Case 7-5: Dell Computer

Background

For years, Dell's seemingly magical power to squeeze efficiencies out of its supply chain and drive down costs made it a darling of the financial markets. Now we learn that the magic was at least partly the result of a huge financial illusion. On July 22, 2010, Dell agreed to pay a $100 million penalty to settle allegations by the SEC that the company had "manipulated its accounting over an extended period to project financial results that the company wished it had achieved."

According to the commission, Dell would have missed analysts' earnings expectations in every quarter between 2002 and 2006 were it not for its accounting shenanigans. This involved a deal with Intel, a big microchip maker, under which Dell agreed to use Intel's central processing unit chips exclusively in its computers in return for a series of undisclosed payments, locking out Advanced Micro Devices (AMD), a big rival. The SEC's complaint said that Dell had maintained cookie-jar reserves using Intel's money that it could dip into to cover any shortfalls in its operating results.

The SEC said that the company should have disclosed to investors that it was drawing on these reserves, but it did not. And it claimed that, at their peak, the exclusivity payments from Intelrepresented 76 percent of Dell's quarterly operating income, which is a shocking figure. The problem arose when Dell's quarterly earnings fell sharply in 2007 after it ended the arrangement with Intel. The SEC alleged that Dell attributed the drop to an aggressive product-pricing strategy and higher-than-expected component prices when the real reason was that the payments from Intel had dried up.

The accounting fraud embarrassed the once-squeaky-clean Michael Dell, the firm's founder and CEO. He and Kevin Rollins, a former top official of the company, agreed to each pay a $4 million penalty without admitting or denying the SEC's allegations. Several senior financial executives at Dell also incurred penalties. "Accuracy and completeness are the touchstones of public company disclosure under the federal securities laws," said Robert Khuzami of the SEC's enforcement division when announcing the settlement deal. "Michael Dell and other senior Dell executives fell short of that standard repeatedly over many years."

In its statement on the SEC settlement, the company played down Michael Dell's personal involvement, saying that his $4 million penalties was not connected to the accounting fraud charges being settled by the company, but was "limited to claims in which only negligence, and not fraudulent intent, is required to establish liability, as well as secondary liability claims for other non- fraud charges."1

Accounting Irregularities

The SEC charged Dell Computer with fraud for materially misstating its operating results from FY2002 to FY2005. In addition to Dell and Rollins, the SEC also charged former Dell chief accounting officer (CAO), Robert W. Davis, for his role in the company's accounting fraud. The SEC's complaint against Davis alleged that he materially misrepresented Dell's financial results by using various cookie-jar reserves to cover shortfalls in operating results and engaged in other reserve manipulations from FY2002 to FY2005, including an improper recording of large payments from Intel as operating expense-offsets. This fraudulent accounting made it appear that Dell was consistently meeting Wall Street earnings targets (i.e., net operating income) through the company's management and operations. The SEC's complaint further alleged that the reserve manipulations allowed Dell to misstate materially its operating expenses as a percentage of revenuean important financial metric that Dell highlighted to investors.2

The company engaged in the questionable use of reserve accounts to smooth net income. Davis directed Dell assistant controller Randall D. Imhoff and his subordinates when they identified reserved amounts that were no longer needed for bona fide liabilities, to check with him about what to do with the excess reserves instead of just releasing them to the income statement. In many cases, he ordered his team to transfer the amounts to an "other accrued liabilities" account. According to the SEC, "Davis viewed the 'Corporate Contingencies' as a way to offset future liabilities. He substantially participated in the 'earmarking' of the excess accruals for various purposes."

Beginning in the 1990s, Intel had a marketing campaign that paid its vendors certain marketing rebates to use their products according to a written contract. These were known as market developing funds (MDFs), which according to accounting rules, Dell could treat as reductions in operating expenses because these payments offset expenses that Dell incurred in marketing Intel'sproducts. However, the character of these payments changed in 2001, when Intel began to provide additional rebates to Dell and a few other companies that were outside the contractual agreements.

Intel made these large payments to Dell from 2001 to 2006 to refrain from using chips or processors manufactured by Intel's main rival, AMD. Rather than disclosing these material payments to investors, Dell decided that it would be better to incorporate these funds into their component costs without any recognition of their existence. The nondisclosure of these payments caused fraudulent misrepresentation, allowing Dell to report increased profitability over these years.

These payments grew significantly over the years making up a rather large part of Dell's operating income. When viewed as a percentage of operating income, these payments started at about 10 percent in FY2003 and increased to about 76 percent in the first quarter of FY2007.

When Dell began using AMD as a secondary supplier of chips in 2006, Intel cut the exclusivity payments off, which resulted in Dell having to report a decrease in profits. Rather than disclose the loss of the exclusivity payments as the reason for the decrease in profitability, Dell continued to mislead investors.

Dell's Internal Investigation

On August 16, 2007, Dell announced it had completed an internal investigation, which had revealed a variety of accounting errors and irregularities, and that it would restate results for FY2003 through FY2006, and the first quarter of 2007. The restatement cited certain accounting errors and irregularities in those financial statements as the reasons the previously issued statements should no longer be relied upon.

Dell said that the investigation of accounting issues found that executives wrongfully manipulated accruals and account balances, often to meet Wall Street's quarterly financial expectations in prior years. The company was forced to restate its earnings during that time period, which lowered its total earnings during that time by $50 million to $150 million.

As a result of the SEC's investigation, Dell took another hit to its bottom line. With the restatement, Dell's first-quarter 2011 earnings looked like this: net income of $341 million and earnings of 17per share. That's instead of the initially reported $441 million and 22 per share.

PriceWaterhouseCoopers (PwC)

PwC had been Dell's independent auditor since 1986 and had signed off on every one of Dell'sfinancial statements that were on file with the SEC. From 2003 to 2007, Dell paid PwC more than $50 million to perform auditing and other services. PwC issued clean (unmodified) audit opinions for 2003 to 2006 financial statements, saying that they fairly represented the financial position of Dell.

It was alleged that PwC had consistently approved the now-restated financial statements as prepared in accordance with generally accepted accounting principles and did not conduct an audit in accordance with generally accepted auditing standards. The argument was that the opinions that the financial statements fairly represented financial position were materially false and misleading. The court ruled that the restatement does not by itself satisfy the scienter (knowledge of the falsehood) requirement to hold the auditors legally liable for the deliberate misrepresentation of material facts or actions taken with severe recklessness as to the accuracy of its audits or reports.

The legal standard for auditor liability under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 requires that the plaintiff must show (1) a misstatement or omission, (2) of a material fact, (3) made with scienter, (4) on which the plaintiff relied, and (5) that proximately caused the injury. The court pointed out in its opinion that "the mere publication of inaccurate accounting figures, or failure to follow GAAP, without more, does not establish scienter." To establish scienter adequately, the plaintiffs must state with particularity facts giving rise to a strong inference that the party knew that it was publishing materially false information, or that it was severely reckless in publishing such information. The court ruled that the plaintiffs did not prove fraudulent intent.3

In a suit by shareholders against the firm, PwC was accused of a variety of charges, including not being truly independent and ignoring red flags. These charges were dismissed on a basis of lack of evidence to support the accusations.

1. In his analysis of the Dell fraud for Forbes, Edward Hess comments: "Too often, the market's maniacal focus on creating ever-increasing quarterly earnings drives bad corporate behavior, as it apparently did at Dell. That behavior produces non-authentic earnings that obscure what is really happening in business. Short-termism can result in a range of corporate and financial games that may enrich management at the expense of market integrity and efficient investor capital allocation." Comment on Hess's statement from two perspectives: earnings management and financial analysts earnings projections.

2. Explain the difference between financial statement fraud and disclosure fraud. How did Dell use each one to produce materially misstated financial results?

3. Do you agree with the court opinion that PwC did not act with fraudulent intent, therefore, not holding it legally liable? How can fraudulent intent be established in a case like Dell?