The Dell Debacle: How Serious is the Damage?
When a parent finds his child with chocolate on her cheeks saying she hasn't been sneaking candy from the pantry, he may find himself giving the oft-repeated lecture about how small lies are just as bad as big ones. If he then goes to work as the chief financial officer of a corporation, he might find himself in the position of explaining away accounting fraud as a minor deficiency in the context of a major company, reminding stockholders that corporate revenues are big and adjustments to those revenues, real or imaginary, are often small.
Dell Computer CFO Don J. Carty attempted to appear less like a parent yesterday afternoon. At his press conference, he first tried to paint a picture of a company where little men made little adjustments to meet little targets, in the context of a big manufacturer with a big customer base and a big number of outstanding shares.
But Carty doesn't wear the role of apologist well; in fact, from an historical perspective, he looks better as a father figure. In 2003, as the chairman and CEO of AMR, the parent company of American Airlines, Carty successfully negotiated a seemingly impossible deal between his company and a flight attendants' union, which was believed to have saved the company from bankruptcy. The thanks Carty got came by way of a note of congratulations from his successor, who took his job literally the following week.
Don Carty may have fixed AMR; and amid the most conspicuous absence of CEO Michael Dell yesterday, he was clearly there to fix Dell. But one gets the feeling that he has assumed the temporary role of "Dad" in this dysfunctional family, to rescue his foster child from financial burden, only to exit the stage later once that child is well enough to resume his role in the world, where he can pretend such burdens don't really matter.
So the little excuse about the lies Dell Computer told on its financial statements being small in the context of a big company, didn't fit this CFO. He did try to make the extent of the "irregularities" seem insignificant quantitatively. But then he started the long, arduous process of leading his foster child in the act of coming clean.
For slightly more than four years, Dell's accountants and Carty's predecessors made adjustments to publicly reported earnings and profit/loss statements to make it appear that certain business segments were doing better than they actually were. The child had chocolate stains on his face, and it was now time to tell the story of where it came from.
Robbing Peter to pay Peter
"The investigation raised questions relating to numerous accounting issues, most of which involved adjustments to various reserves and accrued liability accounts," Carty stated, referring to the company's internal audit, which discovered irregularities in certain kinds of accounts payable. In other words, for certain accounting periods, company divisions may have had expenses that it chose to defer to later periods...which may have been deferred again, and so on.
"The investigation identified evidence that certain adjustments appear to have been motivated by the objective of attaining financial targets," the CFO continued. "According to the investigation, these activities typically occurred on or around quarter-end, and the investigation found evidence that in that time frame, account balances were reviewed sometimes at the request or sometimes with the knowledge of senior executives, with the goal of seeking adjustments so that quarterly performance objectives could be met. The investigation concluded that a number of these adjustments were improper, including the creation and release of accruals and reserves that appear to have been made for the purpose of enhancing internal performance measures or reported results, as well as transfers of excess accruals from one liability account to another, and the use of the excess balances to offset what were unrelated expenses in later periods."
If you've ever filed taxes for your own business, you know the difference between the "cash" method of accounting and the accrual method. With the latter, the principle is that you record expenses at the time they're generated, not when they're paid. The theory is that cash on hand can be "virtually" spent at the time a debt comes up, so it does no good for the cash to be recorded as though it were on hand. But the secret to accrual is deciding when an expense truly occurs.
Expenses offset revenues, with the remainder recorded as income. If you can change the period of time in which expenses occur, you can make it seem that your company is reaping more income than it truly is. Of course, that presumes you truly will record those expenses later, and that they don't just magically disappear.
"Now, many of the errors and irregularities offset each other during the restatement period, and most of them relate to the timing and recognition of income and expenses," Carty told analysts yesterday.
His explanation did not go into specifics - we probably won't see those until the US Securities and Exchange Commission releases its report on its own separate investigation. But Carty suggested that Dell's internal investigation uncovered numerous instances of this kind of time shifting, which some think isn't unethical - or as unethical as other kinds of fraud - because it isn't really so much theft as it is time shifting. This is why he stated repeatedly yesterday that these instances would probably "offset" or "reverse themselves."
It is a problem, however, when you take into account the motivation behind this shifting. Remember that the original SEC investigation started looking into how the company accounted for the distribution of stock options to its managers and senior executives. It might not hurt the balance sheet all that much to shift accrued expenses from one account to another, or to create reserves (receivables from nowhere, payments to oneself) that compensate for expenses. But if the end product is to make the income number look bigger, that affects the appearance of company performance...which affects its stock price, and thus the value of shares held by senior executives, and thus the value of options held by those executives.
As companies in the recent past have been found to do, senior executives are compensated in part with options. The practice of backdating options (the original subject of the Dell investigation) is not illegal; here, companies pretend options were distributed on a date back when its stock value was lower. If a company knew its income numbers might not meet street estimates, its accountants could use those accrual principles Carty referred to adjust the appearance of those numbers. Suddenly, the company's performance appears to "beat the street," and a one-penny difference could trigger a stock rally. In just a few days' time, those executives' options are worth millions more.
Next: Is there an Intel connection?