracts, we discovered errors related principally to the incorrect application of percentage of
completion accounting for certain transactions. We corrected these errors, which resulted in both
deferrals of revenues to subsequent periods and movement of revenues to earlier periods.  
    
    Application of accounting for subsequent eventsAn increase of approximately
$70 million in 2002. A decrease of approximately
$70 million in the three months ended
March 31, 2003. As we reviewed various
transactions, we also considered the impact of subsequent events on
the accounting treatment. As a result of this general review, we
identified two specific transactions recorded in the first quarter of
2003 that should have been recorded in 2002, and made adjustments to
correct these errors. Other accounting practices that management examined and adjusted as part of the Second Restatement
included, among other things, the following (as described in more detail below):  
    
    our foreign exchange accounting, as part of the plan to address the identified material
weakness related to foreign currency translation described above;
    
    intercompany balances that did not eliminate upon consolidation and related provisions;
    
    special charges relating to inventory impairment, contract settlement costs and other charges; and
    
    the accounting treatment of certain elements of discontinued operations. In sum, the key components of the Second Restatement process were as follows:  
    
    involvement and oversight by current senior finance personnel, with regular
communications to the global finance organization to monitor progress and ensure
consistency, and open and regular dialogue with our external auditors; 121




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
    
    maintenance of a restatement database to track issues and adjustments;
    
    establishment of a process to evaluate certain provisions and releases that may not have
been fully addressed in the First Restatement, including a review of all First Restatement
processes, and enhanced balance sheet reviews at the business unit, regional and statutory
entity levels;
    
    establishment of processes to evaluate certain potential restatement items related to
our revenue recognition policies and practices and other accounting issues;
    
    validation processes, including detailed review of supporting documentation to ensure
adjustments were appropriately substantiated; and
    
    identification, development and initial implementation of remedial actions, as further
described under Remedial Measures below. As discussed above under Current Management Conclusions Concerning Disclosure Controls and
Procedures, as a result of the extensive work undertaken in connection with the Second
Restatement, 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.  Principal Adjustments The following are the principal Second Restatement adjustments:  
    
    Adjustments to the previously reported 2003 quarterly
revenues and net earnings applicable to common shares as follows:  
    
    a decrease of $81 million in previously reported
revenues and $108
million in previously reported net earnings applicable to common
shares for the first quarter of 2003, resulting
in our reporting a net loss rather than net earnings for the period;
    
    a decrease of $52 million in previously reported
revenues and $149
million in previously reported net earnings applicable to common
shares for the second quarter of 2003,
resulting in our reporting a net loss rather than net earnings for
the period; and
    
    an increase of $78 million in previously reported revenues and a decrease
of $68 million in previously reported net earnings applicable to
common shares for the third quarter of 2003.  
    
    An increase of $440 million in previously reported
revenues and a reduction of $456
million in previously reported net loss applicable to common shares for the year ended December 31, 2002, with the
following adjustments on a quarterly basis:  
    
    an increase of $246 million in previously reported revenues and a
decrease of $174 million in previously reported net loss
applicable to common shares for the first quarter of
2002;
    
    an increase of $131 million in previously reported revenues and a
decrease of $159 million in previously reported net loss
applicable to common shares for the second quarter of
2002;
    
    a decrease of $28 million in previously reported
revenues and $232
million in previously reported net loss applicable to common shares for the third quarter of 2002; and 122




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
    
    an increase of $91 million in previously reported
revenues and $109
million in previously reported net loss applicable to common shares for the fourth quarter of 2002.  
    
    An increase of $1,491 million in previously reported
revenues and a reduction of $917
million in previously reported net loss applicable to common shares for the year ended December 31, 2001. The principal adjustments for the three months ended March 31, 2003 primarily relate to the
following matters (each of which reflects a number of related adjustments that have been aggregated
for disclosure purposes):  
    
    Adjustments to revenues and cost of revenues to address various aspects of our revenue
recognition policies and practices decreased revenues by a total of
$81 million and
increased cost of revenues by a total of $64 million. The revenue matters adjusted are
discussed in more detail above under Second Restatement Process.
    
    Foreign exchange adjustments decreased our pre-tax loss by a
total of $90 million.
These adjustments resulted primarily from the re-examination of the determination of the
functional currency for certain entities, the incorrect treatment of significant long-term
inter-company positions and revaluation errors related to certain foreign denominated
customer financing provisions within discontinued operations.
    
    Correction of certain inter-company balances that did not properly eliminate upon
consolidation and related provisions resulted in an increase of $6 million to pre-tax loss.
    
    Adjustments to previously recorded special charges for restructuring relating to
contract settlement costs, including real estate related items, severance and fringe
benefit related costs and plant and equipment impairment costs, resulted in an increase to
special charges of $29 million.
    
    Corrections to various accruals, provisions and other transactions, primarily due to the
incorrect application of U.S. GAAP to the initial recording of such liabilities, or the
failure to subsequently adjust such liabilities in the correct
period, resulted in an increase of $10 million to net loss.
    
    Adjustments to the accounting treatment of certain components of discontinued
operations, initially recognized in the second quarter of 2001, resulted in a decrease of
$31 million to net earnings from discontinued operations  net of tax. For additional information concerning the Second Restatement adjustments for the three months ended
March 31, 2003, see note 2 to the accompanying unaudited consolidated financial statements and
Developments in 2004Nortel Networks Audit Committee Independent Review; restatements; related
matters in the MD&A section of this report. For information concerning the Second Restatement
adjustments for 2002 and 2001, see the Controls and Procedures section in our 2003 Annual Report.  Use of Estimates in Financial Reporting; Omission of 1999 and 2000 Selected Financial Data;
Decision Not to Amend Certain Previous Filings As described above, two material weaknesses in our internal control over financial reporting were
identified at the time of the First Restatement. During the Second Restatement process, a number
of additional material weaknesses in our internal control over financial reporting were identified,
as described below. Due to, among other factors, these material weaknesses, the significant
turnover in our finance personnel, changes in accounting systems, documentation weaknesses and the
passage of time generally, the Second Restatement involved the efforts of hundreds of our finance
personnel and a number of outside consultants and advisors. As described above, the process
required the review and verification of a substantial number of documents and communications, and
related accounting entries, over multiple fiscal periods. In addition, the review of accruals and provisions and the application of accounting literature to
certain matters in the Second Restatement, including revenue recognition, foreign exchange, special
charges and discontinued operations, was complicated by the passage of time, the lack of
availability of supporting records and the turnover of finance personnel noted above. As a result
of this complexity, estimates and assumptions that impact both the quantum of the various recorded
adjustments and the fiscal period to which they were attributed were required in the determination
of certain of the Second Restatement adjustments. We believe the procedures followed in
determining such estimates were appropriate and reasonable using the best available information. 123




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Also as a result of the above factors, as well as a likely inability to obtain third party
corroboration in certain cases due to the substantial industry adjustment in the telecommunications
industry beginning in 2001, we believe that extensive additional efforts over an extended period of
time would be required to restate our 1999 and 2000 selected financial data. We also believe that
selected financial data for these periods would not be meaningful to investors due to this industry
adjustment, which significantly impacted our financial results in 2001 and subsequent periods and
limits the relevance of financial results in periods prior to 2001 for purposes of analysis of
trends in subsequent periods. Given the long delay in filing the Reports, we believed that
investor understanding would be better aided by the dedication of our resources to the preparation
of the current financial and other information included in this and future reports. As a result,
except for the selected balance sheet data as at December 31, 2000, financial data for the years
ended December 31, 1999 and 2000 was not restated or presented in the Selected Financial Data
(Unaudited) section of the 2003 Annual Reports. This omitted data is normally required to be
included in an Annual Report on Form 10-K. A number of our and NNCs past filings with the SEC remain subject to ongoing review by the SECs
Division of Corporation Finance (which could result in the need to amend this or our other
filings). In addition, the Second Restatement involved the restatement of our consolidated
financial statements for 2001 and 2002 and the first, second and third quarters of 2003. Amendments
to our prior filings with the SEC would be required in order for us to be in full compliance with
our reporting obligations under the Exchange Act. However, for the same reasons discussed above,
we do not believe that it would be feasible for us to amend our 2002 Form 10-K/A. In addition, we
believe that amended disclosure in the 2002 Form 10-K/A, 2003 Form 10-Q/As and 2003 Form 10-Q would
in large part repeat the disclosure in the 2003 Annual Reports and this report and expected to be
contained in the other 2004 Form 10-Qs. Accordingly, we do not plan to amend our 2002 Form 10-K/A,
2003 Form 10-Q/As or 2003 Form 10-Q. We believe that we have included in the 2003 Annual Reports
and this report all information needed for current investor understanding and will take similar
steps in our other 2004 Form 10-Qs.  Material Weaknesses in Internal Control over Financial Reporting Identified During the Second
Restatement Over the course of the Second Restatement process, we, together with D&T, identified a number of
reportable conditions, each constituting a material weakness, in our internal control over
financial reporting as at December 31, 2003. In September 2004, management first notified the
Audit Committee of the possibility of additional material weaknesses. Over the remainder of the
Second Restatement process, management and D&T identified a total of six material weaknesses. On
January 10, 2005, D&T confirmed to the Audit Committee that it had identified these six material
weaknesses. No other reportable conditions were identified by us or D&T at the
time of the Second Restatement or through January 31, 2005. The material weaknesses identified were:  
    
    lack of compliance with written Nortel Networks 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 Networks 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;
    
    lack of sufficient awareness of, and timely and appropriate remediation of, internal
control issues by Nortel Networks 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, 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. 124




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The foregoing material weaknesses contributed to the need for the Second Restatement. Upon
completion of our assessment of our internal control over financial reporting as at December 31,
2004 pursuant to SOX 404, we currently expect to conclude that the first five of these six material
weaknesses continued to exist as at December 31, 2004, and we continue to identify, develop and
begin to implement remedial measures to address them, as described below. * * * * * *  Current Status of Material Weaknesses in Internal Control Over Financial Reporting and
Expectations as to Required Management Conclusions and Independent Auditor Attestation
Pursuant to Section 404 of the Sarbanes-Oxley Act As noted in
MD&A  Risk factors/Forward looking statements, our 2004 Form 10-K must comply with SOX
404, which requires management to assess the effectiveness of our internal control over financial
reporting annually and to include in our Annual Report on Form 10-K a management report on that
assessment, together with an attestation by our independent registered public accounting firm. As
noted above, upon completion of our assessment of our internal control over financial reporting as
at December 31, 2004, we currently expect to conclude that the first five of the six material
weaknesses in our internal control over financial reporting described immediately above continued
to exist as at December 31, 2004 (and also constitute material weaknesses as now defined under
standards established by the Public Company Accounting Oversight Board). Accordingly, management
expects to conclude that our internal control over financial reporting as at December 31, 2004 is
ineffective, and D&T has advised us that they expect their report on managements assessment of
internal control over financial reporting also to indicate that internal control over financial
reporting is ineffective. * * * * * *  Revenue Independent Review As more fully described above, 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 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 will have a particular emphasis on the underlying
conduct that led to the initial recognition of these revenues. The Audit Committee will seek 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. * * * * * *  Remedial Measures 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 Board of
Directors has directed management to develop a detailed plan and timetable for the implementation
of these recommendations and will monitor their implementation. In addition, 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, including pursuant to
recommendations from D&T. 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 superseded by the
plans for the implementation of the recommendations of the Independent Review. A summary of these
measures, as well as previously announced personnel actions, follows.  
    
    Personnel Actions in Response to the First Restatement and Independent Review.  
    
    We terminated for cause our former president and chief executive officer, former chief
financial officer and former controller in April 2004 (the former chief financial officer and former
controller having been placed on paid leaves of absence in March 2004).
    
    We terminated for cause seven additional senior finance employees with significant
responsibilities for our financial reporting as a whole or for their respective business units and
geographic regions in August 2004. 125




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
    
    Renewed Commitment to Best Corporate Practices and Ethical Conduct.  
    
    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 been filled on an interim basis pending the permanent
appointment of Susan E. Shepard effective February 21, 2005).
    
    Over the course of the Second Restatement, our current CEO and current CFO have communicated
to employees the importance of the Second Restatement process, reliable and transparent financial
reporting and ethical conduct. Those communications included formal presentations as part of our
annual executive conference in November 2004.
    
    In June 2004, management recommended, the joint leadership resources committee recommended
and the Board of Directors subsequently approved that financial accountability be included as a key
qualitative factor in the individual leadership performance objectives for determination of
incentive cash awards under our annual incentive plan.  
    
    Extended Balance Sheet Reviews.We have developed a plan to extend our balance sheet reviews through the implementation of
enhanced review procedures to:  
    
    require greater frequency of timely statutory and segment balance sheet reviews,
    
    clarify responsibilities within Nortel Networks for organizing balance sheet reviews, and
    
    establish minimum documentation requirements with respect to balance sheet entries.  
    
    As part of the initial development of this plan, in the first quarter of 2004, we increased
our focus on the review of specific balance sheet accounts.  
    
    Review of Finance Department Organizational Structure. We announced, and began to implement,
plans to transform our finance organization, which include a renewed commitment to transparency as a
fundamental goal. Measures we have begun to implement include:  
    
    In the first quarter of 2004, we began to enhance our global technical accounting group and
establish global revenue governance and global finance governance teams.
    
    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, with an
expected assessment completion date of March 2005.
    
    We established a global corporate finance Sarbanes-Oxley compliance group beginning in the
third quarter of 2004.
    
    We have hired additional full-time finance personnel (with a focus on qualified accounting
professionals) as part of an initiative introduced by the CFO and controller in March 2004.  
    
    Training Initiatives.  
    
    We re-established our formal training group (led by the global finance governance team
described above) to implement ongoing training programs for finance personnel globally. The groups
focus includes training with respect to SFAS No. 5; accounting for hedging and 126




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derivatives; revenue recognition, accruals and provisions; and SFAS No. 52.  
    
    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 continues
to meet professional internal audit standards and moves towards audit best practices.  
    
    Manual Journal Entry Processes.  
    
    In the fourth quarter of 2003, we began to modify our manual journal entry processes by
implementing new procedures, with a focus on approvals of manual journal entries, more stringent
documentation processes and reduction of user access to manual journal entry functions. As noted above, we continue to identify, develop and begin to implement remedial measures,
including the development of a detailed plan and timetable for the implementation of the
recommendations of the Independent Review. As part of the Revenue Independent Review, the Audit
Committee will also consider any appropriate additional remedial measures, including those
involving internal controls and processes. 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 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. 127




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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 Annual Report on Form 10-K for the year ended December
31, 2003. 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, or JDS, between January 18, 2001 and February 15, 2001,
alleging violations of the same U.S. federal securities laws as the
more than twenty-five purported class action lawsuits subsequent to
the February 15, 2001 announcement in which Nortel Networks
provided revised guidance for financial performance for the 2001
fiscal year and the first quarter of 2001 (see
Contingencies in note 18 of the accompanying
unaudited consolidated financial statements). The
district court granted NNCs motion to dismiss the action on the grounds that plaintiffs lacked
standing to bring the action, and the Second Circuit Court of Appeals affirmed the dismissal.
On January 10, 2005, the U.S. Supreme Court Order denied the plaintiffs appeal, ending the JDS
litigation. Subsequent to the March 10, 2004 announcement in which NNC indicated it was likely that we and
it would need to revise our previously announced unaudited results for the year ended December
31, 2003, and the results reported in certain of our quarterly reports for 2003, and to restate
our 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 NNC 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, NNC 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. 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 18 of the accompanying unaudited consolidated financial statements. 128




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ITEM 6.
    
    Exhibits and Reports on Form 8-K  (a)
    
    Exhibits* 10.1
    
    Notice of Blackout to the Registrants Board of Directors and
Executive Officers Regarding Suspension of Trading dated March
10, 2004 (filed as Exhibit 99.2 to Nortel Networks Limiteds
Current Report on Form 8-K dated March 10, 2004).* 10.2
    
    Master Facility Agreement dated February 14, 2003, as amended
July 10, 2003, between Nortel Networks Limited and Export
Development Canada and as further amended by the Letter
Agreement dated March 29, 2004 (filed as Exhibit 99.2 to Nortel
Networks Limiteds Current Report on Form 8-K dated March 30,
2004).10.3
    
    Nortel Networks Limited SUCCESS Plan as approved on July 25, 2002, as amended on January 23,
2003 with effect from January 1, 2003, as amended on July 28, 2003 with effect from January 1,
2003, as amended on February 26, 2004 with effect from January 1, 2004.31.1
    
    Certification of the President 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 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 President and Chief Executive Officer 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.(b)
    
    Reports on Form 8-KNortel Networks Limited filed a Current Report on Form 8-K dated January 29, 2004 concerning
its financial results for the fourth quarter of 2003 and full year 2003.Nortel Networks Limited filed a Current Report on Form 8-K dated March 10, 2004 related to a
press release announcing the delay of filing of its financial results for the fiscal year of
2003.Nortel Networks Limited filed a Current Report on Form 8-K dated March 15, 2004 related to a
press release announcing the appointments of a new Chief Financial Officer and Controller on
an interim basis.Nortel Networks Limited filed a Current Report on Form 8-K dated March 30, 2004 related to a
press release announcing the waiver from Export Development Canada and update regarding the
timing of the first quarter 2004 results announcement and Annual Shareholders Meeting.Nortel Networks Limited filed a Current Report on Form 8-K dated April 5, 2004 related to a
press release updating the status of the Securities and Exchange Commission inquiry.Nortel Networks Limited filed a Current Report on Form 8-K dated April 14, 2004 related to a
press release updating the status of the Ontario Securities Commission inquiry.Nortel Networks Limited filed a Current Report on Form 8-K dated April 28, 2004 related to a
press release announcing the appointment of William A. Owens as President and Chief
Executive Officer, other management changes and an update on a number of matters, including
the status of certain prior year financial statements.Nortel Networks Limited filed a Current Report on Form 8-K/A dated April 28, 2004 amending
debt securities information contained in a press release dated March 10, 2004.    129




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Nortel Networks Limited filed a Current Report on Form 8-K dated April 29, 2004 related to a
press release announcing the appointment of Dr. rer. Pol. Manfred Bischoff to the Nortel
Networks Board of Directors.Nortel Networks Limited filed a Current Report on Form 8-K dated May 14, 2004 related to a
press release announcing Nortel Networks receipt of a federal grand jury subpoena from the
U.S. Attorneys Office for the production of certain documents.Nortel Networks Limited filed a Current Report on Form 8-K dated May 18, 2004 related to a
press release announcing a temporary cease trade order issued by the Ontario Securities
Commission.Nortel Networks Limited filed a Current Report on Form 8-K dated May 25, 2004 related to the
resignation of Frank Andrew Dunn as a director effective May 21, 2004.Nortel Networks Limited filed a Current Report on Form 8-K dated May 26, 2004 related to a
press release announcing the appointment of The Hon. John Manley to the Nortel Networks
Board of Directors.Nortel Networks Limited filed a Current Report on Form 8-K dated May 31, 2004 related to a
press release announcing that Nortel Networks Limited had obtained a new waiver from Export
Development Canada.Nortel Networks Limited filed a Current Report on Form 8-K dated June 2, 2004 related to a
press release providing a status update on its financial restatement process and other
related matters.Nortel Networks Limited filed a Current Report on Form 8-K dated June 15, 2004 related to a
press release providing a status update on its financial restatement process and other
related matters.Nortel Networks Limited filed a Current Report on Form 8-K dated June 23, 2004 related to a
press release announcing court approval for extending the time for calling the 2004 Annual
Shareholders Meeting.Nortel Networks Limited filed a Current Report on Form 8-K dated June 24, 2004 related to a
letter received from the Toronto Stock Exchange advising of a breach of its financial
statements filing requirements.Nortel Networks Limited filed a Current Report on Form 8-K dated June 29, 2004 related to a
press release providing a status update on its financial restatement process and other
related matters.Nortel Networks Limited filed a Current Report on Form 8-K dated July 6, 2004 related to an
agreement reached with Flextronics International Ltd.Nortel Networks Limited filed a Current Report on Form 8-K dated July 13, 2004 related to a
press release providing a status update on its financial restatement process and other
related matters.Nortel Networks Limited filed a Current Report on Form 8-K dated July 27, 2004 related to a
press release providing a status update on its financial restatement process and other
related matters.Nortel Networks Limited filed a Current Report on Form 8-K dated August 10, 2004 related to
a press release providing a status update on its financial restatement process and other
related matters.Nortel Networks Limited filed a Current Report on Form 8-K dated August 17, 2004 related to
a press release providing a status update of the RCMP review.Nortel Networks Limited filed a Current Report on Form 8-K dated August 19, 2004 related to
a press release providing a status update on its financial restatement process and other
related matters.Nortel Networks Limited filed a Current Report on Form 8-K dated August 20, 2004 related to
a press release announcing a new waiver from Export Development Canada.Nortel Networks Limited filed a Current Report on Form 8-K dated September 2, 2004 related
to a press release providing a status update on its financial restatement process and other
related matters. 130




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Nortel Networks Limited filed a Current Report on Form 8-K dated September 2, 2004 related
to an employment agreement with William Owens, President and Chief Executive Officer.Nortel Networks Limited filed a Current Report on Form 8-K dated September 16, 2004 related
to a press release providing a status update on its financial restatement process and other
related matters.Nortel Networks Limited filed a Current Report on Form 8-K dated September 30, 2004 related
to a press release providing a status update on its financial restatement process and
announcing a new waiver from Export Development Canada.Nortel Networks Limited filed a Current Report on Form 8-K/A dated September 30, 2004
amending details of its previously announced work plan contained in a press release dated
August 19, 2004.Nortel Networks Limited filed a Current Report on Form 8-K dated October 14, 2004 related to
a press release providing a status update on its financial restatement process and other
related matters.Nortel Networks Limited filed a Current Report on Form 8-K/A dated October 18, 2004 updating
certain information concerning the timing and implementation of certain matters under the
existing agreement with Flextronics International Ltd. contained in a press release dated
June 29, 2004.Nortel Networks Limited filed a Current Report on Form 8-K dated October 27, 2004 related to
a press release providing a status update on its financial restatement process and other
matters.Nortel Networks Limited filed a Current Report on Form 8-K dated November 2, 2004 related to
a press release announcing a new waiver from Export Development Canada.Nortel Networks Limited filed a Current Report on Form 8-K dated November 12, 2004 related
to a press release providing a status update on its financial restatement process and other
matters.Nortel Networks Limited filed a Current Report on Form 8-K dated November 19, 2004 related
to a press release announcing a new waiver from Export Development Canada.Nortel Networks Limited filed a Current Report on Form 8-K dated November 24, 2004 related
to a press release providing a status update on its financial restatement process and other
matters.Nortel Networks Limited filed a Current Report on Form 8-K dated November 30, 2004 updating
certain information concerning Nortel Networks Corporations Annual Shareholders Meeting.Nortel Networks Limited filed a Current Report on Form 8-K dated December 8, 2004 related to
a press release providing a status update on its financial restatement process and other
matters.Nortel Networks Limited filed a Current Report on Form 8-K dated December 10, 2004 related
to a press release announcing a new waiver from Export Development Canada.Nortel Networks Limited filed a Current Report on Form 8-K dated December 14, 2004 related
to a press release providing limited estimated unaudited financial results for the third
quarter of 2004, and updated limited estimated unaudited results for the first and second
quarters of 2004 and for the years 2001, 2002 and 2003.Nortel Networks Limited filed a Current Report on Form 8-K dated December 22, 2004 related
to a press release providing a status update on its financial restatement process and other
related matters.Nortel Networks Limited filed a Current Report on Form 8-K dated January 4, 2005 related to
a press release advising that the New York Stock Exchange has granted a three month
extension to file the 2003 Annual Reports on Form 10-K with the Securities and Exchange
Commission.Nortel Networks Limited filed a Current Report on Form 8-K dated January 7, 2005 related to
a press release providing a status update on its financial restatement process and other
related matters. 131




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Nortel Networks Limited filed a Current Report on Form 8-K dated January 10, 2005 related to
a press release regarding the filing of Nortel Networks Corporations 2003 financial
statements.Nortel Networks Limited filed a Current Report on Form 8-K dated January 11, 2005 related to
a press release announcing the filing of Nortel Networks Corporation s Annual Report on
Form 10-K.Nortel Networks Limited filed a Current Report on Form 8-K dated January 13, 2005 related to
an employment agreement with Susan E. Shepard in connection with her appointment of Chief
Ethics and Compliance Officer and the appointment of Richard McCormick and Harry Pearce as
directors.Nortel Networks Limited filed a Current Report on Form 8-K dated January 14, 2005 related to
a press release announcing a new waiver from Export Development Canada.Nortel Networks Limited filed a Current Report on Form 8-K dated January 19, 2005 related to
a press release announcing the filing of Nortel Networks Limiteds 2003 annual financial
statements.Nortel Networks Limited filed a Current Report on Form 8-K dated January 20, 2005 related to
the appointment of two new directors of Nortel Networks Limited and the appointment of the
new directors to certain committees of the Boards of Directors of Nortel Networks
Corporation and Nortel Networks Limited. 132




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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/ WILLIAM R. KERR
    
    /s/ MARYANNE E. PAHAPILLWILLIAM R. KERR
    
    MARYANNE E. PAHAPILLChief Financial Officer
    
    Controller
 Date: January 31, 2005 133