Wall Street Beat: Dell Case Serves As Cautionary Tale

Sometime in the second quarter of 2004, Dell Chief Financial Officer James Schneider was told by the company's EMEA (Europe, Middle East and Asia) financial director that the unit was having difficulty meeting its US$159 million operating income target.

Sometime in the second quarter of 2004, Dell Chief Financial Officer James Schneider was told by the company's EMEA (Europe, Middle East and Asia) financial director that the unit was having difficulty meeting its US$159 million operating income target.

"[W]e need $175m," Schneider replied. "You need to tell me how we will get it. I suggest you not be too proud and see what [D]unning has socked away."

Schneider was referring to "cookie jar" reserves overseen by Nicholas Dunning, who at the time was vice president of marketing for Dell's EMEA Home & Small Business unit, according to an exchange recounted in a complaint filed last week in U.S. District Court by the Securities and Exchange Commission.

The unit reported eight quarters in a row of increasing operating income, but without the reserve, EMEA's operating income would have dropped by about 12.5 percent from the prior quarter, according to the SEC.

That scenario was just one of many accounts of alleged misleading financial practices by Dell that were outlined in the SEC complaint. Coming out in the middle of an earnings season in which IT vendors are bouncing back from recession, the complaint serves as a cautionary tale that a company's ability to meet financial targets quarter after quarter may be an illusion, created under pressure to conform to expectations for smoothly increasing earnings.

Headlines about the complaint and the proposed settlement -- which calls for Dell to pay $100 million and for five company officers including founder Michael Dell to separately pay varying amounts and settle charges -- have centered on the SEC's allegations about payments Intel made to ensure the PC maker continued to boycott AMD chips. As part of the settlement, Dell has admitted to no wrongdoing.

From the first quarter of the 2003 financial year through the first quarter of the 2007 financial year, Intel payments and rebates to Dell through a so-called Meet Competition Request program totaled $4.3 billion, eventually accounting for a whopping 76 percent of the company's operating income, the SEC said.

But beyond the Intel payments, the SEC's account of how Dell used the so-called cookie jar accounts reads like a textbook explanation of some of the accounting manipulations most frequently used by companies desperate to make quarterly estimates.

Dell, after getting wind of the SEC's inquiry, announced in 2007 that it was moving on its own to review accounting procedures and restate financial reports. It acknowledged misstatements, but the SEC goes into much more detail.

The SEC says that Dell manipulated reserves including: a so-called Strat Fund and other corporate contingency funds; reserves identified in "risks and opportunities" schedules; an "improperly-established and used restructuring reserve"; a number of reserves in EMEA; bonus and profit-sharing accounts; and a liability reserve for closure of its Las Cimas facility.

Such reserves are fairly common, experts say.

"Companies give themselves the ability to always make earnings numbers, and one of the ways to do that is through reserves and restructuring charges," said Howard Schilit, a forensic accounting specialist and founder of the Financial Shenanigans Detection Group. Companies may legitimately set up a reserve fund to accrue restructuring expenses to be incurred in future quarters, but often, excess amounts are retained, Schilit said.

In its 2002 financial year, for example, Dell recorded a $482 million charge to income for restructuring liabilities in various accounts. "Dell improperly built excess accruals into the reserve at its inception ... and used this excess to offset the impacts of unrelated period costs resulting in a material misrepresentation of its OpEx [operating expenses]," the SEC said.

The Dell case is just one highly publicized example of how companies cross the line separating legitimate funds from illegal manipulation of reserves.

On June 2, for example, the SEC filed a complaint and proposed settlement with voting machine maker Diebold, accusing the company and some of its officers of "manipulating reserves and accruals; improperly delaying and capitalizing expenses; and improperly writing up the value of used inventory."

In the past four months alone, other tech companies settling with the SEC for various types of accounting fraud charges included Trident Microsystems and data capture technology maker Symbol Technologies. Such practices are not relegated to IT, Schilit stressed. In a highly publicized case last year, the SEC entered into a $50 million settlement with General Electric, he noted.

"GE bent the accounting rules beyond the breaking point," said Robert Khuzami, director of the SEC's Division of Enforcement, in a statement that appears to acknowledge a generally accepted reality that companies strive to "manage" earnings results.

"Companies smooth out earnings to avoid the appearance of volatility ... which might make investors nervous," said Avi Cohen, managing partner at Avian Securities, which specializes in brokerage service and information technology research.

In a climate like the current rebound from the recession, in which companies are generally expected to improve on earlier results, the pressure to manage earnings may be more intense than during a downturn, Cohen noted.

But there are signs that indicate when a company may be going too far and misleading investors about the true nature of their business, experts agree.

"One of the things to watch for is when a company -- like Dell -- says it has met or exceeded analyst forecasts for 16 quarters in a row, and calls attention to that," the FSD Group's Schilit said.

"Look beyond the headlines and the first four sentences in a company press release, where companies put the positive spin on things," said Avian's Cohen.

Company watchers can look for numbers that show how much product was actually shipped, how inventory levels line up with demand, and ask questions about unusual numbers, Cohen said. "An unusually large accounts receivable may simply mean that a number of deals were signed at the end of a quarter," he said.

Savvy institutional investors often ask the right questions, but their data and reports are not always available to the general public.

"The pressure to meet quarterly numbers and the ability to get rich through financial shenanigans will not go away, so individuals have to learn to ask questions themselves," Schilit emphasizes.

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