CASE 4.

Dell Inc.
Accuracy and completeness are the touchstones of public company
­disclosures under the federal securities laws.

Robert Khuzami,
Director, SEC Division of Enforcement

Like most high school graduates, Michael Dell had a sense of anticipation, if not
exhilaration, when he left home to begin his college career. Because Dell planned
to become a doctor, like his father, he declared premed as his major when he
enrolled in the University of Texas in the fall of 1983. Over the next few months,
Dell’s interest in college waned as he began spending most of his time and energy
on a hobby that he had pursued in high school, namely, tinkering with computers.
By the end of his first semester at UT, Dell’s dorm room had become a workshop
in which he and a few friends tore apart, reconfigured, and then reassembled per-
sonal computers (PCs).
In the spring of 1984, Dell decided to go into business for himself. By the end
of the spring semester, Dell’s small business was producing more than $10,000 in
revenues each month from the sale of PCs and PC-related products. The success
of his business convinced him to drop out of college and create Dell Computer
Corporation. Less than a decade later, Michael Dell, at age 27, became the young-
est chief executive officer (CEO) of a Fortune 500 company. Dell’s company,
which had been renamed Dell Inc., surpassed Compaq in 2001 as the world’s
largest manufacturer of PCs. By 2012, Dell’s personal worth was estimated at
nearly $15 billion, which placed him 22nd on the Forbes 400 list of the wealthiest
Americans.
The critical feature of Dell Inc.’s business model that allowed it to grow so rapidly
was the “Dell Direct” strategy of selling custom-designed PCs. The company’s sales
force took purchase orders over the phone or the Internet and then transmitted those
orders to a production facility that assembled the PCs and shipped them in a matter
of days. Unlike competitors, Dell spent only modest amounts on research and devel-
opment. Instead, Dell focused its operations on delivering state-of-the-art computer
technology developed by other companies at the lowest cost possible by emphasiz-
ing operating efficiencies throughout its supply chain.
Increasing competition that caused profit margins to narrow dramatically on PC
sales began undermining Dell’s business model during the late 1990s. In 2002, Dell
faced the unhappy prospect of reporting disappointing earnings to its investors. At
that point, Intel Corporation, which provided the microprocessors for Dell’s PCs,
stepped into the breach and offered Dell “exclusivity payments” that would wipe out
its earnings shortfall. Intel made these payments in exchange for a commitment from
Dell that it would not purchase microprocessors from other suppliers, including Intel’s
principal competitor, Advanced Micro Devices, Inc. (AMD). Because AMD was devel-
oping microprocessors that were reportedly superior to those of Intel, Intel’s manage-
ment had become increasingly concerned that Dell would choose AMD as its primary
supplier of microprocessors.
Over the next several years, Dell executives often asked Intel for additional exclu-
sivity payments when it appeared that their company would fall short of its con-
sensus Wall Street earnings forecast for a given quarter. According to the Securities

359
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360 SECTION FOUR Ethical R esponsibilities of Accountants

and Exchange Commission (SEC), Dell management was “quite open with Intel”1
about the reason it was requesting those payments. Officials of Intel and Dell used
the tongue-in-cheek acronym MOAP (mother of all programs) to refer to their mutu-
ally beneficial arrangement that resulted in Intel paying Dell more than $4 billion
between fiscal 2002 and fiscal 2007.
The exclusivity payments from Intel allowed Dell to meet or surpass its consen-
sus earnings forecasts for 20 consecutive quarterly reporting periods. For fiscal 2003,
Intel’s exclusivity payments accounted for 10 percent of Dell’s reported operating
earnings. That figure rose to 38 percent for fiscal 2006 and to 76 percent for the first
quarter of fiscal 2007. Dell’s impressive earnings trend produced sizable stock mar-
ket gains for the company’s executives. During the time frame that Intel was making
exclusivity payments to Dell, Michael Dell earned more than $450 million in compen-
sation, most of which came in the form of gains on stock options granted to him by
the company’s board.2
Dell’s management failed to disclose the exclusivity payments and their impact
on the company’s reported earnings in its periodic earnings news releases and
registration statements filed with the SEC. For accounting and financial report-
ing purposes, Dell netted those payments against its operating expenses with-
out ­disclosing the payments separately. Instead of disclosing that the exclusivity
­payments were responsible for the company consistently achieving or surpassing
its consensus earnings forecasts, company executives attributed Dell’s remarkable
earnings record to its “ultra-efficient supply chain and direct-sales strategy.”3 In the
company’s 2005 annual report, for example, Michael Dell boasted of the compa-
ny’s “best-ever operating results” and alluded to the company’s superior business
model: “Dell’s exceptional performance again demonstrated the . . . superb execu-
tion of a better way of doing business. . . . Our business is a model for customer
focus, growth, and profitability.”
When Dell announced that it would purchase microprocessors from Intel and
AMD beginning in the second quarter of 2007, Intel slashed the exclusivity payments,
which caused Dell’s earnings to drop sharply. Instead of disclosing the true cause
of the earnings decline, Dell attributed the decline to evolving competitive issues
within its industry. Over the next two years, Dell’s stock price drifted downward. An
SEC investigation eventually revealed the exclusivity payments made by Intel to Dell
and the undisclosed impact those payments had on the company’s reported earn-
ings from 2002 through early 2007.
The SEC investigation also revealed that Dell had used so-called “cookie jar
reserves” to “smooth” its earnings from 2002 through 2005. Company officials inten-
tionally overstated period-ending reserves for expenses such as warranty-related
costs on the products it sold and then “withdrew” those reserves to “cover shortfalls
in operating results” for subsequent periods.4 Dell ultimately issued restated finan-
cial statements to properly reflect its operating results for the periods that had been
affected by the improper accounting for the Intel exclusivity payments and period-
ending reserves.

1.  E. Wyatt, “Dell to Pay $100 Million Settlement,” New York Times (online), 22 July 2010.
2.  E. Hess, “Stark Lessons from the Dell Fraud Case,” Forbes.com, 13 October 2010.
3.  A. Jones, “‘A Bad Way to Run a Railroad’: Dell Pays Big to Settle Fraud Charges,” WSJ.com, 23 July 2010.
4.  Securities and Exchange Commission, SEC Charges Dell and Senior Executives with Disclosure and
Accounting Fraud, www.sec.gov, 22 July 2010.

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 CASE 4.8 Dell Inc. 361

In July 2010, the SEC revealed that it had charged Dell and several of its top execu-
tives, including Michael Dell, with routinely misleading the investing public by issu-
ing misleading financial statements.
Dell manipulated its accounting over an extended period to project financial results
that the company wished it had achieved, but could not. Dell was only able to meet
Wall Street targets consistently during this period by breaking the rules.5
Dell agreed to pay a $100 million fine to settle the charges filed against it by the
SEC. Several Dell officials also agreed to pay significant fines. Michael Dell paid a
$4 million fine for his alleged role in the earnings manipulation scheme, while the
company’s former chief financial officer paid $3 million. In settling the case and
agreeing to the fines, each of the parties, including the company as a whole and
Michael Dell, stipulated that they neither “admitted nor denied” those charges.
Revelations of Dell’s brazen earnings management schemes angered a wide range
of parties and made many critics question how pervasive such schemes are among
large public companies. One business professor suggested that their root cause is the
pressure on public companies to consistently report impressive quarterly earnings.
The Dell case illustrates the perverse short-term view prevalent on Wall Street that
dictates that growth must occur continuously, smoothly, and linearly every quarter. . . .
Too often, the 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 a 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.6

EPILOGUE
A group of Dell Inc.’s stockholders filed a class-
action lawsuit against Michael Dell, other Dell
executives, Intel Corporation, and Dell’s audit
firm PricewaterhouseCoopers (PwC), which
had served as Dell’s auditor since 1986. The
stockholders alleged that the defendants were
responsible for the large stock market losses
they had suffered as a result of Dell’s earnings
management schemes.
The cla s s -action lawsuit charged P wC
with turning a “blind eye” to Dell’s “improper
accounting” and with violating “fundamental”
auditing standards.7 These alleged violations
included failing to maintain a proper attitude of
independence during the Dell audits, failing to
properly plan those audits, and failing to issue
the appropriate audit opinions on Dell’s peri-
odic financial statements. A federal judge even-
tually dismissed the lawsuit after ruling that the
plaintiffs’ allegations against the defendants
were “too vague.”8
In February 2013, Michael Dell announced
that he and a group of investors planned to pur-
chase the outstanding shares of Dell Inc. and
take the company private. Industry analysts and
business journalists speculated that the move
was being made to allow Michael Dell and his
fellow Dell executives to escape the intense
scrutiny and regulator y oversight faced by
the management teams of public companies.

5.  Ibid.
6.  Hess, “Stark Lessons from the Dell Fraud Case.”
7.  Amalgamated Bank et al. vs. Dell, Inc. et al., U.S. District Court for the Western District of Texas, Civ.
Action No. 1: 07-CA-00077-LY, 30 January 2007, 222–223.
8.  S. Howard, “Court Flings Dell Shareholder Class Action Aside,” www.law360.com, 10 October 2008.

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362 SECTION FOUR Ethical R esponsibilities of Accountants

Six months later, in August 2013, billionaire
investor and Dell stockholder Carl Icahn filed
a lawsuit to thwart Michael Dell’s effort to take
the company private. Icahn insisted that the
per share buyout price being offered to Dell’s
stockholders by Michael Dell was too low. One
month later, however, a majority of Dell’s stock-
holders approved that buyout price, meaning
that Michael Dell’s plan to take the company
private had succeeded.

Questions
1. Define the phrase “earnings management.” Under what conditions, if any, is
earnings management acceptable? Do auditors’ responsibilities include actively
searching for instances of earnings management by clients? Defend your
answers.
2. Dell recorded the exclusivity payments as an offset or reduction to its operating
expenses. What “management assertion” did that accounting treatment violate?
What audit procedure or procedures might have resulted in the discovery of that
accounting treatment?
3. During the time frame that Intel was making exclusivity payments to Dell, Dell’s
business model was being adversely affected by the increasingly competitive
nature of the PC industry. What responsibility, if any, do auditors have to analyze
a client’s business model? Do auditors have a responsibility to track and analyze
key developments in a client’s industry? Defend your answers.
4. What ethical issues do exclusivity agreements such as that between Dell and
Intel raise? Are there analogous ethical issues faced by audit firms and their
clients? Explain.

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203