UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the Quarterly Period Ended June 30, 2004

OR

For the Transition Period From                             to                            

Commission file number 001-07260

Nortel Networks Corporation

Registrant’s telephone number including area code (905) 863-0000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days.

Yes          No ü

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ü          No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as at January 21, 2005

4,268,236,086 without nominal or par value

EXPLANATORY NOTE

Nortel Networks Corporation previously announced the need to restate its consolidated financial statements for the years ended December 31, 2002 and 2001 and each of its first three quarterly periods for 2003.

The unaudited consolidated statements of operations for the three and six months ended June 30, 2003 and the unaudited consolidated statements of cash flows for the six months ended June 30, 2003, including the applicable notes, contained in this Quarterly Report on Form 10-Q, have been restated.

A number of Nortel Networks past filings with the United States Securities and Exchange Commission remain subject to ongoing review by the United States Securities and Exchange Commission’s Division of Corporation Finance. In addition, the Second Restatement involved the restatement of Nortel Networks consolidated financial statements for 2001 and 2002 and the first, second and third quarters of 2003. Amendments to Nortel Networks prior filings with the United States Securities and Exchange Commission would be required in order for Nortel Networks to be in full compliance with Nortel Networks reporting obligations under the Securities Exchange Act of 1934. However, Nortel Networks does not believe that it will be feasible to amend Nortel Networks Annual Report on Form 10-K/A for the year ended December 31, 2002, or 2002 Form 10-K/A and our 2003 Quarterly Reports due to, among other factors, identified material weaknesses in Nortel Networks internal control over financial reporting, the significant turnover in Nortel Networks finance personnel, changes in accounting systems, documentation weaknesses, a likely inability to obtain third party corroboration in certain cases due to the substantial industry adjustment in recent years and the passage of time generally. In addition, disclosure in the 2002 Form 10-K/A and 2003 Form 10-Qs would in large part repeat the disclosure contained in our 2003 Annual Report on Form 10-K and this report and expected to be contained in our other 2004 Form 10-Qs. Accordingly, Nortel Networks does not plan to amend our 2002 Form 10-K/A and 2003 Form 10-Qs. Nortel Networks believes that it has included in our 2003 Annual Report on Form 10-K and in this report all information needed for current investor understanding. Ongoing United States Securities and Exchange Commission review may require Nortel Networks to amend this Quarterly Report on Form 10-Q or Nortel Networks other public filings.

For a description of the restatements, see “Restatement” in note 2 of the unaudited consolidated financial statements and “Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations — Developments in 2004 — Nortel Networks Audit Committee Independent Review; restatements; related matters” contained in this Quarterly Report on Form 10-Q.

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TABLE OF CONTENTS

PART I
FINANCIAL INFORMATION

All dollar amounts in this document are in United States dollars unless otherwise stated.

NORTEL, NORTEL NETWORKS, NORTEL NETWORKS LOGO, NT, the GLOBEMARK, BAYSTACK, OPTERA and PASSPORT are trademarks of Nortel Networks.

MOODY’S is a trademark of Moody’s Investor Services, Inc.

RCMP is a trademark of the Royal Canadian Mounted Police.

S&P and STANDARD & POOR’S are trademarks of The McGraw-Hill Companies, Inc.

Any other company or product names may be trademarks of their respective companies.

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PART I
FINANCIAL INFORMATION

NORTEL NETWORKS CORPORATION

The accompanying notes are an integral part of these consolidated financial statements

5

NORTEL NETWORKS CORPORATION

The accompanying notes are an integral part of these consolidated financial statements

6

NORTEL NETWORKS CORPORATION

The accompanying notes are an integral part of these consolidated financial statements

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NORTEL NETWORKS CORPORATION
Notes to Consolidated Financial Statements (unaudited)
(millions of U.S. dollars, except per share amounts, unless otherwise stated)

1.

Significant accounting policies

Basis of presentation

		The unaudited consolidated financial statements of Nortel Networks Corporation (“Nortel Networks”) have been prepared in accordance with accounting principles generally accepted in the United States (“U.S.”) (“GAAP”) and the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”) for the preparation of interim financial information. They do not include all information and notes required by U.S. GAAP in the preparation of annual consolidated financial statements. The accounting policies used in the preparation of the unaudited consolidated financial statements are the same as those described in Nortel Networks audited consolidated financial statements prepared in accordance with U.S. GAAP for the year ended December 31, 2003, except as described in note 3. Although Nortel Networks is headquartered in Canada, the unaudited consolidated financial statements are expressed in U.S. dollars as the greater part of the financial results and net assets of Nortel Networks are denominated in U.S. dollars.
		As described in note 2, the unaudited consolidated statements of operations for the three and six months ended June 30, 2003, and the consolidated statement of cash flows for the six months ended June 30, 2003, including the applicable notes, were restated.
		Nortel Networks believes all adjustments necessary for a fair statement of the results for the periods presented have been made and all such adjustments were of a normal recurring nature. The financial results for the three and six months ended June 30, 2004 are not necessarily indicative of financial results for the full year. The unaudited consolidated financial statements should be read in conjunction with Nortel Networks Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC (“Nortel Networks 2003 Annual Report”).

Comparative figures

Certain 2003 figures in the unaudited consolidated financial statements have been reclassified to conform to the 2004 presentation and certain 2003 figures have been restated as set out in note 2.

Recent accounting pronouncements

	(a)		In March 2004, the Emerging Issues Task Force (“EITF”) reached consensus on Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”). EITF 03-1 provides guidance on determining when an investment is considered impaired, whether that impairment is other than temporary and the measurement of an impairment loss. EITF 03-1 is applicable to marketable debt and equity securities within the scope of Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”), and SFAS No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations”, and equity securities that are not subject to the scope of SFAS 115 and not accounted for under the equity method of accounting. In September 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) EITF 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, ‘The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments’”, which delays the effective date for the measurement and recognition criteria contained in EITF 03-1 until final application guidance is issued. The delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. The adoption of EITF 03-1 is not expected to have a material impact on Nortel Networks results of operations and financial position.
	(b)		On September 30, 2004, the EITF reached a consensus on Issue No. 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings Per Share” (“EITF 04-8”), which addresses when the dilutive effect of contingently convertible debt instruments should be included in diluted earnings (loss) per share. EITF 04-8 requires that contingently convertible debt instruments be included in the computation of diluted earnings (loss) per share regardless of whether the market price trigger has been met. EITF 04-8 also requires that prior period diluted earnings (loss) per share amounts presented for comparative purposes be restated. EITF 04-8 is effective for reporting periods ending after December 15, 2004. The adoption of EITF 04-8 is not expected to have an impact on Nortel Networks diluted earnings (loss) per share.

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2.

Restatement

		First Restatement
		In May 2003, Nortel Networks commenced certain balance sheet reviews at the direction of certain members of former management that led to a comprehensive review and analysis of its assets and liabilities (the “Comprehensive Review”), which resulted in the restatement (effected in December 2003) of its consolidated financial statements for the years ended December 31, 2002, 2001 and 2000 and for the quarters ended March 31, 2003 and June 30, 2003 (the “First Restatement”).
		The Comprehensive Review purported to (i) identify balance sheet accounts that, as of June 30, 2003, were not supportable and required adjustment; (ii) determine whether such adjustments related to the third quarter of 2003 or prior periods; and (iii) document certain account balances in accordance with Nortel Networks accounting policies and procedures. The Comprehensive Review was supplemented by additional procedures carried out between July 2003 and November 2003 to quantify the effects of potential adjustments in the relevant periods and review the appropriateness of releases of certain contractual liability and other related provisions (also called accruals, reserves or accrued liabilities) in the six fiscal quarters ending with the fiscal quarter ended June 30, 2003 and formed the basis for the adjustments made to the financial statements in the First Restatement.
		On December 23, 2003, Nortel Networks filed with the SEC an amended Annual Report on Form 10-K/A for the year ended December 31, 2002 (the “2002 Form 10-K/A”) and amended Quarterly Reports on Form 10-Q/A for the first and second quarters of 2003 (the “2003 Form 10-Q/As”) reflecting the First Restatement. As disclosed in those reports, the net effect of the First Restatement adjustments was a reduction in accumulated deficit of $497, $178 and $31 as of December 31, 2002, 2001 and 2000, respectively.
		Second Restatement
		In late October 2003, the Audit Committee of Nortel Networks and Nortel Networks Limited (“NNL”) Boards of Directors (the “Audit Committee”) initiated an independent review of the facts and circumstances leading to the First Restatement (the “Independent Review”) and engaged the law firm now known as Wilmer Cutler Pickering Hale & Dorr LLP (“WCPHD”) to advise it in connection with the Independent Review. The Audit Committee sought to gain a full understanding of the events that caused significant excess liabilities to be maintained on the balance sheet that needed to be restated, and to recommend that the Board adopt, and direct management to implement, necessary remedial measures to address personnel, controls, compliance and discipline. The Independent Review focused initially on events relating to the establishment and release of contractual liability and other related provisions in the second half of 2002 and the first half of 2003, including the involvement of senior corporate leadership. As the Independent Review evolved, its focus broadened to include specific provisioning activities in each of the business units and geographic regions. In light of concerns raised in the initial phase of the Independent Review, the Audit Committee expanded the review to include provisioning activities in the third and fourth quarters of 2003.
		As the Independent Review progressed, the Audit Committee directed new corporate management to examine in depth the concerns identified by WCPHD regarding provisioning activity and to review provision releases in each of the four quarters of 2003, down to a low threshold. That examination, and other errors identified by management, led to the restatement of Nortel Networks consolidated financial statements for the years ended December 31, 2002 and 2001 and the quarters ended March 31, 2003 and 2002, June 30, 2003 and 2002 and September 30, 2003 and 2002 (the “Second Restatement”).
		Over the course of the Second Restatement process, management also identified certain accounting practices that it determined should be adjusted as part of the Second Restatement. In particular, management identified certain errors related to revenue recognition and undertook a process of revenue reviews. In light of the resulting adjustments to revenues previously reported, the Audit Committee has determined to review the facts and circumstances leading to the restatement of these revenues for specific transactions identified in the Second Restatement. This review will have a particular emphasis on the underlying conduct that led to the initial recognition of these revenues.
		Other accounting practices that management examined and adjusted as part of the Second Restatement included, among other things, the following:

•

Nortel Networks foreign exchange accounting as part of management’s plan to address an identified material weakness related to foreign currency translation;

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	•		intercompany balances that did not eliminate upon consolidation and related provisions;
	•		the accounting treatment of the February 2001 acquisition of the 980 NPLC business from JDS Uniphase Corporation (“JDS”) and the related OEM Purchase and Sale Agreement;
	•		special charges relating to goodwill, inventory impairment, contract settlement costs and other charges; and
	•		the accounting treatment of certain elements of discontinued operations.

		Due to, among other factors, significant turnover in Nortel Networks finance personnel, changes in accounting systems, documentation weaknesses and identified material weaknesses in internal control over financial reporting, the Second Restatement involved hundreds of Nortel Networks finance personnel and a number of outside consultants and advisors. The process required the review and verification of a substantial number of documents and communications and related accounting entries over multiple fiscal periods. In addition, the review of accruals and provisions and the application of accounting literature to certain matters in the Second Restatement, including revenue recognition, foreign exchange, special charges and discontinued operations, was complicated by the passage of time, lack of availability of supporting records and the turnover of finance personnel. As a result of this complexity, estimates and assumptions that impact both the quantum of the various recorded adjustments and the fiscal period to which they were attributed were required in the determination of certain of the Second Restatement adjustments. Nortel Networks believes the procedures followed in determining such estimates were appropriate and reasonable using the best available information.
		The following tables present the impact of the Second Restatement adjustments on Nortel Networks previously reported consolidated statements of operations and a summary of the adjustments from the Second Restatement for the three and six months ended June 30, 2003. The Second Restatement adjustments related primarily to the following items, each of which reflect a number of related adjustments that have been aggregated for disclosure purposes, and are described in the paragraphs following the tables below:

	•		Revenues and cost of revenues;
	•		Foreign exchange;
	•		Intercompany balances;
	•		Special charges;
	•		Other;
	•		Reclassifications; and
	•		Discontinued operations.

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Consolidated Statements of Operations

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Summary of Restatement Adjustments for the three months ended June 30, 2003:

Summary of Restatement Adjustments for the six months ended June 30, 2003:

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		The effect of the Second Restatement adjustments on the consolidated balance sheet as of June 30, 2003 is shown following the discussion below.
		Revenues and cost of revenues
		Revenues and cost of revenues were impacted by various errors related to revenue recognition, corrections to foreign exchange accounting, intercompany related items and other adjustments, including financial statement reclassifications. These items are further described below. The net impact to revenues of the adjustments was a decrease of $53 and a decrease of $132 for the three and six months ended June 30, 2003, respectively. The net impact to cost of revenues related to these revenue adjustments, and the other corrections was an increase of $93 and $163 for the three and six months ended June 30, 2003, respectively. The following table summarizes the revenue recognition adjustments and other adjustments to revenues and cost of revenues, which decreased gross profit by $146 and $295 in the three and six months ended June 30, 2003, respectively:

		Application of SAB 101 or SOP 97-2
		Title and delivery
		Revenues were recognized on certain sales (primarily prior to 2001) for which it was subsequently determined that the criteria for revenue recognition under SAB 101 or SOP 97-2, as applicable, had not been met, including arrangements in which legal title or risk of loss on products did not transfer to the buyer until full payment was received, and arrangements where delivery had not occurred. Revenues and related cost of revenues for these agreements should have been deferred until title or risk of loss had passed and all criteria for revenue recognition had been met. Therefore, adjustments were made to defer revenues and related cost of revenues from the periods in which they were originally recorded and to recognize them in the periods in which all revenue recognition criteria were met.
		Undelivered elements and liquidated damages
		In certain multiple element arrangements, total arrangement fees were recognized as revenue at the time of delivery of software or hardware, but prior to the delivery of future contractual or implicit post-contract support (“PCS”) or other services. Revenues should have been allocated to these future deliverables based on their fair value and recognized ratably over the PCS period or as the future obligations were performed. As well, in certain circumstances where the criteria to treat delivered software and hardware elements and undelivered PCS services as separate accounting units were not met, the entire arrangement fee should have been recognized over the PCS period. Adjustments were made to appropriately allocate revenue among the accounting units and recognize the allocated revenue in accordance with the applicable revenue recognition guidance.

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		Revenues were also recognized for certain contracts that involved undelivered elements as a result of product development delays. The lack of relative fair value for the undelivered element meant that revenues and cost of revenues for all products delivered should have been deferred until the undelivered element was delivered. As originally recorded, revenues were recognized upon delivery of an alternative product and costs were accrued for the undelivered element. To correct for these items, related cost provisions were reversed and revenues and associated cost of revenues were recognized in the appropriate periods when all elements had been delivered.
		Revenues were recognized on certain contracts with potential liquidated damages arising primarily from network outages, shipment delays or product development delays on undelivered elements. Generally, revenues and related cost of revenues should have been deferred up to the maximum potential liquidated damages until the damages had been incurred or there was no longer a possibility of incurring such damages. Specific contracts, primarily in the Asia region, had the potential for liquidated damages plus right of return privileges if such damages exceeded contractually defined thresholds due to a product development delay (undelivered element). Revenues for all products delivered should have been deferred until the undelivered element was delivered. After delivery of the undelivered element, and in light of a lack of a reasonable and reliable history of comparable product returns on which to base a returns allowance, revenues should have been deferred until the right of return had lapsed or until expected returns could be reasonably estimated. After the right of return had lapsed or reasonable estimates of expected returns could be made, revenues should have continued to be deferred up to the amount of the maximum potential liquidated damages until either the earlier of when the damages were incurred, or there was no longer the possibility of incurring any damages. As originally recorded, cost provisions were recorded for the amount of the estimated damages and/or cost of product replacement. To correct these items, related cost provisions were reversed and revenues and associated cost of revenues were recognized in the appropriate periods.
		Application of SOP 81-1
		Adjustments were required to the application of percentage-of-completion accounting for certain long-term construction contracts. In the Europe, Middle East and Africa (“EMEA”) region, revenues and costs of revenues were not recognized using an appropriate measure of progress towards completion. An input method should have been used based on actual costs incurred and known/projected margin estimates at the time. This error was corrected, as well as other application errors that were identified across all regions.
		Persuasive evidence of an arrangement
		For a specific transaction in the Asia Pacific region, revenues were recognized after a notice of award was received but before a contract was executed. Revenues should have been deferred until a contract was executed. To correct for this item, revenues and related cost of revenues were deferred until contract execution occurred.
		Other revenue recognition adjustments
		Other adjustments primarily included corrections related to an overstatement of revenues and cost of revenues as a result of two specific transactions recorded in the first quarter of 2003 which should have been recorded in 2002. In addition, other revenue recognition adjustments were made which related to a specific contract in the Caribbean and Latin American (“CALA”) region, other errors related to non-cash incentives and concessions provided to customers and other calculation errors.
		Foreign exchange
		As part of the plan to address a material weakness reported in Nortel Networks Quarterly Report on Form 10-Q for the period ended September 30, 2003, a review of foreign exchange accounting was undertaken. The net impact was a decrease to pre-tax loss of $15 and $106 for the three and six months ended June 30, 2003, respectively. The following presents the impact of these restatement adjustments on the consolidated statements of operations for the three and six months ended June 30, 2003, which are described below:

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		Functional currency designation
		The determination of the functional currency for certain entities was re-examined, based on the guidance under SFAS No. 52, “Foreign Currency Translation” (“SFAS 52”). As a result, Nortel Networks identified four instances in which the functional currency designation of an entity was incorrect. These revisions resulted in increases or decreases to other income (expense) — net.
		Intercompany transaction designation
		Nortel Networks identified two instances of incorrect treatment of significant foreign currency translation gains and losses arising from intercompany positions. Under SFAS 52, intercompany foreign currency transactions that were long-term in nature should have been recorded in accumulated other comprehensive loss on the balance sheet when translated rather than recorded as a transactional gain or loss in the statement of operations. The net impact of the adjustments was an increase or decrease to other income (expense) — net, with an offset to accumulated other comprehensive loss.
		Revaluation errors related to discontinued operations
		Errors were identified in the revaluation of certain foreign denominated customer financing provisions within discontinued operations, the correction of which increased other income and decreased net earnings from discontinued operations.
		Other errors
		Other errors identified were related to translation of foreign denominated intercompany transactions, revaluation of certain foreign denominated intercompany transactions and accounting for mark-to-market adjustments for foreign exchange contracts as required under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”).
		Intercompany balances
		Historically, Nortel Networks had certain intercompany balances that did not eliminate upon consolidation (“out-of-balance positions”), and provisions had been recorded accordingly. As part of the Second Restatement, Nortel Networks reviewed these provisions and determined that they should not have been recorded. Adjustments were recorded in the appropriate periods to reverse these provisions and to correct the significant out-of-balance positions. The adjustments to reverse the provisions affected the second quarter of 2003 and periods prior to 2000. The net impact was an increase of $14 and $20 to pre-tax loss for the three and six months ended June 30, 2003, respectively.
		Special charges
		As part of the Second Restatement, the components of special charges were re-examined and the impact to special charges was a decrease of $20 and an increase of $8 for the three and six months ended June 30, 2003, respectively.

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Adjustments for restructuring were recorded to special charges related to contract settlement costs, including real estate related items, severance and fringe benefit related costs and plant and equipment impairment costs. Nortel Networks determined that these items were either recorded in special charges in error or, although correctly recorded when originally recognized, were not adjusted in the appropriate subsequent periods for changes in estimates and/or assumptions. The following presents the impact of these other adjustments on special charges for the three and six months ended June 30, 2003:

		Other
		Other adjustments were primarily to correct certain accruals, provisions or other transactions which were either initially recorded incorrectly in prior periods, or not properly released or adjusted for changes in estimates and/or assumptions in the appropriate subsequent periods. The components of these adjustments for the three and six months ended June 30, 2003, are described below.

		Cost of revenues
		For the three months ended June 30, 2003, the increase to cost of revenues of $91 was comprised primarily of an increase of approximately $28 for customer and contract related accruals, approximately $23 for warranty costs, approximately $19 to reflect an adjustment to the timing of employee bonus related accruals, including as a result of the applicable performance metrics for the bonus awards not having been met in the period in which the bonuses were originally awarded as a result of the Second Restatement, approximately $13 for inventory and product related accruals, and approximately $8 related to other accruals.
		For the six months ended June 30, 2003, the increase to cost of revenues of $106 was comprised primarily of an increase of approximately $39 for customer and contract related accruals, approximately $35 for warranty costs, $15 for inventory and product related accruals, and approximately $17 related to other accruals.
		Selling, general and administrative expense
		For the three months ended June 30, 2003, the increase of $24 to selling, general and administrative expense was comprised primarily of increases of approximately $30 related to contract amendments and settlements with certain

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		service providers, increases of approximately $18 to other accruals and an increase of $3 to reflect net adjustments to the timing of employee bonus related accruals, partially offset by a decrease of approximately $24 related to bad debt expense.
		For the six months ended June 30, 2003, the decrease of $9 to selling, general and administrative expense was comprised primarily of reductions of approximately $48 related to bad debt expense and approximately $42 to reflect net adjustments to the timing of employee bonus related accruals, partially offset by approximately $42 related to contract amendments and settlements with certain service providers and increases of approximately $39 to other accruals.
		Research and development expense
		For the three months ended June 30, 2003, the increase of $31 in research and development expense was primarily the result of an increase of approximately $26 to reflect an adjustment to the timing of employee bonus related accruals, including as a result of the applicable performance metrics for the bonus awards not having been met in the period in which the bonuses were originally awarded as a result of the Second Restatement and increases of approximately $21 to accruals related to various research and development projects and other accruals, partially offset by approximately $16 to correctly treat certain software repair costs as warranty costs.
		For the six months ended June 30, 2003, the increase of $9 in research and development expense was primarily the result of approximately $39 to accruals related to various research and development projects and other accruals, partially offset by approximately $30 to correctly treat certain software repair costs as warranty costs.
		Deferred stock option compensation
		For the three and six months ended June 30, 2003, the decrease of $11 and $20, respectively, in deferred stock option compensation was the result of a correction to the calculation of the valuation of deferred compensation on an acquisition in a prior year.
		Other income (expense) — net
		For the three months ended June 30, 2003, the increase of $29 in other income was primarily the result of adjustments of approximately $9 related to sales and use tax provisions, and approximately $20 related to other accruals.
		For the six months ended June 30, 2003, the increase of $11 in other income was primarily the result of an increase of approximately $17 from corrections to the timing of the recognition of the impairment of certain investments, approximately $16 for unused customer credits originally recognized as a reduction to customer revenues in this period and approximately $15 related to other accruals, partially offset by a decrease of approximately $22 related to sales and use tax accruals and adjustments of approximately $15 related to sales of receivables and customer financing.
		Interest expense
		For the three months ended June 30, 2003, the increase to interest expense of $5 was primarily related to long-term debt for corrections to accounting for certain sale-leaseback transactions.
		For the six months ended June 30, 2003, the increase to interest expense of $7 was primarily the result of a $9 increase related to long-term debt for corrections to accounting for certain sale-leaseback transactions, partially offset by a $2 decrease from adjustments to the timing of the recognition of costs associated with sales of receivables and customer financing.
		Income taxes, minority interests and equity in net loss of associated companies — net of tax
		Income tax benefit and minority interests were also adjusted as part of the Second Restatement. The adjustment to income tax benefit was an increase of $4 and $12 for the three and six months ended June 30, 2003, respectively, primarily related to investment tax credits and taxes attributable to preferred share dividends. The adjustment to minority interests as a result of the Second Restatement adjustments was a decrease of $2 and an increase of $26 for the three and six months ended June 30, 2003, respectively.
		As part of the Second Restatement, equity in net loss of associated companies — net of tax was adjusted to reflect the final reported losses of the associated companies for the period rather than the estimates that were used when originally recorded. The adjustment resulted in a decrease to net loss of $17 and $5 for the three and six months ended June 30, 2003, respectively.

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		Reclassifications
		As a result of the restatement process, various presentation inconsistencies were identified. Adjustments were made to appropriately reflect certain items in the consolidated statements of operations. The reclassifications were made for royalty expense, (gain) loss on sale of businesses and assets and other items including certain functional spending and specific expenses. The amounts that were reclassified for the three and six months ended June 30, 2003 are detailed below:

		Discontinued operations
		As a result of the restatement process, the initial provision for loss on disposal of the access solutions discontinued operations recorded in June 2001, and the subsequent activity during 2001 through 2004 were re-examined. Nortel Networks concluded that the net loss on disposal of operations recognized in the second quarter of 2001 was overstated. In addition, other adjustments were necessary to correct certain items that were either initially recorded incorrectly, or not properly released or adjusted for changes in estimates in the appropriate periods subsequent to the second quarter of 2001. The net impact of the adjustments was an increase of $7 (net of tax of $1) to the previously reported net loss from discontinued operations for the three months ended June 30, 2003 and a decrease of $75 (net of tax of $1) to the previously reported net earnings from discontinued operations for the six months ended June 30, 2003.
		For the three months ended June 30, 2003, the $7 increase to net loss from discontinued operations consisted primarily of increases of approximately $12 resulting from additional provisions related to discontinued operations and approximately $9 related to the revaluation of certain foreign denominated customer financing provisions, partially offset by a $17 net decrease from adjustments to contingent liabilities.
		For the six months ended June 30, 2003, the $75 decrease to net earnings from discontinued operations consisted primarily of a decrease of approximately $90 resulting from the elimination of a gain on redemption of an investment interest due to the reversal in an earlier period of a full valuation allowance that had been recorded against the investment interest when acquired, a decrease of approximately $39 related to the revaluation of certain foreign denominated customer financing provisions and a decrease of approximately $12 resulting from additional provisions related to discontinued operations, partially offset by a $50 net increase from adjustments to contingent liabilities and an increase of approximately $11 related to a gain on settlement of a sales representation agreement which had previously been recorded in continuing operations.
		Balance sheet
		The following table presents the impact of the Second Restatement adjustments on Nortel Networks previously reported consolidated balance sheet as of June 30, 2003. The impact on inventories — net and various liabilities, including deferred revenue, was primarily due to the adjustments to revenues and cost of revenues described above. The adjustments to plant and equipment — net and long-term debt primarily related to corrections to the accounting for certain sale-leaseback transactions. In addition, there were reclassifications resulting from the restatement adjustments and to conform to the 2003 presentation in the consolidated balance sheet.

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Consolidated Balance Sheet as of June 30, 2003

3.

Accounting changes

(a)

Stock-based compensation

Effective January 1, 2003, Nortel Networks elected to expense employee stock-based compensation using the fair value based method prospectively for all awards granted or modified on or after January 1, 2003 in accordance with SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of FASB Statement No. 123”. Prior to January 1, 2003, Nortel Networks, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation”, applied the intrinsic value method under Accounting Principles Board Opinion No. 25,

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			“Accounting for Stock Issued to Employees”, and related interpretations, in accounting for its employee stock-based compensation plans. The fair value at grant date of stock options is estimated using the Black-Scholes option-pricing model. Compensation expense is recognized on a straight line basis over the vesting period of the award.
			Had Nortel Networks applied the fair value based method to all stock-based awards in all periods, reported net earnings (loss) and earnings (loss) per common share would have been adjusted to the pro forma amounts indicated below for each of the three and six months ended June 30:

(a)

Stock-based compensation — reported, included:

	i.		Stock option expense for the three and six months ended June 30, 2004 of $21 and $36, respectively, which was net of tax of nil in each period. For the three and six months ended June 30, 2003, the amounts were $7 and $12, respectively, which was net of tax of nil in each period;
	ii.		Employer portion of stock purchase plan contributions expense for the three and six months ended June 30, 2004 of nil. For the three and six months ended June 30, 2003, the amounts were $2 and $3, respectively, which was net of tax of nil in each period;
	iii.		Restricted stock units expense for the three and six months ended June 30, 2004 of nil and $41, respectively, which was net of tax of nil in each period. For the three and six months ended June 30, 2003, the amounts were nil; and
	iv.		Deferred stock units expense for the three and six months ended June 30, 2004 of $(2) and $1, respectively, which was net of tax of nil in each period. For the three and six months ended June 30, 2003, the amounts were $1 and $2, respectively, which was net of tax of nil in each period.

	(b)		Deferred stock option compensation — reported represented the amortization of deferred stock option compensation related primarily to unvested stock options held by employees of companies acquired in a purchase acquisition. For the three and six months ended June 30, 2004, the amounts were net of tax of nil in each period. For the three and six months ended June 30, 2003, the amounts were $6 and $15, respectively, which was net of tax of nil in each period.
	(c)		Stock-based compensation — pro forma was net of tax of nil in each period.

The following weighted-average assumptions were used in computing the fair value of stock options for each of the three months and six months ended June 30: