978-0077862213 Chapter 7 Case Dell Computer

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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 $100m 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 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 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 says that the company should have disclosed to investors that it was drawing on these

reserves, but did not. And it claims that, at their peak, the exclusivity payments from Intel represented 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 penalty was not in connection with 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.”

Accounting Irregularities

The SEC charged Dell Computer with fraud for materially misstating its operating results from FY 2002 to

FY 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 FY2002 to FY2005

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 materially misstate 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 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 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.”

FASB 5 states that a loss accrual should be recognized with a 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 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’s products. However, the characteristic

of these payments changed in 2001, when Intel began to provide additional rebates to Dell and a few other

companies that were outside of the contractual agreements.

Intel Corporation made these large payments to Dell Inc. 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 it would be better to incorporate these funds in 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

the FY 2003 to about 76 percent in the first quarter of the FY 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 the reason for the decrease in profitability, Dell continued 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 had signed

off on every one of Dell’s financial statements that are on file with the SEC. From 2003 to 2007, Dell paid

PwC more than $50 million to perform audit and other services. PwC issued clean (unmodified) audit

opinions for the 2003 to 2006 financial statements saying that the financials fairly represented the financial

position of Dell. However, these statements did not fairly represent Dell, as evidenced by the audit

committee statement that the financial statements for these years 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 a basis of lack of evidence

to support the accusations.

Questions

1. How would you characterize Dell’s accounting for the exclusivity payments with respect to the

financial shenanigans discussed in this chapter?

The use of the cookie-jar reserves for the Intel exclusivity payments to cover shortfalls in operating

earnings is a form of shifting current revenue to a later period (shenanigan number 6). Dell also used the

exclusivity payments as an offset to operating expenses to increase operating income whereas it Should

have been classified in a non-operating category. Dell didn’t receive these amounts from Intel because of

2. Joseph E. Abbott, the vice president and controller of West Pharmaceuticals Service, Inc., in

Lionville, Pennsylvania, once said: “Investors should remember that if we do see companies start

hitting estimates and not beating them, that wouldn’t be such a bad thing. It could mean there is

less earnings management going on.” How does this statement relate to the actions of Dell in this

case?

The motivation for the fraud period of FY 2002 to FY 2005 by Dell was to meeting or exceeding Wall

Street earnings expectations each quarter (i.e., 12 quarters in a row). The odds of doing that are extremely

low. It seems possible that a company could make earnings expectations for four straight quarters but not

3. Identify the red flags that should have alerted PwC that Dell may have been engaging in fraud.

Given that Dell was issued clean opinions during the fraud years, do you think it is possible that

the firm conducted its audit in accordance with GAAS? Why or why not?

It seems a bit strange that an accounting firm that had audited Dell for twenty years would not realize some

of the frauds that were occurring. Especially when you have over 75 percent of Dell’s operating income

coming from Intel. You would think that an auditor would ask for documentation to see the sources of this

operating income. One could see a small percentage getting by auditors, but 75 percent seems to smack of

PwC may not have known of the actual fraud but should have been suspicious when the company

continued to meet earnings expectations every quarter. This was especially true when other computer

The real question in the aftermath of the Dell exclusivity accounting fraud, and other frauds, is whether the

sanctions imposed will do anything to stem the financial fraud that began in earnest in the late 1990s.

Investors expect the regulators to effectively deter managers from manipulating companies’ figures to their

Optional Question

4. Do you agree with the statement from Dell that the actions taken were only negligent and not

fraudulent? Explain your reasoning by using the discussion of legal liability in Chapter 6 for

support.

Officers are fiduciaries of the corporation and are in a relationship of trust and confidence with the

corporation and its shareholders. These fiduciary duties include the duties of care and loyalty. The standard

of care requires that an officer act in good faith, exercise the care that an ordinarily prudent person would

exercise in similar circumstances, and act in the best interests of the corporation. Officers who have not

It appears the actions by Dell were fraudulent. It can’t be considered negligent when 76 percent of

“revenue” is from exclusivity fees and they are purposefully improperly classified to hype operating

The facts indicate that Dell’s CAO, Robert Davis, orchestrated the fraud and gave specific orders what to