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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
