UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended September 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 February 28, 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 nine months ended September 30, 2003 and the unaudited consolidated statements of cash flows for the nine months ended September 30, 2003, including the applicable notes, contained in this Quarterly Report on Form 10-Q, have been restated.

A number of Nortel’s 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 (as defined below) involved the restatement of Nortel’s consolidated financial statements for 2001 and 2002 and the first, second and third quarters of 2003. Amendments to Nortel’s prior filings with the United States Securities and Exchange Commission would be required in order for Nortel to be in full compliance with Nortel’s reporting obligations under the Securities Exchange Act of 1934. However, Nortel does not believe that it will be feasible to amend Nortel’s 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 on Form 10-Q, or 2003 Form 10-Qs, due to, among other factors, identified material weaknesses in Nortel’s internal control over financial reporting, the significant turnover in Nortel’s 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, this report and our other 2004 Form 10-Qs. Accordingly, Nortel does not plan to amend our 2002 Form 10-K/A and 2003 Form 10-Qs. Nortel 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 to amend this Quarterly Report on Form 10-Q or Nortel’s 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 and 2005 — Nortel 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.

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

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NORTEL NETWORKS CORPORATION
Consolidated Statements of Operations (unaudited)

* See note 2

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

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NORTEL NETWORKS CORPORATION
Consolidated Balance Sheets (unaudited)

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

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NORTEL NETWORKS CORPORATION
Consolidated Statements of Cash Flows (unaudited)

* See note 2

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

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

1.		Significant accounting policies
		Basis of presentation
		The unaudited consolidated financial statements of Nortel Networks Corporation (“Nortel”) have been prepared in accordance with accounting principles generally accepted in the United States (“U.S.”) (“GAAP”) and the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”) for the preparation of interim financial information. They do not include all information and notes required by U.S. GAAP in the preparation of annual consolidated financial statements. The accounting policies used in the preparation of the unaudited consolidated financial statements are the same as those described in Nortel’s audited consolidated financial statements prepared in accordance with U.S. GAAP for the year ended December 31, 2003, except as described in note 3. Although Nortel is headquartered in Canada, the unaudited consolidated financial statements are expressed in U.S. dollars as the greater part of the financial results and net assets of Nortel are denominated in U.S. dollars.
		Nortel makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates. Estimates are used when accounting for items and matters such as revenue recognition and accruals for losses on contracts, allowances for uncollectible accounts receivable and customer financing, receivables sales, inventory obsolescence, product warranty, amortization, asset valuations, impairment assessments, employee benefits including pensions, taxes, restructuring and other provisions, stock-based compensation and contingencies.
		As described in note 2, the unaudited consolidated statements of operations for the three and nine months ended September 30, 2003, and the unaudited consolidated statement of cash flows for the nine months ended September 30, 2003, including the applicable notes, were restated.
		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, 2004 are not necessarily indicative of financial results for the full year. The unaudited consolidated financial statements should be read in conjunction with Nortel’s Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC (“Nortel 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’s results of operations and financial position.

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	(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 will not have an impact on Nortel’s diluted earnings (loss) per share.
	(c)		In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”), which requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense in the consolidated financial statements based on their fair values. SFAS 123R also modifies certain measurement and expense recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), that will impact Nortel, including the requirement to estimate employee forfeitures each period when recognizing compensation expense, and requiring that the initial and subsequent measurement of the cost of liability-based service awards each period be based on the fair value (instead of the intrinsic value) of the award. This statement is effective as of the first interim or annual reporting period beginning after June 15, 2005. Nortel elected to expense employee stock-based compensation using the fair value method prospectively for all awards granted or modified on or after January 1, 2003 in accordance with SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of FASB Statement No. 123” (“SFAS 148”). Nortel is currently assessing the impact of SFAS 123R on its results of operations and financial position.
	(d)		In November 2004, the FASB issued SFAS No. 151, “Inventory Costs” (“SFAS 151”). SFAS 151 requires that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage), be recognized as current-period charges rather than capitalized as a component of inventory costs. In addition, SFAS 151 requires that allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. This statement is effective for inventory costs incurred in fiscal periods beginning after June 15, 2005. The guidance should be applied prospectively. Nortel is currently assessing the impact of SFAS 151 on its results of operations and financial position.

2.		Restatement
		First Restatement
		In May 2003, Nortel 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’s 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 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 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

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		(“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’s 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’s foreign exchange accounting as part of management’s plan to address an identified material weakness related to foreign currency translation;
	•		intercompany balances that did not eliminate upon consolidation and related provisions;
	•		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’s 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 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 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’s previously reported consolidated statements of operations and a summary of the adjustments from the Second Restatement for the three and nine months ended September 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;

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	•		Intercompany balances;
	•		Special charges;
	•		Other;
	•		Reclassifications; and
	•		Discontinued operations.

Consolidated Statements of Operations

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

Summary of Restatement Adjustments for the nine months ended September 30, 2003:

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The effect of the Second Restatement adjustments on the consolidated balance sheet as of September 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 an increase of $78 and a decrease of $54 for the three and nine months ended September 30, 2003, respectively. The net impact to cost of revenues related to these revenue adjustments, and the other corrections was an increase of $140 and $303 for the three and nine months ended September 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 $62 and $357 in the three and nine months ended September 30, 2003, respectively:

(a)		Staff Accounting Bulletin (“SAB”) 101, “Revenue Recognition in Financial Statements” (“SAB 101”); Statement of Position (“SOP”) 97-2, “Software Revenue Recognition” (“SOP 97-2”).
(b)		SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (“SOP 81-1”).

Application of SAB 101 or SOP 97-2

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

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criteria to treat delivered software and hardware elements and undelivered PCS services as separate accounting units were not met, the entire arrangement fee should have been recognized over the PCS period. Adjustments were made to appropriately allocate revenue among the accounting units and recognize the allocated revenue in accordance with the applicable revenue recognition guidance.

Revenues were also recognized for certain contracts that involved undelivered elements as a result of product development delays. The lack of relative fair value for the undelivered element meant that revenues and cost of revenues for all products delivered should have been deferred until the undelivered element was delivered. As originally recorded, revenues were recognized upon delivery of an alternative product and costs were accrued for the undelivered element. To correct for these items, related cost provisions were reversed and revenues and associated cost of revenues were recognized in the appropriate periods when all elements had been delivered.

Revenues were recognized on certain contracts with potential liquidated damages arising primarily from network outages, shipment delays or product development delays on undelivered elements. Generally, revenues and related cost of revenues should have been deferred up to the maximum potential liquidated damages until the damages had been incurred or there was no longer a possibility of incurring such damages. Specific contracts, primarily in the Asia Pacific 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 from the second quarter to the third quarter of 2003 when 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 America (“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’s 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 earnings of $8 and a decrease to pre-tax loss of $97 for the three and nine months ended September 30, 2003, respectively. The following presents the impact of these restatement adjustments on the consolidated statements of operations for the three and nine months ended September 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 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 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 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 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 a decrease of $4 to pre-tax earnings and an increase of $23 to pre-tax loss for the three and nine months ended September 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 an increase of $10 and $18 for the three and nine months ended September 30, 2003, respectively. 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

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equipment impairment costs. Nortel 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 nine months ended September 30, 2003:

Other

Other adjustments recorded 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 nine months ended September 30, 2003, are described below.

Cost of revenues

For the three months ended September 30, 2003, the increase to cost of revenues of $32 was comprised primarily of an increase of approximately $15 for inventory and product related accruals, approximately $12 for customer and contract related accruals and approximately $8 for warranty costs, partially offset by $3 related to other accruals.

For the nine months ended September 30, 2003, the increase to cost of revenues of $138 was comprised primarily of an increase of approximately $51 for customer and contract related accruals, approximately $43 for warranty costs, approximately $30 for inventory and product related accruals, and approximately $14 related to other accruals.

Selling, general and administrative expense

For the three months ended September 30, 2003, the increase of $38 to selling, general and administrative expense was comprised primarily of an increase of approximately $6 related to contract amendments and settlements with certain service providers and an increase of approximately $44 to other accruals, partially offset by a decrease of approximately $3 related to bad debt expense and approximately $9 to reflect net adjustments to the timing of employee bonus related accruals.

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For the nine months ended September 30, 2003, the increase of $29 to selling, general and administrative expense was comprised primarily of an increase of approximately $48 related to contract amendments and settlements with certain service providers and an increase of approximately $83 to other accruals, partially offset by decreases of approximately $51 related to bad debt expense and approximately $51 to reflect net adjustments to the timing of employee bonus related accruals.

Research and development expense

For the three months ended September 30, 2003, the decrease of $26 in research and development expense was primarily the result of a decrease of approximately $15 to correctly treat certain software repair costs as warranty costs and a net decrease of approximately $11 related to accruals regarding various research and development projects and other accruals.

For the nine months ended September 30, 2003, the decrease of $16 in research and development expense was primarily the result of approximately $45 to correctly treat certain software repair costs as warranty costs, partially offset by an increase of approximately $29 related to accruals regarding various research and development projects and other accruals.

Deferred stock option compensation

For the three and nine months ended September 30, 2003, the decrease of $14 and $34, 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 September 30, 2003, the increase of $32 in other income was primarily the result of adjustments of approximately $13 related to sales and use and other tax provisions, and approximately $19 related to other accruals.

For the nine months ended September 30, 2003, the increase of $44 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 $35 related to other accruals, partially offset by an adjustment of approximately $15 related to sales of receivables and customer financing and a decrease of approximately $9 related to sales and use and other tax accruals.

Interest expense

For the three months ended September 30, 2003, the increase to interest expense of $4 was primarily related to long-term debt for corrections to accounting for certain sale-leaseback transactions.

For the nine months ended September 30, 2003, the increase to interest expense of $11 was primarily the result of a $13 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 (expense) and minority interests were also adjusted as part of the Second Restatement. The adjustment to income taxes was an increase of $12 to income tax expense and nil to income tax benefit (expense) for the three and nine months ended September 30, 2003, respectively, primarily related to the tax impact of the restatements, investment tax credits and taxes attributable to preferred share dividends. The adjustment to minority interests — net of tax as a result of the Second Restatement adjustments was a decrease of $10 and an increase of $16 for the three and nine months ended September 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 earnings of $8 and an increase to net loss of $3 for the three and nine months ended September 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 nine months ended September 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 concluded that the net loss on disposal of operations recognized in the second quarter of 2001 was overstated. In addition, other adjustments were necessary to correct certain items that were either initially recorded incorrectly, or not properly released or adjusted for changes in estimates in the appropriate periods subsequent to the second quarter of 2001. The net impact of the adjustments was a decrease of $12 and $87 (net of tax of $1), respectively, to the previously reported net earnings from discontinued operations for the three and nine months ended September 30, 2003.

For the three months ended September 30, 2003, the $12 decrease to net earnings from discontinued operations consisted primarily of decreases resulting from additional provisions related to discontinued operations.

For the nine months ended September 30, 2003, the $87 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 net decrease of approximately $24 resulting from additional provisions related to discontinued operations, partially offset by a $51 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’s previously reported consolidated balance sheet as of September 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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3.

Accounting changes

	(a)		Stock-based compensation
			Effective January 1, 2003, Nortel 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 148. Prior to January 1, 2003, Nortel, as permitted by SFAS 123, applied the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, and related interpretations, in accounting for its employee stock-based compensation plans. The fair value at grant date of stock options is estimated using the Black-Scholes option-pricing model. Compensation

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			expense is recognized on a straight line basis over the vesting period of the award. Compensation expense is adjusted for the forfeiture of non-vested awards in the period when the forfeiture occurs.
			Had Nortel 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 nine months ended September 30:

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

	(b)		Asset retirement obligations
			In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”), which applies to certain legal obligations associated with the retirement of tangible long-lived assets. SFAS 143 requires that a liability be initially recognized for the estimated fair value of the obligation when it is incurred. The associated asset retirement cost is capitalized as part of the carrying amount of the long-lived asset and depreciated over the remaining life of the underlying asset and the associated liability is accreted to the estimated fair value of the obligation at the settlement date through periodic accretion charges to net earnings (loss). When the obligation is settled, any difference between the final cost and the recorded amount is recognized as income or loss on settlement. Effective January 1, 2003, Nortel adopted the initial recognition and measurement provisions of SFAS 143 and identified certain asset retirement obligations to remediate leased premises and buildings and equipment situated on leased land. The adoption of SFAS 143 resulted in an increase to net loss of $12 (net of tax of nil) which has been reported as a cumulative effect of accounting change — net of tax, an increase in plant and equipment — net of $4 and an asset retirement obligation liability of $16 as of January 1, 2003. The adoption of SFAS 143 did not have a material impact on depreciation and accretion expense or basic and diluted earnings (loss) per share.
	(c)		Accounting for certain financial instruments with characteristics of both liabilities and equity
			In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 clarifies the accounting for certain financial instruments with characteristics of both liabilities and equity, including mandatorily redeemable non-controlling interests, and requires that those instruments be classified as liabilities on the balance sheets. Previously, many of those financial instruments were classified as equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. In November 2003, the FASB issued FSP Financial Accounting Standard (“FSP FAS”) 150-3, “Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Non-controlling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” (“FSP FAS 150-3”), which deferred indefinitely the effective date for applying the specific provisions within SFAS 150 related to the classification and measurement of mandatorily redeemable non-controlling interests. The adoption of SFAS 150, as amended by FSP FAS 150-3, did not have a material impact on Nortel’s results of operations and financial position.
			As of December 31, 2003 and September 30, 2004, Nortel continued to consolidate two enterprises with limited lives. Upon liquidation in 2024, the net assets of these entities will be distributed to the owners based on their relative interests at that time. The minority interest included in the consolidated balance sheet related to these entities as of September 30, 2004 was $44. Nortel has not yet determined the fair value of this minority interest as of September 30, 2004.

4.		Consolidated financial statement details
		The following consolidated financial statement details are presented for each of the three and nine months ended September 30, 2004 and 2003 for the consolidated statements of operations, as of September 30, 2004 and December 31, 2003 for the consolidated balance

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		sheets and for each of the nine months ended September 30, 2004 and 2003 for the consolidated statements of cash flows.
		Consolidated statements of operations
		In August 2004, Nortel entered into a contract with Bharat Sanchar Nigram Limited to establish a wireless network in India. Nortel’s commitments to date for orders received under this contract have resulted in an estimated project loss of approximately $159, which has been recorded as cost of revenues and accrued within contractual liabilities in the third quarter of 2004.
		During the third quarter of 2004, Nortel reduced revenue by approximately $80 to correct for previously recognized revenue relating to past sales of Optical Networks equipment which we subsequently determined should have been deferred and recognized with the delivery of future contractual PCS and other services over the term of the PCS. The associated costs of revenues were also deferred resulting in no significant impact on Nortel’s gross margin as a percentage of revenues in the third quarter of 2004.
		During the three and nine months ended September 30, 2003, Nortel reversed provisions of $68 and $87, respectively, relating to a customer bankruptcy settlement, which had the effect of reducing cost of revenues by $53 and $53, respectively, and selling, general and administrative (“SG&A”) expense by nil and $4, respectively, and increasing other income (expense) — net by $15 and $30, respectively.
		Other income (expense) — net:

		Other income (expense) — net includes a gain of $31 resulting from a correction in the third quarter of 2004 relating to a cumulative error in functional currency designation of an entity in Brazil.
		Consolidated balance sheets
		Accounts receivable — net: