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
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 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
Accounting Irregularities
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manipulations allowed Dell to misstate materially its operating expenses as a percentage of
revenue—an 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
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.
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
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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.
PricewaterhouseCoopers (PwC)
PwC had been Dell’s independent auditor since 1986 and had 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 (unmodified) audit
opinions for the 2003 to 2006 financial statements, saying that they fairly represented the
financial position of Dell.
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
Questions
1. How would you characterize Dell’s accounting techniques described in the case?
Was it a case of aggressive accounting? Was it earnings management? Link your
discussion to the specific accounting methodology and GAAP rules.
Dell’s actions were illustrative of aggressive accounting because it is a practice of misreporting
income statement and balance sheet items to make a company appear more attractive to
investors. Although some forms of aggressive accounting are illegal, others are not. For example,
selecting a method of accounting that shows higher income levels in early rather than later
periods may be legal, such as using the percentage of completion method instead of completed
contract or a cost recovery basis in recognizing revenue on long-term construction contracts.
2. Identify the red flags that should have alerted PwC that Dell may have been
engaging in fraud. Given that Dell issued clean opinions during the fraud years, do
you think it is possible that the firm conducted its audit in accordance with GAAS?
What indicators would you look for to make that determination?
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 and be more skeptical about the
accounting used by Dell. One could see a small percentage getting by auditors, but 75 percent
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 hardware companies were having problems meeting expectations. Dell was good
but the company did not have a magic formula to continually make money. Where was the risk
assessment?
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3. The court decision relied on the concept of scienter for not holding PwC legally
liable for issuing clean opinions when the financial statements did not fairly present
financial position. Would you reach the same conclusion from an ethical
perspective? Explain.
Knowledge of the falsehood (scienter) is difficult to establish absent a smoking gun, which did
not exist in this case. It is easier to make the case that PwC was grossly negligent in its audit of
Dell and in its failure to gather sufficient competent evidential matter to support recording such
high exclusivity fees as revenue for 4-plus years. PwC’s carelessness was at the extreme and it
may have been influenced by the high audit fees received from Dell.
An interesting issue to discuss with students is whether mandatory rotation of audit firms is
needed. PwC issued a position statement on the PCAOB proposal for mandatory firm rotation.
Here is a summary of its position on this matter.
1
Mandatory audit firm rotation has been examined in the U.S. before – but it has
never been adopted. Changes to auditors’ responsibilities should focus on
improving the overall quality of the audit and the quality of financial reporting for
investors. Mandatory audit firm rotation does not achieve these objectives.
Mandatory audit firm rotation would diminish audit quality, make financial
reporting less reliable, and add costs for investors. We believe the reforms
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