Dell's mis-statements are not trivial

Dell's mis-statements for the years 2003-6 are being downplayed as 'trivial.' Rubbish.
Written by Dennis Howlett, Contributor

Dell's mis-statements for the years 2003-6 are being downplayed as 'trivial.' Rubbish. As Larry Dignan notes:

While the restatements were small, Citigroup analyst Richard Gardner notes that Dell would have missed estimates during its first fiscal quarter of 2003, second quarter of 2003 and fourth quarter of 2005 without the accounting hijinx. That’s hardly meaningless.

The devil is in the detail. According to the relevant 8K filing:

The cumulative change to net income for the Restatement Period is expected to be a reduction of between $50 million and $150 million (compared to previously reported net income of over $12 billion for the Restatement Period), and the cumulative change to EPS for the Restatement Period is expected to be a reduction of $0.02 to $0.07 (compared to previously reported EPS of $4.78 over the Restatement Period). Most of these reductions relate to the timing of net income that would or will be recognized in periods before and after the Restatement Period. Net income and EPS for three of the four annual periods are expected to be reduced by amounts ranging from approximately 0.5% to 5% of the amounts previously reported, while net income and EPS for the remaining annual period (fiscal 2006) are expected to be increased by approximately 1%. The changes to net income and EPS for the quarterly periods will vary, with the adjustments expected to increase net income and EPS in some quarters and reduce net income and EPS in others. The largest percentage changes in quarterly net income and EPS are expected to be in the first quarter of fiscal 2003 and the second quarter of fiscal 2004, each with expected reductions of between 10% and 13%; the fourth quarter of fiscal 2005, with an expected reduction of approximately 7%; and the second quarter of fiscal 2005 and the third and fourth quarters of fiscal 2006, each with an expected increase ranging from approximately 5% to 7%. Net income and EPS for each of the other quarters are expected to change by 5% or less.

In short, Dell was value shifting to ensure it met analyst expectations. How did it do this without detection - that is until the SEC came sniffing? Simple. It created entries that transferred value from one period to another but which were missed by the auditors. In accounting parlance it's called 'teeming and ladling.' The problem with this technique is that sooner or later, the accumulated amount has to fall out, hence the restatements.

I am more concerned as to why it was not discovered as part of the systems audit testing by incumbent auditors Pricewaterhousecoopers (PwC). We will no doubt hear their version of events in due course but there is no escaping the fact that they didn't do a good job. According to the same filing:

Using proprietary search software, the investigative team evaluated over five million documents. Investigative counsel also conducted 233 interviews of 146 individuals, and the KPMG accountants, in connection with their forensic work, conducted numerous less formal discussions with various company employees. In addition, using a proprietary software tool designed to identify potentially questionable journal entries based on selected criteria (for example, entries made late in the quarterly close process, entries containing round dollar line items between $3 million and $50 million, and liability-to-liability transfers), KPMG selected and reviewed in excess of 2,600 journal entries that were highlighted by the tool or specifically identified by the forensic teams investigating specific issues.

In short, KPMG, which was brought in as independent reviewer, developed an audit tool with which to test the records. Why didn't PwC do the same or similar when undertaking its audits? The number of entries KPMG reviewed is miniscule when weighed against the total number likely to have been made over the four year period. Those entries should have stuck out like a sore thumb.

Dell details the steps it has taken to strengthen financial management and tighten up the process steps around which changes to book entries are made. It all looks impressive. Unfortunately, the harsh truth is that no financial system can safeguard against a determined business manager. We saw that at Enron, Tyco and the other financial scandals of the late 90's. That's one reason why we have audits. According to Bob Sutton's The No Asshole Rule:

Michael Dell's subordinates saw him as remote, impatient and unappreciative. People who worked with [Kevin] Rollins saw him as an overly critical, opiniated and a poor listener because he was too quick to jump in with his own suggestion and ignore their ideas.  Neither Dell nor Rollins realisd how much fear and frustration they were breeding in the company [p.98]

According to Sutton, both Dell and Rollins worked hard to clean their act up. Not hard enough, and apparently aided by a docile auditor that didn't go far enough to safeguard the interests of stockholders.

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