1. In his analysis of the Dell fraud for Forbes, Edward Hess comments: "Too often, the market's maniacal focus on creating ever-increasing quarterly earnings drives bad corporate behavior, as it apparently did at Dell. That behavior produces non-authentic earnings that obscure what is really happening in business. Short-termism can result in a range of corporate and financial games that may enrich management at the expense of market integrity and efficient investor capital allocation." Comment on Hess's statement from two perspectives: earnings management and financial analysts earnings projections.

2. Explain the difference between financial statement fraud and disclosure fraud. How did Dell use each one to produce materially misstated financial results?

3. Do you agree with the court opinion that PwC did not act with fraudulent intent, therefore, not holding it legally liable? How can fraudulent intent be established in a case like Dell?

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 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 that 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 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 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 connected to 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.”1
Accounting Irregularities
The SEC charged Dell Computer with fraud for materially misstating its operating results from FY2002 to FY2005. 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 alleged 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 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 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.”