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 can 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 Intel represented 76% 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 $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 law," 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 Dell's personal involvement, saying that his $4 million penalty was not connected to the accounting fraud charges been 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."

Accounting Irregularities

The SEC charged Dell Computer with fraud for materially misstating its operating results from fiscal year 2002 to fiscal year 2005. 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 alleges 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 fiscal year 2002 to fiscal year 2005, including 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 revenue - an important financial metric that Dell highlighted to investors.

The company engaged in the questionable use of reserve accounts to smooth net income. Davis directed 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 'earmarking' of the excess accruals for various purposes."

FASB 5 states that a loss accrual should be recognized with the charge to income when a loss is probable and reasonably estimable. The maintenance of reserves for unspecified business risks (i.e., cookie-jar reserves) is not permitted under GAAP.

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 marketing development 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's products. 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% in fiscal year 2003 and increased to about 76% in the first quarter of fiscal year 2007.

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 a reason for the decrease in profitability Dell continue to mislead investors.

Audit Considerations

In 2006, Dell issued a press release announcing that its audit committee had begun an independent investigation of Dell's accounting and financial reporting practices. After a year of investigation, the audit committee concluded that the financial statements for 2003, 2004, 2005, and 2006 should no longer be relied upon.

PricewaterhouseCoopers (PwC) had been Dell's independent auditor since 1986 and signed off on every one of Dell's financial 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 audit opinions for the 2003 to 2006 financial statements, saying that they fairly represented the financial position of Dell. However, these statements did not fairly represent Dell, as evidenced by the audit committee statement the financial statements should no longer be relied upon.

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 the basis of lack of evidence to support the accusations.

There are two different things going on in this case: 1) the failure to disclose and the tendency to mischaracterize marketing payments received from Intel and 2) the maintenance of generalized cookie-jar reserves which were used to smooth the earnings trend (and more importantly, the operating expense trend).

Questions to Consider:

1.Who are the stakeholders in this debacle and how were they harmed?

2. Discuss the many ethical lapses that you note in the case.

3. What is your perception of the ethical culture at Dell?

4.Great companies adopt a longer-term view when they adopt

new strategies for improvement. This is one of the hallmarks of strategic leadership. However, the stock market has adopted a

"what have you done for me lately" view which is based on

quarterly earnings announcements. Dell's reaction to this short-

term view was to manage earnings. Should company leaders be concerned at all about their stock price? If you

were appointed CEO of Dell, what would you do to turn the ship around?

5. The auditors of Dell (PwC) were initially charged, but not convicted. Discuss PwC's possible role in this case.

6. Make any other observations from a leadership or ethical perspective that you find interesting.

Please answer the above questions separately with detail information. I provided the case of Dell Computer.