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Nortel Networks 10-Q 2007
e10vq
Table of Contents

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
     
         þ     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)      
       OF THE SECURITIES EXCHANGE ACT OF 1934
     
 
For the Quarterly Period Ended September 30, 2007
 
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
 
 
 
 
     
Canada
  98-0535482
(State or Other Jurisdiction of
Incorporation or Organization)
  (I.R.S. Employer
Identification No.)
     
195 The West Mall
  M9C 5K1
Toronto, Ontario, Canada
  (Zip Code)
(Address of Principal Executive Offices)
   
 
 
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 such filing requirements for the past 90 days.
 
Yes þ     No o
 
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
 
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 of October 29, 2007
 
437,040,670 shares of common stock without nominal or par value
 


 

 
 
             
        PAGE
 
  Condensed Consolidated Financial Statements (unaudited)     1  
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     47  
  Quantitative and Qualitative Disclosures About Market Risk     88  
  Controls and Procedures     89  
 
PART II
OTHER INFORMATION
  Legal Proceedings     93  
  Risk Factors     94  
  Unregistered Sales of Equity Securities and Use of Proceeds     95  
  Exhibits     96  
    97  
 EX-10.1
 EX-10.2
 EX-10.3
 EX-12
 EX-31.1
 EX-31.2
 EX-32
 
All dollar amounts in this document are in United States Dollars unless otherwise stated.
 
NORTEL, NORTEL (Logo), NORTEL NETWORKS, The GLOBEMARK, NT, and NORTEL GOVERNMENT SOLUTIONS are trademarks of Nortel Networks.
 
MOODY’S is a trademark of Moody’s Investors Service, Inc.
 
NYSE is a trademark of the New York Stock Exchange, Inc.
 
SAP is a trademark of SAP AG.
 
S&P and STANDARD & POOR’S are trademarks of The McGraw-Hill Companies, Inc.
 
All other trademarks are the property of the respective owners.


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PART I
 
 
ITEM 1.   CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
NORTEL NETWORKS CORPORATION
 
Condensed Consolidated Statements of Operations (unaudited)
(Millions of U.S. Dollars, except per share amounts)
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
          As restated *           As restated *  
 
Revenues:
                               
Products
  $ 2,378     $ 2,595     $ 6,793     $ 7,142  
Services
    327       331       957       954  
                                 
Total revenues
    2,705       2,926       7,750       8,096  
                                 
Cost of revenues:
                               
Products
    1,384       1,614       4,024       4,445  
Services
    158       189       509       535  
                                 
Total cost of revenues
    1,542       1,803       4,533       4,980  
                                 
Gross profit
    1,163       1,123       3,217       3,116  
Selling, general and administrative expense
    613       585       1,812       1,809  
Research and development expense
    416       474       1,248       1,451  
Amortization of intangible assets
    12       8       37       19  
In-process research and development expense
                      16  
Special charges
    56       22       172       76  
Loss (gain) on sales of businesses and assets
    3       (15 )     (8 )     (42 )
Shareholder litigation settlement expense (recovery)
          38       (54 )     (453 )
Regulatory investigation expense
                35        
                                 
Operating earnings (loss)
    63       11       (25 )     240  
Other income — net
    163       58       361       178  
Interest expense
                               
Long-term debt
    (102 )     (85 )     (278 )     (188 )
Other
    (5 )     (20 )     (23 )     (55 )
                                 
Earnings (loss) from operations before income taxes, minority interests and equity in net earnings (loss) of associated companies
    119       (36 )     35       175  
Income tax expense
    (50 )     (15 )     (74 )     (69 )
                                 
      69       (51 )     (39 )     106  
Minority interests — net of tax
    (43 )     (11 )     (76 )     (1 )
Equity in net earnings (loss) of associated companies — net of tax
    1       (1 )     2       (6 )
                                 
Net earnings (loss) before cumulative effect of accounting change
    27       (63 )     (113 )     99  
Cumulative effect of accounting change — net of tax (note 2)
                      9  
                                 
Net earnings (loss)
  $ 27     $ (63 )   $ (113 )   $ 108  
                                 
Basic and diluted earnings (loss) per common share
  $ 0.05     $ (0.14 )   $ (0.24 )   $ 0.25  
                                 
 
 
* See note 3
 
The accompanying notes are an integral part of these condensed consolidated financial statements


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NORTEL NETWORKS CORPORATION
 
Condensed Consolidated Balance Sheets (unaudited)
(Millions of U.S. Dollars, except for share amounts)
 
                 
    September 30,
    December 31,
 
    2007     2006  
 
ASSETS
Current assets
               
Cash and cash equivalents
  $ 3,128     $ 3,492  
Restricted cash and cash equivalents
    64       639  
Accounts receivable — net
    2,538       2,785  
Inventories — net
    2,094       1,989  
Deferred income taxes — net
    472       276  
Other current assets
    598       742  
                 
Total current assets
    8,894       9,923  
Investments
    200       204  
Plant and equipment — net
    1,533       1,530  
Goodwill
    2,537       2,529  
Intangible assets — net
    224       241  
Deferred income taxes — net
    3,982       3,863  
Other assets
    545       689  
                 
Total assets
  $ 17,915     $ 18,979  
                 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
               
Trade and other accounts payable
  $ 1,077     $ 1,125  
Payroll and benefit-related liabilities
    563       640  
Contractual liabilities
    266       243  
Restructuring liabilities
    121       97  
Other accrued liabilities (note 4)
    3,757       4,603  
Long-term debt due within one year
    697       18  
                 
Total current liabilities
    6,481       6,726  
Long-term debt
    3,799       4,446  
Deferred income taxes — net
    16       97  
Other liabilities (note 4)
    3,890       5,810  
                 
Total liabilities
    14,186       17,079  
                 
Minority interests in subsidiary companies
    822       779  
Guarantees, commitments and contingencies (notes 11, 12 and 17)
               
 
SHAREHOLDERS’ EQUITY
                 
Common shares, without par value — Authorized shares: unlimited; Issued and outstanding shares: 437,328,768 as of September 30, 2007 and 433,934,747 as of December 31, 2006
    34,027       33,938  
Additional paid-in capital
    5,008       3,378  
Accumulated deficit
    (35,688 )     (35,574 )
Accumulated other comprehensive loss
    (440 )     (621 )
                 
Total shareholders’ equity
    2,907       1,121  
                 
Total liabilities and shareholders’ equity
  $ 17,915     $ 18,979  
                 
 
The accompanying notes are an integral part of these condensed consolidated financial statements


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NORTEL NETWORKS CORPORATION
 
Condensed Consolidated Statements of Cash Flows (unaudited)
(Millions of U.S. Dollars)
 
                 
    Nine Months Ended September 30,  
    2007     2006  
          As restated *  
 
Cash flows from (used in) operating activities
               
Net earnings (loss)
  $ (113 )   $ 108  
Adjustments to reconcile net earnings (loss) to net cash from (used in) operating activities, net of effects from acquisitions and divestitures of businesses:
               
Amortization and depreciation
    231       222  
In-process research and development expense
          16  
Non-cash portion of shareholder litigation settlement recovery
    (54 )     (453 )
Non-cash portion of special charges
    3       2  
Equity in net loss (earnings) of associated companies — net of tax
    (2 )     6  
Share-based compensation expense
    86       83  
Deferred income taxes
    (8 )     73  
Cumulative effect of accounting change — net of tax
          (9 )
Pension and other accruals
    200       269  
Gain on sales and write downs of investments, businesses and assets — net
    (3 )     (36 )
Minority interests
    76       1  
Other — net
    (187 )     248  
Changes in operating assets and liabilities
               
Other
    (464 )     (813 )
Global Class Action Settlement — net
    (585 )      
                 
Net cash used in operating activities
    (820 )     (283 )
                 
Cash flows from (used in) investing activities
               
Expenditures for plant and equipment
    (140 )     (260 )
Proceeds on disposals of plant and equipment
    89       125  
Change in restricted cash and cash equivalents
    575       (546 )
Acquisitions of investments and businesses — net of cash acquired
    (81 )     (134 )
Proceeds from the sales of investments and businesses and assets — net
    (29 )     199  
                 
Net cash from (used in) investing activities
    414       (616 )
                 
Cash flows from (used in) financing activities
               
Dividends paid by subsidiaries to minority interests
    (35 )     (46 )
Increase in notes payable
    47       88  
Decrease in notes payable
    (52 )     (75 )
Increase in loan payable
          3,300  
Proceeds from issuance of long-term debt
    1,150        
Repayments of long-term debt
    (1,125 )     (2,725 )
Debt issuance costs
    (23 )     (42 )
Decrease in capital leases payable
    (18 )     (12 )
Issuance of common shares
    10       1  
                 
Net cash from (used in) financing activities
    (46 )     489  
                 
Effect of foreign exchange rate changes on cash and cash equivalents
    88       59  
                 
Net decrease in cash and cash equivalents
    (364 )     (351 )
Cash and cash equivalents at beginning of period
    3,492       2,951  
                 
Cash and cash equivalents at end of period
  $ 3,128     $ 2,600  
                 
 
 
* See note 3
 
The accompanying notes are an integral part of these condensed consolidated financial statements


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited)
(Millions of U.S. Dollars, except per share amounts, unless otherwise stated)
 
1.   Significant accounting policies
 
 
The unaudited condensed 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 condensed 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, 2006 except as discussed in note 2. The condensed consolidated balance sheet as of December 31, 2006 is derived from the December 31, 2006 audited financial statements. Although Nortel is headquartered in Canada, the unaudited condensed consolidated financial statements are expressed in U.S. Dollars as the majority 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 unaudited condensed 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 and depreciation, asset valuations, impairment assessments, employee benefits including pensions, taxes and related valuation allowances and provisions, restructuring and other provisions, share-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, 2007 are not necessarily indicative of financial results for the full year. The unaudited condensed consolidated financial statements should be read in conjunction with Nortel’s Annual Report on Form 10-K for the year ended December 31, 2006 filed with the SEC and Canadian securities regulatory authorities (the “2006 Annual Report”).
 
On November 6, 2006, Nortel’s Board of Directors approved a consolidation of Nortel’s outstanding common shares at a ratio of 1 consolidated share for 10 pre-consolidated shares in accordance with the authority given to the Board by Nortel’s shareholders at its annual and special meeting of shareholders held on June 29, 2006. Nortel’s common shares began trading on the Toronto Stock Exchange (“TSX”) and New York Stock Exchange (“NYSE”) on a consolidated basis on December 1, 2006. All references to share and per share data for all periods presented in the unaudited condensed consolidated financial statements have, where necessary, been adjusted to give effect to the 1 for 10 common share consolidation.
 
 
Certain 2006 figures in the unaudited condensed consolidated financial statements have been reclassified to conform to the 2007 presentation and certain 2006 figures have been restated as set out in note 3.
 
 
In February 2007, the United States Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 allows the irrevocable election of fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities and other items on an instrument-by-instrument basis. Changes in fair value would be reflected in earnings as they occur. The objective of SFAS 159 is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. For Nortel, SFAS 159 is effective as of January 1, 2008. Nortel is currently evaluating whether it will elect to apply the fair value option for any of its eligible financial instruments and other items.
 
In June 2007, the FASB Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 06-11, “Accounting for Income Tax Benefits on Dividends on Share-Based Payment Awards” (“EITF 06-11”). EITF 06-11 provides accounting


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
guidance on how to recognize the realized tax benefits associated with the payment of dividends under a share-based payment arrangement. EITF 06-11 requires that the realized tax benefits associated with dividends on unvested share-based payments be charged to equity as an increase in additional paid-in capital and included in the pool of excess tax benefits available to absorb potential future tax deficiencies on share-based payment awards. Nortel will adopt the provisions of EITF 06-11 on January 1, 2008. The adoption of EITF 06-11 is not expected to have a material impact on Nortel’s results of operations and financial condition.
 
In June 2007, the EITF reached a consensus on EITF Issue No. 07-3 “Accounting for Advance Payments for Goods or Services to be Received for Use in Future Research and Development Activities” (“EITF 07-3”). EITF 07-3 provides clarification surrounding the accounting for non-refundable research and development advance payments, whereby such payments should be recorded as an asset when the advance payment is made and recognized as an expense when the research and development activities are performed. Nortel will adopt the provisions of EITF 07-3 on January 1, 2008. Nortel is currently assessing the impact of EITF 07-3 on its results of operations and financial condition.
 
In April 2007, the FASB issued FASB Staff Position (“FSP”), FASB Interpretation No. (“FIN”) 39-1, an amendment to paragraph 10 of FIN 39, “Offsetting of Amounts Related to Certain Contracts” (“FSP FIN 39-1”). FSP FIN 39-1 replaces the terms “conditional contract” and “exchange contracts” in FIN 39 with the term “derivative instruments” as defined in SFAS No. 133, “Accounting for Derivatives Instruments and Hedging Activities” (“SFAS 133”). FSP FIN 39-1 also amends FIN 39 to allow for the offsetting of fair value amounts recognized for the right to reclaim cash collateral (a receivable), or the obligation to return cash collateral (a payable) against fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting arrangement. Nortel will adopt the provisions of FSP FIN 39-1 on January 1, 2008. The implementation of FSP FIN 39-1 is not expected to have a material impact on Nortel’s results of operations and financial condition.
 
2.   Accounting changes
 
(a)   Accounting for Certain Hybrid Financial Instruments
 
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment to FASB Statements No. 133 and 140” (“SFAS 155”). SFAS 155 simplifies the accounting for certain hybrid financial instruments containing embedded derivatives. SFAS 155 allows fair value measurement, at the option of the entity, for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation under SFAS 133. In addition, it amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, to eliminate certain restrictions on passive derivative financial instruments that a qualifying special-purpose entity can hold. SFAS 155 is effective for all financial instruments acquired, issued or subject to a re-measurement event occurring after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Pursuant to SFAS 155, Nortel has not elected to measure its hybrid instruments at fair value.
 
(b)   Accounting for Servicing of Financial Assets
 
In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140” (“SFAS 156”). SFAS 156 simplifies the accounting for assets and liabilities arising from loan servicing contracts. SFAS 156 requires that servicing rights be valued initially at fair value and subsequently either (i) accounted for at fair value or (ii) amortized over the period of estimated net servicing income (loss), with an assessment for impairment or increased obligation each reporting period. The adoption of SFAS 156 has not had a material impact on Nortel’s results of operations and financial condition.
 
(c)   Accounting for Uncertainty in Income Taxes
 
In June 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). The interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides accounting guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The evaluation of tax positions under FIN 48 is a two-step process, whereby (1) Nortel determines whether it is more likely than not that the tax positions will be sustained based on the technical merits of the position and (2) for those tax positions that meet the


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
more-likely-than-not recognition threshold, Nortel would recognize the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement with the related tax authority. The adoption of FIN 48 resulted in an increase of $1 to opening accumulated deficit as at January 1, 2007. For additional information, see note 7.
 
On May 2, 2007, the FASB issued FSP FIN 48-1, “Definition of Settlement in FASB Interpretation 48” (“FSP FIN 48-1”). FSP FIN 48-1 amends FIN 48 to provide guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. Nortel applied the provisions of FSP FIN 48-1 effective January 1, 2007. The adoption of FSP FIN 48-1 did not have a material impact on Nortel’s results of operations and financial condition.
 
(d)   Accounting for Sabbatical Leave and Other Similar Benefits
 
In June 2006, the EITF reached a consensus on EITF Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, Accounting for Compensated Absences” (“EITF 06-2”). EITF 06-2 provides clarification surrounding the accounting for benefits in the form of compensated absences, whereby an employee is entitled to paid time off after working for a specified period of time. EITF 06-2 is effective for fiscal years beginning after December 15, 2006. The adoption of EITF 06-2 has not had a material impact on Nortel’s results of operations and financial condition.
 
(e)   How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement
 
In June 2006, the EITF reached a consensus on EITF Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation)” (“EITF 06-3”). EITF 06-3 provides guidance on how taxes directly imposed on revenue-producing transactions between a seller and customer that are remitted to governmental authorities should be presented in the income statement (i.e. gross versus net presentation). Nortel elected to follow its existing policy of net presentation allowed by EITF 06-3 and, therefore, its adoption of EITF 06-3 had no impact on Nortel’s results of operations and financial condition.
 
(f)   Share-Based Payment
 
On January 1, 2006, Nortel adopted SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”). Nortel previously elected to account for 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”. SEC Staff Accounting Bulletin No. 107, “Share-Based Payment” (“SAB 107”), was issued by the SEC in March 2005 and provides supplemental SFAS 123R application guidance based on the views of the SEC. As a result of the adoption of SFAS 123R in the first quarter of 2006, Nortel recorded a gain of $9 or $0.02 per common share on a basic and diluted basis as a cumulative effect of an accounting change. There were no other material impacts on Nortel’s results of operations and financial condition as a result of the adoption of SFAS 123R. For additional disclosure related to SFAS 123R, see note 15.
 
3.   Restatement of previously issued financial statements
 
In the course of the preparation of Nortel’s 2006 annual financial statements, management identified certain errors primarily through discussions with Nortel’s North American pension and post-retirement actuaries and through its ongoing remediation efforts with respect to its material weakness related to revenue recognition and its other previously reported material weaknesses and other internal control deficiencies. As a result, Nortel restated its consolidated balance sheet as of December 31, 2005 and consolidated statements of operations, changes in equity and comprehensive income (loss) and cash flows for each of the years ended December 31, 2005 and 2004 and the first three quarters of 2006. The adjustments related to:
 
  •  Pension and post-retirement benefits errors;
  •  Revenue recognition errors;
  •  A prior year tax error; and
  •  Other errors.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
The following tables present the impact of the adjustments on Nortel’s previously reported unaudited condensed consolidated statements of operations and a summary of the adjustments for the three and nine months ended September 30, 2006. Restated amounts presented herein are consistent with the unaudited quarterly financial data disclosed in Nortel’s 2006 Annual Report.
 
Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006
 
                                                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2006     September 30, 2006  
    As Previously
                As Previously
             
    Reported(a)     Adjustments     As Restated     Reported(a)     Adjustments     As Restated  
 
Revenues:
                                               
Products
  $ 2,640     $ (45 )   $ 2,595     $ 7,141     $ 1     $ 7,142  
Services
    315       16       331       940       14       954  
                                                 
Total revenues
    2,955       (29 )     2,926       8,081       15       8,096  
                                                 
Cost of revenues:
                                               
Products
    1,646       (32 )     1,614       4,453       (8 )     4,445  
Services
    184       5       189       529       6       535  
                                                 
Total cost of revenues
    1,830       (27 )     1,803       4,982       (2 )     4,980  
                                                 
Gross profit
    1,125       (2 )     1,123       3,099       17       3,116  
Selling, general and administrative expense
    605       (20 )     585       1,796       13       1,809  
Research and development expense
    480       (6 )     474       1,447       4       1,451  
Amortization of intangible assets
    8             8       19             19  
In-process research and development expense
                      16             16  
Special charges
    25       (3 )     22       75       1       76  
Gain on sales of businesses and assets
    (16 )     1       (15 )     (41 )     (1 )     (42 )
Shareholder litigation settlement expense (recovery)
    38             38       (453 )           (453 )
                                                 
Operating earnings (loss)
    (15 )     26       11       240             240  
Other income — net
    51       7       58       171       7       178  
Interest expense
                                               
Long-term debt
    (85 )           (85 )     (190 )     2       (188 )
Other
    (20 )           (20 )     (55 )           (55 )
                                                 
Earnings (loss) from operations before income taxes, minority interests and equity in net earnings (loss) of associated companies
    (69 )     33       (36 )     166       9       175  
Income tax expense
    (9 )     (6 )     (15 )     (59 )     (10 )     (69 )
                                                 
      (78 )     27       (51 )     107       (1 )     106  
Minority interests — net of tax
    (19 )     8       (11 )     (9 )     8       (1 )
Equity in net loss of associated companies — net of tax
    (2 )     1       (1 )     (7 )     1       (6 )
                                                 
Net earnings (loss) before cumulative effect of accounting change
    (99 )     36       (63 )     91       8       99  
Cumulative effect of accounting change — net of tax
                      9             9  
                                                 
Net earnings (loss)
  $ (99 )   $ 36     $ (63 )   $ 100     $ 8     $ 108  
                                                 
Basic and diluted earnings (loss) per common share
  $ (0.23 )   $ 0.09     $ (0.14 )   $ 0.23     $ 0.02     $ 0.25  
                                                 
 
 
(a) In the third quarter of 2006, Nortel began disclosing revenues and cost of revenues from both its products and services. Previous quarters have been updated to reflect this presentation change. Additionally, earnings per share amounts have been adjusted to reflect Nortel’s 1 for 10 share consolidation of its common shares effected on December 1, 2006.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
 
 
The following table summarizes the restatement adjustments to revenues, cost of revenues, and net earnings (loss).
 
                                                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2006     September 30, 2006  
          Cost of
    Net
          Cost of
    Net
 
    Revenues     Revenues     Loss     Revenues     Revenues     Earnings  
 
As previously reported
  $ 2,955     $ 1,830     $ (99 )   $ 8,081     $ 4,982     $ 100  
Adjustments:
                                               
Pension and post-retirement benefits errors
          1       (2 )           7       (18 )
Revenue recognition errors
    (29 )     (4 )     (22 )     15       (6 )     17  
Other errors
          (24 )     60             (3 )     9  
                                                 
As restated
  $ 2,926     $ 1,803     $ (63 )   $ 8,096     $ 4,980     $ 108  
                                                 
 
 
As a result of the previously announced pension plan changes, third party actuarial firms retained by Nortel performed re-measurements of the U.S. and Canadian pension and post-retirement benefit plans in the third quarter of 2006, at which time one of the firms discovered potential errors (generally originating in the late 1990s) in the historical actuarial calculations they had originally performed for the U.S. pension plan assets. Throughout the fourth quarter of 2006 and into 2007, Nortel investigated these potential errors, including initiating a comprehensive review by Nortel and its third party actuaries of each of its significant pension and post-retirement benefit plans.
 
As a result, Nortel determined that the accounting for the U.S. pension plan contained a historical adjustment that overstated the actuarial calculation of the market-related value of assets, resulting in increased pension expense of nil and $10 for the three and nine months ended September 30, 2006, respectively. In addition, Nortel discovered an error in the Canadian pension plan accounting related to the amortization of unrealized gains within the actuarial calculation of the market-related value of assets over a longer period than permitted under SFAS No. 87, “Employers’ Accounting for Pensions”. This error resulted in a decrease of $1 and an increase of $3 in pension expense for the three and nine months ended September 30, 2006, respectively. Additionally, as a result of the comprehensive review, errors were identified in the U.S. post-retirement plan. The actuarial valuation omitted certain U.S. retirees in the calculation of post-retirement benefit obligations resulting in increased post-retirement benefit expense of $3 and $5 for the three and nine months ended September 30, 2006, respectively.
 
The correction of the pension and post-retirement benefits errors, in aggregate, resulted in net increases in pension and post-retirement benefits expense of $2 and $18 for the three and nine months ended September 30, 2006, respectively. The $2 increase in pension and post-retirement benefit expense for the three months ended September 30, 2006 increased cost of revenues, selling, general and administrative (“SG&A”) and research and development (“R&D”) expenses by $1, $1 and nil, respectively. The $18 increase in pension and post-retirement benefits expense for the nine months ended September 30, 2006 increased cost of revenues, and SG&A and R&D expenses by $7, $6 and $5, respectively. As a result of the pension and post-retirement benefits errors, Nortel recorded a cumulative $18 increase to other long-term liabilities as of September 30, 2006.
 
 
As a result of the significant ongoing remedial efforts to address Nortel’s internal control material weaknesses and other deficiencies, throughout 2006 Nortel identified a number of individually immaterial revenue recognition errors it corrected as a result of this restatement, the more individually significant of which are discussed below.
 
Revenue recognition errors related principally to complex arrangements with multiple deliverables in which the timing of revenue recognition was determined to be incorrect. For certain of Nortel’s multiple element arrangements where certain elements such as post-contract customer support (“PCS”), specified upgrade rights and/or non-essential hardware or software products or services remained undelivered, Nortel determined that the undelivered element could not be treated as a separate unit of accounting because fair value could not be established. Accordingly, Nortel should have deferred revenue, and related costs, until the earlier of the point in time that fair value of the undelivered element could be established or all the remaining elements have been delivered. These corrections resulted in increases in revenues of $10


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
and $16 for the three and nine months ended September 30, 2006, respectively. These corrections also resulted in an increase in cost of revenues of $13 and $9 for the three and nine months ended September 30, 2006, respectively.
 
In the third quarter of 2006, Nortel recognized $40 of revenue that had been previously deferred by Nortel’s business venture with LG Electronics Inc. (“LGE”), named LG-Nortel Co. Ltd. (“LG-Nortel”), due to the fact that Nortel believed that it was LG-Nortel’s practice to provide implicit PCS for which they did not have fair value. A subsequent detailed review of the enterprise products sold by LG-Nortel led to the conclusion in the third quarter of 2006 that LG-Nortel did not have a practice of providing implicit PCS for such enterprise products. As a result, revenue should have been recognized upon the delivery of such products. Nortel had previously recorded a cumulative correction of this error in the third quarter of 2006 and, as a result of the restatement, recorded it in the appropriate periods. The correction of this error resulted in decreases of $40 and $10 in revenues for the three and nine months ended September 30, 2006, respectively, and decreases of $17 and $6 in cost of revenues for the three and nine months ended September 30, 2006, respectively. Included in “other errors” are reductions to LGE’s minority interest to reflect its share of the impact of these restatement adjustments.
 
The previous misapplication of American Institute of Certified Public Accountants Statement of Position (“SOP”) 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts”, resulted in errors in revenues recognized in an arrangement between 2003 and the first quarter of 2006. The misapplication related to the calculation of liquidated damages estimated to be incurred as a result of contractual commitments related to network outages. Prior to the second quarter of 2006, Nortel estimated its liquidated damages based on a quarterly network outage estimate. In the second quarter of 2006, Nortel determined that it should have been recognizing product credits based on an estimate of the total expected outages for the arrangement. Nortel had previously corrected the resulting revenue recognition errors in the second quarter of 2006 and, as a result of the restatement, has recorded the correction in the appropriate periods. The corrections resulted in increases in revenues of $5 and $18 for the three and nine months ended September 30, 2006, respectively.
 
In 2004, Nortel entered into a software arrangement where the customer had the right to suspend payments until delivery of certain future products; therefore, the arrangement fee was not fixed or determinable. Pursuant to SOP 97-2, “Software Revenue Recognition”, if at the outset of the arrangement the fee is not fixed or determinable, once all other revenue recognition criteria have been satisfied, revenue should be recognized as payments become due. Previously, the fee was recognized ratably over the term. Due to the lack of a fixed or determinable fee, the amount recognized ratably should have been limited to the amount that was due and payable from the customer. The correction of this error resulted in decreases in revenues and gross profit of $4 and $8 for the three and nine months ended September 30, 2006, respectively.
 
 
As part of the restatement, Nortel identified and corrected several individually immaterial adjustments relating to prior periods that had been previously recorded in the third quarter of 2006. The more significant of these errors identified related to errors in warranty calculations, inventory valuation and other errors. The correction of these errors resulted in a $24 reduction in cost of revenues in the third quarter of 2006, with an offsetting $24 increase in cost of revenues in the second quarter of 2006. The more individually significant errors are discussed below.
 
In the third quarter of 2006, Nortel corrected for royalty payments that should have been accrued in the second quarter of 2006. As part of the restatement, Nortel recorded the royalty payments in the correct period, resulting in a $7 reduction in cost of revenues in the third quarter of 2006 with a corresponding $7 increase in the second quarter of 2006.
 
As part of the restatement, Nortel corrected for various individually immaterial expenses recorded in the third quarter of 2006 which related to the second quarter of 2006. The errors related to invoicing issues by certain suppliers and invoicing cut-off errors, which resulted in delayed recognition of accruals. The correction of these errors resulted in an $18 reduction in SG&A expense in the third quarter of 2006, with an offsetting $18 increase in the second quarter of 2006.
 
As part of the restatement, Nortel corrected for asset impairments that were previously provided for under Nortel’s restructuring plans in the second quarter of 2006 and errors in the timing of accruals for special charges related to Nortel’s 2006 Restructuring Plan. These corrections resulted in a $3 reduction in special charges in the third quarter of 2006, with an offsetting increase in the second quarter of 2006.
 
In the third quarter of 2006, Nortel expensed $4 in R&D costs related to inventory that was incorrectly deferred in the first and second quarters of 2006. As part of this restatement, Nortel recorded this correction in the appropriate period,


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
resulting in a $4 reduction in R&D expense in the third quarter of 2006, with an offsetting increase in the second quarter of 2006.
 
 
The restatement had no impact on the condensed consolidated statements of cash flows for the three and nine months ended September 30, 2006, other than conforming changes to the components of the reconciliation to net cash used in operating activities.
 
4.   Consolidated financial statement details
 
The following tables provide details of selected items presented in the condensed consolidated statements of operations and cash flows, and the condensed consolidated balance sheets. For further information with respect to the accounting policies used in the preparation of the consolidated financial statement details below, refer to the 2006 Annual Report.
 
Consolidated statements of operations
 
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Interest and dividend income
  $ 62     $ 35     $ 177     $ 93  
Loss on sales and write downs of investments
          (7 )     (5 )     (6 )
Currency exchange gains — net
    67       1       136       20  
Other — net
    34       29       53       71  
                                 
Other income — net
  $ 163     $ 58     $ 361     $ 178  
                                 
 
There was no material impact on net earnings (loss) for the three and nine months ended September 30, 2007 or 2006 related to hedges that became ineffective, and cash flow hedges and fair value hedges that were discontinued and accounted for in accordance with SFAS 133. Changes in the fair value of derivative financial instruments that did not meet the criteria for hedge accounting, increased earnings by $16 for the three months ended September 30, 2007.
 
Consolidated balance sheets
 
 
                 
    September 30,
    December 31,
 
    2007     2006  
 
Trade receivables
  $ 2,245     $ 2,464  
Notes receivable
    11       7  
Contracts in process
    371       402  
                 
      2,627       2,873  
Less: provisions for doubtful accounts
    (89 )     (88 )
                 
Accounts receivable — net
  $ 2,538     $ 2,785  
                 


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
 
                 
    September 30,
    December 31,
 
    2007     2006  
 
Raw materials
  $ 636     $ 725  
Work in process
    12       11  
Finished goods
    760       727  
Deferred costs
    1,817       1,952  
                 
      3,225       3,415  
Less: provision for inventories
    (893 )     (1,007 )
                 
Inventories — net
    2,332       2,408  
Less: long-term deferred costs(a)
    (238 )     (419 )
                 
Current inventories — net
  $ 2,094     $ 1,989  
                 
 
 
(a) Long-term portion of deferred costs is included in other assets.
 
 
                 
    September 30,
    December 31,
 
    2007     2006  
 
Prepaid expenses
  $ 166     $ 175  
Income taxes recoverable
    73       64  
Current investments
    103       51  
Other
    256       452  
                 
Other current assets
  $ 598     $ 742  
                 
 
 
Investments included balances of $102 and $97 as of September 30, 2007 and December 31, 2006, respectively, related to long-term investment assets held in an employee benefit trust in Canada, and restricted as to its use in operations by Nortel.
 
 
                 
    September 30,
    December 31,
 
    2007     2006  
 
Cost:
               
Land
  $ 38     $ 35  
Buildings
    1,117       1,185  
Machinery and equipment
    2,148       2,048  
Assets under capital lease
    215       215  
Sale lease-back assets
    94       92  
                 
      3,612       3,575  
                 
Less accumulated depreciation:
               
Buildings
    (382 )     (444 )
Machinery and equipment
    (1,574 )     (1,488 )
Assets under capital lease
    (104 )     (96 )
Sale lease-back assets
    (19 )     (17 )
                 
      (2,079 )     (2,045 )
                 
Plant and equipment — net(a)
  $ 1,533     $ 1,530  
                 
 
 
(a) Includes assets held for sale with a carrying value of $52 as of December 31, 2006, related to owned facilities that were being actively marketed for sale. These assets were written down in previous periods to their estimated fair values less estimated costs to sell. The write downs were included in special charges. Nortel disposed of all the assets held for sale in the second quarter of 2007, with such disposition having no material impact on net earnings (loss). The assets held for sale had gross and net book values of


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
approximately $168 and $56, respectively, as of the date of their disposition. There are no material assets held for sale as of September 30, 2007.
 
 
                                                 
                Metro
                   
    Enterprise
    Carrier
    Ethernet
    Global
             
    Solutions     Networks     Networks     Services     Other     Total  
 
Balance — as of December 31, 2006(a)
  $ 481     $ 144     $ 655     $ 1,078     $ 171     $ 2,529  
Change:
                                               
Additions
                                   
Disposals
                                   
Foreign exchange
    1       2       1       4             8  
Other
                                   
                                                 
Balance — as of September 30, 2007
  $ 482     $ 146     $ 656     $ 1,082     $ 171     $ 2,537  
                                                 
 
 
(a) Opening balances for Enterprise Solutions, Carrier Networks and Metro Ethernet Networks have been decreased by $27, $21 and $113, respectively, and the opening balance for Global Services has been increased by $161, from the amounts previously presented to reflect the reclassification of Nortel’s network implementation services to Global Services, as described in note 5.
 
As a result of a reduction in the 2007 forecasted revenues for Nortel Government Solutions (“NGS”), Nortel concluded that triggering events related to NGS had occurred requiring goodwill impairment tests in the second and third quarters of 2007 in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”. Nortel performed these tests and concluded that there were no impairments related to NGS in these periods.
 
 
                 
    September 30,
    December 31,
 
    2007     2006  
 
Cost
  $ 331     $ 307  
Less: accumulated amortization
    (107 )     (66 )
                 
Intangible assets — net
  $ 224     $ 241  
                 
 
 
                 
    September 30,
    December 31,
 
    2007     2006  
 
Long-term deferred costs
  $ 238     $ 419  
Long-term inventories
    26        
Debt issuance costs
    65       57  
Hedge assets
    54       37  
Financial assets
    64       60  
Other
    98       116  
                 
Other assets
  $ 545     $ 689  
                 


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
 
 
                 
    September 30,
    December 31,
 
    2007     2006  
 
Outsourcing and selling, general and administrative related provisions
  $ 247     $ 400  
Customer deposits
    61       78  
Product related provisions
    86       93  
Warranty provisions (note 11)
    209       217  
Deferred revenue
    1,268       1,127  
Advance billings in excess of revenues recognized to date on contracts(a)
    1,450       1,352  
Miscellaneous taxes
    24       75  
Income taxes payable
    71       72  
Deferred income tax
    17        
Tax uncertainties (note 7)
    20        
Interest payable
    66       114  
Global Class Action Settlement provision (note 17)
          814  
Regulatory investigation provision (note 17)
    35        
Other
    203       261  
                 
Other accrued liabilities
  $ 3,757     $ 4,603  
                 
 
 
(a) Includes amounts which may be recognized beyond one year due to the duration of certain contracts.
 
 
                 
    September 30,
    December 31,
 
    2007     2006  
 
Pension benefit liabilities
  $ 1,883     $ 1,965  
Post-employment and post-retirement benefits liabilities
    878       794  
Restructuring liabilities (note 6)
    182       177  
Deferred revenue
    595       919  
Global Class Action Settlement provision (note 17)
          1,680  
Tax uncertainties (note 7)
    71        
Other long-term provisions
    281       275  
                 
Other liabilities
  $ 3,890     $ 5,810  
                 
 
Consolidated statements of cash flows
 
 
                 
    Nine Months Ended
 
    September 30,  
    2007     2006  
 
Accounts receivable — net
  $ 247     $ 190  
Inventories — net
    (60 )     116  
Deferred costs
    104       (263 )
Income taxes
    2       (51 )
Accounts payable
    (48 )     (282 )
Payroll, accrued and contractual liabilities
    (532 )     (291 )
Deferred revenue
    (181 )     (13 )
Advance billings in excess of revenues recognized to date on contracts
    109       175  
Restructuring liabilities
    23       1  
Other
    (128 )     (395 )
                 
Change in operating assets and liabilities excluding Global Class Action Settlement — net
  $ (464 )   $ (813 )
                 


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
 
                 
    Nine Months Ended
 
    September 30,  
    2007     2006  
 
Cash interest paid
  $ 328     $ 196  
Cash taxes paid
  $ 77     $ 42  
 
 
                 
Extinguishment of Global Class Action Settlement provision through an increase in common shares and additional paid-in capital (note 17)
  $ 1,626     $  —  
 
5.   Segment information
 
 
In the first quarter of 2007, Nortel changed the name of its Mobility and Converged Core Networks segment to Carrier Networks (“CN”). Additionally, revenues from network implementation services consisting of engineering, installation and project management services bundled in customer contracts and previously included with sales in each of its CN, Enterprise Solutions (“ES”) and Metro Ethernet Networks (“MEN”) segments have been reallocated to its Global Services (“GS”) segment for management reporting purposes beginning in 2007. The segments are described below. The amounts reallocated to the GS segment were based primarily on the stated value of the services in the respective bundled customer arrangements. Prior period segment information has been recast to conform to the current segment presentation.
 
  •  CN provides mobility networking solutions using (i) Code Division Multiple Access (“CDMA”) solutions, Global System for Mobile Communication (“GSM”) and Universal Mobile Telecommunication System (“UMTS”) solutions, and Worldwide Interoperability for Microwave Access (“WiMAX”) solutions, and (ii) carrier circuit and packet voice solutions. Mobility networking refers to communications networks that enable end users to be mobile while they send and receive voice and data communications using wireless devices such as cellular telephones, personal digital assistants, laptops and other computing and communications devices. These networks use specialized network access equipment and specialized core networking equipment that enable an end user to be connected and identified when not in a fixed location and to roam globally. In addition, Nortel’s carrier circuit and packet voice solutions provide a broad range of voice solutions to its service provider customers for business and residential subscribers, traditional, full featured voice services as well as internet-based voice and multimedia communications services using either circuit or packet-based switching technologies. These service provider customers include local and long distance telephone companies, wireless service providers, cable operators and other communication service providers. Increasingly, CN addresses customers who want to provide services across both wireless as well as wired devices.
 
  •  ES provides solutions to enterprise customers using (i) enterprise circuit and packet voice solutions, (ii) data networking and security solutions, which supply data, voice and multi-media communications solutions, and (iii) software solutions for multi-media messaging, conferencing and call centers. Nortel’s solutions for enterprises are used to build new networks and transform their existing communications networks into packet-based networks supporting data, voice and multi-media communications. Nortel’s ES customers consist of a broad range of enterprises around the world, including large businesses at their headquarters, data centers, call centers and branch offices, small and medium-size businesses and home offices, as well as government agencies, educational and other institutions and utility organizations.
 
  •  GS provides a broad range of services to address the requirements of Nortel’s carrier and enterprise customers throughout the entire lifecycle of their networks. The GS portfolio is organized into four main service product groups: (i) network implementation services, including network integration, planning, installation, optimization and security services, (ii) network support services, including technical support, hardware maintenance, equipment spares logistics and on-site engineers, (iii) network managed services, including services related to the monitoring and management of customer networks and providing a range of network managed service options, and (iv) network application services, including applications development, integration and web services. Nortel’s GS market mirrors that of its carrier and enterprise markets along with a broad range of customers in all geographic regions where


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
  Nortel conducts business, including small and medium-size businesses, large global enterprises and all levels of government.
 
  •  MEN combines Nortel’s optical networking solutions and the carrier portion of its data networking solutions to transform its carrier and large enterprise customers’ networks to be more scalable and reliable for the high speed delivery of diverse multi-media communications services. By combining Nortel’s optical expertise and data knowledge, Nortel creates carrier ethernet solutions that help service providers and enterprises better manage increasing bandwidth demands. Nortel believes that carrier ethernet technology, created by integrating Nortel’s data ethernet capabilities with Nortel’s optical technology expertise is particularly suited to these solutions. In addition to increased capacity and lower cost per bit, Nortel differentiates its MEN solutions on the basis of being able to deliver carrier-grade reliability. The metropolitan, or metro, network is a key focus area as bandwidth demands are increasing as a result of the growth of network based broadcast and on-demand video delivery, wireless “backhaul” for a variety of data services including video, as well as traditional business, internet, and private line and voice services. MEN serves the long haul optical market using common products and technologies from the metro optical market. MEN also serves high performance, mission critical enterprise networks.
 
Other miscellaneous business activities and corporate functions, including the operating results of NGS, do not meet the quantitative criteria to be disclosed separately as reportable segments and have been reported in “Other”. Costs associated with shared services and other corporate costs are allocated to Nortel’s reportable segments based on usage determined generally by headcount. Costs not allocated to the segments are primarily related to Nortel’s corporate compliance, interest attributable to its long-term debt and other non-operational activities, and are included in “Other”.
 
Nortel’s president and chief executive officer (the “CEO”) has been identified as the Chief Operating Decision Maker in assessing segment performance and in deciding how to allocate resources to the segments. The primary financial measures used by the CEO in assessing performance and allocating resources to the segments are management earnings (loss) before income taxes (“Management EBT”) and operating margin. Management EBT is a measure that includes the cost of revenues, SG&A expense, R&D expense, interest expense, other income (expense) — net, minority interests — net of tax and equity in net 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”. Nortel believes that Management EBT is determined in accordance with the measurement principles most consistent with those used by Nortel in measuring the corresponding amounts in its consolidated financial statements. The accounting policies of the reportable segments are the same as those applied to the consolidated financial statements. The CEO does not review asset information on a segmented basis in order to assess performance and allocate resources.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
Segments
 
The following tables set forth information by segment for the following periods:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Revenues
                               
Carrier Networks
  $ 1,080     $ 1,337     $ 3,147     $ 3,670  
Enterprise Solutions
    671       571       1,858       1,504  
Global Services
    540       541       1,482       1,592  
Metro Ethernet Networks
    360       416       1,096       1,142  
                                 
Total reportable segments
    2,651       2,865       7,583       7,908  
Other
    54       61       167       188  
                                 
Total revenues
    2,705       2,926       7,750       8,096  
                                 
Management EBT
                               
Carrier Networks
    145       107       454       246  
Enterprise Solutions
    16       (4 )     21       (81 )
Global Services
    101       89       253       280  
Metro Ethernet Networks
    3       32       (1 )     61  
                                 
Total reportable segments
    265       224       727       506  
Other
    (117 )     (219 )     (584 )     (722 )
                                 
Total Management EBT
    148       5       143       (216 )
Amortization of intangible assets
    (12 )     (8 )     (37 )     (19 )
In-process research and development expense
                      (16 )
Special charges
    (56 )     (22 )     (172 )     (76 )
Gain (loss) on sales of businesses and assets
    (3 )     15       8       42  
Shareholder litigation settlement recovery (expense)
          (38 )     54       453  
Regulatory investigation expense
                (35 )      
Income tax expense
    (50 )     (15 )     (74 )     (69 )
                                 
Net earnings (loss) before cumulative effect of accounting change
  $ 27     $ (63 )   $ (113 )   $ 99  
                                 
 
Nortel had one customer that generated revenues of approximately $275 and $854 or 10% and 11% of total consolidated revenues for the three and nine months ended September 30, 2007, respectively. For the three and nine months ended September 30, 2006, the same customer generated revenues of approximately $320 and $833 or 11% and 10%, respectively, of total consolidated revenues. The revenues from this customer for the three and nine months ended September 30, 2007 and 2006 were generated throughout all of Nortel’s reportable segments.
 
6.   Special charges
 
During the first quarter of 2007, as part of its continuing efforts to increase competitiveness by improving profitability and overall business performance, Nortel announced a restructuring plan that includes workforce reductions of approximately 2,900 positions and shifting an additional 1,000 positions from higher-cost locations to lower-cost locations. The reductions will occur through both voluntary and involuntary terminations. In addition to the workforce reductions, Nortel announced steps to achieve additional cost savings by efficiently managing its various business locations and consolidating real estate requirements. Collectively, these efforts are referred to as the “2007 Restructuring Plan”. Nortel originally estimated the total charges to earnings and cash outlays associated with the 2007 Restructuring Plan would be approximately $390 and $370, respectively, to be incurred over fiscal 2007 and 2008. As a result of higher voluntary terminations and redeployment of employees, Nortel now expects total charges to earnings and cash outlays to be approximately $350 and $330, respectively, to be incurred over fiscal 2007 and 2008. Nortel currently expects that workforce reductions and shifting of positions will account for $260 of the estimated expense, and $90 will relate to real


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
estate consolidation. Approximately $144 of the total charges relating to the 2007 Restructuring Plan have been incurred during the nine months ended September 30, 2007.
 
During the second quarter of 2006, in an effort to increase competitiveness by improving profitability and overall business performance, Nortel announced a restructuring plan that included workforce reductions of approximately 1,900 employees (the “2006 Restructuring Plan”). The workforce reductions were expected to include approximately 350 middle management positions throughout Nortel, with the balance of the reductions to occur primarily in the U.S. and Canada and span all of Nortel’s segments. Nortel currently estimates that the workforce reduction, which includes both voluntary and involuntary reductions, will be 1,750 positions compared to the original estimate of 1,900 employees. The change in the estimated workforce reduction is primarily due to a reduction in the number of affected middle management positions. Nortel originally estimated the total charges to earnings and cash outlays associated with the 2006 Restructuring Plan to be approximately $100, of which $86 had been incurred as at September 30, 2007 since the inception of the 2006 Restructuring Plan. Nortel currently estimates the total charges to earnings and cash to be approximately $91, with the remaining $5 expected to be incurred in the remainder of 2007.
 
During 2004 and 2001, Nortel implemented work plans to streamline operations through workforce reductions and real estate optimization strategies (the “2004 Restructuring Plan” and the “2001 Restructuring Plan”). Substantially all of the charges with respect to the workforce reductions have been incurred and the remainder of the charges for ongoing lease costs are to be substantially incurred by the end of 2016 for the 2004 Restructuring Plan and the end of 2013 for the 2001 Restructuring Plan.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
During the nine months ended September 30, 2007, Nortel continued to implement these restructuring work plans. Special charges were as follows:
 
                                                 
          Contract
                Special Charges  
          Settlement
    Plant and
          Three Months
    Nine Months
 
    Workforce
    and Lease
    Equipment
          Ended
    Ended
 
    Reduction     Costs     Write Downs     Total     September 30, 2007     September 30, 2007  
 
2007 Restructuring Plan
                                               
Provision balance as of December 31, 2006
  $     $     $     $                  
Other special charges
    116       30       4       150     $ 41     $ 150  
Revisions to prior accruals
    (4 )     (2 )           (6 )     (5 )     (6 )
Cash drawdowns
    (58 )     (4 )           (62 )                
Non-cash drawdowns
    (2 )           (4 )     (6 )                
Foreign exchange and other adjustments
    3                   3                  
                                                 
Provision balance as of September 30, 2007
  $ 55     $ 24     $     $ 79                  
                                                 
2006 Restructuring Plan
                                               
Provision balance as of December 31, 2006
  $ 38     $     $     $ 38                  
Other special charges
    25                   25       14       25  
Revisions to prior accruals
    (7 )                 (7 )     (1 )     (7 )
Cash drawdowns
    (36 )                 (36 )                
Non-cash drawdowns
    (1 )                 (1 )                
Foreign exchange and other adjustments
    1                   1                  
                                                 
Provision balance as of September 30, 2007
  $ 20     $     $     $ 20                  
                                                 
2004 Restructuring Plan
                                               
Provision balance as of December 31, 2006
  $ 3     $ 53     $     $ 56                  
Other special charges
                                   
Revisions to prior accruals
          4       1       5       3       5  
Cash drawdowns
    (2 )     (8 )           (10 )                
Non-cash drawdowns
                (1 )     (1 )                
Foreign exchange and other adjustments
          1             1                  
                                                 
Provision balance as of September 30, 2007
  $ 1     $ 50     $     $ 51                  
                                                 
2001 Restructuring Plan
                                               
Provision balance as of December 31, 2006
  $ 2     $ 178     $     $ 180                  
Other special charges
                                   
Revisions to prior accruals
    (2 )     6       1       5       4       5  
Cash drawdowns
          (33 )           (33 )                
Non-cash drawdowns
                (1 )     (1 )                
Foreign exchange and other adjustments
          2             2                  
                                                 
Provision balance as of September 30, 2007
  $     $ 153     $     $ 153                  
                                                 
Total provision balance as of September 30, 2007(a)
  $ 76     $ 227     $     $ 303                  
                                                 
Total special charges
                                  $ 56     $ 172  
                                                 
 
 
(a) As of September 30, 2007 and December 31, 2006, the short-term provision balances were $121 and $97, respectively, and the long-term provision balances were $182 and $177, respectively.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
 
2007 Restructuring Plan
 
Three and nine months ended September 30, 2007
 
During the three and nine months ended September 30, 2007, Nortel recorded special charges of $35 and $112, respectively, including revisions of $(2) and $(4), respectively, related to severance and benefit costs associated with a workforce reduction of approximately 1,280 employees, of which 230 and 1,100 were notified of termination during the three and nine months ended September 30, 2007, respectively. This portion of the workforce reduction was primarily in the U.S., Canada, and EMEA. The real estate initiative referred to above resulted in costs of nil and $28 during the three and nine months ended September 30, 2007, respectively. Cash expenditures of $27 and $62 were incurred during the three and nine months ended September 30, 2007, respectively. Approximately half of the total restructuring expense related to the 2007 Restructuring Plan is expected to be incurred by the end of 2007.
 
2006 Restructuring Plan
 
Three and nine months ended September 30, 2007
 
During the three and nine months ended September 30, 2007, Nortel recorded special charges of $13 and $18, respectively, including revisions of $(1) and $(7), respectively, related to severance and benefit costs associated with a cumulative workforce reduction of approximately 940 employees, of which 28 and 374 were notified of termination during the three and nine months ended September 30, 2007, respectively. During the three and nine months ended September 30, 2007, Nortel incurred total cash costs related to the 2006 Restructuring Plan of approximately $7 and $36, respectively, with the remaining cash costs expected to be incurred primarily in the remainder of 2007. The remaining provision is expected to be substantially drawn down by the end of 2007.
 
2004 and 2001 Restructuring Plans
 
Three and nine months ended September 30, 2007
 
During the nine months ended September 30, 2007, the provision balance for workforce reduction was substantially drawn down to $1 and nil for the 2004 and 2001 Restructuring Plans, respectively. During the three and nine months ended September 30, 2007, the provision balance for contract settlement and lease costs was drawn down by cash payments of $2 and $8 for the 2004 Restructuring Plan, respectively, and $9 and $33 for the 2001 Restructuring Plan, respectively. For the 2004 and 2001 Restructuring Plans, the remaining provisions, which are net of approximately $33 and $134, respectively, in estimated sublease income, is expected to be substantially drawn down by the end of 2016 and 2013, respectively.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
Segments
 
The following table summarizes the total special charges incurred for each of Nortel’s restructuring plans by segment during the three and nine months ended September 30, 2007 and 2006:
 
                                                 
                Metro
                   
    Enterprise
    Carrier
    Ethernet
    Global
             
    Solutions     Networks     Networks     Services     Other     Total  
 
2007 Restructuring Plan
  $ 5     $ 20     $ 4     $ 7     $     $ 36  
2006 Restructuring Plan
    2       3       1       7             13  
2004 Restructuring Plan
    1       2                         3  
2001 Restructuring Plan
    1       3                         4  
                                                 
Total special charges for the three months ended September 30, 2007
  $ 9     $ 28     $ 5     $ 14     $     $ 56  
                                                 
2007 Restructuring Plan
  $ 22     $ 86     $ 24     $ 12     $     $ 144  
2006 Restructuring Plan
    3       6       2       7             18  
2004 Restructuring Plan
    2       3                         5  
2001 Restructuring Plan
    1       4                         5  
                                                 
Total special charges for the nine months ended September 30, 2007
  $ 28     $ 99     $ 26     $ 19     $     $ 172  
                                                 
2006 Restructuring Plan
  $ 1     $ 3     $ 1     $     $     $ 5  
2004 Restructuring Plan
    2       5       5                   12  
2001 Restructuring Plan
    1       4                         5  
                                                 
Total special charges for the three months ended September 30, 2006
  $ 4     $ 12     $ 6     $     $     $ 22  
                                                 
2006 Restructuring Plan
  $ 8     $ 25     $ 17     $ 1     $     $ 51  
2004 Restructuring Plan
    3       7       6                   16  
2001 Restructuring Plan
    1       8                         9  
                                                 
Total special charges for the nine months ended September 30, 2006
  $ 12     $ 40     $ 23     $ 1     $     $ 76  
                                                 
 
As described in note 5, segment Management EBT does not include special charges. A significant portion of Nortel’s provisions for workforce reductions and contract settlement and lease costs are associated with shared services. These costs have been allocated to the segments in the table above based generally on headcount.
 
7.   Income taxes
 
During the nine months ended September 30, 2007, Nortel recorded a tax expense of $74 on earnings from operations before income taxes, minority interests and equity in net earnings (loss) of associated companies of $35. The tax expense of $74 is largely comprised of several significant items including $67 of income taxes on profitable entities in Asia and Europe, including a reduction of Nortel’s deferred tax assets in EMEA, $33 of income taxes relating to tax rate reductions enacted during the first nine months of 2007 in EMEA and Asia, and other taxes of $12 primarily related to tax on preferred share dividends in Canada. This tax expense is partially offset by a $22 benefit derived from various tax credits, primarily R&D related incentives, and a $14 benefit in EMEA as a result of transfer pricing adjustments.
 
During the nine months ended September 30, 2006, Nortel recorded a tax expense of $69 on earnings from operations before income taxes, minority interests and equity in net earnings (loss) of associated companies of $175. The tax expense of $69 is primarily related to the reduction of Nortel’s deferred tax assets and tax on profitable entities in Asia and Europe of $71, various corporate and minimum taxes including $11 of income taxes on preferred share dividends in Canada, partially offset by the benefit derived from various tax credits, primarily R&D related incentives.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
As of September 30, 2007, Nortel’s net deferred tax assets were $4,421 reflecting temporary differences between the financial reporting and tax treatment of certain current assets and liabilities and non-current assets and liabilities, in addition to the tax benefit of net operating and capital loss carryforwards and tax credit carryforwards.
 
As a result of having adopted FIN 48, Nortel recognized approximately a $1 increase to reserves for uncertain tax positions. This increase was accounted for as a $1 increase to the January 1, 2007 accumulated deficit. Additionally, Nortel reduced its gross deferred tax assets by approximately $1,533, including a reduction of $758 related to the future tax benefit of the Global Class Action Settlement, as defined in note 17, and $620 related to capital losses.
 
Nortel had approximately $1,750 of total gross unrecognized tax benefits as of the adoption of FIN 48 at January 1, 2007. As of September 30, 2007, Nortel’s gross unrecognized tax benefit was $1,360. Of this total, $56 represented the amount of unrecognized tax benefits that would favorably affect the effective income tax rate in future periods, if recognized. The decrease since adoption of $390 resulted from a $637 decrease related to settlements during the first three quarters of 2007, offset by an increase of $53 for new uncertain tax positions arising in the first three quarters of 2007, combined with an increase of $194 resulting from changes to measurement of existing uncertain tax positions for changes to foreign exchange rates, tax rates and other measurement criteria. Included in the $637 of settlements is $620 related to an agreed reduction of Nortel’s capital loss carryforward in the United Kingdom (“U.K.”), and $9 related to statute expiration in Brazil of which $6 has favorably impacted the effective tax rate for 2007.
 
Nortel recognizes interest and penalties accrued related to unrecognized tax benefits in income tax expense. During the first nine months of 2007, Nortel recognized approximately $8 in interest and penalties. Nortel had approximately $26 and $34 accrued for the payment of interest and penalties as of January 1, 2007 and September 30, 2007, respectively. There was a $7 decrease in interest accrual directly related to positions settled during the first three quarters of 2007, offset by an increase of $15 of interest and penalties accrued on existing positions during the year.
 
Nortel believes it is reasonably possible that $107 of its gross unrecognized tax benefit will decrease during the twelve months ending September 30, 2008. Of this amount, $43 will result from the potential resolution of current advance pricing negotiations, $57 will result from including unrecognized tax benefits on amended income tax returns, and $7 will result from the potential settlement of an audit exposure in South America. It is anticipated that these potential decreases in unrecognized tax benefits would not materially impact Nortel’s effective tax rate.
 
Nortel is subject to tax examinations in all major taxing jurisdictions in which it operates and currently has examinations open in Canada, the U.S., France, Australia, Germany and Brazil. In addition, we have ongoing audits in other smaller jurisdictions including, but not limited to, Colombia, the Philippines and Puerto Rico. Nortel’s 2000 through 2006 tax years remain open in most of these jurisdictions primarily as a result of ongoing negotiations regarding Advance Pricing Arrangements (“APAs”) affecting these periods.
 
In accordance with SFAS 109, Nortel reviews all available positive and negative evidence to evaluate the recoverability of its deferred tax assets. This includes a review of such evidence as the carry forward periods of the significant tax assets, Nortel’s history of generating taxable income in its significant tax jurisdictions (namely Canada, the U.S., the U.K. and France), Nortel’s cumulative profits or losses in recent years, and Nortel’s projections of earnings in its significant jurisdictions. On a jurisdictional basis, Nortel is in a cumulative loss position in certain of its significant jurisdictions. For these jurisdictions, Nortel continues to maintain a valuation allowance against a portion of its deferred income tax assets. Nortel has concluded that it is more likely than not, that the remaining deferred tax assets in these jurisdictions 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. Specifically, the tax authorities in Brazil have completed an examination of prior taxation years and have issued assessments in the amount of $83 for the taxation years of 1999 and 2000. In addition, the tax authorities in France issued assessments in respect of the 2001, 2002 and 2003 taxation years. These assessments collectively propose adjustments to increase taxable income of approximately $1,197, additional income tax liabilities of $47 inclusive of interest, as well as certain increases to withholding and other taxes of approximately $79 plus applicable interest and penalties. Nortel withdrew from discussions at the tax auditor level during the first quarter of 2007 and is in the process of entering into Mutual Agreement Procedures with competent authority under the Canada-France tax treaty to


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
settle the dispute. Nortel believes that it has adequately provided for tax adjustments that are more likely than not to be realized as a result of any ongoing or future examinations.
 
Nortel had previously entered into 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 U.K. that applied to the taxation years beginning in 2001. The APA requests are currently under consideration and the tax authorities are in the process of negotiating the terms of the arrangements. Although Nortel continues to monitor the progress, it is not a party to these negotiations. Nortel has applied the transfer pricing methodology proposed in the APA requests in preparing its tax returns and accounts beginning in 2001.
 
Nortel has requested that the APAs apply to the 2001 through 2005 taxation years. Nortel is also in the initial stages of preparing a new APA request which Nortel anticipates will be filed to include tax years 2007 through at least 2010 following methods generally similar to those under negotiation for 2001 through 2005, with a request for rollback to 2006. Nortel continues to apply the transfer pricing methodology proposed in the APAs to its current year financial statements and has filed its 2006 corporate income tax returns consistent with the methodology described in its new APA request.
 
The outcome of the APA application requests is uncertain and possible reallocation of losses, as they relate to the APA negotiations, cannot be determined at this time. However, Nortel believes that, more likely than not, the ultimate resolution of these negotiations will not 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 and cash flows.
 
8.   Employee benefit plans
 
Nortel maintains various capital accumulation and retirement programs covering substantially all of its employees including: the 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; the 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. These 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.
 
In the second quarter of 2006, Nortel announced changes to its North American pension and post-retirement plans effective January 1, 2008. Nortel will reallocate employees currently enrolled in its defined benefit pension plans to defined contribution plans. In addition, Nortel will eliminate post-retirement healthcare benefits for employees who were not yet age 50 with five years of service as of July 1, 2006.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
The following details the net pension expense for the defined benefit plans for the following periods:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Pension expense:
                               
Service cost
  $ 28     $ 31     $ 88     $ 102  
Interest cost
    121       116       354       346  
Expected return on plan assets
    (127 )     (115 )     (373 )     (337 )
Amortization of prior service cost
    1       1       3       2  
Amortization of net losses
    27       33       79       103  
Curtailment, contractual and special termination losses
          (5 )     2       4  
                                 
Net pension expense
  $ 50     $ 61     $ 153     $ 220  
                                 
 
The following details the net cost components of post-retirement benefits other than pensions for the following periods:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Post-retirement benefits cost:
                               
Service cost
  $ 1     $ 2     $ 3     $ 6  
Interest cost
    10       11       27       33  
Amortization of prior service cost
    (6 )     (1 )     (10 )     (3 )
Amortization of net losses
    (1 )           (1 )     1  
Curtailment gains
          (29 )           (29 )
                                 
Net post-retirement benefits cost (recovery)
  $ 4     $ (17 )   $ 19     $ 8  
                                 
 
During the nine months ended September 30, 2007, contributions of $272 were made to the defined benefit plans and $27 to the post-retirement benefit plans. Nortel expects to contribute an additional $58 during the remainder of 2007 to the defined benefit pension plans for a total contribution in 2007 of $330, and an additional $10 in 2007 to the post-retirement benefit plans for a total contribution in 2007 of $37.
 
9.   Acquisitions and divestitures
 
Acquisition
 
 
On November 3, 2005, Nortel entered into a business venture with LGE, named LG-Nortel. Certain assets of Nortel’s South Korean distribution and services business were combined with the service business and certain assets of LGE’s telecommunications infrastructure business. In exchange for a cash contribution of $155 paid to LGE, Nortel received 50% plus one share of the equity in LG-Nortel. Separately, LGE will be entitled to payments from Nortel over a two-year period based on the achievement by LG-Nortel of certain business goals in the 2006 and 2007 fiscal years, of up to a maximum of $80. Nortel and LGE agreed that the payment related to the 2006 fiscal year was $29 and this amount was recognized in the three months ended March 31, 2007.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
Divestiture
 
 
In 2004, Nortel entered into an agreement with Flextronics Telecom Systems, Ltd. (“Flextronics”) for the divestiture of substantially all of Nortel’s remaining manufacturing operations and related activities, including certain product integration, testing, repair operations, supply chain management, third party logistics operations and design assets. Nortel transferred approximately $404 of inventory and equipment to Flextronics relating to the transfer of the optical design activities in Ottawa and Monkstown and the manufacturing activities in Montreal and Calgary in Canada, and Chateaudun in France. As Flextronics has the ability to exercise its unilateral rights to return certain inventory and equipment to Nortel after the expiration of a specified period following each respective transfer date (up to fifteen months), Nortel has retained these assets on its balance sheet to the extent the assets have not been consumed as part of ongoing operations as at September 30, 2007. Nortel continues to finalize arrangements with Flextronics in respect of the return of certain inventory and currently expects that Flextronics will exercise its rights in 2007 as it relates to $6 of inventory remaining on hand. Nortel has recorded a deferred gain of $16 on this transaction as of September 30, 2007 as a result of continuing involvement in the underlying transferred assets.
 
10.   Long-term debt
 
 
On March 28, 2007, Nortel completed an offering of $1,150 aggregate principal amount of unsecured convertible senior notes (the “Convertible Notes”) to repay a portion of the $1,800 outstanding principal amount of 4.25% convertible senior notes due 2008 (the “4.25% Notes due 2008”). The offering was made to qualified institutional buyers pursuant to Rule 144A under the U.S. Securities Act of 1933, as amended (the “Securities Act”), and in Canada to qualified institutional buyers that are also accredited investors pursuant to applicable Canadian private placement exemptions. The Convertible Notes consist of $575 principal amount of Senior Convertible Notes due 2012 (the “2012 Notes”) and $575 of Senior Convertible Notes due 2014 (the “2014 Notes”). In each case, the principal amount of Convertible Notes includes $75 issued pursuant to the exercise in full of the over-allotment options granted to the initial purchasers. The 2012 Notes pay interest semi-annually at a rate per annum of 1.75% and the 2014 Notes pay interest semi-annually at a rate per annum of 2.125%.
 
The 2012 Notes and 2014 Notes are each convertible into common shares of Nortel at any time based on an initial conversion rate of 31.25 common shares per $1,000.00 principal amount of Convertible Notes (which is equal to an initial conversion price of $32.00 per common share). This rate is not considered to represent a beneficial conversion option. In each case, the conversion rate is subject to adjustment if certain events occur, such as a change of control. Holders who convert their Convertible Notes in connection with certain events that result in a change in control may be entitled to a “make-whole” premium in the form of an increase in the conversion rate.
 
Upon a change of control, Nortel would be required to offer to repurchase the Convertible Notes for cash at 100% of the outstanding principal amount thereof plus accrued and unpaid interest and additional interest, if any, up to but not including the date of repurchase.
 
Nortel may redeem in cash the 2012 Notes and the 2014 Notes at any time on or after April 15, 2011 and April 15, 2013, respectively, at repurchase prices equal to 100.35% and 100.30% of their outstanding principal amounts, respectively, plus accrued and unpaid interest and any additional interest up to but excluding the applicable redemption date. Nortel may redeem each series of Convertible Notes at any time in cash at a repurchase price equal to 100% of the aggregate principal amount, together with accrued and unpaid interest and any additional interest to the redemption date, in the event of certain changes in applicable Canadian withholding taxes.
 
The Convertible Notes are fully and unconditionally guaranteed by Nortel Networks Limited (“NNL”) and initially guaranteed by Nortel Networks Inc. (“NNI”). The Convertible Notes are senior unsecured obligations of Nortel and rank pari passu with all of its other senior obligations. Each guarantee is the senior unsecured obligation of the respective guarantor and ranks pari passu with all other senior obligations of that guarantor.
 
In connection with the issuance of the Convertible Notes, Nortel, NNL and NNI entered into a registration rights agreement obligating Nortel to file with the SEC, prior to or on October 5, 2007, and to use its reasonable best efforts to


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
cause to become effective prior to or on January 5, 2008, a resale shelf registration statement covering the Convertible Notes, the related guarantees and the common shares issuable upon conversion of the Convertible Notes. Holders of the Convertible Notes will be entitled to the payment of certain additional interest if any of the conditions above, or certain other conditions, are not met. Nortel filed a resale shelf registration statement on Form S-3 with the SEC on September 24, 2007.
 
The net proceeds from the sale of the Convertible Notes were approximately $1,127 after deducting commissions payable to the initial purchasers and other offering expenses. On September 28, 2007, Nortel redeemed at par value $1,125, plus accrued and unpaid interest, of its $1,800 outstanding principal amount of 4.25% Notes due 2008. As at September 30, 2007 the outstanding $675 principal amount of 4.25% Notes due 2008 has been reclassified as long-term debt due within one year.
 
11.   Guarantees
 
Nortel has entered into agreements that contain features which meet the definition of a guarantee under FIN 45. FIN 45 defines a guarantee, as applicable to Nortel, as a contract that contingently requires Nortel to make payments (either in cash, financial instruments, other assets, common shares of Nortel 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. As of September 30, 2007, Nortel had accrued $1 in respect of these guarantees. A description of the major types of Nortel’s outstanding guarantees and related contingent obligations, where applicable, as of September 30, 2007, 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 that relate to business events occurring prior to the 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 January 2012.
 
Nortel has also entered into guarantees related to the escrow of shares in business combinations in prior periods. These types of agreements generally include terms that require Nortel to indemnify counterparties for losses 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 payments under such indemnification agreements.
 
In conjunction with the sale of a certain subsidiary to a third party, Nortel guaranteed to the purchaser that specified annual sales 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, 2007 is $10. A liability of $8 has been accrued in the condensed consolidated financial statements as of September 30, 2007 with respect to the contingent obligation associated with this guarantee.
 
(b)   Intellectual property indemnification obligations
 
Nortel has periodically entered into agreements with customers and suppliers which 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.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
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. As of September 30, 2007, no liability has been accrued in the condensed consolidated financial statements with respect to Nortel’s intellectual property indemnification obligations.
 
(c)   Lease agreements
 
Nortel has entered into agreements with its lessors to guarantee the lease payments of certain assignees of its facilities. 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 estimated to be $44 as of September 30, 2007. 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.
 
(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, Nortel’s guarantee is secured, usually by the assets being purchased or financed. As of September 30, 2007, Nortel had no third party debt agreements that would require it to make any debt payments for its customers.
 
(e)   Other indemnification agreements
 
(i)  Nortel has agreed to indemnify the banks and their agents under its credit facilities against costs or losses resulting from changes in laws and regulations which would increase the banks’ costs or reduce their return and from any legal action brought against the banks or their agents related to the use of loan proceeds.
 
On February 14, 2003, NNL entered into an agreement with Export Development Canada (“EDC”) regarding arrangements to provide support for certain performance related obligations arising out of normal course business (the “EDC Support Facility”). Nortel has also agreed to indemnify EDC under the EDC Support Facility against any legal action brought against EDC that relates to the provision of support under the EDC Support Facility. This indemnification generally applies to issues that arise during the term of the EDC Support Facility. As of September 30, 2007, there was approximately $137 of outstanding support utilized under the EDC Support Facility, approximately $97 of which was outstanding under the revolving small bond sub-facility, with the remaining balance outstanding under the revolving large bond sub-facility.
 
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.
 
(ii)  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, under certain conditions if the receivable is not paid by the obligor. As of September 30, 2007, Nortel had approximately $65 of securitized receivables which were subject to repurchase, in which case Nortel would assume from the purchaser of the receivables all rights to collect such


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
receivables. The indemnification provisions generally expire upon expiration of the securitization agreements, which extend through 2007, or collection of the receivable amounts by the purchaser.
 
Nortel is not able 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.
 
Nortel has made indemnification payments of $39 and $26 as at September 30, 2007 and December 31, 2006, respectively, under such agreements relating to the repurchase of certain receivables.
 
(iii)  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 (in addition to 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 and officers. 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.
 
(iv)  Nortel has identified specified price trade-in rights in certain customer arrangements that qualify as guarantees. As of September 30, 2007, Nortel had accrued $18 with respect to these guarantee obligations.
 
(v)  On March 17, 2006, in connection with the Global Class Action Settlement (as defined in note 17), Nortel announced that it had reached an agreement with the lead plaintiffs on the related insurance and corporate governance matters, including Nortel’s insurers agreeing to pay $229 in cash towards the settlement and Nortel agreeing with its insurers to certain indemnification obligations. Nortel believes that these indemnification obligations would be unlikely to materially increase its total cash payment obligations under the Global Class Action Settlement. Nortel is aware of three claims made to the insurers by former officers, but information is not available at this time to make a reasonable estimate of the amount for which Nortel may be liable. As a result, Nortel has not recorded a contingent liability as at September 30, 2007. The insurers’ payments would not reduce the amounts payable by Nortel as disclosed in note 17.
 
 
The following summarizes changes in the accrual for product warranties that was recorded as part of other accrued liabilities in the condensed consolidated balance sheet as of September 30, 2007:
 
         
Balance as of December 31, 2006
  $ 217  
Payments
    (127 )
Warranties issued
    182  
Revisions
    (63 )
         
Balance as of September 30, 2007
  $ 209  
         


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
12.   Commitments
 
 
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:
 
                 
    September 30,
    December 31,
 
    2007     2006  
 
Bid and performance-related bonds(a)
  $ 154     $ 231  
Other bonds(b)
    40       30  
                 
Total bid, performance related and other bonds
  $ 194     $ 261  
                 
 
 
(a) Net of restricted cash and cash equivalent amounts of $5 and $7 as of September 30, 2007 and December 31, 2006, respectively.
 
(b) Net of restricted cash and cash equivalent amounts of $27 and $628 as of September 30, 2007 and December 31, 2006, respectively.
 
 
Nortel has entered into agreements with selected venture capital firms where the venture capital firms make and manage investments in start-up businesses 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 any of the venture capital firms. Nortel had remaining commitments, if requested, of $22 as of September 30, 2007. These commitments expire at various dates through to 2016.
 
 
In the third quarter of 2006, Nortel and Microsoft Corporation (“Microsoft”) entered into a four-year agreement, with provisions for extension, to form a strategic alliance to jointly develop, market and sell communications solutions. Under the agreement, Nortel and Microsoft agreed to form joint teams to collaborate on product development spanning enterprise, mobile and wireline carrier solutions. The agreement engages the companies at the technology, marketing and business levels and includes joint product development, solutions and systems integration and go-to-market initiatives. Both companies will invest resources in marketing, business development and delivery.
 
Microsoft will make available to Nortel up to $52 in marketing and telephony systems integration funds to be offset against marketing costs incurred by Nortel and up to $40 in research and development funds over the initial four-year term of the agreement. Microsoft will recoup its payment of research and development funds by receiving payments from Nortel consisting of five percent of revenue, as defined, over a mutually agreed upon enterprise voice and application business base plan. Any research and development funds that have not been recouped must be repaid in full by Nortel to Microsoft by March 31, 2012. As of September 30, 2007, Nortel had not received any of the research and development funds from Microsoft.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
13.   Earnings (loss) per common share
 
The following table details the weighted-average number of Nortel common shares outstanding for the purposes of computing basic and diluted earnings (loss) per common share for the following periods:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007(a)     2006(b)     2007(a) & (b)     2006  
 
(Number of common shares in millions)
                               
Basic weighted-average shares outstanding:
                               
Issued and outstanding
    497       434       479       434  
                                 
Basic weighted-average shares outstanding
    497       434       479       434  
                                 
Weighted-average shares dilution adjustments:
                               
Dilutive stock options
    3                    
                                 
Diluted weighted-average shares outstanding
    500       434       479       434  
                                 
Weighted-average shares dilution adjustments — exclusions:
                               
Stock options
    28       31       31       31  
4.25% Convertible Senior Notes(c)
    7       18       7       18  
1.75% Convertible Senior Notes(c)
    18             18        
2.125% Convertible Senior Notes(c)
    18             18        
 
 
(a) Shares issuable as a result of the Global Class Action Settlement of 62,866,775 and 44,444,277 for the three and nine months ended September 30, 2007, respectively, have been included in the calculation of basic and diluted weighted average number of shares outstanding with effect from March 20, 2007. For additional information, see note 17.
 
(b) As a result of the net loss from operations for the nine months ended September 30, 2007 and the three months ended September 30, 2006, all potential dilutive securities were considered anti-dilutive.
 
(c) All potential dilutive securities issuable related to the Convertible Senior Notes for the three and nine months ended September 30, 2007 and 2006 were anti-dilutive.
 
14.   Shareholders’ equity
 
The following are the changes in shareholders’ equity during the nine months ended September 30, 2007 (numbers of common shares in thousands):
 
                                                 
                      Accumulated
       
          Additional
          Other
       
          Paid-in
    Accumulated
    Comprehensive
       
    Common Shares     Capital     Deficit     Loss     Total  
 
Balance as of December 31, 2006
    433,935     $ 33,938     $ 3,378     $ (35,574 )   $ (621 )   $ 1,121  
Net loss
                      (113 )           (113 )
Foreign currency translation adjustment
                            120       120  
Unrealized loss on investments — net
                            (9 )     (9 )
Pension and post-retirement amortization items — net
                            42       42  
Unrealized derivative gain on cash flow hedges — net
                            28       28  
Share-based compensation
    743       23       72                   95  
Global Class Action Settlement (note 17)
    2,647       69       1,557                   1,626  
Adoption of FIN 48 (notes 2 and 7)
                      (1 )           (1 )
Other
    4       (3 )     1                   (2 )
                                                 
Balance as of September 30, 2007
    437,329     $ 34,027     $ 5,008     $ (35,688 )   $ (440 )   $ 2,907  
                                                 


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
Nortel is authorized to issue an unlimited number of common shares without nominal or par value.
 
The following are the components of comprehensive income, net of tax, for the following periods:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Net earnings (loss)
  $ 27     $ (63 )   $ (113 )   $ 108  
Other comprehensive income (loss) adjustments:
                               
Change in foreign currency translation adjustment
    36       66       120       203  
Unrealized gain (loss) on investments — net(a)
    (6 )     18       (9 )     (2 )
Pension and post-retirement amortization items — net
    13       146       42       145  
Unrealized derivative gain (loss) on cash flow hedges — net(b)
    (1 )     (7 )     28       (4 )
                                 
Comprehensive income
  $ 69     $ 160     $ 68     $ 450  
                                 
 
 
(a) Certain securities deemed available-for-sale by Nortel were measured at fair value. Unrealized holding losses related to these securities were excluded from net earnings (loss) and were included in accumulated other comprehensive income until realized. Unrealized gain (loss) on investments was net of tax of nil for each of the three and nine months ended September 30, 2007 and 2006.
 
(b) During the three and nine months ended September 30, 2007 and 2006, $9 and $4, and $4 and $13 of net derivative gains were reclassified to other income — net, respectively. Nortel estimates that $18 of net derivative gains included in accumulated other comprehensive income will be reclassified into net earnings (loss) within the next 12 months.
 
15.   Share-based compensation plans
 
 
Prior to 2006, Nortel granted options to employees to purchase Nortel common shares under two existing stock option plans, 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”). Under these two plans, options to purchase Nortel common shares could be granted to employees and, under the 2000 Plan, options could be also granted to directors of Nortel. The options under both plans entitle the holders to purchase one common share at a subscription price of not less than 100% of the market value on the effective date of the grant. Subscription prices are stated and payable in U.S. Dollars for U.S. options and in Canadian Dollars for Canadian options. Options granted prior to 2003 generally vest 331/3% each year over a three-year period on the anniversary date of the grant. Commencing in 2003, options granted generally vest 25% each year over a four-year period on the anniversary of the date of grant. The Compensation and Human Resources Committee of the Boards of Directors of Nortel and NNL (the “CHRC”) that administers both plans generally has the discretion to vary the period during which the holder has the right to exercise options and, in certain circumstances, may accelerate the right of the holder to exercise options, but in no case shall the term of an option exceed ten years. Nortel meets its obligations under both plans by issuing Nortel common shares. Common shares remaining available for grant after December 31, 2005 under the 2000 Plan and the 1986 Plan (and including common shares that become available upon expiration or termination of options granted under such plans) have been rolled over and are available for grant under the Nortel 2005 Stock Incentive Plan (the “SIP”) effective January 1, 2006.
 
In 2005, Nortel’s shareholders approved the SIP, a share-based compensation plan, which permits grants of stock options, including incentive stock options, stock appreciation rights (“SARs”), performance stock units (“PSUs”) and restricted stock units (“RSUs”) to employees of Nortel and its subsidiaries. Nortel meets its obligations under the SIP by issuing Nortel common shares. On November 6, 2006, the SIP was amended and restated effective as of December 1, 2006, to adjust the number of common shares available for grant thereunder to reflect the 1 for 10 consolidation of Nortel’s issued and outstanding common shares. The subscription price for each share subject to an option shall not be less than 100% of the market value of common shares of Nortel on the date of the grant. Subscription prices are stated and payable in U.S. Dollars for U.S. options and in Canadian Dollars for Canadian options. Options granted under the SIP generally vest 25% each year over a four-year period on the anniversary of the date of grant. The CHRC, which administers the SIP, generally has the discretion to accelerate or waive any condition related to the vesting of options, but in no case shall options granted become exercisable within the first year (except in the event of death), and in no case shall the exercise


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
period exceed ten years. All stock options granted have been classified as equity instruments based on the settlement provisions of the share-based compensation plans.
 
Stand-alone SARs or SARs issued in tandem with options may be granted under the SIP. Upon the exercise of a vested SAR, a holder will be entitled to receive payment, in cash, shares or any combination thereof, of an amount equal to the excess of the market value of a common share of Nortel on the date of exercise over the subscription or base price under the SAR. On the exercise of a tandem SAR, the related option shall be cancelled. Generally, SARs awarded under the SIP vest in equal installments on the first four anniversary dates of the grant date of the award.
 
During the nine months ended September 30, 2007, Nortel granted 91,512 stand-alone SARs under the SIP, of which 86,118 are outstanding as of September 30, 2007. The SARs awarded under the SIP program will be settled in cash at the time of vesting. All SARs granted have been classified as liability awards based on their cash settlement provisions.
 
In January 1995, a key contributor stock option program (the “Key Contributor Program”) was established and options have been granted under the 1986 Plan and the 2000 Plan in connection with this program. Under that program, a participant was granted concurrently an equal number of initial options and replacement options. The initial options and the replacement options expire ten years from the date of grant. The initial options have an exercise price equal to the market value of a Nortel common share on the date of grant and the replacement options have an exercise price equal to the market value of a Nortel common share on the date all of the initial options are fully exercised, provided that in no event will the exercise price be less than the exercise price of the initial options. Replacement options are generally exercisable commencing 36 months after the date all of the initial options are fully exercised, provided that the participant beneficially owns a number of Nortel common shares at least equal to the number of common shares subject to the initial options less any common shares sold to pay for options costs, applicable taxes and brokerage costs associated with the exercise of the initial options. No Key Contributor Program options were granted for the nine months ended September 30, 2007 and 2006.
 
Nortel also assumed stock option plans in connection with the acquisition of various companies. Common shares of Nortel are issuable upon the exercise of options under the assumed stock option plans, although no further options may be granted under the assumed plans. The vesting periods for options granted under these assumed stock option plans may differ from the SIP, 2000 Plan and 1986 Plan, but are not considered significant to Nortel’s overall use of share-based compensation.
 
The following is a summary of the total number of outstanding stock options and the maximum number of stock options available for grant as of the following dates:
 
                                         
          Weighted-
    Weighted-
             
          Average
    Average
    Aggregate
    Available
 
    Options
    Exercise
    Life
    Intrinsic
    for Grant
 
    (Thousands)(a)     Price     (In years)     Value     (Thousands)(a)  
 
Balance as of December 31, 2006
    29,782     $ 81.72       5.7     $ 36,952       15,703  
Granted options under all stock option plans
    4,491       25.32                     (7,033 )
Options exercised
    (408 )     23.59               1,776        
Options forfeited
    (926 )     35.65                     1,197  
Options expired
    (2,419 )     114.89                     2,345  
                                         
Balance as of September 30, 2007
    30,520     $ 76.79       5.8     $ 112       12,212  
                                         
 
 
(a) Amount is inclusive of RSUs and PSUs granted or cancelled. RSUs and PSUs reduce shares available for grant under the SIP.
 
 
As noted above, RSUs and PSUs can be issued under the SIP. RSUs generally become vested based on continued employment and PSUs generally become vested subject to the attainment of performance criteria. Each RSU or PSU granted under the SIP generally represents one Nortel common share. Under the SIP, vested units will generally be settled upon vesting by delivery of a Nortel common share for each vested unit or payment of a cash amount equal to the market


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
value of a Nortel common share at the time of settlement, or a combination thereof, as determined at the discretion of the CHRC. All RSUs currently granted will be settled in shares based on the terms and conditions of the respective grants.
 
The number of RSUs granted during the nine months ended September 30, 2007 was 2,021,011. Generally, RSUs awarded to executive officers beginning in 2005, and employees from January 1, 2007, prospectively vest in equal installments on the first three anniversary dates of the grant date of the award. The RSUs awarded under the SIP will be settled in shares at the time of vesting. All RSUs granted have been classified as equity instruments based on the settlement provisions of the share-based compensation plans.
 
The number of PSUs granted during the nine months ended September 30, 2007 was 520,600. Vesting and settlement of PSUs at the end of the three year performance period will depend upon the level of achievement of certain performance criteria based on the relative total shareholder return on Nortel common shares compared to the total shareholder return on the common shares of a comparative group of companies included in the Dow Jones Technology Titans 30 Index (the “Technology Index”). The number of Nortel common shares to be issued for the vested PSUs are determined based on Nortel’s ranking within the Technology Index and can range from 0% to 200%. All PSUs granted have been classified as equity instruments based on the settlement provisions of the share-based compensation plans.
 
The following is a summary of the total number of outstanding RSU and PSU awards granted as of the following dates:
 
                                                 
    RSU     PSU  
                Weighted-
                Weighted-
 
    RSU
    Weighted-
    Average
    PSU
    Weighted-
    Average
 
    Awards
    Average
    Contractual
    Awards
    Average
    Contractual
 
    Granted
    Grant Date
    Life
    Granted
    Grant Date
    Life
 
    (Thousands)     Fair Value     (In years)     (Thousands)     Fair Value     (In years)  
 
Balance as of December 31, 2006
    1,240     $ 24.83       2.5       447     $ 22.63       2.5  
Granted awards
    2,021       25.33               521       21.47          
Awards exercised
    (336 )     24.21                              
Awards forfeited
    (182 )     25.62               (89 )     22.17          
Awards expired
                                       
                                                 
Balance as of September 30, 2007
    2,743     $ 25.23       2.3       879     $ 21.99       2.1  
                                                 
 
 
The following table provides the share-based compensation recorded for the following periods:
 
                                 
    Three Months
    Nine Months
 
    Ended
    Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006(a)  
 
Share-based compensation:
                               
Stock option expense
  $ 23     $ 26     $ 64     $ 67  
RSU expense
    7       3       17       6  
PSU expense
    1       1       5       1  
                                 
Total share-based compensation reported
  $ 31     $ 30     $ 86     $ 74  
                                 
 
 
(a) Includes a reduction of share-based compensation expense of approximately $9 recognized in the first quarter of 2006 to align Nortel’s recognition of stock option forfeitures with the adoption of SFAS 123R.
 
Nortel estimates the fair value of stock options and SARs using the Black-Scholes-Merton option-pricing model, consistent with the provisions of SFAS 123R and SAB 107. The key input assumptions used to estimate the fair value of stock options and SARs include the grant price of the options, the expected term of the options, the volatility of Nortel’s stock, the risk-free rate and Nortel’s dividend yield. Nortel believes that the Black-Scholes-Merton option-pricing model sufficiently captures the substantive characteristics of the option and SAR awards and is appropriate to calculate the fair values of Nortel’s stock options.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
The following ranges of assumptions were used in computing the fair value of stock options and SARs for purposes of expense recognition, for the following periods:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Black-Scholes-Merton assumptions
                               
Expected dividend yield
    0.00 %     0.00 %     0.00 %     0.00 %
Expected volatility(a)
    51.07% - 52.33 %     52.33% - 69.40 %     51.07% - 53.56 %     52.33% - 72.74 %
Risk-free interest rate(b)
    4.25% - 4.72 %     4.76% - 4.86 %     4.25% - 4.72 %     4.76% - 5.04 %
Expected option life in years(c)
    3.65 - 4.00       4.00       3.65 - 4.00       4.00  
Range of stock option fair values per option granted
  $ 4.94 - $8.74     $ 11.22 - 11.47     $ 4.94 - $11.86     $ 11.22 - $12.26  
 
 
(a) The expected volatility of Nortel’s stock is estimated using the daily historical stock prices over a period equal to the expected term.
 
(b) Nortel used the five-year U.S. government treasury bill rate to approximate the four-year risk free rate.
 
(c) The expected term of the stock options is estimated based on historical grants with similar vesting periods.
 
The fair value of RSU awards is calculated using an average of the high and low stock prices from the highest trading volume of either the NYSE or the TSX on the date of the grant. Nortel estimates the fair value of PSU awards using a Monte Carlo simulation model. Certain assumptions used in the model include (but are not limited to) the following:
 
                 
    Three Months Ended
  Nine Months Ended
    September 30,   September 30,
    2007   2006   2007   2006
 
Monte Carlo assumptions
               
Beta
  1.53 - 1.58   2.00   1.53 - 1.88   2.00 - 2.10
Risk-free interest rate(a)
  4.15% - 4.66%   4.79% - 4.87%   4.15% - 4.66%   4.79% - 5.07%
 
 
(a) The risk-free rate used was the three-year U.S. government treasury bill rate.
 
As of September 30, 2007, the annual forfeiture rates applied to Nortel’s stock option plans, SARs, RSU and PSU awards were 15.67%, 15.67%, 12.96% and 6.90%, respectively.
 
Cash received from exercises under all share-based payment arrangements was $10 and $1 for the nine months ended September 30, 2007 and 2006, respectively. Tax benefits realized by Nortel related to these exercises were nil and nil, for the nine months ended September 30, 2007 and 2006, respectively.
 
16.   Related party transactions
 
In the ordinary course of business, Nortel engages in transactions with certain of its equity-owned investees and certain other business partners. These transactions are sales and purchases of goods and services under usual trade terms and are measured at their exchange amounts.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
Transactions with related parties are summarized for the following periods:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Revenues:
                               
LGE(a)
  $ 5     $ 21     $ 17     $ 22  
Vertical Communications, Inc. (“Vertical”)(b)
    4             10       4  
Other
    1       3       6       4  
                                 
Total
  $ 10     $ 24     $ 33     $ 30  
                                 
Purchases:
                               
LG Electronics Inc.(a)
  $ 63     $ 61     $ 245     $ 172  
Sasken Communications Technology Ltd. (“Sasken”)(c)
    7       7       20       25  
GNTEL Co., Ltd. (“GNTEL”)(d)
    29       32       69       53  
Other
    5       13       12       31  
                                 
Total
  $ 104     $ 113     $ 346     $ 281  
                                 
 
 
(a) LGE holds a minority interest in LG-Nortel. Nortel’s sales and purchases relate primarily to certain inventory-related items. As of September 30, 2007, accounts payable to LGE was net $51, compared to net $76 as at December 31, 2006.
 
(b) LG-Nortel currently owns a minority interest in Vertical. Vertical supports LG-Nortel’s efforts to distribute Nortel’s products to the North American market.
 
(c) Nortel currently owns a minority interest in Sasken. Nortel’s purchases from Sasken relate primarily to software and other software development-related purchases. Accounts payable to Sasken were $4 and $2 as at September 30, 2007 and December 31, 2006, respectively.
 
(d) Nortel holds a minority interest in GNTEL through its business venture LG-Nortel. Nortel’s purchases from GNTEL relate primarily to installation and warranty services. Accounts payable to GNTEL were $17 as at September 30, 2007 and December 31, 2006.
 
As of September 30, 2007 and December 31, 2006, accounts receivable from related parties were $5 and $13, respectively. As of September 30, 2007 and December 31, 2006, accounts payable to related parties were $74 and $97, respectively.
 
17.   Contingencies
 
Subsequent to Nortel’s announcement on February 15, 2001, in which it provided revised guidance for its 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 several purported class action lawsuits in the U.S. and Canada (collectively, the “Nortel I Class Actions”). These lawsuits in the U.S. District Court for the Southern District of New York, where all the U.S. lawsuits were consolidated, the Ontario Superior Court of Justice, the Supreme Court of British Columbia and the Quebec Superior Court were filed on behalf of shareholders who acquired securities of Nortel during certain periods between October 24, 2000 and February 15, 2001. The lawsuits alleged, 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.
 
Subsequent to Nortel’s announcement on March 10, 2004, in which it indicated it was likely that Nortel 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 in 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 several purported class action lawsuits in the U.S. and Canada (collectively, the “Nortel II Class Actions”). These lawsuits in the U.S. District Court for the Southern District of New York, the Ontario Superior Court of Justice and the Quebec Superior Court were filed on behalf of shareholders who acquired securities of Nortel during certain periods between February 16, 2001 and July 28, 2004. The lawsuits alleged, among other things, violations of U.S. federal and Canadian provincial securities laws, negligence, misrepresentations, oppressive conduct, insider trading and violations of Canadian corporation and competition laws in connection with certain of Nortel’s financial results. These matters are also the subject of investigations by Canadian and U.S. securities regulatory and criminal investigative authorities.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
During 2006, Nortel entered into agreements to settle all of the Nortel I Class Actions and Nortel II Class Actions (the “Global Class Action Settlement”) concurrently, except one related Canadian action described below. In December 2006 and January 2007, the Global Class Action Settlement was approved by the courts in New York, Ontario, British Columbia and Quebec, and became effective on March 20, 2007.
 
Under the terms of the Global Class Action Settlement, Nortel will pay $575 in cash and issue approximately 62,866,775 Nortel common shares to the plaintiffs (representing approximately 14.5% of Nortel’s common shares outstanding as of February 7, 2006, the date an agreement in principle was reached with the plaintiffs in the U.S. class action lawsuits), reflecting Nortel’s 1 for 10 common share consolidation on December 1, 2006. Nortel will also contribute to the plaintiffs one-half of any recovery from its ongoing litigation against certain of its former senior officers who were terminated for cause in 2004, which seeks the return of payments made to them in 2003 under Nortel’s bonus plan. The total settlement amount will include all plaintiffs’ court-approved attorneys’ fees. On June 1, 2006, Nortel placed $575 plus accrued interest of $5 into escrow and has classified this amount as restricted cash. As a result of the Global Class Action Settlement, Nortel established a litigation reserve and recorded a charge in the amount of $2,474 to its full-year 2005 financial results, $575 of which related to the cash portion of the Global Class Action Settlement, while $1,899 related to the equity component. The equity component of the litigation reserve has been adjusted each quarter since February 2006 to reflect the fair value of the common shares issuable.
 
The effective date of the Global Class Action Settlement was March 20, 2007, on which date the number of shares issuable in connection with the equity component was fixed. As such, a final measurement date occurred for the equity component of the settlement and the value of the shares issuable was fixed at their fair value of $1,626 on the effective date. No further fair value adjustments have been made beyond March 20, 2007.
 
Nortel recorded a shareholder litigation settlement recovery of $54 during the first quarter of 2007 as a result of a final fair value adjustment for the equity component of the Global Class Action Settlement made on March 20, 2007. In addition, the litigation reserve related to the equity component was reclassified to additional paid-in capital within shareholders’ equity on March 20, 2007 as the number of issuable shares was fixed on that date. The reclassified amount will be further reclassified to common shares as the shares are issued. At the effective date of March 20, 2007, Nortel also removed the restricted cash and corresponding litigation reserve related to the cash portion of the settlement, as the funds are now controlled by the escrow agents and Nortel’s obligation has been extinguished. The administration of the settlement will be a complex and lengthy process. Plaintiffs’ counsel will submit lists of claims approved by the claims administrator to the appropriate courts for approval. Once all the courts have approved the claims, the process of distributing cash and share certificates to claimants will begin. Although it is not possible to predict how long the process will take, approximately 4% of the settlement shares have been issued, and Nortel currently expects the issuance of the balance to commence in the first half of 2008.
 
Nortel’s insurers have agreed to pay $229 in cash toward the settlement and Nortel has agreed to certain indemnification obligations with them. Nortel believes that it is unlikely that these indemnification obligations will materially increase its total cash payment obligations under the Global Class Action Settlement.
 
Under the terms of the Global Class Action Settlement, Nortel also agreed to certain corporate governance enhancements. These enhancements include the codification of certain of Nortel’s current governance practices in the written mandate for its Board of Directors and the inclusion in its Statement of Corporate Governance Practices contained in Nortel’s annual proxy circular and proxy statement of disclosure regarding certain other governance practices.
 
In August 2006, Nortel reached a separate agreement in principle to settle a class action lawsuit in the Ontario Superior Court of Justice that is not covered by the Global Class Action Settlement, subject to court approval (the “Ontario Settlement”). In February 2007, the court approved the Ontario Settlement. The settlement did not have a material impact on Nortel’s financial condition and an accrued liability was recorded as it was paid in the third quarter of 2006.
 
In April 2004, Nortel announced that it was under investigation by the SEC in connection with the restatements of its financial statements in 2003 and 2004. As a result of discussions with the Enforcement Staff of the SEC for purposes of resolving the investigation, Nortel recorded an accrual in its condensed consolidated financial statements in the second quarter of 2007 in the amount of $35, which it believes represents the current best estimate for the liability associated with this matter. For additional information relating to this matter, see note 18.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
In April 2004, Nortel also announced that it was under investigation by the Ontario Securities Commission (the “OSC”) in connection with the same matters as the SEC investigation. In May 2007, Nortel and NNL entered into a settlement agreement with the Staff of the OSC in connection with its investigation. On May 22, 2007, the OSC issued an order approving the settlement agreement, which fully resolves all issues with the OSC. Under the terms of the OSC order, Nortel and NNL are required to deliver to the OSC Staff quarterly and annual written reports detailing, among other matters, their progress in implementing their remediation plan. This reporting obligation began following the filing of the second quarter quarterly report on Form 10-Q and will end upon the earlier of the elimination of its remaining material weakness relating to revenue recognition and the completion of their remediation plan. The OSC order did not impose any administrative penalty or fine. However, Nortel made a payment to the OSC in the amount CAD $1 million as a contribution toward the cost of its investigation.
 
In May 2004, Nortel 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. In August 2005, Nortel received an additional federal grand jury subpoena seeking additional documents, including documents relating to the Nortel Retirement Income Plan and the Nortel Long-Term Investment Plan. This investigation is ongoing. A criminal investigation into Nortel’s financial accounting situation by the Integrated Market Enforcement Team of the Royal Canadian Mounted Police is also ongoing.
 
Beginning in December 2001, Nortel, together with certain of its then-current and former directors, officers and employees, was named as a defendant in several purported class action lawsuits pursuant to the United States Employee Retirement Income Security Act. These lawsuits have been consolidated into a single proceeding in the U.S. District Court for the Middle District of Tennessee. This lawsuit is on behalf of participants and beneficiaries of the Nortel Long-Term Investment Plan, who held shares of the Nortel Networks Stock Fund during the class period, which has yet to be determined by the court. The lawsuit alleges, among other things, material misrepresentations and omissions to induce participants and beneficiaries to continue to invest in and maintain investments in Nortel’s common shares through the investment plan. The court has not yet ruled as to whether the plaintiff’s proposed class action should be certified.
 
In January 2005, Nortel and NNL filed a Statement of Claim in the Ontario Superior Court of Justice against Messrs. Frank Dunn, Douglas Beatty and Michael Gollogly, their former senior officers who were terminated for cause in April 2004, seeking the return of payments made to them under Nortel’s bonus plan in 2003.
 
In April 2006, Mr. Dunn filed a Notice of Action and Statement of Claim in the Ontario Superior Court of Justice against Nortel and NNL asserting claims for wrongful dismissal, defamation and mental distress, and seeking punitive, exemplary and aggravated damages, out-of-pocket expenses and special damages, indemnity for legal expenses incurred as a result of civil and administrative proceedings brought against him by reason of his having been an officer or director of the defendants, pre-judgment interest and costs.
 
In May and October 2006, respectively, Messrs. Gollogly and Beatty filed Statements of Claim in the Ontario Superior Court of Justice against Nortel and NNL asserting claims for, among other things, wrongful dismissal and seeking compensatory, aggravated and punitive damages, and pre-and post-judgment interest and costs.
 
In June 2005, Ipernica Limited (formerly known as QSPX Development 5 Pty Ltd), an Australian patent holding firm, filed a lawsuit against Nortel in the U.S. District Court for the Eastern District of Texas alleging patent infringement. In April 2007, the jury reached a verdict to award damages to the plaintiff in the amount of $28. Post-trial motions have been filed. The trial judge will next enter a judgment that could range from increasing the damages award against Nortel to a reversal of the jury’s verdict.
 
Except as otherwise described herein, in each of the matters described above, the plaintiffs are seeking an unspecified amount of monetary damages. 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. With the exception of $2,474 and the related fair value adjustments, which Nortel recorded in 2006 and first quarter of 2007 financial results as a result of the Global Class Action Settlement and the accrued liability for the Ontario Settlement, Nortel has not made any provisions for any potential judgments, fines, penalties or settlements that may result from these actions, suits, claims and investigations. Except for the Global Class Action Settlement, Nortel cannot determine whether these actions, suits, claims and


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
proceedings will, individually or collectively, have a material adverse effect on its business, results of operations, financial condition or liquidity. Except for matters encompassed by the Global Class Action Settlement and the Ontario Settlement, Nortel intends to 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.
 
Nortel is also a defendant in various other suits, claims, proceedings and investigations which arise in the normal course of business.
 
 
Nortel’s business is subject to a wide range of continuously evolving environmental laws in various jurisdictions. Nortel seeks to operate its business in compliance with these changing laws and regularly evaluates their impact on operations, products and facilities. Existing and new laws may cause Nortel to incur additional costs. In some cases, environmental laws affect Nortel’s ability to import or export certain products to or from, or produce or sell certain products in, some jurisdictions, or have caused it to redesign products to avoid use of regulated substances. Although costs relating to environmental compliance have not had a material adverse effect on the business, results of operations, financial condition or liquidity to date, there can be no assurance that such costs will not have a material adverse effect going forward. Nortel continues to evolve compliance plans and risk mitigation strategies relating to the new laws and requirements. Nortel intends to design and manufacture products that are compliant with all applicable legislation and meet its quality and reliability requirements.
 
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 generation, management and disposal of hazardous substances and wastes. As of September 30, 2007, the accruals on the condensed consolidated balance sheet for environmental matters were $27. Based on information available as of September 30, 2007, 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 13 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 $27.
 
Nortel is also listed as a potentially responsible party under the U.S. Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) at four Superfund sites in the U.S. (at three of the Superfund sites, Nortel is considered a de minimis potentially responsible party). A potentially responsible party within the meaning of CERCLA is generally considered to be a major contributor to the total hazardous waste at a Superfund site (typically 10% or more, depending on the circumstances). A de minimis potentially responsible party is generally considered to have contributed less than 10% (depending on the circumstances) of the total hazardous waste at a Superfund site. 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 $27 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.


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NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
18.   Subsequent events
 
As described in note 17, in April 2004, Nortel announced that it was under investigation by the SEC in connection with the previous restatements of its consolidated financial statements. On October 15, 2007, it was announced that Nortel had reached a settlement on all issues with the SEC in connection with the investigation. As part of the settlement, Nortel agreed to pay a civil penalty of $35 and Nortel and NNL consented to be restrained and enjoined from future violations of certain provisions of federal securities laws in the U.S. Nortel and NNL also agreed to provide to the SEC quarterly written reports detailing the progress in implementing Nortel’s and NNL’s remediation plan and actions to address their remaining weakness relating to revenue recognition.
 
19.   Supplemental condensed consolidated financial information
 
On July 5, 2006, NNL completed an offering of $2,000 aggregate principal amount of senior notes (the “July 2006 Notes”) to qualified institutional buyers pursuant to Rule 144A and to persons outside the United States pursuant to Regulation S under the Securities Act. The July 2006 Notes consist of $450 of senior fixed rate notes due 2016, $550 of senior fixed rate notes due 2013 and $1,000 of senior floating rate notes due 2011. The July 2006 Notes are fully and unconditionally guaranteed by Nortel and initially guaranteed by NNI.
 
On March 28, 2007, Nortel completed an offering of $1,150 aggregate principal amount of Convertible Notes to qualified institutional buyers pursuant to Rule 144A under the Securities Act and in Canada to qualified institutional buyers that are also accredited investors pursuant to applicable Canadian private placement exemptions. The Convertible Notes consist of $575 principal amount of the 2012 Notes and $575 principal amount of the 2014 Notes. The Convertible Notes are fully and unconditionally guaranteed by NNL and initially guaranteed by NNI. See note 10 for more information.
 
The guarantee by NNI of the July 2006 Notes or the Convertible Notes will be released if the July 2006 Notes or the Convertible Notes, as applicable, are rated Baa3 or higher by Moody’s and BBB− or higher from Standard & Poor’s, in each case, with no negative outlook.
 
The following supplemental condensed consolidated financial data has been prepared in accordance with Rule 3-10 of Regulation S-X promulgated under the Securities Act and illustrates, in separate columns, the composition of Nortel, NNL, NNI as the Guarantor Subsidiary of the July 2006 Notes and the Convertible Notes, the subsidiaries of Nortel that are not issuers or guarantors of the July 2006 Notes and the Convertible Notes (the “Non-Guarantor Subsidiaries”), eliminations and the consolidated total as of September 30, 2007 and December 31, 2006, and for the three and nine month periods ended September 30, 2007 and 2006.
 
Investments in subsidiaries are accounted for using the equity method for purposes of the supplemental consolidated 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.


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Table of Contents

 
NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
Supplemental Condensed Consolidated Statements of Operations for the three months ended September 30, 2007 (unaudited):
 
                                                 
    Nortel
    Nortel
          Non-
             
    Networks
    Networks
    Guarantor
    Guarantor
             
(Millions of U.S. Dollars)   Corporation     Limited     Subsidiary     Subsidiaries     Eliminations     Total  
 
Revenues
  $     $ 880     $ 1,116     $ 1,528     $ (819 )   $ 2,705  
Cost of revenues
          459       802       1,100       (819 )     1,542  
                                                 
Gross profit
          421       314       428             1,163  
Selling, general and administrative expense
          113       219       281             613  
Research and development expense
          204       174       38             416  
Amortization of intangible assets
                2       10             12  
Special charges
          3       1       52             56  
Loss on sale of businesses and assets
          1       1       1             3  
                                                 
Operating earnings (loss)
          100       (83 )     46             63  
Other income (expense) — net
    (4 )     136       3       27       1       163  
Interest expense
                                               
Long-term debt
    (31 )     (58 )     (3 )     (10 )           (102 )
Other
    4       (7 )     (19 )     17             (5 )
                                                 
Earnings (loss) from operations before income taxes, minority interests and equity in net earnings (loss) of associated companies
    (31 )     171       (102 )     80       1       119  
Income tax benefit (expense)
          (5 )     1       (46 )           (50 )
                                                 
      (31 )     166       (101 )     34       1       69  
Minority interests — net of tax
    (10 )                 (33 )           (43 )
Equity in net earnings (loss) of associated companies — net of tax
    68       (77 )     50       1       (41 )     1  
                                                 
Net earnings (loss) before cumulative effect of accounting change
    27       89       (51 )     2       (40 )     27  
Cumulative effect of accounting change — net of tax
                                   
                                                 
Net earnings (loss)
    27       89       (51 )     2       (40 )     27  
Dividends on preferred shares
          10                   (10 )      
                                                 
Net earnings (loss) applicable to common shares
  $ 27     $ 79     $ (51 )   $ 2     $ (30 )   $ 27  
                                                 


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Table of Contents

 
NORTEL NETWORKS CORPORATION
 
Notes to Condensed Consolidated Financial Statements (unaudited) — (Continued)
 
Supplemental Condensed Consolidated Statements of Operations for the three months ended September 30, 2006 (unaudited):
 
                                                 
    Nortel
    Nortel
          Non-
             
    Networks
    Networks
    Guarantor
    Guarantor
             
(Millions of U.S. Dollars)   Corporation     Limited     Subsidiary     Subsidiaries     Eliminations     Total  
 
Revenues
  $     $ 915     $ 1,329     $ 1,436     $ (754 )   $ 2,926  
Cost of revenues
          542       1,083       932       (754 )     1,803  
                                                 
Gross profit
          373       246       504             1,123  
Selling, general and administrative expense
    (5 )     147       217       226