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Nortel Networks 10-Q 2005
e10vq
Table of Contents

 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
     
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Quarterly Period Ended September 30, 2005
 
OR
 
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From                      to                     
Commission file number: 001-07260
Nortel Networks Corporation
(Exact name of registrant as specified in its charter)
     
Canada
  Not Applicable
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
 
8200 Dixie Road, Suite 100
Brampton, Ontario, Canada
(Address of principal executive offices)
  L6T 5P6
(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 þ          No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes þ          No o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o          No þ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as at October 14, 2005.
4,334,867,037 shares of common stock without nominal or par value
 
 


TABLE OF CONTENTS
             
        Page
         
   Consolidated Financial Statements (Unaudited)     4  
   Management’s Discussion and Analysis of Financial Condition and Results of Operations     55  
   Quantitative and Qualitative Disclosures About Market Risk     128  
   Controls and Procedures     128  
 
 PART II
OTHER INFORMATION
   Legal Proceedings     136  
   Unregistered Sales of Equity Securities and Use of Proceeds     138  
   Other Information     139  
   Exhibits     139  
 SIGNATURES     140  
All dollar amounts in this document are in United States dollars unless otherwise stated.
NORTEL, NORTEL (Logo), NORTEL NETWORKS, GLOBEMARK (Logo), NT, and > THIS IS THE WAY > THIS IS NORTEL (Logo) are trademarks of Nortel Networks.
MOODY’S is a trademark of Moody’s Investor Services, Inc.
NYSE is a trademark of the New York Stock Exchange, Inc.
SAP is a trademark of SAP AG.
S&P and STANDARD & POOR’S are trademarks of The McGraw-Hill Companies, Inc.
All other trademarks are the property of their respective owners.

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PART I
FINANCIAL INFORMATION
         
    Page
     
ITEM 1. Consolidated Financial Statements (Unaudited)
    4  
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
    55  
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
    128  
ITEM 4. Controls and Procedures
    128  

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NORTEL NETWORKS CORPORATION
Consolidated Statements of Operations (unaudited)
                                   
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
    (Millions of U.S. dollars,
    except per share amounts)
Revenues
  $ 2,655     $ 2,179     $ 8,046     $ 7,213  
Cost of revenues
    1,648       1,393       4,747       4,319  
                         
Gross profit
    1,007       786       3,299       2,894  
Selling, general and administrative expense
    572       512       1,725       1,596  
Research and development expense
    449       501       1,402       1,465  
Amortization of intangibles
    6       2       10       7  
Special charges
    37       93       148       99  
(Gain) loss on sale of businesses and assets(a)
    4       (39 )     41       (114 )
                         
Operating earnings (loss)
    (61 )     (283 )     (27 )     (159 )
Other income (expense) — net
    66       44       170       112  
Interest expense
                               
 
Long-term debt
    (55 )     (45 )     (156 )     (132 )
 
Other
    (2 )     (3 )     (6 )     (18 )
                         
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net earnings (loss) of associated companies
    (52 )     (287 )     (19 )     (197 )
Income tax benefit (expense)
    (40 )     30       (49 )     32  
                         
      (92 )     (257 )     (68 )     (165 )
Minority interests — net of tax
    (15 )     (7 )     (46 )     (29 )
Equity in net earnings (loss) of associated companies — net of tax
    1             3       (2 )
                         
Net earnings (loss) from continuing operations
    (106 )     (264 )     (111 )     (196 )
Net earnings (loss) from discontinued operations — net of tax
    1       5       2       12  
                         
Net earnings (loss)
  $ (105 )   $ (259 )   $ (109 )   $ (184 )
                         
Basic earnings (loss) per common share
                               
 
— from continuing operations
  $ (0.02 )   $ (0.06 )   $ (0.03 )   $ (0.04 )
 
— from discontinued operations
    0.00       0.00       0.00       0.00  
                         
Basic earnings (loss) per common share
  $ (0.02 )   $ (0.06 )   $ (0.03 )   $ (0.04 )
                         
Diluted earnings (loss) per common share
                               
 
— from continuing operations
  $ (0.02 )   $ (0.06 )   $ (0.03 )   $ (0.04 )
 
— from discontinued operations
    0.00       0.00       0.00       0.00  
                         
Diluted earnings (loss) per common share
  $ (0.02 )   $ (0.06 )   $ (0.03 )   $ (0.04 )
                         
 
(a)  Includes related costs.
The accompanying notes are an integral part of these consolidated financial statements

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NORTEL NETWORKS CORPORATION
Consolidated Balance Sheets (unaudited)
                   
    September 30,   December 31,
    2005   2004
         
    (Millions of U.S. dollars,
    except for share amounts)
ASSETS
Current assets
               
 
Cash and cash equivalents
  $ 2,997     $ 3,686  
 
Restricted cash and cash equivalents
    73       80  
 
Accounts receivable — net
    2,616       2,551  
 
Inventories — net
    1,232       1,414  
 
Deferred income taxes — net
    371       255  
 
Other current assets
    580       356  
             
Total current assets
    7,869       8,342  
Investments
    166       159  
Plant and equipment — net
    1,575       1,651  
Goodwill
    2,519       2,303  
Intangible assets — net
    150       78  
Deferred income taxes — net
    3,606       3,736  
Other assets
    579       715  
             
Total assets
  $ 16,464     $ 16,984  
             
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
               
 
Trade and other accounts payable
  $ 984     $ 996  
 
Payroll and benefit-related liabilities
    536       515  
 
Contractual liabilities
    396       569  
 
Restructuring liabilities
    131       254  
 
Other accrued liabilities
    2,500       2,823  
 
Long-term debt due within one year
    1,455       15  
             
Total current liabilities
    6,002       5,172  
Long-term debt
    2,428       3,862  
Deferred income taxes — net
    227       144  
Other liabilities
    3,373       3,189  
             
Total liabilities
    12,030       12,367  
             
Minority interests in subsidiary companies
    641       630  
Guarantees, commitments and contingencies (notes 10, 11 and 17)
               
 
SHAREHOLDERS’ EQUITY
 
Common shares, without par value — Authorized shares: unlimited;
               
 
Issued and outstanding shares: 4,339,186,267 as of September 30, 2005 and 4,272,671,213 as of December 31, 2004
    33,932       33,840  
Additional paid-in capital
    3,252       3,282  
Accumulated deficit
    (32,692 )     (32,583 )
Accumulated other comprehensive income (loss)
    (699 )     (552 )
             
Total shareholders’ equity
    3,793       3,987  
             
Total liabilities and shareholders’ equity
  $ 16,464     $ 16,984  
             
The accompanying notes are an integral part of these consolidated financial statements

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NORTEL NETWORKS CORPORATION
Consolidated Statements of Cash Flows (unaudited)
                     
    Nine Months
    Ended
    September 30,
     
    2005   2004
         
    (Millions of
    U.S. dollars)
Cash flows from (used in) operating activities
               
 
Net earnings (loss) from continuing operations
  $ (111 )   $ (196 )
 
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
    231       260  
   
Non-cash portion of special charges and related asset write downs
    3        
   
Equity in net (earnings) loss of associated companies — net of tax
    (3 )     2  
   
Stock option compensation
    58       55  
   
Deferred income taxes
    58       (12 )
   
Other liabilities
    251       190  
   
(Gain) loss on sale or write down of investments, businesses and assets
    25       (147 )
   
Other — net
    (3 )     98  
   
Change in operating assets and liabilities
    (813 )     (697 )
             
 
Net cash from (used in) operating activities of continuing operations
    (304 )     (447 )
             
Cash flows from (used in) investing activities
               
 
Expenditures for plant and equipment
    (167 )     (194 )
 
Proceeds on disposals of plant and equipment
    10       10  
 
Restricted cash and cash equivalents
    9       (14 )
 
Acquisitions of investments and businesses — net of cash acquired
    (449 )     (7 )
 
Proceeds on sale of investments and businesses
    308       143  
             
 
Net cash from (used in) investing activities of continuing operations
    (289 )     (62 )
             
Cash flows from (used in) financing activities
               
 
Dividends paid by subsidiaries to minority interests
    (33 )     (24 )
 
Increase in notes payable
    58       54  
 
Decrease in notes payable
    (64 )     (56 )
 
Repayments of long-term debt
          (107 )
 
Repayments of capital leases payable
    (8 )     (5 )
 
Issuance of common shares
    4       30  
             
 
Net cash from (used in) financing activities of continuing operations
    (43 )     (108 )
             
Effect of foreign exchange rate changes on cash and cash equivalents
    (86 )     (6 )
             
Net cash from (used in) continuing operations
    (722 )     (623 )
Net cash from (used in) in operating activities of discontinued operations
    33       16  
             
Net increase (decrease) in cash and cash equivalents
    (689 )     (607 )
Cash and cash equivalents at beginning of period
    3,686       3,997  
             
Cash and cash equivalents at end of period
  $ 2,997     $ 3,390  
             
See note 3 for supplemental cash flow information.
The accompanying notes are an integral part of these consolidated financial statements

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited)
(millions of U.S. dollars, except per share amounts, unless otherwise stated)
1. Significant accounting policies
Basis of presentation
The unaudited consolidated financial statements of Nortel Networks Corporation (“Nortel”) have been prepared in accordance with accounting principles generally accepted in the United States (“U.S.”) (“GAAP”) and the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”) for the preparation of interim financial information. They do not include all information and notes required by U.S. GAAP in the preparation of annual consolidated financial statements. The accounting policies used in the preparation of the unaudited consolidated financial statements are the same as those described in Nortel’s audited consolidated financial statements prepared in accordance with U.S. GAAP for the year ended December 31, 2004. Although Nortel is headquartered in Canada, the unaudited consolidated financial statements are expressed in U.S. dollars as the greater part of the financial results and net assets of Nortel are denominated in U.S. dollars.
Nortel makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates. Estimates are used when accounting for items and matters such as revenue recognition and accruals for losses on contracts, allowances for uncollectible accounts receivable and customer financing, receivables sales, inventory obsolescence, product warranty, amortization, asset valuations, impairment assessments, employee benefits including pensions, taxes and related valuation allowance, restructuring and other provisions, stock-based compensation and contingencies.
Nortel believes all adjustments necessary for a fair statement of the results for the periods presented have been made and all such adjustments were of a normal recurring nature unless otherwise disclosed. The financial results for the three and nine months ended September 30, 2005 are not necessarily indicative of financial results for the full year. The unaudited consolidated financial statements should be read in conjunction with Nortel’s Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC (the “2004 Annual Report”).
Comparative figures
Certain 2004 figures in the unaudited consolidated financial statements have been reclassified to conform to the 2005 presentation.
Recent accounting pronouncements
(a) In March 2004, the Emerging Issues Task Force (“EITF”) reached consensus on Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”). EITF 03-1 provides guidance on determining when an investment is considered impaired, whether that impairment is other than temporary and the measurement of an impairment loss. EITF 03-1 is applicable to marketable debt and equity securities within the scope of Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”), and SFAS No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations”, and equity securities that are not subject to the scope of SFAS 115 and not accounted for under the equity method of accounting. The Financial Accounting Standards Board (“FASB”), at its June 29, 2005 Board meeting, decided not to provide additional guidance on the meaning of other-than-temporary impairment, but instead issued proposed FASB Staff Position (“FSP”) EITF 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1”, as final, superseding EITF 03-1 and EITF Topic No. D-44, “Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value”. The final FSP, retitled FSP FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP FAS 115-1”), would be applied prospectively and the effective date would be reporting periods beginning after December 15, 2005. The adoption of FSP FAS 115-1, once issued by the FASB, is not expected to have a material impact on Nortel’s results of operations and financial condition.
(b) In November 2004, the FASB issued SFAS No. 151, “Inventory Costs” (“SFAS 151”). SFAS 151 requires that abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage) be recognized as current period charges rather than capitalized as a component of inventory costs. In addition, SFAS 151 requires allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. This statement is effective for inventory costs incurred in fiscal periods beginning after June 15, 2005. The guidance should

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
be applied prospectively. The adoption of SFAS 151 did not have a material impact on Nortel’s results of operations and financial condition.
(c) In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”), which requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense in the consolidated financial statements based on their fair values. SFAS 123R also modifies certain measurement and expense recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), that will impact Nortel, including the requirement to estimate employee forfeitures each period when recognizing compensation expense, and requiring that the initial and subsequent measurement of the cost of liability-based awards each period be based on the fair value (instead of the intrinsic value) of the award. This statement is effective for Nortel as of January 1, 2006. Nortel previously elected to expense employee stock-based compensation using the fair value method prospectively for all awards granted or modified on or after January 1, 2003 in accordance with SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of FASB Statement No. 123” (“SFAS 148”). Nortel is currently assessing the impact of SFAS 123R on its results of operations and financial condition, as well as the impact of SEC Staff Accounting Bulletin 107, “Share-Based Payment” (“SAB 107”). SAB 107 was issued by the SEC in March 2005, and provides supplemental SFAS 123R application guidance based on the views of the SEC.
(d) In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”), which replaces Accounting Principles Board (“APB”) Opinion No. 20, “Accounting Changes”, and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements — An Amendment of APB Opinion No. 28”. SFAS 154 provides guidance on the accounting for and reporting of changes in accounting principles and error corrections. SFAS 154 requires retrospective application to prior period financial statements of voluntary changes in accounting principle and changes required by new accounting standards when the standard does not include specific transition provisions, unless it is impracticable to do so. SFAS 154 also requires certain disclosures for restatements due to correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, and is required to be adopted by Nortel as of January 1, 2006. The impact that the adoption of SFAS 154 will have on Nortel’s consolidated results of operations and financial condition will depend on the nature of future accounting changes adopted by Nortel and the nature of transitional guidance provided in future accounting pronouncements.
(e) In June 2005, the FASB issued FSP No. 143-1, “Accounting for Electronic Equipment Waste Obligations” (“FSP 143-1”). FSP 143-1 provides guidance on how commercial users and producers of electronic equipment should recognize and measure asset retirement obligations associated with the European Union (“EU”) Directive 2002/96/EC on Waste Electrical and Electronic Equipment. FSP 143-1 applies to the later of Nortel’s fiscal quarter ended June 30, 2005 or the date of the adoption of the law by the applicable EU-member country. In the second quarter of 2005, Nortel adopted FSP 143-1 with respect to those EU-member countries that transposed the directive into country specific laws. In the third quarter of 2005, Nortel adopted FSP 143-1 with respect to additional EU-member countries that enacted country specific laws in the current period. The adoption of the FSP 143-1 in the second and third quarter of 2005 did not have a material impact on Nortel’s results of operations and financial condition. Due to the fact that certain EU-member countries have not yet enacted country-specific laws, Nortel cannot estimate the impact of applying this guidance in future periods.
(f) In September 2005, the EITF reached consensus on Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty” (“EITF 04-13”). EITF 04-13 provides guidance on the purchase and sale of inventory to another entity that operates in the same line of business. The purchase and sale transactions may be pursuant to a single contractual arrangement or separate contractual arrangements and the inventory purchased or sold may be in the form of raw materials, work-in-process, or finished goods. EITF 04-13 applies to new arrangements entered into, or modifications or renewals of existing arrangements in reporting periods beginning after March 15, 2006. The impact of the adoption of EITF 04-13 on Nortel’s consolidated results of operations and financial condition will depend on the nature of future arrangements entered into, or modifications or renewals of existing arrangements by Nortel.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
2. Accounting changes
          (a) Implicit Variable Interests
In March 2005, the FASB issued FSP No. 46(R)-5, “Implicit Variable Interests under FASB Interpretation No. (“FIN”) 46 (revised December 2003), Consolidation of Variable Interest Entities” (“FSP FIN 46R-5”). FSP FIN 46R-5 provides guidance for a reporting enterprise on whether it holds an implicit variable interest in Variable Interest Entities (“VIEs”) or potential VIEs when specific conditions exist. This FSP is effective in the first period beginning after March 3, 2005 in accordance with the transition provisions of FIN 46 (Revised 2003), “Consolidation of Variable Interest Entities — an Interpretation of Accounting Research Bulletin No. 51” (“FIN 46R”). The adoption of FSP FIN 46R-5 had no impact on Nortel’s results of operations and financial condition.
          (b) The Effect of Contingently Convertible Debt on Diluted Earnings per Share
On September 30, 2004, the EITF reached a consensus on Issue No. 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share” (“EITF 04-8”), which addresses when the dilutive effect of contingently convertible debt instruments should be included in diluted earnings (loss) per share. EITF 04-8 requires that contingently convertible debt instruments be included in the computation of diluted earnings (loss) per share regardless of whether the market price trigger has been met. EITF 04-8 also requires that prior period diluted earnings (loss) per share amounts presented for comparative purposes be restated. EITF 04-8 became effective for reporting periods ending after December 15, 2004. The adoption of EITF 04-8 did not have an impact on Nortel’s diluted earnings (loss) per share.
          (c) Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 clarifies the accounting for certain financial instruments with characteristics of both liabilities and equity, including mandatorily redeemable non-controlling interests, and requires that those instruments be classified as liabilities on the balance sheets. Previously, many of those financial instruments were classified as equity. SFAS 150 became effective for financial instruments entered into or modified after May 31, 2003 and otherwise became effective at the beginning of the first interim period beginning after June 15, 2003. In November 2003, the FASB issued FSP FAS 150-3, “Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Non-controlling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” (“FSP FAS 150-3”), which deferred indefinitely the effective date for applying the specific provisions within SFAS 150 related to the classification and measurement of mandatorily redeemable non-controlling interests.
Nortel continues to consolidate two enterprises with limited lives, which have mandatory liquidation at the end of their prescribed lives in 2024. Upon liquidation, the net assets of these entities will be distributed to the owners based on their relative interests at that time. The minority interests included in the consolidated balance sheets related to these entities were a total of $57 and $50 as of September 30, 2005 and December 31, 2004, respectively. As of September 30, 2005, the fair value of these minority interests was approximately $73. The adoption of SFAS 150, as amended by FSP FAS 150-3, did not have a material impact on Nortel’s results of operations and financial condition.
3. Consolidated financial statement details
The following consolidated financial statement details are presented for each of the three and nine months ended September 30, 2005 and 2004 for the consolidated statements of operations, as of September 30, 2005 and December 31, 2004 for the consolidated balance sheets and for the nine months ended September 30, 2005 and 2004 for the consolidated statements of cash flows.
Consolidated statements of operations
During the three and nine months ended September 30, 2005, Nortel recorded adjustments related to prior periods. These adjustments resulted in a net increase of approximately $15 and $40 to net loss for the three and nine months ended September 30, 2005, respectively. The adjustments related primarily to various revenue and other corrections, which reduced revenue by $21 and $39 and gross margin by $20 and $18 for the three and nine months ended September 30, 2005, respectively, a foreign exchange gain (loss) of $8 and $(2) for the three and nine months ended

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
September 30, 2005, respectively, and a $16 correction to the accounting treatment of certain costs attributable to Nortel’s ongoing divestiture of its remaining manufacturing operations to Flextronics International Ltd. (“Flextronics”), which was recorded in the second quarter of 2005 (see note 8). The aggregate impact of these adjustments was not material to Nortel’s results for the three and nine months ended September 30, 2005 or to any individual segment or geographical region or to the results for any individual prior annual or interim period.
Other income (expense) — net:
                                 
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
Interest income
  $ 16     $ 16     $ 45     $ 47  
Gain (loss) on sale or write down of investments
          1       16       33  
Currency exchange gains (losses)
    21       53       55       53  
Other — net
    29       (26 )     54       (21 )
                         
Other income (expense) — net
  $ 66     $ 44     $ 170     $ 112  
                         
Other income (expense) — net for the three and nine months ended September 30, 2004 includes a gain of $31 resulting from a correction in the third quarter of 2004 relating to a cumulative error in functional currency designation of an entity in Brazil.
Hedge ineffectiveness and the discontinuance of cash flow hedges and fair value hedges that were accounted for in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), had no material impact on the net earnings (loss) for the three and nine months ended September 30, 2005 and 2004 and were reported within other income (expense) — net in the consolidated statements of operations.
Consolidated balance sheets
Accounts receivable — net:
                 
    September 30,   December 31,
    2005   2004
         
Trade receivables
  $ 1,954     $ 2,010  
Notes receivable
    66       42  
Contracts in process
    692       608  
             
      2,712       2,660  
Less: provision for doubtful accounts
    (96 )     (109 )
             
Accounts receivable — net
  $ 2,616     $ 2,551  
             
Inventories — net:
                 
    September 30,   December 31,
    2005   2004
         
Raw materials
  $ 838     $ 935  
Work in process
    45       125  
Finished goods
    1,784       1,863  
             
      2,667       2,923  
Less: provision for inventory
    (1,046 )     (1,141 )
             
Inventories — net
    1,621       1,782  
Less: long-term inventory(a)
    (389 )     (368 )
             
Current inventories — net
  $ 1,232     $ 1,414  
             
 
(a)  Long-term portion of inventory related to deferred costs discussed below, which is included in other assets.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Finished goods inventory includes certain direct and incremental costs associated with arrangements where title and risk of loss was transferred to the customer but revenue was deferred due to other revenue recognition criteria not being met. As of September 30, 2005 and December 31, 2004, these deferred costs totaled $796 and $829, respectively.
Other current assets:
                 
    September 30,   December 31,
    2005   2004
         
Prepaid expenses
  $ 222     $ 175  
Income taxes recoverable
    69       38  
Current assets of discontinued operations
    13       14  
Other
    276       129  
             
Other current assets
  $ 580     $ 356  
             
Plant and equipment — net:
                   
    September 30,   December 31,
    2005   2004
         
Cost:
               
 
Land
  $ 56     $ 63  
 
Buildings
    1,328       1,514  
 
Machinery and equipment
    2,253       2,455  
 
Capital lease assets — buildings, machinery and equipment
    206       42  
             
      3,843       4,074  
             
Less accumulated depreciation:
               
 
Buildings
    (453 )     (502 )
 
Machinery and equipment
    (1,743 )     (1,889 )
 
Capital lease assets — buildings, machinery and equipment
    (72 )     (32 )
             
      (2,268 )     (2,423 )
             
Plant and equipment — net(a)(b)
  $ 1,575     $ 1,651  
             
 
(a)   Includes assets held for sale with a carrying value of $71 and $29 as of September 30, 2005 and December 31, 2004, respectively, related to owned facilities that were being actively marketed. These assets were written down to their estimated fair values less costs to sell. The write downs were included in special charges. Nortel expects to dispose of all of these facilities by the end of the first half of 2006.
 
(b)  Includes assets accounted for as a financing under sale-leaseback accounting guidelines with a carrying value of $54 and $43 as of September 30, 2005 and December 31, 2004, respectively.
Goodwill:
The following table outlines goodwill by reportable segment:
                                           
    Carrier       GSM and        
    Packet   CDMA   UMTS   Enterprise    
    Networks   Networks   Networks   Networks   Total
                     
Balance — net as of December 31, 2004
  $ 571     $ 28     $ 9     $ 1,695     $ 2,303  
Changes:
                                       
 
Addition (note 8)
                      269       269  
 
Disposal
    (38 )                       (38 )
 
Foreign exchange
    (7 )     (2 )     (1 )     (5 )     (15 )
                               
Balance — net as of September 30, 2005
  $ 526     $ 26     $ 8     $ 1,959     $ 2,519  
                               

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Due to the change in operating segments and reporting segments as described in note 4, a triggering event occurred requiring a goodwill impairment test in the first quarter of 2005 in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”. Nortel performed this test and concluded that there was no impairment.
Intangible assets — net:
                 
    September 30,   December 31,
    2005   2004
         
Other intangible assets(a)
  $ 109     $ 38  
Pension intangible assets
    41       40  
             
Intangible assets — net
  $ 150     $ 78  
             
 
(a)  Includes intangible assets related to an acquisition during the second quarter of 2005, see note 8.
Other intangible assets are being amortized over an approximately ten year period ending in 2014, based on their expected pattern of benefit to future periods using estimates of undiscounted cash flows. The amortization expense is partially denominated in a foreign currency and may fluctuate due to changes in foreign exchange rates.
Other accrued liabilities:
                 
    September 30,   December 31,
    2005   2004
         
Outsourcing and selling, general and administrative related provisions
  $ 285     $ 323  
Customer deposits
    28       28  
Product related provisions
    64       57  
Warranty provisions (note 10)
    233       275  
Deferred revenue
    1,079       1,210  
Miscellaneous taxes
    58       53  
Income taxes payable
    51       112  
Interest payable
    35       65  
Advance billings in excess of revenues recognized to date on contracts
    525       581  
Other
    142       119  
             
Other accrued liabilities
  $ 2,500     $ 2,823  
             
Other liabilities:
                 
    September 30,   December 31,
    2005   2004
         
Pension, post-employment and post-retirement benefit liabilities
  $ 2,300     $ 2,208  
Restructuring liabilities (note 5)
    217       209  
Deferred revenue
    625       509  
Other long-term provisions
    231       263  
             
Other liabilities
  $ 3,373     $ 3,189  
             

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Consolidated statements of cash flows
Change in operating assets and liabilities:
                 
    Nine Months
    Ended
    September 30,
     
    2005   2004
         
Accounts receivable — net
  $ (143 )   $ 355  
Inventories — net
    78       (313 )
Income taxes
    (50 )     (64 )
Restructuring liabilities
    (112 )     (70 )
Accounts payable, payroll and contractual liabilities
    (618 )     (535 )
Other operating assets and liabilities
    32       (70 )
             
Change in operating assets and liabilities
  $ (813 )   $ (697 )
             
Interest and taxes paid (recovered):
                 
    Nine Months
    Ended
    September 30,
     
    2005   2004
         
Cash interest paid
  $ 184     $ 182  
Cash taxes paid (recovered) — net
  $ 44     $ 39  
4. Segment information
General description
During 2004, Nortel’s operations were organized and represented by four operating segments, which were also its reportable segments: Wireless Networks, Enterprise Networks, Wireline Networks, and Optical Networks. Effective October 1, 2004, Nortel established a new streamlined organizational structure that is comprised of the following operating segments: (a) Carrier Packet Networks, which is substantially an amalgamation of Nortel’s previous Wireline Networks and Optical Networks operating segments; (b) Code Division Multiple Access (“CDMA”) Networks, which previously represented a portion of the Wireless Networks operating segment; (c) Global System for Mobile communications (“GSM”) and Universal Mobile Telecommunications Systems (“UMTS”) Networks, which also previously represented a portion of the Wireless Networks operating segment; and (d) Enterprise Networks, which remains substantially unchanged from the previous Enterprise Networks operating segment.
Although certain structural changes were made to reflect the reorganization effective October 1, 2004, Nortel did not meet the criteria to change its reportable segments under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS 131”), for the 2004 fiscal year. Nortel’s operating results on a segmented basis for the new organizational structure were not available for review by the chief operating decision maker (“CODM”) during the 2004 fiscal year, as a significant amount of Nortel’s finance resources were allocated to the restatement activity that was completed during January 2005. Commencing in the first quarter of 2005, Nortel met the criteria under SFAS 131 to change its reportable segments to reflect the four operating segments established effective October 1, 2004. Nortel’s four reportable segments and other business activities are described below:
  •  Carrier Packet Networks provides: (i) circuit and packet voice solutions, (ii) data networking and security solutions and (iii) optical long-haul and metropolitan optical network solutions. Together, these solutions provide or transport data, voice and multimedia communications solutions to Nortel’s service provider customers that operate wireline networks. These service provider customers include local and long distance telephone companies, wireless service providers (for the wireline portion of their networks), cable operators and other communication service providers.
 
  •  CDMA Networks provides communication network solutions to wireless service provider customers based on CDMA and Time Division Multiple Access (“TDMA”) technologies to enable those customers to offer their customers, the subscribers for wireless communication services, the ability to be mobile while they send and

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
  receive voice and data communications using wireless devices, such as cellular telephones, personal digital assistants and other computing and communications devices.
 
  •  GSM and UMTS Networks also provides communication network solutions to Nortel’s wireless service provider customers; however, these solutions are based on GSM and UMTS technologies.
 
  •  Enterprise Networks provides: (i) circuit and packet voice solutions and (ii) data networking and security solutions which provide data, voice and multimedia communications solutions to Nortel’s enterprise customers. Nortel’s Enterprise Networks customers consist of a broad range of enterprise customers around the world, including large businesses and their branch offices, small businesses and home offices, as well as government agencies, educational and other institutions and utility organizations.
 
  •  “Other” represents miscellaneous business activities and corporate functions. None of these activities meet the quantitative criteria to be disclosed separately as reportable segments. Costs associated with shared services and other corporate costs are allocated to the segments based on usage determined generally by headcount. Costs not allocated to the segments are primarily related to Nortel’s corporate compliance and other non-operational activities and are included in “Other”.
On September 30, 2005, Nortel announced a new organizational structure that it expects will strengthen its enterprise focus, drive product efficiencies, and deliver global services. The new alignment includes two product groups: (i) Enterprise Solutions and Packet Networks which combines core assets such as ethernet and enterprise telephony, optical, and wireline data into a unified product group; and (ii) Mobility and Converged Core Networks which consolidates its wireless businesses and combines them with critical core network technologies. By creating two product groups, Nortel expects to simplify its business model and create new cost efficiencies by leveraging common hardware and software platforms. In addition, in an effort to heighten Nortel’s responsiveness to customers, Nortel is forming four region-based teams: North America; Eurasia; Greater China; and Caribbean and Latin America and Emerging Markets. Nortel expects its financial reporting reflecting this new organizational alignment will commence in fiscal 2006 and is not expected to result in a change to its reportable segments for the fiscal year 2005. Nortel is currently assessing the impact of these changes on its reportable segments for 2006.
Nortel’s vice-chairman and chief executive officer (the “CEO”) has been identified as the CODM in assessing the performance of the segments and the allocation of resources to the segments. The CEO relies on the information derived directly from Nortel’s management reporting system. The primary financial measure used by the CEO in assessing performance and allocating resources to the segments is management earnings (loss) before income taxes (“Management EBT”), a measure that includes the cost of revenues, selling, general and administrative (“SG&A”) expense, research and development (“R&D”) expense, interest expense, other income (expense) — net, minority interests — net of tax and equity in net earnings (loss) of associated companies — net of tax. Interest attributable to long-term debt is not allocated to a reportable segment and is included in “Other”. 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. Prior period segment results have been adjusted to conform to the current period presentation to reflect the movement of certain products and functional allocations.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Segments
The following tables set forth information by segment for each of the three and nine months ended:
                                 
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
Revenues
                               
Carrier Packet Networks
  $ 754     $ 533     $ 2,156     $ 1,940  
CDMA Networks
    539       511       1,743       1,647  
GSM and UMTS Networks
    674       543       2,182       1,910  
Enterprise Networks
    685       591       1,962       1,703  
                         
Total reportable segments
    2,652       2,178       8,043       7,200  
Other(a)
    3       1       3       13  
                         
Total revenues
  $ 2,655     $ 2,179     $ 8,046     $ 7,213  
                         
Management EBT
                               
Carrier Packet Networks
  $ 48     $ (131 )   $ 51     $ (229 )
CDMA Networks
    137       140       499       519  
GSM and UMTS Networks
    (67 )     (179 )     12       (185 )
Enterprise Networks
    38       39       164       78  
                         
Total reportable segments
    156       (131 )     726       183  
Other(a)
    (175 )     (107 )     (589 )     (419 )
                         
Total Management EBT
    (19 )     (238 )     137       (236 )
                         
Amortization of intangibles
    (6 )     (2 )     (10 )     (7 )
Special charges
    (37 )     (93 )     (148 )     (99 )
Gain (loss) on sale of businesses and assets
    (4 )     39       (41 )     114  
Income tax benefit (expense)
    (40 )     30       (49 )     32  
                         
Net earnings (loss) from continuing operations
  $ (106 )   $ (264 )   $ (111 )   $ (196 )
                         
 
(a)  “Other” represents miscellaneous business activities and corporate functions and includes interest attributable to long-term debt.
5. Special charges
During 2001, Nortel implemented a work plan to streamline operations and activities around core markets and leadership strategies in light of the significant downturn in both the telecommunications industry and the economic environment, and capital market trends impacting operations and expected future growth rates (the “2001 Restructuring Plan”).
In addition, activities were initiated in 2003 to exit certain leased facilities and leases for assets no longer used across all segments. The liabilities associated with these activities were measured at fair value and recognized under SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”).
In 2005, Nortel’s focus is on managing each of its businesses based on financial performance, the market and customer priorities. In the third quarter of 2004, Nortel announced a strategic plan that includes a work plan involving focused workforce reductions, including a voluntary retirement program, of approximately 3,250 employees, real estate optimization and other cost containment actions such as reductions in information services costs, outsourced services and other discretionary spending across all segments, but primarily in Carrier Packet Networks (the “2004 Restructuring Plan”). Nortel estimates charges to earnings associated with the 2004 Restructuring Plan in the aggregate of approximately $390 comprised of approximately $220 with respect to the workforce reductions and approximately $170 with respect to the real estate actions. No additional special charges are expected to be recorded with respect to the other cost containment actions. Approximately $160 of the aggregate charges were incurred in 2004 and $148 for the nine months ended September 20, 2005, with the remainder expected to be substantially incurred by the end of 2006.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
During the three and nine months ended September 30, 2005, Nortel continued to implement these restructuring work plans. Changes in the provisions related to special charges recorded from January 1, 2005 to September 30, 2005 were as follows:
                                                   
                    Special Charges
                     
        Contract           Three Months   Nine Months
        Settlement   Plant and       Ended   Ended
    Workforce   and Lease   Equipment       September 30,   September 30,
    Reduction   Costs   Write Downs   Total   2005   2005
                         
2001 Restructuring Plan
                                               
Provision balance as of December 31, 2004(a)
  $ 15     $ 326     $     $ 341                  
Revisions to prior accruals:
                                               
 
For the three months ended March 31, 2005
    (3 )           (1 )     (4 )   $     $ (4 )
 
For the three months ended June 30, 2005
    (2 )     4       (2 )                  
 
For the three months ended September 30, 2005
          3             3       3       3  
Cumulative provision (drawdowns) adjustments in 2005:
                                               
 
Cash drawdowns
    (5 )     (86 )           (91 )                
 
Non-cash drawdowns
                3       3                  
 
Foreign exchange and other adjustments
    (1 )     (9 )           (10 )                
                                     
Provision balance as of September 30, 2005
  $ 4     $ 238     $     $ 242                  
                                     
2004 Restructuring Plan
                                               
Provision balance as of December 31, 2004(a)
  $ 122     $     $     $ 122                  
Other special charges:
                                               
 
For the three months ended March 31, 2005
    18       8       1       27             27  
 
For the three months ended June 30, 2005
    32       46       4       82             82  
 
For the three months ended September 30, 2005
    18       13       1       32       32       32  
Revisions to prior accruals:
                                               
 
For the three months ended March 31, 2005
    (2 )                 (2 )           (2 )
 
For the three months ended June 30, 2005
    7             1       8             8  
 
For the three months ended September 30, 2005
    (3 )     5             2       2       2  
Cumulative provision (drawdowns) adjustments in 2005:
                                               
 
Cash drawdowns
    (148 )     (7 )           (155 )                
 
Non-cash drawdowns
                (6 )     (6 )                
 
Foreign exchange and other adjustments
    (1 )     (2 )     (1 )     (4 )                
                                     
Provision balance as of September 30, 2005
  $ 43     $ 63     $     $ 106                  
                                     
Total provision balance as of September 30, 2005(a)
  $ 47     $ 301     $     $ 348                  
                                     
Total special charges
                                  $ 37     $ 148  
                                     
 
(a)  As of September 30, 2005 and December 31, 2004, the short-term provision balance was $131 and $254, respectively, and the long-term provision balance was $217 and $209, respectively.
Regular full-time (“RFT”) employee notifications resulting in special charges were as follows:
                           
    Employees (Approximate)
     
    Direct(a)   Indirect(b)   Total
             
RFT employee notifications for the three months ended:
                       
 
March 31, 2005
    20       220       240  
 
June 30, 2005
    15       445       460  
 
September 30, 2005
    26       228       254  
 
(a)   Direct employees included employees performing manufacturing, assembly, testing and inspection activities associated with the production of Nortel’s products.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
(b)  Indirect employees included employees performing manufacturing, management, sales, marketing, research and development and administrative activities.
2001 Restructuring Plan
Three and nine months ended September 30, 2005
During the three and nine months ended September 30, 2005, Nortel recorded revisions of $3 and $(1), respectively, related to prior accruals.
The workforce reduction provision balance was drawn down by cash payments of $1 and $5 during the three and nine months ended September 30, 2005, respectively. The remaining provision is expected to be substantially drawn down by the end of 2005.
No new contract settlement and lease costs were incurred during the period. During the three and nine months ended September 30, 2005, the provision balance for contract settlement and lease costs was drawn down by cash payments of $21 and $86, respectively. The remaining provision, net of approximately $195 in estimated sublease income, is expected to be substantially drawn down by the end of 2013.
Three and nine months ended September 30, 2004
During the three and nine months ended September 30, 2004, Nortel recorded special charges of $21 and $27, respectively, which included revisions of $21 and $21, respectively, related to prior accruals.
Workforce reduction charges of $6 were related to severance and benefit costs associated with approximately 80 employees notified of termination during the three months ended March 31, 2004, which related entirely to Carrier Packet Networks, and were partially offset by revision to prior accruals in the three months ended September 30, 2004 of $4. During the nine months ended September 30, 2004, the workforce reduction provision balance was drawn down by cash payments of $45.
No new contract settlement and lease costs were incurred during the period. Net revisions to prior accruals for contract settlement and lease costs of $24 were identified for the nine months ended September 30, 2004. During the nine months ended September 30, 2004, the provision balance for contract settlement and lease costs was drawn down by cash payments of $133.
In 2003, Nortel initiated activities to exit certain leased facilities and leases for assets no longer used, across all segments. The costs associated with these planned activities have been valued using the estimated fair value method prescribed under SFAS 146. The table below summarizes the total costs estimated to be incurred as a result of these activities, which have met the criteria described in SFAS 146, the balance of these accrued expenses as of September 30, 2005 and the movement in the accrual for the nine months ended September 30, 2005. These costs are included in the provision balance above as of September 30, 2005.
                                         
        Costs During   Payments Made   Adjustments    
    Accrued   the Nine   During the Nine   During the Nine   Accrued
    Balance as of   Months Ended   Months Ended   Months Ended   Balance as of
    December 31,   September 30,   September 30,   September 30,   September 30,
    2004   2005   2005   2005   2005
                     
Lease costs(a)
  $ 31     $     $ (2 )   $ 2     $ 31  
 
(a)  Total estimated costs, net of estimated sublease income, associated with these accruals are $69, of which $19 was drawn down by cash payments of $21 and offset by non-cash adjustments of $2 prior to January 1, 2005.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Special charges — by segment
The following table outlines special charges incurred by segment for the three and nine months ended September 30:
                                   
        Contract        
        Settlement   Plant and    
    Workforce   and Lease   Equipment    
    Reduction   Costs   Write Downs   Total
                 
2001 Restructuring Plan
                               
Carrier Packet Networks:
                               
 
For the three months ended March 31, 2005
  $ (1 )   $     $ (1 )   $ (2 )
 
For the three months ended June 30, 2005
    (1 )     2       (1 )      
 
For the three months ended September 30, 2005
          1             1  
GSM and UMTS Networks:
                               
 
For the three months ended March 31, 2005
    (1 )                 (1 )
 
For the three months ended June 30, 2005
    (1 )     1       (1 )     (1 )
 
For the three months ended September 30, 2005
          1             1  
Enterprise Networks:
                               
 
For the three months ended March 31, 2005
    (1 )                 (1 )
 
For the three months ended June 30, 2005
          1             1  
 
For the three months ended September 30, 2005
          1             1  
                         
Total special charges for the nine months ended September 30, 2005
  $ (5 )   $ 7     $ (3 )   $ (1 )
                         
Carrier Packet Networks:
                               
 
For the three months ended March 31, 2004
  $ 6     $ 1     $     $ 7  
 
For the three months ended June 30, 2004
          (1 )           (1 )
 
For the three months ended September 30, 2004
    (4 )     9       1       6  
GSM and UMTS Networks:
                               
 
For the three months ended September 30, 2004
          8             8  
Enterprise Networks:
                               
 
For the three months ended September 30, 2004
          7             7  
                         
Total special charges for the nine months ended September 30, 2004
  $ 2     $ 24     $ 1     $ 27  
                         
Management EBT does not include special charges. A significant portion of Nortel’s provisions for workforce reductions and contract settlement and lease costs is associated with shared services. These costs have been allocated to the segments in the table above based generally on headcount.
2004 Restructuring Plan
Three and nine months ended September 30, 2005
During the three and nine months ended September 30, 2005, Nortel recorded special charges of $34 and $149, which included revisions of $2 and $8, respectively, related to prior accruals.
Workforce reduction charges of $15 and $70, including revisions to prior accruals of $(3) and $2, were related to severance and benefit costs associated with approximately 254 and 954 employees notified of termination during the three and nine months ended September 30, 2005, respectively. The workforce reduction provision balance was drawn down by cash payments of $29 and $148 during the three and nine months ended September 30, 2005, respectively. The workforce reduction was primarily in the U.S., Canada and Europe, Middle East and Africa (“EMEA”) and extended across all segments. The remaining provision is expected to be substantially drawn down by the end of the first half of 2006.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Contract settlement and lease costs of $18 and $72, including revisions to prior accruals of $5 and $5, for the three and nine months ended September 30, 2005, respectively, consisted of negotiated settlements to cancel or renegotiate contracts and net lease charges related to leased facilities (comprised of office space) and leased furniture that were identified as no longer required primarily in the U.S. and EMEA and in the Carrier Packet Networks and Enterprise Networks segments. These lease costs, net of anticipated sublease income, included costs relating to non-cancelable lease terms from the date leased facilities ceased to be used and termination penalties. During the three and nine months ended September 30, 2005, the provision balance for contract settlement and lease costs was drawn down by cash payments of $4 and $7, respectively. The remaining provision, net of approximately $28 in estimated sublease income, is expected to be substantially drawn down by the end of 2018.
Three and nine months ended September 30, 2004
During the three and nine months ended September 30, 2004, Nortel recorded special charges of $72 and $72, respectively.
Workforce reduction charges of $72 were related to severance and benefit costs associated with approximately 1,300 employees identified for termination under ongoing benefit arrangements. The workforce reduction was primarily in the U.S., Canada, and EMEA and extended across all segments but primarily in Carrier Packet Networks.
Special charges — by segment
The following table outlines special charges incurred by segment for the three and nine months ended September 30, 2005:
                                   
        Contract        
        Settlement   Plant and    
    Workforce   and Lease   Equipment    
    Reduction   Costs   Write Downs   Total
                 
2004 Restructuring Plan
                               
Carrier Packet Networks:
                               
 
For the three months ended March 31, 2005
  $ 9     $ 1     $ 1     $ 11  
 
For the three months ended June 30, 2005
    28       36       4       68  
 
For the three months ended September 30, 2005
    5       9       1       15  
CDMA Networks:
                               
 
For the three months ended March 31, 2005
    1                   1  
 
For the three months ended June 30, 2005
    2       1             3  
 
For the three months ended September 30, 2005
    2       2             4  
GSM and UMTS Networks:
                               
 
For the three months ended March 31, 2005
    3                   3  
 
For the three months ended June 30, 2005
    6       6       1       13  
 
For the three months ended September 30, 2005
    5       4             9  
Enterprise Networks:
                               
 
For the three months ended March 31, 2005
    3       7             10  
 
For the three months ended June 30, 2005
    3       3             6  
 
For the three months ended September 30, 2005
    3       3             6  
                         
Special charges for the nine months ended September 30, 2005
  $ 70     $ 72     $ 7     $ 149  
                         
Carrier Packet Networks:
                               
 
For the three months ended September 30, 2004
  $ 49     $     $     $ 49  
CDMA Networks:
                               
 
For the three months ended September 30, 2004
    6                   6  
GSM and UMTS Networks:
                               
 
For the three months ended September 30, 2004
    4                   4  
Enterprise Networks:
                               
 
For the three months ended September 30, 2004
    13                   13  
                         
Special charges for the nine months ended September 30, 2004
  $ 72     $     $     $ 72  
                         

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
6. Income taxes
During the nine months ended September 30, 2005, Nortel recorded a tax expense of $49 on loss from continuing operations before income taxes, minority interests and equity in net earnings (loss) of associated companies of $19. The tax expense of $49 is primarily related to the drawdown of Nortel’s deferred tax assets and current tax provisions in certain taxable jurisdictions, various corporate minimum and other taxes and a net charge of $20, including interest, related to an amendment to a loss carryback as a consequence of refiling Nortel’s corporate income tax returns due to the restatement of its financial statements. These charges were partially offset by the recognition of R&D related incentives and the benefit of favourable settlement of certain tax audits. In addition, Nortel recorded additional valuation allowances against the tax benefit of losses realized in some jurisdictions.
During the nine months ended September 30, 2004, Nortel recorded a tax benefit of $32 on a loss from continuing operations before income taxes, minority interests and equity in net loss of associated companies of $197. The tax benefit of $32 resulted from the favourable settlement of certain tax audits and the recognition of R&D related incentives partially offset by the drawdown of Nortel’s deferred tax assets and current income tax provisions in certain taxable jurisdictions and various corporate minimum related income taxes.
As of September 30, 2005, Nortel’s deferred tax assets, excluding discontinued operations, were $3,750. The most significant components of the gross deferred tax assets are the tax benefit of loss carryforwards and investment tax credits and temporary differences related to certain liabilities (primarily provisions, pensions and other post-retirement obligations). The majority of the carryforward amounts do not begin to expire until 2017.
The deferred tax assets are net of a valuation allowance of $3,521. The valuation allowance was recorded in accordance with SFAS No. 109, “Accounting for Income Taxes”, which requires that a valuation allowance be established when it is more likely than not that some portion or all of a company’s deferred tax assets will not be realized. The valuation allowance was determined based on an assessment of the positive and negative evidence of the recoverability of deferred tax assets, which included the carryforward periods attributable to the significant tax assets, Nortel’s history of generating taxable income in its material jurisdictions, and Nortel’s cumulative loss position.
Primarily as a result of the losses realized in 2001 and 2002, Nortel determined that it is more likely than not that a portion of its deferred tax assets will not be realized. Accordingly, a valuation allowance has been recorded against a portion of the assets. However, due to the fact that the majority of the carryforward amounts do not expire in the near future, Nortel’s extended history of profitability in its material tax jurisdictions, exclusive of the 2001 and 2002 losses, and Nortel’s future projections of profitability, Nortel determined that it is more likely than not that the remaining portion of its deferred tax assets recorded as of September 30, 2005 will be realized.
Nortel is subject to ongoing examinations by certain tax authorities of the jurisdictions in which it operates. Nortel regularly assesses the status of these examinations and the potential for adverse outcomes to determine the adequacy of the provision for income and other taxes. Nortel believes that it has adequately provided for tax adjustments that are probable as a result of any ongoing or future examinations.
Specifically, the tax authorities in Brazil have recently completed an examination of a prior taxation year and have issued an assessment in the amount of $56. Nortel is currently in the process of appealing this assessment and believes that it has adequately provided for tax adjustments that are probable as a result of the outcome of the ongoing appeals process.
In addition, tax authorities in France have recently begun an examination of a prior taxation year and have issued a preliminary notice of proposed assessment for a material amount. No amount has been provided for this assessment since Nortel believes that this proposed assessment is without merit and any potential tax adjustments that could result from this ongoing examination cannot be quantified at this time.
Nortel had previously entered into Advance Pricing Arrangements (“APAs”) with the taxation authorities of the U.S. and Canada in connection with its intercompany transfer pricing and cost sharing arrangements between Canada and the U.S. These arrangements expired in 1999 and 2000. In 2002, Nortel filed APA requests with the taxation authorities of the U.S., Canada and the United Kingdom (“U.K.”) that are expected to apply to the taxation years beginning in 2000. The APA requests are currently under consideration but the tax authorities have not begun to negotiate the terms of the arrangement. Nortel has applied the transfer pricing methodology proposed in the APA requests since 2001. As part of the APA applications, Nortel has requested that the methodology adopted in 2001 be

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
applied retroactively to the 2000 taxation year. If the retroactive application is accepted by the taxation authorities, it would result in an increase in taxable income in certain jurisdictions offset by an equal decrease in taxable income in the other jurisdictions. Nortel has provided approximately $140 for any taxes and interest in various tax jurisdictions that would be due as a result of retroactive application of the APAs.
Although the outcome of the APA applications is uncertain, Nortel does not believe it is probable that the ultimate resolution of these negotiations will have a material adverse effect on its consolidated financial position, results of operations or cash flows. Despite Nortel’s current belief, if this matter is resolved unfavorably, it could have a material adverse effect on Nortel’s consolidated financial position, results of operations or cash flows. Additional possible losses, as they relate to the APA negotiations, cannot be determined at this time.
7. Employee benefit plans
Nortel maintains various retirement programs covering substantially all of its employees, consisting of defined benefit, defined contribution and investment plans.
Nortel has four kinds of capital accumulation and retirement programs: balanced capital accumulation and retirement programs (the “Balanced Program”) and investor capital accumulation and retirement programs (the “Investor Program”) available to substantially all of its North American employees; flexible benefits plan, which includes a group personal pension plan (the “Flexible Benefits Plan”), available to substantially all of its employees in the U.K. and traditional capital accumulation and retirement programs that include defined benefit pension plans (the “Traditional Program”) which are closed to new entrants in the U.K. and portions of which are closed to new entrants in the U.S. and Canada. Although these four kinds of programs represent Nortel’s major retirement programs and may be available to employees in combination and/or as options within a program, Nortel also has smaller pension plan arrangements in other countries.
Nortel also provides other benefits, including post-retirement benefits and post-employment benefits. Employees in the Traditional Program are eligible for their existing company sponsored post-retirement benefits or a modified version of these benefits, depending on age or years of service. Employees in the Balanced Program are eligible for post-retirement benefits at reduced company contribution levels, while employees in the Investor Program have access to post-retirement benefits by purchasing a Nortel-sponsored retiree health care plan at their own cost.
The following details the net pension expense, all related to continuing operations, for the defined benefit plans for the three and nine months ended:
                                   
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
Pension expense:
                               
 
Service cost
  $ 32     $ 30     $ 97     $ 90  
 
Interest cost
    112       104       342       311  
 
Expected return on plan assets
    (105 )     (102 )     (321 )     (305 )
 
Amortization of prior service cost
    1       1       3       3  
 
Amortization of net losses (gains)
    24       19       72       57  
 
Curtailment, contractual and special termination losses (gains)
    1             25        
                         
Net pension expense
  $ 65     $ 52     $ 218     $ 156  
                         
For the nine months ended September 30, 2005, curtailment, contractual and special termination losses are the result of the divestiture to Flextronics (see note 8) and the 2004 Restructuring Plan (see note 5).

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
The following details the net cost components, all related to continuing operations, of post-retirement benefits other than pensions for the three and nine months ended:
                                   
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
Post-retirement benefit cost:
                               
 
Service cost
  $ 2     $ 2     $ 6     $ 7  
 
Interest cost
    10       10       31       31  
 
Expected return on plan assets
                (2 )     (1 )
 
Amortization of prior service cost
    (1 )           (3 )     (2 )
 
Amortization of net losses (gains)
                      2  
                         
Net post-retirement benefit cost
  $ 11     $ 12     $ 32     $ 37  
                         
During the nine months ended September 30, 2005, contributions of $137 were made to the defined benefit plans and $18 to the post-retirement benefit plans. Nortel expects to contribute an additional $52 in 2005 to the defined benefit pension plans for a total contribution of $189, and an additional $4 in 2005 to the post-retirement benefit plans for a total contribution of $22.
8. Acquisitions, divestitures and change in investments
Acquisitions
PEC Solutions, Inc.
On June 3, 2005, Nortel Networks Inc. (“NNI”), an indirect subsidiary of Nortel, indirectly acquired approximately 26,693,725 shares of PEC Solutions, Inc. (“PEC”) representing approximately 95.6 percent of the outstanding shares of common stock of PEC, through a cash tender offer at a price of $15.50 per share. The aggregate cash consideration payable in connection with the acquisition of PEC (including $33 paid on June 9, 2005, with respect to stock options) was approximately $449, including estimated costs of acquisition of $8. Nortel acquired more than 90 percent of the outstanding shares of PEC pursuant to the tender offer. Any shares that were not purchased in the tender offer ceased to be outstanding and were converted into the right to receive cash in the amount of $15.50 per share.
PEC provides professional technology services that enable government entities to use the Internet to enhance productivity and improve services to the public. PEC’s primary customers are executive agencies and departments of the U.S. Federal Government, the Federal Judiciary, and prime contractors to the U.S. government. Nortel expects the PEC acquisition to allow Nortel to pursue opportunities in areas that complement Nortel’s existing products and to compete in the government market. In order to comply with the U.S. National Industrial Security Program and to mitigate foreign ownership, control or influence, voting control of PEC must be vested in citizens of the U.S. Accordingly, proxy holders for Nortel’s shares of PEC have been appointed and approved by the U.S. Defense Security Service. In accordance with a proxy agreement executed in July 2005, the proxy holders exercise all prerogatives of ownership with complete freedom to act independently and have assumed full responsibility for the voting stock. Notwithstanding, for accounting purposes, Nortel has determined that PEC is a VIE, and Nortel is the primary beneficiary (see note 12).
This acquisition was accounted for using the purchase method. Nortel has recorded approximately $269 of non-amortizable intangible assets associated with the acquisition of PEC, which assets consist solely of goodwill. The goodwill of PEC is not deductible for tax purposes, and has been allocated to Nortel’s Enterprise Networks segment.
The allocation of the purchase price presented below is based on management’s best current estimate of the relative values of the assets acquired and liabilities assumed in the PEC acquisition. However, because a full valuation of those assets and liabilities has not yet been finalized, the final allocation of the purchase price may differ from the allocation presented below, and the difference may be material.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
The following table sets out the preliminary purchase price allocation information for the PEC acquisition.
           
Purchase price
  $ 449  
       
Assets acquired:
       
 
Cash and cash equivalents
  $ 26  
 
Accounts receivable — net
    65  
 
Other current assets
    34  
 
Investments
    8  
 
Plant and equipment
    32  
 
Other intangible assets
    84  
 
Goodwill
    269  
 
Other assets
    5  
       
      523  
       
Less liabilities assumed:
       
 
Trade and other accounts payable
    6  
 
Payroll and benefit-related liabilities
    15  
 
Other accrued liabilities
    17  
 
Long-term debt
    33  
 
Other liabilities
    3  
       
      74  
       
Fair value of net assets acquired
  $ 449  
       
As a result of the acquisition of PEC, a net deferred tax liability of $23 was recognized, due to differences between the estimated fair value of assets acquired and liabilities assumed, and PEC’s tax basis in those assets and liabilities. This deferred tax liability is fully offset; however, by an adjustment to Nortel’s deferred tax valuation allowance because Nortel will be able to offset the tax liability by drawing down previously unrecognized loss carryforwards.
The preliminary estimates of the fair values and amortization periods of intangible assets are as follows:
                 
        Amortization
    Fair Value   Period (Years)
         
Trade name
  $ 7       4  
Software licenses
    1       5  
Customer contracts and relationships
    76       10  
             
Total intangible assets
  $ 84          
             
The consolidated financial statements of Nortel include PEC’s operating results from the date of the acquisition. The following unaudited pro forma information presents a summary of consolidated results of operations of Nortel and PEC as if the acquisition had occurred on January 1, 2004, with pro forma adjustments to give effect to amortization of intangible assets and certain other adjustments:
                         
        Nine Months
    Three Months   Ended
    Ended   September 30,
    September 30,    
    2004   2005   2004
             
Revenues
  $ 2,234     $ 8,155     $ 7,357  
Net earnings (loss)
  $ (257 )   $ (118 )   $ (176 )
                   
Basic earnings (loss) per common share
  $ (0.06 )   $ (0.03 )   $ (0.04 )
Diluted earnings (loss) per common share
  $ (0.06 )   $ (0.03 )   $ (0.04 )
                   

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Divestitures
Manufacturing operations
On June 29, 2004, Nortel announced an agreement with Flextronics, regarding the divestiture of substantially all of Nortel’s remaining manufacturing operations, including product integration, testing and repair operations carried out in Calgary and Montreal, Canada and Campinas, Brazil, as well as certain activities related to these locations, including the management of the supply chain, related suppliers and third-party logistics. In Europe, Flextronics made an offer to purchase similar Nortel operations at Monkstown, Northern Ireland and Chateaudun, France, subject to the completion of the required information and consultation process. This information and consultation process was completed for Chateaudun in the second quarter of 2005.
Under the terms of the agreement and offer, Flextronics will also acquire Nortel’s global repair services, as well as certain design assets in Ottawa, Canada and Monkstown related to hardware and embedded software design, and related product verification for certain established optical products.
Nortel and Flextronics have entered into a four year supply agreement for manufacturing services (whereby after completion of the transaction Flextronics will manage approximately $2,500 of Nortel’s annual cost of revenues) and a three year supply agreement for design services. The portion of the transaction related to the optical design activities in Ottawa and Monkstown was completed on November 1, 2004. On February 8, 2005, Nortel announced the completion of the portion of the transaction related to the manufacturing activities in Montreal. On August 22, 2005, Nortel completed the transfer of the manufacturing operations and related activities in Chateaudun. Nortel previously reported that the portion of the transaction related to the manufacturing activities in Calgary was expected to close in the second quarter of 2005 and that the balance of the transaction was expected to close on separate dates occurring during the first half of 2005. On September 19, 2005, Nortel announced that it expects to transfer the manufacturing operations and related activities in Calgary, and Campinas to Flextronics by the end of the first quarter of 2006. Nortel also announced that it will establish a regional supply chain center in Monkstown to lead its supply chain operations in the EMEA region. Nortel and Flextronics have agreed that Nortel will retain its Monkstown manufacturing operations. The portions of the transaction which remain to be completed are subject to customary conditions and regulatory approvals.
The successful completion of the agreement with Flextronics will result in the transfer of approximately 2,140 employees from Nortel to Flextronics. As of the end of the third quarter of 2005, Nortel has transferred approximately 1,450 of its employees to Flextronics. Nortel expects that the decision to retain its Monkstown manufacturing operations will result in a reduction of estimated cash proceeds from assets divested of approximately $100 and a revised total range of proceeds of approximately $575 to $625, of which approximately $200 to $250 is expected to be received in 2006. Such payments will be subject to a number of adjustments, including potential post-closing date asset valuations and potential post-closing indemnity payments. Nortel is expecting proceeds on the sale of this business to exceed the net book value of the assets transferred, including goodwill. The resulting net gain on the sale of this business will be recognized once substantially all of the risks and other incidents of ownership have been transferred.
As of September 30, 2005, Nortel has received net cash of approximately $261 and short-term notes and other receivables of $79, transferred approximately $247 of inventory and equipment to Flextronics relating to the closing of the optical design activities in Ottawa and Monkstown and the manufacturing activities in Montreal and Chateaudun and recorded deferred income of approximately $20. As Flextronics has the ability to exercise rights to sell back to Nortel certain inventory and equipment after the expiration of a specified period (up to fifteen months) following each respective closing date, Nortel has retained these assets on its balance sheet to the extent they have not been consumed as part of ongoing operations as at September 30, 2005. Nortel does not expect that such rights will be exercised with respect to any material amount of inventory and/or equipment.
During the three and nine months ended September 30, 2005, Nortel recorded charges through (gain) loss on sale of businesses and assets of $2 and $41, respectively, related to the ongoing divestiture of its remaining manufacturing operations to Flextronics. The charges relate to legal and professional fees, pension adjustments and real estate impairments. Nortel has determined that $16 of the charges recorded during the nine months ended September 30, 2005, which accumulated as deferred costs starting in 2004 and through the first quarter of 2005, should have been recognized as incurred in those prior periods.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Change in investments
On February 3, 2004, Nortel sold approximately 7 million common shares of Entrust Inc. (“Entrust”) for cash consideration of $33, and recorded a gain of $18 in other income (expense) — net. As a result of this transaction, Nortel no longer holds any equity interest in Entrust.
During March 2004, Nortel sold 1.8 million shares of Arris Group, Inc. (“Arris Group”) for cash consideration of $17, which resulted in a gain of $13, which was recorded in other income (expense) — net. Following this transaction, Nortel owned 3.2 million Arris Group common shares or 4.2 percent of Arris Group outstanding common shares. During the second quarter of 2005, Nortel sold 3.2 million Arris Group common shares for net cash proceeds of $27 and recorded a gain of $21 in other income (expense) — net. As a result, Nortel no longer holds any equity interest in Arris Group.
Other
On May 7, 2004, Nortel received $80 in proceeds from the sale of certain assets in connection with a customer contract settlement in the Caribbean and Latin America (“CALA”) region. This resulted in a gain of $78, which was included in (gain) loss on sale of businesses and assets for the nine months ended September 30, 2004.
On August 2, 2004, Nortel completed the contribution of certain fixed assets, intangible assets including customer contracts, software and other licenses, and liabilities of its directory and operator services (“DOS”) business to VoltDelta Resources LLC (“VoltDelta”), a wholly owned subsidiary of Volt Information Sciences, Inc. (“VIS”), in return for a 24 percent interest in VoltDelta which was valued at $55. After a period of two years, Nortel and VIS each have an option to cause Nortel to sell its VoltDelta shares to VIS for proceeds ranging from $25 to $70. As a result of this transaction, approximately 160 Nortel DOS employees in North America and Mexico joined VoltDelta. Nortel recorded a gain on sale of businesses and assets of approximately $38 for the three months ended September 30, 2004.
9. Long-term debt and support facilities
As a result of the delay in the filing of Nortel’s and Nortel Networks Limited’s (“NNL”) 2003 Annual Reports on Form 10-K for the year ended December 31, 2003 (the “2003 Annual Reports”), 2004 Quarterly Reports on Form 10-Q for the first, second and third quarters of 2004 (the “2004 Quarterly Reports”), 2004 Annual Reports on Form 10-K for the year ended December 31, 2004 (the “2004 Annual Reports”) and 2005 Quarterly Reports on Form 10-Q for the first quarter of 2005 (the “2005 First Quarter Reports”, and together with the 2003 Annual Reports, the 2004 Quarterly Reports and the 2004 Annual Reports, the “Reports”), Nortel and NNL were not in compliance with their obligations to deliver their respective SEC filings to the trustees under Nortel’s and NNL’s public debt indentures. As a result of filing the 2005 First Quarter Reports with the SEC and delivering the 2005 First Quarter Reports to the trustees under Nortel’s and NNL’s public debt indentures, Nortel and NNL are now in compliance with their delivery obligations under the public debt indentures. Approximately $1,800 of notes of NNL (or its subsidiaries) and $1,800 of convertible debt securities of Nortel were outstanding under such indentures as of September 30, 2005.
Approximately $1,275 of NNL’s 6.125% Notes are due in February 2006 and $150 of Nortel’s 7.40% Notes issued by an indirect wholly-owned subsidiary of NNL and guaranteed by NNL are due in June 2006. These Notes have been reclassified from long-term debt to current liabilities. Nortel expects to have sufficient cash to meet these future obligations.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Support facility
On February 14, 2003, Nortel’s principal operating subsidiary, NNL, entered into an agreement with Export Development Canada (“EDC”) regarding arrangements to provide for support, on a secured basis, of certain performance related obligations arising out of normal course business activities for the benefit of Nortel (the “EDC Support Facility”). On December 10, 2004, NNL and EDC amended the terms of the EDC Support Facility by extending the termination date of the EDC Support Facility to December 31, 2006 from December 31, 2005.
On February 14, 2003, NNL’s obligations under the EDC Support Facility became secured on an equal and ratable basis under the security agreements entered into by NNL and various of its subsidiaries that pledged substantially all of the assets of NNL in favor of the banks under the NNL and NNI $750 April 2000 five year credit facilities (the “Five Year Facilities”) and the holders of Nortel’s public debt securities. For additional information relating to the security agreements, see note 20.
The EDC Support Facility provides up to $750 in support. As of September 30, 2005, there was approximately $181 of outstanding support utilized under the EDC Support Facility, approximately $131 of which was outstanding under the revolving small bond sub-facility.
The delayed filing of the Reports with the SEC, the trustees under Nortel’s and NNL’s public debt indentures and EDC gave EDC the right to (i) terminate its commitments under the EDC Support Facility, relating to certain of Nortel’s performance related obligations arising out of normal course business activities, and (ii) exercise certain rights against the collateral pledged under related security agreements or require NNL to cash collateralize all existing support.
Throughout 2004 and into 2005, NNL obtained waivers from EDC with respect to these matters to permit continued access to the EDC Support Facility in accordance with its terms while Nortel and NNL worked to complete their filing obligations. The waivers also applied to certain related breaches under the EDC Support Facility relating to the delayed filings and the restatements and revisions to Nortel’s and NNL’s prior financial results (the “Related Breaches”). In connection with such waivers, EDC reclassified the previously committed $300 revolving small bond sub-facility of the EDC Support Facility as uncommitted support during the applicable waiver period. On May 31, 2005, NNL obtained a permanent waiver from EDC of certain defaults and the Related Breaches by NNL under the EDC Support Facility (the “Permanent Waiver”). As a result of the filing and delivery to the trustees under Nortel’s and NNL’s public debt indentures and EDC of the 2005 First Quarter Reports and obtaining the Permanent Waiver, NNL is now in compliance with its obligations under the EDC Support Facility and the $300 revolving small bond sub-facility was reclassified as committed support.
For additional information related to the recent amendment of the EDC Support Facility see note 18.
10. Guarantees
Nortel 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 to make payments (either in cash, financial instruments, other assets, common shares of Nortel Networks Corporation or through the provision of services) to a third party based on changes in an underlying economic characteristic (such as interest rates or market value) that is related to an asset, a liability or an equity security of the guaranteed party or a third party’s failure to perform under a specified agreement. A description of the major types of Nortel’s outstanding guarantees as of September 30, 2005 is provided below:
          (a) Business sale and business combination agreements
In connection with agreements for the sale of portions of its business, including certain discontinued operations, Nortel has typically retained the liabilities of a business which relate to events occurring prior to its sale, such as tax, environmental, litigation and employment matters. Nortel generally indemnifies the purchaser of a Nortel business in the event that a third party asserts a claim against the purchaser that relates to a liability retained by Nortel. Some of these types of guarantees have indefinite terms while others have specific terms extending to June 2008.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Nortel also entered into guarantees related to the escrow of shares in business combinations in prior periods. These types of agreements generally include indemnities that require Nortel to indemnify counterparties for loss incurred from litigation that may be suffered by counterparties arising under such agreements. These types of indemnities apply over a specified period of time from the date of the business combinations and do not provide for any limit on the maximum potential amount.
Nortel is unable to estimate the maximum potential liability for these types of indemnification guarantees as the business sale agreements generally do not specify a maximum amount and the amounts are dependent upon the outcome of future contingent events, the nature and likelihood of which cannot be determined.
Historically, Nortel has not made any significant indemnification payments under such agreements and no significant liability has been accrued in the consolidated financial statements with respect to the obligations associated with these guarantees.
In conjunction with the sale of a subsidiary to a third party, Nortel guaranteed to the purchaser that specified annual volume levels would be achieved by the business sold over a ten year period ending December 31, 2007. The maximum amount that Nortel may be required to pay under the volume guarantee as of September 30, 2005 is $10. A liability of $8 has been accrued in the consolidated financial statements with respect to the obligation associated with this guarantee as of September 30, 2005.
          (b) Intellectual property indemnification obligations
Nortel has periodically entered into agreements with customers and suppliers that include intellectual property indemnification obligations that are customary in the industry. These types of guarantees typically have indefinite terms and generally require Nortel to compensate the other party for certain damages and costs incurred as a result of third party intellectual property claims arising from these transactions.
The nature of the intellectual property indemnification obligations generally prevents Nortel from making a reasonable estimate of the maximum potential amount it could be required to pay to its customers and suppliers. Historically, Nortel has not made any significant indemnification payments under such agreements. A liability of $6 has been accrued in the consolidated financial statements with respect to the obligations associated with these guarantees as of September 30, 2005.
          (c) Lease agreements
Nortel has entered into agreements with its lessors that guarantee the lease payments of certain assignees of its facilities to lessors. Generally, these lease agreements relate to facilities Nortel vacated prior to the end of the term of its lease. These lease agreements require Nortel to make lease payments throughout the lease term if the assignee fails to make scheduled payments. Most of these lease agreements also require Nortel to pay for facility restoration costs at the end of the lease term if the assignee fails to do so. These lease agreements have expiration dates through June 2015. The maximum amount that Nortel may be required to pay under these types of agreements is $46 as of September 30, 2005. Nortel generally has the ability to attempt to recover such lease payments from the defaulting party through rights of subrogation.
Historically, Nortel has not made any significant payments under these types of guarantees and no significant liability has been accrued in the consolidated financial statements with respect to the obligations associated with these guarantees.
          (d) Third party debt agreements
From time to time, Nortel guarantees the debt of certain customers. These third party debt agreements require Nortel to make debt payments throughout the term of the related debt instrument if the customer fails to make scheduled debt payments. Under most such arrangements, the Nortel guarantee is secured, usually by the assets being purchased or financed. As of September 30, 2005, Nortel had no third party debt agreements that would require it to make any debt payments for its customers.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
          (e) Indemnification of banks and agents under EDC Support Facility and security agreements
Nortel has agreed to indemnify EDC under the EDC Support Facility against any legal action brought against EDC that relates to the provision of support under the EDC Support Facility. Nortel has also agreed to indemnify the collateral agent under the security agreements against any legal action brought against the collateral agent in connection with the collateral pledged under the security agreements. These indemnifications generally apply to issues that arise during the term of the EDC Support Facility, or for as long as the security agreements remain in effect (see note 9). For additional information related to the recent amendment of the EDC Support Facility see note 18.
Nortel is unable to estimate the maximum potential liability for these types of indemnification guarantees as the agreements typically do not specify a maximum amount and the amounts are dependent upon the outcome of future contingent events, the nature and likelihood of which cannot be determined at this time.
Historically, Nortel has not made any significant indemnification payments under such agreements and no significant liability has been accrued in the consolidated financial statements with respect to the obligations associated with these indemnification guarantees.
Nortel has agreed to indemnify certain of its counterparties in certain receivables securitization transactions. The indemnifications provided to counterparties in these types of transactions may require Nortel to compensate counterparties for costs incurred as a result of changes in laws and regulations (including tax legislation) or in the interpretations of such laws and regulations, or as a result of regulatory penalties that may be suffered by the counterparty as a consequence of the transaction. Certain receivables securitization transactions include indemnifications requiring the repurchase of the receivables if the particular transaction becomes invalid. As of September 30, 2005, Nortel had approximately $281 of securitized receivables which were subject to repurchase under this provision, in which case Nortel would assume all rights to collect such receivables. The indemnification provisions generally expire upon expiration of the securitization agreements, which extend through 2006, or collection of the receivable amounts by the counterparty.
Nortel is generally unable to estimate the maximum potential liability for these types of indemnification guarantees as certain agreements do not specify a maximum amount and the amounts are dependent upon the outcome of future contingent events, the nature and likelihood of which cannot be determined at this time.
Historically, Nortel has not made any significant indemnification payments or receivable repurchases under such agreements and no significant liability has been accrued in the consolidated financial statements with respect to the obligations associated with these guarantees.
          (f) Other indemnification agreements
Nortel has also entered into other agreements that provide indemnifications to counterparties in certain transactions including investment banking agreements, guarantees related to the administration of capital trust accounts, guarantees related to the administration of employee benefit plans, indentures for its outstanding public debt and asset sale agreements (other than the business sale agreements noted above). These indemnification agreements generally require Nortel to indemnify the counterparties for costs incurred as a result of changes in laws and regulations (including tax legislation) or in the interpretations of such laws and regulations and/or as a result of losses from litigation that may be suffered by the counterparties arising from the transactions. These types of indemnification agreements normally extend over an unspecified period of time from the date of the transaction and do not typically provide for any limit on the maximum potential payment amount. In addition, Nortel has entered into indemnification agreements with certain of its directors and officers for the costs reasonably incurred in any proceeding in which they become involved by reason of their position as directors or officers to the extent permitted under applicable law.
The nature of such agreements prevents Nortel from making a reasonable estimate of the maximum potential amount it could be required to pay to its counterparties and directors. The difficulties in assessing the amount of liability result primarily from the unpredictability of future changes in laws, the inability to determine how laws apply to counterparties and the lack of limitations on the potential liability.
Historically, Nortel has not made any significant indemnification payments under such agreements and no significant liability has been accrued in the consolidated financial statements with respect to the obligations associated with these guarantees.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Product warranties
The following summarizes the accrual for product warranties that was recorded as part of other accrued liabilities in the consolidated balance sheet as of September 30, 2005:
           
Balance as of December 31, 2004
  $ 275  
 
Payments
    (183 )
 
Warranties issued
    146  
 
Revisions
    (5 )
       
Balance as of September 30, 2005
  $ 233  
       
11. Commitments
Bid, performance related and other bonds
Nortel has entered into bid, performance related and other bonds associated with various contracts. Bid bonds generally have a term of less than twelve months, depending on the length of the bid period for the applicable contract. Other bonds primarily relate to warranty, rental, real estate and customs contracts. Performance related and other bonds generally have a term of twelve months and are typically renewed, as required, over the term of the applicable contract. The various contracts to which these bonds apply generally have terms ranging from two to five years. Any potential payments which might become due under these bonds would be related to Nortel’s non-performance under the applicable contract. Historically, Nortel has not had to make material payments under these types of bonds and does not anticipate that any material payments will be required in the future. The following table sets forth the maximum potential amount of future payments under bid, performance related and other bonds, net of the corresponding restricted cash and cash equivalents, as of the following dates:
                 
    September 30,   December 31,
    2005   2004
         
Bid and performance related bonds(a)
  $ 244     $ 362  
Other bonds(b)
    45       68  
             
Total bid, performance related and other bonds
  $ 289     $ 430  
             
 
(a)  Net of restricted cash and cash equivalent amounts of $37 and $36 as of September 30, 2005 and December 31, 2004, respectively.
(b)  Net of restricted cash and cash equivalent amounts of $29 and $28 as of September 30, 2005 and December 31, 2004, respectively.
Venture capital financing
Nortel has entered into agreements with selected venture capital firms where the venture capital firms make and manage investments in start-ups and emerging enterprises. The agreements require Nortel to fund requests for additional capital up to its commitments when and if requests for additional capital are solicited by the venture capital firm. Nortel had remaining commitments, if requested, of $13 as of September 30, 2005. These commitments expire at various dates through 2012.
Other commitments
Due to an amendment of outsourcing contracts with a service provider for a portion of Nortel’s information services function, contractual obligations for outsourcing contracts have been substantially reduced as of September 30, 2005. The following table sets forth the minimum commitment contained in the amended outsourcing contracts:
                                                 
                        Total
    2006   2007   2008   2009   Thereafter   Obligations
                         
Outsourcing contracts
  $ 24     $ 18     $ 18     $ 15     $     $ 75  
                                     

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
12. Financing arrangements
Customer financing
Pursuant to certain financing agreements with its customers, Nortel is committed to provide future financing in connection with purchases of Nortel’s products and services. Generally, Nortel facilitates customer financing agreements through customer loans, and Nortel’s commitment to extend future financing is generally subject to conditions related to funding, fixed expiration or termination dates, specific interest rates and qualified purposes. Where permitted, customer financings may also be utilized by Nortel’s customers for their own working capital purposes and may be in the form of equity financing. Nortel’s internal credit committee monitors and attempts to limit Nortel’s exposure to credit risk. Nortel’s role in customer financing consists primarily of arranging financing by matching its customers’ needs with external financing sources. Nortel only provides direct customer financing where a compelling strategic customer or technology purpose supports such financing. The following table sets forth customer financing related information and commitments, excluding discontinued operations, as of the following dates:
                 
    September 30,   December 31,
    2005   2004
         
Drawn and outstanding — gross
  $ 51     $ 118  
Provisions for doubtful accounts
    (35 )     (38 )
             
Drawn and outstanding — net(a)
    16       80  
Undrawn commitments
    52       69  
             
Total customer financing
  $ 68     $ 149  
             
 
(a)  Included short-term and long-term amounts. Short-term and long-term amounts were included in accounts receivable — net and other assets, respectively, in the consolidated balance sheets.
During the nine months ended September 30, 2005 and 2004, net customer financing bad debt expense (recovery) as a result of settlements and adjustments to other existing provisions was $4 and $(11), respectively.
During the nine months ended September 30, 2005 and 2004, Nortel entered into certain agreements to restructure and/or settle various customer financing and related receivables, including rights to accrued interest. As a result of these transactions, Nortel received cash consideration of approximately $112 ($36 of the proceeds was included in discontinued operations) and $15, respectively, to settle outstanding receivables with a net carrying value of $101 ($33 of the net carrying value was included in discontinued operations) and $14, respectively.
During the nine months ended September 30, 2005 and 2004, Nortel reduced undrawn customer financing commitments by $17 ($8 relates to a VIE which Nortel began consolidating effective April 1, 2005) and $129, respectively, as a result of the expiration or cancellation of commitments and changing customer business plans. As of September 30, 2005, all undrawn commitments were available for funding under the terms of the financing agreements.
Consolidation of variable interest entities
Certain lease financing transactions of Nortel were structured through single transaction VIEs that did not have sufficient equity at risk as defined in FIN 46R. Effective July 1, 2003, Nortel prospectively began consolidating two VIEs for which Nortel was considered the primary beneficiary following the guidance of FIN 46, “Consolidation of Variable Interest Entities — an interpretation of Accounting Research Bulletin No. 51, ‘Consolidated Financial Statements”’ (“FIN 46”), on the basis that Nortel retained certain risks associated with guaranteeing recovery of the unamortized principal balance of the VIEs’ debt, which represented the majority of the risks associated with the respective VIEs’ activities. The amount of the guarantees will be adjusted over time as the underlying debt matures. During the nine months ended September 30, 2004, the debt related to one of the VIEs was extinguished and, as a result, consolidation of this VIE was no longer required. As of September 30, 2005, Nortel’s consolidated balance sheet included $85 of long-term debt and $85 of plant and equipment — net related to the remaining VIE. These amounts represented both the collateral and maximum exposure to loss as a result of Nortel’s involvement with the VIE.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Effective April 1, 2005, Nortel began consolidating a VIE for which Nortel was considered the primary beneficiary under FIN 46R. The VIE is a cellular phone operator in Russia. Loans to this entity comprise the majority of the entity’s subordinated financial support. No creditor of the VIE has recourse to Nortel. This entity’s financial results have been consolidated using the most recent financial information available, which was as of June 30, 2005.
On June 3, 2005, Nortel acquired PEC, a VIE, for which Nortel was considered the primary beneficiary under FIN 46R. The consolidated financial results of Nortel include PEC’s operating results from the date of the acquisition (see note 8).
As of September 30, 2005, Nortel did not have any variable interests related to transfers of financial assets. Nortel has other financial interests and contractual arrangements which would meet the definition of a variable interest under FIN 46R, including investments in other companies and joint ventures, customer financing arrangements, and guarantees and indemnification arrangements. As of September 30, 2005, none of these other interests or arrangements were considered significant variable interests and, therefore, did not meet the requirements for consolidation or disclosure under FIN 46R.
13. Capital stock and stock-based compensation plans
Common shares
Nortel Networks Corporation is authorized to issue an unlimited number of common shares without nominal or par value. The outstanding number of common shares and prepaid forward purchase contracts included in shareholders’ equity consisted of the following as of the following date:
                     
    Number   $
         
(Number of common shares in thousands)
               
Common shares:
               
Balance as of December 31, 2004
    4,272,671     $ 33,840  
 
Shares issued pursuant to:
               
   
Stock option plans
    1,724       10  
   
Prepaid forward purchase contracts
    64,791       82  
             
Balance as of September 30, 2005
    4,339,186     $ 33,932  
             
(Number of prepaid forward purchase contracts)
               
Prepaid forward purchase contracts:(a)
               
Balance as of December 31, 2004
    3,840     $ 82  
 
Prepaid forward purchase contracts settled
    (3,837 )     (82 )
             
Balance as of September 30, 2005
    3     $  
             
 
(a)  Included in additional paid-in capital in the consolidated balance sheets.
At the Nortel annual and special shareholders’ meeting on April 24, 2003, shareholders approved the reconfirmation and amendment of Nortel’s shareholder rights plan, which will expire at the annual meeting of shareholders to be held in 2006 unless it is reconfirmed at that time. Under the rights plan, Nortel issues one right for each Nortel Networks Corporation common share outstanding. These rights become exercisable upon the occurrence of certain events associated with an unsolicited takeover bid.
Prepaid forward purchase contracts
As a result of the delayed filing of the Reports, Nortel was unable to permit holders of Nortel’s prepaid forward purchase contracts to exercise certain “early settlement” rights and receive Nortel Networks Corporation common shares in advance of the otherwise applicable August 15, 2005 settlement date. These rights would have become exercisable following the filing of the Reports upon the effectiveness of a registration statement (or a post-effective amendment to the shelf registration statement) filed with the SEC (with respect to the Nortel Networks Corporation common shares to be delivered) that contains a related current prospectus. Under the terms of the Purchase Contract

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
and Unit Agreement which governs the prepaid forward purchase contracts, Nortel agreed to use commercially reasonable efforts to have an effective registration statement covering the Nortel Networks Corporation common shares to be delivered and to provide a prospectus in connection therewith. Nortel was not able, through the use of commercially reasonable efforts, to have an effective long-form registration statement relating to the exercise of these early settlement rights by holders of Nortel’s prepaid forward purchase contracts in advance of August 15, 2005. Since August 15, 2005, 3,837 of the remaining 3,840 forward purchase contracts outstanding prior to that date have been settled by holders, resulting in an issuance of 64,791,308 common shares of Nortel Networks Corporation.
Stock-based compensation plans
On March 10, 2004, Nortel announced, among other things, that it was likely that Nortel would need to revise certain previously announced results and restate previously filed financial results for one or more earlier periods. As a result of Nortel’s March 10, 2004 announcement, Nortel suspended as of March 10, 2004: the purchase of Nortel Networks Corporation common shares under the stock purchase plans for eligible employees in eligible countries, and a stock purchase plan for eligible unionized employees in Canada (collectively, the “ESPPs”); the granting of additional options, and the exercise of previously granted outstanding options, under and pursuant to the Nortel Networks Corporation 2000 Stock Option Plan (the “2000 Plan”) and the Nortel Networks Corporation 1986 Stock Option Plan As Amended and Restated (the “1986 Plan”), as well as the exercise of outstanding options granted under employee stock option plans previously assumed by Nortel in connection with mergers and acquisitions; and the purchase of units in a Nortel stock fund or purchase of Nortel Networks Corporation common shares under Nortel’s defined contribution and investment plans, until such time, at the earliest, that Nortel and NNL became compliant with U.S. and Canadian regulatory securities filing requirements. Upon the filing of the 2005 First Quarter Reports, the suspension of the above transactions was lifted. Certain individuals, however, remained restricted in their ability to trade in securities of Nortel Networks Corporation until certain cease trade orders associated with the delayed filings were lifted by certain securities commissions in Canada, the last remaining cease trade order having been lifted on June 23, 2005. Due to changes in the New York Stock Exchange listing standards, which took effect on June 30, 2004, Nortel is unable to continue to offer the ESPPs that were effective when the suspension was put in place.
On June 29, 2005, the shareholders of Nortel approved a new stock-based compensation plan, the Nortel 2005 Stock Incentive Plan, which permits grants of stock options, including incentive stock options, stock appreciation rights, performance stock units and restricted stock units (“RSUs”). The number of RSUs issued during the three months ended September 30, 2005 was approximately 3 million. On June 29, 2005, the shareholders of Nortel also approved three new stock purchase plans, the Nortel Global Stock Purchase Plan, the Nortel U.S. Stock Purchase Plan and the Nortel Savings and Retirement Program which have been launched in certain jurisdictions.
Effective January 1, 2003, Nortel elected to adopt the fair value based method for measurement and recognition of all stock-based compensation prospectively for all awards granted, modified, or settled on or after January 1, 2003 in accordance with SFAS 148. Prior to January 1, 2003, Nortel, as permitted under SFAS 123, applied the intrinsic value method under APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and related interpretations in accounting for its employee stock-based compensation plans.
The fair value at grant date of stock options is estimated using the Black-Scholes-Merton option-pricing model. Compensation expense is recognized on a straight-line basis over the stock option vesting period. Adjustments to compensation expense due to not meeting employment vesting requirements are accounted for in the period when they occur.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Pro forma disclosure
Had Nortel applied the fair value method to all stock-based compensation 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 the three and nine months ended:
                                   
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
Net earnings (loss) — reported
  $ (105 )   $ (259 )   $ (109 )   $ (184 )
 
Stock-based compensation — reported
    23       17       59       95  
 
Stock-based compensation — pro forma(a)
    (23 )     (34 )     (66 )     (190 )
                         
Net earnings (loss) — pro forma
  $ (105 )   $ (276 )   $ (116 )   $ (279 )
                         
Basic earnings (loss) per common share:
                               
 
Reported
  $ (0.02 )   $ (0.06 )   $ (0.03 )   $ (0.04 )
 
Pro forma
  $ (0.02 )   $ (0.06 )   $ (0.03 )   $ (0.06 )
                         
Diluted earnings (loss) per common share:
                               
 
Reported
  $ (0.02 )   $ (0.06 )   $ (0.03 )   $ (0.04 )
 
Pro forma
  $ (0.02 )   $ (0.06 )   $ (0.03 )   $ (0.06 )
                         
 
(a)  Stock-based compensation — pro forma expense was net of tax of nil in each period.
The following table presents stock-based compensation recorded for the three and nine months ended:
                                   
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
Stock-based compensation:
                               
 
Stock option expense
  $ 21     $ 20     $ 58     $ 55  
 
Employer portion of ESPPs(a)
                       
 
Restricted Stock Units expense(a)
                      41  
 
Deferred Stock Units expense(a)
    2       (3 )     1       (1 )
                         
Total stock-based compensation reported — net of tax
  $ 23     $ 17     $ 59     $ 95  
                         
 
(a)  Compensation related to employer portion of ESPPs, RSUs and Deferred Stock Units (“DSUs”) was net of tax of nil in each period.
During the three and nine months ended September 30, 2005, approximately 55 million stock options were granted. During the three and nine months ended September 30, 2004, nil and approximately 38 million stock options were granted. The following weighted-average assumptions were used in computing the fair value of stock options for purposes of expense recognition and pro forma disclosures, as applicable, for the three and nine months ended:
                                   
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004(a)   2005   2004
                 
Black-Scholes weighted-average assumptions
                               
 
Expected dividend yield
    0.00 %           0.00 %     0.00 %
 
Expected volatility
    86.40 %           86.40 %     94.49 %
 
Risk-free interest rate
    4.06 %           4.06 %     2.96 %
 
Expected option life in years
    4             4       4  
Weighted-average stock option fair value per option granted
  $ 1.86     $     $ 1.86     $ 5.21  
 
(a)  For the three months ended September 30, 2004, no stock options were granted.

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Notes to Consolidated Financial Statements (unaudited) — (Continued)
14. Earnings (loss) per common share
The following table details the weighted-average number of Nortel Networks Corporation common shares outstanding for the purposes of computing basic and diluted earnings (loss) per common share for the three and nine months ended:
                                   
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
    (Number of common shares in millions)
Basic weighted-average shares outstanding:
                               
 
Issued and outstanding
    4,339       4,273       4,338       4,260  
 
Prepaid forward purchase contracts(a)
          65             76  
                         
Basic weighted-average shares outstanding
    4,339       4,338       4,338       4,336  
                         
Weighted-average shares dilution adjustments:
                               
 
Dilutive stock options
                       
                         
Diluted weighted-average shares outstanding
    4,339       4,338       4,338       4,336  
                         
Weighted-average shares dilution adjustments — exclusions:
                               
 
Stock options
    307       300       307       300  
 
4.25% Convertible Senior Notes(b)
    180       180       180       180  
 
(a)  The minimum number of Nortel Networks Corporation common shares to be issued upon settlement of the prepaid forward purchase contracts on a weighted-average basis was approximately nil for each of the three and nine months ended September 30, 2005, respectively, and 65 and 76 for the three and nine months ended September 30, 2004, respectively. As of September 30, 2005 and 2004, the minimum number of Nortel Networks Corporation common shares to be issued upon settlement of the prepaid forward purchase contracts was approximately nil and 65, respectively.
(b)  The 4.25% Convertible Senior Notes were anti-dilutive for the three and nine months ended September 30, 2005 and 2004.
15. Comprehensive income (loss)
The following are the components of comprehensive income (loss), net of tax, for the three and nine months ended:
                                   
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
Net earnings (loss)
  $ (105 )   $ (259 )   $ (109 )   $ (184 )
Other comprehensive income (loss) adjustments:
                               
 
Change in foreign currency translation adjustment(a)
    220       43       (140 )     (29 )
 
Unrealized gain (loss) on investments — net(b)
    20       (19 )     (3 )     (79 )
 
Minimum pension liability adjustment — net
                3       1  
 
Unrealized derivative gain (loss) on cash flow hedges — net(c)
    12       10       (7 )     (2 )
                         
Comprehensive income (loss)
  $ 147     $ (225 )   $ (256 )   $ (293 )
                         
 
(a)  The change in the foreign currency translation adjustment was not adjusted for income taxes since it related to indefinite term investments in non-U.S. subsidiaries. The change in foreign currency translation adjustment for the three months ended September 30, 2005 includes a reversal of $187, which was originally reclassified to deferred income in the first quarter of 2005 as a result of the ongoing divestiture of Nortel’s manufacturing operations to Flextronics.
(b)  Certain securities deemed available-for-sale by Nortel were measured at fair value. Unrealized holding gains (losses) related to these securities were excluded from net earnings (loss) and were included in accumulated other comprehensive income (loss) until realized. Unrealized gain (loss) on investments was net of tax of nil and nil for the three and nine months ended September 30, 2005 and 2004, respectively.
(c)  During the three and nine months ended September 30, 2005, $1 and $14 of net derivative gains (losses) were reclassified to other income (expense) — net, respectively. During the three and nine months ended September 30, 2004, $(1) and $1 of net derivative gains (losses) were reclassified to other income (expense) — net, respectively. Nortel estimates that $11 of net derivative gains (losses) included in accumulated other comprehensive income (loss) will be reclassified into net earnings (loss) within the next 12 months.

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16. Related party transactions
In the ordinary course of business, Nortel purchases certain inventory for its Carrier Packet Networks business from Bookham, Inc. (“Bookham”), a related party due to Nortel’s equity interest in Bookham. Bookham is a sole supplier of key optical components to Nortel’s optical networks solutions in its Carrier Packet Networks segment. During the three and nine months ended September 30, 2005, Nortel’s aggregate purchases from Bookham were $7 and $12, respectively. During the three and nine months ended September 30, 2004, Nortel’s aggregate purchases from Bookham were $18 and $53, respectively. As of September 30, 2005 and December 31, 2004, accounts payable to Bookham were $5 and $5, respectively. Nortel also has certain notes receivable due from Bookham with a carrying amount of $20 and $20 as of September 30, 2005 and December 31, 2004, respectively.
On December 2, 2004, Nortel and Bookham entered into a restructuring agreement which, among other changes, extended the maturity date of a senior secured note (the “Series B Note”) by one year from November 8, 2005 to November 8, 2006, and eliminated the conversion feature of a senior unsecured note (the “Series A Note”). Bookham also agreed to secure the Series A Note, provide additional collateral for the Series A Note and the Series B Note, and provide Nortel with other debt protection covenants.
In February 2005, Nortel agreed to waive until November 6, 2006 the requirement under the Series A Note and Series B Note for Bookham to maintain a minimum cash balance. In May 2005, Nortel entered into an amendment to adjust the prepayment provisions of these notes and received additional collateral for these notes. In May 2005, Nortel entered into an amendment to its supply agreement with Bookham to include for a twelve month period price increases for certain products, and acceleration of certain planned purchase orders and invoice payment terms. These May 2005 amendments were agreed to by Nortel to provide Bookham with financial flexibility to continue the supply of optical components for Nortel’s Carrier Packet Networks products.
17. Contingencies
Subsequent to the February 15, 2001 announcement in which Nortel provided revised guidance for financial performance for the 2001 fiscal year and the first quarter of 2001, Nortel and certain of its then current officers and directors were named as defendants in more than twenty-five purported class action lawsuits. These lawsuits in the U.S. District Courts for the Eastern District of New York, for the Southern District of New York and for the District of New Jersey and in courts in the provinces of Ontario, Quebec and British Columbia in Canada, on behalf of shareholders who acquired Nortel Networks Corporation securities as early as October 24, 2000 and as late as February 15, 2001, allege, among other things, violations of U.S. federal and Canadian provincial securities laws. These matters also have been the subject of review by Canadian and U.S. securities regulatory authorities. On May 11, 2001, the defendants filed motions to dismiss and/or stay in connection with the three proceedings in Quebec primarily based on the factual allegations lacking substantial connection to Quebec and the inclusion of shareholders resident in Quebec in the class claimed in the Ontario lawsuit. The plaintiffs in two of these proceedings in Quebec obtained court approval for discontinuances of their proceedings on January 17, 2002. The motion to dismiss and/or stay the third proceeding was heard on November 6, 2001 and the court deferred any determination on the motion to the judge who will hear the application for authorization to commence a class proceeding. On December 6, 2001, the defendants filed a motion seeking leave to appeal that decision. The motion for leave to appeal was dismissed on March 11, 2002. On October 16, 2001, an order in the Southern District of New York was filed consolidating twenty-five of the related U.S. class action lawsuits into a single case, appointing class plaintiffs and counsel for such plaintiffs. The plaintiffs served a consolidated amended complaint on January 18, 2002. On December 17, 2001, the defendants in the British Columbia action served notice of a motion requesting the court to decline jurisdiction and to stay all proceedings on the grounds that British Columbia is an inappropriate forum. The motion has been adjourned at the plaintiffs’ request to a future date to be set by the parties.
On April 1, 2002, Nortel filed a motion to dismiss the above consolidated U.S. shareholder class action on the ground that it failed to state a cause of action under U.S. federal securities laws. On January 3, 2003, the District Court denied the motion to dismiss the consolidated U.S. class action complaint. 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

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Notes to Consolidated Financial Statements (unaudited) — (Continued)
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 September 30, 2005, Nortel announced that a mediator has been jointly appointed by the two U.S. District Court Judges presiding over two class action lawsuits pending in the U.S. District Court for the Southern District of New York to oversee settlement negotiations between Nortel and the lead plaintiffs in both the above consolidated U.S. shareholder class action and the U.S. shareholder class action consolidated on June 30, 2004 described below. The appointment of the mediator was pursuant to a request by Nortel and the lead plaintiffs for the Courts’ assistance to facilitate the possibility of achieving a global settlement regarding these actions. The settlement discussions before the mediator will be confidential and non-binding on the parties without prejudice to their respective positions in the litigation. In the event that the parties reach agreement, any such proposed resolution would be subject to the Courts’ approval. There can be no assurance that the parties will agree upon a proposed resolution and, in the event they do not, the actions would continue to proceed.
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 Nortel, certain of its current and former officers and directors and its auditors as defendants. The factual allegations in the Ontario Claim are substantially similar to the allegations in the consolidated amended complaint filed in the U.S. District Court described above. The Ontario Claim is on behalf of all Canadian residents who purchased Nortel Networks Corporation securities (including options on Nortel Networks Corporation securities) between October 24, 2000 and February 15, 2001. The plaintiffs claim damages of Canadian $5,000, plus punitive damages in the amount of Canadian $1,000, prejudgment and postjudgment interest and costs of the action. On September 23, 2003, the Court issued an order allowing the plaintiffs to proceed to amend the Ontario Claim and requiring that the plaintiffs serve class certification materials by December 15, 2003. On September 24, 2003, the plaintiffs filed a notice of discontinuance of the original action filed in Ontario. On December 12, 2003, plaintiffs’ counsel requested an extension of time to January 21, 2004 to deliver class certification materials. On January 21, 2004, plaintiffs’ counsel advised the Court that the two representative plaintiffs in the action no longer wished to proceed, but counsel was prepared to deliver draft certification materials pending the replacement of the representative plaintiffs. On February 19, 2004, the plaintiffs’ counsel advised the Court of a potential new representative plaintiff. On February 26, 2004, the defendants requested the Court to direct the plaintiffs’ counsel to bring a motion to permit the withdrawal of the current representative plaintiffs and to substitute the proposed representative plaintiff. On June 8, 2004, the Court signed an order allowing a Second Fresh as Amended Statement of Claim that substituted one new representative plaintiff, but did not change the substance of the prior claim.
A purported class action lawsuit was filed in the U.S. District Court for the Middle District of Tennessee on December 21, 2001, on behalf of participants and beneficiaries of the Nortel Long-Term Investment Plan (the “Plan”) at any time during the period of March 7, 2000 through the filing date and who made or maintained Plan investments in Nortel Networks Corporation common shares, under the Employee Retirement Income Security Act (“ERISA”) for Plan-wide relief and alleging, among other things, material misrepresentations and omissions to induce Plan participants to continue to invest in and maintain investments in Nortel Networks Corporation common shares in the Plan. A second purported class action lawsuit, on behalf of the Plan and Plan participants for whose individual accounts the Plan purchased Nortel Networks Corporation common shares during the period from October 27, 2000 to February 15, 2001 and making similar allegations, was filed in the same court on March 12, 2002. A third purported class action lawsuit, on behalf of persons who are or were Plan participants or beneficiaries at any time since March 1, 1999 to the filing date and making similar allegations, was filed in the same court on March 21, 2002. The first and second purported class action lawsuits were consolidated by a new purported class action complaint, filed on May 15, 2002 in the same court and making similar allegations, on behalf of Plan participants and beneficiaries who directed the Plan to purchase or hold shares of certain funds, which held primarily Nortel Networks Corporation common shares, during the period from March 7, 2000 through December 21, 2001. On September 24, 2002, plaintiffs in the consolidated action filed a motion to consolidate all the actions and to transfer them to the U.S. District Court for the Southern District of New York. The plaintiffs then filed a motion to withdraw the pending motion to consolidate and transfer. The withdrawal was granted by the District Court on December 30, 2002. A fourth purported class action lawsuit, on behalf of the Plan and Plan participants for whose individual accounts the Plan held Nortel Networks Corporation common shares during the period from March 7, 2000 through March 31, 2001 and making similar allegations, was filed in the U.S. District Court for the Southern District of New York on March 12, 2003. On March 18, 2003, plaintiffs in the fourth purported class action filed a motion with

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Notes to Consolidated Financial Statements (unaudited) — (Continued)
the Judicial Panel on Multidistrict Litigation to transfer all the actions to the U.S. District Court for the Southern District of New York for coordinated or consolidated proceedings pursuant to 28 U.S.C. section 1407. On June 24, 2003, the Judicial Panel on Multidistrict Litigation issued a transfer order transferring the Southern District of New York action to the U.S. District Court for the Middle District of Tennessee (the “Consolidated ERISA Action”). On September 12, 2003, the plaintiffs in all the actions filed a consolidated class action complaint. On October 28, 2003, the defendants filed a motion to dismiss the complaint and a motion to stay discovery pending disposition of the motion to dismiss. On March 30, 2004, the plaintiffs filed a motion for certification of a class consisting of participants in, or beneficiaries of, the Plan who held shares of the Nortel 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 June 17, 2005, the plaintiffs filed a Second Amended Consolidated Class Action Complaint that added additional current and former directors, officers and employees as defendants and alleged breach of fiduciary duty on behalf of the Plan and as a purported class action on behalf of participants and beneficiaries of the Plan who held shares of the Nortel Networks Stock Fund during the period from March 7, 2000 through June 17, 2005. On July 8, 2005, the defendants filed a Renewed Motion to Dismiss Plaintiffs’ Second Amended Class Action Complaint. On July 29, 2005, plaintiffs filed an opposition to the motion, and defendants filed a reply memorandum on August 12, 2005.
Subsequent to the March 10, 2004 announcement in which Nortel indicated it was likely that it would need to revise its previously announced unaudited results for the year ended December 31, 2003, and the results reported in certain of its quarterly reports for 2003, and to restate its previously filed financial results for one or more earlier periods, Nortel and certain of its then current and former officers and directors were named as defendants in 27 purported class action lawsuits. These lawsuits in the U.S. District Court for the Southern District of New York on behalf of shareholders who acquired Nortel Networks Corporation securities as early as February 16, 2001 and as late as May 15, 2004, allege, among other things, violations of U.S. federal securities laws. These matters are also the subject of investigations by Canadian and U.S. securities regulatory and criminal investigative authorities. On June 30, 2004, the Court signed Orders consolidating the 27 class actions and appointing lead plaintiffs and lead counsel. The plaintiffs filed a consolidated class action complaint on September 10, 2004, alleging a class period of April 24, 2003 through and including April 27, 2004. On November 5, 2004, Nortel Networks Corporation and the Audit Committee Defendants filed a motion to dismiss the consolidated class action complaint. On January 18, 2005, the lead plaintiffs, Nortel and the Audit Committee Defendants reached an agreement in which Nortel would withdraw its motion to dismiss and plaintiffs would dismiss Count II of the complaint which asserts a claim against the Audit Committee Defendants. On May 13, 2005, the plaintiffs filed a motion for class certification. On September 16, 2005, lead plaintiffs filed an amended consolidated class action complaint that rejoined the previously dismissed Audit Committee Defendants as parties to the action.
On April 5, 2004, Nortel announced that the SEC had issued a formal order of investigation in connection with Nortel’s previous restatement of its financial results for certain periods, as announced in October 2003, and Nortel’s announcements in March 2004 regarding the likely need to revise certain previously announced results and restate previously filed financial results for one or more periods. The matter had been the subject of an informal SEC inquiry. On April 13, 2004, Nortel announced that it had received a letter from the staff of the Ontario Securities Commission (“OSC”) advising that there is an OSC Enforcement Staff investigation into the same matters that are the subject of the SEC investigation.
On May 14, 2004, Nortel announced that it had received a federal grand jury subpoena for the production of certain documents, including financial statements and corporate, personnel and accounting records, in connection with an ongoing criminal investigation being conducted by the U.S. Attorney’s Office for the Northern District of Texas, Dallas Division. On August 23, 2005, Nortel received an additional federal grand jury subpoena in this investigation seeking production of additional documents, including documents relating to The Nortel Retirement Income Plan and The Nortel Long Term Investment Plan.
On May 18, 2004, a purported class action lawsuit was filed in the U.S. District Court for the Middle District of Tennessee on behalf of individuals who were participants and beneficiaries of the Plan at any time during the period of December 23, 2003 through the filing date and who made or maintained Plan investments in Nortel Networks

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Notes to Consolidated Financial Statements (unaudited) — (Continued)
Corporation common shares, under the ERISA for Plan-wide relief and alleging, among other things, breaches of fiduciary duty. On September 3, 2004, the Court signed a stipulated order consolidating this action with the Consolidated ERISA Action described above. On June 16, 2004, a second purported class action lawsuit, on behalf of the Plan and Plan participants for whose individual accounts the Plan purchased Nortel Networks Corporation common shares during the period from October 24, 2000 to June 16, 2004, and making similar allegations, was filed in the U.S. District Court for the Southern District of New York. On August 6, 2004, the Judicial Panel on Multidistrict Litigation issued a conditional transfer order to transfer this action to the U.S. District Court for the Middle District of Tennessee for coordinated or consolidated proceedings pursuant to 28 U.S.C. section 1407 with the Consolidated ERISA Action described above. On August 20, 2004, plaintiffs filed a notice of opposition to the conditional transfer order with the Judicial Panel. On December 6, 2004, the Judicial Panel denied the opposition and ordered the action transferred to the U.S. District Court for the Middle District of Tennessee for coordinated or consolidated proceedings with the Consolidated ERISA Action described above. On January 3, 2005, this action was received in the U.S. District Court for the Middle District of Tennessee and consolidated with the Consolidated ERISA Action described above.
On July 28, 2004, Nortel and NNL, and certain directors and officers, and certain former directors and officers, of Nortel and NNL, 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 Nortel 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 Nortel alleging, among other things, breach of fiduciary duties owed to Nortel during the period from 2000 to 2003 including by causing Nortel to engage in unlawful conduct or failing to prevent such conduct; causing Nortel to issue false statements; and violating the law. On February 14, 2005, the defendants filed motions to dismiss the derivative complaint. On April 29, 2005, the plaintiffs filed an opposition to the motions to dismiss. On May 26, 2005, the defendants filed a reply memorandum in support of the motions to dismiss. On August 24, 2005, the Court issued an opinion and order granting the defendants’ motions to dismiss the derivative complaint. Since the plaintiffs did not appeal the dismissal and the time to file an appeal has passed, this action is concluded.
On August 16, 2004, Nortel received a letter from the Integrated Market Enforcement Team of the Royal Canadian Mounted Police (“RCMP”) advising Nortel that the RCMP would be commencing a criminal investigation into Nortel’s financial accounting situation.
On February 16, 2005, a motion for authorization to institute a class action on behalf of residents of Québec, who purchased Nortel securities between January 29, 2004 and March 15, 2004, was filed in the Québec Superior Court naming Nortel as a defendant. The motion alleges that Nortel made misrepresentations about 2003 financial results.
On March 9, 2005, Nortel and certain of its current and former officers and directors and its auditors were named as defendants in a purported class action proceeding filed in the Ontario Superior Court of Justice, Commercial List, on behalf of all Canadian residents who purchased Nortel Networks Corporation securities from April 24, 2003 to April 27, 2004. This lawsuit alleges, among other things, negligence, misrepresentations, oppressive conduct, insider trading and violations of Canadian corporation and competition laws in connection with Nortel’s 2003 financial results and seeks damages of Canadian $3,000, plus punitive damages in the amount of Canadian $1,000, prejudgment and postjudgment interest and costs of the action.
Except as otherwise described herein, in each of the matters described above, the plaintiffs are seeking an unspecified amount of monetary damages.
Nortel is also a defendant in various other suits, claims, proceedings and investigations which arise in the normal course of business.

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Notes to Consolidated Financial Statements (unaudited) — (Continued)
Nortel is unable to ascertain the ultimate aggregate amount of monetary liability or financial impact to Nortel of the above matters which, unless otherwise specified, seek damages from the defendants of material or indeterminate amounts or could result in fines and penalties. Nortel cannot determine whether these actions, suits, claims and proceedings will, individually or collectively, have a material adverse effect on the business, results of operations, financial condition or liquidity of Nortel. Nortel intends to vigorously defend these actions, suits, claims and proceedings, litigating or settling cases where in management’s judgment it would be in the best interest of shareholders to do so. Nortel will continue to cooperate fully with all authorities in connection with the regulatory and criminal investigations.
Environmental matters
Nortel’s operations are subject to a wide range of environmental laws in various jurisdictions around the world. Nortel seeks to operate its business in compliance with such laws. In 2004, Nortel became subject to new European product content laws and product takeback and recycling requirements that will require full compliance by 2006. It is expected that these laws will require Nortel to incur additional compliance costs. Although costs relating to environmental matters have not resulted in a material adverse effect on the business, results of operations, financial condition or liquidity in the past, there can be no assurance that Nortel will not be required to incur such costs in the future. Nortel has a corporate environmental management system standard and an environmental program to promote such compliance. Moreover, Nortel has a periodic, risk-based, integrated environment, health and safety audit program.
Nortel’s environmental program focuses its activities on design for the environment, supply chain and packaging reduction issues. Nortel works with its suppliers and other external groups to encourage the sharing of non-proprietary information on environmental research.
Nortel is exposed to liabilities and compliance costs arising from its past and current generation, management and disposal of hazardous substances and wastes. As of September 30, 2005, the accruals on the consolidated balance sheet for environmental matters were $28. Based on information available as of September 30, 2005, management believes that the existing accruals are sufficient to satisfy probable and reasonably estimable environmental liabilities related to known environmental matters. Any additional liabilities that may result from these matters, and any additional liabilities that may result in connection with other locations currently under investigation, are not expected to have a material adverse effect on the business, results of operations, financial condition and liquidity of Nortel.
Nortel has remedial activities under way at 12 sites which are either currently or previously owned or occupied facilities. An estimate of Nortel’s anticipated remediation costs associated with all such sites, to the extent probable and reasonably estimable, is included in the environmental accruals referred to above in an approximate amount of $28.
Nortel is also listed as a potentially responsible party under the U.S. Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) at six Superfund sites in the U.S. An estimate of Nortel’s share of the anticipated remediation costs associated with such Superfund sites is expected to be de minimis and is included in the environmental accruals of $28 referred to above.
Liability under CERCLA may be imposed on a joint and several basis, without regard to the extent of Nortel’s involvement. In addition, the accuracy of Nortel’s estimate of environmental liability is affected by several uncertainties such as additional requirements which may be identified in connection with remedial activities, the complexity and evolution of environmental laws and regulations, and the identification of presently unknown remediation requirements. Consequently, Nortel’s liability could be greater than its current estimate.
Other
In August 2004, Nortel entered into a contract with Bharat Sanchar Nigam Limited (“BSNL”) to establish a wireless network in India for which Nortel expected to realize revenues of approximately $500 throughout 2005 and the first half of 2006, of which a significant portion has been recognized in 2005. Included in the contract is an option, subject to Nortel’s acceptance, for BSNL to increase the amounts purchased up to an additional 50% of the initial network build to allow for business expansion. This contract resulted in a project loss of approximately $160 in 2004. Nortel recorded an additional loss of approximately $103 in the first nine months of 2005, approximately $71 of

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Notes to Consolidated Financial Statements (unaudited) — (Continued)
which was recorded in the third quarter of 2005. The additional losses are primarily driven by an increase in project implementation costs and the pricing pressures as a result of the competitive nature of India’s telecommunications market. Nortel and BSNL are currently in negotiations for the expansion business which, depending on the outcome of the negotiations, could result in a reduction in the initial revenue estimate of $500 (which includes the expansion business) and has the potential to result in additional project losses in the fourth quarter of 2005 and into 2006.
18. Subsequent events
Effective October 24, 2005, NNL and EDC amended the EDC Support Facility to maintain the total EDC Support Facility at up to $750, including the existing $300 of committed support for performance bonds and similar instruments, and the extension of the maturity date of the EDC Support Facility for an additional year to December 31, 2007. In connection with this amendment (the “EDC Amendment”), all guarantee and security agreements previously guaranteeing or securing the obligations of Nortel and its subsidiaries under the EDC Support Facility and Nortel’s public debt securities were terminated and the assets of Nortel and its subsidiaries pledged under the security agreements were released in full. EDC also agreed to provide future support under the EDC Support Facility on an unsecured basis and without the guarantees of NNL’s subsidiaries provided that should NNL or its subsidiaries incur or guarantee certain indebtedness in the future above agreed thresholds, equal and ratable security and/or guarantees of NNL’s obligations under the EDC Support Facility will be required at that time.
On October 25, 2005, Nortel announced that it entered into an agreement to sell its facility in Brampton, Ontario to Rogers Communications Inc., (“Rogers”) for approximately $84. The sale includes approximately one million square feet, fixtures and certain personal property located at the facility and 63 acres of land. Pending completion of the prospective buyer’s due diligence by mid-December and other customary closing conditions, Rogers is expected to take possession of the facility on January 4, 2006.
On August 17, 2005, Nortel signed a definitive agreement with LG Electronics, Inc. (“LG”) to form a joint venture that will offer telecom and networking solutions to Korea and other markets globally. Nortel will own 50 percent plus one share in the joint venture in exchange for which it will contribute its South Korean distribution and services business and pay $145 and other non-monetary consideration. On November 2, 2005, Nortel announced the closing of the transaction forming a joint venture between Nortel and LG named LG-Nortel Co. Ltd.
19. Reconciliation from U.S. GAAP to Canadian GAAP
New Canadian regulations allow issuers that are required to file reports with the SEC, upon meeting certain conditions, to satisfy their Canadian continuous disclosure obligations by using financial statements prepared in accordance with U.S. GAAP. Accordingly, for fiscal 2005 and 2004, Nortel is including in the notes to its consolidated financial statements a reconciliation highlighting the material differences between its financial statements prepared in accordance with U.S. GAAP as compared to financial statements prepared in accordance with accounting principles generally accepted in Canada (“Canadian GAAP”). Subsequent to 2005, no further reconciliation will be required under current Canadian regulations. Prior to 2004, Nortel prepared financial statements (with accompanying notes) and Management’s Discussion and Analysis — Canadian Supplement in accordance with Canadian GAAP and Canadian securities regulations, all of which were presented as a separate report and filed with the relevant Canadian securities regulators in compliance with its Canadian continuous disclosure obligations.

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Notes to Consolidated Financial Statements (unaudited) — (Continued)
The consolidated financial statements of Nortel have been prepared in accordance with U.S. GAAP and the accounting rules and regulations of the SEC which differ in certain material respects from those principles and practices that Nortel would have followed had its consolidated financial statements been prepared in accordance with Canadian GAAP. The following is a reconciliation of the net earnings (loss) between U.S. GAAP and Canadian GAAP for the three and nine months ended September 30, 2005 and 2004, and accumulated deficit as of September 30, 2005 and 2004 and earnings per share data under Canadian GAAP for the three and nine months ended September 30, 2005 and 2004:
                                     
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
Net earnings (loss)
                               
 
U.S. GAAP
  $ (105 )   $ (259 )   $ (109 )   $ (184 )
   
Derivative accounting(b) ((i)(i))
    (4 )           (15 )     22  
   
Financial instruments(c)
    (17 )     (17 )     (51 )     (49 )
   
Stock option expense(f)
    (21 )           (21 )      
   
Other(f)
    5       10       5       16  
                         
 
Canadian GAAP
  $ (142 )   $ (266 )   $ (191 )   $ (195 )
                         
Canadian GAAP:
                               
Accumulated deficit
                               
   
Deficit at the beginning of the period
                  $ (32,203 )   $ (32,098 )
   
Net earnings (loss)
                    (191 )     (195 )
   
Accretion of prepaid forward purchase contracts
                    (5 )     (7 )
                         
Deficit at the end of the period
                  $ (32,399 )   $ (32,300 )
                         
Canadian GAAP:
                               
Basic earnings (loss) per common share
                               
   
— from continuing operations
  $ (0.03 )   $ (0.06 )   $ (0.05 )   $ (0.04 )
   
— from discontinued operations
    0.00       0.00       0.00       0.00  
                         
Basic earnings (loss) per common share
  $ (0.03 )   $ (0.06 )   $ (0.05 )   $ (0.04 )
                         
Diluted earnings (loss) per common share
                               
   
— from continuing operations
  $ (0.03 )   $ (0.06 )   $ (0.05 )   $ (0.04 )
   
— from discontinued operations
    0.00       0.00       0.00       0.00  
                         
Diluted earnings (loss) per common share
  $ (0.03 )   $ (0.06 )   $ (0.05 )   $ (0.04 )
                         

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
The following details the material differences between U.S. GAAP and Canadian GAAP for balance sheet information as of September 30, 2005 and December 31, 2004:
                                                 
    September 30, 2005   December 31, 2004
         
    U.S.       Canadian   U.S.       Canadian
    GAAP   Adjustments   GAAP   GAAP   Adjustments   GAAP
                         
ASSETS
Current assets(g)
  $ 7,869     $ (9 )   $ 7,860     $ 8,342     $ 5     $ 8,347  
Investments(d)(g)
    166       (13 )     153       159       (16 )     143  
Plant and equipment — net
    1,575       (4 )     1,571       1,651       (2 )     1,649  
Goodwill(a)
    2,519       (895 )     1,624       2,303       (910 )     1,393  
Intangible assets — net(h)
    150       (41 )     109       78       (40 )     38  
Deferred income taxes — net(h)
    3,606       (201 )     3,405       3,736       (220 )     3,516  
Other assets(b)(h)
    579       28       607       715       (19 )     696  
                                     
Total assets
  $ 16,464     $ (1,135 )   $ 15,329     $ 16,984     $ (1,202 )   $ 15,782  
                                     
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities(g)
  $ 6,002     $ (91 )   $ 5,911     $ 5,172     $ (41 )   $ 5,131  
Long-term debt(b)(c)
    2,428       (203 )     2,225       3,862       (287 )     3,575  
Deferred income taxes — net(h)
    227       12       239       144       14       158  
Other liabilities(b)(h)
    3,373       (1,241 )     2,132       3,189       (1,360 )     1,829  
                                     
Total liabilities
    12,030       (1,523 )     10,507       12,367       (1,674 )     10,693  
                                     
Minority interests in subsidiary companies
    641             641       630             630  
Total shareholders’ equity (b)(c)(d)(g)(h)
    3,793       388       4,181       3,987       472       4,459  
                                     
Total liabilities and shareholders’ equity
  $ 16,464     $ (1,135 )   $ 15,329     $ 16,984     $ (1,202 )   $ 15,782  
                                     
The significant differences between U.S. GAAP and Canadian GAAP that impact the consolidated financial statements of Nortel include the following:
          (a) Business combinations
All of Nortel’s business combinations have been accounted for using the purchase method. Until June 30, 2001, under Canadian GAAP, when common share consideration was involved, the purchase price of Nortel’s acquisitions was determined based on the average trading price per Nortel Networks Corporation common share for a reasonable period before and after the date the transaction was closed. Under U.S. GAAP, when common share consideration was involved, the purchase price of the acquisitions was determined based on the average price per Nortel Networks Corporation common share for a reasonable period before and after the date the acquisition was announced or the date on which the exchange ratio became fixed. After June 30, 2001, treatment under Canadian GAAP was the same as under U.S. GAAP for measurement of share consideration. As a result of the difference between Canadian GAAP and U.S. GAAP until June 30, 2001, the value of purchase price consideration assigned to acquisitions may have varied significantly depending on the length of time between the announcement date and the closing date of the transaction and the volatility of Nortel Networks Corporation common share price within that time frame.
Stock options assumed on acquisitions were recorded at fair value for acquisitions on or after July 1, 2000 under U.S. GAAP, and for acquisitions on or after July 1, 2001 under Canadian GAAP. Beginning with acquisitions completed subsequent to July 1, 2000, U.S. GAAP requires an allocation of a portion of the purchase price to deferred compensation related to the intrinsic value of unvested options held by employees of the companies acquired. The deferred compensation is amortized to net earnings (loss) based on the remaining vesting period of the option awards. With the adoption of The Canadian Institute of Chartered Accountants (“CICA”) Handbook Section 3870, “Stock-based Compensation and Other Stock-based Payments”, on January 1, 2002, unearned compensation is recorded on unvested options held by employees of acquired companies. Previously, there was no requirement to

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
record deferred compensation in respect of such unvested options under Canadian GAAP. 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. On June 3, 2005, Nortel completed the acquisition of PEC (see note 8). There are no significant differences between U.S. and Canadian GAAP that impacted this acquisition.
          (b) Derivative accounting
Under U.S. GAAP, effective January 1, 2001, Nortel adopted SFAS 133, which was subsequently amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities — an Amendment of SFAS No. 133”, and SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. Under Canadian GAAP, gains and losses on derivatives that are designated as hedges and that manage the underlying risks of anticipated transactions are not recorded until the underlying hedged item is recorded in net earnings (loss) and hedge ineffectiveness is not recorded until settlement. Under U.S. GAAP, the accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For fair value hedges, changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are reported in net earnings (loss) from continuing operations immediately. For cash flow hedges, the effective portion of the gains or losses is reported as a component of other comprehensive income (loss) and the ineffective portion is reported in net earnings (loss) from continuing operations immediately. Foreign currency hedges can be either fair value hedges or cash flow hedges and are accounted for accordingly.
Under U.S. GAAP, an embedded derivative is accounted for at fair value separate from the host contract when certain specified conditions are met. Under Canadian GAAP, embedded derivatives are not accounted for separately from the host contract.
          (c) Financial instruments
Under Canadian GAAP, a financial instrument that contains both a liability and equity component must be allocated to those components based on fair value. As a result, the $1,800 proceeds on the 4.25% Convertible Senior Notes issued on August 15, 2001, convertible at the holders’ option into Nortel Networks Corporation common shares, were allocated based on the fair value of the debt component calculated at $1,325, with the residual of $475 being assigned to the equity component. Under Canadian GAAP, the debt component is accreted to the face value of the 4.25% Convertible Senior Notes over their seven year term, with the resulting charge recorded in interest expense. Under U.S. GAAP, such instruments are not broken out into their component parts but rather are reported as the type of instrument of which they are principally comprised. Therefore, the 4.25% Convertible Senior Notes are reported as debt under U.S. GAAP.
          (d) Investments
Under U.S. GAAP, certain investment securities deemed available-for-sale by Nortel are re-measured to fair value each period, with unrealized holding gains (losses) included in other comprehensive income (loss) until realized. Under Canadian GAAP, these investments are recorded at historical cost unless a loss that is considered other than temporary occurs.
          (e) Other financial statement presentation differences
Under Canadian GAAP, global investment tax credits are required to be deducted from R&D expense while under U.S. GAAP, these amounts are deducted from the income tax benefit (expense). The impact of this difference in the three and nine months ended September 30, 2005 of $4 and $22, respectively, and in the three and nine months ended September 30, 2004 of $10 and $35, respectively, was to increase or decrease net earnings (loss) from

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
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).
Under Canadian GAAP, Nortel is required to present a consolidated statement of cash flows for the three and nine months ended September 30, 2005 and 2004, whereas under U.S. GAAP, a consolidated statement of cash flows is only required for the nine months ended September 30, 2005 and 2004. The following table presents consolidated statements of cash flows data for the three and nine months ended September 30, 2005 and 2004 prepared in accordance with Canadian GAAP. There are no significant differences between U.S. and Canadian GAAP that impact the consolidated statement of cash flows.
                                 
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
Net cash from (used in) operating activities of continuing operations
  $ (143 )   $ (208 )   $ (301 )   $ (451 )
Net cash from (used in) investing activities of continuing operations
    92       (106 )     (289 )     (62 )
Net cash from (used in) financing activities of continuing operations
    (8 )     (31 )     (45 )     (108 )
Effect of foreign exchange rate changes on cash and cash equivalents
    (1 )     3       (86 )     (6 )
                         
Net cash from (used in) continuing operations
    (60 )     (342 )     (721 )     (627 )
Net cash from (used in) operating activities of discontinued operations
    (1 )     24       33       21  
                         
Net increase (decrease) in cash and cash equivalents
    (61 )     (318 )     (688 )     (606 )
Cash and cash equivalents at beginning of period
    3,063       3,713       3,690       4,001  
                         
Cash and cash equivalents at end of period
  $ 3,002     $ 3,395     $ 3,002     $ 3,395  
                         
          (f) Other
Under U.S. GAAP, translation adjustments for self-sustaining subsidiaries are reported as a component of other comprehensive income (loss), whereas, under Canadian GAAP, these translation adjustments are classified as foreign currency translation adjustment, also a component of shareholders’ equity.
Under both U.S. and Canadian GAAP, stock option expense should be recognized if an employee is eligible for retirement at the date of the grant and is eligible for acceleration of vesting upon retirement. U.S. GAAP has provided relief from this interpretation until January 1, 2006, the effective date of SFAS 123R. Nortel has made an adjustment of $21(including $10 related to prior periods) for stock option expense under Canadian GAAP in the three months ended September 30, 2005.
          (g) Joint ventures
Nortel has a number of joint ventures with other parties. Under U.S. GAAP, investments in joint ventures are accounted for under the equity method, whereas, under Canadian GAAP, the proportionate consolidation method is used. The difference in accounting does not impact net earnings (loss), but does impact certain other consolidated financial statement items.
          (h) Pension and other post-retirement benefits
Under U.S. GAAP, a minimum pension liability adjustment must be recognized in the amount of the excess of the unfunded accumulated benefit obligation over the recorded pension benefit liability. An offsetting intangible pension asset is recorded equal to the unrecognized prior service costs, with any difference recorded in accumulated other comprehensive loss. No such adjustments are required under Canadian GAAP.

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
          (i) Accounting changes
(i)     Derivative accounting
Effective January 1, 2004, Nortel adopted CICA Accounting Guideline (“AcG”) 13, “Hedging Relationships” (“AcG-13”), which establishes specific criteria for derivatives to qualify for hedge accounting. Nortel had been previously applying these criteria under U.S. GAAP. Therefore, there was no impact on adoption of AcG-13.
Concurrent with the adoption of AcG-13, Nortel also adopted the CICA’s Emerging Issues Committee (“EIC”) 128, “Accounting for Trading, Speculative or Non-Hedging Derivative Financial Instruments” (“EIC 128”), which requires that certain freestanding derivative instruments that give rise to a financial asset or liability, and do not qualify for hedge accounting under AcG-13, be recognized on the balance sheet and measured at fair value, with changes in fair value recognized in earnings (loss) in each period. As a result of the adoption of EIC 128, certain warrants, which had been previously recorded at cost under Canadian GAAP, are required to be recorded at fair value consistent with U.S. GAAP. The impact of this accounting change, which has been recorded prospectively as at January 1, 2004, was an increase to investments and other income of $23 for the nine months ended September 30, 2004.
(ii)     Determining whether an arrangement contains a lease
In December 2004, the EIC issued abstract 150, “Determining Whether an Arrangement Contains a Lease” (“EIC 150”). EIC 150 provides guidance on how to determine whether an arrangement contains a lease that is within the scope of CICA Handbook Section 3065, “Leases”. The guidance in EIC 150 is based on whether the arrangement conveys to the purchaser the right to use a tangible asset, and is effective for Nortel for arrangements entered into or modified after January 1, 2005. Equivalent guidance in U.S. GAAP has already been adopted by Nortel. The adoption of EIC 150 did not have any material impact on Nortel’s results of operations and financial condition.
(iii)     Financial instruments — presentation and disclosure
In January 2004, the CICA issued amendments to CICA Handbook Section 3860, “Financial Instruments — Presentation and Disclosure” (“Section 3860”), to require obligations that must or may be settled at the issuer’s option, by a variable number of the issuer’s own equity instruments to be presented as liabilities. Thus, securities issued by an enterprise that give the issuer unrestricted rights to settle the principal amount in cash or in the equivalent value of its own equity instruments will no longer be presented as equity. The amendments to Section 3860 are applicable to Nortel beginning January 1, 2005 on a retroactive basis. The adoption of the amendments to Section 3860 did not have any material impact on Nortel’s results of operations and financial condition.
(iv)     Accounting by a customer (including a reseller) for certain consideration received from a vendor
In January 2005, the EIC issued amended abstract 144, “Accounting by a Customer (including a Reseller) for Certain Consideration Received from a Vendor”. The amendment is effective retroactively for periods commencing on or after February 15, 2005. The amendment requires companies to recognize the benefit of non-discretionary rebates for achieving specified cumulative purchasing levels as a reduction of the cost of purchases over the relevant period, provided the rebate is probable and reasonably estimable. Otherwise, the rebates would be recognized as purchasing milestones are achieved. The adoption of the new amendment did not have a material impact on Nortel’s results of operations and financial condition.
          (j) Recently issued accounting pronouncements
In January 2005, the CICA issued Section 3855, “Financial Instruments — Recognition and Measurement”, Section 1530, “Comprehensive Income”, and Section 3865, “Hedges”. The new standards will be effective for interim and annual financial statements commencing in 2007. Most significantly for Nortel under Canadian GAAP, the new standards will introduce comprehensive income to Canadian GAAP, a concept Nortel has been following under U.S. GAAP. Foreign exchange gains and losses on the translation of the financial statements of self-sustaining subsidiaries previously recorded in a separate section of shareholders’ equity will be presented in comprehensive income. Also, mark-to-market adjustments on available for sale investments will be recorded in comprehensive

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
income. Derivative financial instruments will be recorded in the balance sheet at fair value and the changes in fair value of derivatives designated as cash flow hedges will be reported in comprehensive income.
20. Supplemental consolidating financial information
As of September 30, 2005, and as a result of NNL’s credit ratings, various liens, pledges and guarantees were effective under security agreements entered into by NNL and various of its subsidiaries (see note 9).
The security agreements were originally entered into in connection with the $1,510 December 2001 364-day credit facilities (which expired on December 13, 2002). The security became effective April 4, 2002, following Moody’s Investors Service, Inc. (“Moody’s”) downgrade of NNL’s senior long-term debt rating to below investment grade, in respect of the then existing credit facilities including the Five Year Facilities. Consequently, on April 4, 2002 and in accordance with the negative pledge covenants in the indentures for all Nortel’s outstanding public debt securities, all such public debt securities became, under the terms of the security agreements, secured equally and ratably with the obligations under NNL’s and NNI’s then existing credit facilities. NNL’s obligations under the EDC Support Facility became secured on an equal and ratable basis under the security agreements on February 14, 2003.
As of September 30, 2005, the security agreements pledge substantially all of the assets of NNL located in the U.S. and Canada and those of most of its U.S. and Canadian subsidiaries, including the shares of certain of NNL’s U.S. and Canadian subsidiaries, in favor of EDC and the holders of Nortel’s and NNL’s outstanding public debt securities (see note 9). In addition, certain of NNL’s wholly owned subsidiaries, including NNI, most of NNL’s Canadian subsidiaries, Nortel Networks (Asia) Limited, Nortel Networks (Ireland) Limited and Nortel Networks U.K. Limited, have guaranteed NNL’s obligations under the EDC Support Facility and Nortel’s and NNL’s outstanding public debt securities (the “Guarantor Subsidiaries”). Non-guarantor subsidiaries (the “Non-Guarantor Subsidiaries”) represented either wholly owned subsidiaries of NNL whose shares were pledged, or were the remaining subsidiaries of NNL which did not provide liens, pledges or guarantees.
If NNL’s senior long-term debt rating by Moody’s returns to Baa2 (with a stable outlook) and its rating by Standard & Poor’s returns to BBB (with a stable outlook), the security and guarantees will be released in full. If the EDC Support Facility is terminated, or expires, the security and guarantees will also be released in full. NNL may provide EDC with cash collateral in an amount equal to the total amount of its outstanding obligations and undrawn commitments and expenses under the EDC Support Facility (or any other alternative collateral or arrangements acceptable to EDC) in lieu of the security provided under the security agreements. Accordingly, if the EDC Support Facility is secured by cash or other alternate collateral or arrangements acceptable to EDC, the security and guarantees will also be released in full. For additional information related to the recent amendment of the EDC Support Facility see note 18.
The following supplemental consolidating financial data illustrates, in separate columns, the composition (as described below) of Nortel Networks Corporation, NNL, the Guarantor Subsidiaries, the Non-Guarantor Subsidiaries, eliminations and the consolidated total for the three and nine months ended September 30, 2005 and 2004 and as of September 30, 2005 and December 31, 2004, respectively.
Investments in subsidiaries are accounted for using the equity method for purposes of the supplemental consolidating financial data. Net earnings (loss) of subsidiaries are therefore reflected in the investment account and net earnings (loss). The principal elimination entries eliminate investments in subsidiaries and intercompany balances and transactions. The financial data may not necessarily be indicative of the results of operations or financial position had the subsidiaries been operating as independent entities and are not indicative of future performance.
Nortel records intercompany transfer pricing and cost sharing adjustments in accordance with the methodologies proposed in its APA requests and recognizes transfer pricing adjustments as they are determined and invoiced (see note 6). Costs and revenues are reported within the entity in which they originated until transferred in accordance with intercompany billing practices.
In particular, in the nine months ended September 30, 2005 Nortel recorded transfer pricing adjustments which reduced the revenue and net earnings (loss) of the Guarantor subsidiaries by approximately $500, primarily in the second quarter of 2005, (nil for the first half of 2004), with a corresponding increase in the revenue and no impact to the net earnings (loss) of Nortel Networks Limited because of the impact of equity accounting. These adjustments

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
represent the impact of revisions to prior period transfer pricing adjustments. These adjustments are eliminated on consolidation.
Supplemental Consolidating Statements of Operations for the three months ended September 30, 2005:
                                                   
    Nortel   Nortel       Non-        
    Networks   Networks   Guarantor   Guarantor        
    Corporation   Limited   Subsidiaries   Subsidiaries   Eliminations   Total
                         
    (Millions of U.S. dollars)
Revenues
  $     $ 953     $ 1,827     $ 907     $ (1,032 )   $ 2,655  
Cost of revenues
          418       1,364       898       (1,032 )     1,648  
                                     
Gross profit
          535       463       9             1,007  
Selling, general and administrative expense
          150       310       112             572  
Research and development expense
          192       189       68             449  
Amortization of intangibles
                      6             6  
Special charges
          8       24       5             37  
(Gain) loss on sale of businesses and assets
          (2 )     4       2             4  
                                     
Operating earnings (loss)
          187       (64 )     (184 )           (61 )
Other income (expense) — net
          68       9       (11 )           66  
Interest expense
                                               
 
Long-term debt
    (22 )     (22 )     (3 )     (8 )           (55 )
 
Other
                (16 )     14             (2 )
                                     
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net earnings (loss) of associated companies
    (22 )     233       (74 )     (189 )           (52 )
Income tax benefit (expense)
          (75 )     (32 )     67             (40 )
                                     
      (22 )     158       (106 )     (122 )           (92 )
Minority interests — net of tax
                      (6 )     (9 )     (15 )
Equity in net earnings (loss) of associated companies — net of tax
    (84 )     (236 )     130       36       155       1  
                                     
Net earnings (loss) from continuing operations
    (106 )     (78 )     24       (92 )     146       (106 )
Net earnings (loss) from discontinued operations — net of tax
    1       1                   (1 )     1  
                                     
Net earnings (loss)
  $ (105 )   $ (77 )   $ 24     $ (92 )   $ 145     $ (105 )
                                     

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Supplemental Consolidating Statements of Operations for the three months ended September 30, 2004:
                                                   
    Nortel   Nortel       Non-        
    Networks   Networks   Guarantor   Guarantor        
    Corporation   Limited   Subsidiaries   Subsidiaries   Eliminations   Total
                         
    (Millions of U.S. dollars)
Revenues
  $     $ 779     $ 1,592     $ 709     $ (901 )   $ 2,179  
Cost of revenues
          640       1,133       521       (901 )     1,393  
                                     
Gross profit
          139       459       188             786  
Selling, general and administrative expense
          114       312       86             512  
Research and development expense
          174       258       69             501  
Amortization of intangibles
                      2             2  
Special charges
          4       82       7             93  
(Gain) loss on sale of businesses and assets
          (2 )     (37 )                 (39 )
                                     
Operating earnings (loss)
          (151 )     (156 )     24             (283 )
Other income (expense) — net
    (7 )     17       59       (25 )           44  
Interest expense
                                               
 
Long-term debt
    (21 )     (16 )           (8 )           (45 )
 
Other
          (2 )     (13 )     12             (3 )
                                     
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net earnings (loss) of associated companies
    (28 )     (152 )     (110 )     3             (287 )
Income tax benefit (expense)
          2       9       19             30  
                                     
      (28 )     (150 )     (101 )     22             (257 )
Minority interests — net of tax
                      1       (8 )     (7 )
Equity in net earnings (loss) of associated companies — net of tax
    (236 )     (73 )     (1 )     19       291        
                                     
Net earnings (loss) from continuing operations
    (264 )     (223 )     (102 )     42       283       (264 )
Net earnings (loss) from discontinued operations — net of tax
    5       5       3             (8 )     5  
                                     
Net earnings (loss)
  $ (259 )   $ (218 )   $ (99 )   $ 42     $ 275     $ (259 )
                                     

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Supplemental Consolidating Statements of Operations for the nine months ended September 30, 2005:
                                                   
    Nortel   Nortel       Non-        
    Networks   Networks   Guarantor   Guarantor        
    Corporation   Limited   Subsidiaries   Subsidiaries   Eliminations   Total
                         
    (Millions of U.S. dollars)
Revenues
  $     $ 2,859     $ 5,370     $ 2,891     $ (3,074 )   $ 8,046  
Cost of revenues
          1,365       3,996       2,460       (3,074 )     4,747  
                                     
Gross profit
          1,494       1,374       431             3,299  
Selling, general and administrative expense
          397       977       351             1,725  
Research and development expense
          585       603       214             1,402  
Amortization of intangibles
                      10             10  
Special charges
          10       115       23             148  
(Gain) loss on sale of businesses and assets
          31       8       2             41  
                                     
Operating earnings (loss)
          471       (329 )     (169 )           (27 )
Other income (expense) — net
          89       89       (8 )           170  
Interest expense
                                               
 
Long-term debt
    (64 )     (61 )     (9 )     (22 )           (156 )
 
Other
          (7 )     (39 )     40             (6 )
                                     
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net earnings (loss) of associated companies
    (64 )     492       (288 )     (159 )           (19 )
Income tax benefit (expense)
          (126 )     (47 )     124             (49 )
                                     
      (64 )     366       (335 )     (35 )           (68 )
Minority interests — net of tax
                      (18 )     (28 )     (46 )
Equity in net earnings (loss) of associated companies — net of tax
    (47 )     (395 )     302       86       57       3  
                                     
Net earnings (loss) from continuing operations
    (111 )     (29 )     (33 )     33       29       (111 )
Net earnings (loss) from discontinued operations — net of tax
    2       2                   (2 )     2  
                                     
Net earnings (loss)
  $ (109 )   $ (27 )   $ (33 )   $ 33     $ 27     $ (109 )
                                     

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Table of Contents

NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Supplemental Consolidating Statements of Operations for the nine months ended September 30, 2004:
                                                   
    Nortel   Nortel       Non-        
    Networks   Networks   Guarantor   Guarantor        
    Corporation   Limited   Subsidiaries   Subsidiaries   Eliminations   Total
                         
    (Millions of U.S. dollars)
Revenues
  $     $ 2,443     $ 5,073     $ 2,533     $ (2,836 )   $ 7,213  
Cost of revenues
          1,648       3,488       2,019       (2,836 )     4,319  
                                     
Gross profit
          795       1,585       514             2,894  
Selling, general and administrative expense
          327       956       313             1,596  
Research and development expense
          598       649       218             1,465  
Amortization of intangibles
                      7             7  
Special charges
          8       78       13             99  
(Gain) loss on sale of businesses and assets
          (2 )     (38 )     (74 )           (114 )
                                     
Operating earnings (loss)
          (136 )     (60 )     37             (159 )
Other income (expense) — net
    (8 )     32       140       (52 )           112  
Interest expense
                                               
 
Long-term debt
    (63 )     (48 )     (1 )     (20 )           (132 )
 
Other
          (3 )     (50 )     35             (18 )
                                     
Earnings (loss) from continuing operations before income taxes, minority interests and equity in net earnings (loss) of associated companies
    (71 )     (155 )     29                   (197 )
Income tax benefit (expense)
          48       (17 )     1             32  
                                     
      (71 )     (107 )     12       1             (165 )
Minority interests — net of tax
                      (5 )     (24 )     (29 )
Equity in net earnings (loss) of associated companies — net of tax
    (125 )     48       173       13       (111 )     (2 )
                                     
Net earnings (loss) from continuing operations
    (196 )     (59 )     185       9       (135 )     (196 )
Net earnings (loss) from discontinued operations — net of tax
    12       12       7             (19 )     12  
                                     
Net earnings (loss)
  $ (184 )   $ (47 )   $ 192     $ 9     $ (154 )   $ (184 )
                                     

50


Table of Contents

NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited) — (Continued)
Supplemental Consolidating Balance Sheets as of September 30, 2005:
<
                                                   
    Nortel   Nortel       Non-        
    Networks   Networks   Guarantor   Guarantor        
    Corporation   Limited   Subsidiaries   Subsidiaries   Eliminations   Total
                         
    (Millions of U.S. dollars)
ASSETS
Current assets
                                               
 
Cash and cash equivalents
  $ 72     $ 57     $ 1,817     $ 1,051     $     $ 2,997  
 
Restricted cash and cash equivalents
          45       20       8             73  
 
Accounts receivable — net
          617       1,176       823             2,616  
 
Intercompany/related party accounts receivable
    49       608       975       1,001       (2,633 )      
 
Inventories — net
          229       550       453             1,232  
 
Deferred income taxes — net
          47       324                   371  
 
Other current assets
          92       227       261             580  
                                     
Total current assets
    121       1,695       5,089       3,597       (2,633 )     7,869  
Investments
    5,706       1,795       (6,346 )     632       (1,621 )     166  
Intercompany advances
          426       1,063       1,695       (3,184 )      
Plant and equipment — net
          474       730       371             1,575  
Goodwill
                1,907       612             2,519  
Intangible assets — net
          36       1       113             150  
Deferred income taxes — net
          1,883       1,645       78             3,606  
Other assets
    19       (50 )     256       354             579  
                                     
Total assets
  $ 5,846     $ 6,259     $ 4,345     $ 7,452     $ (7,438 )   $ 16,464  
                                     
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
                                               
 
Trade and other accounts payable
  $ 2     $ 452     $ 517     $ 11     $     $ 982  
 
Intercompany/related party accounts payable
    244       (3,746 )     3,528       2,609       (2,633 )     2  
 
Payroll and benefit-related liabilities
          66       333       137             536  
 
Contractual liabilities
          78       138       180