1) For years, Dell was seen as efficiently managed due to its supply chain efficiencies. However, the SEC found Dell had engaged in accounting fraud from 2002-2006 through an undisclosed deal with Intel where Intel paid Dell billions to exclusively use its chips. 2) The SEC charged Dell and its executives with fraud for misstating financials and hiding the large payments from Intel, which comprised up to 76% of Dell's operating income. Dell restated earnings from 2003-2007 after an internal investigation. 3) While Dell's auditor, PwC, signed off on the fraudulent financials for years, a court ruled PwC did not have fraudulent intent and was not liable despite its failure to catch

1. Background For years, Dell’s seemingly magical power to squeeze
efficiencies
BackgroundFor 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%
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.”1Accounting
IrregularitiesThe SEC charged Dell Computer with fraud for materially misstating its

2. 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.2The 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.”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 character of these payments changed
in 2001, when Intel began to provide additional rebates to Dell and a few other companies
that were outside the contractual agreements.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.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% in FY2003 and increased to about 76% in the first quarter of FY2007.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.Dell’s Internal InvestigationOn 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 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.Dell said that the investigation of accounting issues found that executives
wrongfully manipulated accruals and account balances, often to meet Wall Street quarterly

3. financial expectations in prior years. The company was forced to restate its earnings during
that time period, which lowered its total earnings during that time by $50 million to $150
million.As result of the SEC’s investigation, Dell took another hit to its bottom line. With the
restatement, Dell’s first quarter 2011 earnings looked like this: net income of $341 million
and earnings of 17¢ per share. That’s instead of the initially reported $441 million and 22¢
per share.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.It was alleged
that PwC had consistently approved the now-restated financial statements as prepared in
accordance with generally accepted accounting principles and did not conduct an audit in
accordance with generally accepted auditing standards. The argument was that the
opinions that the financial statements fairly represented financial position were materially
false and misleading. The court ruled that the restatement does not by itself satisfy the sci-
enter (knowledge of the falsehood) requirement to hold the auditors legally liable for
deliberate misrepresentation of material facts or actions taken with severe recklessness as
to the accuracy of its audits or reports.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 strong inference that the party
knew that it was publishing materially false information, or that it was severely reckless in
publishing such information. The court ruled that the plaintiffs did not prove fraudulent
intent.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.QuestionsIn 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.”4 Comment on Hess’s statement from two perspectives: earnings
management and financial analysts earnings projections.Explain the difference between
financial statement fraud and disclosure fraud. How did Dell use each one to produce
materially misstated financial results?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?