The defense I've heard (I think the creators may have put this one out to keep people from OMGWTFing) is that the FF7 Nibelheim scene is from Cloud's memories. Since Cloud was outside/fainting for the bits with Genesis, they're not included in his memories. Nothing to do with how "fucked up" or "lame" he is. I love Cloud, but he was outside right then. (Then again, this explanation always seemed a little farfetched to me. It tries too hard, and Cloud was outside for the rest of the scene, too.) However, since Zack was there, it's part of the scene for him.

That's a lie, and if Square said that, they should stfu. Sakaguchi himself (the guy who produced FFI-IX) stated that he was against doing sequels/prequels/remakes for established FF games, so obviously Genesis and Angeal, along with the entirety of the Compilation, are retcons.